Mishkin_FMI9ge_PPT_C15.pdf

Financial Markets and Institutions
Ninth Edition, Global Edition
Chapter 15
The Foreign Exchange
Market
Copyright © 2018 Pearson Education, Ltd. All Rights Reserved.

Why Are Exchange Rates Important?
• When the currency of your country appreciates relative to
another country, your country’s goods prices ↑ abroad and
foreign goods prices ↓ in your country.
– Makes domestic businesses less competitive
– Benefits domestic consumers
• When the currency of your country depreciates relative to
another country, your country’s goods prices ↓ abroad and
foreign goods prices ↑ in your country.
– Makes domestic businesses more competitive
– Detriments domestic consumers

What are Foreign Exchange Rates?
• Two kinds of exchange rate transactions make up the
foreign exchange market:
– Spot transactions involve the near-immediate
exchange of bank deposits, completed at the spot
rate.
– Forward transactions involve exchanges at some
future date, completed at the forward rate.
▪ This difference in the timing of trades sets futures trades apart
from spot trades.
▪ Derivative: An asset which derives its value from an underlying
asset.
▪ Used to reduce exchange rate risk

How is Foreign Exchange Traded?
• FX traded
– In the over-the-counter market.
– Involve buying / selling bank deposits denominated in
different currencies by commercial banks.
– Typical consumers buy foreign currencies from retail
dealers or brokers.

Exchange Rate Determination
• Like the price of any good or asset in a free market,
exchange rates are determined by the interaction of supply
and demand.
• To simplify our analysis of exchange rates in a free market,
we divide it into two parts.
– First, we examine how exchange rates are determined in the long
run
– Then we use our knowledge of the long-run determinants of the
exchange rate to help us understand how they are determined in
the short run.

Exchange Rates in the Long Run
• Exchange rates are determined in markets by the
interaction of supply and demand.
• An important concept that drives the forces of supply and
demand is the Law of One Price.

Law of One Price
• Law of One Price: states that the price of an identical
good will be the same throughout the world, regardless of
which country produces it.
• In other words, the price for any asset will be the same
because the exchange rate will change to reflect the price
change.

Purchasing Power Parity (PPP)
• The theory of PPP states that the value of two currencies
is equal when a basket of identical goods is priced the
same in both countries.
• Therefore, exchange rates between two currencies will
adjust to reflect changes in price levels.
• A 10% rise in the yen price of Japanese steel results in a
10% appreciation of the dollar
– Application of law of one price to national price levels
– Works in long run, not short run
• https://www.economist.com/big-mac-index

Figure 15.2 Purchasing Power Parity, United States/United
Kingdom, 1973–2016 (Index: March 1973 = 100)
Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/CP0000GBM086NEST;
https://fred.stlouisfed.org/series/CPIAUCNS; https://fred.stlouisfed.org/series/EXUSUK.
[Real Exchange Rate]
Real Exchange Rate: the rate
at which domestic goods can
be exchanged for foreign
goods.

Problems with PPP
• Only applicable over long periods of time i.e., 1973 to 2016
but may have deviations over the short-term.
• Transportation costs and trade barriers can differ between
countries.
• All goods are not identical in both countries (i.e., Toyota
versus Chevy)
• Many goods and services are not traded (e.g., haircuts,
Restaurant meals, housing, cooking / Karate lessons etc.)

Factors Affecting in Long Run
Anything that increases the demand for domestically
produced goods relative to foreign traded goods tends to
appreciate the domestic currency.
– Relative price levels: a rise in relative price levels cause a
country’s currency to depreciate.
– Putting Tariffs and quotas: increasing trade barriers causes a
country’s currency to appreciate.
– Preferences for domestic vs. foreign goods: increased demand
for a country’s good causes its currency to appreciate; increased
demand for imports causes the domestic currency to depreciate.
– Productivity: if a country is more productive relative to another, its
currency appreciates.

Table 15.1 Summary Factors That Affect Exchange Rates in
the Long Run
Factor Change in
Factor
Response of the Exchange
Rate, E*
(in terms of domestic
currency)
Domestic price level Increase Depreciation
Trade barriers Increase Appreciation
Import demand Increase Depreciation
Export demand Increase Appreciation
Productivity Increase Appreciation

Exchange Rates in the Short Run
• In the short run, an exchange rate is the price of domestic
bank deposits in terms of foreign bank deposits.
• We will rely on the tools developed in Chapter 4 for the
determinants of asset demand (Theory of Portfolio
Choice).

Demand & Supply Curve Analysis
• We will use the US as the “home country,” so domestic
assets are denominated in US dollars. We will use “euros”
the generically represent any foreign country's currency.
• A lower spot exchange rate is a signal for rising future
exchange rates (as a correction), therefore more dollar
denominated assets would be demanded. So, the demand
curve, D, is downward sloping.
• Dollar assets supplied is primarily the quantity of bank
deposits, bonds, and equities in the United States. This is
fairly fixed in the short-run. So, the supply curve, S, is
vertical.

Figure 15.3 Equilibrium in the Foreign Exchange Market

Explaining Changes in Exchange Rates
• To understand how exchange rates shift in time, we need
to understand the factors that shift expected returns for
domestic and foreign deposits.

Figure 15.4 Response to an Increase in the Domestic
Interest Rate, iD

Figure 15.5 Response to an Increase in the Foreign Interest
Rate, iF

Figure 15.6 Response to an Increase in the Expected
Future Exchange Rate, Ee
t+1
Any factor that causes the
expected future exchange rate, to
rise increases the expected
appreciation of the dollar.
The result is a higher relative
expected return on dollar assets,
which increases the demand for
dollar assets at every exchange
rate

Explaining Future Changes in Exchanges
Rates
• Similar to determinants of exchange rates in the long-run,
the following changes increase the demand for foreign
goods (shifting the demand curve to the right).
– Expected fall in relative U.S. price levels
– Expected increase in relative U.S. trade barriers
– Expected lower U.S. import demand
– Expected higher foreign demand for U.S. exports
– Expected higher relative U.S. productivity

Table 15.2 Summary: Summary Factors That Shift the
Demand Curve for Domestic Assets and Affect the Exchange
Rate (1 of 2)

Table 15.2 Summary: Summary Factors That Shift the
Demand Curve for Domestic Assets and Affect the Exchange
Rate (2 of 2)

Application: Interest Rate Changes
• Changes in domestic interest rates are often cited in the
press as affecting exchange rates.
• The Fisher equation tells us: i = ir + πe
• When interest rates increase in the economy they are the
nominal interest rates.
• We must carefully examine the source of the change to
make such a statement. Interest rates change because
either (a) the real rate or (b) the expected inflation is
changing. The effect of each differs.
• Therefore, we need to disentangle the effects for better
understanding.

Effect of Changes in Interest Rates on the
Equilibrium Exchange Rate
• When the domestic real interest rate increases, the
domestic currency appreciates. We have already seen this
situation in Figure 15.4.
• When the domestic expected inflation increases, the
domestic currency reacts in the opposite direction—it
depreciates. This is shown on the next slide.

Figure 15.7 Effect of a Rise in the Domestic Interest Rate as
a Result of an Increase in Expected Inflation

Figure 15.8 Value of the Dollar and Interest Rates, 1973–
2016
Source: Federal Reserve Bank of St. Louis FRED database: https://fred.stlouisfed.org/series/TWEXMMTH;
https://fred.stlouisfed.org/series/TB3MS; real interest rate from Figure 3.1 in Chapter 3.
A failure to distinguish
between real and nominal
interest rates can lead to
poor predictions of
exchange rate movements!

Mishkin_FMI9ge_PPT_C15.pdf

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