Exchange Rates

1
Exchange Rates
2
Exchange Rates

• An exchange rate is the price of one currency in
  terms of another.
• It indicates how many units of one currency can
  be bought with a single unit of another currency.
• Exchange rates are important because exports
  imports and all international financial
  transactions are affected by the prices at which
  currencies exchange for one another.

3
Exchange Rates and Trade

• Currency Appreciation
• Increase in the value of the currency
• When a countrys currency appreciates its
  exports become more expensive and its imports
  become less expensive.
• Currency Depreciation
• Decrease in the value of the currency
• When a countrys currency depreciates its
  exports become less expensive and its imports
  become more expensive.

4
Exchange Rates and Capital Mobility

• Currency appreciation
• Increase in the value of the currency
• When the dollar appreciates U.S. assets become
  more attractive relative to foreign assets.
• Currency depreciation
• Decrease in the value of the currency
• When the dollar depreciates U.S. assets become
  less attractive relative to foreign assets.

5
Exchange Rates Long Run

• Factors that affect exchange rates in the long
  run include
• Relative Price Levels/Purchasing Power Parity
• Trade Barriers
• Preferences for Domestic Versus Foreign Goods
• Productivity

6
Relative Price Levels and Exchange Rates

• Purchasing power parity (PPP) says that when the
  prices charged for essentially the same goods in
  different countries diverge exchange rates will
  move in the opposite direction and equalize the
  effective prices between the two countries.

7
Determination of Exchange Rates PPP

• Purchasing power parity says that in the long run
  exchange rates adjust to reflect changes in the
  price levels of two countries.
• If one countrys price level rises relative to
  another its currency tends to depreciate.
• If one countrys price level falls relative to
  another its currency tends to appreciate.

8
PPP Simple Example

• Assume that the USA and Canada produce identical
  bushels of wheat and that the exchange rate is 1
  Canadian for 1 U.S.
• Let the price of wheat in Canada rise to
  3/bushel while the price of wheat in the U.S.
  remains 2.50/bushel.
• What will happen

9
Purchasing Power Parity Example

• Canadians will buy U.S. wheat. In order to do
  this they must first buy U.S. dollars.
• The supply of Canadian dollars in the global
  marketplace increases.
• The demand for U.S. dollars in the global
  marketplace increases
• The Canadian dollar depreciates and the U.S
  dollar appreciates.

10
Purchasing Power Parity Example

• The price of U.S. wheat increases for Canadians
  for two reasons.
• The dollar has appreciated.
• The increase in demand for U.S. wheat pushes its
  price towards 3.00.
• The decrease in demand for Canadian wheat pushes
  down its price down from 3.00 towards 2.50.

11
PPP Simple Example

• Over time these effects combine to bring about a
  single price for U.S. and Canadian wheat.
• Conclusion
• A rise in the price level puts downward pressure
  on a currency.
• A fall in the price level puts upward pressure on
  a currency.

12
Why PPP Works Poorly in the Short Run

• Assumptions
• All goods are identical in both countries.
• All goods and services are traded across borders.
• Both countries have similar levels of
  productivity.
• Consumers do not prefer one countrys goods over
  anothers.
• No tariffs or quotas.

13
Trade Barriers and Exchange Rates

• Barriers to free trade increase the demand for
  domestic goods causing the domestic currency to
  tend to appreciate.
• If the rising value of the currency does not
  decrease foreign demand the domestic currency
  appreciates because the supply of that currency
  decreases in world markets.

14
Preferences and Exchange Rates

• Increased demand for a countrys exports causes
  its currency to appreciate.
• If the rising value of the currency does not
  decrease foreign demand the demand for the
  domestic currency in world markets increases and
  its value rises.

15
Preferences and Exchange Rates

• Decreased demand for a countrys exports causes
  its currency to depreciate.
• If the falling value of the currency does not
  increase foreign demand the demand for the
  domestic currency in world markets decreases and
  its value falls.

16
Productivity and Exchange Rates

• As a country becomes more productive than other
  countries costs fall permitting that country to
  sell at lower prices.
• The decrease in price increases demand for the
  countrys goods and services causing the value
  of the countrys currency to rise.

17
Productivity and Exchange Rates

• As a country becomes less productive than other
  countries costs rise forcing that country to
  sell at higher prices.
• The increase in price decreases demand for the
  countrys goods and services causing the value
  of the countrys currency to fall.

18
Exchange Rates Short Run

• The modern asset market approach to explain
  exchange rate determination emphasizes financial
  flows.
• Financial transactions in the U.S. are over 25
  times greater than the amount of exports and
  imports.
• In the short run decisions to hold domestic or
  foreign assets play a more important role than
  trade.

19
Expected Return

• Demand for dollar deposits vis a vis foreign
  deposits depends on the relative expected return
  on the deposits.
• A higher expected return on dollar deposits
  relative to foreign deposits results in a higher
  demand for dollar deposits.
• A higher expected return on foreign deposits
  relative to dollar deposits results in a higher
  demand for foreign deposits.

20
Expected Return Foreign Perspective

• The return on dollar deposits received by a
  foreigner depends on the interest rate and the
  exchange rate between dollars and the foreign
  currency because.
• Interest earned on U.S. deposits is denominated
  in dollars and must be converted into the foreign
  currency.

21
Expected Return Stable Currencies

• Assume you are French and you have bought a U.S.
  asset that pays 10 interest.
• If the exchange rate between the U.S. and France
  does not change you receive the full 10.

22
Expected Return Changing Currency Values

• Assume you are French and you have bought a U.S.
  asset that pays 10 interest.
• Also assume that the exchange rate between France
  and the U.S. changes.
• You will not receive 10.
• You may receive more than 10 or less than 10.

23
Expected Return Dollar Appreciation

• Assume you are French and you own a U.S. asset
  that pays 10.
• Assume also that the dollar has appreciated
  relative to the euro.
• This means that the dollar buys
  euros.
• This means that you earn than 10.

24
Expected Return Dollar Depreciation

• Assume you are French and you own a U.S. asset
  that pays 10.
• Assume also that the dollar has depreciated
  relative to the euro.
• This means that the dollar buys euros.
• This means that you earn than 10.

25
Expected Return The Math

• The formula for the expected return on dollar
  deposits (RET) in terms of euros is
• RET i (Et1 Et)/Et
• The expected return equals the interest return
  denominated in dollars (i ) plus the expected
  dollar appreciation.
• Et1 is the expected value of the dollar in the
  next period.
• Et is the expected value of the dollar today.

26
Expected Return French Assets

• If you are French the expected return on French
  deposits is the French interest rate.
• There is no exchange rate exposure.

27
Relative Expected Return

• If you are French the relative expected return
  on dollar deposits is the difference between the
  expected return on dollar deposits and the
  expected return on euro deposits.
• To invest profitably we must compare the two.

28
Relative Expected Return The Math

• The relative expected return on dollar deposits
  equals
• Relative RET i if (Et1 Et)/Et
• The relative expected return equals the interest
  return denominated in dollars minus the interest
  on French deposits plus the dollar appreciation.

29
Expected Return American Perspective

• The return on euro deposits received by an
  American depends on the French interest rate and
  the exchange rate between dollars and the euro
  because.
• Interest earned on French deposits is denominated
  in euros and must be converted into dollars.

30
Expected Return The Math

• The formula for the expected return on French
  deposits (RETF) in terms of dollars is
• RETF if (Et1 Et)/Et
• The expected return equals the interest return
  denominated in euros (if ) plus the appreciation
  in the euro.
• Euro appreciation is the negative of dollar
  appreciation so we subtract dollar appreciation
  from our return.

31
Expected Return U.S. Assets

• The expected return on U.S. deposits for
  Americans is the U.S. interest rate because there
  is no exchange rate exposure.

32
Relative Expected Return

• If you are American the relative expected return
  on French deposits in terms of dollars is the
  difference between the expected return on dollar
  deposits and the expected return on euro
  deposits.
• To invest profitably we must compare the two.

33
Relative Expected Return The Math

• The relative expected return on French deposits
  equals
• Relative RETF i (if (Et1 Et)/Et)
• i if (Et1
  Et)/Et
• The relative expected return equals the interest
  return denominated in dollars minus the interest
  on French deposits plus the dollar appreciation.

34
Conclusion

• The relative expected return on dollar deposits
  is the same whether it is calculated form the
  foreign point of view or the domestic point of
  view.
• When the dollar is expected to appreciate
  Americans and foreigners prefer to hold dollar
  denominated deposits.

35
Interest Rate Parity

• Understanding Exchange Rates in the Short Run

36
Explaining Interest Rates with Interest Rate
Parity

• Interest rate parity says that the higher
  domestic real rates of interest are relative to
  foreign real interest rates the higher will be
  the value of the domestic currency other things
  remaining the same.

37
Interest Rate Parity Assumptions

• Foreign and U.S. deposits have similar risk and
  liquidity characteristics.
• There are few impediments to capital mobility.
• Foreigners can easily purchase American assets
  and Americans can easily purchase foreign assets.
• Therefore foreign and American deposits are
  perfect substitutes.

38
Interest Rate Parity Investor Behavior

• When capital is mobile and bank deposits are
  perfect substitutes.
• If the expected return on dollar deposits is
  above foreign deposits everyone will want to
  hold dollar deposits.
• If the expected return on foreign deposits is
  above American deposits everyone will want to
  hold foreign deposits.

39
Interest Rate Parity Condition

• For existing supplies of both dollar and foreign
  deposits to be held it must be true that there
  is no difference in their expected returns.
• The relative expected return must equal zero.
• Relative RET i if (Et1 Et)/ Et 0
  or
• i if (Et1 Et)/ Et

40
Interest Rate Parity Condition Implications

• If the domestic rate is above the foreign
  interest rate positive expected appreciation of
  the foreign currency is expected.
• The expected appreciation compensates for the
  lower foreign interest rate.
• i if (Et1 Et)/ Et
• 10 8 x

41
Interest Rate Parity Condition Implications

• If the domestic rate is below the foreign
  interest rate positive expected appreciation of
  the domestic currency is expected.
• The expected appreciation compensates for the
  lower domestic interest rate.
• i if (Et1 Et)/ Et
• 8 10 x

42
Foreign Exchange Market Model
Et
RETD
RETF
Et is the exchange rate euros/dollars. RETD is
the return on dollar deposits in the U.S. RETF
is the expected return on euro deposits in terms
of dollars. RET is the expected return on
deposits in terms of dollars.
1.05 1.00 .95
0
5 10 15
RET
43
Foreign Exchange Market Model Derivation
Et
RETD
RETF
Let if 10 Et .95 and Et1 1.00 RETF
0.10 (1 .95)/.95 0.10 0.052
0.048 We plot the combination .95 and 4.8 at
point 1.
1.05 1.00 .95
1
0
5 10 15
RET
44
Foreign Exchange Market Model Derivation
Et
RETD
RETF
Let if 10 Et 1.00 and Et1 1.00. RETF
0.10 (1 1)/1 0.10 0
0.10 We plot the combination 1 and 10 at point
2.
1.05 1.00 .95
2
1
0
5 10 15
RET
45
Foreign Exchange Market Model Derivation
Et
RETD
RETF
3
Let if 10 Et 1.05 and Et1 1.00. RETF
0.10 (1 1.05)/1.05 0.10 (
0.048) 0.148 We plot the combination 1.05 and
14.8 at point 3.
1.05 1.00 .95
2
1
0
RET
5 10 15
46
Foreign Exchange Market Model
RETF
Et
RETD
1.05 1.00 .95
Equilibrium occurs where the return on foreign
assets equals the return on domestic assets.
0
RET
5 10 15
47
Stability of Equilibrium

• At equilibrium there are either no forces causing
  change or there are equal off-setting forces.
• If the equilibrium is stable disequilibrium
  positions cannot exist indefinitely.
• Forces in the model will tend to eliminate either
  the excess supply or excess demand.

48
Foreign Exchange Market Model
RETF
Et
RETD
Equilibrium occurs where the return on foreign
assets equals the return on domestic assets. If
the return on foreign assets exceeds the return
on domestic assets the currency will depreciate.
1.05 1.00
0
RET
5 10 15
49
Equilibrium

• Let the exchange rate be 1.05
• The expected return on euro deposits is now
  greater than the return on dollar deposits.
• Holders of dollar deposits now will try to sell
  them and buy euro deposits but no one will want
  them at the exchange rate of 1.05.
• The excess supply of dollars will cause the
  dollar to fall.
• The dollar falls until equilibrium is reached at
  the exchange rate of 1.

50
Foreign Exchange Market Model
RETF
Et
RETD
Equilibrium occurs where the return on foreign
assets equals the return on domestic assets. If
the return on foreign assets is less than the
return on domestic assets the currency will
appreciate.
1.00 .95
0
RET
5 10 15
51
Equilibrium

• Let the exchange rate be .95
• The expected return on dollar deposits is now
  greater than the return on euro deposits.
• Holders of euro deposits now will try to sell
  them and buy dollar deposits but no one will
  want them at the exchange rate of .95.
• The excess demand for dollars will cause the
  dollar to rise.
• The dollar rises until equilibrium is reached at
  the exchange rate of 1.00.

52
Changes in Exchange Rates

• To explain how exchange rates change over time
  we have to understand the factors that shift the
  expected-return schedules for domestic dollar
  deposits and foreign deposits.

53
Shifting the Expected-Return Schedule for Foreign
Deposits
RETF3
RETF1
Et
RETD1
Other things remaining the same a change in i f
changes the expected return on foreign
deposits. If i f rises at any given exchange
rate RETF is higher so we shift the
RETF schedule to the right. If i f falls at any
given exchange rate RETF is lower so we shift
the RETF schedule to the left.
RETF2
RET
0
54
Shifting the Expected-Return Schedule for Foreign
Deposits

• The RETF schedule shifts when there is a change
  in the foreign interest rate.
• An increase in the foreign interest rate shifts
  the RETF schedule to the right and causes the
  domestic currency to depreciate.
• A decrease in the foreign interest rate shifts
  the RETF schedule to the left and causes the
  domestic currency to appreciate.

55
Foreign Interest Rate Rises
An increase in the expected return on foreign
deposits causes the domestic currency to
depreciate. The higher rates of return on
foreign financial assets attract U.S. buyers. In
order to buy foreign financial assets U.S.
investors must first buy foreign currency. The
supply of dollars increases in the global
marketplace and the dollar depreciates.
Et
RETD
RETF1
RETF2
E1 E2
1
2
0
RET
56
Shifting the Expected-Return Schedule for Foreign
Deposits
RETF2
RETF1
Et
RETD1
Other things remaining the same a change in Et1
changes the expected appreciation of the
dollar. If Et1 rises the euro is expected to
fall and RETF will be lower. We shift the RETF
schedule to the left. If Et1 falls the euro is
expected to rise and RETF will be higher. We
shift the RETF schedule to the right.
RETF3
RET
0
57
Shifting the Expected-Return Schedule for Foreign
Deposits

• The RETF schedule shifts when there is a change
  in the expected future exchange rate.
• A rise in the expected future exchange rate
  shifts the RETF schedule to the left and causes
  the domestic currency to appreciate.
• A fall in the expected future exchange rate
  shifts the RETF schedule to the right and causes
  the domestic currency to depreciate.

58
The Expected Future Exchange Rate Rises
An increase in the expected future exchange rate
causes the domestic currency to appreciate. The
higher expected future exchange rate increases
foreign demand for U.S. assets. In order to buy
U.S. financial assets foreign investors must
first buy U.S.currency. The supply of foreign
currency increases in the global marketplace and
the dollar appreciates.
Et
RETD
RETF2
RETF1
E2 E1
2
1
0
RET
59
Shifting the Expected-Return Schedule for
Domestic Deposits
Et
RETD2
RETD3
RETD1
RETF
A rise in the domestic interest rate shifts RETD
to the right and causes an appreciation of the
domestic currency. A fall in the domestic
interest rate shifts RETD to the left and
causes a depreciation of the domestic currency.
0
RET
60
Real Rate of Interest Rises
A rise in the real domestic rate of interest
causes the currency to appreciate. The higher
rates of return on U.S. financial assets attract
foreign buyers. In order to buy U.S. financial
assets foreigners must first buy dollars. The
demand for dollars increases in the global
marketplace and the dollar appreciates.
Et
RETD1
RETF
RETD2
E2 E1
2
1
0
RET
61
Inflation and the Exchange Rate
Et
RETD
RETF1
RETD2
RETF2
An increase in inflation causes the currency to
depreciate. If nominal interest rates rise
because of an increase in the inflation premium
the rise in expected domestic inflation leads
to a decline in the expected appreciation of the
dollar.
E1 E2
1
2
0
RET
62
Money Supply and the Exchange Rate
Et
RETD1
RETF1
RETD2
RETF2
An increase in the money supply can cause
the domestic currency to depreciate if it causes
an increase in the domestic price level that
leads to a lower expected future exchange
rate. The decline in the expected
appreciation of the dollar raises the expected
return of foreign deposits. In the short run
domestic interest rates fall to RETD2 and the
exchange rate falls to E2.
1
E1
E3
3
E2
2
0
RET
63
Exchange Rate Overshooting

• In the long run according to the theory of
  monetary neutrality a onetime percentage rise in
  the money supply is matched by an equal onetime
  percentage rise in the price level leaving the
  real money supply and all other economic
  variables unchanged.

64
Exchange Rate Overshooting

• The quantity theory of money states
• MV PY where
• M Money Supply
• P Price Level
• V Velocity of Money
• Y Aggregate Income
• If V and Y are constant then any change in M is
  matched by an equal change in P.

65
Exchange Rate Overshooting

• Monetary neutrality says that in the long run
  the rise in the money supply would not lead to a
  change in RETD.
• A shift in RETD2 back to RETD1 in the long run
  causes the exchange rate to rise to E3.
• The phenomenon where the exchange rate falls by
  more in the short run than it does in the long
  run in known as exchange rate overshooting.

66
Volatility of Exchange Rates

• Because expected appreciation of the domestic
  currency affects the expected return on foreign
  deposits expectations about the price level
  inflation trade barriers productivity import
  demand export demand and the money supply play
  important roles in determining the exchange rate.

67
Productivity and the Exchange Rate
Et
RETD1
RETF2
RETF1
An increase in productivity makes a country
more competitive and increases demand for the
countrys currency. As Et1 rises RETF shifts
to the left and the exchange rate rises from E1
to E2.
2
E2
E1
1
0
RET
68
The Expected Domestic Price Level and the
Exchange Rate
Et
RETD1
RETF1
RETF2
A decline in the expected appreciation of the
dollar raises the expected return of foreign
deposits. RETF increases and shifts to the
right. The exchange rate falls from E1 to E2.
1
E1
E2
2
0
RET
69
Expected Trade Barriers and the Exchange Rate
Et
RETD1
RETF2
RETF1
Expectations of rising trade barriers
cause people to expect the domestic currency
to rise. As Et1 rises RETF decreases and
shifts to the left. The exchange rate rises from
E1 to E2.
2
E2
E1
1
0
RET
70
Expected Import Demand and the Exchange Rate
Et
RETD1
RETF1
RETF2
An increase in expected import demand means the
supply of the domestic currency will increase
relative to demand. This expected increase in
supply in the world marketplace causes Et1 to
fall. A fall in Et1 causes RETF to increase
and shift to the right. The exchange rate falls
from E1 to E2.
1
E1
E2
2
0
RET
71
Expected Export Demand and the Exchange Rate
Et
RETD1
RETF1
RETF2
An increase in expected export demand means the
demand for domestic currency will increase
relative to supply. This expected increase in
demand in the world marketplace causes Et1 to
rise. A rise in Et1 causes RETF to decrease
and shift to the left. The exchange rate rises
from E1 to E2.
2
E2
E1
1
0
RET
72
Volatility of Exchange Rates

• Exchange rates are volatile because
• Exchange rates are determined by expectations
  about domestic interest rates foreign interest
  rates inflation and many other variables.
• When expectations change about any of these
  variables exchange rates are affected.