Chapter 19 The Foreign Exchange Market © 2005 Pearson Education Canada Inc Foreign Exchange Rates © 2005 Pearson Education 19-2 The Foreign Exchange Market Definitions: Spot exchange rate Forward exchange rate Appreciation Depreciation Currency appreciates, country’s goods prices ↑ abroad and foreign goods prices ↓ in that country Makes domestic businesses less competitive Benefits domestic consumers FX traded in over-the-counter market Trade is in bank deposits denominated in different currencies © 2005 Pearson Education 19-3 Law of One Price Example: Canadian steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are: Canadian Steel In Canada $100 In Japan 5000 yen Japanese Steel $200 10,000 yen If E = 100 yen/$ then prices are: Canadian Steel In Canada $100 In Japan 10,000 yen Japanese Steel $100 10,000 yen Law of one price ⇒ E = 100 yen/$ © 2005 Pearson Education Canada Inc 19-4 Purchasing Power Parity (PPP) PPP ⇒ Domestic price level ↑ 10%, domestic currency ↓ 10% Application of law of one price to price levels Works in long run, not short run Problems with PPP All goods not identical in both countries: Toyota vs Chevy Many goods and services are not traded: e.g haircuts © 2005 Pearson Education 19-5 PPP: Canada and U.S © 2005 Pearson Education 19-6 Factors Affecting E in Long Run Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E ↑ © 2005 Pearson Education Canada Inc 19-7 Expected Returns and Interest Parity Re for Al iD $ Deposits Francois iD + (Eet+1 – Et)/Et Euro Deposits iF iF – (Eet+1 – Et)/Et Relative Re iD – iF + (Eet+1 – Et)/Et iD – iF + (Eet+1 – Et)/Et Interest Parity Condition: $ and Euro deposits perfect substitutes iD = iF – (Eet+1 – Et)/Et Example: if iD = 10% and expected appreciation of $, (Eet+1– Et)/Et, = 5% ⇒ iF = 15% © 2005 Pearson Education 19-8 Deriving RF Curve Assume iF = 10%, Eet+1 = euro/$ Point A: Et = 0.95, RF = 10 – (1 – 0.95)/0.95 = 048 = 4.8% B: Et = 1.00, RF = 10 – (1 – 1.0)/1.0 = 100 =10.0% C: Et = 1.05, RF = 10 – (1 – 1.05)/1.05 = 148 = 14.8% RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF ↑ Deriving RD Curve Points B, D, E, RD = 10%: so curve is vertical Equilibrium RD = RF at E* If Et > E*, RF > RD, sell $, Et ↓ If Et < E*, RF < RD, buy $, Et ↑ © 2005 Pearson Education 19-9 Deriving RETF Curve Assume iF = 10%, Eet+1 = euro/$ Point A: Et = 0.95 RETF = 10 – (1 – 0.95)/0.95 = 048 = 4.8% B: Et = 1.00 RETF = 10 – (1 – 1.0)/1.0 = 100 =10.0% C: Et = 1.05 RETF = 10 – (1 – 1.05)/1.05 = 148 = 14.8% RETF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RETF ↑ Deriving RETD Curve Points B, D, E, RETD = 10%: so curve is vertical Equilibrium RETD = RETF at E* If Et > E*, RETF > RETD, sell $, Et ↓ Et < Pearson E*, RET Education < RET , buy $, Et ↑ © If2005 F D 19-10 Equilibrium in the Foreign Exchange Market © 2005 Pearson Education 19-11 Shifts in RF RF curve shifts right when iF ↑: because RF ↑ at each Et Eet+1 ↓: because expected appreciation of F ↑ at each Et and RF ↑ Occurs Eet+1 ↓ iF: 1) Domestic P ↑, 2) Trade Barriers ↓ 3) Imports ↑, 4) Exports ↓, 5) Productivity ↓ © 2005 Pearson Education Canada Inc 19-12 Shifts in RD RD shifts right when iD ↑; because RD ↑ at each Et Assumes that domestic πe unchanged, so domestic real rate ↑ © 2005 Pearson Education 19-13 Factors that Shift RF and RD © 2005 Pearson Education 19-14 Response to i ↑ Because πe ↑ πe ↑, Eet+1 ↓, expected appreciation of F ↑, RF shifts out to right iD ↑, RD shifts to right However because πe ↑ > iD ↑, real rate ↓, Eet+1 ↓ more than iD ↑ ⇒ RF out > RD out and Et ↓ © 2005 Pearson Education Canada Inc 19-15 Response to Ms ↑ Ms ↑, P ↑, Eet+1 ↓, expected appreciation of F ↑, RF shifts right Ms ↑, iD ↓, RD shifts left Go to point and Et ↓ In the long run, iD returns to old level, RD shifts back, go to point and get Exchange Rate Overshooting © 2005 Pearson Education Canada Inc 19-16 Why Exchange Rate Volatility? Expectations of Eet+1 fluctuate Exchange rate overshooting © 2005 Pearson Education 19-17 ... out and Et ↓ © 2005 Pearson Education Canada Inc 19-15 Response to Ms ↑ Ms ↑, P ↑, Eet+1 ↓, expected appreciation of F ↑, RF shifts right Ms ↑, iD ↓, RD shifts left Go to point and Et ↓ In the. .. (Eet+1 – Et)/Et Interest Parity Condition: $ and Euro deposits perfect substitutes iD = iF – (Eet+1 – Et)/Et Example: if iD = 10% and expected appreciation of $, (Eet+1– Et)/Et, = 5% ⇒ iF = 15% ©... 10 – (1 – 1.05)/1.05 = 148 = 14.8% RF curve connects these points and is upward sloping because when Et is higher, expected appreciation of F higher, RF ↑ Deriving RD Curve Points B, D, E, RD