The foreign exchange market

The Foreign Exchange Market 70 Month Sep-99 Jul-99 M ay-99 Mar-99 Jan-99 Nov-98 Sep-98 Jul-98 May-98 Mar-98 Jan-98 Nov-97 Sep-97 Jul-97 M ay-97 Mar-97 Jan-97 Nov-96 Sep-96 Jul-96 May-96 Mar-96 Jan-96 Nov-95 Sep-95 Jul-95 M ay-95 M ar-95 Jan-95 Inde x Asian Currencies vs U.S Dollar 210 190 170 MYR/USD PHP/USD 150 SGD/USD 130 KRW/USD TWD/USD 110 THB/USD 90 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 The Foreign Exchange Market Exchange rate Peso/$ D S Supply of Dollars by people who want pesos Demand for Dollars by people who have pesos Foreign exchange (dollars) Currency Depreciation and Appreciation  Currency depreciation is an increase in the number of units of a particular currency needed to purchase one unit of foreign exchange  Currency appreciation is a decrease in the number of units of a particular currency needed to purchase one unit of foreign exchange Changes in the Equilibrium Exchange Rate Exchange rate Peso/$ D Supply of Dollars S by people who S’ want pesos $ -depreciation Peso- appreciation Demand for Dollars by people who have pesos Foreign exchange (dollars) Exchange Rate Regimes  Flexible  Fixed – – (Floating) exchange rates exchange rates Currency Board Monetary Union  Managed Float (Dirty Float) exchange rates The Central Bank Can Intervene to Maintain Exchange Rates Exchange rate $/pound D’ D’’ S Foreign exchange (pounds) China 10 Response to i  Because  e  e , Eet+1 , expected appreciation of F , RF shifts out to right iD , RD shifts to right However because e  > iD , real rate , Eet+1  more than iD  RF out > RD out and Et  67 Response to Ms  Ms , P , Eet+1  expected appreciation of F , RF shifts right Ms , iD , RD shifts left Go to point and Et  68 In the long run, iD returns to old level, RD shifts back, go to point and get Exchange Rate Overshooting Why Exchange Rate Volatility? Expectations of Eet+1 fluctuate Exchange rate overshooting 69 The Dollar and Interest Rates 70 Value of $ and real rates rise and fall together, as theory predicts No association between $ and nominal rates: $ falls in late 70s as nominal rate rises 71 72 73 74 75 Chapter 18 The International Financial System Unsterilized Foreign Exchange Intervention Federal Reserve System Assets Foreign Assets (International Reserves) 77 Federal Reserve System Liabilities -$1B Currency in circulation Assets -$1B Foreign Assets (International Reserves) Liabilities -$1B Deposits with the Fed -$1B (reserves)  A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base  A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base Unsterilized Intervention  An unsterilized intervention in which domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency 78 79 Sterilized Foreign Exchange Intervention Federal Reserve System Assets Liabilities Foreign Assets (International Reserves) -$1B (reserves) Government Bonds +$1B   80 Monetary Base To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation There is no effect on the monetary base and no effect on the exchange rate Balance of Payments  Current Account –  81 International transactions that involve currently produced goods and services Trade Balance  Capital Account –  Net receipts from capital transactions Sum of these two is the official reserve transactions balance ... rather than financial reform  Too slow, which worsens crisis and increases costs 44 Direct Effects of the Foreign Exchange Market on the Money Supply  Intervention in the foreign exchange market. .. relative to foreign goods, E  Exchange Rates in the Short Run 18  An exchange rate is the price of domestic assets in terms of foreign assets  Using the theory of asset demand? ?the most important... unit used Et ? ?the spot exchange rate Et+1  the exchange rate for the next period e Et+1 - Et  the expected rate of appreciation for the dollar Et 19 Comparing Expected Returns II The expected