Chapter 13
The Foreign
Exchange
Market
Chapter Preview
• In the mid-1980s, American businesses
became less competitive relative to their
foreign counterparts. By the 2000s,
though, competitiveness increased. Why?
• Part of the answer can be found in
exchange rates. In the 1980s, the dollar
was strong, and US goods were expensive
to foreign buyers.
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Chapter Preview
• By the 1990s and 2000s, the dollar
weakened, so American goods became
cheaper and American businesses became
more competitive.
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Chapter Preview
• In this chapter, we develop a modern view
of exchange rate determination that
explains recent behavior in the foreign
exchange market. Topics include:
– Foreign Exchange Market
– Exchange Rates in the Long Run
– Exchange Rates in the Short Run
– Explaining Changes in Exchange Rates
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Foreign Exchange Market
• Most countries of the world have their own
currencies: the U.S dollar., the euro in
Europe, the Brazilian real, and the Chinese
yuan, just to name a few.
• The trading of currencies and banks
deposits is what makes up the foreign
exchange market.
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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.
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Foreign Exchange Market
• The next slide shows exchange rates for
four currencies from 1990-2006.
• Note the difference in rate fluctuations
during the period. Which appears most
volatile? The least?
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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.
1. Makes domestic businesses less competitive
2. Benefits domestic consumers (you)
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Why Are Exchange Rates Important?
• For example, in 1999, the euro was valued
at $1.18. On April 26, 2006, it was valued
at $1.36.
– Euro appreciated 15% (1.36-1.18) / 1.18
– Dollar depreciated 13% (0.75-0.85) / 0.85
Note: 0.75 = 1 / 1.36, and 0.85 = 1 / 1.18
We can see exchange rates in the WSJ.
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Foreign
Exchange
Market:
Exchange
Rates
Current foreign exchange rates
http://www.federalreserve.gov/releases/H10/hist
How is Foreign Exchange Traded?
• FX traded in over-the-counter market
1. Most trades involve buying and selling bank
deposits denominated in different currencies.
2. Trades in the foreign exchange market
involve transactions in excess of $1 million.
3. Typical consumers buy foreign currencies
from retail dealers, such as American
Express.
• FX volume exceeds $3 trillion per day.
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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.
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Exchange Rates in the Long Run: Law of
One Price
• The 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.
• Example: American steel costs $100 per
ton, while Japanese steel costs 10,000 yen
per ton.
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Exchange Rates in the Long Run: Law of
One Price
If E = 50 yen/$ then price are:
In U.S.
In Japan
American Steel
Japanese Steel
$100
5000 yen
$200
10,000 yen
If E = 100 yen/$ then price are:
In U.S.
In Japan
American Steel
Japanese Steel
$100
10,000 yen
$100
10,000 yen
• Law of one price  E = 100 yen/$
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Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)
• The theory of PPP states that exchange
rates between two currencies will adjust to
reflect changes in price levels.
• PPP  Domestic price level  10%,
domestic currency  10%
– Application of law of one price to price levels
– Works in long run, not short run
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Exchange Rates in the Long Run: Theory of
Purchasing Power Parity (PPP)
• Problems with PPP
1. All goods are not identical in both countries
(i.e., Toyota versus Chevy)
2. Many goods and services are not traded
(e.g., haircuts, land, etc.)
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Exchange Rates in the Long Run: PPP
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Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• Basic Principle: If a factor increases
demand for domestic goods relative to
foreign goods, the exchange rate 
• The four major factors are relative price
levels, tariffs and quotas, preferences for
domestic v. foreign goods, and productivity.
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Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• Relative price levels: a rise in relative
price levels cause a country’s currency
to depreciate.
• Tariffs and quotas: increasing trade barriers
causes a country’s currency to appreciate.
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Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• Preferences for domestic v. 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.
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Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
• The following table summarizes these
relationships. By convention, we are
quoting, for example, the exchange rate, E,
as units of foreign currency / 1 US dollar.
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Exchange Rates in the Long Run: Factors
Affecting Exchange Rates in Long Run
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Exchange Rates in the Short Run
• In the short run, it is key to recognize that
an exchange rate is nothing more than the
price of domestic bank deposits in terms of
foreign bank deposits.
• Because of this, we will rely on the tools
developed in Chapter 4 for the
determinants of asset demand.
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13-24
Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
• We will illustrate this with a simple example
• François the Foreigner can deposit excess
euros locally, or he can convert them to
U.S. dollars and deposit them in a U.S.
bank. The difference in expected returns
depends on two things: local interest rates
and expected future exchange rates.
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Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
• Al the American has a similar problem. He
can deposit excess dollars locally, or he
can convert them to euros and deposit
them in a foreign bank. The difference in
expected returns depends on two things:
local interest rates and expected future
exchange rates.
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Exchange Rates in the Short Run:
Expected Returns and Interest Parity
e
e
R for François
i
$ Deposits
D
E


R for Al
 Et 
e
t 1
iD
Et
NOTE – I corrected this term
Relative R
e
iiDF 
iF
F Deposits
D
i i
F
E


e
t 1
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 Et 
Et
D
i i
F
e
E
 t 1  Et 
Et
E


e
t 1
 Et 
Et
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Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Assets
• What this shows is simple. As the relative
expected return on dollar assets increases
(decreases), both François and Al respond
by holding more (fewer) dollar assets and
fewer (more) foreign assets.
• This leads us to our formal title for what is
going on here: Interest Parity
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Exchange Rates in the Short Run:
Expected Returns and Interest Parity
• Interest Parity Condition
– $ and F deposits perfect substitutes
e
E
D
F
t 1  Et
i i 
Et
(2)
Example: if iD = 6% (US interest rate) and iF = 3%
(foreign currency interest rate), what is the expected
appreciation of the foreign currency?
Ete1  Et
 6%  3%  3%
Et
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Exchange Rates in the Short Run:
Expected Returns and Interest Parity
Several things to recognize about the
interest rate parity condition:
•Expected returns are the same in both dollars
and foreign assets
•Equilibrium condition for the foreign exchange
market
Next, we will develop supply/demand curves to
explain how the exchange rate is determined.
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Exchange Rates in the Short Run:
Expected Returns and Interest Parity
• To determine the equilibrium condition, we
must first determine the expected return in
terms of dollars on foreign deposits, RF.
• Next, we must determine the expected
return in terms of dollars on dollar
deposits, RD.
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Deriving the Demand Curve
Assume iF = 5%, Eet+1 = 1 euro/$
Point
A: Et = 1.05
(1.00 – 1.05)/1.05 = -4.8%
B: Et = 1.00
(1.00 – 1.00)/1.00 = 0.0%
C: Et+1 = 0.95
(1.00 – 0.95)/0.95 = 5.2%
• The demand curve connects these points and is
downward sloping because when Et is higher,
expected appreciation of the dollar is higher.
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Deriving the Supply Curve
• Deriving the Supply Curve
– There isn’t really anything to derive. We
will take the quantity of bank deposits,
bonds, and equities as fixed with respect
to exchange rates.
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Exchange Rates in the Short Run:
Equilibrium
• Equilibrium
– Supply = Demand at E*
– If Et > E*, Demand < Supply, buy $, Et 
– If Et < E*, Demand > Supply, sell $, Et 
• The following figure illustrates this.
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Exchange Rates in the Short Run:
Equilibrium
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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.
• We will examine these separately, as well
as changes in the money supply and
exchange rate overshooting.
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Explaining Changes in Exchange Rates:
Increase in iD
1. Demand curve
shifts right when
– iD : because
people want to
hold more dollars
2. This causes
domestic currency
to appreciate.
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Explaining Changes in Exchange Rates:
Increase in iF
1. Demand curve
shifts left when
– iF : because
people want to
hold fewer dollars
2. This causes
domestic currency
to depreciate.
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Explaining Changes in Exchange Rates:
Increase in Expected Future FX Rates
1. Demand curve
shifts left when
– Ete1 : because
people want to
hold more dollars
2. This causes
domestic currency
to appreciate.
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Explaining 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), increasing Ete1
– 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
• These are summarized in the following slides.
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Explaining Changes in Exchanges Rates
Explaining Changes
in Exchanges Rates (cont.)
Applications
Our analysis allows us to take a look at the
response of exchange rates to a variety of
macro-economic factors. For example, we can
use this framework to examine (1) the impact
of changes in interest rates, and (2) the impact
of money growth.
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Application: Interest Rate Changes
• Changes in domestic interest rates are
often cited in the press as affecting
exchange 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.
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Application: Interest Rate Changes
• When the domestic real interest rate
increases, the domestic currency
appreciates. We have already seen this
situation in Figure 4 (slide 37).
• When the domestic expected inflation
increases, the domestic currency reacts in
the opposite direction – it depreciates. This
is shown on the next slide.
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Explaining Changes in Exchange Rates:
Response to i  Because πe 
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Application: Interest Rate Changes
• Changes in domestic money supply are a
bit more complicated. We summarize the
results on the next slide. However, you
may want to read the text on this section to
fully digest the effects.
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Explaining Changes in Exchange Rates:
Changes in the Money Supply
1. Ms , P , Eet+1 ,
shifting demand
curve from D1 to D2.
2. In long run, iD returns
to old level, and
demand shifts from
D2 to D3 (exchange
rate overshooting)
Exchange rate volatility
• Exchange rate overshooting is important
because it helps explain why foreign
exchange rates are so volatile.
• Another explanation deals with changes in
the expected appreciation of exchange
rates. As anything changes our
expectations (price levels, productivity,
inflation, etc.), exchange rates will change
immediately.
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Applications
Our analysis also allows us to take a look at
the weak dollar in the 1980s, and (partially)
explain why it became stronger in the 1990s
and 2000s. We present a summary in Figure
9, on the next slide.
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The Dollar and Interest Rates
1. Value of $ and
real rates rise and
fall together, as
theory predicts
2. No association
between $ and
nominal rates:
$ falls in late
1970s as nominal
rate rises
Daily foreign exchange rate
http://quotes.ino.com/exchanges/
?e=FOREX
Case: The Euro’s First Nine Years
• The euro debuted in 1999 at $1.18 / euro.
It declined to $0.83 by October 2000, but
has recovered, trading at $1.35 by the end
of 2007.
• Initially, the European countries had
relatively weaker economies, but that has
reversed in recent years, weakening the
dollar relative to the euro.
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Reading the WSJ
• The figure on the next slide shows the
“Currency Trading” column from the Wall
Street Journal on July 11, 2007.
• Some highlights include:
– Warnings from Home Depot and other sectors
that the economy is weakening – signaling
possible Fed rate cuts (did that happen?)
– Dollar returns expected to be lower in the
future – dollar expected to depreciate
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The Practicing Manger:
Profiting from FX Forecasts
• Forecasters look at factors discussed here
• FX forecasts affect financial institutions
managers' decisions
• If forecast yen appreciate, yen depreciate,
– Sell franc assets, buy euro assets
– Make more euros loans, less yen loans
– FX traders sell yen, buy euros
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Chapter Summary
• Foreign Exchange Market: the market for
deposits in one currency versus deposits
in another.
• Exchange Rates in the Long Run: driven
primarily by the law of one price as it
affects the four factors discussed.
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13-56
Chapter Summary (cont.)
• Exchange Rates in the Short Run: shortrun rates are determined by the demand for
assets denominated in both domestic and
foreign currencies.
• Explaining Changes in Exchange Rates:
factors leading to shifts in the demand and
supply schedules were explored.
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