Chapter 13
The Foreign
Exchange
Market
Chapter Preview
• 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., France, Brazil, and
India, just to name a few.
• The trading of currencies and banks
deposits is what makes up the foreign
exchange market.
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Foreign Exchange Market
• The next slide shows exchange rates for
four currencies from 1990-2004.
• Note the difference in rate fluctuations
during the period. Which appears most
volatile? The least?
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Foreign Exchange Market:
Historical Exchange Rates
Figure 13.1: Exchange Rates, 1990–2004
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Current foreign exchange rates
http://www.federalreserve.gov/releases/H10/hist
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The Foreign Exchange Market
• Definitions
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
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Foreign Exchange Market:
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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Foreign Exchange Market:
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.
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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 $100 per ton,
Japanese steel 10,000 yen per ton
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Exchange Rates in the Long Run:
Law of One Price
If E = 50 yen/$ then price are:
In U.S.
In Japan
American Steel
Japanese Steel
$100
5,000 yen
$100
5,000 yen
If E = 100 yen/$ 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
Figure 13.2 Purchasing Power Parity,
United States/United Kingdom, 1973–2004 (Index: March 1973 = 100)
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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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Exchange Rates in the Short Run: Expected
Returns on Domestic and Foreign Deposits
• We will illustrate this with a simple example
• Francois 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 and Interest Parity
RD for Francois
$ Deposits
F Deposits
Relative Re
iD 
i
e
E
 t 1  Et 
Et
F
iD  iF 
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RF for Al
i
D
iF
e
E
 t 1  Et 
Et
E

 Et
Et
e
t 1
iD  iF 

e
E
 t 1  Et 
Et
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Exchange Rates in the Short Run:
Expected Returns and Interest Parity
• Interest Parity Condition
– $ and F deposits perfect substitutes
D
F
i i 
 Et
Et
e
t 1
E
(2)
Example: if iD = 10% and expected appreciation of $,
Ete1  Et
F
 5%  i  15%
Et
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Exchange Rates in the Short Run:
Expected Returns and Interest Parity
• To determine the equilibrium condition, we
must first determine the expected return in
terms of dollars on foreign deposits, RF.
• Next, we must determine the expected
return in terms of dollars on dollar
deposits, RD.
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Exchange Rates in the Short Run:
Deriving RF Curve
Assume iF = 10%, Eet+1 = 1 euro/$
Point
A: Et = 0.95
R F  0.10  1.0  0.95 .95  0.048  4.8%
B: Et = 1.0
RF
C: Et+1 = 1.05
RF = 0.10 - (1.0 - 1.05)/1.05 =15%


 0.10  1.0  1.0  1.0  0.100  10.0%
• RF curve connects these points and is upward sloping
because when Et is higher, expected appreciation
of F higher, RF 
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Exchange Rates in the Short Run:
Deriving RD Curve
• Deriving RD Curve
– Points B, D, E, RD = 10%, so curve
is vertical
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Exchange Rates in the Short Run:
Equilibrium
• Equilibrium
– RD = RF at E*
– If Et > E*, RF > RD, sell $, Et 
– If Et < E*, RF < RD, buy $, Et 
• The following figure illustrates this.
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Exchange Rates in the Short Run:
Equilibrium
Figure 13.3 Equilibrium in the Foreign Exchange Market
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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: Shifts in RF
RF curve shifts right
when
1.
–
–
2.
iF : because RF  at
each Et
Eet+1 : because
expected appreciation
of F  at each Et
and RF 
Occurs: 1. Domestic
P ; 2. Restrictions on
trade ; 3. Imports ;
4. Exports ;
5. Productivity 
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Figure 13.4 Shifts in the Schedule
for the Expected Return on Foreign Deposits RF
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Explaining Changes in Exchange
Rates: Shifts in RD
1. RD shifts right when
– iD , because RD 
at each Et
– Assumes that
domestic πe
unchanged, so
domestic real
rate 
Figure 13.5 Shifts in the Schedule
for the Expected Return on Domestic Deposits RD
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Explaining Changes in Exchange
Rates: Factors that Shift RF and RD
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Explaining Changes in Exchange Rates:
Factors that Shift RF and RD (cont.)
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Explaining Changes in Exchange
Rates: Response to i  Because πe 
1.
πe , Eet+1 ,
expected appreciation
of F , RF shifts out to
right
2.
iD , RD shifts to right
3.
However because πe
 > iD , real rate ,
Eet+1  more than iD 
 RF shifts out > RD
shifts out and Et 
Figure 13.6 Effect of a Rise in the Domestic
Nominal Interest Rate as a Result of an Increase in Expected Inflation
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Explaining Changes in Exchange
Rates: Changes in the Money Supply
1.
Ms , P , Eet+1 ,
expected appreciation
of F , RF shifts right
2.
Ms , i D , RD shifts
left—go to point 2
and Et 
3.
In long run, i D returns
to old level, RD shifts
back, go to point 3
and get exchange
rate overshooting
Figure 13.7 Effect of a Rise in the Money Supply
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Case: Why are Exchange Rates
So Volatile
• Expectations of Eet+1 fluctuate
• Exchange rate overshooting
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The Dollar and Interest Rates
1. Value of $ and
Real Interest
Rates rise and
fall together, as
theory predicts
2. No association
between $ and
Nominal Interest
Rate.
Figure 13.8 Value of the Dollar
and Interest Rates, 1973–2004
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Daily foreign exchange rate
http://quotes.ino.com/exchanges/?e=FOREX
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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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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 RF and RD
schedules were explored.
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