Task 3 banking π π = foreign interest rate π π· = domestic interest rate π πΈπ‘+1 −πΈπ‘ πΈπ‘ : expected appreciation of the domestic currency Equation (1) states that the difference between foreign interest rate and domestic interest rate is equal to the appreciation of the domestic currency. Also known as interest parity condition, it states that if the domestic interest rate is higher than the foreign interest rate, there is a positive expected appreciation of the foreign currency, compensating for the lower foreign interest rate. 2. In the same chapter, the Purchasing Power Parity Theory (PPP) is contrasted with the theory above; it is stressed that PPP represents a theory of the exchange rate in the long run. What is meant by ‘long run’ and ‘short run’ here? The exchange rate between two currencies, is such that the basket of goods and services costs the same in both currencies’ countries. This was a short definition of the PPP. However, it is only applicable in the long run, as factors such as foreign/domestic interest rate changes et al. can lead to quick price level changes, in the short run. In essence: - The PPP holds in the long run and exchange rates are slow moving. Factors for changes in the exchange rate are: different price levels, different preferences for domestic or foreign goods, relative trade barriers and differences is productivity. - In the short run, exchange rate changes depend on demand curve shifts, resulting from changes in the relative expected return on domestic assets. The PPP does not hold. Factors influencing the demand for domestic assets are changes in the: domestic interest rate, foreign interest rate, expected domestic price level, expected trade barriers, expected import demand, expected export demand and expected productivity. 3. A lot of emerging country currencies (F) show huge positive interest differentials ππ − πD relative to both the euro and the US dollar (D). What does this signal about the future expected value of the emerging currency vis-aΜ-vis Dollars or euros? 4. What happens to the spot exchange rate π¬π when its market expectation π¬ππ+π is adjusted upwards? ( π¬ππ+π increases assuming interest rates stay unchanged) (p.481)ο goes up An increase in the future expected exchange rate leads to an increase of the relative expected return on domestic assets. This increases the demand for domestic assets at every exchange rate. In the supply and demand model, the demand curve therefore shifts to the right and now crosses the vertical supply curve at a higher point. The equilibrium exchange rate raises. 5. What happens to πΈπ‘ when the domestic interest rate is increased (assume a constant foreign interest rate and constant expectation)? Assuming a constant foreign interest rate and constant expectation, an increase in the domestic interest rate leads to an increased return on domestic assets relative to foreign assets. As the quantity of dollar assets demanded increases for every exchange rate, we can see a right shift of the demand curve in the supply and demand model. The equilibrium moves up to the point where the vertical supply curve and the new demand curve intersect. The new exchange rate is higher than the old one, the domestic currency appreciated. Is it real or nominal? 6. Financial economists say that foreign exchange markets are “forward looking”. What do you think they mean by that? There are many factors shifting the demand curve for domestic assets, which ultimately affects the exchange rate in the short run. Specifically, Domestic interest rate, foreign interest rate, expected domestic price level, expected trade barriers, expected import demand, expected export demand and expected productivity. More than 50% of the factors named, rely on expected events. The parties involved in the foreign exchange market make these predictions, in order to evaluate the profitability and risk associated with foreign markets, as well as for their domestic market. Predicting, the market environment, sales et al. is important for a company, as their goal is to maximize future profits.
