The Foreign Exchange Market
1
2
3
Month
Sep-99
Jul-99
May-99
Mar-99
Jan-99
Nov-98
Sep-98
Jul-98
May-98
Mar-98
Jan-98
Nov-97
Sep-97
Jul-97
May-97
Mar-97
Jan-97
Nov-96
Sep-96
Jul-96
May-96
Mar-96
Jan-96
Nov-95
Sep-95
Jul-95
May-95
Mar-95
Jan-95
Index
Asian Currencies vs. U.S. Dollar
210
190
170
MYR/USD
150
PHP/USD
SGD/USD
130
KRW/USD
TWD/USD
110
THB/USD
90
70
The Foreign Exchange Market
Definitions:
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
Currency appreciates, country’s goods prices  abroad and foreign
goods prices  in that country
1. Makes domestic businesses less competitive
2. Benefits domestic consumers
4
FX traded in over-the-counter market
1. 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)
5
Currency Depreciation and
Appreciation
6

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)
7
Exchange Rate Regimes

Flexible (Floating) exchange rates.

Fixed exchange rates.
–
–

8
Currency Board
Monetary Union
Managed Float (Dirty Float) exchange rates.
The Central Bank Can Intervene to Maintain
Exchange Rates
Exchange rate
$/pound
D’
D’’
S
Foreign exchange (pounds)
9
10
3/2/2007
2/2/2007
1/2/2007
12/2/2006
11/2/2006
10/2/2006
9/2/2006
8/2/2006
7/2/2006
6/2/2006
5/2/2006
4/2/2006
3/2/2006
2/2/2006
1/2/2006
12/2/2005
11/2/2005
10/2/2005
9/2/2005
8/2/2005
7/2/2005
6/2/2005
5/2/2005
4/2/2005
3/2/2005
2/2/2005
1/2/2005
12/2/2004
11/2/2004
10/2/2004
9/2/2004
8/2/2004
7/2/2004
6/2/2004
5/2/2004
4/2/2004
3/2/2004
2/2/2004
1/2/2004
China
Chinese Yuan to One U.S. Dollar
8.4
8.3
8.2
8.1
8
7.9
7.8
7.7
7.6
7.5
7.4
Currency Crisis
Exchange rate
Baht/$
52
D’
D
S
25
Foreign exchange ($)
11
12
Month
Sep-99
Jul-99
May-99
Mar-99
Jan-99
Nov-98
Sep-98
Jul-98
May-98
Mar-98
Jan-98
Nov-97
Sep-97
Jul-97
May-97
Mar-97
Jan-97
Nov-96
Sep-96
Jul-96
May-96
Mar-96
Jan-96
Nov-95
Sep-95
Jul-95
May-95
Mar-95
Jan-95
Index
Asian Currencies vs. U.S. Dollar
210
190
170
MYR/USD
150
PHP/USD
SGD/USD
130
KRW/USD
TWD/USD
110
THB/USD
90
70
Law of One Price
Example: American steel $100 per ton, Japanese steel 10,000 yen per ton
If E = 50 yen/$ then prices are:
In U.S.
In Japan
American Steel
Japanese Steel
$100
5000 yen
$200
10,000 yen
If E = 100 yen/$ then prices are:
In U.S.
In Japan
13
American Steel
Japanese Steel
$100
10,000 yen
$100
10,000 yen
Law of one price  E = 100 yen/$
Purchasing Power Parity (PPP)
PPP  Domestic price level  10%, domestic
currency  10%
1. Application of law of one price to price levels
2. Works in long run, not short run
Problems with PPP
1. All goods not identical in both countries: Toyota vs Chevy
2. Many goods and services are not traded: e.g. haircuts
14
Big
Mac
Index
15
PPP: U.S. and U.K
16
Factors Affecting E in Long Run
17
Basic Principle: If factor increases demand for domestic
goods 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 factor affecting the demand for domestic
(dollar) assets and foreign (euro) assets is the
expected return on these assets relative to each
other
Expected Returns and Interest
Parity
Re for
$ Deposits
Euro Deposits
Francois
iD + (Eet+1 – Et)/Et
iF
Al
iD
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:
19
if iD = 10% and expected appreciation of $,
(Eet+1– Et)/Et, = 5%  iF = 15%
Deriving RF Curve
Assume iF = 10%, Eet+1 = 1 euro/$
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 
20
Equilibrium in the Foreign Exchange Market
21
Shifts in RF
RF curve shifts right when
1. iF : because RF  at
each Et
2. 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 
22
Shifts in RD
RD shifts right when
1. iD ; because RD 
at each Et
Assumes that domestic e
unchanged, so domestic
real rate 
23
Foreign Exchange I



Exchange rate—price of one currency in terms of
another
Foreign exchange market—the financial market where
exchange rates are determined
Spot transaction—immediate (two-day) exchange of
bank deposits
–

Forward transaction—the exchange of bank deposits
at some specified future date
–
24
Spot exchange rate
Forward exchange rate
Foreign Exchange II
25

Appreciation—a currency rises in value relative to
another currency

Depreciation—a currency falls in value relative to
another currency

When a country’s currency appreciates, the country’s
goods abroad become more expensive and foreign
goods in that country become less expensive and
vice versa

Over-the-counter market mainly banks
Exchange Rates in the Long
Run

Law of one price

Theory of Purchasing Power Parity
–
–
–
26
Assumes all goods are identical in
both countries
Trade barriers and transportation costs
are low
Many goods and services are not traded across
borders
Factors that Affect Exchange
Rates in the Long Run
27

Relative price levels

Trade barriers

Preferences for domestic versus
foreign goods

Productivity
Factors that Shift RF and RD
28
Response to i  Because e 
1. e , Eet+1 , expected
appreciation of F ,
RF shifts out to
right
2. iD , RD shifts to
right
However because e  > iD ,
real rate , Eet+1  more than
iD 
RF out > RD out and Et 
29
Response to Ms 
30
1. Ms , P , Eet+1 
expected appreciation
of F , RF shifts
right
2. Ms , iD , RD shifts
left
Go to point 2 and Et 
3. In the long run, iD
returns to old level,
RD shifts back, go
to point 3 and get
Exchange Rate
Overshooting
Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting
31
The Dollar and Interest Rates
1.
2.
32
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
33
34
35
36
37
Chapter 18
The International
Financial System
Unsterilized Foreign Exchange
Intervention
Federal Reserve System
Assets
Foreign
Assets
(International
Reserves)
39
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

40
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
41
Sterilized
Foreign Exchange Intervention
Federal Reserve System
Assets
Liabilities
Foreign Assets
(International Reserves)
-$1B (reserves)
Government Bonds
+$1B


42
Monetary Base
0
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
–

43
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
Monetary Policy Strategy: The
International Experience
Role of a Nominal Anchor
Ties Down  Expectations
Helps Avoid Time-Consistency Problem
1. Arises from pursuit of short-term goals which lead to bad
long-term outcomes
2. Time-consistency resides more in political process
3. Nominal anchor limits political pressure for time-consistency
45
Exchange-Rate Targeting
Advantages
1. Fixes  for internationally traded goods
2. Anchors  expectations
3. Automatic rule, avoids time-consistency
4. Easy to understand: “sound currency” as rallying
cry
5. Helps economic integration
6. Successful in reducing 
France, UK, Mexico
46
Exchange-Rate Targeting
Disadvantages
47
1. Loss of independent monetary policy
Problems after German reunification: UK, French
monetary policy too tight
2. Open to speculative attacks
Europe, Sept. 1992; Mexico: 1994; Asia: 1997
3. Successful speculative attack disastrous for
emerging market countries because it leads to
financial crisis
4. Weakened accountability: lose exchange-rate
signal
Currency Boards vs. Dollarization
Currency Boards
1. Domestic currency exchanged at fixed rate for foreign
currency automatically
2. Fixed exchange rate with very strong commitment
mechanism and no discretion
3. Usual disadvantages of fixed exchange rate
4. Still subject to speculative attack
5. Lose ability to have lender of last resort
Dollarization
1. Even stronger commitment mechanism
2. No possibility of speculative attack
3. Usual disadvantages of fixed exchange rtae
4. Lose seignorage
48
Summary: Advantages and Disadvantages
of Different Monetary Policy Strategies
49
Summary: Advantages and Disadvantages
of Different Monetary Policy Strategies
50
Monetary Targeting
Canada
1. Targets M1 till 1982, then abandons it
2. 1988: declining  targets, M2 as guide
United Kingdom
1. Targets M3 and later M0
2. Problems of M as monetary indicator
Japan
1. Forecasts M2 + CDs
2. Innovation and deregulation makes less useful as monetary indicator
3. High money growth 1987-1989: “bubble economy,” then tight money policy
Germany and Switzerland
1. Not monetarist rigid rule
2. Targets using M0 and M3: changes over time
3. Allows growth outside target for 2-3 years, but then reverses overshoots
4. Key elements: flexibility, transparency, and accountability
51
Monetary Targeting
Advantages
1. Able to cope with domestic considerations
2. Signals are immediate
3. Immediate accountability of central bank
Disadvantages
1. Big if: all advantages require reliable relationship between
goal and targeted aggregate
2. In many countries, weak relationship between goal and Maggregate
Poor communications device and accountability
52
Inflation Targeting
Five Elements
1. Public announcement of medium-term štarget
2. Institutional commitment to price stability
3. Information inclusive strategy
4. Increased transparency through public
communication
5. Increased accountability
53
Inflation
Targeting in
New
Zealand,
Canada,
and the UK
54
Inflation Targeting
Advantages
1. Allows focus on domestic considerations
2. Not dependent on reliable relationship between Maggregate and inflation
3. Readily understood by public
4. Reduce political pressures for time-consistent policy
5. Focus on transparency and communication
6. Increased accountability of central bank
7. Performance good:  and e  , and stays low in business
cycle upturn
55
Inflation Targeting
Disadvantages
1. Delayed signalling
2. Too much rigidity
3. Potential for increased output fluctuations
4. Low economic growth
Nominal GDP Targeting
1. Close to inflation targeting with concern about output
fluctuations
2. Problem of announcing specific target for real GDP growth
3. Harder for public to understand
56
Monetary Policy
with an Implicit Nominal Anchor
Forward-Looking and Preemptive to Deal With Long
Lags
Advantages
1. Focus on domestic considerations
2. Has worked very well in the U.S.
3. If It Ain’t Broke Why Fix It?
Disadvantages
1. Lack of transparency and accountability
2. Dependence on personalities
3. Inconsistent with democratic principles
57
Comparing Expected Returns I
Dollar assets pay an interest rate of i D and do not have any capital gain
Foreign assets have an interest rate of i F and there is no capital gain
To compare the expected returns on dollar assets and foreign assets
the returns must be converted into the currency 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
58
Comparing Expected Returns II
The expected return on dollar assets R D in terms of foreign currency
is the sum of the interest rate on dollar assets
plus the expected appreciation of the dollar
R
D
Ete1  Et
in term of euros = i 
Et
D
The expected return on foreign assets R F is i F
Ete1  Et
Relative R  i  i 
Et
D
D
F
As the relative expected return on dollar assets increases, foreigners
will want to hold more dollar assets
59
Comparing Expected Returns III
The expected return on foreign assets R F in terms of dollars
is the interest rate on foreign assets i F plus the expected appreciation
of the foreign currency, equal to minus the expected appreciation of the dollar
e
Et1
 Et
R in terms of dollars = i 
Et
F
F
The expected return on the dollar assets R D is i D
e
e
Et1
 Et
Et1
 Et
D
F
Relative R  i  (i 
) i i 
Et
Et
D
D
F
Which is the same as previously
Relative expected return on dollar assets is the same whether it is
calculated in terms of euros or in terms of dollars
As the relative expected return on dollar assets increases, both foreigners and
60
domestic residents will want to hold more dollar assets
Interest Parity Condition
i i 
D
61
F
 Et
Et
e
t1
E

Capital mobility with similar risk and liquidity 
the assets are perfect substitutes

The domestic interest rate equals the foreign
interest rate minus the expected appreciation of the domestic
currency

Expected returns are the same on both domestic and foreign
assets

An equilibrium condition
Demand and Supply
for Domestic Assets

Demand
–
–

Supply
–
–
62
Relative expected return
At lower current values of the dollar (everything
else equal), the quantity demanded of dollar assets
is higher
The amount of bank deposits, bonds,
and equities in the U.S.
Vertical supply curve
63
64
65
66
Exchange Rate Overshooting

Monetary Neutrality
–

The exchange rate falls by more in the short run than
in the long run
–
67
In the long run, a one-time percentage rise in the money
supply is matched by the same one-time percentage rise in
the price level
Helps to explain why exchange rates exhibit so much
volatility
68
The Dollar and Interest Rates

69
While there is a strong correspondence
between real interest rates and the exchange
rate, the relationship between nominal
interest rates and exchange rate movements
is not nearly as pronounced
70
Exchange Rate Regimes

Fixed exchange rate regime
–

Floating exchange rate regime
–

Value of a currency is allowed to fluctuate against all other
currencies
Managed float regime (dirty float)
–
71
Value of a currency is pegged relative to the value of one
other currency (anchor currency)
Attempt to influence exchange rates by buying and selling
currencies
Past Exchange Rate Regimes

Gold standard
–
–
–

Bretton Woods System
–
–
72
Fixed exchange rates
No control over monetary policy
Influenced heavily by production of gold and
gold discoveries
Fixed exchange rates using U.S. dollar as
reserve currency
International Monetary Fund (IMF)
Past Exchange Rate Regimes
(cont’d)

Bretton Woods System (cont’d)
–
–
World Bank
General Agreement on Tariffs and Trade (GATT)


European Monetary System
–
73
World Trade Organization
Exchange rate mechanism
74
75
How a Fixed Exchange Rate
Regime Works
76

When the domestic currency is overvalued, the
central bank must purchase domestic currency to
keep the exchange rate fixed, but as a result, it loses
international reserves

When the domestic currency is undervalued, the
central bank must sell domestic currency to keep the
exchange rate fixed, but as a result, it gains
international reserves
How Bretton Woods Worked
77

Exchange rates adjusted only when experiencing a ‘fundamental
disequilibrium’ (large persistent deficits in balance of payments)

Loans from IMF to cover loss in international reserves

IMF encourages contractionary monetary policies

Devaluation only if IMF loans are not sufficient

No tools for surplus countries

U.S. could not devalue currency
Managed Float

Hybrid of fixed and flexible
–
–
78
Small daily changes in response to market
Interventions to prevent large fluctuations

Appreciation hurts exporters and employment

Depreciation hurts imports and
stimulates inflation

Special drawing rights as substitute for gold
European Monetary System
79

8 members of EEC fixed exchange rates with one
another and floated against the U.S. dollar

ECU value was tied to a basket of specified amounts
of European currencies

Fluctuated within limits

Led to foreign exchange crises involving speculative
attack
Capital Controls

Outflows
–
–
–
–

Inflows
–
80
Promote financial instability by forcing
a devaluation
Controls are seldom effective and may increase capital
flight
Lead to corruption
Lose opportunity to improve the economy
Lead to a lending boom and excessive risk taking by
financial intermediaries
Capital Controls (cont’d)

Inflows (cont’d)
–
–
–

81
Controls may block funds for productions uses
Produce substantial distortion and misallocation
Lead to corruption
Strong case for improving bank regulation
and supervision
The IMF: Lender of Last Resort
82

Emerging market countries with poor central
bank credibility and short-run debt contracts
denominated in foreign currencies have
limited ability to engage in this function

May be able to prevent contagion

The safety net may lead to excessive risk
taking (moral hazard problem)
How Should the IMF Operate?



83
May not be tough enough
Austerity programs focus on tight
macroeconomic policies rather than financial
reform
Too slow, which worsens crisis and increases
costs
Direct Effects of the Foreign Exchange
Market on the Money Supply
84

Intervention in the foreign exchange market
affects the monetary base

U.S. dollar has been a reserve currency:
monetary base and money supply is less
affected by foreign exchange market
Balance-of-Payments
Considerations
85

Current account deficits in the U.S. suggest
that American businesses may be losing
ability to compete because the dollar is too
strong

U.S. deficits mean surpluses in other
countries large increases in their
international reserve holdings
world inflation
Exchange Rate Considerations
86

A contractionary monetary policy will raise
the domestic interest rate and strengthen the
currency

An expansionary monetary policy
will lower interest rates and
weaken currency
Advantages of
Exchange-Rate Targeting
87

Contributes to keeping inflation
under control

Automatic rule for conduct of
monetary policy

Simplicity and clarity
Disadvantages of
Exchange-Rate Targeting
88

Cannot respond to domestic shocks and
shocks to anchor country are transmitted

Open to speculative attacks on currency

Weakens the accountability of policymakers
as the exchange rate loses value as signal
Exchange-Rate Targeting
for Industrialized Countries
89

Domestic monetary and political institutions
are not conducive to good policy making

Other important benefits such
as integration
Exchange-Rate Targeting
for Emerging Market Countries
90

Political and monetary institutions
are weak

Stabilization policy of last resort
Currency Boards
91

Solution to lack of transparency and commitment to
target

Domestic currency is backed 100% by a foreign
currency

Note issuing authority establishes a fixed exchange
rate and stands ready to exchange currency at this
rate

Money supply can expand only when foreign
currency is exchanged for domestic currency
Currency Boards (cont’d)
92

Stronger commitment by central bank

Loss of independent monetary policy
and increased exposure to shock from
anchor country

Loss of ability to create money and act as lender of
last resort
Dollarization
93

Another solution to lack of transparency
and commitment

Adoption of another country’s money

Even stronger commitment mechanism

Completely avoids possibility of speculative attack
on domestic currency

Lost of independent monetary policy
and increased exposure to shocks from
anchor country
Dollarization (cont’d)
94

Inability to create money and act as lender
of last resort

Loss of seignorage
Appendix
95

Slides after this point will most likely not be
covered in class. However they may contain
useful definitions, or further elaborate on
important concepts, particularly materials
covered in the text book.

They may contain examples I’ve used in the
past, or slides I just don’t want to delete as I
may use them in the future.