Chapter 19.Chapter 19.The Foreign Exchange MarketThe Foreign Exchange MarketChapter 19.Chapter 19.The Foreign Exchange MarketThe Foreign Exchange Market

• Exchange rates

• Long run factors

• Short run factors

• Exchange rates

• Long run factors

• Short run factors

I. Exchange ratesI. Exchange ratesI. Exchange ratesI. Exchange rates

• definitions, data, examples

• typically exchange rate =• definitions, data, examples

• typically exchange rate =

Mexican Peso, Japanese Yen

• also quoted as• also quoted as

British pound, Canadian dollar, euro

exchange rate marketexchange rate marketexchange rate marketexchange rate market

• spot exchange rates currency exchanges w/in 2 days

• forward exchange rates currency exchange at future date,

but ratio is set today

• spot exchange rates currency exchanges w/in 2 days

• forward exchange rates currency exchange at future date,

but ratio is set today

why care?why care?why care?why care?

• determines relative prices imports in U.S. our exports abroad

• determines relative returns U.S. investments vs. foreign

investments financing U.S. debt

• determines relative prices imports in U.S. our exports abroad

• determines relative returns U.S. investments vs. foreign

investments financing U.S. debt

exampleexampleexampleexample

• GM Saturn $13,500 in U.S.

• Toyota Corolla 1.8 million yen

• GM Saturn $13,500 in U.S.

• Toyota Corolla 1.8 million yen

case 1: 120 yen/$case 1: 120 yen/$case 1: 120 yen/$case 1: 120 yen/$

• price of Corolla in U.S.:

1.8 million/120 = $15,000

• price of Saturn in Japan:

13,500 x 120 = 1.62 million yen

• price of Corolla in U.S.:

1.8 million/120 = $15,000

• price of Saturn in Japan:

13,500 x 120 = 1.62 million yen

case 2: 110 yen/$case 2: 110 yen/$case 2: 110 yen/$case 2: 110 yen/$

• $ has depreciated against yen yen has appreciated against $

• $ has fallen yen has risen

• $ is weaker yen is stronger

• $ has depreciated against yen yen has appreciated against $

• $ has fallen yen has risen

• $ is weaker yen is stronger

• price of Corolla in U.S.

1.8 million/110 = $16,364

• price of Saturn in Japan

13,500 x 110 = 1.485 million yen

• $ depreciated Corolla is more expensive here Saturn is cheaper in Japan

• price of Corolla in U.S.

1.8 million/110 = $16,364

• price of Saturn in Japan

13,500 x 110 = 1.485 million yen

• $ depreciated Corolla is more expensive here Saturn is cheaper in Japan

In general,In general,In general,In general,

• $ appreciates imports cheaper, exports pricier U.S. trade deficit rises

• $ depreciates imports pricier, exports cheaper U.S. trade deficit falls

• $ appreciates imports cheaper, exports pricier U.S. trade deficit rises

• $ depreciates imports pricier, exports cheaper U.S. trade deficit falls

• exchange rate movement short-run volatility long-run trends

• exchange rate movement short-run volatility long-run trends

II. Exchange rates in LRII. Exchange rates in LRII. Exchange rates in LRII. Exchange rates in LR

A. Purchasing power parity (PPP)

• if countries have different inflation rates, exchange rate movement

• law of one price identical goods should have same

value all over world

A. Purchasing power parity (PPP)

• if countries have different inflation rates, exchange rate movement

• law of one price identical goods should have same

value all over world

exampleexampleexampleexample

• pack of gum

• 120 yen/$

• gum = $1 in U.S.

• gum = 120 yen in Japan

• pack of gum

• 120 yen/$

• gum = $1 in U.S.

• gum = 120 yen in Japan

• U.S. prices double gum = $2

• if still 120 yen/$ gum is cheaper in Japan (120 yen) everyone buys gum in Japan

• exchange rate moves, 120 yen/$2 or 60 yen/$

• U.S. prices double gum = $2

• if still 120 yen/$ gum is cheaper in Japan (120 yen) everyone buys gum in Japan

• exchange rate moves, 120 yen/$2 or 60 yen/$

PPPPPPPPPPPP

• if U.S. prices rise faster than world,

$ depreciates

• if U.S. prices rise more slowly,

$ appreciates

• if U.S. prices rise faster than world,

$ depreciates

• if U.S. prices rise more slowly,

$ appreciates

• PPP works in LR

• PPP lousy in SR

• why? assumes goods transportable

cheaply

-- gum, yes

-- haircuts, no assumes goods identical

• PPP works in LR

• PPP lousy in SR

• why? assumes goods transportable

cheaply

-- gum, yes

-- haircuts, no assumes goods identical

B. Other factorsB. Other factorsB. Other factorsB. Other factors

• anything impacting relative demand for U.S. stuff vs. foreign stuff

• increase demand U.S. stuff,

increase demand for $,

$ appreciates

• anything impacting relative demand for U.S. stuff vs. foreign stuff

• increase demand U.S. stuff,

increase demand for $,

$ appreciates

tariffs and quotastariffs and quotastariffs and quotastariffs and quotas

• U.S. tariffs

• increase domestic demand

• $ appreciates

• (but other nations could retaliate)

• U.S. tariffs

• increase domestic demand

• $ appreciates

• (but other nations could retaliate)

preferencespreferencespreferencespreferences

• U.S. consumers prefer foreign SUVs

• increase import demand,

decrease $ demand,

$ depreciates

• U.S. consumers prefer foreign SUVs

• increase import demand,

decrease $ demand,

$ depreciates

productivityproductivityproductivityproductivity

• U.S. more productive,

make goods at lower cost,

U.S. goods more desirable,

$ demand increases,

$ appreciates

• U.S. more productive,

make goods at lower cost,

U.S. goods more desirable,

$ demand increases,

$ appreciates

III. Exchange rates in SRIII. Exchange rates in SRIII. Exchange rates in SRIII. Exchange rates in SR

• driven by investor behavior

• capital mobility investors chose assets globally

• driven by investor behavior

• capital mobility investors chose assets globally

example: Japanese investorexample: Japanese investorexample: Japanese investorexample: Japanese investor

• U.S. CD ($) or

• Japanese CD (yen)

• i$ = 7%, iyen = 5%

• currently 105 yen/$

• expect 90 yen/$ in 1 year

• U.S. CD ($) or

• Japanese CD (yen)

• i$ = 7%, iyen = 5%

• currently 105 yen/$

• expect 90 yen/$ in 1 year

Japanese CDJapanese CDJapanese CDJapanese CD

• deposits 105,000 yen

• in one year

105,000 (1+.05)

= 110,250 yen

• deposits 105,000 yen

• in one year

105,000 (1+.05)

= 110,250 yen

U.S. CDU.S. CDU.S. CDU.S. CD

• convert yen to $ (105 yen/$):

105,000/105 = $1000

• deposit $1000 in CD

• in one year:

$1000(1+.07) = $1070

• convert back to yen (90 yen/$):

$1070 x 90 = 96,300 yen

• convert yen to $ (105 yen/$):

105,000/105 = $1000

• deposit $1000 in CD

• in one year:

$1000(1+.07) = $1070

• convert back to yen (90 yen/$):

$1070 x 90 = 96,300 yen

• U.S. interest rate is higher BUT

• given expected depreciation of $,

• investor better off w/ Japanese CD

• U.S. interest rate is higher BUT

• given expected depreciation of $,

• investor better off w/ Japanese CD

U.S. investorU.S. investorU.S. investorU.S. investor

• U.S. CD: $1070

• Japanese CD:

$1000 x 105 = 105,000 yen

105,000(1.05) = 110,250 yen

110,250/90 = $1225

• U.S. investor better off holding Japanese CD

• U.S. CD: $1070

• Japanese CD:

$1000 x 105 = 105,000 yen

105,000(1.05) = 110,250 yen

110,250/90 = $1225

• U.S. investor better off holding Japanese CD

• in this example, no one would hold a U.S. CD

• so it must be the case that expected returns equalize across

countries interest rate parity

• in this example, no one would hold a U.S. CD

• so it must be the case that expected returns equalize across

countries interest rate parity

Interest Rate ParityInterest Rate ParityInterest Rate ParityInterest Rate Parity

• exp. returns equalize across countries based on interest rate, exchange

rates

• so a change in interest rate

will cause exchange rate to change

• exp. returns equalize across countries based on interest rate, exchange

rates

• so a change in interest rate

will cause exchange rate to change

Interest rates & exchange ratesInterest rates & exchange ratesInterest rates & exchange ratesInterest rates & exchange rates

• nominal interest rate =

real interest rate + exp. inflation rate

• if nominal interest rate rises, either

real interest rate increased

or

exp. inflation rate increased

• nominal interest rate =

real interest rate + exp. inflation rate

• if nominal interest rate rises, either

real interest rate increased

or

exp. inflation rate increased

• U.S. real interest rate rises increase demand for $ $ appreciates

• foreign real interest rate rises decrease demand for $ $ depreciates

• U.S. real interest rate rises increase demand for $ $ appreciates

• foreign real interest rate rises decrease demand for $ $ depreciates

• U.S. expected inflation rises under PPP, $ depreciates

• U.S. money supply rises increase exp. inflation decrease nominal interest rate $ depreciates

• U.S. expected inflation rises under PPP, $ depreciates

• U.S. money supply rises increase exp. inflation decrease nominal interest rate $ depreciates

Why has the U.S. dollar fallen Why has the U.S. dollar fallen since 2002?since 2002?Why has the U.S. dollar fallen Why has the U.S. dollar fallen since 2002?since 2002?

• decline in private foreign investment EU becoming more attractive?

• twin deficits U.S. trade deficit U.S. federal budget deficits large amount of borrowing makes

our currency less attractive

• decline in private foreign investment EU becoming more attractive?

• twin deficits U.S. trade deficit U.S. federal budget deficits large amount of borrowing makes

our currency less attractive

Why do we care?Why do we care?Why do we care?Why do we care?

• U.S. $ as world reserve currency allows us to borrow cheaply falling $ place this status as risk

• Currency instability huge disruptions to trade, financial

markets

• U.S. $ as world reserve currency allows us to borrow cheaply falling $ place this status as risk

• Currency instability huge disruptions to trade, financial

markets

The future?The future?The future?The future?

• some predict continued decline of $ compare to British pound 60 years

ago…

• however, $ has been lower… mid 1990s dollar much lower

against yen, deutschmark

• some predict continued decline of $ compare to British pound 60 years

ago…

• however, $ has been lower… mid 1990s dollar much lower

against yen, deutschmark