The Foreign Exchange Market
1
2
Asian Currencies vs. U.S. Dollar
The Foreign Exchange Market
Definitions:
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
210
190
170
MYR/USD
PHP/USD
150
Index
SGD/USD
Currency appreciates, country’s goods prices  abroad and foreign
goods prices  in that country
KRW/USD
130
TWD/USD
THB/USD
110
1. Makes domestic businesses less competitive
2. Benefits domestic consumers
90
3
Month
Jul-99
Sep-99
Jan-99
Mar-99
May-99
Jul-98
Nov-98
Sep-98
Jan-98
Mar-98
May-98
Jul-97
Nov-97
Sep-97
Jan-97
Mar-97
May-97
Jul-96
Nov-96
Sep-96
Jan-96
Mar-96
May-96
Jul-95
Nov-95
Mar-95
Sep-95
May-95
Jan-95
70
4
FX traded in over-the-counter market
1. Trade is in bank deposits denominated in different currencies
Currency Depreciation and
Appreciation
The Foreign Exchange Market
Exchange rate
Peso/$
D
S

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
Supply of Dollars by
people who want pesos
Demand for Dollars by
people who have pesos
Foreign exchange (dollars)
5
6
Changes in the Equilibrium
Exchange Rate
Exchange rate
Peso/$
D
Exchange Rate Regimes
Supply of Dollars
S by people who
S’ want pesos

Flexible (Floating) exchange rates.

Fixed exchange rates.
$ -depreciation
Peso- appreciation
–
–
Demand for Dollars by
people who have pesos

Foreign exchange (dollars)
7
8
Currency Board
Monetary Union
Managed Float (Dirty Float) exchange rates.
11
Foreign exchange ($)
12
Month
Sep-99
Jul-99
May-99
Mar-99
Jan-99
Nov-98
Sep-98
Jul-98
May-98
Mar-98
Jan-98
Nov-97
Sep-97
Jul-97
May-97
Mar-97
Jan-97
Nov-96
Sep-96
Jul-96
May-96
25
Mar-96
S
Jan-96
Currency Crisis
Nov-95
9
Sep-95
Foreign exchange (pounds)
170
110
90
70
3/2/2007
2/2/2007
1/2/2007
12/2/2006
11/2/2006
10/2/2006
9/2/2006
8/2/2006
7/2/2006
6/2/2006
5/2/2006
4/2/2006
3/2/2006
2/2/2006
1/2/2006
12/2/2005
11/2/2005
10/2/2005
9/2/2005
8/2/2005
7/2/2005
6/2/2005
5/2/2005
4/2/2005
3/2/2005
2/2/2005
1/2/2005
12/2/2004
11/2/2004
10/2/2004
9/2/2004
8/2/2004
7/2/2004
6/2/2004
5/2/2004
4/2/2004
3/2/2004
2/2/2004
1/2/2004
S
Jul-95
52
D
D’’
May-95
Exchange rate
Baht/$
D’
Mar-95
Index
Exchange rate
$/pound
Jan-95
The Central Bank Can Intervene to Maintain
Exchange Rates
China
8.4
Chinese Yuan to One U.S. Dollar
8.3
8.2
8.1
7.9
8
7.8
7.7
7.6
7.5
7.4
10
Asian Currencies vs. U.S. Dollar
D’
210
190
150
MYR/USD
PHP/USD
130
SGD/USD
KRW/USD
TWD/USD
THB/USD
Law of One Price
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
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
$200
10,000 yen
Problems with PPP
1. All goods not identical in both countries: Toyota vs Chevy
2. Many goods and services are not traded: e.g. haircuts
If E = 100 yen/$ then prices are:
In U.S.
In Japan
13
American Steel
Japanese Steel
$100
10,000 yen
$100
10,000 yen
Law of one price  E = 100 yen/$
14
PPP: U.S. and U.K
Big
Mac
Index
15
16
Exchange Rates in the Short
Run
Factors Affecting E in Long Run
17
Basic Principle: If factor increases demand for domestic
goods relative to foreign goods, E 
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
18
Comparing Expected Returns I
Comparing Expected Returns II
Dollar assets pay an interest rate of i D and do not have any capital gain
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
F
Foreign assets have an interest rate of i 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
R D in term of euros = i D 
E
Ete1  Et
Et
The expected return on foreign assets R F is i F
Et+1  the exchange rate for the next period
Relative R D  i D  i F 
e
t+1
19

- Et
 the expected rate of appreciation for the dollar
Et
Ete1  Et
Et
As the relative expected return on dollar assets increases, foreigners
will want to hold more dollar assets
20
Comparing Expected Returns III
Interest Parity Condition
The expected return on foreign assets R F in terms of dollars
iD  iF 
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
R F in terms of dollars = i F 
e
Et1
 Et
Et

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
The expected return on the dollar assets R D is i D
E e  Et
E e  Et
Relative R D  i D  (i F  t1
)  i D  i F  t1
Et
Et
21
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
domestic residents will want to hold more dollar assets
22
Demand and Supply
for Domestic Assets

Demand
–
–

Supply
–
–
23
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
24
e
Et1
 Et
Et
25
26
Exchange Rate Overshooting

Monetary Neutrality
–

The exchange rate falls by more in the short run than
in the long run
–
27
28
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
The Dollar and Interest Rates

29
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
30
Exchange Rate Regimes

Fixed exchange rate regime
–

Floating exchange rate regime
–

32
Value of a currency is allowed to fluctuate against all other
currencies
Managed float regime (dirty float)
–
31
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
(cont’d)
Past Exchange Rate Regimes

–
–
–


Gold standard
–
–
World Bank
General Agreement on Tariffs and Trade (GATT)


Fixed exchange rates using U.S. dollar as
reserve currency
International Monetary Fund (IMF)
33
34
35
36
World Trade Organization
European Monetary System
–
Bretton Woods System
–
Bretton Woods System (cont’d)
–
Fixed exchange rates
No control over monetary policy
Influenced heavily by production of gold and
gold discoveries
Exchange rate mechanism
How a Fixed Exchange Rate
Regime Works


How Bretton Woods Worked
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
37
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
38
Managed Float

–
Small daily changes in response to market
Interventions to prevent large fluctuations

Appreciation hurts exporters and employment

Depreciation hurts imports and
stimulates inflation

European Monetary System
Hybrid of fixed and flexible
–
39

Special drawing rights as substitute for gold
40

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 (cont’d)
Capital Controls

Outflows
–
–
–
–


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
–
–
–

Controls may block funds for productions uses
Produce substantial distortion and misallocation
Lead to corruption
Strong case for improving bank regulation
and supervision
Inflows
–
Lead to a lending boom and excessive risk taking by
financial intermediaries
41
42
The IMF: Lender of Last Resort

43
Inflows (cont’d)
How Should the IMF Operate?
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)



44
May not be tough enough
Austerity programs focus on tight
macroeconomic policies rather than financial
reform
Too slow, which worsens crisis and
increases costs
Balance-of-Payments
Considerations
Direct Effects of the Foreign Exchange
Market on the Money Supply

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
45
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
46
Advantages of
Exchange-Rate Targeting
Exchange Rate Considerations
47


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
48

Contributes to keeping inflation
under control

Automatic rule for conduct of
monetary policy

Simplicity and clarity
Disadvantages of
Exchange-Rate Targeting
Exchange-Rate Targeting
for Industrialized Countries

Cannot respond to domestic shocks and
shocks to anchor country are transmitted

Domestic monetary and political institutions
are not conducive to good policy making

Open to speculative attacks on currency


Weakens the accountability of policymakers
as the exchange rate loses value as signal
Other important benefits such
as integration
49
50
Exchange-Rate Targeting
for Emerging Market Countries
51

Political and monetary institutions
are weak

Stabilization policy of last resort
Currency Boards
52

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)
Dollarization

Stronger commitment by central bank


Loss of independent monetary policy
and increased exposure to shock from
anchor country
Another solution to lack of transparency
and commitment

Adoption of another country’s money

Even stronger commitment mechanism
Loss of ability to create money and act as lender of
last resort

Completely avoids possibility of speculative attack
on domestic currency

Lost of independent monetary policy
and increased exposure to shocks from
anchor country

53
54
Dollarization (cont’d)
55

Inability to create money and act as lender
of last resort

Loss of seignorage
Appendix
56

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.
Expected Returns and Interest
Parity
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 
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:
Deriving RD Curve
Points B, D, E, RD = 10%: so curve is vertical
$ and Euro deposits perfect substitutes
iD = iF – (Eet+1 – Et)/Et
Example:
Equilibrium
RD = RF at E*
If Et > E*, RF > RD, sell $, Et 
If Et < E*, RF < RD, buy $, Et 
if iD = 10% and expected appreciation of $,
(Eet+1– Et)/Et, = 5%  iF = 15%
57
58
Shifts in RF
Equilibrium in the Foreign Exchange Market
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 
59
60
Shifts in RD
Foreign Exchange I

RD shifts right when
1. iD ; because RD 
at each Et
Assumes that domestic e
unchanged, so domestic
real rate 


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
–

–
61
Forward exchange rate
62
Exchange Rates in the Long
Run
Foreign Exchange II

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

63
Spot exchange rate
Forward transaction—the exchange of bank deposits
at some specified future date

Law of one price

Theory of Purchasing Power Parity
–
–
–
Over-the-counter market mainly banks
64
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 Shift RF and RD
Factors that Affect Exchange
Rates in the Long Run

Relative price levels

Trade barriers

Preferences for domestic versus
foreign goods

Productivity
65
66
Response to Ms 
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 
67
68
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
The Dollar and Interest Rates
Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting
1.
2.
69
70
71
72
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
73
74
Chapter 18
The International
Financial System
75
Unsterilized Foreign Exchange
Intervention
Federal Reserve System
Assets
Foreign
Assets
(International
Reserves)
77
-$1B
Currency in
circulation
Unsterilized Intervention
Federal Reserve System
Liabilities
Assets
-$1B
Foreign
Assets
(International
Reserves)
Liabilities
-$1B
Deposits with
the Fed
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

-$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
78
Sterilized
Foreign Exchange Intervention
Federal Reserve System
Assets
Liabilities
Foreign Assets
(International Reserves)
-$1B (reserves)
Government Bonds
+$1B


79
80
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
–

81
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