Foreign Exchange and
Exchange Rate
What determines the exchange rate?
{
{
In the long run, (nominal) exchange
rate is determined by PPP
But in the short run, nominal
exchange rate is determined by the
demand and supply of foreign
exchanges in the FE market
The foreign exchange market
{
{
The foreign exchanges (foreign
currencies) are just like
commodities traded in the foreign
exchange market.
Although central banks time to time
intervenes in the market
The foreign exchange market
S
e
e’
D
0
FE’
Foreign exchange (euro € )
Demand for FE
e goes up
e
FE is more expensive
Quantity demand for FE goes down
e’
D
0
Foreign exchange (euro € )
The FE demand curve
{
{
{
{
{
When e goes up
American tourists need to pay more
dollars for one euro
Many American tourists cancels the
trips
Quantity demanded for euro goes
down.
So the demand for FE is downward
sloping.
Supply for FE
S
e
e goes up
e’
euro is more expensive and $ cheaper
More people sell/supply more euros
in exchange for dollars.
0
FE’
Foreign exchange (euro € )
The FE supply curve
{
{
{
{
{
{
When e goes up
FE more expensive / dollar cheaper
Many foreign tourists visit U.S.
They need to sell their foreign
currencies in exchange for dollars
Quantity supplied for FE goes up
So the supply for FE is upward
sloping.
The equilibrium in the foreign exchange
market
{
{
{
The equilibrium exchange rate is
determined by the supply and
demand for FE in the FE market.
Note this is the short run / spot
market equilibrium.
Deviation from the equilibrium will
cause either surplus or shortage of
FEs.
The foreign exchange market
S
e
e’
D
0
FE’
Foreign exchange (euro)
The foreign exchange market
S
e
e”
FE shortage
0
D
Foreign exchange (euro)
The foreign exchange market
{
{
{
The intervention of the government
in the FE market
Breton Woods System required the
U.S. to maintain a fixed exchange
rate between dollar and gold (FE),
referred to as par-value.
Deviation from equilibrium caused
shortage of the gold.
The foreign exchange market
{
{
{
Government intervention to
maintain stability of the exchange
rate
Sell FE (foreign researve) to meet
the shortage and maintain the
overvalued domestic currency
Domestic money supply decreases
The foreign exchange market
{
{
{
{
{
In the case the domestic currency is
undervalued
The government has to buy FE
(foreign reserve) to get rid of the
surplus of FE in the market
Hence foreign reserve increases
Domestic money supply increases
The recent China’s case.
Foreign exchange
{
{
{
The government cannot continuously buy
or sell FE for long time
They will either deplete all foreign reserve
or build up a monster of foreign reserve
that is very costly to maintain.
In both cases, when the government
keeps the exchange rate fixed, they lose
the control of money supply
The Bretton Woods System
{
{
{
{
In 1944, 44 allied nations signed Bretton
Woods Agreements.
The U.S. had 70% of the world gold
reserve.
Each country to adopt a monetary policy
that maintained the exchange rate of its
currency within a fixed value—plus or
minus one percent—in terms of gold; and
the ability of the IMF to bridge temporary
imbalances of payments.
the IMF to bridge temporary imbalances
of payments.
The Bretton Woods System
{
{
{
As foreign countries exchange their
dollars to gold, the U.S. faces an
increasing strain of the gold
reserve.
in 1971, Nixon abandoned the
convertibility of dollars to gold
The Breton Woods system
collapsed.
Backward bending FE supply
e
S
e’
0
Foreign exchange (euro)
Backward bending FE supply
{
{
The supply curve may be backward
bending at a high e level
Why? When e is too high, the FE is
too expensive, it is possible for the
foreigners to use less euros to trade
for more dollars!
Backward bending FE supply
{
An numerical example
e
Dollars
demand by
European
tourists
Euros
supplied by
European
tourists
Supply
of Euros
1
1000
1000/1
1000
2
1400
1400/2
700
Condition for backward bending FE
supply
{
Supply euros equals demand for dollars
S euro ( e) = D $ ( e) / e
{
Backward sloping condtion:
∂D $ ( e)
$
e−D
euro
dS ( e)
= ∂e 2
<0
de
e
Condition for backward bending FE
supply
{
So we have
∂D $ ( e)
e < D$
∂e
{
That is,
∂D ( e) e
<1
$
∂e D
$
{
That is, the demand for $ is price inelastic.
Backward bending FE supply
e
Unstable equilibrium
e’
Surplus
S
0
D
Foreign exchange (euro)
Determinants of the FE demand
{
{
To help understanding, you may
think that the demand is made by
the Americans who plan to tour
Europe and want to buy Euros.
Domestic income
z
z
A high income will raise the demand for
foreign goods and services
Thus increase the demand for FE
Determinants of the FE demand
{
Difference between domestic and
foreign inflation rates: Π – Π*
z
{
If positive, foreign money as safe
heaven, so demand for FE up
Difference between domestic and
foreign interest rates: i – i*
z
difference in returns. If positive,
domestic assets are more attractive,
hence demand for FE down.
Determinants of the FE demand
{
Expectation for future change in e
z
z
z
z
{
If expects a rise in e in future
Expects a depreciation in dollar
Demand for FE increases
Note that change in expectation will
affect the stop market rate
Other factors, such as preference
for foreign goods, services, etc.
Determinants of the FE supply
{
To help understanding, you may
think that the supply of FE is made
by the Europeans who plan to tour
the U.S. and want to sell euros in
order to get dollars.
Determinants of the FE supply
{
{
The determinants for the FE supply
are similar to those affecting the
demand, because, as foreigners’
demand for dollar increases
(decreases), supply of FE increases
(decreases) as well.
Except: domestic income changes
will affect the demand for FE, not
supply of FE.
Determinants of the FE supply
{
{
{
{
Difference between domestic and
foreign inflation rates: Π – Π*
Difference between domestic and
foreign interest rates: i – i*
Expectation for future change in e
Other factors, such as preference
for foreign goods, services, etc.
Spot foreign exchange rate
{
{
{
{
{
Suppose the Fed lows the interest
rate
Demand for FE increases
Supply of the FE decreases
The spot exchange rate goes up
Dollar depreciates.
Spot foreign exchange rate
S’
e
S
e’
e
D’
D
0
FE’
Foreign exchange (euro)
Exchange rates table
Key Currency Cross Rates
Dollar
Euro
Pound
SFranc
Peso
Yen
CdnDlr
Canada
1.1581
1.5454
2.2740
0.95270
0.10515
0.00983
...
Japan
117.87
157.29
231.45
96.964
10.702
...
101.78
Mexico
11.014
14.697
21.627
9.0605
...
0.09344
9.5104
Switzerland
1.2156
1.6221
2.3870
...
0.11037
0.01031
1.0497
U.K.
0.50927
0.67957
...
0.41894
0.04624
0.00432
0.43975
Euro
0.74940
...
1.4715
0.61649
0.06804
0.00636
0.64709
U.S.
...
1.3344
1.9636
0.82264
0.09079
0.00848
0.86348
Exchange rates table
12:38 a.m. EDT 03/30/07asia
Last (bid)
Prior Day †
Australian Dollar
0.8074
0.8066
Hong Kong Dollar
7.8147
7.8127
Indian Rupee
43.558
43.384
Indonesian Rupiah
9121
9124
Japanese Yen
117.83
117.98
Malaysian Ringitt
3.4545
3.4542
Singapore Dollar
1.5168
1.5175
South Korean Won
940.60
940.56
Taiwanese Dollar
33.075
33.058
Thai Baht
34.990
32.352
† Late Thursday in New York.
Exchange rates table
Europe & Others
12:42 a.m. EDT 03/30/07
Last (bid)
Prior Day †
Euro
1.3343
1.3337
Czech Republic Koruna
20.9980
21.0260
Denmark Krone
5.5815
5.5866
Norwegian Krone
6.0793
6.0864
Polish Zloty
2.8990
2.9002
Russian Ruble
25.9939
26.0080
Swedish Krona
6.9749
6.9930
Swiss Franc
1.2158
1.2174
U.K. Pound
1.9633
1.9624
Egyptian Pound
5.6925
5.6964
Israeli Shekel
4.1580
4.1649
South African Rand
7.2400
7.2674
† Late Thursday in New York.
Time lag of the determinants
{
{
The exchange rate is determined by
various determinants, according to
the time span under consideration
In the long run, e is determined by
PPP
Time lag of the determinants
{
{
In the medium run, e is strongly
influenced by trade, i.e., the flow of
goods and services, and physical capital
investment.
In the very short run, the fluctuation of
the exchange rate, et, is mostly affected
by the transfer of financial assets across
the border. It just takes minutes to
transfer billions dollars across borders
now. These determinants shift the supply
and demand of FEs instantly.