Ch. 15: The Foreign Exchange Market

Nominal exchange rates

£/$: The value of the U.S. dollar in terms of British pounds (from a U.S. perspective).

$/£: The value of the British pound in terms of U.S. dollars (from a U.K. perspective).

Appreciation of dollar means it gains value and can buy more pounds

Depreciation of pound means loses value and buys fewer dollars

Spot and forward transactions

Spot: immediate exchange (within 1 or 2 days)

Forward: specified future date, with terms (exchange rate) agreed in advance

Why are exchange rates important?

Influence relative price of domestic and foreign goods. If the £/$ exchange rate increases, British imports to the U.S. become cheaper, while if the $/£ exchange rate decreases, U.S. exports to the U.K. become more expensive.

A depreciating currency raises costs of imports.

Law of one price & PPP

If 2 countries produce identical good (transportation costs/trade barriers minimal), price of good should be same globally after adjusting exchange rates.

PPP extends this, suggesting exchange rates between 2 currencies adjust to reflect relative price levels of 2 countries.

The big mac index

Created by the economist 1986 compares price of big mac across countries to test PPP. 7/2024, Swiss franc most overvalued (+42%), new Taiwan dollar least (-60%). Canada close (-3%) because economic conditions similar to U.S., reducing price disparities.

Real exchange rates

Rate at which domestic goods can be exchanged for foreign goods.

Nominal exchange rate * domestic price all divided by foreign price

This rate should tend toward 1

Factors affecting long-run exchange rates

Direct or inverse w factor change & exchange rate?

Relative price (PPP theory - inverse)

Trade barriers (removal supports PPP - direct)

Consumer preference (import vs. domestic - inverse)

Production location (cost advantage affects rates - direct)

Productivity (higher boosts export demand - inverse)

How do other factors change quantity demanded?

Increase iD: shift demand domestic right, currency appreciation (E up)

Increase iF: shift demand domestic left, currency depreciation (E down)

Rise Eet+1: shift demand domestic right, currency appreciation (E up)

Increase expected inflation: decrease demand domestic, currency depreciation (E down)

Uncovered interest parity and international arbitrage

UIP assets return on domestic and foreign bonds should be equal when adjusted for exchange rate risk. Based on idea of no arbitrage.

Domestic interest rate is foreign interest rate minus expected change in exchange rate

Case study: Japan revisited

Japan raised while we cut rates. Gap widened from 2.9 to 3.34

Dollar appreciated against yen Q1. U.S. asset demand low Japan asset demand high

Dollar appreciate further Q2 UIP predicts