Open Economy Macroeconomics: Exchange Rate & Competitiveness

Foreign Exchange (FOREX) Market

Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
Exchange rates allow us to denominate the cost or price of a good or service in a common currency.
Depreciation: A decrease in the value of a currency relative to another currency. A depreciated currency is less valuable and can be exchanged for a smaller amount of foreign currency.
Appreciation: An increase in the value of a currency relative to another currency. An appreciated currency is more valuable and can be exchanged for a larger amount of foreign currency.
FOREX markets are sets of markets where foreign currencies and other assets are exchanged for domestic ones, where institutions buy and sell deposits of currencies or other assets for investment purposes.
Daily volume of foreign exchange transactions was 4.0 trillion in April 2010, up from 500 billion in 1989.
Most transactions (85% in April 2010) exchange foreign currencies for U.S. dollars.
Participants in FOREX Market:
- Commercial banks: buying/selling of deposits in different currencies for investment purposes.
- Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment.
- Non-financial businesses conduct foreign currency transactions to buy/sell goods, services, and assets.
- Central banks conduct official international reserves transactions.
Buying and selling in the foreign exchange market are dominated by commercial and investment banks.
Inter-bank transactions of deposits in foreign currencies occur in amounts \$1 million or more per transaction.
Computer & telecommunications technology transmit information rapidly and have integrated markets. Integration of financial markets implies that there can be no significant differences in exchange rates across locations.
Arbitrage: Buy at a low price and sell at a higher price for a profit.
Example: If euro were to sell for \$1.1 in New York and \$1.2 in London, you could buy euros in New York (where cheaper) and sell them in London at a profit.
Spot rates: Exchange rates for currency exchanges “on the spot,” or when trading is executed in the present.
Forward rates: Exchange rates for currency exchanges that will occur at a future (“forward”) date.
Forward dates are typically 30, 90, 180, or 360 days in the future.
Rates are negotiated between two parties in the present, but the exchange occurs in the future.
Foreign exchange swaps: A combination of a spot sale with a forward repurchase.
Swaps allow parties to meet each other’s needs for a temporary amount of time, and they often cost less in fees than separate transactions.
Example: Suppose Toyota receives \$1 million from American sales, plans to use it to pay its California suppliers in three months but wants to invest the money in euro bonds in the meantime.
Factors that influence the return on assets determine the demand for those assets.
- Rate of return: The percentage change in value that an asset offers during a time period.
  Example: Annual return for \$100 savings deposit with an interest rate of 2% is 100 × 1.02 = \$102.
- Risk: Risk of holding assets also influences decisions about whether to buy them.
- Liquidity of an asset: It is the ease of using the asset to buy goods and services.
Risk and liquidity of currency deposits in foreign exchange markets are essentially the same, regardless of their currency denomination.
Investors are primarily concerned about the rates of return on currency deposits, determined by:
- Interest rates that the assets will earn
- Expectations about appreciation or depreciation
Rate of return for a deposit in domestic currency is the interest rate that the deposit earns.

Demand for Currency Deposits

To compare the rate of return on a deposit in domestic currency with one in foreign currency, let’s consider:
- Interest rate for the foreign currency deposit
- Expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency.
  Example:
- Suppose the interest rate on a dollar deposit is 2%.
- Suppose the interest rate on a euro deposit is 4%.
- If today the exchange rate is \$1/€1, and the expected rate one year in the future is \$0.97/€1, then \$100 can be exchanged today for €100. These €100 will yield €104 after one year (at 4% interest rate). These €104 are expected to be worth \$0.97/€1 × €104 = \$100.88 in one year.
The rate of return in terms of dollars from investing in euro deposits is:
Expected rate of appreciation of the euro was:
Dollar rate of return on euro deposits approximately equals:
- Interest rate on euro deposits PLUS
- Expected rate of appreciation of euro deposits
- 4% + (−3%) = 1% ≈ 0.88%

Model of Foreign Exchange Markets

Equilibrium: Model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity.
Interest parity implies that deposits in all currencies are equally desirable assets.
Interest parity implies that arbitrage in the foreign exchange market is not possible.
Interest parity condition:
If the interest parity condition does not hold, then no investor would want to hold euro deposits, driving down the demand and price of euros. All investors would want to hold dollar deposits, driving up the demand and price of dollars. Dollar would appreciate and euro would depreciate, increasing the right side until equality was achieved.

Model of Foreign Exchange Markets

How do changes in current exchange rate affect the expected rate of return of foreign currency deposits?
* Depreciation of domestic currency today lowers the expected rate of return on foreign currency deposits. When domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits.
* Appreciation of domestic currency today raises the expected return of deposits on foreign currency deposits. When domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby lowering the expected rate of return of foreign currency deposits.

Equilibrium in the foreign exchange market is where the expected dollar returns on dollar and euro deposits are equal.
Effects of changing interest rates:
- Increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. This leads to an appreciation of the currency.
  - Higher interest rates on dollar-denominated assets cause the dollar to appreciate.
  - Higher interest rates on euro-denominated assets cause the dollar to depreciate.
If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollar-denominated goods. Expected rate of return on euros therefore increases.
Expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy).
Covered interest parity relates interest rates across countries and the rate of change between forward exchange rate and spot exchange rate:
where F\$ /€ is the forward exchange rate.
It says that rates of return on dollar deposits and “covered” foreign currency deposits are the same.

Money Market & FOREX Market

Domestic interest rates directly affect the rates of return on domestic currency deposits in the foreign exchange markets. Now, what determines the domestic interest rates?
- Money Supply: The central bank substantially controls the quantity of money that circulates in an economy.
- Money demand represents the amount of monetary assets that people are willing to hold (instead of illiquid assets).
  What influences willingness to hold monetary assets?
Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non-monetary assets.
Risk: The risk of holding monetary assets principally comes from unexpected inflation, which reduces the purchasing power of money.
Liquidity: A need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions increases.
Interest rates/expected rates of return: Monetary assets pay little or no interest, so the interest rate on non-monetary assets like bonds, loans, and deposits is the opportunity cost of holding monetary assets. Higher interest rate means a higher opportunity cost of holding monetary assets ® lower demand for money.
Prices: Prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions. Higher level of average prices means a greater need for liquidity to buy the same amount of goods and services ® higher demand for money.
Income: Greater income implies more goods and services can be bought, so that more money is needed to conduct transactions. Higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity ® higher demand for money.
Aggregate demand for money can be expressed as:
Where:
P is the price level
Y is real national income
R is a measure of interest rates on nonmonetary assets
L(R,Y) is the aggregate demand for real monetary assets.
Aggregate demand for real monetary assets is a function of national income and interest rates.
Money market is where monetary or liquid assets, which are loosely called “money,” are lent and borrowed.
Domestic interest rates directly affect the rates of return on domestic currency deposits in the foreign exchange markets.
When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium:
Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium:
For a given price level, P, and real income level, Y, an increase in the money supply from M1 to M2 reduces the interest rate from R1 to R2 .
Given the real money supply, , a rise in real income from Y1 to Y2 raises the interest rate from R1 to R2 .
Both asset markets are in equilibrium at the interest rate R1 and exchange rate E1; at these values, the money supply equals money demand and the interest parity condition holds.
Monetary policy actions by Fed affect the U.S. interest rate, changing the dollar/euro exchange rate that clears the foreign exchange market. The ECB can affect exchange rate by changing the European money supply and interest rate.
Given PUS and YUS when money supply rises from M1 to M2 the dollar interest rate declines (as money market equilibrium is reestablished at point 2) and the dollar depreciates against the euro (as foreign exchange market equilibrium is reestablished at point 2’).

Changes in Money Supply

(A) Changes in Domestic Money Supply
- Increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate.
- Decrease in a country’s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate.
(B) Changes in Foreign Money Supply
- How would a change in the supply of euros affect the U.S. money market and foreign exchange markets?
- Increase in the supply of euros causes a depreciation of euro (an appreciation of dollar).
- Decrease in the supply of euros causes an appreciation of euro (a depreciation of dollar).
- Increase in the supply of euros reduces interest rates in the EU, reducing the expected rate of return on euro deposits. This reduction in the expected rate of return on euro deposits causes the euro to depreciate.
By lowering dollar return on euro deposits (shown as a leftward shift in the expected euro return curve), an increase in Europe’s money supply causes the dollar to appreciate against the euro. Equilibrium in the foreign exchange market shifts from point 1’ to point 2’ but equilibrium in the U.S. money market remains at point 1.

Long Run and Short Run

The analysis heretofore has been a short-run analysis.
In the short run, prices do not have sufficient time to adjust to market conditions.
In the long run, prices of factors of production and of output have sufficient time to adjust to market conditions.
Wages adjust to the demand and supply of labor.
(Real) interest rates depend on the supply of saved funds and the demand for saved funds.
In the long run, the quantity of money supplied is predicted not to influence the amount of output, (real) interest rates, and the aggregate demand for real monetary assets L(R,Y).
Quantity of money supplied is predicted to make the level of average prices adjust proportionally in the long run.
Equilibrium condition shows that P is predicted to adjust proportionally when Ms adjusts because L(R,Y) does not change.
In the long run, there is a direct relationship between inflation rate and changes in money supply.
Inflation rate is predicted to equal the growth rate in money supply minus the growth rate in money demand.

Money and Prices in the Long Run

How does a change in money supply cause prices of output and inputs to change?

Excess demand for goods and services: A higher quantity of money supplied implies that people have more funds available to pay for goods and services. To meet high demand, producers hire more workers, creating a strong demand for labor services, or make existing employees work harder. Wages rise to attract more workers or to compensate workers for overtime. Prices of output will eventually rise to compensate for higher costs.
Alternatively, for a fixed amount of output and inputs, producers can charge higher prices and still sell all of their output due to the high demand.
Inflationary expectations: If workers expect future prices to rise due to an expected money supply increase, they will want to be compensated. And if producers expect the same, they are more willing to raise wages. Producers will be able to match higher costs if they expect to raise prices. Result: expectations about inflation caused by an expected increase in money supply causes actual inflation.
When we consider price changes in the long run, inflationary expectations will have an effect in foreign exchange markets. Suppose that expectations about inflation change as people change their minds, but actual adjustment of prices occurs afterward.
Permanent increase in a country’s money supply causes a proportional long-run depreciation of its currency. However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation.
Permanent decrease in a country’s money supply causes a proportional long-run appreciation of its currency. However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation.
Exchange rate is said to overshoot when its immediate response to a change is greater than its long-run response.
Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation.
Overshooting helps explain why exchange rates are so volatile.

Summary

Equilibrium in foreign exchange market occurs when rates of returns on deposits in domestic currency and in foreign currency are equal: interest rate parity.
Increase in interest rate on a currency’s deposit leads to an increase in its expected rate of return and to an appreciation of currency.
Expected appreciation of a currency leads to an increase in expected rate of return for that currency and leads to an actual appreciation.
Covered interest parity says that rates of return on domestic currency deposits and “covered” foreign currency deposits using forward exchange rate are the same.
When money market is in equilibrium, there are no surpluses or shortages of monetary assets: the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded.
Short-run scenario: changes in money supply affect domestic interest rates, as well as exchange rate.
- An increase in domestic money supply lowers domestic interest rates, thus lowering the rate of return on deposits of domestic currency and thus causing the domestic currency to depreciate.
Long-run scenario: changes in the quantity of money supplied are matched by a proportional change in prices and do not affect real income and real interest rates.