Chapter 6: The Foreign Exchange Market

Introduction to Exchange Rates and Quotation

Nominal Exchange Rate Definition: The nominal exchange rate is defined as the price of one currency expressed in units of another currency. It is the equilibrium price determined on the foreign exchange market.
Quotation Perspectives:
- - Indirect Quotation: The price of one unit of domestic currency expressed in units of foreign currency ( $E$ ).
- - Direct Quotation: The price of one unit of foreign currency expressed in units of domestic currency (the inverse, $\frac{1}{E}$ ).
Swiss Perspective Examples (Source: xe.com as of December 3rd, 2023):
- - Indirect Quotation (1 CHF): - Direct Quotation (1 Foreign Unit):
  - - $1\text{ CHF} = 1.06\text{ EUR}$ - $1\text{ EUR} = 0.94\text{ CHF}$
  - - $1\text{ CHF} = 0.91\text{ GBP}$ - $1\text{ GBP} = 1.10\text{ CHF}$
  - - $1\text{ CHF} = 1.15\text{ USD}$ - $1\text{ USD} = 0.87\text{ CHF}$
  - - $1\text{ CHF} = 1.55\text{ CAD}$ - $1\text{ CAD} = 0.64\text{ CHF}$
  - - $1\text{ CHF} = 169\text{ JPY}$ - $1\text{ JPY} = 0.0059\text{ CHF}$

Nominal vs. Real Exchange Rate: - Nominal Exchange Rate: The simple price of currency against another. - Real Exchange Rate: This is the ratio comparing the price of foreign goods and services (G&S) converted into local/domestic currency versus the price of domestic goods and services in domestic currency.

The Foreign Exchange Market Model

Market Participants: A market where agents wishing to exchange one currency for another meet. Commercial banks act as the primary intermediaries in this market.
General Framework: The exchange rate ( $E$ ) varies based on shifts in supply and demand (expansions or contractions). This is distinct from the traditional money market approach.
Core Components of the Model: - Part A: International Trade in Goods and Services: Includes Imports (domestic residents buying foreign G&S) and Exports (non-residents buying domestic G&S). - Part B: Foreign Investments: Includes Capital Outflows (domestic residents buying foreign assets, typically securities like stocks and bonds) and Capital Inflows (non-residents buying domestic assets).
Key Assumptions: Residents do not hoard foreign currency; they exchange it for domestic currency as needed.

Part A: International Trade and Partial Net Demand (PND)

Mechanics of Exchange: - Exports: Give rise to a supply of foreign currency (e.g., EUR) and a demand for domestic currency (e.g., CHF). Example: A Swiss watch manufacturer sells watches. If paid in EUR, they sell EUR for CHF. If paid in CHF, the buyer must first sell EUR for CHF. - Imports: Give rise to a demand for foreign currency (e.g., EUR) and a supply of domestic currency (e.g., CHF).
Net Exports (NX): - Formula: $\text{NX} = \text{Exports} - \text{Imports}$ . - Identity: $\text{NX} \equiv \text{Demand for CHF} - \text{Supply of CHF}$ .
Partial Net Demand (PND): This is the net quantity of domestic currency demanded for international trade transactions. - $\text{PND} \equiv \text{D}{\text{CHF}} - \text{S}{\text{CHF}}$ (for international trade). - $\text{PND} = \text{NX}$ . - Note: NX and PND have the same value ( $\Delta \text{NX} = \Delta \text{PND}$ ).
Shocks to NX and PND: - Appreciation of CHF (Increase in E): Decrease in NX and PND (Swiss goods become more expensive for foreigners; foreign goods become cheaper for Swiss). - Domestic Inflation (Swiss price increase): Decrease in NX and PND (Swiss goods become less competitive). - Foreign Inflation (Foreign price increase): Increase in NX and PND. - Fall in foreign demand for Swiss goods: Decrease in NX and PND. - Increase in Swiss demand for foreign goods: Decrease in NX and PND. - Import Barriers in Switzerland: Increase in NX and PND.
The PND Curve Graph: - The curve is downward sloping relative to the exchange rate ( $E$ ). - Movement along the curve: Caused by a change in the exchange rate ( $E$ ). - Shift of the curve: Caused by factors other than $E$ (e.g., Swiss inflation or increased needs for foreign G&S cause a contraction/leftward shift).

Part B: Foreign Investments and Partial Net Supply (PNS)

Mechanics of Investment: - Capital Outflow: Purchasing a foreign asset (e.g., a Swiss firm buying a French bond). This requires buying EUR by selling CHF (Supply of CHF, Demand for EUR). - Capital Inflow: A non-resident buying a domestic asset (Demand for CHF, Supply of EUR).
Net Foreign Investments (NFI): - Formula: $\text{NFI} = \text{Capital Outflows} - \text{Capital Inflows}$ . - Identity: $\text{NFI} \equiv \text{Supply of CHF} - \text{Demand for CHF}$ .
Partial Net Supply (PNS): This is the net quantity of national currency supplied for foreign investment purposes. - $\text{PNS} \equiv \text{S}{\text{CHF}} - \text{D}{\text{CHF}}$ (for foreign investments). - $\text{PNS} = \text{NFI}$ .
Shocks to NFI and PNS: - Swiss Interest Rate ( $i$ ) Increase: Decrease in NFI and PNS (Inflows increase, Outflows decrease). - Foreign Interest Rate ( $i^*$ ) Increase: Increase in NFI and PNS (Residents seek higher returns abroad). - Anticipation of CHF Rise (Rise in E): Decrease in NFI and PNS (Investors want to hold CHF). - Anticipation of EUR Depreciation: Decrease in NFI and PNS. - Lack of interest in domestic (Swiss) bonds: Increase in NFI and PNS. - Barriers to capital inflows: Increase in NFI and PNS.
The PNS Curve Graph: - The curve is vertical. This is because, in the absence of anticipations, the current exchange rate $E$ has no impact on NFI or PNS. - Movement along the curve: The exchange rate does not influence PNS. - Shift of the curve: Caused by changes in interest rates or anticipations (e.g., $\Delta+ i \rightarrow \Delta- \text{NFI} \rightarrow \text{PNS contraction/leftward shift}$ ).

Equilibrium in the Foreign Exchange Market

Market Equilibrium: Occurs where $\text{PND} = \text{PNS}$ . - This equality implies $\text{NX} = \text{NFI}$ . - At the equilibrium exchange rate ( $E^*$ ), the quantity of CHF supplied matches the quantity demanded ( $\text{S}{\text{CHF}} - \text{D}{\text{CHF}} = \text{D}{\text{CHF}} - \text{S}{\text{CHF}}$ ).
Adjustment Process (Example: Fall in domestic interest rate $i$ ): - A fall in $i$ leads to a rise in NFI, causing a PNS expansion (rightward shift). - At the initial exchange rate ( $E_0$ ), there is now an Excess Supply ( $S_{EXC}$ ): investors want to sell more CHF than merchants want to buy. - Sellers must reduce the price (E) to find buyers. - As $E$ decreases: - NX and PND increase (movement along the PND curve). - PNS is unaffected by the current $E$ change (movement along the vertical PNS). - The market converges to a new, lower equilibrium exchange rate ( $E_1$ ) where the excess supply is absorbed.

Examples of Market Shocks

Example 1: Increase in Domestic Interest Rate ( $i$ ): - Logic: $\Delta+ i \rightarrow \Delta- \text{Outflows, } \Delta+ \text{Inflows} \rightarrow \Delta- \text{NFI}$ . - Graphical Impact: PNS shifts left (contraction). - Result: CHF appreciation (Increase in $E$ ).
Example 2: Increase in Foreign Interest Rate ( $i^$ ): - Logic: $\Delta+ i^ \rightarrow \Delta+ \text{Outflows, } \Delta- \text{Inflows} \rightarrow \Delta+ \text{NFI}$ . - Graphical Impact: PNS shifts right (expansion). - Result: CHF depreciation (Decrease in $E$ ).
Example 3: Increase in Foreign Demand for Swiss G&S: - Logic: $\Delta+ \text{Foreign demand} \rightarrow \Delta+ \text{Swiss Exports} \rightarrow \Delta+ \text{NX}$ . - Graphical Impact: PND shifts right (expansion). - Result: CHF appreciation (Increase in $E$ ).

Central Bank Interventions

Objective: Central banks (CB) may intervene to maintain the exchange rate within a specific predefined range.
Tools for Intervention: - Interest Rates: Acting on $i$ to influence NFI and consequently $E$ . - Buying/Selling Foreign Assets: The CB can enter the market as an investor, exchanging domestic currency for foreign assets.
Specific SNB Actions: - To Depreciate CHF: The Swiss National Bank (SNB) lowers $i$ and/or buys EUR (foreign assets) while selling CHF. - To Appreciate CHF: The SNB increases $i$ and/or buys CHF while selling EUR (foreign assets).