The Foreign Exchange Market

3
Index
110 130 150 170 190 210 70 90

Jan-95 Mar-95 May-95 Jul-95 Sep-95 Nov-95 Jan-96 Mar-96 May-96 Jul-96 Sep-96 Nov-96 Jan-97 Mar-97 May-97 Jul-97 Sep-97 Nov-97 Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99
Month THB/USD TWD/USD KRW/USD

Asian Currencies vs. U.S. Dollar

PHP/USD

SGD/USD

MYR/USD

The Foreign Exchange Market

Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Appreciation 4. Depreciation Currency appreciates, countrys goods prices abroad and foreign goods prices in that country

1. Makes domestic businesses less competitive 2. Benefits domestic consumers

FX traded in over-the-counter market 1. Trade is in bank deposits denominated in different currencies

The Foreign Exchange Market

Exchange rate Peso/$

S
Supply of Dollars by people who want pesos

Demand for Dollars by people who have pesos

Foreign exchange (dollars)

Currency Depreciation and Appreciation

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

Changes in the Equilibrium Exchange Rate

Exchange rate Peso/$

Supply of Dollars S by people who S want pesos

$ -depreciation Peso- appreciation

Demand for Dollars by people who have pesos

Foreign exchange (dollars)

Exchange Rate Regimes

Flexible (Floating) exchange rates. Fixed exchange rates.

Currency Board Monetary Union

Managed Float (Dirty Float) exchange rates.

The Central Bank Can Intervene to Maintain Exchange Rates

Exchange rate $/pound

Foreign exchange (pounds)

10
7.4 8 7.5 7.6 7.7 7.8 7.9 8.1 8.2 8.3 8.4

1/2/2004 2/2/2004 3/2/2004 4/2/2004 5/2/2004 6/2/2004 7/2/2004 8/2/2004 9/2/2004 10/2/2004 11/2/2004 12/2/2004 1/2/2005 2/2/2005 3/2/2005 4/2/2005 5/2/2005 6/2/2005 7/2/2005 8/2/2005 9/2/2005 10/2/2005 11/2/2005 12/2/2005 1/2/2006 2/2/2006 3/2/2006 4/2/2006 5/2/2006 6/2/2006 7/2/2006 8/2/2006 9/2/2006 10/2/2006 11/2/2006 12/2/2006 1/2/2007 2/2/2007 3/2/2007

China
Chinese Yuan to One U.S. Dollar

Currency Crisis
Exchange rate Baht/$

52

25

Foreign exchange ($)

11

12
Index
110 130 150 170 190 210 70 90

Jan-95 Mar-95 May-95 Jul-95 Sep-95 Nov-95 Jan-96 Mar-96 May-96 Jul-96 Sep-96 Nov-96 Jan-97 Mar-97 May-97 Jul-97 Sep-97 Nov-97 Jan-98 Mar-98 May-98 Jul-98 Sep-98 Nov-98 Jan-99 Mar-99 May-99 Jul-99 Sep-99
Month THB/USD TWD/USD KRW/USD

Asian Currencies vs. U.S. Dollar

PHP/USD

SGD/USD

MYR/USD

Law of One Price

Example: American steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are: American Steel In U.S. In Japan $100 5000 yen Japanese Steel $200 10,000 yen

If E = 100 yen/$ then prices are: American Steel In U.S. In Japan $100 10,000 yen Japanese Steel $100 10,000 yen

13

Law of one price E = 100 yen/$

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 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

14

Big Mac Index

15

PPP: U.S. and U.K

16

Factors Affecting E in Long Run

17

Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E

Exchange Rates in the Short Run

An exchange rate is the price of domestic assets in terms of foreign assets Using the theory of asset demandthe 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

Dollar assets pay an interest rate of i D and do not have any capital gain Foreign assets have an interest rate of i F 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 Et+1 the exchange rate for the next period
e Et+1 - Et the expected rate of appreciation for the dollar Et

19

Comparing Expected Returns II

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 R
D

Ete1 Et in term of euros = i Et

D

The expected return on foreign assets R F is i F Ete1 Et Relative R i i Et

D D F

As the relative expected return on dollar assets increases, foreigners will want to hold more dollar assets

20

Comparing Expected Returns III

The expected return on foreign assets R F in terms of dollars 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 Ete1 Et R in terms of dollars = i Et
F F

The expected return on the dollar assets R D is i D Ete1 Et Ete1 Et D F Relative R i ( i ) i i Et Et

D D F

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

21

As the relative expected return on dollar assets increases, both foreigners and domestic residents will want to hold more dollar assets

Interest Parity Condition

i i
D F

e t 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

22

Demand and Supply for Domestic Assets

Demand

Relative expected return At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher

Supply

The amount of bank deposits, bonds, and equities in the U.S. Vertical supply curve

23

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25

26

27

Exchange Rate Overshooting

Monetary Neutrality

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

The exchange rate falls by more in the short run than in the long run

Helps to explain why exchange rates exhibit so much volatility

28

29

The Dollar and Interest Rates

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

31

Exchange Rate Regimes

Fixed exchange rate regime

Value of a currency is pegged relative to the value of one other currency (anchor currency)

Floating exchange rate regime

Value of a currency is allowed to fluctuate against all other currencies

Managed float regime (dirty float)

Attempt to influence exchange rates by buying and selling currencies

32

Past Exchange Rate Regimes

Gold standard

Fixed exchange rates No control over monetary policy Influenced heavily by production of gold and gold discoveries

Bretton Woods System

Fixed exchange rates using U.S. dollar as reserve currency International Monetary Fund (IMF)

33

Past Exchange Rate Regimes (contd)

Bretton Woods System (contd)

World Bank General Agreement on Tariffs and Trade (GATT)

World Trade Organization

European Monetary System

Exchange rate mechanism

34

35

36

How a Fixed Exchange Rate Regime Works

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

How Bretton Woods Worked

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

Hybrid of fixed and flexible

Small daily changes in response to market Interventions to prevent large fluctuations

Appreciation hurts exporters and employment

Depreciation hurts imports and stimulates inflation

Special drawing rights as substitute for gold

39

European Monetary System

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

40

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

Inflows

Lead to a lending boom and excessive risk taking by financial intermediaries

41

Capital Controls (contd)

Inflows (contd)

Controls may block funds for productions uses Produce substantial distortion and misallocation Lead to corruption

Strong case for improving bank regulation and supervision

42

The IMF: Lender of Last Resort

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)

43

How Should the IMF Operate?

May not be tough enough Austerity programs focus on tight macroeconomic policies rather than financial reform Too slow, which worsens crisis and increases costs

44

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

Balance-of-Payments Considerations

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

Exchange Rate Considerations

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

47

Advantages of Exchange-Rate Targeting

Contributes to keeping inflation under control Automatic rule for conduct of monetary policy Simplicity and clarity

48

Disadvantages of Exchange-Rate Targeting

Cannot respond to domestic shocks and shocks to anchor country are transmitted Open to speculative attacks on currency Weakens the accountability of policymakers as the exchange rate loses value as signal

49

Exchange-Rate Targeting for Industrialized Countries

Domestic monetary and political institutions are not conducive to good policy making Other important benefits such as integration

50

Exchange-Rate Targeting for Emerging Market Countries

Political and monetary institutions are weak Stabilization policy of last resort

51

Currency Boards

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

52

Currency Boards (contd)

Stronger commitment by central bank Loss of independent monetary policy and increased exposure to shock from anchor country Loss of ability to create money and act as lender of last resort

53

Dollarization

Another solution to lack of transparency and commitment Adoption of another countrys money

Even stronger commitment mechanism

Completely avoids possibility of speculative attack on domestic currency

Lost of independent monetary policy and increased exposure to shocks from anchor country

54

Dollarization (contd)

Inability to create money and act as lender of last resort Loss of seignorage

55

Appendix

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 Ive used in the past, or slides I just dont want to delete as I may use them in the future.

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Expected Returns and Interest Parity

Re for $ Deposits Euro Deposits Relative Re

Francois iD + (Eet+1 Et)/Et iF

iD iF + (Eet+1 Et)/Et

Al iD iF (Eet+1 Et)/Et
iD iF + (Eet+1 Et)/Et

Interest Parity Condition:

$ and Euro deposits perfect substitutes iD = iF (Eet+1 Et)/Et Example: if iD = 10% and expected appreciation of $, (Eet+1 Et)/Et, = 5% iF = 15%

57

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

Deriving RD Curve Points B, D, E, RD = 10%: so curve is vertical

Equilibrium RD = RF at E* If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et

58

Equilibrium in the Foreign Exchange Market

59

Shifts in RF

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

60

Shifts in RD
RD shifts right when 1. iD ; because RD at each Et Assumes that domestic e unchanged, so domestic real rate

61

Foreign Exchange I

Exchange rateprice of one currency in terms of another Foreign exchange marketthe financial market where exchange rates are determined Spot transactionimmediate (two-day) exchange of bank deposits

Spot exchange rate

Forward transactionthe exchange of bank deposits at some specified future date

Forward exchange rate

62

Foreign Exchange II

Appreciationa currency rises in value relative to another currency Depreciationa currency falls in value relative to another currency When a countrys currency appreciates, the countrys goods abroad become more expensive and foreign goods in that country become less expensive and vice versa Over-the-counter market mainly banks

63

Exchange Rates in the Long Run

Law of one price Theory of Purchasing Power Parity

Assumes all goods are identical in both countries Trade barriers and transportation costs are low Many goods and services are not traded across borders

64

Factors that Affect Exchange Rates in the Long Run

Relative price levels Trade barriers

Preferences for domestic versus foreign goods

Productivity

65

Factors that Shift RF and RD

66

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

Response to Ms

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

Why Exchange Rate Volatility?

1. Expectations of Eet+1 fluctuate 2. Exchange rate overshooting

69

The Dollar and Interest Rates

1.

2.

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

70

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Chapter 18

The International Financial System

Unsterilized Foreign Exchange Intervention

Federal Reserve System Assets Foreign Assets (International Reserves) -$1B Liabilities Currency in circulation -$1B Assets Foreign Assets (International Reserves) -$1B

Federal Reserve System Liabilities Deposits with the Fed (reserves) -$1B

A central banks 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 banks 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

77

Unsterilized Intervention

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

78

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Sterilized Foreign Exchange Intervention

Federal Reserve System Assets Foreign Assets Monetary Base Liabilities

(International Reserves)
Government Bonds

-$1B (reserves)
+$1B

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

80

Balance of Payments

Current Account

Capital Account

International transactions that involve currently produced goods and services

Net receipts from capital transactions

Trade Balance

Sum of these two is the official reserve transactions balance

81