22/02/2018

THE FOREIGN EXCHANGE

MARKET

Econ 190.2: Monetary, fiscal, and development policy

Preliminaries

• The nominal exchange rate, e, is the price of one

currency in terms of another:

P P43.60
$ $1.00
• It also links the price levels of countries with each other.
domestic price = exchange rate x foreign price
P = e x P*

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Preliminaries

• Appreciation – an increase in the value of a

currency as measured by the amount of
foreign currency it can buy.

P43.60 P42.00
$1.00 $1.00

Preliminaries

• Depreciation – a decrease in the value of a

currency as measured by the amount of
foreign currency it can buy.

P43.60 P44.00
$1.00 $1.00

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Preliminaries

• The peso DEPRECIATES in value when the

peso per dollar INCREASES.
P
$
• The peso APPRECIATES in value when the
peso per dollar DECREASES.

P
$

Preliminaries

• Foreign exchange market - the financial market

where exchange rates are determined

• Spot transaction - immediate (two-day) exchange

of bank deposits

• Forward transaction - the exchange of bank

deposits at some specified future date

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Preliminaries

• The exchange rate may be explained by the

demand and supply for dollars.

• The supply of dollars may come from

earnings from exports and services provided
by Filipinos

• The demand for dollars may come from

payments from imported goods and services
provided by foreigners

Preliminaries

a. Imports
Pesos 120
per
Dollar 100

80

60

40

20

0 2 4 6 8 10 12 14 16 18
Quantity –
Million
Dollars

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Preliminaries

b. Exports
Pesos 120
per
Dollar 100

80

60

40

20

0 2 4 6 8 10 12 14 16 18
Quantity –
Million
Dollars

Preliminaries

c. Remittances
Pesos 120
per
Dollar 100

80

60

40

20

0 2 4 6 8 10 12 14 16 18
Quantity –
Million
Dollars

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Preliminaries

Exchange rates and exports

• Consider
1 kilo of garlic in Irvine, CA = $11.60
1 kilo of garlic in Alfonso, CA = P90.00

e = (P/$) Imported P($) Local P($)

35.00 P406.00 ($11.60) P90.00 ($2.57)
40.00 P464.00 ($11.60) P90.00 ($2.25)
45.00 P522.00 ($11.60) P90.00 ($2.00)

Application: forex and international reserves

BSP/Philippines extends $1B loan to IMF
• For 40 years, PHL was a net borrower from the IMF until we fully
paid our loans to IMF in December 2006.
• The prolonged and deepening economic crisis in Europe prompted
IMF to seek and raise $600B to help European nations in crisis
which will contribute to securing global economic and financial
stability.
• Because of the country’s sound economic fundamentals and stable
banking system, the IMF invited the PHL to participate in its lending
facilities (it asked the PHL if it can lend money to help European
countries).
• PHL committed $1B to the facility, joining the other 36 countries
that have announced their pledges amounting to a total of $456B.

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Application: forex and international reserves

Can the PHL afford to

lend $1B?

Application: forex and international reserves

PHL Gross International Reserves
(in USD billion)
90
83.83 83.19
The $1B loan 80.87
80 75.30
accounts for only
70
1.3 percent of the 62.37
60 GIR
50
44.24

40 37.55
33.75 33.75

30
22.97
18.49
20 15.06 15.69 16.36 17.06

10

0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: BSP

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Application: forex and international reserves

What are reserves? Where

did it come from?

Application: forex and international reserves

• Gross international reserves are external assets that are controlled

by a central bank. The BSP builds up its GIR through
• outright purchase of foreign exchange in the market
• income from investments in foreign assets
• gold purchases
• This means that OFW remittances fall under BSP’s reserves. Other
items that may increase the reserves are earnings from exports,
BPOs, tourism revenues, FDIs and portfolio investments (foreign
investment in the stock market).
• Reserves are used to fund the country’s need for foreign exchange
when it buys imported goods or when BSP intervenes in the market
(to stabilize the peso).

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Application: forex and international reserves

Aren’t reserves part of the

national budget? Why lend it?
Why not use it to fund gov’t
projects? For the poor?

Application: forex and international reserves

• The reserves are not part of the national budget. It forms part of
BSP’s total assets. It follows, then, that the government cannot use
BSP’s money to fund its national projects. The government should
only use money coming from its legal sources of revenues: taxes,
custom duties, etc.
• However, the BSP, as a government corporation, is required to
remit part of its annual earnings to the national government in the
form of dividends.
• By lending a part of its reserves to the IMF, BSP can earn through
interest payments and part of it will go to the government and can,
indirectly, be used to fund its projects. This is more desirable than
just letting the money “sleep” inside the vault.

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Preliminaries

• The real exchange rate, q, tells us the rate at

which we can trade the goods of one country for
the goods of another. The real exchange rate is
sometimes called the terms of trade.
∗⁄
=
q > 1: the local good is cheaper
q < 1: the imported good is cheaper
• q is a measure of competitiveness. As q rises,
competitiveness increases: exports rise and
imports fall.

Preliminaries

• Holding domestic and foreign price levels

constant, therefore, exports increase with e and
imports fall as e increases.
( ) = ( )− ( )
( )= ( )− ( )
where r is the interest rate

• The size of the saving-investment gap will

determine the exchange rate

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Law of one price

If two countries produce an identical good, and

transportation costs and trade barriers are very
low, the price of the good should be the same
throughout the world no matter which country
produces it.

Theory of purchasing power parity

• Exchange rates between any two currencies will

adjust to reflect changes in the price levels of
the two countries.

• The theory of PPP is simply an application of

the law of one price to national price levels
rather than to individual prices.

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Problems with PPP

• Assumes all goods are identical in both countries

• Assumes that trade barriers and transportation costs

are low

• Does not take into account that many goods and

services are not traded across borders

Factors affecting exchange rates in the long run

• Relative price levels: a rise in a country’s price level (relative to

the foreign price level) causes its currency to depreciate, and a
fall in the country’s relative price level causes its currency to
appreciate
• Trade barriers: increasing trade barriers cause a country’s
currency to appreciate in the long run.
• Preferences for domestic vs. foreign goods: Increased demand
for a country’s exports causes its currency to appreciate in the
long run; conversely, increased demand for imports causes the
domestic currency to depreciate.
• Productivity: as a country becomes more productive relative to
other countries, its currency appreciates.

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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 demand—the most

important factor affecting the demand for
domestic (peso) assets and foreign (dollar)
assets is the expected return on these assets
relative to each other

Comparing expected returns

• Domestic assets pay an interest rate of iD and do not have any
capital gain.
• Foreign assets pay an interest rate of iF and do not have any
capital gain.
• To compare expected returns on dollar assets and foreign
assets, returns must be converted into the currency unit used:

Et = the spot exchange rate

Et+1 = the exchange rate for the next period

= the expected exchange rate for the next period

= the expected rate of appreciation for the domestic

currency

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Comparing expected returns

• The expected return on domestic assets RD in terms of foreign

currency is the sum of the interest rate on domestic assets plus
the expected appreciation of the domestic currency.

RD in terms of foreign currency = +

• The expected return on foreign assets RF is iF

Relative RD = − +

 As the relative expected return on domestic assets increases,

foreigners will want to hold more domestic assets.

Comparing expected returns

• The expected return on foreign assets RF in terms of domestic

currency is the interest rate on foreign assets iF plus the expected
appreciation of the foreign currency, equal to minus the expected
appreciation of the domestic currency.

RF in terms of domestic currency = −

• The expected return on domestic assets RD is iD

Relative RD = − − = − +

 Relative expected return on domestic assets is the same whether it is

calculated in terms of foreign or in terms of domestic currency.
 As the relative expected return on domestic assets increases, both
foreigners and locals will want to hold more domestic assets.

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Interest parity condition

iD = −
• When capital is mobile and bank deposits are perfect
substitutes, if the expected return on domestic deposits is
higher than foreign deposits, both foreigners and locals will
want to hold only domestic deposits, and vice versa.

• Interest parity condition states that the domestic interest rate

equals the foreign interest rate minus the expected
appreciation of the domestic currency.

Equilibrium in the foreign exchange market

RD = R F
- at B where the exchange rate E* is 1
euro per dollar, the interest parity
condition is satisfied because the
expected returns on dollar deposits
and on euro deposits are equal.

Source: Mishkin (2004)

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Shifts in expected-return schedule

for foreign deposits

• Changes in foreign interest rate

• An increase in the foreign interest rate iF shifts the RF
schedule to the right and causes the domestic currency to
depreciate (E↓).
• A decrease in iF shifts the RF schedule to the left and
causes the domestic currency to appreciate (E↑).
• Changes in the expected future exchange rate
• a rise in the expected future exchange rate shifts the RF
schedule to the left and causes an appreciation of the
domestic currency; a fall in the expected future exchange
rate shifts the RF schedule to the right and causes a
depreciation of the domestic currency.

Shifts in expected-return schedule

for foreign deposits

Source: Mishkin (2004)

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Shifts in expected-return schedule

for domestic deposits

• Changes in domestic interest rate

• A rise in the domestic interest rate iD shifts the RD
schedule to the right and causes an appreciation of the
domestic currency; a fall in iD shifts the RD schedule to the
left and causes a depreciation of the domestic currency.

Shifts in expected-return schedule

for domestic deposits

Source: Mishkin (2004)

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Changes in equilibrium exchange rate

due to change in interest rate

• Recall the Fisher equation: = +

• The Fisher equation indicates that an interest rate i
can change for two reasons: Either the real interest
rate ir changes or the expected inflation rate πe
changes. The effect on the exchange rate is quite
different, depending on which of these two factors
is the source of the change in the nominal interest
rate.

Changes in equilibrium exchange rate

due to change in interest rate

• Suppose ir increases  i ↑ and Δ πe = 0

• The expected appreciation of the dollar will be

unchanged because expected inflation is
unchanged, and so the expected return on foreign
deposits will remain unchanged for any given
exchange rate. The result is that the RF schedule
stays put and the RD schedule shifts to the right.
 domestic currency appreciates

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Changes in equilibrium exchange rate

due to change in interest rate
Suppose ir increases  i ↑

Source: Mishkin (2004)

Changes in equilibrium exchange rate

due to change in interest rate

• Suppose πe increases  i ↑

• The rise in expected domestic inflation leads to a

decline in the expected appreciation of the dollar (a
higher appreciation of the euro), which is typically
thought to be larger than the increase in the domestic
interest rate iD As a result, at any given exchange rate,
the expected return on foreign deposits rises more than
the expected return on dollar deposits.
 domestic currency depreciates

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Changes in equilibrium exchange rate

due to change in interest rate

Suppose πe increases  i ↑

Source: Mishkin (2004)

Changes in equilibrium exchange rate

due to change in money supply

• Suppose the central bank decides to increase MS:

 increase in price levels and lower expected future
exchange rate

• The resulting decline in the expected appreciation of the dollar

increases the expected return on foreign deposits at any given
current exchange rate and so shifts the RF schedule rightward.
In addition, rise in the real money supply causes the domestic
interest rate to fall which lowers the expected return on
domestic (dollar) deposits, shifting the RD schedule leftward.
 domestic currency depreciates

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Changes in equilibrium exchange rate

due to change in money supply
Suppose MS increases

Source: Mishkin (2004)

Exchange rate overshooting

• Increasing money supply has a long term impact on exchange

rates: money 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, leaving unchanged the
real money supply and all other economic variables such
as interest rates
 Monetary neutrality tells us that in the long run, the
rise in the money supply would not lead to a change in
the domestic interest rate and so it would return to
in the long run, and the schedule for the expected return
on domestic deposits would return to .

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Exchange rate overshooting

… this means that the exchange rate would rise from E2 to E3 in the
long run

Source: Mishkin (2004)

Exchange rate overshooting

- It occurs when the exchange rate falls by more in the short run
than it does in the long run when the money supply increases.

- When the domestic interest rate falls in the short run,

equilibrium in the foreign exchange market means that the
expected return on foreign deposits must be lower. With the
foreign interest rate given, this lower expected return on foreign
deposits means that there must be an expected appreciation of
the dollar (depreciation of the euro) in order for the expected
return on foreign deposits to decline when the domestic interest
rate falls. This can happen only if the current exchange rate falls
below its long run value.

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Application: the peso and t-bill rates

120.00 40.00

35.00
100.00
Real effective exchange rate 30.00
80.00
25.00
(index: 1980 = 100)

(all maturities)
T-bill rate
REER

60.00 20.00

15.00
40.00
T-bill rate 10.00

20.00
5.00
Marcos C. Aquino Ramos Estrada Arroyo B. Aquino
0.00 0.00

REER (index: 1980 = 100) T-bill rates (all maturities)

Source: BSP

Application: the peso and t-bill rates

94 B. Aquino Duterte 2.5

92
90 2
88
(index: 1980 = 100)

(all maturities)

86 1.5
T-bill rate
REER

84
82 1
80
78 0.5
76
74 0
2010 2011 2012 2013 2014 2015 2016 2017
REER (index: 1980 = 100) T-bill rate (91-days)

Source: BSP

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END

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