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Department of Economics |
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exchange rate: the price of one currency in terms of another See Figure 1 foreign exchange market:
the financial market where exchange rates are determined What Are Foreign Exchange Rates? spot transactions: involve the immediate (two-day) exchange of bank deposits forward transactions: involve the exchange of bank deposits at some specified future date spot exchange rate: exchange rate for the spot transaction forward exchange rate: exchange rate for the forward tranaction appreciation: when a currency increases in value depreciation: when a currency decreases in value Why Are Exchange Rates Important? When a country’s currency appreciates (rises in value relative to other currencies), the country’s goods abroad become more expensive and foreign goods in that country become cheaper (holding domestic prices constant in the two countries). Conversely, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive. How Is Foreign Exchange Traded? |
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Law of One Price 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 theory of purchasing power parity (PPP): states that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries See Figure 2 Why the Theory of Purchasing Power Parity Cannot
Fully Explain Exchange Rates Factors That Affect Exchange Rates in the Long
Run Relative
Price Levels In the long run, 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 county’s currency to appreciate in the long run. Preferences
for Domestic Versus 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 In the long run, as a country becomes more productive relative to other countries, its currency appreciates. See Table 1 |
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Comparing Expected Returns on Domestic and
Foreign Deposits RD in terms of euros = iD + (Et+1e – Et)/Et Relative RD = iD – iF + (Et+1e – Et)/Et RF in terms of dollars = iF – (Et+1e – Et)/Et Relative RF = iD – [iF – (Et+1e – Et)/Et] = iD – iF + (Et+1e – Et)/Et Interest Parity Condition capital mobility: situation in which foreigners can easily purchase American assets such as dollar deposits, and Americans can easily purchase foreign assets such as euro deposits iD = iF – (Et+1e – Et)/Et interest parity condition: domestic interest rate equals the foreign interest rate minus the expected appreciation of the domestic currency Demand
Curve for Domestic Assets Supply
Curve for Domestic Assets Equilibrium in the Foreign Exchange Market See Figure 3 |
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Shifts in the Demand for Domestic Assets Domestic
Interest Rate, iD See Figure 4 An increases in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the right and causes the domestic currency to appreciate. A decreases in the domestic interest rate iD shifts the demand curve for domestic assets, D, to the left and causes the domestic currency to depreciate. Foreign
Interest Rate, iF See Figure 5 An increase in the foreign interest rate iF shifts the demand curve D to the left and causes the domestic currency to depreciate; a fall in the foreign interest rate iF shifts the demand curve D to the right and causes the domestic currency to depreciate. Changes
in the Expected Future Exchange Rate See Figure 6 A rise in the expected future exchange rate, Et+1e, shifts the demand curve to the right and causes an appreciation of the domestic currency; a fall in the expected future exchange rate, Et+1e, shifts the demand curve to the left and causes a depreciation of the currency. See Table 2 APPLICATION Changes in the Equilibrium Exchange Rate: Two Examples Changes
in Interest Rates When domestic real interest rates rise, the domestic currency appreciates. When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreicates. See Figure 7 Changes
in the Money Supply A higher domestic money supply causes the domestic currency to depreciate. See Figure 8 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, leaving unchanged the real money supply and all other economic variables such as interest rates exchange rate overshooting: situation in which the exchange rate falls by more in the short run than it does in the long run when the money supply increases APPLICATION Why Are Exchange Rates So Volatile? APPLICATION The Dollar and Interest Rates, 1973-2005 effective exchange rate index: value of the dollar in terms of a basket of foreign currencies See Figure 9 APPLICATION The Euro’s First Seven Years APPLICATION Reading the Wall Street Journal: The “Currency Trading” Column |
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Disclaimer: pages.slu.edu is a service of Saint Louis University, Saint Louis University does not control, monitor or guarantee the information contained in these sites. For more information » |