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Mishkin PPT Ch17

Mishkin PPT Ch17

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414 views

Mishkin PPT Ch17

Mishkin PPT Ch17

Uploaded by

atulkirar
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 22

Chapter 17

The Foreign
Exchange Market

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Foreign Exchange I
Exchange rate: price of one currency in terms of
another
Foreign exchange market: the financial market
where exchange rates are determined
Spot transaction: immediate (two-day) exchange of
bank deposits
Spot exchange rate

Forward transaction: the exchange of bank deposits


at some specified future date
Forward exchange rate

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-2

Foreign Exchange II
Appreciation: a currency rises in value
relative to another currency
Depreciation: a 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
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-3

FIGURE 1 Exchange Rates, 1990


2008

Source: Federal Reserve: www.federalreserve.gov/releases/h10/hist.


Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-4

Exchange Rates in the Long


Run
Law of one price
Theory of Purchasing Power Parity
assumptions:
All goods are identical in both countries
Trade barriers and transportation costs are low
Many goods and services are not traded across
borders

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-5

Factors that Affect Exchange


Rates in the Long Run
Relative price levels
Trade barriers
Preferences for domestic versus foreign
goods
Productivity

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-6

FIGURE 2 Purchasing Power Parity, United


States/United Kingdom, 19732008 (Index:
March 1973 = 100.)

Source: ftp.bls.gov/pub/special/requests/cpi/cpiai.txt.
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-7

Summary Table 1 Factors That Affect


Exchange Rates in the Long Run

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-8

Exchange Rates in the Short Run: A


Supply and Demand Analysis
An exchange rate is the price of domestic
assets in terms of foreign assets
Supply curve for domestic assets
Assume amount of domestic assets is fixed
(supply curve is vertical)

Demand curve for domestic assets


Most important determinant is the relative
expected return of domestic assets
At lower current values of the dollar (everything
else equal), the quantity demanded of dollar
assets is higher
Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-9

FIGURE 3 Equilibrium in the


Foreign Exchange Market

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-10

Explaining Changes in
Exchange Rates
Shifts in the demand for domestic assets
Domestic interest rate
Foreign interest rate
Expected future exchange rate

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-11

FIGURE 4 Response to an Increase


in the Domestic Interest Rate, iD

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17-12

FIGURE 5 Response to an Increase


in the Foreign Interest Rate, iF

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-13

FIGURE 6 Response to an Increase in


the Expected Future ExchangeRate, Eet+1

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-14

Summary Table 2 Factors That Shift the


Demand Curve for Domestic Assets and Affect
the Exchange Rate

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-15

FIGURE 7 Effect of a Rise in the Domestic


Interest Rate as a Result of an Increase in
Expected Inflation

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-16

Application: Changes in the


Equilibrium Exchange Rate
Changes in Interest Rates
When domestic real interest rates raise, the
domestic currency appreciates.
When domestic interest rates rise due to an
expected increase in inflation, the domestic
currency depreciates.

Changes in the Money Supply


A higher domestic money supply causes the
domestic currency to depreciate.

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-17

Application: Changes in the


Equilibrium Exchange Rate
Exchange Rate Overshooting
Monetary Neutrality
In the long run, a one-time percentage rise in
the money supply is matched by the same onetime 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

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-18

FIGURE 8 Effect of a Rise in the


Money Supply

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-19

Application: 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

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-20

FIGURE 9 Value of the Dollar and


Interest Rates, 19732008

Sources: Federal Reserve: www.federalreserve.gov/releases/h10/summary/indexn_m.txt; real interest rate from Figure 1 in Chapter 4.

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-21

Application: The Subprime


Crisis and the Dollar
During 2007 interest rates fell in the United
States and remained unchanged in Europe.
The dollar depreciated

Starting in the summer of 2008 interest


rated fell in Europe.
Increased demand for U.S. Treasuries flight
to quality
The dollar appreciated

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-22

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