The Foreign Exchange Market
1
2
Asian Currencies vs. U.S. Dollar
The Foreign Exchange Market Definitions: 1. Spot exchange rate 2. Forward exchange rate 3. Appreciation 4. Depreciation
210
190
170
MYR/USD PHP/USD
150
Index
SGD/USD
Currency appreciates, country’s goods prices abroad and foreign goods prices in that country
KRW/USD 130 TWD/USD THB/USD
110
1. Makes domestic businesses less competitive 2. Benefits domestic consumers
90
3
Month
Jul-99
Sep-99
Jan-99
Mar-99
May-99
Jul-98
Nov-98
Sep-98
Jan-98
Mar-98
May-98
Jul-97
Nov-97
Sep-97
Jan-97
Mar-97
May-97
Jul-96
Nov-96
Sep-96
Jan-96
Mar-96
May-96
Jul-95
Nov-95
Mar-95
Sep-95
May-95
Jan-95
70
4
FX traded in over-the-counter market 1. Trade is in bank deposits denominated in different currencies
Currency Depreciation and Appreciation
The Foreign Exchange Market Exchange rate Peso/$
D
S
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
Supply of Dollars by people who want pesos
Demand for Dollars by people who have pesos
Foreign exchange (dollars)
5
6
Changes in the Equilibrium Exchange Rate Exchange rate Peso/$
D
Exchange Rate Regimes Supply of Dollars
S by people who S’ want pesos
Flexible (Floating) exchange rates.
Fixed exchange rates.
$ -depreciation Peso- appreciation
– –
Demand for Dollars by people who have pesos Foreign exchange (dollars)
7
8
Currency Board Monetary Union
Managed Float (Dirty Float) exchange rates.
11
Foreign exchange ($)
12
Month
Sep-99
Jul-99
May-99
Mar-99
Jan-99
Nov-98
Sep-98
Jul-98
May-98
Mar-98
Jan-98
Nov-97
Sep-97
Jul-97
May-97
Mar-97
Jan-97
Nov-96
Sep-96
Jul-96
May-96
25
Mar-96
S
Jan-96
Currency Crisis
Nov-95
9
Sep-95
Foreign exchange (pounds)
170
110
90
70
3/2/2007
2/2/2007
1/2/2007
12/2/2006
11/2/2006
10/2/2006
9/2/2006
8/2/2006
7/2/2006
6/2/2006
5/2/2006
4/2/2006
3/2/2006
2/2/2006
1/2/2006
12/2/2005
11/2/2005
10/2/2005
9/2/2005
8/2/2005
7/2/2005
6/2/2005
5/2/2005
4/2/2005
3/2/2005
2/2/2005
1/2/2005
12/2/2004
11/2/2004
10/2/2004
9/2/2004
8/2/2004
7/2/2004
6/2/2004
5/2/2004
4/2/2004
3/2/2004
2/2/2004
1/2/2004
S
Jul-95
52
D D’’
May-95
Exchange rate Baht/$
D’
Mar-95
Index
Exchange rate $/pound
Jan-95
The Central Bank Can Intervene to Maintain Exchange Rates
China 8.4
Chinese Yuan to One U.S. Dollar
8.3
8.2
8.1
7.9
8
7.8
7.7
7.6
7.5
7.4
10
Asian Currencies vs. U.S. Dollar
D’ 210
190
150 MYR/USD
PHP/USD
130 SGD/USD
KRW/USD
TWD/USD
THB/USD
Law of One Price
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
Example: American steel $100 per ton, Japanese steel 10,000 yen per ton If E = 50 yen/$ then prices are:
In U.S. In Japan
American Steel
Japanese Steel
$100 5000 yen
$200 10,000 yen
Problems with PPP 1. All goods not identical in both countries: Toyota vs Chevy 2. Many goods and services are not traded: e.g. haircuts
If E = 100 yen/$ then prices are:
In U.S. In Japan
13
American Steel
Japanese Steel
$100 10,000 yen
$100 10,000 yen
Law of one price E = 100 yen/$
14
PPP: U.S. and U.K Big Mac Index
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16
Exchange Rates in the Short Run
Factors Affecting E in Long Run
17
Basic Principle: If factor increases demand for domestic goods relative to foreign goods, E
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 (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other
18
Comparing Expected Returns I
Comparing Expected Returns II
Dollar assets pay an interest rate of i D and do not have any capital gain
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
F
Foreign assets have an interest rate of i 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
R D in term of euros = i D
E
Ete1 Et Et
The expected return on foreign assets R F is i F
Et+1 the exchange rate for the next period
Relative R D i D i F
e t+1
19
- Et the expected rate of appreciation for the dollar Et
Ete1 Et Et
As the relative expected return on dollar assets increases, foreigners will want to hold more dollar assets
20
Comparing Expected Returns III
Interest Parity Condition
The expected return on foreign assets R F in terms of dollars
iD iF
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 R F in terms of dollars = i F
e Et1 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
The expected return on the dollar assets R D is i D E e Et E e Et Relative R D i D (i F t1 ) i D i F t1 Et Et
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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 As the relative expected return on dollar assets increases, both foreigners and domestic residents will want to hold more dollar assets
22
Demand and Supply for Domestic Assets
Demand – –
Supply – –
23
Relative expected return At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher The amount of bank deposits, bonds, and equities in the U.S. Vertical supply curve
24
e Et1 Et Et
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26
Exchange Rate Overshooting
Monetary Neutrality –
The exchange rate falls by more in the short run than in the long run –
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28
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
Helps to explain why exchange rates exhibit so much volatility
The Dollar and Interest Rates
29
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
Exchange Rate Regimes
Fixed exchange rate regime –
Floating exchange rate regime –
32
Value of a currency is allowed to fluctuate against all other currencies
Managed float regime (dirty float) –
31
Value of a currency is pegged relative to the value of one other currency (anchor currency)
Attempt to influence exchange rates by buying and selling currencies
Past Exchange Rate Regimes (cont’d)
Past Exchange Rate Regimes
– – –
Gold standard
–
–
World Bank General Agreement on Tariffs and Trade (GATT)
Fixed exchange rates using U.S. dollar as reserve currency International Monetary Fund (IMF)
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34
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36
World Trade Organization
European Monetary System –
Bretton Woods System –
Bretton Woods System (cont’d) –
Fixed exchange rates No control over monetary policy Influenced heavily by production of gold and gold discoveries
Exchange rate mechanism
How a Fixed Exchange Rate Regime Works
How Bretton Woods Worked
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
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
–
Small daily changes in response to market Interventions to prevent large fluctuations
Appreciation hurts exporters and employment
Depreciation hurts imports and stimulates inflation
European Monetary System
Hybrid of fixed and flexible –
39
Special drawing rights as substitute for gold
40
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
Capital Controls (cont’d)
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
– – –
Controls may block funds for productions uses Produce substantial distortion and misallocation Lead to corruption
Strong case for improving bank regulation and supervision
Inflows –
Lead to a lending boom and excessive risk taking by financial intermediaries
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42
The IMF: Lender of Last Resort
43
Inflows (cont’d)
How Should the IMF Operate?
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)
44
May not be tough enough Austerity programs focus on tight macroeconomic policies rather than financial reform Too slow, which worsens crisis and increases costs
Balance-of-Payments Considerations
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
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
Advantages of Exchange-Rate Targeting
Exchange Rate Considerations
47
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
48
Contributes to keeping inflation under control
Automatic rule for conduct of monetary policy
Simplicity and clarity
Disadvantages of Exchange-Rate Targeting
Exchange-Rate Targeting for Industrialized Countries
Cannot respond to domestic shocks and shocks to anchor country are transmitted
Domestic monetary and political institutions are not conducive to good policy making
Open to speculative attacks on currency
Weakens the accountability of policymakers as the exchange rate loses value as signal
Other important benefits such as integration
49
50
Exchange-Rate Targeting for Emerging Market Countries
51
Political and monetary institutions are weak
Stabilization policy of last resort
Currency Boards
52
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
Currency Boards (cont’d)
Dollarization
Stronger commitment by central bank
Loss of independent monetary policy and increased exposure to shock from anchor country
Another solution to lack of transparency and commitment
Adoption of another country’s money
Even stronger commitment mechanism
Loss of ability to create money and act as lender of last resort
Completely avoids possibility of speculative attack on domestic currency
Lost of independent monetary policy and increased exposure to shocks from anchor country
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54
Dollarization (cont’d)
55
Inability to create money and act as lender of last resort
Loss of seignorage
Appendix
56
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 I’ve used in the past, or slides I just don’t want to delete as I may use them in the future.
Expected Returns and Interest Parity
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
Re for $ Deposits Euro Deposits
Francois iD + (Eet+1 – Et)/Et iF
Al iD iF – (Eet+1 – Et)/Et
Relative Re
iD – iF + (Eet+1 – Et)/Et
iD – iF + (Eet+1 – Et)/Et
Interest Parity Condition:
Deriving RD Curve Points B, D, E, RD = 10%: so curve is vertical
$ and Euro deposits perfect substitutes iD = iF – (Eet+1 – Et)/Et Example:
Equilibrium RD = RF at E* If Et > E*, RF > RD, sell $, Et If Et < E*, RF < RD, buy $, Et
if iD = 10% and expected appreciation of $, (Eet+1– Et)/Et, = 5% iF = 15%
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58
Shifts in RF
Equilibrium in the Foreign Exchange Market
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
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60
Shifts in RD
Foreign Exchange I
RD shifts right when 1. iD ; because RD at each Et Assumes that domestic e unchanged, so domestic real rate
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 –
–
61
Forward exchange rate
62
Exchange Rates in the Long Run
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 country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa
63
Spot exchange rate
Forward transaction—the exchange of bank deposits at some specified future date
Law of one price
Theory of Purchasing Power Parity – – –
Over-the-counter market mainly banks
64
Assumes all goods are identical in both countries Trade barriers and transportation costs are low Many goods and services are not traded across borders
Factors that Shift RF and RD
Factors that Affect Exchange Rates in the Long Run
Relative price levels
Trade barriers
Preferences for domestic versus foreign goods
Productivity
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Response to Ms
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
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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
The Dollar and Interest Rates Why Exchange Rate Volatility? 1. Expectations of Eet+1 fluctuate 2. Exchange rate overshooting
1.
2.
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70
71
72
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
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Chapter 18
The International Financial System
75
Unsterilized Foreign Exchange Intervention Federal Reserve System
Assets Foreign Assets (International Reserves)
77
-$1B
Currency in circulation
Unsterilized Intervention
Federal Reserve System
Liabilities
Assets -$1B
Foreign Assets (International Reserves)
Liabilities -$1B
Deposits with the Fed
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
-$1B
(reserves)
A central bank’s 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 bank’s 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
78
Sterilized Foreign Exchange Intervention Federal Reserve System Assets
Liabilities
Foreign Assets (International Reserves)
-$1B (reserves)
Government Bonds
+$1B
79
80
Monetary Base 0
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
Balance of Payments
Current Account –
81
International transactions that involve currently produced goods and services
Trade Balance
Capital Account –
Net receipts from capital transactions
Sum of these two is the official reserve transactions balance
