Foreign Exchange Market - International Economics - Lecture Slides, Slides of Economics

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Exchange Rates

and the Foreign

Exchange

Market: An Asset

Approach

Preview

• The basics of exchange rates
• Exchange rates and the prices of goods
• Foreign exchange markets
• The demand for currency and other assets
• A model of foreign exchange markets

 role of interest rates on currency deposits

 role of expectations about future exchange rates

Domestic and foreign currencies

• Domestic currency refers to the US dollar
• Foreign currency refers to the Euro, or at times to

the Yen or the Yuan

• The exchange rate is the price of the foreign

currency

 The exchange rate is the amount of the domestic

currency that one unit of the foreign currency is worth

 Its symbol is E

 Example: if €1 is worth $1.54, then E = 1.

Definitions of Exchange Rates

• Exchange rates allow us to show the price of a good or service in any currency.  What is the price of a Honda Accord? - ¥3,000, - Or, ¥3,000,000 x $0.0098 = $29,  Because ¥1 is assumed to be worth $0.0098: E = 0.

Depreciation and Appreciation

• Example:

 €1 used to be worth $1.

 Now €1 is worth $1.46.

 The euro is now more valuable. It has appreciated.

 So, the dollar is less valuable. It has depreciated.

 E has increased from 1.00 to 1.

Depreciation and Appreciation

• As E is the value of the euro in dollars,

 E ↑ means appreciation of the euro (and depreciation of the dollar)

 E ↓ means depreciation of the euro (and appreciation of the dollar)

Depreciation and Appreciation (cont.)

• A depreciated currency is less valuable , and therefore it can buy fewer foreign-made goods.
• When our currency depreciates:  imports are more expensive for us, and conversely  domestically produced goods are less expensive for foreigners.
• A depreciated currency lowers the price of exports relative to the price of imports.

Depreciation and Appreciation (cont.)

• Suppose E decreases from 0.0098 to 0.0090.  How much does a Honda cost? ¥3,000,  3,000,000 x 0.0098 = $29,  3,000,000 x 0.0090 = $27,
• An appreciated currency is more valuable , and therefore it can buy more foreign-made goods.
• An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive.
• An appreciated currency raises the price of exports relative to the price of imports.

The Foreign Exchange Market

The main participants:

1. Commercial banks and other depository institutions: their transactions involve buying/selling of bank deposits in different currencies for their clients.
2. Non bank financial institutions (pension funds, insurance funds) may buy/sell foreign assets.
3. Private firms: they conduct foreign currency transactions to buy/sell goods, assets or services.
4. Central banks: conduct official international reserves transactions.
5. Private individuals, such as tourists

In which country should you keep your

savings?

• This chapter focuses on currency trades that are

motivated by our constant search for a good

return on our savings

• If you think that your savings would grow fastest

in a European bank, you will need to

 Turn your US dollars into euros

 Deposit your euros in a European bank

• Such trades represent supply and demand in

currency markets

Where would you keep a dollar?

In an American bank

• Deposit dollar in bank
• A year later, the bank

gives you your dollars back with interest  You want R , the domestic interest rate, to be high

In a European bank

• Buy euros with dollar  You want E to be low
• Deposit euros in bank
• A year later, the bank gives you your euros back with interest  You want R* , the foreign interest rate, to be high
• Sell the euros and get dollars  Now, you want E to be high

The Demand for Foreign Currency Assets

• The rate of return on a bank deposit

denominated in the domestic currency is

simply the domestic interest rate on bank

deposits, R.

• The rate of return on a bank deposit

denominated in the foreign currency is

 the foreign interest rate on bank deposits, R* , plus

 the expected rate of appreciation of the foreign currency (relative to the domestic currency).

The Demand for Foreign Currency Assets

• Suppose today $1 = €1: that is, E = 1.
• Suppose the exchange rate expected one year in the future is $0.97 = €1: that is, Ee^ = 0.97.

 This means that the euro is expected to depreciate by 3%: (0.97 – 1.00)/1.00 = – 0.03.

 In general, the expected rate of increase in E is:

E

E

E

E E

e e

The Demand for Foreign Currency Assets

• Again, suppose today’s exchange rate is $1 for €1: that is, E = 1.
• Suppose the rate expected one year in the future is $0.97 for €1: that is, Ee^ = 0.97.
• $100 can be exchanged today for €100.
• These €100 will yield €104 after one year, as the interest rate on euro deposits is 4% ( R* = 0.04).
• These €104, when received a year in the future, are expected to be worth 0.97  104 = $100.88.