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Exchange Rates

Exchange Rates. Exchange Rates. Exchange Rate: S - # of domestic currency units purchased for 1 US$. An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation . . Exchange Rates are Volatile. Interest Parity. Saving .

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Exchange Rates

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  1. Exchange Rates

  2. Exchange Rates • Exchange Rate: S - # of domestic currency units purchased for 1 US$. • An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation.

  3. Exchange Rates are Volatile

  4. Interest Parity

  5. Saving It is January 1st, and you have D$1000 to save for 1 year. You can put it into: • Put it into a domestic currency bank account at an interest rate i. • a foreign currency bank account at interest rate iF.

  6. Payoff to strategy #2 • Strategy two has three parts. • Buy foreign exchange at spot rate S01/01to get {D$1000/S01/01} US dollars. • Put {S01/01 × D$1000} into bank account. After 1 year get US$(1+iF)×{D$1000/S01/01 } • Convert these funds into US at exchange rate prevailing in 1 year.

  7. Uncovered Interest Parity • If > 1+i, deposit funds then deposit in US$ account. • If < 1+i, deposit funds then deposit in HK$ account. • Then in equilibrium

  8. Interest Rate Parity • The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rate would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. • Approximately

  9. Why the failure?Two Reasons • Future exchange rates are risky, uncovered interest parity does not account for risk. • Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons.

  10. Supply and Demand Model

  11. Why do exchange rates change? • Relative values of two currency determined by supply and demand by traders of the two currencies. • People trade currencies to engage in foreign trade and international investment.

  12. Consider the spot foreign exchange market. • Price of US$: S is the price of US$ in terms of DCU. • Supply of US$: Foreign people who want to acquire DCU to buy domestic goods or assets. • When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency. • Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment. • When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises

  13. Equilibrium in Forex MarketSupply Equals Demand S Supply 1 S* Demand

  14. Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods S S** 2 Domestic Currency Depreciates S* 1 Demand ' Supply Demand

  15. Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods S Supply Supply' Domestic Currency Appreciates 1 S* S** 2 Demand

  16. US Monetary Policy Causes US$ Interest Rates Go UpRelative Demand for US$ Goes Up S 2 S** Domestic Currency Depreciates S* 1 Supply' Demand' Supply Demand

  17. Domestic Monetary Policy CausesD.C. Interest Rates Go UpRelative Demand for US$ Goes Down S Supply Supply' Domestic Currency Appreciates 1 S* S** 2 Demand Demand '

  18. Monetary Policy & Exchange Rates • The central impact of the foreign currency intervention is on domestic interest rates. • Monetary policy that shifts domestic interest rates will also shift exchange rates regardless of whether it occurs through currency intervention, OMO, or some other change in quantity of bank reserves. • Monetary policy that does not shift interest rates will not shift exchange rates.

  19. Future Exchange Rate Level • If people’s expectation of the future exchange rate indicates a future depreciation, this will reduce the expected returns on investing in the domestic economy at any given interest rate. • This will increase demand for US$ and reduce supply. • An expected depreciation leads to a current depreciation!

  20. Expectation of St+1 Increases S 2 S** Domestic Currency Depreciates S* 1 Supply' Demand ' Supply Demand

  21. Learning Outcomes Students should be able to: • Use interest differentials to calculate expected depreciation rate under UIRP. • Use the Supply-Demand model of the forex model to explain: • the effect of international trade conditions on the exchange rate. • the impact of interest rates and other financial market conditions on exchange rates.

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