Exchange Rates

1. Exchange Rates

2. Exchange Rates • An exchange rate is the price of one currency in terms of another. • It indicates how many units of one currency can be bought with a single unit of another currency. • Exchange rates are important because exports, imports and all international financial transactions are affected by the prices at which currencies exchange for one another.

3. Exchange Rates and Trade • Currency Appreciation • Increase in the value of the currency • When a country’s currency appreciates, its exports become more expensive and its imports become less expensive. • Currency Depreciation • Decrease in the value of the currency • When a country’s currency depreciates, its exports become less expensive and its imports become more expensive.

4. Exchange Rates and Capital Mobility • Currency appreciation • Increase in the value of the currency • When the dollar appreciates, U.S. assets become more attractive relative to foreign assets. • Currency depreciation • Decrease in the value of the currency • When the dollar depreciates, U.S. assets become less attractive relative to foreign assets.

5. Exchange Rates: Long Run • Factors that affect exchange rates in the long run include: • Relative Price Levels • Trade Barriers • Preferences for Domestic Versus Foreign Goods • Productivity

6. Relative Price Levels and Exchange Rates • Purchasing power parity (PPP) says that when the prices charged for essentially the same goods in different countries diverge, exchange rates will move in the opposite direction and equalize the effective prices between the two countries.

7. Determination of Exchange Rates: PPP • Purchasing power parity says that in the long run exchange rates adjust to reflect changes in the price levels of two countries. • If one country’s price level rises relative to another, its currency tends to depreciate. • If one country’s price level falls relative to another, its currency tends to appreciate.

8. PPP: Simple Example • Assume that the USA and Canada produce identical bushels of wheat and that the exchange rate is $1 Canadian for $1 U.S. • Let the price of wheat in Canada rise to $3/bushel while the price of wheat in the U.S. remains $2.50/bushel. • What will happen?

9. Purchasing Power Parity: Example • Canadians will buy U.S. wheat. In order to do this, they must first buy U.S. dollars. • The supply of Canadian dollars in the global marketplace increases. • The demand for U.S. dollars in the global marketplace increases • The Canadian dollar depreciates and the U.S dollar appreciates.

10. Purchasing Power Parity: Example • The price of U.S. wheat increases for Canadians for two reasons. • The dollar has appreciated. • The increase in demand for U.S. wheat pushes its price towards $3.00. • The decrease in demand for Canadian wheat pushes down its price down from $3.00 towards $2.50.

11. PPP: Simple Example • Over time these effects combine to bring about a single price for U.S. and Canadian wheat. • Conclusion: • A rise in the price level puts downward pressure on a currency. • A fall in the price level puts upward pressure on a currency.

12. Why PPP Works Poorly in the Short Run • Assumptions: • All goods are identical in both countries. • All goods and services are traded across borders. • Both countries have similar levels of productivity. • Consumers do not prefer one country’s goods over another’s. • No tariffs or quotas.

13. Trade Barriers and Exchange Rates • Barriers to free trade, increase the demand for domestic goods, causing the domestic currency to tend to appreciate. • If the rising value of the currency does not decrease foreign demand, the domestic currency appreciates because the supply of that currency decreases in world markets.

14. Preferences and Exchange Rates • Increased demand for a country’s exports causes its currency to appreciate. • If the rising value of the currency does not decrease foreign demand, the demand for the domestic currency in world markets increases and its value rises.

15. Preferences and Exchange Rates • Decreased demand for a country’s exports causes its currency to depreciate. • If the falling value of the currency does not increase foreign demand, the demand for the domestic currency in world markets decreases and its value falls.

16. Productivity and Exchange Rates • As a country becomes more productive than other countries, costs fall, permitting that country to sell at lower prices. • The decrease in price increases demand for the country’s goods and services, causing the value of the country’s currency to rise.

17. Productivity and Exchange Rates • As a country becomes less productive than other countries, costs rise, forcing that country to sell at higher prices. • The increase in price decreases demand for the country’s goods and services, causing the value of the country’s currency to fall.

18. Exchange Rates: Short Run • The modern asset market approach to explain exchange rate determination emphasizes financial flows. • Financial transactions in the U.S. are over 25 times greater than the amount of exports and imports. • In the short run, decisions to hold domestic or foreign assets play a more important role than trade.

19. Expected Return • Demand for dollar deposits vis a vis foreign deposits depends on the relative expected return on the deposits. • A higher expected return on dollar deposits relative to foreign deposits results in a higher demand for dollar deposits. • A higher expected return on foreign deposits relativeto dollar deposits results in a higher demand for foreign deposits.

20. Expected Return: Foreign Perspective • The return on dollar deposits received by a foreigner depends on the interest rate and the exchange rate between dollars and the foreign currency because…. • Interest earned on U.S. deposits is denominated in dollars and must be converted into the foreign currency.

21. Expected Return: Stable Currencies • Assume you are French and you have bought a U.S. asset that pays 10% interest. • If the exchange rate between the U.S. and France does not change, you receive the full 10%.

22. Expected Return: Changing Currency Values • Assume you are French and you have bought a U.S. asset that pays 10% interest. • Also assume that the exchange rate between France and the U.S. changes. • You will not receive 10%. • You may receive more than 10% or less than 10%.

23. Expected Return: Dollar Appreciation • Assume you are French and you own a U.S. asset that pays 10%. • Assume also that the dollar has appreciated relative to the euro. • This means that the dollar buyseuros. • This means that you earnthan 10%.

24. Expected Return: Dollar Depreciation • Assume you are French and you own a U.S. asset that pays 10%. • Assume also that the dollar has depreciated relative to the euro. • This means that the dollar buyseuros. • This means that you earnthan 10%.

25. Expected Return: The Math • The formula for the expected return on dollar deposits (RET$) in terms of euros is: • RET$ = i$+ (E$t+1 –E$t)/E$t • The expected return equals the interest return denominated in dollars (i$ ) plus the expected dollar appreciation. • E$t+1 is the expected value of the dollar in the next period. • E$t is the expected value of the dollar today.

26. Expected Return: French Assets • If you are French, the expected return on French deposits is the French interest rate. • There is no exchange rate exposure.

27. Relative Expected Return • If you are French, the relative expected returnon dollar deposits is the difference between the expected return on dollar deposits and the expected return on euro deposits. • To invest profitably, we must compare the two.

28. Relative Expected Return: The Math • The relative expected return on dollar deposits equals: • Relative RET$ = i$ –if + (E$t+1 –E$t)/E$t • The relative expected return equals the interest return denominated in dollars minus the interest on French deposits plus the dollar appreciation.

29. Expected Return: American Perspective • The return on euro deposits received by an American depends on the French interest rate and the exchange rate between dollars and the euro because…. • Interest earned on French deposits is denominated in euros and must be converted into dollars.

30. Expected Return: The Math • The formula for the expected return on French deposits (RETF) in terms of dollars is: • RETF = if – (E$t+1 –E$t)/E$t • The expected return equals the interest return denominated in euros (if ) plus the appreciation in the euro. • Euro appreciation is the negative of dollar appreciation so we subtract dollar appreciation from our return.

31. Expected Return: U.S. Assets • The expected return on U.S. deposits for Americans is the U.S. interest rate because there is no exchange rate exposure.

32. Relative Expected Return • If you are American, the relative expected returnon dollar deposits is the difference between the expected return on dollar deposits and the expected return on euro deposits. • To invest profitably, we must compare the two.

33. Relative Expected Return: The Math • The relative expected return on dollar deposits equals: • Relative RET$ = i$ –(if – (E$t+1 – E$t)/E$t) • = i$ – if + (E$t+1 – E$t)/E$t • The relative expected return equals the interest return denominated in dollars minus the interest on French deposits plus the dollar appreciation.

34. Conclusion • The relative expected return on dollar deposits is the same whether it is calculated form the foreign point of view or the domestic point of view. • When the dollar is expected to appreciate, Americans and foreigners prefer to hold dollar denominated deposits.

35. Interest Rate Parity Understanding Exchange Rates in the Short Run

36. Explaining Interest Rates with Interest Rate Parity • Interest rate parity says that the higher domestic real rates of interest are relative to foreign real interest rates, the higher will be the value of the domestic currency, other things remaining the same.

37. Interest Rate Parity: Assumptions • Foreign and U.S. deposits have similar risk and liquidity characteristics. • There are few impediments to capital mobility. • Foreigners can easily purchase American assets and Americans can easily purchase foreign assets. • Therefore, foreign and American deposits are perfect substitutes.

38. Interest Rate Parity: Investor Behavior • When capital is mobile and bank deposits are perfect substitutes…. • If the expected return on dollar deposits is above foreign deposits, everyone will want to hold dollar deposits. • If the expected return on foreign deposits is above American deposits, everyone will want to hold foreign deposits.

39. Interest Rate Parity Condition • For existing supplies of both dollar and foreign deposits to be held, it must be true that there is no difference in their expected returns. • The relative expected return must equal zero. • Relative RET$ = i$ – if + (Et+1 – Et)/ Et = 0 or i$ = if – (Et+1– Et)/ Et

40. Interest Rate Parity Condition: Implications • If the domestic rate is above the foreign interest rate, positive expected appreciation of the foreign currency is expected. • The expected appreciation compensates for the lower foreign interest rate. • i$ = if – (Et+1– Et)/ Et • 10% = 8% – x

41. Interest Rate Parity Condition: Implications • If the domestic rate is below the foreign interest rate, positive expected appreciation of the domestic currency is expected. • The expected appreciation compensatesfor the lower domestic interest rate. • i$ = if – (Et+1– Et)/ Et • 8% = 10% – x

42. Foreign Exchange Market Model Et RETD RETF Et is the exchange rate = euros/dollars. RETD is the return on dollar deposits in the U.S. RETF is the expected return on euro deposits in terms of dollars. RET$ is the expected return on deposits in terms of dollars. 10.5 10.0 9.5 0 5% 10% 15% RET$

43. Foreign Exchange Market Model: Derivation Et RETD RETF Let if = 10%, Et = 9.5 and Et+1=10. RETF = 0.10 – (10 –9.5)/9.5 = 0.10 –0.052 = 0.48 We plot the combination 9.5 and 4.8 at point 1. 10.5 10.0 9.5 1 0 5% 10% 15% RET$

44. Foreign Exchange Market Model: Derivation Et RETD RETF Let if = 10%, Et = 10 and Et+1 =10. RETF = 0.10 – (10 –10)/10 = 0.10 –0 = 0.10 We plot the combination 10 and 10 at point 2. 10.5 10.0 9.5 2 1 0 5% 10% 15% RET$

45. Foreign Exchange Market Model: Derivation Et RETD RETF 3 Let if = 10%, Et = 10.5 and Et+1 = 10. RETF = 0.10 – (10 – 10.5)/10.5 = 0.10 – (–0.048) = 0.148 We plot the combination 10.5 and 14.8 at point 3. 10.5 10.0 9.5 2 1 0 RET$ 5% 10% 15%

46. Foreign Exchange Market Model RETF Et RETD 10.5 10.0 9. 5 Equilibrium occurs where the return on foreign assets equals the return on domestic assets. 0 RET$ 5% 10% 15%

47. Stability of Equilibrium • At equilibrium there are either no forces causing change or there are equal off-setting forces. • If the equilibrium is stable, disequilibrium positions cannot exist indefinitely. • Forces in the model will tend to eliminate either the excess supply or excess demand.

48. Foreign Exchange Market Model RETF Et RETD Equilibrium occurs where the return on foreign assets equals the return on domestic assets. If the return on foreign assets exceeds the return on domestic assets, the currency will depreciate. 10.5 10.0 0 RET$ 5% 10% 15%

49. Equilibrium • Let the exchange rate be 10.5 • The expected return on euro deposits is now greater than the return on dollar deposits. • Holders of dollar deposits now will try to sell them and buy euro deposits, but no one will want them at the exchange rate of 10.5. • The excess supply of dollars will cause the dollar to fall. • The dollar falls until equilibrium is reached at the exchange rate of 10.

50. Foreign Exchange Market Model RETF Et RETD Equilibrium occurs where the return on foreign assets equals the return on domestic assets. If the return on foreign assets is less than the return on domestic assets, the currency will appreciate. 10.0 9. 5 0 RET$ 5% 10% 15%