Chapter 2 The Market for Foreign Exchange

1. Chapter 2The Market for Foreign Exchange Lecture 2b

2. The Demand for a Currency • The demand for a currency is a derived demand. That is, the demand for the currency is derived from the demand for the goods, services, and financial assets the currency is used to purchase. • If, for example, foreign demand for European goods and services increases, the demand for the euro increases.

3. The Demand Curve is Downward Sloping • If, for example, the euro depreciates, European goods, services, and financial assets become less expensive to foreign residents. Foreign residents will increase their quantity demanded of the euro to purchase more European goods, services, and financial assets. • The downward slope of the demand curve shows the negative relationship between the exchange rate and the quantity demanded.

4. The Demand Curve The downward slope of the demand curve shows the negative relationship between the exchange rate and the quantity demanded.

5. Important Note • It is vital to construct and label supply and demand diagrams properly. • Note here we are diagramming the market for the euro. Hence, it is crucial to represent the correct exchange rate on the vertical axis. • The correct exchange rate is one that reflects the “price” of the euro. That is, it must be an indirect quote.

6. An Increase in Demand • Consider an increase in the demand for the euro. • Suppose, for example, that savers desire euro-denominated financial assets relative to dollar-denominated financial assets because of a change in economic conditions. • The demand for the euro rises as savers desire more euros to purchase greater amounts of European financial assets.

7. An Increase in the Demand for the Euro The demand for the euro rises as savers desire more euros to purchase greater amounts of European financial assets.

8. The Supply of a Currency • The supply of one currency is derived from the demand for another currency. • Consider the demand schedule for the dollar. If the dollar depreciates relative to the euro, there is an increase in the quantity demanded of dollars. • As more dollars are purchased, the quantity of euros supplied in the foreign exchange market increases.

9. The Supply of the Euro Consider the demand schedule for the dollar. If the dollar depreciates relative to the euro, there is an increase in the quantity demanded of dollars. As more dollars are purchased, the quantity of euros supplied in the foreign exchange market increases.

10. An Increase in the Supply of the Euro An increase in the demand for the U.S. dollar by German residents leads to an increase in the supply of the euro.

11. Equilibrium • The market is in equilibrium when the quantity supplied of a currency is equal to the quantity demanded. • The equilibrium rate of exchange is also referred to as the market clearing exchange rate because there is neither a surplus nor a shortage of the currency.

12. Market Equilibrium At exchange rate Sb the quantity supplied of the euro exceeds the quantity demanded and the euro will depreciate. At exchange rate Sc, the quantity of euros demanded exceeds the quantity supplied and the euro will appreciate.

13. Increase in the Demand for the Euro An increase in U.S. consumers’ demand for German goods results in an increase in the demand for the euro. The euro appreciates relative to the dollar.

14. Central Bank Intervention • Suppose a nation’s policymakers desire to keep the value of the currency stable (relative to the currency of an important partner). • They may request the central bank to intervene in foreign exchange (FX) markets. • Basically, FX intervention entails the buying and selling of foreign reserves (foreign currency denominated financial instruments).

15. FX Intervention - Continued • Let’s continue with the previous example and assume that there is an increase in the demand for the euro. • As shown, the demand curve for the euro shifts to the right, resulting in an appreciation of the euro relative to the dollar.

16. FX Intervention - Continued • Now let’s suppose that the European Central Bank (ECB) desires to maintain the value of the euro at Se rather than the market determined rate S'. • The ECB would need to accommodate the increase in demand for the euro with an equivalent increase in the quantity of euros supplied.

17. Buying and Selling Foreign Reserves • Suppose the ECB buys dollar-denominated deposits from commercial banks. (In effect, the ECB is removing these dollars from circulation.) • The ECB must pay the banks for the dollar-denominated financial instruments it bought from them. • The ECB pays the banks with euro-denominated deposits – increasing the quantity of euros supplied.

18. FX Intervention The ECB accommodates the increase in the demand for the euro by increasing the quantity supplied of the euro via a purchase of dollar-denominated financial instruments.

19. FX Intervention - Conclusion • The increase in the quantity of euros supplied accommodates the increase in the demand for the euro. • The exchange rate remains at Se. • The quantity transacted, however, rises to Q2. • The amount (euro value) of the intervention is given by difference between Q‘d and Qe.

20. Over and Under-Valued Currencies • If a currency’s value is market determined, how can it be over- or under-valued? • A currency is said to be over- or under-valued if the market exchange rate is different from the rate that a model or individual predicts to be the “correct” rate. • In other words, the individual believes the market “has it wrong.”

21. Undervalued • Suppose your predicted spot value, Sb, lies above the market determined rate, Se. • Hence, you believe it should take a greater amount of dollars to buy each euro. You would conclude, therefore, that euro is undervalued.

22. Purchasing Power ParityAbsolute or the Law of One Price • Suppose The Economist magazine sells for £2.50 in the UK and $3.95 in the US. • Arbitrage, therefore, should guarantee that the exchange rate between the dollar and the pound to be s = 3.95/2.50 = 1.580 ($/£). • In words, the dollar price of The Economist in the UK should equal the dollar price of the Economist in the US (ignoring transportation costs).

23. Absolute PPP • Absolute PPP is expressed as P = P*×S, where P is the domestic price, P* is the foreign price, and S is the spot rate, expressed as domestic to foreign currency units. • Often it is rearranged as: S = P/P*. • The previous slide was an example of absolute PPP.

24. Relative PPP • Rearrange APPP to S = P/P*. • Often economists will take the log of this expression to obtain: %S = -  *. • In words, domestic inflation less foreign inflation should equal the change in the spot rate. • Relative PPP implies that the higher inflation country should see its currency depreciate. • This is the version that economists would test.