Mishkin PPT Ch17

7/25/2019 Mishkin PPT Ch17

1/22

Copyright 2010 Pearson Addison-Wesley. All rights reserved.

Chapter 17

The ForeignExchange Market


2/22

Copyright 2010 Pearson Addison-Wesley. All rights reserved.17-2

Foreign Exchange I

Exchange rate: price of one currency in terms ofanother

Foreign exchange market: the financial market

where exchange rates are determined Spot transaction: immediate (two-day) exchange of

bank deposits

Spot exchange rate

Forward transaction: the exchange of bank depositsat some specified future date

Forward exchange rate


3/22


Foreign Exchange II

!ppreciation: a currency rises in "aluerelati"e to another currency

#epreciation: a currency falls in "alue

relati"e to another currency

$hen a country%s currency appreciates& thecountry%s goods abroad become more

expensi"e and foreign goods in that countrybecome less expensi"e and "ice "ersa

'"er-the-counter market mainly banks


4/22


FIGURE 1 Exchange ates& **+,++

Source:Federal eser"e: www.federalreser"e.go"/releases/h+/hist.


5/22


Exchange Rates in the LongRun

0aw of one price

1heory of 2urchasing 2ower 2arityassumptions:

!ll goods are identical in both countries

1rade barriers and transportation costs are low

3any goods and ser"ices are not traded acrossborders


6/22


Factors that Affect ExchangeRates in the Long Run

elati"e price le"els

1rade barriers

2references for domestic "ersus foreigngoods

2roducti"ity


7/22Copyright 2010 Pearson Addison-Wesley. All rights reserved.17-7

FIGURE 2 2urchasing 2ower 2arity& 4nitedStates/4nited 5ingdom& *67,++ (8ndex:3arch *67 9 ++.)

Source:ftp.bls.go"/pub/special/reuests/cpi/cpiai.txt.



u!!ar" Ta#$e 1 Factors 1hat !ffectExchange ates in the 0ong un



Exchange Rates in the hort Run% Aupp$" an& 'e!an& Ana$"sis

!n exchange rate is the price of domesticassets in terms of foreign assets

Supply cur"e for domestic assets

!ssume amount of domestic assets is fixed(supply cur"e is "ertical)

#emand cur"e for domestic assets

3ost important determinant is the relati"eexpected return of domestic assets

!t lower current "alues of the dollar (e"erythingelse eual)& the uantity demanded of dollarassets is higher


10/22Copyright 2010 Pearson Addison-Wesley. All rights reserved.

17-10

FIGURE ( Euilibrium in theForeign Exchange 3arket



17-11

Exp$aining Changes inExchange Rates

Shifts in the demand for domestic assets

#omestic interest rate

Foreign interest rateExpected future exchange rate



17-12

FIGURE ) esponse to an 8ncreasein the #omestic 8nterest ate& iD



17-13

FIGURE * esponse to an 8ncreasein the Foreign 8nterest ate& iF



17-14

FIGURE + esponse to an 8ncrease inthe Expected Future Exchangeate& Ee

t+1


15/22


u!!ar" Ta#$e 2 Factors 1hat Shift the#emand ;ur"e for #omestic !ssets and !ffectthe Exchange ate


16/22


FIGURE 7 Effect of a ise in the #omestic8nterest ate as a esult of an 8ncrease inExpected 8nflation


17/22


App$ication% Changes in theE,ui$i#riu! Exchange Rate

;hanges in 8nterest ates

$hen domestic real interest rates raise& thedomestic currency appreciates.

$hen domestic interest rates rise due to anexpected increase in inflation& the domesticcurrency depreciates.

;hanges in the 3oney Supply

! higher domestic money supply causes thedomestic currency to depreciate.


18/22


App$ication% Changes in theE,ui$i#riu! Exchange Rate

Exchange ate '"ershooting

3onetary


19/22


FIGURE - Effect of a ise in the3oney Supply


20/22


App$ication% The 'o$$ar an&Interest Rates

$hile there is a strong correspondencebetween real interest rates and theexchange rate& the relationship between

nominal interest rates and exchange ratemo"ements is not nearly as pronounced


21/22


FIGURE . >alue of the #ollar and8nterest ates& *67,++

Sources:Federal eser"e: www.federalreser"e.go"/releases/h+/summary/indexn?m.txt@ real interest rate from Figure in ;hapter A.


22/22

Copyright 2010 Pearson Addison Wesley All rights reserved17-22

App$ication% The u#pri!eCrisis an& the 'o$$ar

#uring ,++6 interest rates fell in the 4nitedStates and remained unchanged in Europe.

1he dollar depreciated

Starting in the summer of ,++ interestrated fell in Europe.

8ncreased demand for 4.S. 1reasuries Bflightto ualityC

1he dollar appreciated

Documents

Mishkin PPT Ch17