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EXCHANGE RATES AND THE MARKET FOR FOREIGN EXCHANGE
Exchange rate (nominal version): Price of one currency in terms of another, ex. E$/€ = 1,46 Use of exchange rate: Makes it possible to compare prices of goods produced in different countries. Direct and indirect versions of the exchange rate:
Direct: Value of a unit of foreign currency in terms of the domestic currency. Indirect: Value of a unit of domestic currency in terms of the foreign currency. Ex. Compute the dollar value of a product worth £50 when E is 1,50$/£: 1,50$/£*£50 = $75. Assume now that the value of the £ decreases to 1,25$/£ (note that this is an increase of the value of $, an appreciation). Then the product would be worth 1,25$/£*£50 = $62,50. Assume that the value of the £ increases to 1,75$/£ (note that this is an decrease of the value of $, an depreciation). Then the product would be worth 1,75$/£*£50 = $87,50. A depreciation of the domestic currency means that foreign products become more expensive in the home country, but the domestic products become cheaper to buy for foreigners. Hence an appreciation of a country’s currency raises the relative price of its exports and lowers the relative price of its imports.
The market for foreign exchange The exchange rate is determined by the interaction of supply and demand for the currency. Most trade in currencies takes place in financial centres (London, NY,
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Tokyo, Hong Kong, Singapore etc.). Arbitrage (buying cheap and selling dear) ensures that the rates are quickly equalised all over the globe.
The demand for foreign currency assets Ceteris paribus, economic agents want to keep their assets where the total return is highest. In the international context, the return is = interest + gain/loss due to exchange rate change. To see the point, denote R€ = today’s interest on one-year euro deposits E$/€ = today’s $/€ exchange rate (dollars per euro) Ee$/€ = expected exchange rate one year from today Then the expected return on a euro deposit, in terms of dollars is (approx.) (1) R€ + (Ee$/€ – E$/€)/E$/€
If this expression is larger than R$, then it pays to invest in euro assets, if it is smaller, it pays to invest in dollar assets.
Assume now, for simplicity, that all assets are equally risky and that liquidity of assets is unimportant.
Equilibrium: the interest parity condition The foreign exchange market is in equilibrium when deposits in all currencies give the same expected rate of return. If this is not the case there will be international capital flows eventually equalising the returns, changing interest rates, exchange rates or both. The interest parity condition is: R$ = R€ + (Ee$/€ – E$/€)/E$/€
(2)
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Note also: If R$ – R€ > 0 the dollar is expected to depreciate over the period in question. If R$ was equal to R€ before an increase in R$ leads to an immediate appreciation of the dollar.
Changes in the current exchange rate and expected rate of return Observation of (1) shows that An increase of the current exchange rate (depreciation of $) reduces expected rate of return on € deposits over the next year, cet. par. A decrease of the current exchange rate (appreciation of $) increases the expected rate of return on € deposits over the next year, cet. par.
The equilibrium exchange rate Assume that R$, R€ and Ee$/€ are given. In Figure1 the expected return on euro deposits is shown as a function of E$/€. At E1$/€ we have interest parity: Expected returns on foreign and domestic assets are equal. E2$/€: Return on euro deposits lower than that on dollar deposits. Holders of euro deposits try to sell them for dollars, i.e., $ appreciates and € depreciates until the equilibrium rate is reached. E3$/€: Return on euro deposits higher than that on dollar deposits. Holders of dollar deposits try to sell them for euros, i.e., $ depreciates and € appreciates.
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Figure 1.
E$/€
E2$/€
E1$/€
E3$/€
Expected return on euro deposits
R$
R€ + (Ee$/€ - E$/€)/ E$/€
Effect of changing interest rates on current exchange rates a) Rise of the US interest rate, Figure 2. Figure 2.
E$/€
E1$/€
E3$/€
Expected return on euro deposits
R1$
R2$
R€ + (Ee$/€ - E$/€)/ E$/€
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Assume an increase in the US rate of interest At the given exchange rate, the return on a euro deposit is now less than that on a dollar deposit Euro deposits are sold and dollar deposits are bought The $ appreciates against the € Since Ee$/€ is assumed given the dollar is now expected to depreciate more during the next period!
b) Rise of the Euro interest rate, Figure 3.
Figure 3.
E$/€
E2$/€
E1$/€
Expected return on euro deposits
R$
R€ + (Ee$/€ - E$/€)/ E$/€
An increase in the € interest rate makes the return on a euro deposit higher than that of a dollar deposit. Agents sell dollars and buy euros and the $ depreciates Since Ee$/€ and R$ are assumed given, the dollar is expected to depreciate less during the next period.
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In general: An increase in the interest rate paid on deposits of a currency causes that currency to appreciate against other currencies.
Note, however: The assumption of a constant expected exchange rate may not hold. Thus we need to investigate the case
c) Effect of changing expected exchange rate on the current rate. Figure 3 can be used. A rise in the expected exchange rate increases the dollar’s future expected depreciation The dollar return on euro deposits increases, so the demand for euro deposits increases causing the current $ exchange rate to depreciate
In general: A rise in the expected future exchange rate leads to a rise in the current exchange rate as well, and vice versa.