Chapter

Explaining Changes in Exchange Rates

Assume the amount of dollar assets is fixed: The supply curve is vertical at a given quantity and does not shift. We need to look at only those facts that shift the demand curve for dollar assets. If the relative expected return of dollar assets rises, hold exchange rates constant, the demand curve shifts right. If the relative expected return falls, the demand curve shifts left. Domestic Interest Rates: An increase in the domestic interest rate iD shifts the demand curve for domestic assets to the right and causes domestic currency to appreciate. Foreign Interest Rates: An increase in the foreign interest rate IF shifts the demand curve to the left and causes the domestic currency to depreciate. Changes in Expected Future Exchange Rate: Important because the demand for domestic assets depends on the future resale price. A rise in the expected future exchange rate E(t+1) shifts the demand curve to the right and causes an appreciation of the domestic currency.

Why are Exchange Rates so Volatile?

Because expected appreciation of domestic currency affects the expected return on domestic assets, expectation about the price level, inflation, trade barriers, productivity, import demand, export demand, and the money supply all play important roles. So, when the expectations of any of these change, and they do often, then exchange rates are immediately affected.

Factors that Affect Long Term Exchange Rates

If a factor increases the demand for domestic goods relative to foreign goods, the domestic currency will appreciate. If a factor decreases the relative demand for domestic goods, the domestic currency will depreciate. Relative Price Levels: In the long run, a rise in a country's price level (relative to foreign price level) causes its currency to depreciate, and a fall in the country's relative price level causes its currency to appreciate. Trade Barriers: Increasing trade barriers such as tariffs (taxes on imported goods) and quotas (restriction on the amount of foreign goods that can be imported) causes a country's currency to appreciate in the long run. Preference for Domestic vs. Foreign goods: Increased demand for a country's exports causes its currency to appreciate in the long run; conversely, increased demand for imports causes the domestic currency to appreciate. Productivity: In the long run, as a country becomes more productive relative to other countries, its currency appreciates.

Law of One Price

If two countries produce an identical good, and transportation costs and trade barriers are low, the price of the good should be the same throughout the world no matter what country produces it.

Theory of Purchasing Power Parity (PPP)

States that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. The theory of PPP is simply an application of the law of one price to national price levels rather than to individual prices. Real Exchange Rate: The rate at which domestic goods can be exchanged for foreign goods. It is the price of domestic goods relative to the price of foreign goods denominated in the domestic currency.

Why does PPP fail to explain long term exchange rates?

The PPP theory fails to predict long tern exchange rates because it requires the assumption that transportation costs and trade barriers are low. It also assumes that all products in a categories of goods are the same, which is not true for things like cars and clothing, but is true for commodities like steel. Furthermore, PPP does not take into account that many goods and services are not traded across borders, such as houses and golf lessons.

Exchange Rate

The price of one currency in terms of another Appreciation: Currency increases in value Depreciation: Currency decreases in value Exchange rates are important because they affect the relative price of domestic and foreign goods. When a country's currency appreciates, the country's goods abroad become more expensive and foreign goods in that country become cheaper (holding prices constant). Conversely, when a country's currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.

Exchange Rates in the Short Run

Understand that exchange rate is the price of domestic assets (bank deposits, bonds, equities denominated in county's currency) in terms of foreign assets (same shit). Supply Curve: The quantity of dollar assets supplied is the quantity of bank deposits, bonds and equities with respect to the exchange rate. Represented by Es. Demand Curve: The quantity demanded at each current exchange rate by holding everything else constant, particularly the expected future value of the exchange rate. Represented by Et. Excess supply causes value to fall, excess demand causes value to rise. E* is the equilibrium exchange rate.

Effects of Interest Rate on Exchange Rate

When domestic real interest rates rise, the domestic currency appreciates When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreicates

Foreign Exchange Market

Where the trading of currencies and bank deposits denominated in particular currencies. Types of transactions: Spot: Involve immediate (two day) exchange of bank deposits. Uses the spot exchange rate. Forward: Involve the exchange of bank deposits at some future point. Uses the forward exchange rate. Countries trade currencies in foreign bank deposits. The volume of trades in this market is over $4 trillion per day. When you trade currencies for a vacation, you're buying them from dealers like American Express at a high rate.