Money and Banking Chapter 18 Foreign Exchange

Chapter 18 Foreign Exchange CHAPTER OBJECTIVES By the end of this chapter , students should be able to . Define foreign exchange and explain its importance . Describe the market for foreign exchange . Explain why countries should be proud that it takes many units of foreign currencies to purchase a single unit of their currency . Define purchasing power parity and explain its importance . List and explain the of exchange rates . List and explain the of exchange rates . Define the interest parity condition and explain when and why it holds . URL books 372

The Economic Importance of Currency Markets LEARNING OBJECTIVE . What is foreign exchange and why is it important ?

Before we turn to monetary theory ( gulp ! in Chapter 20 Money Demand , there is one more world market we need to investigate in this and the next chapter , the market for foreign currencies or foreign exchange , where the relative prices of national units of account or exchange rates are determined . Why should you care how many dollars ( it takes to buy a euro or a yen , a pound ( sterling ) or a dollar ( of Canada or Australia , respectively ) If you plan to travel to any of those places , you want to know so you can evaluate prices . Is a good price for a hotel room ?

How about ?

But even ifyou remain your entire life in a small village in Alaska , one of Hawaii outer islands , Michigan Upper Peninsula , or the northern reaches , the value of will your life deeply , whether you know it or not . Come again ?

How could that possibly be ?

Every nation in the world trades with other nations . Some trade more than others ( little islands like Iceland , and Ireland lead the way , in percentage of gross domestic product terms anyway ) but all do it , even illicitly , when the United Nations says that they can because they ve been We know from Chapter Money that conducting trade via barter isn practical in most circumstances . So we use money . But what happens when people who want to trade use types ofmoney , when their units are not the same ?

There are several solutions to . The most frequent solution today is for one party , usually the buyer , to exchange the money of his or her country for the money of the seller country , then to consummate the transaction . How does this affect you ?

Well , when the unit of account of your country , say , US . dollars ( or plain ) is strong , when it can buy many units of a foreign currency , say , Canadian dollars ( Canadian goods look cheap to you . And we all know what happens when goods are cheap . So you stop drinking Bud and start drinking . Instead of going to Manhattan to shop , you go to , and check out some Maple Leafs , Raptors , and Blue Jays games while you re at it . You go in April , that magical month for sports fans . When the Blue Jays game gets snowed out , you go instead to the Canadian ballet . Do you have any sense of humor at all ?

You might even consider URL books 373 buying a Canadian computer or automobile . Okay , let not get crazy . The point is you and your fellow Americans import Canada . The Canadians are very happy about this , but they are not so thrilled with American goods , which look dreadfully expensive to them because they have to give up many of their dear loonies to buy . So they too eschew Manhattan for and drink rather than Bud . In other words , exports to Canada fall . And because Canada is a major trading partner , that does not bode well for the economy overall , or US . residents , even those in remote villages . If were to continue to appreciate ( strengthen , buy yet more ) the situation would grow increasingly worse . Were the dollar to depreciate ( weaken , the situation would ameliorate and eventually reverse , and you go back to Bad , Manhattan shopping sprees , and the Yankees , Mets , Knicks , Nets , Islanders , and Rangers . Stop and Think Box A chain of pizza parlors in the southwestern part of the United States accepts Mexican pesos in payment for its pizzas . Many retail stores located near the Canadian border accept Canadian currency . Many Canadian businesses accept dollars , too . Why do these businesses accept payment in a foreign currency ?

Well , maybe they are good folks who want to help out others and maybe some of them need foreign currencies to purchase supplies . But those are at best ulterior motives in most instances because the exchange rate offered usually heavily favors the retailer . For example , the pizza parlor exchange rate was 12 pesos to the dollar when the market exchange rate was closer to 11 . So a 10 pizza costs 120 pesos ( 10 12 ) instead of 110 pesos ( 10 11 ) In short , it makes a tidy and largely riskless profit from the offer . Or imagine you don have many assets or a high income , but you need an automobile . You see a commercial that says that there are three ( Volkswagen automobile models ) under . You think you can afford that and begin to make arrangements to buy a Rabbit . But look The dollar price of a Rabbit and the euro price of a 10 computer fan at what happens to the dollar price of a Rabbit when the exchange rate changes . Say that the Rabbit of your dreams costs . When the dollar and the euro are at parity ( to ) the Rabbit costs URL books 374

. If the dollar ( buys fewer euro , and more are needed to buy ) the Rabbit grows increasingly costly to you . If the dollar appreciates ( buys more euro , and fewer are needed to buy ) that cool automotive bunny gets very cheap indeed ! Figure The ofa Rabbit and the euro price ofa 10 Now imagine that in your remote little town you make fans for French computers that you can sell for . The dollar movements will affect you as a producer , but in precisely the opposite way as it affected you as a consumer . When the dollar appreciates against the euro , your computer fans grow more expensive in France ( and indeed the entire euro zone ) which will undoubtedly cut into sales and maybe your salary or your job . When the dollar , the euro price of your fans plummet , sales become increasingly brisk , and you think about buying a Cadillac ( a more expensive American car ) KEY TAKEAWAYS Foreign exchange is the trading of different national currencies or units of account . URL books 375

It is important because the exchange rate , the price of one currency in terms of another , is a major determinant of a nation economic health and hence the wellbeing of all the people residing in it . The symbol for the euro , the currency of the European Union , is . The symbol for the Japanese yen is . overview URL books 376

Determining the Exchange Rate LEARNING OBJECTIVES . What is the structure of the foreign exchange market ?

Why should countries be proud that it takes many units of foreign currencies to purchase a single unit of their currency ?

We can teach you how to predict future exchange rates because the markets are highly and because exchange rates follow a random walk . Check out Chapter Rational Expectations , Markets , and the Valuation of Corporate Equities again if you need to . Trying to make a living predicting exchange rate changes is difficult indeed . That said , you should be able to why exchange rates changed or , in other words , to narrate plausible reasons why past changes , like those depicted in Figure How many did it take to buy Canadian dollar ?

and Figure How many Canadian dollars did it take to buy ?

may have occurred . This is similar to what we did with interest rates . Figure How many did it take to buy Canadian dollar ?

01 ! URL books ( 377 Figure How many Canadian dollars did it take to buy ?

I In I ! The , like the exchange rates in Figure The dollar price of a Rabbit and the euro price of a 10 computer fan , are mathematical of each other . Both express the exchange rate but from perspectives . Figure How many did it take to buy Canadian dollar ?

how many it took to buy , or mathematically . Figure How many Canadian dollars did it take to buy ?

asks how many it took to buy , or . In Figure How many did it take to buy Canadian dollar ?

weakens as the line moves up the chart because it takes more to buy . The dollar strengthens as it moves down the chart because it takes fewer to buy . Everything is reversed in Figure How many Canadian dollars did it take to buy ?

where upward movements indicate a strengthening of ( a weakening of ) because it takes more to buy , and downward movements indicate a weakening of ( a strengthening of ) because it takes fewer to buy . Again , the tell the same story strengthened the Canadian dollar from 2000 to early 2003 , then weakened considerably , experiencing many ups and downs along the way . We could do the same URL , 378

exercise ad nauseam ( Latin for until we vomit ) with every pair of currencies in the world . But we won because the mode of analysis would be precisely the same . We concentrate on the spot exchange rate , the price of one currency in terms of another today . The forward exchange rate , the price today of future exchanges of foreign currencies , is also important but follows the same general principles as the spot market . Both types of trading are conducted on a wholesale ( basis by afew international banks in an ( market . Investors and travelers can buy foreign currencies in a variety of ways , via everything from brokerage accounts to airport kiosks , to their credit cards . Retail purchasers give up more of their domestic currency to receive a given number of units of a foreign currency than the wholesale banks do . To put the same idea another way , they receive fewer units of the foreign currency for each unit of their domestic currency . That partly why the big banks are in the business . The big boys also try to earn via speculation , buying ( selling ) a currency when it is low ( high ) and selling ( buying ) it when it is high ( low ) They also seek out arbitrage opportunities , but those are rare and . Each day , over trillion of ( million plus per transaction ) foreign exchange transactions take place . Before we go any further , a few words of caution . Students sometimes think that a strong currency is always better than a weak one . That undoubtedly stems from the fact that strong sounds good and weak sounds bad . As noted above , however , a strong ( weak ) currency is neither good nor bad but rather advantageous ( disadvantageous ) for imports consumers and disadvantageous ( advantageous ) for of exportable goods and services . Another thing no need to thump your chest patriotically because it takes many units currencies to buy . That would be like proclaiming that you are hot because your temperature is degrees Fahrenheit instead of 37 degrees Centigrade ( that the same temperature , measured two different ways ) or that you are 175 centimeters tall instead of inches ( another equivalent ) Most countries have a very small unit of account compared to the United States , that is all . Other countries , like Great Britain , have units of account that are larger than the , so it takes more than to buy a unit of those currencies . The nominal level of the exchange rate in no way means that one country or economy is better than URL books 379

another . Changes in exchange rates , by contrast , have profound consequences , as we have seen . They also have profound causes . KEY TAKEAWAYS At the wholesale level , the market for foreign exchange is conducted by a few score large international players in huge ( trillion per day ) spot and forward markets . Those markets appear to be efficient in the sense that exchange rates follow a random walk and arbitrage opportunities , which appear infrequently , are quickly eliminated . In the retail segment of the market , tourists , business travelers , and investors buy and sell foreign currencies , including physical media of exchange ( paper notes and coins ) where appropriate . Compared to the wholesale ( million plus per transaction ) players , retail purchasers of a foreign currency obtain fewer units of the foreign currency , and retail sellers of a foreign currency receive fewer units of their domestic currency . The nominal level of exchange rates is essentially arbitrary . Some countries simply chose a smaller unit of account , a smaller amount of value . That why it often takes over to buy . But if the United States had chosen a smaller unit of account , like a cent , or had chosen a larger one ( like ) the yen and ( and the euro , as it turns out ) would be roughly at parity . A strong currency is not necessarily a good thing because it promotes imports over exports ( because it makes foreign goods look so cheap and domestic goods look so expensive to foreigners ) A weak currency , despite the to it , means strong exports because domestic goods now look cheap both at home and abroad . Imports will decrease , too , because foreign goods will look more expensive to domestic consumers and businesses . URL books 380

of Exchange Rates LEARNING OBJECTIVES . What is purchasing power parity ?

What are the other of exchange rates ?

costs are zero , identical goods should have the same price no matter what unit that price is expressed in . Or so says the law of one price . The reason is clear if they did not , would buy where the good was cheapest and sell where it was highest until the prices were equalized . Where transaction costs are or goods are similar but not identical , we don expect a single price , but rather a band or range of prices . So if product cost 100 in Country and 110 in Country , and it costs 10 to transport from to , there would be no arbitrage opportunity and the price differential could persist . If the price of rose in to 120 , we expect it to increase in to at least 110 , or would start buying it in and selling it in until the prices were within 10 of each other . Similarly , beer is not the same as beer . But it is close enough that we would not expect the prices to vary widely or otherwise consumers would dump Bud , Miller , and in favor of and ( or vice Versa , as the case may be ) This sort of analysis has led economists to apply the law of one price to entire economies in what they call the theory power parity ( which predicts that , in the long run , exchange rates will price level changes . In other words , higher rates of in compared to Country will cause Country A currency to depreciate Country currency in the long run . In the short run , however , matters are quite different , as Figure Purchasing power parity , United Kingdom and United States , shows , If held in the short run , should have appreciated against the pound ( the blue line should be above zero ) every year in which in the United Kingdom exceeded in the United States ( the red line is above zero ) and vice versa . Clearly , that was not the case . But has the right , in sign but not quite in magnitude . Between 1975 and 2005 , prices rose in Great Britain a shade under 205 percent all told . In that same period , they rose just under 142 percent in the United States . In other words , prices rose about 44 URL books 381

percent ( 205 142 142 ) more in Britain than in the United States . Over that same period , the pound sterling 22 percent against ( from to per or from to per ) just as theory predicts it should have . But why the discrepancy in magnitude ?

Figure Purchasing power parity , United Kingdom and United States , 05 . ev Yam Percentage at For starters , not all goods and services are traded internationally . Land and haircuts come immediately to mind , but many other things as well when you think about it hard enough . There is no reason for prices of those goods to be the same or even similar in different countries . can not buy low in one place and sell high in another because transaction costs are simply too high . For example , you could get a great haircut in Malaysia for cents but it would cost several thousand dollars and several days to get there and back . Figure rates in the long run URL books 382

In addition , three other factors exchange rates in the long run relative trade barriers , preferences for domestic and foreign goods , and in productivity . Tariffs ( taxes on imported goods ) quotas ( caps on the quantity of imported goods ) and sundry nontariff barriers ( to trade increase demand for domestic over foreign goods , thereby allowing the domestic currency to appreciate without injuring sales of domestic goods . Preferences for domestic goods have the same effect preferences for foreign goods ( French wine , German beer , Japanese automobiles ) have the opposite effect , depreciating the domestic currency by maintaining demand for foreign goods even in the face of higher prices . Finally , as a country becomes relatively more productive than other countries , the price of its wares tends to fall . Its currency , therefore , appreciates because it can do so without injuring exports . If a country productivity lags that of other countries , by contrast , its currency will depreciate . Of course , this is all . Figure of exchange rates in the long run summarizes the discussion . KEY TAKEAWAYS Purchasing power parity ( is the application ofthe law of one price to entire economies . I It predicts that exchange rates will adjust to relative price level changes , to differential inflation rates between two countries . They indeed do , but only in the long run and not to precisely the same degree . In the long run , exchange rates are determined by ( as described above ) and relative differences in productivity , trade barriers , and import and export demand . URL books 383

As Country A price level and import demand increase , and as Country A productivity , trade barriers , and export demand decrease another Country , Country A currency and Country appreciates . Basically , anything that lowers demand for Country A goods , services , and currency induces the currency to depreciate anything that increases demand for Country A stuff induces the currency to appreciate in response . Higher inflation relative to Country makes Country A stuff look more expensive , lowering demand and inducing depreciation . If economic actors in Country A take a fancy to Country stuff , they will import it even if Country currency weakens , making Country stuff more expensive . Reductions in trade barriers ( lower tariffs , higher quotas , fewer ) will exacerbate that . If , for whatever reason , economic actors in Country do like Country A stuff as much as they used to , they buy less of it unless Country A currency , making it cheaper . Finally , if Country A productivity slips relative to Country , Country A goods and services will get more expensive than Country so it will sell in Country only if its currency . URL books 384

of Exchange Rates LEARNING OBJECTIVES . What are the of exchange rates ?

What is the interest parity condition and when and why does it hold ?

As Figure South States exchange rate , June 2006 shows , exchange rates can be very volatile . In a single month ( June 2006 ) the South African rand from about to rand to , with various ups and downs along the way . The rand then reversed course and appreciated toward . Such are by no means unusual . Why do exchange rates undergo such ?

Figure of exchange rates in the short run summarizes the major factors affecting exchange rates in the short run . Note that it looks very much like Figure of exchange rates in the long run but with three key . First , instead of actual relative price levels , trade barriers , exports , imports , and productivity driving changes , expectations of their future direction drive changes . Given the discussion in Chapter Rational Expectations , Efficient Markets , and the Valuation of Corporate Equities , this should not be surprising . Second , two additional variables have entered the equation foreign and domestic interest rates . The intuition behind the variables is the same as those discussed above , but in the short run , the mere expectation of a change in a variable moves the market . The intuition behind the interest rates is also straightforward . If something increases demand for the domestic currency , like domestic interest rates increasing or foreign interest rates decreasing , it will appreciate . If something reduces demand for the domestic currency , like domestic interest rates decreasing or foreign interest rates increasing , it will depreciate . If this doesn make sense to you , review the discussion in Chapter The Economics of Fluctuations regarding the theory of asset demand . Because expectations and interest rates change frequently , so , too , do exchange rates under the current rate regime . Figure ( Slates ( June 2006 URL books 385

) IA 73 71 i 63 Figure rates in the short run URL books 386 Stop and Think Box We learned in Chapter Interest Rates that there is an important distinction between real and nominal interest rates . Through the Fisher Equation , we know that the nominal interest rate equals the real interest rate plus expectations . Is that distinction important when considering foreign exchange markets ?

Absolutely , and here is why . An increase in nominal interest rates caused by a rise in the real interest rate would leave expectations about future exchange rates unchanged and hence would cause the domestic currency to appreciate . An increase in nominal interest rates caused solely by an increase in expectations , by contrast , would cause the expected future exchange rate to decrease through the expected and actual price level effects . So the domestic currency would depreciate instead . The third between the long and short terms is that , in the short term , the expectation ofthe future direction of the exchange rate plays an important role . The easiest way to see this is to compare two investments with a time horizon a domestic ( say , bank account that pays percent per year and a foreign ( say , account paying percent per year . Before you jump for the sterling ( you need to consider that , in a year , you re going to want dollars again because you reside in the United States and need to buy lunch , pay the rent , and so forth . If the dollar appreciates more than percent over the course of the year , you be better off with the dollar deposit . Say that you invest in sterling when the exchange rate is or , in other words , Your investment today would buy . Multiply that by the interest on the sterling deposit ( and you get in a year . If the exchange rate is unchanged , you re cool because you have , which is greater than invested at percent , which equals . But what if , over the course of that year , the dollar appreciated strongly , to per pound ?

Then your would buy you only . You just took a bath , and not the good kind , because you should have invested in the dollar deposit ! Of course , if the dollar to , say , you be phat at . Stop and Think Box URL books 388 We learned in Chapter The Economics of Fluctuations that increases in the growth rate of the money supply will eventually cause the price level to increase , but its effect on nominal interest rates in the short term can vary rates can dip strongly , then rebound but remain permanently lower than the previous level , decrease temporarily before increasing permanently , or increase immediately . What does this mean for the market for foreign exchange ?

The fact that a major determinant of the exchange rate , foreign and domestic interest rates , moves around a lot helps to explain why the foreign exchange market is volatile . That market is also volatile because expectations of many things , including future differential price levels , productivity , and trading levels , will affect it via the variable . As noted above , the markets for foreign exchange and deposits are highly competitive and efficient , so we wouldn expect discrepancies in returns to last long . The law of one price , of course , applies most stringently markets in which international capital mobility is allowed because huge sums ofmoney ( deposits ) can be sent hither and thither almost immediately and , ideal conditions for the law of one price to prevail . So what economists call the interest parity condition often holds ( is true ) More formally , iD iF ( where in domestic interest rate if foreign interest rate Eat expected future exchange rate exchange rate today In plain English , if the interest parity condition holds , the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency . If i ! is i , the domestic currency must be expected to appreciate otherwise , everyone would sell their domestic deposits to buy the foreign ones . If iF is iv , the domestic currency must be expected to depreciate URL books 389

( have a negative sign , two of which make a positive , augmenting if ) otherwise , everyone would sell the foreign deposits and buy the domestic ones . If you find this confusing , there is another , more intuitive way of stating it the domestic interest rate must equal the foreign interest rate plus the expected appreciation of the foreign currency . If iF is iD , the expected appreciation of the foreign currency compensates for the lower interest rate , allowing equilibrium . You can practice calculating interest parity in Exercise . EXERCISE . Use the interest parity formula ( i ( to calculate the following URL books 15 15 15 10 15 10 390

( Rule ' I ' Rule I Rule 10 10 10 10 10 10 10 10 10 10 KEY TAKEAWAYS Because foreign exchange markets are efficient , in the short run , the mere expectation of changes in relative inflation , exports , imports , trade barriers , and productivity moves the markets . Also in the short run , differences in interest rates and expectations of the future exchange rate play key roles in exchange rate determination . The interest parity condition equates the domestic interest rate to the foreign interest rate minus the appreciation of the domestic currency . Or , by rearranging the terms , it equates the foreign interest rate to the domestic interest rate plus the expected appreciation of the domestic currency . The interest parity condition holds whenever there is capital mobility , whenever deposits ( units of account ) can move freely and cheaply from one country to another . It holds under those conditions because if it did , an arbitrage condition would exist , inducing to sell the overvalued deposit ( side of the equation ) and buy the undervalued one until the equation held . URL books 391

Modeling the Market for Foreign Exchange LEARNING OBJECTIVE . How can the market for foreign exchange be modeled ?

Like other markets , the exchange can be graphically modeled to help us visualize the action , as in Figure Equilibrium in the market for . There are a number of ways to do this , but perhaps the easiest is to plot the quantity of dollars on the horizontal and the exchange rate , stated in terms of foreign divided by domestic ( say , yen or ) on the vertical . The supply of dollar assets will be perfectly vertical , unchanged at every exchange rate . The demand for dollars , by contrast , will have the usual downward slope because , at higher exchange rates , fewer dollar assets will he demanded than at lower exchange rates . So at to , relatively few assets will be demanded compared to only or per dollar . The intersection of the supply and demand curves will determine , which in this case is , and , which in this case is 100 billion . Figure ( in 150 140 130 120 100 90 Rate ( 80 Quantity of dollars URL books 392

We can immediately see that , holding all else constant , anything that increases demand for assets ( shifts the demand curve to the right ) including an increase in the domestic interest rate , a decrease in the foreign interest rate , or an increase in ( for any reason , including the variables in Figure of exchange rates in the long run ) will cause the dollar to appreciate ( to increase when stated in terms of domestic or in this case ) Anything that causes demand for assets , including a decrease in the domestic interest rate , an increase in the foreign interest rate , or a decrease in , to decrease ( shift the demand curve to the left ) will cause the dollar to depreciate ( to decrease when stated in terms of domestic ) Stop and Think Box Figure exchange rate , using Figure Interest rates in Europe and the United States , and Figure Differential in the United States and the Euro zone , Figure rate , 115 11 . av . Figure rates in Europe and the United States , 00 ( URL books ( 393

Lo . I iv i ' a i Figure in the United States and the Euro zone , EU 93 ( LA A LA , I ?

a . From the beginning of 2000 until early 2002 , the dollar appreciated against the euro , moving from rough parity ( to ) to to per . This isn surprising given that interest rates ( here URL books 394 by the fed funds rate ) were higher than euro zone interest rates ( here by , the fed funds equivalent ) Moreover , except for the spike in early 2001 , the price level in the United States did not rise appreciably faster than prices in the euro zone did . Since , prices in the United States have risen faster than prices in the euro zone . There are more periods when the consumer price index in the United States was the in the euro zone , for example , when the red line is above zero . Since 2004 , interest rates have risen more quickly in the United States than in the euro zone , but not enough to offset the higher rate . Fears of a recession in the United States and slowing productivity also dragged on the dollar . KEY TAKEAWAYS URL The market for foreign exchange can be modeled in many different ways . The easiest way , perhaps , is to think of the price of a domestic currency , say , There is a given quantity of that is insensitive to the exchange rate . Demand for the domestic currency slopes downward for the usual reasons that economic actors demand more of an asset when it is cheaper . The intersection of the two lines determines the exchange rate . books 395

Suggested Reading Galant , Mark , and Brian . Currency Trading for Dummies . John Wiley and Sons , 2007 . A Foreign Exchange Primer , John Wiley and Sons , 2009 . URL org books Qo 396