The Foreign Exchange Market. Prof. Irina A. Telyukova UBC Economics 345 Fall 2008

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1 The Foreign xchange Market Prof. Irina A. Telyukova UBC conomics 345 Fall 2008

2 Outline The foreign exchange market is the market where assets denominated in different currencies are traded against each other. This market determines the values of currencies in terms of each other the exchange rates of currencies. We examine what determines foreign exchange rates in the short and long run. We also look at intervention by central banks in the market to affect the value of their currencies. 2

3 Why do we care? The exchange rate of a currency has effects on: the country s exports and imports Canadian dollar appreciation hurts Canadian producers, but helps Canadian consumers inflation when the Canadian dollar depreciates, the relatively higher prices of imports feed into the domestic price measurements (the CPI includes imports) output when the Canadian dollar depreciates, demand for its exports increase, thus increasing output 3

4 I. Foreign xchange Market Spot trades and forward trades Over-the-counter markets, players are mostly banks The market is very competitive Trade in foreign exchange literally means trade in assets denominated in different currencies (think bonds or deposit accounts) It is a wholesale market, volume of > $1 trillion per day Retail prices are higher than wholesale: you get a worse deal than the market exchange rate if you purchase foreign currency for a trip 4

5 II. xchange Rates in the Long Run The law of one price: if two countries produce an identical good, and transport costs and trade barriers are low, the price of the good should be the same everywhere regardless of who produces it that is, adjusting the prices for the exchange rates if Canadian maple syrup sells for CAD 4/litre, and Vermont maple syrup sells for USD 3/litre, the exchange rate must be 0.75 USD/CAD Theory of Purchasing Power Parity (PPP): exchange rates between any two currencies will adjust to reflect changes in the relative price levels of two countries if Canada s price level rises relative to the US, then CAD should depreciate (and USD will appreciate) 5

6 Caveats The law of one price / PPP theory do not fully capture the movement of the exchange rate. In particular, movements in relative prices in different countries have little predictive power for exchange rates in the short run. Reasons: many goods are not identical across countries (and so people may have preferences for one or the other) there are trade barriers and transport costs many goods are not traded, thus the CPI contains many goods that do not reflect/affect the exchange rate 6

7 Factors Affecting xchange Rate in the Long Run Any factor that increases the demand for domestically produced (Canadian) traded goods relative to foreigntraded goods will tend to appreciate domestic currency (CAD). Relative price levels when prices of Canadian goods rise relative to foreign goods, the CAD will depreciate. Trade tariffs (import taxes) and quotas (limits on quantities) make foreign goods relatively more expensive; increase demand for domestic goods, causing CAD to appreciate. Preference for domestic over foreign goods will appreciate domestic currency. Here, scope is important. Gains in domestic productivity tend to happen more in traded sectors. Increased productivity cheaper domestic goods increased demand currency appreciation. 7

8 III. xchange Rates in Short Run: Asset Trade We want to understand how spot exchange rates are determined xchange rates are the price at which domestic assets (e.g. bonds denominated in CAD) trade for foreign assets (e.g. bonds denominated in euro). Relative demand for domestic versus foreign assets will be an important determinant of exchange rates. Older theories of exchange rates focused on imports and exports But trade in assets is 25 times larger in terms of volume. 8

9 Demand for Domestic vs Foreign Assets Demand for the assets is determined by their relative returns (as always) Suppose CAD asset (bond) pays return i D, no capital gains; and euro asset (bond) pays i F. To compare the two, we also need to figure in the exchange rates. xpected return on domestic bond in terms of euro is: R D eur = i D e t+1 xpected relative return on domestic bond in terms of euro: RR D eur = i D i + F + t e t+1 t t t 9

10 Interest Rate Parity Imagine that returns on Canadian bonds relative to euro-denominated bonds are high. Then everyone in the world will want to hold Canadian bonds, and no one will want to hold the euro-denominated ones. Yet both are held in positive amounts usually. Assuming (reasonably) that the assets are perfect substitutes, in order for both to be held, the returns on the two assets must be equivalent! i D = i F e t+1 t t 10

11 Demand and Supply of Domestic Assets The demand curve for domestic assets is determined by their relative returns. The higher the current exchange rate, the less we can expect the CAD to appreciate Relative returns on the CAD assets will be lower Demand for CAD assets will be lower Downward-sloping demand curve The supply curve is the amount of bonds, deposits and shares in Canada, it is not determined by the foreign exchange market vertical supply curve. 11

12 Demand and Supply of Domestic Assets S D Quantity of CAD assets 12

13 Short-Run Shifters of xchange Rates xchange rates in this framework shift whenever demand for domestic assets shifts due to: Domestic interest rate if i D rises, people will want to hold more dollar assets (in the short run); demand for domestic assets increases (curve shifts right). Foreign interest rate if i F rises, people will want to hold more foreign assets; demand for domestic assets falls. xpected future exchange rate due to any of the longrun shifters of exchange rates (relative prices, trade barriers, preferences, productivity). xpected appreciation will increase demand for domestic assets. 13

14 Increase in Domestic Interest Rate S D D Quantity of CAD assets 14

15 Increase in Foreign Interest Rate S D D Quantity of CAD assets 15

16 Increase in Relative Prices of Canadian Goods: e decrease S D D Quantity of CAD assets 16

17 IV. Foreign xchange Market Intervention There are two types of foreign exchange intervention that the Bank of Canada can conduct: an unsterilized foreign exchange intervention results in a change in the monetary base a sterilized intervention does not In any foreign exchange intervention, the Bank buys foreign assets or sells its holdings of them, in exchange for Canadian currency 17

18 Unsterilized Intervention Suppose the Bank sells $1 billion dollars worth of its foreign assets. This reduces its holdings of those assets, and the Bank receives in exchange Canadian currency which it now holds it removes $1bln from circulation Assets Foreign assets -$1 bln Bank of Canada Liabilities Currency in circulation -$1bln 18

19 Unsterilized Foreign xchange Intervention Alternatively, the Bank could receive payment in cheques drawn on a domestic (Canadian) bank Bank of Canada Assets Foreign assets -$1 bln Liabilities Settlement balances (reserves) -$1bln A sale of foreign assets (purchase of domestic currency) results in a 1-for-1 decrease in monetary base. A purchase of foreign assets results in an increase in MB. 19

20 Sterilized Foreign xchange Intervention If the Bank does not want its foreign exchange intervention to result in a change in monetary base, it can conduct an offsetting open market operation..g. if it sells foreign assets, it can simultaneously buy domestic bonds in the same amount. The first will decrease the MB, but the second will increase it. Bank of Canada Assets Foreign assets - $1 bln Gov t bonds + $1 bln Liabilities Monetary base -- no change 20

21 Unsterilized Intervention: ffect on xchange Rate Suppose the Bank buys foreign assets (sells Canadian dollars) This will lead to an increase in the monetary base Two effects: higher domestic money supply leads to an increase in the Canadian price level in the long run, so to a lower future expected exchange rate currently this means lower expected returns on dollar-denominated assets demand for dollar assets falls also, in the short run, an increase in money supply will cause interest rates to fall, further lowering expected returns on dollar assets in the long run, the interest rate will return to its previous level demand for dollar assets will recover somewhat 21

22 Unsterilized Intervention S Initial decrease in demand due to a fall in expected returns on dollar assets for two reasons: lower short-run interest rates and higher expected relative price level D D Quantity of CAD assets 22

23 Unsterilized Intervention S Some of the demand eventually recovers as interest rates recover to their initial level (or higher) in the long run D D D Quantity of CAD assets 23

24 Sterilized Intervention: ffect on xchange Rate A sterilized intervention leaves the monetary base unchanged Thus there are no effects on the price level or the short-run interest rates A sterilized intervention has no effect on the exchange rate So if the Central Bank wants to affect the exchange rate, it has to do so by unsterilized intervention 24

25 V. xchange Rate Regimes There are three types of exchange rate regimes: a fixed exchange rate regime is one where one country s currency is pegged to the value of another currency (e.g. yuan to the US dollar) a floating exchange rate regime is one where a country s currency value is allowed to fluctuate freely a dirty float (managed exchange rate regime) is a system where countries attempt to influence their currency value by foreign exchange intervention 25

26 Fixed xchange Rate Regimes: Gold Standard Before WWI, the world operated under the gold standard This effectively fixed the exchange rates: a British pound was worth ¼ oz gold, a CAD = 1/20 oz. So the exchange rate would be $5 to the pound. World money supply was heavily tied to gold production in the world: could not grow fast enough to keep pace with the economy, resulting in deflation. After 1890 s new sources of gold discovered, money supplies rose rapidly, resulting in inflation. Made it difficult for countries to have control over their monetary policy 26

27 Fixed xchange Rate Regimes: Bretton Woods ( ) Set up the IMF, the World Bank and General Agreement on Tariffs and Trade (today s WTO) US dollar as reserve currency: based on its convertibility to gold, the system was to be maintained by foreign exchange interventions where other countries central banks would buy dollar assets If domestic currency is overvalued a the fixed rate, the central bank intervenes by selling foreign assets (purchasing domestic currency), causing demand for domestic assets to increase; and vice versa If a country ever runs out of foreign reserves, it cannot keep its currency from depreciating a devaluation occurs Loss of monetary policy control 27

28 An Overvalued Currency: Intervention S par D D Quantity of domestic assets 28

29 Reading These slides are based on: all of chapter 19 chapter 20, pages only 29

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