Long run: Law of one price Purchasing Power Parity. Short run: Market for foreign exchange Factors affecting the market for foreign exchange

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1 Lctur 6: Th Forign xchang Markt xchang Rats in th long run CON 34 Mony and Banking Profssor Yamin Ahmad xchang Rats in th Short Run Intrst Parity Big Concpts Long run: Law of on pric Purchasing Powr Parity Short run: Markt for forign xchang Factors affcting th markt for forign xchang Intrst t Parity Forign xchang I xchang rat: pric of on currncy in trms of anothr Forign xchang markt: th financial markt whr xchang rats ar dtrmind Spot transaction: immdiat (two-day) xchang of bank dposits Spot xchang rat Forward transaction: ti th xchang of bank dposits at som spcifid futur dat Forward xchang rat Forign xchang II Apprciation: a currncy riss in valu rlativ to anothr currncy Dprciation: a currncy falls in valu rlativ to anothr currncy Whn a country s currncy apprciats, th country s goods abroad bcom mor xpnsiv and forign goods in that country bcom lss xpnsiv and vic vrsa Currncy xchangd at ovr-th-countr markt mainly banks

2 xchang Rats, XCHANG RATS IN TH LONG RUN Sourc: Fdral Rsrv: xchang Rats in th Long Run Law of on pric Factors that Affct xchang Rats in th Long Run Rlativ pric lvls Thory of fpurchasing Powr Parity assumptions: All goods ar idntical in both countris Trad barrirs and transportation costs ar low Many goods and srvics ar not tradd across bordrs Trad barrirs Prfrncs for domstic vrsus forign goods Productivity

3 Purchasing Powr Parity, Unitd Stats/Unitd Kingdom, (Indx: Jan 73 = 00.) US-UK xchang rat CPIUS/CPIUK Summary Tabl Factors That Affct xchang Rats in th Long Run dx (73 = 00) Ind Sourc: Ahmad, Y. and W. Craighad (200), Tmporal Aggrgation and Purchasing Powr Parity Prsistnc XCHANG RATS IN TH SHORT RUN xchang Rats in th Short Run: A Supply ppy and Dmand Analysis An xchang rat is th pric of domstic assts in trms of forign assts Supply curv for domstic assts Assum amount of domstic assts is fixd (supply curv is vrtical) Dmand curv for domstic assts Most important dtrminant is th rlativ xpctd rturn of domstic assts At lowr currnt valus of th dollar (vrything ls qual), th quantity dmandd of dollar assts is highr

4 quilibrium in th Forign xchang Markt xplaining Changs in xchang Rats Shifts in th dmand for domstic assts Domstic intrst rat Forign i intrst rat xpctd futur xchang rat Rspons to an Incras in th Domstic Intrst Rat, i D Rspons to an Incras in th Forign Intrst Rat, i F

5 Rspons s to an Incras in th xpctd d Futur xchang Rat, t+ Summary Tabl 2 Factors That Shift th Dmand Curv for Domstic Assts and Affct th xchang Rat ffct of a Ris in th Domstic Intrst Rat as a Rsult of an Incras in xpctd Inflation Application: Changs in th quilibrium xchang Rat Changs in Intrst Rats Whn domstic ral intrst rats rais, th domstic currncy apprciats. Whn domstic intrst rats ris du to an xpctd incras in inflation, th domstic currncy dprciats. Changs in th Mony Supply A highr domstic mony supply lowrs th domstic intrst rat and causs th domstic currncy to dprciat.

6 Application: Changs in th quilibrium xchang Rat xchang Rat Ovrshooting Montary Nutrality In th long run, a on-tim prcntag ris in th mony supply is matchd by th sam on-tim prcntag ris in th pric lvl Th xchang rat falls by mor in th short run than in th long run Hlps to xplain why xchang rats xhibit so much volatility ffct of a Ris in th Mony Supply Application: Th Dollar and Intrst Rats Valu of th Dollar and Intrst Rats, Whil thr is a strong corrspondnc btwn ral intrst rats and th xchang rat, th rlationship btwn nominal intrst rats and xchang rat movmnts is not narly as pronouncd Sourcs: Fdral Rsrv:

7 Application: Th Subprim Crisis and th Dollar During 2007 intrst t rats fll in th Unitd Stats t and rmaind unchangd in urop. Th dollar dprciatd Starting in th summr of 2008 intrst ratd fll in urop. Incrasd dmand for U.S. Trasuris flight to quality Th dollar apprciatd INTRST PARITY Comparing xpctd Rturns I Dollar assts pay an intrst rat of i D and do not hav any capital gain Forign assts hav an intrst rat of i F and thr is no capital gain To compar th xpctd rturns on dollar assts and forign assts th rturns must b convrtd into th currncy unit usd th spot xchang rat + th xchang rat for th nxt priod t+ - th xpctd rat of apprciation for th dollar Comparing xpctd Rturns II Th xpctd rturn on dollar assts R D in trms of forign currncy is th sum of th intrst rat on dollar assts plus th xpctd apprciation of th dollar R D in trm of uros = i D t t Th xpctd rturn on forign assts R F is i F Rlativ R D i D i F t t As th rlativ xpctd rturn on dollar assts incrass, forignrs will want to hold mor dollar assts

8 Comparing xpctd Rturns III Th xpctd rturn on forign assts R F in trms of dollars is th intrst rat on forign assts i F plus th xpctd apprciation of th forign currncy, qual to minus th xpctd apprciation of th dollar R F in trms of dollars = i F t Th xpctd rturn on th dollar assts R D is i D Rlativ R D i D (i F t Which is th sam as prviously ) i D i F t t Rlativ xpctd rturn on dollar assts is th sam whthr it is calculatd in trms of uros or in trms of dollars As th rlativ xpctd rturn on dollar assts incrass, both forignrs and domstic rsidnts will want to hold mor dollar assts Intrst Parity Condition I i D i F t Capital mobility with similar risk and liquidity th assts ar prfct substituts Th domstic intrst rat quals th forign intrst rat minus th xpctd apprciation of th domstic currncy xpctd rturns ar th sam on both domstic and forign assts An quilibrium condition Intrst Parity Condition II F t t F i t t i i t F D i i D D i t t t t F D i i Th last xprssion can b usd to xplain th rsults obtaind with th supply and dmand analysis t