FOREIGN

EXCHANGE
MARKET AND
EXCHANGE RATES
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
 Today’s global economy characterized by
high degree of international capital mobility.
 Hence investors can buy financial assets
denominated in many different currencies in
many markets around the world.
 Would a situation in which investors could
earn a higher expected return from buying
Japanese rather than U.S. assets persist for a
long time?
 What would the opportunity for traders to
make profits result into?
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
 If the Japanese assets have a higher
expected rate of return than the U.S. assets.
 Traders around the world will recognize a
chance to make a profit by selling U.S. assets
and buying Japanese assets.
 What effects do these buying and selling
transactions have on the expected return?
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
 As traders and investors sell dollar-
denominated assets and buy yen-
denominated assets.
 This increases demand for yen.

 This leads to appreciation of yen against

dollar.
 This appreciation continues till the point
when investors are indifferent between
holding U.S. or Japan assets.
 This means the return from both the assets
will be equal.
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
 Lets assume U.S. interest rate to be 5%. Lets
call it R the domestic expected rate of return.
 Suppose that future yen/dollar exchange rate
is 100 and Japanese interest rates are 5%. Le
 If current exchange rate is also 100
yen/dollar, then Rf the expected rate of return
from foreign assets equals R.
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
 But if current exchange rate is 105 yen/dollar
and the future expected exchange rate is 100
yen/dollar, that means dollar is expected to
depreciate.
 The dollar is expected to fall by 4.8%.

 This depreciation of dollar will increase the

expected return from foreign assets Rf to
9.8% (5% interest rate minus -4.8% expected
appreciation of dollar).
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
 Alternatively, if current exchange rate is 97
yen/dollar and the expected future exchange
rate is 100 yen/dollar.
 The dollar is expected to appreciate by 3.1%.

 This would imply that the expected rate of

return from foreign assets Rf will fall to 1.9%
(5% interest rate minus 3.1% expected
appreciation of dollar).
 If we plot these points and join them we get
an upward sloping Rf line.
 FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
Current exchange rate, EX (yen/dollar)

10
5 R < Rf

R = Rf
10
0

R > Rf
97

1.9% 5%
9.8%
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN DOMESTIC REAL INTEREST
RATES
 Interest rate is sum of real interest rate and
expected rate of inflation.
 We assume expected inflation is kept
constant.
 An increase in the domestic interest rates
increases expected rate of return on
domestic assets.
 This shifts the R curve from R to R towards
0 1
right.
 This indicates a rise in exchange rate, that
means the domestic currency will appreciate.
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN DOMESTIC REAL INTEREST
RATES
 Alternately if the domestic real interest rates
fall, it will lead to shifting of expected real
rate of return towards left.
 This would result in falling of exchange rates.

 That means depreciation of the domestic

currency.
EXAMPLE
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN DOMESTIC EXPECTED
INFLATION
 A change in nominal interest rate can also be caused
by a change in expected inflation for any real
interest rate.
 Initially due to increase in expected inflation the
nominal interest rate rises, this shifts R towards right
leading to higher exchange rate.
 But later due to inflation, the value of the domestic
currency is eroded, resulting in rightward shift of the
Rf curve, this causes exchange rate to fall down.
 Most empirical studies have shown that the second
effect dominates the first.
 Thus it results in depreciation of domestic currency.
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN FOREIGN INTEREST
RATES
 An increase in foreign interest rate shifts the
expected rate of return from foreign assets Rf
to right.
 This means the exchange rate will fall
leading to depreciation of the domestic
currency.
 An opposite scenario, i.e. decrease in foreign
interest rate, will trigger an opposite
movement, it will lead to appreciation of
domestic currency.
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN EXPECTED FUTURE
EXCHANGE RATES
 An increase or decrease in the expected
future exchange rate reflects shifts in one or
more underlying determinants of exchange
rate
 Differences in price levels.
 Differences in productivity growth.
 Shifts in preferences for domestic or foreign
goods.
 Differences in trade barriers.
 Also changes in expected future interest rates.
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN EXPECTED FUTURE
EXCHANGE RATES
 Factors that cause an increase in expected
future exchange rate shift the foreign
expected rate of return to the left and cause
the domestic currency to appreciate.
 Factors that decrease the expected exchange
rate have the opposite effect of resulting in
depreciation of domestic currency.
CURRENCY PREMIUMS IN
FOREIGN-EXCHANGE MARKETS
 Sometimes the investors would want something
extra to treat two financial assets as equal and be
indifferent to them while making their investment
decisions.
 Example:
 One year U.S. Treasury bill gives a rate of 8%.
 One year Germany government bond gives an interest
rate of 5%.
 Also suppose investors expect dollar to depreciate
against deutsche marc by 4% over the coming year.
 Thus we get, 8% = 5% – (– 4%) – hf,d
 We get hf,d =1%.
FOREIGN-EXCHANGE INTERVENTION
AND THE EXCHANGE RATE
 Central banks and governments seek to minimize
changes in exchange rates.
 A depreciating domestic currency raises costs of
foreign goods and may lead to inflation.
 Central banks attempt to reduce depreciation by
buying their own currency in foreign exchange
market.
 An appreciating domestic currency ca make
country’s goods uncompetitive in world markets.
 Central banks attempt to reduce appreciation by
selling their own currencies in the foreign exchange
markets.
UNSTERILIZED INTERVENTION
 When a central bank allows the monetary base to
respond to the sale or purchase of domestic
currency in the foreign exchange market.
 Now to raise the value of it’s currency, the central
bank must buy domestic currency from foreigners
and sell foreign assets.
 Foreign exchange intervention reduces the
monetary base.
 If nothing else changes, the intervention increases
the domestic short-term interest rate.
 As a result, domestic expected rate of return shifts
towards right .
 This leads to increase in exchange rate
UNSTERILIZED INTERVENTION
 The central bank buys foreign assets and sell
domestic currency, increasing the monetary
base and reducing the short-term interest
rates.
 This leads to shifting of domestic expected
rate of return towards left, i.e. it has
declined.
 This leads to falling of exchange rates.
STERILIZED INTERVENTION
 Central banks could use domestic open market
operations to offset the change in the monetary
base caused by foreign exchange intervention.
 Consider if Fed sells $1 billion of foreign assets.

 In absence of any offsetting intervention, monetary

base falls by $1 billion.
 However it could at the same time conduct an open
market purchase of $1 billion of government bonds.
 This will eliminate the decrease in the monetary
base arising from the foreign exchange
intervention.
SPECULATIVE ATTACK
 In 1991, to reduce inflationary pressures
German central bank Bundesbank raised
short term interest rates.
 As the interest rates rose above England,
France, Italy and other European countries,
speculators questioned if they would raise
their interest rates or devalue their
currencies.
 Sweden raised the interest rates.

 England became the first test case.

SPECULATIVE ATTACK
 Bank of England sold its foreign exchange
reserves of marks to buy large quantities of
pounds to support its exchange rate against
marc under ERM.
 The purchase shrank the money supply and
raised the short-term interest rates.
 This restored the exchange rate.

 Here speculators used pounds to buy marks

from Bank of England.
 They believed pound’s devaluation would
enable them to buy back more pounds later.
SPECULATIVE ATTACK
 There was shift in Rf towards right.
 This meant deflecting the devaluation of
pound would result in high short-term
interest rates.
 England was suffering from recession.

 After a week, British government withdrew

pound from ERM.
 After British, some other countries also
withdrew from ERM.