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Exchange rate - price of one currency in terms of another Foreign exchange market - the financial market where exchange rates are determined Spot transaction - immediate (two-day) exchange of bank deposits Spot exchange rate Forward transaction - the exchange of bank deposits at some specified future date Forward exchange rate
Copyright 2011 Pearson Canada Inc. 19 - 1 Chapter 19 The Foreign Exchange Market Copyright 2011 Pearson Canada Inc. 19 - 2 Foreign Exchange • Exchange rate - price of one currency in terms of another • Foreign exchange market - the financial market where exchange rates are determined • Spot transaction - immediate (two-day) exchange of bank deposits – Spot exchange rate • Forward transaction - the exchange of bank deposits at some specified future date – Forward exchange rate Copyright 2011 Pearson Canada Inc. 19 - 3 Canadian Exchange Rates Copyright 2011 Pearson Canada Inc. 19 - 4 Foreign Exchange • Appreciation—a currency rises in value relative to another currency • Depreciation—a currency falls in value relative to another currency • When a country’s currency appreciates, the country’s goods abroad become more expensive and foreign goods in that country become less expensive and vice versa Copyright 2011 Pearson Canada Inc. 19 - 5 Exchange Rates in the Long Run • Law of one price • Theory of Purchasing Power Parity – Assumes all goods are identical in both countries – Trade barriers and transportation costs are low – Many goods and services are not traded across borders Copyright 2011 Pearson Canada Inc. 19 - 6 Factors that Affect Exchange Rates in the Long Run • 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 – Trade barriers – Preferences for domestic versus foreign goods – Productivity Copyright 2011 Pearson Canada Inc. 19 - 7 Purchasing Power Parity Canada/United States Copyright 2011 Pearson Canada Inc. 19 - 8 Factors Affecting Exchange Rates in the Long Run Copyright 2011 Pearson Canada Inc. 19 - 9 Exchange Rates in the Short Run • An exchange rate is the price of domestic assets in terms of foreign assets • Using the theory of asset demand—the most important factor affecting the demand for domestic (dollar) assets and foreign (euro) assets is the expected return on these assets relative to each other Copyright 2011 Pearson Canada Inc. 19 - 10 Supply Curve for Domestic Assets • Treat Canada as the home country • Domestic assets denominated in dollars • Generally use euros to represent foreign country’s currency. • Quantity of dollar assets is supplied by bank deposits, bonds and equities in Cnaada • Can take this amount as fixed with respect to exchange rate • vertical supply curve [...]... of the dollar (everything else equal), the quantity demanded of dollar assets is higher • Supply – The amount of bank deposits, bonds, and equities in the U.S – Vertical supply curve Equilibrium in the Foreign Exchange Market Response to an Increase in the Domestic Interest Rate Response to an Increase in the Foreign Interest Rate Response to an Increase in the Expected Future Exchange Rate Factors the. .. supply causes the domestic currency to depreciate Exchange Rate Overshooting • Monetary Neutrality – In the long run, a one-time percentage rise in the money supply is matched by the same one-time percentage rise in the price level • The exchange rate falls by more in the short run than in the long run – Helps to explain why exchange rates exhibit so much volatility Effect of a Rise in the Money Supply... the Money Supply • An increase in the level of the money supply leads to a higher Canadian price level • This leads to a lower expected future exchange rate • Decline in expected appreciation of the dollar decreases the quantity of dollar assets demanded at each level of the exchange rate – Demand curve shifts left • Rise in real money supply causes the domestic interest rate to fall which lowers the. .. Exchange Rate Factors the Shift the Demand Curve for Domestic Assets & Affect the Exchange Rate I Changes in the Equilibrium Exchange Rate • Changes in Interest Rates – When the domestic real interest rate rise, the domestic currency appreciates – When domestic interest rates rise due to an expected increase in inflation, the domestic currency depreciates Effect or an Increase in the Domestic Interest Rate