mishkin ppt ch17
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Chapter 17
The ForeignExchange Market
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Foreign Exchange I
Exchange rate: price of one currency in terms ofanother
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 depositsat some specified future date
Forward exchange rate
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Foreign Exchange II
!ppreciation: a currency rises in "aluerelati"e to another currency
#epreciation: a currency falls in "alue
relati"e to another currency
$hen a country%s currency appreciates& thecountry%s goods abroad become more
expensi"e and foreign goods in that countrybecome less expensi"e and "ice "ersa
'"er-the-counter market mainly banks
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FIGURE 1 Exchange ates& **+,++
Source:Federal eser"e: www.federalreser"e.go"/releases/h+/hist.
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Exchange Rates in the LongRun
0aw of one price
1heory of 2urchasing 2ower 2arityassumptions:
!ll goods are identical in both countries
1rade barriers and transportation costs are low
3any goods and ser"ices are not traded acrossborders
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Factors that Affect ExchangeRates in the Long Run
elati"e price le"els
1rade barriers
2references for domestic "ersus foreigngoods
2roducti"ity
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FIGURE 2 2urchasing 2ower 2arity& 4nitedStates/4nited 5ingdom& *67,++ (8ndex:3arch *67 9 ++.)
Source:ftp.bls.go"/pub/special/reuests/cpi/cpiai.txt.
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u!!ar" Ta#$e 1 Factors 1hat !ffectExchange ates in the 0ong un
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Exchange Rates in the hort Run% Aupp$" an& 'e!an& Ana$"sis
!n exchange rate is the price of domesticassets in terms of foreign assets
Supply cur"e for domestic assets
!ssume amount of domestic assets is fixed(supply cur"e is "ertical)
#emand cur"e for domestic assets
3ost important determinant is the relati"eexpected return of domestic assets
!t lower current "alues of the dollar (e"erythingelse eual)& the uantity demanded of dollarassets is higher
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FIGURE ( Euilibrium in theForeign Exchange 3arket
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Exp$aining Changes inExchange Rates
Shifts in the demand for domestic assets
#omestic interest rate
Foreign interest rateExpected future exchange rate
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FIGURE ) esponse to an 8ncreasein the #omestic 8nterest ate& iD
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FIGURE * esponse to an 8ncreasein the Foreign 8nterest ate& iF
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FIGURE + esponse to an 8ncrease inthe Expected Future Exchangeate& Ee
t+1
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u!!ar" Ta#$e 2 Factors 1hat Shift the#emand ;ur"e for #omestic !ssets and !ffectthe Exchange ate
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FIGURE 7 Effect of a ise in the #omestic8nterest ate as a esult of an 8ncrease inExpected 8nflation
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App$ication% Changes in theE,ui$i#riu! Exchange Rate
;hanges in 8nterest ates
$hen domestic real interest rates raise& thedomestic currency appreciates.
$hen domestic interest rates rise due to anexpected increase in inflation& the domesticcurrency depreciates.
;hanges in the 3oney Supply
! higher domestic money supply causes thedomestic currency to depreciate.
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App$ication% Changes in theE,ui$i#riu! Exchange Rate
Exchange ate '"ershooting
3onetary
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FIGURE - Effect of a ise in the3oney Supply
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App$ication% The 'o$$ar an&Interest Rates
$hile there is a strong correspondencebetween real interest rates and theexchange rate& the relationship between
nominal interest rates and exchange ratemo"ements is not nearly as pronounced
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FIGURE . >alue of the #ollar and8nterest ates& *67,++
Sources:Federal eser"e: www.federalreser"e.go"/releases/h+/summary/indexn?m.txt@ real interest rate from Figure in ;hapter A.
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App$ication% The u#pri!eCrisis an& the 'o$$ar
#uring ,++6 interest rates fell in the 4nitedStates and remained unchanged in Europe.
1he dollar depreciated
Starting in the summer of ,++ interestrated fell in Europe.
8ncreased demand for 4.S. 1reasuries Bflightto ualityC
1he dollar appreciated
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