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THE FOREIGN EXCHANGE MARKET

The price of one currency in terms of the other is called the exchange rate. It is defined as thenumber of domestic currency units that are necessary to buy one unit of foreign currency, e.g.,KD 0.300 to buy US$ 1.

What are Foreign Exchange Rates.

There are two kinds of foreign exchange transactions;

Spot Transactions: involve the immediate exchange of currencies ( it may take two days forthe exchange to take place ), based on the spot exchange rate.

Forward Transactions: involve the exchange of currencies at some specified future date; 30,60, 90 days,.etc., based on the ( current ) forward exchange rate.

Changes in Exchange Rates.

When a currency increases in value, it has appreciated, e.g., if

e ( KD, $ ) = KD 0.300 = $ 1,

where e ( KD, $ ) = the exchange rate of dollars in KD. If the exchange rate changed to KD 0.250= $ 1.

The value of KD vis-a-vis the dollar increased. When a currency increases in value itexperiences appreciation. When a countrys currency appreciates ( rises in value to othercurrencies ), the countrys goods abroad become more expensive and foreign goods in thecountry become cheaper.

If the exchange rate changed to Changed to KD 0.350 = $ 1. The value of KD vis-a-vis the dollardecreased. When a currency increases in value it undergoes depreciation. When a countryscurrency depreciates, its goods abroad become cheaper, while foreign goods in that countrybecome more expensive.

Exchange Rates in the Long Run.

The Theory of Purchasing Power Parity. States that exchange rates between any two currencieswill adjust to reflect changes in the price levels of the two countries.

Factors that Affect Exchange Rates in the Long Run.

Relative Price levels.

When the prices of domestic goods rise ( relative to foreign goods ), the demand for them fallsand the domestic currency tends to depreciate, and vice versa. In the long run a rise in thecountrys price level ( relative to foreign price levels ) causes its currency to depreciate, while afall in the countrys relative price level causes its currency to appreciate.

Tariffs and Quotas.

Barriers to free trade such as tariffs and quotas can affect the exchange rate. Tariffs andquotas cause a countrys currency to appreciate relative in the long run.

Preference for Domestic Versus Foreign Goods.

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Increased demand for a countrys exports causes its currency to appreciate in the long run,while increased demand for imports causes its currency to depreciate .

Productivity

In the long run, as a country becomes more productive relative to other countries, its currencyappreciates.

Exchange Rates in the Short Run.

We understood that exchange rates in the long run is determined by purchasing power parity,however, in the short run exchange rates may exhibit large changes from day to day.

The key to understand short-run behavior of exchange rates is to recognize that exchange rateis the price of domestic bank deposits ( i.e., denominated in domestic currency ) in terms of foreign bank deposits ( i.e., denominated in the foreign currency ). Hence exchange rate in theshort run will be determined using the asset market approach.

Comparing Expected Returns on Domestic and Foreign Deposits.

Suppose that KD deposits have a interest rate , while US $ deposits interest rate is . Tocompare the expected returns on KD deposits and US$ deposits we must convert the returnsinto the currency investors use.

Expected return on deposits is the nominal interest rate plus expected depreciation (), i.e. the expected return on domestic deposits equals;

while the expected return on foreign ( $ ) deposits is;

;

hence the relative return ( the difference between expected return on domestic deposits andforeign deposits ) is;

;

Interest Parity Condition.

Since foreign bank deposits and domestic bank deposits have similar risk and liquidity and

because there are few impediments to capital mobility, it is reasonable to assume that thedeposits are perfect substitutes. Under these conditions, if the expected return on domesticdeposits is above that on foreign deposits both national and foreign investors will want to hold

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KD deposits, and vice versa. For existing supplies of both KD deposits and $ deposits to be held,it must therefore be true that there is no difference in the expected returns, that is the relativeexpected return must equal zero, i.e.,

; ( expected returns in terms of KD )

This equation is called the INTEREST PARITY CONDITION, and it states that the domesticinterest rate equals the foreign interest rate plus the expected appreciation ( depreciation ) of thedomestic currency. Hence;

if domestic interest rate is above the foreign interest rate, this means that there is a positiveexpected appreciation of the foreign currency which compensates for lower foreign interestrate.

Given our assumption that domestic and foreign bank deposits are perfect substitutes, the

interest parity condition is an equilibrium condition for the foreign exchange market.

Equilibrium in the Foreign Exchange Market.

To see how the interest parity equilibrium condition works in determining the exchange rate letus examine how the expected returns on $ and KD deposits change as the current exchange ratechanges.

Expected Return on Foreign Deposits.

Equilibrium in foreign exchange market will be determined by the intersection of the schedulesfor the expected return on $ deposits and expected return on KD deposits. As shown in the

following figure.

figure

The expected return on $ slopes upward, i.e., as the exchange rate E rises, the expected return on$ deposits rises. A higher current exchange rate means a greater expected appreciation of the

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foreign currency in the future, which increases the expected return on foreign deposits in termsof KD.

Expected Return on KD deposits.

The expected return on KD deposits is always interest rate on KD deposits no matter what theexchange rate is.

Equilibrium.

The intersection of the schedules for the expected return on KD deposits and the expectedreturn on $ deposits is equilibrium in the exchange market, i.e.,

At equilibrium exchange rate the interest parity condition is satisfied because the expected

returns on KD and $ deposits are equal.

Explaining Changes in Exchange Rates.

Shifts in the Expected-Return Schedule for Foreign Deposits.

Factors that shift this schedule are the foreign interest rate, and the expected future exchangerate.

Changes in the Foreign Interest Rate.

If interest on foreign deposits increases, the expected return on these deposits must alsoincrease. Hence at a given exchange rate, the increase in foreign interest rate leads to a rightwardshift in the expected return schedule for foreign deposits. The outcome is a depreciation of KD.Alternatively we recognize that the increase on expected return on $ deposits at the originalequilibrium

exchange rate resulting from the rise in foreign interest rate means that people will want to buydollars and sell KDs, so the value of KD must fall.

Figure

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Conclusion: An increase in the foreign interest rate shifts the expected return schedule forforeign deposits to the right and causes the domestic currency to depreciate, and vice versa.

Changes in the Expected Future Exchange Rate.

Any factor that causes the expected future exchange rate to fall decreases the expectedappreciation of KD and hence raises the expected appreciation of the $. The result is a higherexpected return on $ deposits to the right and leads to a decline in the exchange rate.

Conclusion: a rise in the expected future exchange rate shifts the expected return schedule forforeign deposits to the left and causes a depreciation of KD, a fall in the expected exchange rateshifts the expected return schedule for foreign deposits to the right and causes an appreciation of KD.

Shifts in the Expected Return Schedule for Domestic Deposits.

Expected return on domestic deposits is the domestic interest rate.

Changes in the Domestic Interest Rate.

A rise in the domestic interest rate raised the expected return on KD deposits, shifts in theexpected return on domestic deposits to the right, and leads to a rise in the exchange rate.

Figure

Conclusion: a rise in the domestic interest rate shifts the expected return schedule for domesticdeposits to the right and causes an appreciation of the domestic currency; a fall in domesticinterest rate shifts the expected return schedule for domestic deposits to the left and causes adepreciation of the domestic currency.

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