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Exchange rates

Outline
1

Exchange rate denitions
Denitions

2

Short run
Foreign exchange market
Money market (interest rates)
Links between money and foreign exchange markets
Fixed exchange rate regimes

3

Long run
Purchasing power parity

4

Summary
Main conclusions

Exchange rate denitions
Exchange rates may be quoted as:

foreign currency per unit of domestic currency

How much can be exchanged for ¿1: e1
...
8475/e

Allow us to denominate the cost of a good or service in a common
currency

How much does a Renault cost?

25,000
25,000 x ¿0
...
8/
euro

less valuable and can buy fewer Euros
...
8 = ¿20, 000 −→ 25, 000 ∗ 1 = ¿25, 000)
exports cheaper
Appreciation is an increase in the value of a currency relative to
another currency

¿  ¿0
...
8/
the Euro

pound more valuable
imports cheaper (Renault ¿20, 000 −→ 25, 000 ∗ 0
...
6
1
...
2
1

0
...
6

Periods of dollar appreciation and depreciation

Foreign exchange market

Major factor inuences the demand for currencies is:

Rate of return - the percentage change in the value of currency
deposits

determined by:

interest rates that the assets will earn in each currency
expectations about appreciation or depreciation of currencies

investors want to hold currency oering highest overall return
Other factors, e
...
risk and liquidity, less important

Calculating return in dierent currencies
Imagine you hold $100, and may invest in dollars or euros

interest rate on a dollar deposit is 2%
interest rate on a euro deposit is 4%
exchange rate today is $1/ 1 and expected rate in one year is
$0
...
02 = 2%
$100

Calculating return in dierent currencies
Imagine you hold $100, and may invest in dollars or euros

interest rate on a dollar deposit is 2%
interest rate on a euro deposit is 4%
exchange rate today is $1/ 1 and expected rate in one year is
$0
...
04 +

E$/¿

(0
...
04 + −0
...
03/ 1

¿

¿

1

What is the rate of return if you invest in dollars?

2

What is the rate of return if you invest in euros?

Return on

3

¿ in dollars = R¿ +

Which would you invest in?

e
(E$/¿ − E$/¿ )

E$/¿

Interest parity

Use this logic to construct

interest parity model of exchange rates:

Equlibrium where all currencies oer same expected return:

R$ = R¿ +

e
(E$/¿ − E$/¿ )

E$/¿

all currencies equally desirable
no arbitrage possibilities

Interest parity (cont
...
g
...
)
Aggregate demand for real money balances:

M d = L (R , Y )
P

Supply of money
Money supply determined by central bank
money printed and supplied into economy
reserve ratios (money multiplier)

Equlibrium in money market where:

Ms = Md
Ms
= L (R , Y )
P

Interest rate determination
Interest rate determined by equlibrium in money market:

M s = L (R , Y )
P

Changes in interest rates

1

What would be the eect on interest rates of an increase in money
supply?

2

What would be the eect on interest rates of an increase in real
income (output)?

Eect of changes in money supply

Eect of changes in income

So far

So far we have:
1

Model of foreign exchange market in which interest rates determine
exchange rate

2

Model on money market which determines interest rates

Combine to create monetary model of exchange rates
...
)
Overall
equilibrium
requires
equilibrium in
both money
market and
foreign exchange
market

Eect of change in US money supply
Increase in US money
supply leads to
depreciation of dollar
Interest rates fall

return on
domestic
currency
deposits falls
currency
depreciates
e
...
Quantitative
Easing

Eect of change in European money supply?

1

What would be the eect on the $/

¿ exchange rate of an increase in

European money supply?

Eect of change in European money supply

Eect of changes in output
e
...
current account
improvement - more
exports, fewer
imports
increases
demand for
money
raises interest
rates
domestic
currency
appreciates
Expectations of
output increase also
cause appreciation
(through

Ee)

Fixed exchange rate regimes

Until now we have assumed that exchange rates determined in foreign
exchange market

exchange rates determined by market not government (though has
inuence through money supply/monetary policy)
Many countries pursue xed (to exchange rate regime, e
...
Denmark,
Qatar

to maintain xed exchange rate at E0 central bank must be prepared to
buy or sell as much currency as is required at the xed rate
must eliminate excess supply or demand to maintain constant rate

Maintaining x
Say output increases
(current account
improvement)
Cannot allow
appreciation

must remove excess
demand for dollars
Bank buys foreign
assets using
domestic currency

increases
domestic supply
and foreign
exchange
reserves

until equilibrium ar
R ∗ and E 0
...


PUK = E¿/¿ ∗ PEU
Exchange rates determined by levels of average prices:

E¿/¿ =

PUK
PEU

If price of basket of goods in UK is ¿150 and same basket costs
Ireland:

E¿/¿ =

150
200

¿200 in

= 0
...
)
Two forms of PPP:

Absolute PPP: Exchange rates equal the level of relative average
prices across countries

E¿/¿ =

PUK
PEU

Relative PPP: changes in exchange rates equal changes in prices
(ination) between two periods

(E¿/¿,t − E¿/¿,t −1 )

E¿/¿,t −1

= πUK ,t − πEU ,t

Does it hold?

Does it hold?

Relative PPP - perhaps in the very long run

Shortcomings of PPP

1

Empirical evidence mixed

little support for absolute PPP
relative PPP more consistent with data, but predicts exchange rates
poorly
2

Trade barriers, transport costs and non-traded goods

3

Imperfect competition

price discrimination between markets
4

Dierences in baskets measured between countries

Short run conclusions
1
...
g
...
Adopting xed exchange rate regime directs monetary policy to
exchange rate targeting rather than ination/output objectives

Long run conclusions

Dierences in ination rates determine exchange rates in (very) long
run

evidence mixed
predictive power of PPP poor

Reading

Krugman et al (2011)

Chapter 14 (Exchange rates and the foreign exchange market: an asset
approach), pp 350-380
Chapter 15 (Money, interest rates and exchange rates), pp 384-413
Chapter 18 (Fixed exchange rates and foreign exchange intervention),
pp 493-509
Kenen, P
...


Cato Journal

20 (1) 109-113
...
and M
...


Journal of Economic Perspectives 18 (4) 135-158

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