Chapter 7 The Foreign Exchange Market
Foreign Exchange Markets • Exchange rate—price of one currency in terms of another: EYTL/USD = 1.34 YTL/dollar • Foreign exchange market—the financial market where exchange rates are determined • Spot transaction—immediate (two-day) exchange of bank deposits at spot exchange rate • Forward transaction—the exchange of bank deposits at some specified future date at the aggreed forward exchange rate
Foreign Exchange Markets • Appreciation—a currency rises in value relative to another currency: EYTL/USD decreases. • Depreciation—a currency falls in value relative to another currency: EYTL/USD increases. • Why is Exchange Rate important? • 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
Foreign Exchange Markets • Over-the-counter market mainly banks. • Mostly deposits are traded, not paper currency. • Global foreign exchange market volume is ~ $1 trillion per day.
Exchange Rates in the Long Run • Law of one price. Price of the same good must be the same in different countries. Assume 1 ton Turkish steel is sold at 134 YTL and 1 ton American steel sold for 100 dollar. So if the exchange rate is 1.34 YTL/dollar, their price is equal (there is only one price). Assume tariffs and cost of transportation are zero.
Exchange Rates in the Long Run • Theory of Purchasing Power Parity • Exchange Rates between any two currencies adjusts to changes in the price levels of the two countries. This is a generalization of the law of one price to all goods.
Exchange Rates in the Long Run • Btw 1973-2005, British price level rose 84% relative to the US price level. Dollar appreciated against the pound by 43%. Although the theory predicts 84% appreciation. • Why does the theory of PPP cannot fully explain ER movements?
Exchange Rates in the Long Run • Why does the theory of PPP cannot fully explain ER movements? • Assumes trade barriers (tariffs and quotas) and transportation costs are zero. • Assumes all goods are tradable across borders. But in practice many goods and services are not tradedacross borders (nontradables) like houses, haircuts, health services, etc. • Assumes all goods are identical in both countries. Is Turkish steel the same as American?
Factors that Affect Exchange Rates in the Long Run • Anything that increases demand for Turkish goods increases the value of YTL in terms of foreign currency.
Factors that Affect Exchange Rates in the Long Run • Relative price levels. If prices of Turkish goods rise (fall) relative to foreign goods, demand for Turkish goods fall (rise), then YTL depreciates (appreciates). • Trade barriers. If tariffs increase (decrease), then YTL appreciates (depreciates). Ex: if tariffs on German cars decrease, demand for Turkish cars decrease, YTL depreciates.
Factors that Affect Exchange Rates in the Long Run • Preferences for domestic versus foreign goods. If Turks start to like Italian furniture more than Turkish furniture then YTL depreciates. • Productivity. If Turkey’s productivity increases, then prices in Turkey decline and causes YTL to appreciate.
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 (YTL) assets and foreign (dollar) assets is the expected return on these assets relative to each other.
Comparing Expected Returns • YTL denominated assets pay a real interest rate of iD • Dollar (foreign) assets pay real interest rate of iF • Expected depreciation of YTL against dollar is where Et is YTL/dollar exchange rate at time t. This is also appreciation of dollar against lira.
Comparing Expected Returns • From a Turkish investor’s perspective, expected return on holding dollar assets is equal to • Expected return on holding YTL assets in terms of liras is iD.
Comparing Expected Returns II So relative return of holding dollar assets is equal to • For example, if iD is 9%, iFis 3%, and YTL will depreciate 5% against dollar next year, then relative return from holding dollar assets is -1% (1% loss). Relative return from holding YTL assets is 1%.
Comparing Expected Returns III • Now think of holding YTL assets from an American investor’s perspective. Return on YTL assets for him is • If the American holds dollar assets instead of YTL, then loses the above return.
Comparing Expected Returns III • If the American holds dollar assets, then his return is iF . But he loses the return he could have earned by holding YTL assets. His returnrelative to YTL assets is
Comparing Expected Returns III • Result: relative RF in terms of liras = relative RF in terms of dollars • Regardless of the nationality of the investor, relative returns from holding dollar assets (which is equal to the minus relative returns from YTL assets) is the same in terms of dollars or liras. If relative returns from holding YTL assets increase, both Turks and Americans will (buy) hold more YTL assets and (sell) hold less dollar assets. This causes lira to appreciate.
Interest Parity Condition • An equilibrium condition: If both domestic and foreign assets are held, then expected returns must be the same on both domestic and foreign assets. Otherwise everybody would hold the one with positive relative return. Nobody will hold the other asset. • Capital mobility with similar risk and liquidity the assets are perfect substitutes. • The domestic interest rate equals the foreign interest rate plus the expected depreciation of the domestic currency
Demand for Domestic Assets • Demand increases if relative expected return increases. • Suppose Eet+1 = 1,45 . In which case is your YTL demand higher? İf Et= 1,31 YTL/dollar now or if Et= 1,60 YTL now? • At lower current values of YTL (everything else equal), the quantity demanded of YTL assets is higher
Demand for Domestic Assets 1/E 1/1,31 1/1,60 D Quantity of YTL assets
Supply of Domestic Assets • Supply • The amount of bank deposits, bonds, and equities in Turkey. This amount does not depend on the current exchange rate. • Vertical supply curve
EQUILIBRIUM S 1/E 1/1,31 1/1,60 D Quantity of YTL assets
IF REAL INTEREST RATE (iD) INCREASES IN TURKEY S 1/E 1/1,20 1/1,31 D’ 1/1,60 D Quantity of YTL assets
IF EXPECTED INFLATION INCREASES IN TURKEY S 1/E 1/1,20 1/1,31 D 1/1,60 D’ Quantity of YTL assets
IF FED INCREASES INTEREST RATE S 1/E 1/1,20 1/1,31 D 1/1,60 D’ Quantity of YTL assets
IF EXPECTED FUTURE EXCHANGE RATE Eet+1 APPRECİATES S 1/E 1/1,20 1/1,31 D’ 1/1,60 D Quantity of YTL assets
IF CBRT INCREASES MONEY SUPPLY • When the CB increases the money supply, the long run price level will increase. This means YTL will depreciate in the long run, due to purchasing power parity theory. Since the expected value of YTL next year is smaller, current demand for YTL assets decline. Causes YTL to depreciate.
Exchange Rate Overshooting • Monetary Neutrality in the long run • In the long run, a one percentincrease in the money supply is matched by the same one percent increase in the price level • But in the short run, price level cannot increase immediately. Prices are “sticky”. So, M/P (real money supply) increases. This causes domestic real interest rate to fall (liquidity preference theory). Demand for YTL declines further.
Exchange Rate Overshooting • But in the long-run, prices increase, M/P decreases back to original level and interest rate goes up again. This increases demand for YTL assets. But not completely because prices are higher than before. • The exchange rate depreciates more in the short run than in the long run • Helps to explain why exchange rates exhibit so much volatility
Exchange Rate Overshooting 1/E ($/YTL) 1/1,31 1/1,60 1/2 Time
The EURO’S FIRST SEVEN YEARS • Euro initially depreciated in 1999&2000. Strong US growth and poor growth & low real interest rates in Europe. But after 2001, euro started to appreciate because of the recession in the US.The recession still did not finish completely today.