Exchange Rate Determination

Question 1

What affects the demand for deposits denominated in foreign or domestic currency?

Answer 1

• return on assets denominated in domestic or foreign currency

Question 2

What is the rate of return that investors expect to earn determined by?

Answer 2

• interest rates
• expectations about appreciation and depreciation

Question 3

What is the interest rate parity condition?

Answer 3

RH= RF + (E*eH/F - EH/F/EH/F)

I.e.
The return on domestic assets equals the return on foreign assets + the expected depreciation of the home currency

Question 4

What does interest rate parity imply?

Answer 4

• deposits in all currencies are equally desirable
• arbitrage in the foreign exchange market is not possible

Question 5

What is the covered interest rate parity?

Answer 5

RH= RF + (FH/F-EH/F / EH/F)

The return on domestic assets in the return on foreign assets plus the forward premium

Question 6

What is the difference between the uncovered and covered interest rate parity conditions?

Answer 6

• covered interest rate parity - investment is risk less as forward rate is agreed tofay
• uncovered interest rate parity - expected exchange rate may be different from actual future exchange rate - risky position

Question 7

How can both UIP and CIP hold at the same time?

Answer 7

• only both hold of the forward rate is equal to the expected future spot rate
• I.e the forward premium should equal the expected depreciation of the home currency

Question 8

When is the model of foreign exchange markets in equilibrium?

Answer 8

• when interest rate parity holds
• I.e. when all currencies offer the same expected rate of return

Question 9

What happens when the exchange rate is below the the equilibrium rate?

Answer 9

• expected rate of return on domestic assets is less than the rate of return on foreign assets
• demand for foreign assets increased
• supply of domestic assets increases
• foreign currency appreciates
• domestic currency depreciates
• Exchange rate rises until equilibrium restored

Question 10

What happens when the exchange rate is above the equilibrium?

Answer 10

• rate of return on domestic assets is greater than expected return abroad
• demand for domestic assets increases
• supply of foreign assets increases
• domestic currency appreciates
• foreign currency depreciates
• exchange rate falls until equilibrium restored

Question 11

Assume US- home and Europe-Abroad
What happens when the FED increases the interest rate?

Answer 11

• rate of return on US assets increased
• vertical line shifts right
• individuals want to hold more dollars
• demand for dollars increases
• supply of euros increases
• dollar appreciates
• euro depreciates
• RHS of interest parity increases
• exchange rate falls until new equilibrium reached

Question 12

Assume US-home and Europe-Abroad
What happens when the ECB increases the interest rate?

Answer 12

• rate of return on euro deposits increases
• curve shifts up
• demand for euros increases
• supply of dollars increases
• euro appreciates
• dollar depreciates
• RHS of interest parity falls
• exchange rate increases until new equilibrium reaches

Question 13

Assume US-home and Europe-abroad
What happens if we expect the euro to appreciate on the future?

Answer 13

• curve shifts right
• expected return on euro deposits increases (greater than dollar return)
• demand for euros increases
• supply of dollars increases
• euro appreciates
• dollar depreciates
• RHS of interest parity condition falls
• exchange rate rises until new equilibrium