Handout 3: Exchange Rates and the Foreign Exchange Market

Question 1

Nominal exchange rate

Answer 1

the price of one currency in terms of another (“bilateral” rate). Two ways to quote an exchange rate:

• units of foreign currency for one unit of somestic currency: 2$ for one £, denoted e£/$
• units of domestic currency for one unit of foreign currency: 0.5£ for one $, denoted e£/$

e£/$ = 1/ e£/$

Question 2

Depreciation

Answer 2

the value of a country’s currency falls with respect to another (its goods become cheaper to foreigners)

Question 3

Appreciation

Answer 3

the value of a country’s currency increases with respect to another (its goods become more expensive for foreigners).

Question 4

expected real rate of return (purchasing power for future consumption)

Answer 4

• the interest rate for each currency

- the expected change in the exchange rate between domestic and foreign currency

Question 5

risk

Answer 5

assets with high expected returns may become undesirable if the return is highly unpredictable

Question 6

liquidity

Answer 6

preference for holding liquid assets as a precaution for unexpected expenses

Question 7

Uncovered Interest Rate Parity Condition

Answer 7

The domestic interest rate must be equal to the foreign interest rate plus the expected rate of depreciation (appreciation) of the domestic currency.

r£ = r$ + (Change)e^e £/$

Question 8

What is the role in international trade that the exchange rate plays?

Answer 8

It is important because they allow us to compare the prices of goods and services produced in different countries.

Question 9

What is formula for the domestic strategy (expected rates of return)?

Answer 9

1 + r£

Question 10

What is the formula for the foreign strategy (expected rates of return)

Answer 10

1+r$(e^e£/$ / e£/$)

Question 11

How do the changes in the current excahnge rate affect expected returns?

Answer 11

Assume that interest rate r£ and r$ and expectations about future exchange rates (Change)e^e£/$ do not change:
r£ = r$ + e^e£/$ -e£/$ / e£/$

Then if e£/$ increases (depreciation of the £), e^e£/$ - e£/$ / e£/$, decreases so the expected domestic currency (£) return on foreign currency ($) deposits decreases (and conversely)

Question 12

What are the assumptions of exchange rate determination in the short run?

Answer 12

• Price level is fixed (SR); output and expectations are given.
• the interest rate is determined by the equilibrium in the monetary market.
• Money market equilibrium: money supply = money demand (M^d = M^s)
• M^s / P = L (Y,r)
• If Ms increases (Change in P = 0), r decreases for Y given.
• If Y increases, r increases for a given money supply Ms

Question 13

What is the short run effect of an increase in money supply on the exchange rate?

Answer 13

• Money supply Ms increases.
• At the curern interest rate there is an excess supply of money. This implies an excess demand for bonds so now the price of bonds goes up and the interest rate goes down.
• The equilibrium requires the interest rate to fall.
• At the current exchange rate this lowers the domestic return on deposits. (Excess S of £ ) implies an depreciation of the £.
• The foreign exchange market equiblirum requires the domestic currency to depreciate.