Interest Rate and Exchange Rate Flashcards
What does E represent?
The nominal exchange rate of the domestic currency in units of the foreign currency ($1 = E euros)
What does it mean when E increases?
The Euro depreciates
what is the structure of the Foreign exchange market
-traders and investors buy and sell currencies in largely Inter-bank, over-the-counter transactions
-small transaction cost, high liquidity
What is the spot rate
price of currency agreed upon today for immediate transaction
What is the forward rate
price of currency agreed upon today for future transactions
Why is the dollar a vehicle currency
Large majority of future transactions made through dollar
What is Uncovered Interest Parity condition (UIP)
The link between the current exchange rate, the expected exchange rate, and the interest rate differential
What investment strategy should a risk-neutral investor follow?
They should be indifferent to either holding assets in domestic currency or trading currencies.
What is equilibrium on FOREX market
-r€ = r$ + (Ee –E)/E
-Ex. If E increases (€ depreciates), the return on $ assets decreases today because it is more expensive to buy $.
What are five assumptions of valid UIP
-Perfect mobility of capital
-Rational expectations
-No speculative bubble
-No risk aversion
-Assets are perfectly substitutable
What is the difference between Random Walk and UIP
The Random Walk is better for short-run (1-12 months) expectations, where as UIP is better for long-run expectations
Where does UIP fail
-Risk premiums non-observable: varies with time
-Speculative behaviours and bubbles
What is the covered interest parity condition (CIP)
-The link between E, forward rate, and interest rate differential
-A risk-adverse investor trades domestic currency for foreign currency with a higher interest rate and agrees future exchange rate today.
How do you calculate (CIP)
-(1+r€) = F(1+r$)/E
-if Forward rate>Exchange rate –> investor must be compensated with a higher interest rate –> making it worth while to exchange currencies for high forward rate
What must be true for a valid CIP
-Free capital movements
-Agents are profit maximizers (do not give up riskless opportunity of profit)
What three factors affect money demand
-interest rate, r€
-Price level, P€
-Transactions, Y€
What is the opportunity cost of money
-The interest rate, r; if r increases –> money demand decreases –> people invest
-Demand for money increases with economic activity (or GDP, Y)
How do you find money market equilibrium
-MS€ = Md€ = P€ x L (r€ , Y€)
-money supply determined by central banks
What is monetary neutrality
-in the long run, a change in monetary policy will have an impact on future exchange rates if prices are flexible
What impact does money supply have on market equilibrium in the long run
-Money supply only impacts prices
-No real impact on interest rate (r) or output (Y)
-Thus: P€ = MS€ / L (r€ , Y€)
What is the Quantity Theory of Money
-In long run increasing money supply only increases price level
-Inflation moves one for one with money growth in the long
run
What will be the result of permanent increase in money supply
-Currency overshoots, causing it to decrease by more than the long-run expected value (Dornbush)
-Overshoot due to slow adjustment of goods prices and immediate adjustment of the exchange rate
what is the result of overshooting
A permanent money supply leads to long-term depreciation of currency and long term increase in prices
