L6: Money, Interest Rates and Exchange Rates Flashcards
2 types of exchange rates
exchange rate that determines the relative price of goods across borders because of trade
exchange rates as determining the value of different assets in different currencies
the foreign exchange market
decentralised, largely dominated by financial institutions, permanent/concentrated, small transaction costs, high liquidity/volumes
key/central role of the USD on any foreign market
spot rate
price agreed today for a contract to buy and sell FOREX immediately (immediate trade)
forward rate
price agreed today for a forward contract to buy and sell FOREX in the future
dollar as a vehicle currency
a lot of trade of any currency with respect to the dollar
high liquidity so low transaction costs
network effects
coordination mechanism means that since everyone coordinates to use the dollar as the main currency, it lowers transaction costs of the dollar so obviously they coordinate to use it since it is cheaper
- also means that it is easier to find a buyer/seller of dollars and there are many of them so transaction costs are low
theory of exchange rates relies on?
returns on an asset in a foreign country depends on the foreign exchange rate
exchange rate adjusts to make sure people are indifferent between holding assets in different countries
uncovered interest rate parity (UIP) theory
the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period
assumptions of the UIP theory
perfect mobility of capital (zero transaction costs)
rational expectations
- agents do not make systematic errors in forecasting and use all information
no speculative bubble
- any asset that has high returns will have many buying it so high returns do not last long
no risk aversion
- only expected returns matter for the choice of investors
- people cannot care about risk: once they do, relationships do not hold perfectly
assets are perfectly substitutable
risk premium
when investors are risk averse, there is a premium to hold assets
compensation for the risk on that given asset
predictions from the theory of exchange rates
when the interest rate of a given currency increases, then the exchange rate should adapt
high interest rate currencies in the future should depreciate so investors are indifferent between holding the two currencies
empirical failures of the UIP theory
risk premium is non-observable and varies with time
- assumption that it moves in a way to rationalise it
- expectation that it moves a lot and creates volatility
speculative bubbles/behaviours
- markets are not perfectly rational when they make trades
- high interest rates tend to appreciate the currency
UIP is still useful to understand the response of exchange rates to unexpected changes of fundamentals but seems to work much better over the long run
covered interest rate parity condition
the relationship between interest rates and spot and forward currency values of two countries are in equilibrium
pricing a forward
1 + r€ = F (1 + r$) / E
covered interest parity condition
arbitrage between two risk-less investments (same returns)
factors affecting demand for money/liquidity (by firms/households)
interest rate (on a risk-less asset)
price level
transactions (GDP)
