The Foreign Exchange Market

Question 1

Defining the nominal exchange rate

Answer 1

Assumption: exchange rate is a jump variable affected by news

Question 2

Why is the exchange rate important

Answer 2

• » Exchange rates allow us to denominate the cost or price of a good or service in a common currency.
• » Exchange rates represent a cost to firms.
• » Exchange rate changes create a risk to those firms that hold assets in currencies other than Sterling.
• » Exchange rates affect the price of exports.

Question 3

Depreciation and appreciation of a home currency

Answer 3

» Depreciation of a currency relative to another currency implies it is less valuable.
» Appreciation is a rise in the value of a currency relative to another currency.

If the value of e increases, then it is a depreciation of home’s currency.
Why?
» One unit of foreign’s currency will buy more units of home’s currency.

Question 4

Spot and forward rates

Answer 4

Spot rates: exchange rates for currency exchanges ‘on the spot,’ or
when trading is executed in the present.
» Forward rates: exchange rates for currency exchanges that will occur
at a future (‘forward’) date.

Question 5

Real exchange rate

Answer 5

Concept of the real exchange rate Home’s real exchange rate (RER or Q):

Question 6

The foreign exchange market

Answer 6

The set of markets where foreign currencies and other assets are exchanged for domestic ones.

Statistics imply that forex market is the largest financial market in the world.

Question 7

Arbitrage in the forex market

Answer 7

In order to take advantage of arbitrage opportunities in the bond market, an agent must have the relevant national cur¬ rency. For example, to buy US Treasury Bills, it is necessary to have US dollars; to buy German government Bunds, it is necessary to have euros. The exchange rate will depend on supply and demand in the foreign exchange market. An important source of demand and supply of foreign exchange arises from the desire of economic agents to buy and sell government bonds in order to take advantage of differences in interest rates.

Take the possibility of profiting from an interest rate differential opened up by a decision of one central bank to change its interest rate. This is a form of arbitrage opportunity. If, for example, the Bank of England increased the UK interest rate so that the return on UK bonds was higher than on US bonds, there would be a rush into UK pounds and out of US dollars until the chance of profiting from one rather than the other kind of bond has vanished.

Question 8

In this example, we as¬sume that the UK is the home economy and the US is the foreign economy. There will therefore be a rush out of US dollars and into UK pounds, due to the higher return on UK bonds. What happens to the exchange rate between UK pounds and US dollars as a result of this?

Answer 8

In this example, the interest differential in favour of UK bonds results in stronger demand for UK pounds, which forces the currency to appreciate.

An appreciated currency will increase the price of the home economy’s exports in terms of foreign currency, depressing demand for home-produced goods in foreign markets.

It will also reduce the price of foreign-produced goods that are imported to the home economy (in terms of home currency), boosting demand for foreign goods.

In other words, it will make the British economy less competitive and depress aggregate demand for home-produced goods and services.

Question 9

Two different channels

Answer 9

in addition to the interest rate channel, there is a second channel operating to produce the central bank’s desired negative output gap: this is the exchange rate channel. With the higher interest rate in the UK and the appreciation of the UK pound both bearing down on output, the central bank will know that it needs to raise the interest rate by less than would be the case in the closed economy to achieve the same negative output gap.

Both parties solve the central bank’s stabilization problem-this implies an assumption that both the central bank and the foreign exchange market form expectations rationally.

Question 10

The 3 Equation Model in the Open Economy

Answer 10

IS relation

Central bank behaviour, MR curve

Phillips curve, PC

Question 11

IS relation

Answer 11

the IS, we need to amend the model to recognize that home’s households, firms and government spend on imported as well as home-produced goods, and that foreigners buy goods produced at home. Since imports will depend on the level of activity in the home economy, some of the additional demand generated by higher incomes will leak abroad because of purchases of imports.
An improvement in home’s competitiveness, i.e. a depreciation of the real exchange rate, boosts the demand for exports and dampens the demand for imports as home goods become relatively more attractive both abroad and at home.

Question 12

What shifts the IS curve

Answer 12

In graphical terms, the presence of imports in reducing the multiplier makes the IS curve steeper because a given fall in the interest rate is associated with a smaller increase in output; and a depreciation of the real exchange rate shifts the IS curve to the right. An appreciation of the real exchange rate-a deterioration in home’s competitiveness-shifts the IS to the left.

Question 13

Phillips curve

Answer 13

As in the closed economy, we shall assume that households use domestic inflation in their wage-setting calculations.

This means we can continue to work with a situation in which the equilibrium rate of unemployment is unique, i.e. it only shifts as a consequence of supply-side shifts in the WS curve (changes in the cost of job loss, wage¬ bargaining arrangements, employment regulation, etc.) or in the PS curve (changes in the degree of monopoly, the tax wedge, etc.).

Question 14

Central Bank behaviour and marginal revenue curve

Answer 14

There is no reason why opening the economy to international trade and capital flows should affect the policy maker’s preferences, and hence, the MR curve.

We continue to assume that the central bank suffers a loss of utility according to how far away it is from its inflation target and from equilibrium output. We keep to the simple case where the central bank targets domestic inflation.

Question 15

Simplifying assumptions for 3 equation model

Answer 15

1. There is perfect international capital mobility. This means that home residents can buy or sell foreign bonds with the fixed nominal world interest rate, /*, in unlimited quantities at low transactions costs.
2. The home country is assumed to be small in the sense that its behaviour cannot affect the world interest rate.
3. Just as in the closed economy, we assume there are just two assets that households can hold-bonds and money. But now they can hold foreign or home bonds. We assume that they hold only home money.
4. There is perfect substitutability between foreign and home bonds. This assumption means that the riskiness of foreign and home bonds is identical, so the only relevant difference between them is the expected return.

The last assumption means we rule out differences in the risk of default of bonds issued by different governments and we assume that investors do not care about the balance between home and foreign bonds in their portfolio

Question 16

Participants and actors

Answer 16

• Commercial banks and other depository institutions.
• Non-bank financial institutions e.g. mutual funds, hedge funds, securities firms, insurance companies, pension funds. Non-financial businesses conduct foreign currency transactions.
• Central banks: conduct official international reserves transactions.

Buying and selling in the foreign exchange market are dominated by commercial and investment banks.

Question 17

Interbank

Answer 17

» Interbank transactions of deposits in foreign currencies occur in amounts $1 million or more per transaction.

• » Central banks sometimes intervene, but the direct effects of their transactions are small and transitory in many countries.
• » FX dealers set a price discovery (benchmark) for different currencies depending on:
  1. Supply and demand.
  2. Macroeconomic and microeconomic factors.
• » (1) and (2) determine the fluidity of a currency.
  The US dollar is the most fluid currency in the world.

Question 18

Integration of financial markets

Answer 18

The integration of financial markets implies that there can be no significant differences in exchange rates across locations.
» Arbitrage: buy at low price and sell at higher price for a profit. Exception to the above rule exists.
» A powerful financial player.

Question 19

Why is the UIP condition important

Answer 19

• » The link between monetary policy and the foreign exchange market.
• » Predicts movement of the nominal exchange rate - forex traders responses.
• » Implies 2 stabilisation channels in an open economy:
  1. 1interest rate.
  2. 2exchange rate.
• » So CBs change the interest rate by less when responding to shocks in an open economy.

Question 20

The Uncovered interest parity condition (UIP)

Answer 20

How do expectations and interest rate arbitrage determine the exchange rate?
» The uncovered interest parity (UIP) condition can help us answer this! The UIP condition dictates the interaction between the nominal
exchange rate and the interest rate, and it can be represented as:

Question 21

Implications of the UIP condition

Answer 21

The UIP condition implies two things:
that deposits in all currencies are equally desirable assets. that arbitrage in the foreign exchange market is not possible.

Question 22

Relevant markets

Answer 22

1. The foreign exchange market: currencies are traded.
2. The government bond market (or money market): bonds issued by governments are traded.
   If we want to buy US dollar-bonds we need US dollars.
   This implies we need to focus on both the forex market and bond market.

Question 23

Key assumptions of international financial markets

Answer 23

Perfect international capital mobility

Home country is a small open economy.

Home households can hold two assets.
i. Money: only home money.
ii. Bonds:

Home bonds BH , whose return is the home nominal interest rate. Foreign bonds BF , whose return is the foreign nominal interest rate.

Perfect asset substitutability (PAS) between BH and BF .

PAS: usually an innocuous assumption when analysing advanced economies.

Question 24

other assumptions

Answer 24

Under PAS, BH and BF are perfect substitutes thus only two things influence the choice between them

Question 25

Suppose the UK is the home economy and US the foreign economy. Assume there is an initial equilibrium: it = i∗t , eEt+1 = et. Suppose Bank of England suddenly announces it is increasing the nominal interest rate by 2.5% such that i > i∗ for one period. Assume the expected exchange rate remains unchanged. What must happen now to the nominal exchange rate?

Answer 25

Suppose that initially the interest rate on both bonds is 4%. Now let us see what happens if the Bank of England suddenly raised the UK interest rate to 6.5%. This case is shown in Fig. 9.2, where e is used to denote the UK pound nominal exchange rate (i.e. £/$), t is used to denote the time period, i is used to denote the home interest rate and i* is used to denote the world (or foreign) interest rate. The interest rate change makes UK bonds more attractive, and investors will sell US dollars and buy UK pounds in order to take advantage of the higher expected return. But the move out of dollars and into UK pounds leads the US dollar to depreciate (weaken) and the UK pound to appreciate (strengthen). As investors try to maximize their returns, the UK pound will appreciate by exactly 2.5% so that the expected return on UK and US bonds is identical. An American investor holding UK bonds for the duration of the interest differential (i.e. one year) gets 2.5% more in interest receipts than he would holding US bonds. On the flipside, however, the American investor loses 2.5% as the UK pound depreciates back to its 'normal' level over the course of the year. We assume that the underlying expected level of the exchange rate is exogenous and remains constant. The American investor will have to buy UK pounds at the start of the year in order to purchase the UK bonds but wants US dollars at the end of the year to spend in the US (Assumption 3). Figure 9.2 shows how this process of arbitrage in the international bond markets works to equalize the expected return on bonds.

Question 26

The Log formulation of the UIP condition

Answer 26

Question 27

Shifting the UIP curve

Answer 27

The shift in the UIP curve from UIP to UIP' due to the fall in the world interest rate is shown in Fig. 9.4. The economy is initially at point A on the UIP curve. With the expected exchange rate equal to logeE and with home's interest rate unchanged and now above the world interest rate of /*, arbitrage in the financial market will lead to an immediate appreciation of the home exchange rate as shown by point B on the new UIP curve, UIP'. At the end of the period, /* reverts to its initial level (and the UIP curve reverts to the original one). There is no interest differential and the exchange rate is back at its initial level.

Question 28

Implications from the diagram

Answer 28

If the home country is the UK, the pound depreciates continuously over the period during which the interest rates differ. As the UIP condition makes clear, for example, just before the US interest rate is raised at the end of the period, there is little to be gained by switching to UK bonds: the tiny, expected interest gain would be matched by a tiny expected depreciation of the pound: hence it would be very close to its expected level. The diagram also illustrates that there will be no change in the exchange rate at all if the central bank in the home country immediately follows the interest rate move by the foreign central bank. The economy would shift from A to C. At the end of the period, if home again follows the interest rate move of the foreign central bank, then the move is from C back to A and the exchange rate does not change

Question 29

A change in sentiment in the foreign exchange market

Answer 29

If traders suddenly change their view about the likely exchange rate in a year's time, the UIP curve will shift. If a depreciated home exchange rate is expected, the UIP curve will shift to the right. With the home and world interest rates equal, such a change in sentiment will have the effect of leading to an immediate depreciation of the actual exchange rate to its new expected value (so that the UIP condition holds). This illustrates that expectations about future developments are incorporated into today's exchange rate.

Question 30

Key features of the diagram

Answer 30

The UIP condition: it − i∗t = log eEt+1 − log et * » Each UIP curve has a slope of −45 degrees and must go through the point (log eE, i∗). * » A change in home’s interest rate causes a movement along the UIP (for a given log eE and i∗). * » For a given expected exchange rate , any change in the foreign interest rate shifts the UIP curve. * » For a given foreign interest rate, any change in the expected exchange rate shifts the UIP curve.

Question 31

Exchange rate responses to interest rates changes Suppose the Bank of England announces a rise in the UK interest rate.

Answer 31

If the announcement of the interest rise is unexpected and the expected exchange rate remains constant: * » First we have to assume when the announcement is made. We assume beginning period t = 1. * » Then i is expected to exceed i∗ for one period, say one year. * » The gain from holding UK bonds over this time needs to be offset by a depreciation of the Sterling pound (£). * » This implies the exchange rate must immediately appreciate, so that it can depreciate over the following year when there is an interest rate differential between home and foreign. Result is the standard prediction of the UIP condition in Figure 9.

Question 32

Explaining the response to interest rate changes

Answer 32

In this case, just as in the closed economy, the central bank will raise the interest rate in order to reduce output and dampen inflation. However, the foreign exchange market will also react to the knowledge that home's interest rate will be kept above that of the rest of the world for some time. The UIP condition tells us that home's exchange rate will therefore appreciate, as there will be increased demand for home's currency. This occurs as investors buy home currency to buy home bonds so as to take advantage of their higher yields. We know from the IS curve that the appreciation of the exchange rate will depress demand by reducing net exports. This means the central bank will not have to raise the interest rate as much as they would in the closed economy, as they correctly anticipate some of the adjustment will take place through the foreign exchange market. In other words, in the open economy, the dampening of demand needed to get the economy back onto the MR curve occurs through a combination of a higher interest rate and exchange rate appreciation.

Question 33

if the change in interest rate is widely anticipated

Answer 33

In this case there is no appreciation of e. Why does this happen? * » Again, we assume the announcement will be made, beginning period t = 1. * » Then we have to go back to period t=0. In this period we assume international financial markets became convinced that the interest rate would be raised in the following period, t = 1. * » Since the change is widely anticipated by international financial markets in time t = 0, this will be reflected in their expectations for the exchange rate in a year’s time. * » UIP curve shifts to UIP’ in period t = 0. * » The e immediately appreciates to eE1 in period t = 0 for the UIP condition to hold. * Beginning period t = 1, when the interest rate increase is actually announced, there is no immediate change in e. * » This is because e is already in a position where it can depreciate over the period when there is an interest rate differential between home and foreign so as to offset the gains from holding UK bonds.

Question 34

if the change in interest rate is widely anticipated diagram

Answer 34

Question 35

Diagram 2

Answer 35

Question 36

What is meant by rational expectations

Answer 36

Under the rational expectation hypothesis, rational agents do not make systematic errors Rational expectations is where agents in the economy use all available information to forecast and therefore do not make systematic errors implying they are forward looking

Question 37

Are rational, forward-looking banks, often wrong?

Answer 37

Yes, CB's build, test and refine their models of the economy Their models and forecasts are subject to extensive external scrutiny and its unlikely that a CB would make systematic mistakes without being forced to reconsider their methods They can therefore be seen as rational, forward-looking agents However, not making systematic errors does not preclude the possibility of delivering wrong forecasts

Question 38

The role of communication by CBs in influencing the economy following an economic shock

Answer 38

Communication affects the extent to which inflation expectations are anchored to target which affects the Phillips curve

Question 39

What is meant by agents making systematic errors under adaptive expectations ?

Answer 39

The adaptive expectations hypothesis states that wage setters respond to their forecasting errors in a mechanical way. If there is a positive output gap where Y>YP, the real wage outcome is below what had been expected since the inflation outturn is higher than expected As a result, agents are systematically wrong and thus make systematic errors in forecasting future inflation

Question 40

If a CB is an inflation targeting bank, how might it go about increasing its credibility?

Answer 40

Credibility is assessed on the grounds of the ability of a CB to stick with its policy objective The ability of a bank to shape expectations is crucial Communication is relevant to show the independence of a CB's monetary policy decisions from political pressure Independence is not the only driver of CB credibility, transparency also plays a role A transparent CB is one that lets the public and financial markets into their decision-making process The more the CB communicates what they are doing and why, and their view of the future path of the economy and interest rates, the more easily the general public and the private sector can form inflation expectations.