Foreign Exchange Market

1. Learning Unit #15
Foreign Exchange
Market Basics

2. Objectives of Learning Unit
• Foreign Exchange Rate
• Foreign Exchange Rate and Economy
• Demand and Supply Model of Foreign
Exchange Market
• Determinants of Exchange Rate
• Law of One Price
– Purchasing Power Parity
– Interest Rate Parity
• Foreign Exchange Intervention

3. Foreign Exchange Rate
• Foreign Exchange Market: Currencies of many
countries are traded and their prices (foreign
exchange rates) are determined.
• (Foreign) Exchange Rate: the price of one country’s
currency in terms of another’s.
Example: $1 = ¥100 or ¥1 = $0.01 (1¢)
• Spot (exchange) rate: Exchange rate for an
immediate exchange of currencies.
• Forward (exchange) rate: Exchange rate on an
agreement to exchange currencies in future.

4. Foreign Exchange Rates, 1990-2011
Foreign exchange rates
change from time to time.
Each rate changes to a
different direction.
In general, values of foreign
currencies relative to US
dollar declined early 2000s,
then started to increase in
2003. This was due to a
change in U.S. economic
conditions, which affected
the value of dollar.
A value of Japanese yen
relative to US dollar
declined significantly in mid-
1990s due to its economic
condition.

5. Changes in Exchange Rates
• Appreciation: An increase in the value of a currency
against another currency.
– This situation is often called “Strong currency.”
• Depreciation: A decrease in the value of a currency
against another currency.
– This situation is often called “Weak currency.”
• A change in its value (appreciation or depreciation) is
measured by Rate of Appreciation/Depreciation:
(Pt+1-Pt)/Pt x 100
where P is a value of currency in terms of another.

6. Example of Changes in Exchange Rates
Initially (t), $1 = ¥100 or ¥1 = $0.01 (1¢).
Now (t+1), $1 = ¥200 or ¥1 = $0.005 (1/2¢)
• A value of $ increased against ¥ ($1 can get more ¥
now) and a value of ¥ decreased against $ (¥1 can
get less $ now).
• $ appreciated against ¥ and ¥ depreciated against $.
• Rate of appreciation of $
= (¥200-¥100)/¥100x100 = +100%
 a positive sign “appreciation”
Rate of depreciation of ¥
= ($0.005-$0.01)/$0.01 x 100 = -50%
 a negative sign “depreciation”

7. Foreign Exchange Rates on Barron’s
• Dow Jones’ publishes foreign exchange
rates every day on the Wall Street
Journal and weekly on Barron’s.
– See “Reading Foreign Exchange Quotation
Information of Barron’s” on Blackboard

8. Exchange Rate and the Economy
• When U.S. dollar appreciates (depreciates)
against foreign currency, a price of goods in
U.S. becomes more expensive (cheaper)
relative to the same goods in foreign country.
• As relative prices of goods, services, and
financial assets (GS&FA) change, consumers
in each country become more likely to buy one
country’s GS&FA and less likely to buy other
country’s GS&FA.
⇒ Trade deficit (surplus)

9. Example of Effects of Changes in Foreign
Exchange Rates
Price of Toyota Prius in Japan = ¥2,500,000
Price of Ford Explorer in U.S. = $30,000
Initially, $1 = ¥100 or ¥1 = $0.01 (1¢).
Price of Prius in U.S. = ¥2,500,000/100 = $25,000
Price of Explorer in Japan = $30,000/0.01= ¥3,000,000
Now, $1 = ¥80 or ¥1 = $0.0125 (1.25¢)
Price of Prius in U.S. = ¥2,500,000/80 = $31,250
Price of Explorer in Japan = $30,000/0.0125 = ¥2,400,000
When U.S. dollar depreciates against Japanese yen, what
should happen to prices of Japanese goods in the U.S.?
How about prices of American goods in Japan?

10. Demand and Supply Model of Foreign
Exchange Market
• A demand-supply model of foreign exchange
market is similar to any asset market model
(e.g. bond or stock market).
• Along the horizontal axis, a quantity of
currency demanded or supplied for exchange
is measured.
• Along the vertical axis, a value of currency (in
terms of other currency) is measured.
– For U.S. dollar market, a value of one U.S. dollar is
measured along the vertical axis.
– E.g. €0.8401 for one U.S. dollar

11. Demand for Currencies in Foreign Exchange
Market
• Demand for currencies ($) in foreign exchange
market ($ market) comes from people who want
currencies (demand $) in exchange for their
currencies (€).
– A quantity demanded of currencies ($) increases as its
value ($) decreases.
– As a value of currency ($) decreases, people get more
currencies ($) for their currencies (€) and are able to
purchase more goods and services denominated in
currency ($).
Ex. U.S. goods and services become cheap for
European consumers as $ depreciates against €.
– So, people demand more currencies ($) to purchase
more goods and services denominated in $.

12. Supply of Currencies in Foreign Exchange
Market
• Supply of currencies ($) in foreign exchange
market ($ market) comes from people who give
up their currencies (supply $) in exchange for
another currencies (€).
– A quantity supplied of currencies ($) decreases as its
value ($) decreases.
– As a value of currency ($) decreases, people have to
give up more currencies ($) to get another currencies
(€) and are able to purchase less goods and services
denominated in another currency (€).
Ex. European goods and services become expensive
for U.S. consumers as $ depreciates against €.
– So, people supply less currencies ($) to purchase less
goods and services denominated in €.

13. Demand-Supply Diagram of Foreign
Exchange Market
• Supply curve of
currency is upward-
sloping, while demand
curve of currency is
downward-sloping.
• Demand and supply of
currencies in foreign
exchange market
determines an
equilibrium exchange
rate.
Value of $
Quantity of $
Supply of $
U.S. dollar market
Demand
for $
E€0.8401

14. Dual of Foreign Exchange Market
• Because in foreign exchange market a currency
is exchanged for another currency, two currency
markets are analyzed together.
• Demand for one currency ($) is supply of
another currency (€), while supply of one
currency ($) is demand for another currency (€).
Ex. If you are exchanging $ for €, then you are
supplying $ and demanding €. If someone is
exchanging € for $ with you, that person is
supplying € and demanding $.

15. Demand and Supply Model of Foreign
Exchange Market
P$
: Value of US dollar in terms of foreign currency ($1=FC?)
PFC
: Value of foreign currency in terms of US dollar (FC1=$?)
S$ = DFC
D$ = SFC

16. Example of US Dollar vs. Euro Markets
Foreign Currency in US$ US$ in Foreign Currency
Thu. Wed Thu Wed
Euro 1.1919 1.1903 .8390 .8401
• On Thursday, one euro was traded for $1.1919
(€1=$1.1919), and one U.S. dollar was traded for €0.8390.
A value of U.S. dollar was €0.8390, while a value of euro
was $1.1919.
• Note: 1/$1.1919 = €0.8390. Exchange rates are
reciprocal.

17. Example of Diagrams of US Dollar and Euro
Foreign Exchange Markets
€0.8401
$1.1903
Foreign Currency in US$ US$ in Foreign Currency
Thu. Wed Thu Wed
Euro 1.1919 1.1903 .8390 .8401

18. Changes in Foreign Exchange Rates
• From Wednesday to Thursday, a value of euro
increased from $1.1903 to $1.1919, that is an
appreciation of euro against U.S. dollar. At the same
time, a value of U.S. dollar decreased from €0.8401 to
€0.8390, that is a depreciation of U.S. dollar against
euro.
• Any changes in demand or supply of currencies in
foreign exchange markets affect foreign exchange rates.
Foreign Currency in US$ US$ in Foreign Currency
Thu. Wed Thu Wed
Euro 1.1919 1.1903 .8390 .8401

19. Changes in Foreign Exchange Rates
• An increase in value of euro maybe resulted from an
increase in demand for euro (or a decrease in supply of
euro). Since the demand for euro is the supply of U.S.
dollar, there must be an increase in U.S. dollar, which
resulted in a decrease in value of U.S. dollar.
€0.8390
€0.8401
$1.1919
$1.1903

20. Why Exchange Currencies?
Households and business firms want to
exchange currencies because of
– Trade in goods and services
– Trade in financial assets (bonds & stocks)
Anything that affects trade in goods, services,
and financial assets affects demand and supply
of foreign currencies and its exchange rate.

21. Determinants of Foreign Exchange Rate
Five factors affecting foreign exchange rate:
• Long-run (Factors affecting demand and
supply of currencies over long period of time)
– Preferences for Domestic or Foreign Goods
– Productivity
– Trade Barriers
– Price Level (Inflation)
• Short-run (Factors affecting demand and
supply of currencies in short time period)
– Interest Rate & Expected Return

22. Preferences of Domestic or Foreign Goods
• Consumers’ preference of one good produced in one
country and denominated in that currency over another
good produced in another country and denominated in
another currency affects their demand for one currency
over another.
• Example: U.S. consumers prefer to buy more foreign cars
than American cars.
⇒U.S. consumers need more foreign currencies to buy
foreign cars
⇒Demand for foreign currency increases and supply of U.S.
dollar increases in foreign exchange markets.

23. Preferences of Domestic or Foreign Goods
• Then, U.S. dollar depreciates (from Po to P1 on P$) and
foreign currencies appreciates (from Po to P1 on PFC).

24. Productivity
• Productivity: amount of output produced by a given input.
When productivity increases, more output can be produced
with the same amount of input. If it costs the same
(because the same amount of input), then higher
productivity means less cost of production per output.
• Ex. One worker costs $7 per hour. He makes 7
hamburgers an hour, so it costs $1 for each hamburger
made. If his productivity increases to 14 hamburgers an
hour, then it will cost $0.50 for each hamburger made.
• When costs of production of a good change, a price of
product also changes.
• Ex. If the price of oil increases, then gasoline price will
increase.

25. Productivity
• Example: Productivity in U.S. increases more than other
countries
⇒Cost of production decreases in U.S. relative to other
countries.
⇒Prices of output decreases in U.S. relative to other
countries.
⇒U.S. consumers want to buy more (relatively cheap) U.S.
goods and less (relatively expensive) foreign goods.
⇒Demand for foreign currency decreases (as U.S.
consumers need less foreign currencies) and supply of U.S.
dollar decreases.

26. Productivity
Then, U.S. dollar appreciates (from Po to P1 on P$) and
foreign currency depreciates (from Po to P1 on PFC).

27. Trade Barriers
• Trade barriers are impediments imposed by the
government on a particular import.
• Two major types trade barriers are
– Tariffs: Tax on imports
Ex. The U.S. government imposed 100% tariff (tax)
on luxury cars imported from Japan.
– Quotas: Maximum amount of imports
Ex. The U.S. government limits an import of
tomatoes from Mexico up to 1 million units each
month.
• Trade barriers intend to raise prices of imports and
discourage U.S. consumers to purchase imports and
encourage them to purchase American goods.

28. Trade Barriers
• Example: U.S. government imposes tariffs on imports
⇒Foreign goods are more expensive in U.S.
⇒Demand fore foreign goods by U.S. consumers
decreases.
⇒Demand fore foreign currencies decreases and
supply of U.S. dollar decreases.

29. Trade Barriers
• Then, U.S. dollar appreciates and foreign currency
depreciates.

30. Trade Barriers
• Unintended consequence of trade barriers is an
appreciation of U.S. dollar against foreign currency.
– As U.S. dollar appreciates, prices of all foreign goods
and services become relatively cheap for the U.S.
consumers.
– U.S. consumers will purchase more foreign goods and
services not subject to trade barriers and less of
American goods and services.
• Ex. Imposing tariffs and quotas of tomatoes imports from
Mexico, the U.S. dollar appreciates against Mexican peso,
and U.S. wheat, apples, and beef will cost more for
Mexican consumers. As a result, the U.S. wheat, apple,
and beef farmers export less.

31. Price Level
• Inflation, a general rise in prices of goods and
services, makes domestic goods and services
relatively more expensive to foreign goods.
• Consumers prefer to purchase cheaper foreign goods
and services.
• Inflation also means a purchasing power of money
decreases, that is, its value relative to goods and
services decreases.

32. Price Level
• Example: The prices of goods and services increase
in U.S. (inflation).
⇒Demand for foreign goods and services by U.S.
consumers increases.
⇒Demand for foreign currencies increases and supply
of U.S. dollar increases

33. Price Level
Then, U.S. dollar depreciates and foreign currencies
appreciate

34. Summary: Factors That Affect Exchange Rates in
the Long Run

35. Changes in Exchange Rate in Short Run
• Factors described above (Price level, Trade barriers,
Preference, and Productivity) affect the exchange
rate through changes in demand for (trade of) goods
and services between two countries. They may
affect changes or a trend in the foreign exchange rate
over long time period. However, they do not change
every day, so these factors cannot explain changes in
the foreign exchange rate everyday.
• Short-term changes (daily volatility) in the foreign
exchange rate are primarily caused by changes in
demand and supply of financial assets in two
countries, which are affected by interest rates and
return/risk of financial assets.

36. Interest Rate
• If two bonds have identical characteristics except for
interest rates, savers will prefer one with higher
interest rate.
• Depending on domestic economic condition, each
country may have different interest rates.
• U.S. savers as well as foreign savers will put their
funds in a country with the highest interest rate.

37. Interest Rate
• Example: The interest rate in U.S. decreases.
⇒Demand for U.S. financial assets by U.S. savers
decreases and demand for foreign financial assets by
U.S. savers increases.
⇒Demand for foreign currencies increases and supply
of U.S. dollar increases.

38. Interest Rate
Then, U.S. dollar depreciates and foreign currencies
appreciate.

39. Value of the Dollar and Interest Rates,
1973–2008
From 1973 to
2008, the value
of the dollar
(Effective
exchange rate)
and the measure
of real interest
rates tend to rise
and fall together

40. Asset Demand and Foreign Exchange
Rate
Any factors affecting demand for domestic
(U.S.) and/or foreign financial assets (e.g.
stocks, bonds), including interest rates, will
affect the foreign exchange rate in the short run.
•Expected return: Higher expected return on domestic
(U.S.) financial assets relative to foreign financial assets
leads to higher demand for domestic currency (U.S.$)
and an appreciation of domestic currency (U.S.$)
against foreign currencies.

41. Asset Demand and Foreign Exchange
Rate
• Liquidity: Higher liquidity of domestic (U.S.) financial assets
relative to foreign financial assets leads to higher demand
for domestic currency (U.S.$) and an appreciation of
domestic currency (U.S.$) against foreign currencies.
• Risk: Higher risk on domestic (U.S.) financial assets
relative to foreign financial assets leads to lower demand
for domestic currency (U.S.$) and a depreciation of
domestic currency (U.S.$) against foreign currencies.
─ Flight to quality: When the global financial markets
experience financial crises, investors seek the safest
assets (e.g. U.S. Treasury securities) and the U.S.
dollar tends to appreciate against foreign currencies.

42. Asset Demand and Foreign Exchange
Rate
• Expectations: Expectations on domestic and/or
foreign financial assets and markets as well as
foreign exchange rates can affect the foreign
exchange rate.
• As you learned in Learning Unit 14 (Chapter 7) about
rational expectations, any new information about
domestic and foreign economies and financial
markets can affect the foreign exchange rates.
─ Financial crisis in Greece, Spain, and Italy since
2011 has caused a continuous depreciation of
euro against U.S. dollar.

43. Demand-Supply Analysis from Foreigners’
Perspectives
• All demand-supply analysis in this section is based
on U.S. consumers’ or savers’ perspectives,
where they demand more or less foreign
currencies in response to changes in factors.
• Foreign consumers and savers also respond to
changes in factors. Although it will involve
changes in demand for U.S. dollar and supply of
foreign currencies (rather than demand for foreign
currencies and supply of U.S. dollar), the final
conclusion (appreciation or depreciation of
currency) will be the same.

44. Example of Demand-Supply Analysis from
Foreigners’ Perspectives
• Example: The prices of goods and services increase in
U.S. (inflation).
⇒Demand for U.S. goods and services by foreign consumers
decreases.
⇒Demand for U.S. dollar decreases and supply of foreign
currencies decreases.
⇒U.S. dollar depreciates against foreign currencies, while
foreign currencies appreciate against U.S. dollar.
This is identical conclusion!
$ FC
SFC
D$

45. Law of One Price
• Law of One Price: the price of a good in one country
must be equal to the price of the same good in other
country after taking account of the exchange rate
between two countries.
• Arbitrage guarantees that prices of identical goods must
be equal in two markets (countries) at equilibrium.
– Of course from time to time prices could be different.
However, whenever such discrepancy occurs, an
arbitrage will take places and equalize their prices.

46. Example of Law of One Price
• The price of BMW is $50,000 in U.S. and the price of
the same BMW is €100,000 in Germany.
• The exchange rate between U.S. dollar and euro is
$1= €2.
• Then, the U.S. dollar price of German BMW should
be $50,000(= € 100,000/ €2).
• Law of one price holds!

47. Law of One Price and Foreign Exchange
• When the price of a good in one country changes, prices
are no longer same in two countries.
• Then, the exchange rate between two counties changes in
a way that prices become equal again in two countries after
taking account of new exchange rate between two
countries.
– Arbitrage activity between two countries causes a
change in exchange rate between two currencies.
– An arbitrager purchases goods in a low price country
(Europe), demanding more of its currency (€), causing
an appreciation of that currency (€), while he sells the
goods in a high price country (U.S.), selling more of its
currency ($), causing a depreciation of that currency ($).

48. Example of Law of One Price and
Exchange Rate Change
• The price of BMW in U.S. increases to $100,000, while the
price of the same BMW in Germany remains at €100,000.
• At $1=€2 exchange rate, the U.S. dollar price of German
BMW is still $50,000.
– Law of one price does not holds any more (German
BMW is cheaper than American BMW)!
• U.S. consumers want cheaper German BMW.
• Demand for euro and supply of U.S. dollar increase in
foreign exchange markets.
• U.S. dollar depreciates against euro and euro appreciates
against U.S. dollar to $1=€1.
• At $1=€1 exchange rate, the U.S. dollar price of German
BMW becomes $100,000 (= €100,000/€1).
• Law of one price holds again!

49. Two Variations of Law of One Price
• Law of one price is extended to two situations: one for
overall prices of (tradable) goods between two countries,
and the other for interest rates on similar bonds in two
countries.
– Purchasing Power Parity (PPP) Theory: an exchange
rate between two currencies adjusts to reflect
differences in the price levels in the two countries.
– Interest Rate Parity (IRP) Theory: an expected change
in exchange rate between two currencies reflects
differences in the interest rates in the two countries.

50. Two Versions of PPP
• Two versions of purchasing power parity
theory
– Absolute PPP: The exchange rate is equal to the
ratio of the price levels in the two countries.
– Relative PPP: The change in the exchange rate is
proportional to the relative change in the price
levels in the two countries.

51. Absolute PPP
• The exchange rate is equal to the ratio of the price levels
in the two countries.
E = Pf / Pus
E: value of one US dollar in terms of foreign currency
Pf: price level in foreign country
Pus: price level in US
• CPI or GDP deflator is often used to measure a price level
in economy. [See Learning Unit 1]
• The absolute PPP is a simple extension of “Law of One
Price” that is, prices must be equal between two countries
after taking into account of exchange rate.
– The equation above is equivalent to PUS = Pf/E
where Pf/E is a U.S. dollar price of foreign good.

52. Example of Absolute PPP
• CPI in US = 100 and CPI in Euro-zone = 80
Then, E = 80/100 = 0.8
Therefore, the exchange rate between U.S. dollar and
euro is $1 = €0.8.
• The CPIs indicate that if a set of goods commonly
purchased by households costs $100 in U.S., it will cost
€80 in Eurozone. If an arbitrage takes place in the set of
goods in CPI, then their prices must be equal.
Therefore, the absolute PPP postulates that the
exchange rate between two currencies must be one
which make two CPIs equal.

53. Shortcomings of Absolute PPP
• Absolute PPP may not hold exactly for many reasons.
– Goods included in CPI in different countries are not
same or consumed in same quantity.
Ex. French may drink more wine and drive small cars,
while American drink more beer and drive large
SUVs.
– Some goods included in CPI cannot be traded, so an
arbitrage will not take place.
Ex. Housing, medical service, education, and
personal services (e.g. hair cut) are major
components of CPI, but not many consumers bother
to get those services from other countries.

54. Relative PPP
• The change in the exchange rate is proportional to the
relative change in the price levels in the two countries.
(Et – Et-1)/Et-1 x 100 = πf - πus
(Et – Et-1)/Et-1 x 100: rate of appreciation/depreciation of US dollar
against foreign currency
πf: inflation rate in foreign country
πus: inflation rate in US
• An inflation rate may be computed from CPI or GDP
deflator. [See Learning Unit 1]
• Relative PPP does not assume that prices of goods are
equal after taking account of exchange rate. It
postulates that if one country experiences an inflation
(general price increases), its currency must depreciate
proportionally.

55. Example of Relative PPP
• Inflation rate in US=5% & inflation rate in Eurozone=3%
Then, πf - πus = 3% - 5% = -2% = (Et – Et-1)/Et-1 x 100
Therefore, the U.S. dollar should depreciate against
euro by 2%.
• When one country experiences an inflation, consumers
find foreign goods cheaper and demand more foreign
goods, and in turn, more foreign currencies, leading to a
depreciation of the currency.

56. Inflation and Exchange Rate
• Since most countries experience inflation, what matters
is a relative inflation rate. Relative PPP postulates that
a country with high inflation experiences its currency to
depreciate, while a country with low inflation
experiences its currency to appreciate.
• Higher the inflation, greater the depreciation of currency.
• Ex. In October 2007, Zimbabwe experienced an annual
inflation rate of 14,840%. The exchange rates between
U.S. dollar and Zimbabwe dollar were $1 = Z$300,000
in July 2007 and $1= Z$724,346,000,000 in July 2008.
Can you compute a rate of depreciation of Zimbabwe
dollar from July 2007 to July 2008?

57. Relative PPP: 1973 - 2011
Relative PPP does not hold year by year. Foreign exchange rate
tends to fluctuate much more than inflation rates in a short period of
time. However, the relative PPP indicates a trend of foreign
exchange rate over a long period of time.

58. Exchange Rate and PPP
• Although relative PPP indicates a trend of
foreign exchange rate, it does not fully explain
changes in exchange rates in a long period of
time.
• There are other factors which affect foreign
exchange rates and inflation rates, which leads
to imperfection of relative PPP.
– Goods are not perfectly identical in two countries
– Transportation costs
– Trade barriers
– Some goods and services are not-tradable

59. Foreign Exchange Rate in Short Run
• In a short period of time most foreign
exchanges are dominated by trade of
financial assets rather than goods.
• Capital mobility: foreigners can easily
purchase American assets and Americans
can easily purchase foreign assets. (due to
financial globalization)
– Foreign exchange transactions in the U.S. are
well over 25 times greater than the amount of
U.S. exports and imports.

60. Interest Rate Parity
• Assumption: domestic and foreign assets are
perfect substitutes (they are alike in terms of
risk, liquidity, and other characteristics).
– Savers purchase whichever providing a higher
return.
– If interest rates are higher in one country than
another, savers around the world want to
purchase financial assets (e.g. bonds) in that
country, and in turn, demand the currency of the
country, leading an appreciation of the currency.

61. Interest Rate Parity Condition
• Because financial assets (e.g. bonds) involve cash flows,
the interest rate parity condition involves more than one
exchange rate in different time period.
• Interest Rate Parity (IRP) Theory: an expected change in
exchange rate between two currencies reflects differences
in the interest rates in the two countries.
i$
= iF
- (Et+1-Et)/Et x 100
i$
: Interest rate in U.S.
iF
: Interest rate in foreign country
(Et+1-Et)/Et x 100: Expected rate of
appreciation/depreciation of U.S. dollar
Et+1 : Value of U.S. dollar at time period t+1
Et : Value of U.S. dollar at time period t

62. Interest Rate Parity Condition
• IRP condition shows that an expected return (interest rate)
on domestic financial assets must be equal to an expected
return (interest rate) on similar foreign financial assets
once a change in foreign exchange rate is taken into
account.
i$
= iF
- (Et+1-Et)/Et x 100
• The left hand side of the condition (i$
) is an expected return
(interest rate) from dollar denominated financial assets.
• The right hand side of the condition is an expected return
(interest rate) from foreign currency denominated financial
assets as sum of its expected return in foreign country (iF
)
and an expected rate of appreciation/depreciation of U.S.
dollar against the foreign currency [- (Et+1-Et)/Et x 100].

63. Example of IRP: Assumptions
• Interest rates of 1-year CDs are 10% in the U.S. and 5%
in the U.K.
• Exchange rates between U.S. dollar and U.K. pound are
$1=£1 for spot rate and $1=£0.95 for 1-year forward
rate.
• As savers you have two choices: save your $100 in the
U.S., or save your $100 in the U.K.
– The second choice involves exchanging currencies
since U.K. banks pay 5% interest rate on U.K. pound
deposit.
– If you want to save your $100 in the U.K., you must
exchange your U.S. dollar to U.K. pound first, then
later exchange back to U.S. dollar from U.K. pound.

64. Interest Rates and Exchange Rates
• Since interest rates of 1-year CDs are 10% in U.S. and
5% in U.K., everyone seems to earn more in U.S.
• If foreigners want to save in the U.S. to take an
advantage of higher interest rate, then they will demand
more U.S. dollar now (so they can deposit U.S. dollar in
the U.S.) and will need to exchange back to U.K. pound
(supplying U.S. dollar) one year later when CDs mature.
• This leads to an appreciation of U.S. dollar in a spot
(foreign exchange) market and a depreciation of U.S.
dollar in a forward (foreign exchange) market.
• Therefore, exchange rates between U.S. dollar and U.K.
pound are $1=£1 for spot rate and $1=£0.95 for 1-year
forward rate.

65. Example of IRP: Two Alternatives
• If you purchase $100 CD in the U.S., you will get back
$110 next year. [Remember FV formula?]
• If you want to purchase CD in the U.K.,
– you must exchange $100 to U.K. pound at $1= £1 spot
rate to get £100 today,
– you purchase £100 CD today at 5% interest rate,
– next year the CD matures and you will get £105,
– finally, you exchange £105 back to U.S. dollar at
$1=£0.95 forward rate to receive $110.
• Therefore, you get the same interest rate on the similar
financial assets once a change in exchange rate is taken
into account!

66. Example of IRP: IRP Condition
• Exchange rates between U.S. dollar and U.K. pound are
$1=£1 for spot rate and $1=£0.95 for 1-year forward rate.
– US dollar is expected to depreciate by 5% next year.
(Et+1-Et)/Et x 100 = (0.95-1)/1x100 = -5%
• The interest rate of 1-year CDs is 5% in U.K.
– An expected return on U.K. pound denominated financial
assets for American savers is 10%.
iF
- (Et+1-Et)/Et x 100 = 5% - (-5%) = 10%
• The expected return on U.K. pound denominated financial
assets must be equal to an expected return on U.S. dollar
denominated financial assets.
i$
= 10% = iF
- (Et+1-Et)/Et x 100
IRP condition holds!

67. IRP Condition and Foreign Exchange Rate
• The IRP condition can be used to explain changes in
foreign exchange rates.
• The IRP condition can be modified as
i$
- iF
= - (Et+1-Et)/Et x 100
• The left hand side of the equation is a difference in
interest rates in two countries, while the right hand side is
an expected rate of depreciation of US dollar against
foreign currency (it has a negative sign, indicating a
depreciation).
• For example, if interest rates of 1-year CDs are 10% in
U.S. and 5% in U.K..
– i$
- iF
= 10% - 5% = 5%.
– (Et+1-Et)/Et x 100 = -5%, so the U.S. dollar is expected
to depreciate by 5% next year

68. Interest Rate Parity: 1973 - 2008
The IRP condition based on real interest rates can explain
many changes in foreign exchange rate, but not perfect.
There are many other factors affecting the exchange rates.

69. Foreign Exchange Intervention
• Beside households and business firms, governments
may sell or purchase foreign currencies in attempt to
affect foreign exchange rates.
• Foreign Exchange Intervention: An international
financial transaction in which a central bank buys or
sells currency to influence foreign exchange rates.
• Ex. The Fed sells or purchases U.S. dollar in order to
influence the value of U.S. dollar relative to other
currencies.

70. Foreign Exchange Intervention
• Since the Fed has unlimited power to issue U.S.
dollars, it is simply to issue new U.S. dollars and
sell them in the foreign exchange market.
• When the Fed wants to purchase U.S. dollars in
the foreign exchange market, it must sell foreign
currencies that it holds.
• International Reserves: Central bank holdings of
assets denominated in foreign currencies.

71. Example of Government Intervention
• Ex. The Fed sells U.S. dollar and purchases
euro in the foreign exchange market.
⇒Supply of US dollar increases in the US
dollar market and demand for euro increases
in the euro market.
⇒US dollar depreciates and euro appreciates.

72. Disclaimer
Please do not copy, modify, or distribute this presentation
without author’s consent.
This presentation was created and owned by
Dr. Ryoichi Sakano
North Carolina A&T State University