The Foreign Exchange Market

Prof. Irina A. TelyukovaUBC Economics 345Fall 2008

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Outline The foreign exchange market is the market where assets denominated in different currencies are traded against each other.

This market determines the values of currencies in terms of each other – the exchange rates of currencies.

We examine what determines foreign exchange rates in the short and long run.

We also look at intervention by central banks in the market to affect the value of their currencies.

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Why do we care?The exchange rate of a currency has effects on:

the country’s exports and imports – Canadian dollar appreciation hurts Canadian producers, but helps Canadian consumers

inflation – when the Canadian dollar depreciates, the relatively higher prices of imports feed into the domestic price measurements (the CPI includes imports)

output – when the Canadian dollar depreciates, demand for its exports increase, thus increasing output

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I. Foreign Exchange Market

Spot trades and forward tradesOver-the-counter markets, players are mostly banksThe market is very competitiveTrade in foreign exchange literally means trade in assets denominated in different currencies (think bonds or deposit accounts)It is a wholesale market, volume of > $1 trillion per dayRetail prices are higher than wholesale: you get a worse deal than the market exchange rate if you purchase foreign currency for a trip

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II. Exchange Rates in the Long Run

The law of one price:if two countries produce an identical good, and transport costs and trade barriers are low, the price of the good should be the same everywhere regardless of who produces itthat is, adjusting the prices for the exchange ratesif Canadian maple syrup sells for CAD 4/litre, and Vermont maple syrup sells for USD 3/litre, the exchange rate must be 0.75 USD/CAD

Theory of Purchasing Power Parity (PPP):exchange rates between any two currencies will adjust to reflect changes in the relative price levels of two countriesif Canada’s price level rises relative to the US, then CAD should depreciate (and USD will appreciate)

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CaveatsThe law of one price / PPP theory do not fully capture the movement of the exchange rate. In particular, movements in relative prices in different countries have little predictivepower for exchange rates in the short run.Reasons:

many goods are not identical across countries (and so people may have preferences for one or the other)there are trade barriers and transport costsmany goods are not traded, thus the CPI contains many goods that do not reflect/affect the exchange rate

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Factors Affecting Exchange Rate in the Long Run

Any factor that increases the demand for domestically produced (Canadian) traded goods relative to foreign-traded goods will tend to appreciate domestic currency (CAD).

Relative price levels – when prices of Canadian goods rise relative to foreign goods, the CAD will depreciate.Trade tariffs (import taxes) and quotas (limits on quantities) make foreign goods relatively more expensive; increase demand for domestic goods, causing CAD to appreciate.Preference for domestic over foreign goods will appreciate domestic currency. Here, scope is important.Gains in domestic productivity tend to happen more in traded sectors. Increased productivity cheaper domestic goods increased demand currency appreciation.

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III. Exchange Rates in Short Run: Asset Trade

We want to understand how spot exchange rates are determinedExchange rates are the price at which domestic assets (e.g. bonds denominated in CAD) trade for foreign assets (e.g. bonds denominated in euro).

Relative demand for domestic versus foreign assets will be an important determinant of exchange rates.Older theories of exchange rates focused on imports and exports……But trade in assets is 25 times larger in terms of volume.

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Demand for Domestic vsForeign Assets

Demand for the assets is determined by their relative returns (as always)Suppose CAD asset (bond) pays return iD, no capital gains; and euro asset (bond) pays iF . To compare the two, we also need to figure in the exchange rates.Expected return on domestic bond in terms of euro is:

Expected relative return on domestic bond in terms of euro:

t

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Deur

D

EEEiR −

+= +1

t

tte

FDeur

D

EEEiiRR −

+−= +1

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Interest Rate ParityImagine that returns on Canadian bonds relative to euro-denominated bonds are high.Then everyone in the world will want to hold Canadian bonds, and no one will want to hold the euro-denominated ones.Yet both are held in positive amounts usually.Assuming (reasonably) that the assets are perfect substitutes, in order for both to be held, the returns on the two assets must be equivalent!

t

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FD

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−= +1

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Demand and Supply of Domestic Assets

The demand curve for domestic assets is determined by their relative returns.

The higher the current exchange rate, the less we can expect the CAD to appreciate Relative returns on the CAD assets will be lowerDemand for CAD assets will be lowerDownward-sloping demand curve

The supply curve is the amount of bonds, deposits and shares in Canada, it is not determined by the foreign exchange market vertical supply curve.

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Demand and Supply of Domestic Assets

Quantity of CAD assets

E S

D

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Short-Run Shifters of Exchange Rates

Exchange rates in this framework shift whenever demand for domestic assets shifts due to:

Domestic interest rate – if iD rises, people will want to hold more dollar assets (in the short run); demand for domestic assets increases (curve shifts right). Foreign interest rate – if iF rises, people will want to hold more foreign assets; demand for domestic assets falls.Expected future exchange rate – due to any of the long-run shifters of exchange rates (relative prices, trade barriers, preferences, productivity). Expected appreciation will increase demand for domestic assets.

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Increase in Domestic Interest Rate

Quantity of CAD assets

E S

D

D’E

E’

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Increase in Foreign Interest Rate

Quantity of CAD assets

E S

D’

DE’

E

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Increase in Relative Prices of Canadian Goods: Ee decrease

Quantity of CAD assets

E S

D’

DE’

E

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IV. Foreign Exchange Market Intervention

There are two types of foreign exchange intervention that the Bank of Canada can conduct:

an unsterilized foreign exchange intervention results in a change in the monetary basea sterilized intervention does not

In any foreign exchange intervention, the Bank buys foreign assets or sells its holdings of them, in exchange for Canadian currency

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Unsterilized Intervention

Suppose the Bank sells $1 billion dollars worth of its foreign assets.

This reduces its holdings of those assets, and the Bank receives in exchange Canadian currency which it now holds it removes $1bln from circulation

Assets Liabilities

Foreign assets -$1 bln Currency in circulation -$1bln

Bank of Canada

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Unsterilized Foreign Exchange Intervention

Alternatively, the Bank could receive payment in chequesdrawn on a domestic (Canadian) bank

A sale of foreign assets (purchase of domestic currency) results in a 1-for-1 decrease in monetary base. A purchase of foreign assets results in an increase in MB.

Assets Liabilities

Foreign assets -$1 bln Settlement balances (reserves) -$1bln

Bank of Canada

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Sterilized Foreign Exchange Intervention

If the Bank does not want its foreign exchange intervention to result in a change in monetary base, it can conduct an offsetting open market operation.E.g. if it sells foreign assets, it can simultaneously buy domestic bonds in the same amount. The first will decrease the MB, but the second will increase it.

Assets Liabilities

Foreign assets - $1 blnGov’t bonds + $1 bln

Monetary base -- no change

Bank of Canada

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Unsterilized Intervention: Effect on Exchange Rate

Suppose the Bank buys foreign assets (sells Canadian dollars)This will lead to an increase in the monetary baseTwo effects:

higher domestic money supply leads to an increase in the Canadian price level in the long run, so to a lower future expected exchange rate currentlythis means lower expected returns on dollar-denominated assets demand for dollar assets fallsalso, in the short run, an increase in money supply will cause interest rates to fall, further lowering expected returns on dollar assetsin the long run, the interest rate will return to its previous level demand for dollar assets will recover somewhat

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Unsterilized Intervention

Quantity of CAD assets

E S

D’

DE’

E

Initial decrease in demanddue to a fall in expected returnson dollar assets for two reasons:lower short-run interest ratesand higher expected relative price level

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Unsterilized Intervention

Quantity of CAD assets

E S

D’

DE’

E

D’’

E’’

Some of the demand eventually recovers asinterest rates recover to their initial level (or higher)in the long run

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Sterilized Intervention: Effect on Exchange Rate

A sterilized intervention leaves the monetary base unchangedThus there are no effects on the price level or the short-run interest ratesA sterilized intervention has no effect on the exchange rate

So if the Central Bank wants to affect the exchange rate, it has to do so by unsterilized intervention

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V. Exchange Rate Regimes

There are three types of exchange rate regimes:a fixed exchange rate regime is one where one country’s currency is pegged to the value of another currency (e.g. yuan to the US dollar)a floating exchange rate regime is one where a country’s currency value is allowed to fluctuate freelya dirty float (managed exchange rate regime) is a system where countries attempt to influence their currency value by foreign exchange intervention

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Fixed Exchange Rate Regimes: Gold Standard

Before WWI, the world operated under the gold standardThis effectively fixed the exchange rates: a British pound was worth ¼ oz gold, a CAD = 1/20 oz. So the exchange rate would be $5 to the pound.World money supply was heavily tied to gold production in the world: could not grow fast enough to keep pace with the economy, resulting in deflation. After 1890’s – new sources of gold discovered, money supplies rose rapidly, resulting in inflation.Made it difficult for countries to have control over their monetary policy

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Fixed Exchange Rate Regimes: Bretton Woods (1944-71)Set up the IMF, the World Bank and General Agreement on Tariffs and Trade (today’s WTO)US dollar as reserve currency: based on its convertibility to gold, the system was to be maintained by foreign exchange interventions where other countries’ central banks would buy dollar assetsIf domestic currency is overvalued at the fixed rate, the central bank intervenes by selling foreign assets (purchasing domestic currency), causing demand for domestic assets to increase; and vice versaIf a country ever runs out of foreign reserves, it cannot keep its currency from depreciating – a devaluation occursLoss of monetary policy control

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An Overvalued Currency: Intervention

Quantity of domestic assets

E S

D

D’E’

Epar

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Reading

These slides are based on:all of chapter 19chapter 20, pages 496-512 only