This document provides an overview of key concepts related to foreign exchange rates and the foreign exchange market. It defines spot and forward exchange rates, currency appreciation and depreciation, and discusses how these impact domestic businesses and consumers. The law of one price and purchasing power parity (PPP) are explained. Factors that can affect exchange rates in the long run are also outlined, including how expected returns, interest rate parity, and shifts in the RF and RD curves impact the equilibrium exchange rate. The document examines sources of exchange rate volatility such as fluctuations in expectations of future exchange rates and the potential for exchange rate overshooting.

1. Chapter 19
The Foreign Exchange
Market
© 2005 Pearson Education Canada Inc.

2. © 2005 Pearson Education
Canada Inc. 19-2
Foreign Exchange Rates

3. © 2005 Pearson Education
Canada Inc. 19-3
The Foreign Exchange Market
Definitions:
1. Spot exchange rate
2. Forward exchange rate
3. Appreciation
4. Depreciation
Currency appreciates, country’s goods prices ↑ abroad and
foreign goods prices ↓ in that country
1. Makes domestic businesses less competitive
2. Benefits domestic consumers
FX traded in over-the-counter market
1. Trade is in bank deposits denominated in different
currencies

4. 19-4
Law of One Price
Example: Canadian steel $100 per ton, Japanese steel 10,000 yen
per ton
If E = 50 yen/$ then prices are:
Canadian Steel Japanese Steel
In Canada $100 $200
In Japan 5000 yen 10,000 yen
If E = 100 yen/$ then prices are:
Canadian Steel Japanese Steel
In Canada $100 $100
In Japan 10,000 yen 10,000 yen
Law of one price ⇒ E = 100 yen/$
© 2005 Pearson Education Canada Inc.

5. © 2005 Pearson Education
Canada Inc. 19-5
Purchasing Power Parity (PPP)
PPP ⇒ Domestic price level ↑ 10%, domestic
currency ↓ 10%
1. Application of law of one price to price levels
2. Works in long run, not short run
Problems with PPP
1. All goods not identical in both countries: Toyota vs
Chevy
2. Many goods and services are not traded: e.g. haircuts

6. © 2005 Pearson Education
Canada Inc. 19-6
PPP: Canada and U.S.

7. 19-7
Factors Affecting E in Long Run
Basic Principle: If factor increases demand for domestic goods
relative to foreign goods, E ↑
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8. © 2005 Pearson Education
Canada Inc. 19-8
Expected Returns and Interest Parity
Re for
Francois Al
$ Deposits iD + (Ee
t+1 – Et)/Et iD
Euro Deposits iF iF – (Ee
t+1 – Et)/Et
Relative Re iD – iF + (Ee
t+1 – Et)/Et iD – iF + (Ee
t+1 – Et)/Et
Interest Parity Condition:
$ and Euro deposits perfect substitutes
iD = iF – (Ee
t+1 – Et)/Et
Example: if iD = 10% and expected appreciation of $,
(Ee
t+1– Et)/Et, = 5% ⇒ iF
= 15%

9. © 2005 Pearson Education
Canada Inc. 19-9
Deriving RF
Curve
Assume iF = 10%, Ee
t+1 = 1 euro/$
Point
A: Et = 0.95, RF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00, RF = .10 – (1 – 1.0)/1.0 = .100 =10.0%
C: Et = 1.05, RF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%
RF curve connects these points and is upward sloping because when
Et is higher, expected appreciation of F higher, RF ↑
Deriving RD Curve
Points B, D, E, RD = 10%: so curve is vertical
Equilibrium
RD = RF at E*
If Et > E*, RF > RD, sell $, Et ↓
If Et < E*, RF < RD, buy $, Et ↑

10. © 2005 Pearson Education
Canada Inc. 19-10
Deriving RETF
Curve
Assume iF = 10%, Ee
t+1 = 1 euro/$
Point
A: Et = 0.95 RETF = .10 – (1 – 0.95)/0.95 = .048 = 4.8%
B: Et = 1.00 RETF = .10 – (1 – 1.0)/1.0 = .100 =10.0%
C: Et = 1.05 RETF = .10 – (1 – 1.05)/1.05 = .148 = 14.8%
RETF curve connects these points and is upward sloping because when Et is
higher, expected appreciation of F higher, RETF ↑
Deriving RETD Curve
Points B, D, E, RETD = 10%: so curve is vertical
Equilibrium
RETD = RETF at E*
If Et > E*, RETF > RETD, sell $, Et ↓
If Et < E*, RETF < RETD, buy $, Et ↑

11. © 2005 Pearson Education
Canada Inc. 19-11
Equilibrium in the Foreign Exchange Market

12. 19-12
Shifts in RF
RF curve shifts right when
1. iF ↑: because RF ↑ at each
Et
2. Ee
t+1 ↓: because expected
appreciation of F ↑ at
each Et and RF ↑
Occurs Ee
t+1 ↓ iF:
1) Domestic P ↑,
2) Trade Barriers ↓
3) Imports ↑,
4) Exports ↓,
5) Productivity ↓
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13. © 2005 Pearson Education
Canada Inc. 19-13
Shifts in RD
RD shifts right when
1. iD ↑; because RD ↑
at each Et
Assumes that domestic πe
unchanged, so domestic
real rate ↑

14. © 2005 Pearson Education
Canada Inc. 19-14
Factors that
Shift RF
and RD

15. 19-15
Response to i ↑ Because πe ↑
1. πe ↑, Ee
t+1 ↓, expected
appreciation of F ↑,
RF shifts out to
right
2. iD ↑, RD shifts to
right
However because πe ↑ > iD ↑,
real rate ↓, Ee
t+1 ↓ more than iD
↑ ⇒
RF out > RD out and Et ↓
© 2005 Pearson Education Canada Inc.

16. 19-16
Response to Ms
↑
1. Ms
↑, P ↑, Ee
t+1 ↓,
expected appreciation
of F ↑, RF shifts
right
2. Ms
↑, iD ↓, RD shifts
left
Go to point 2 and Et ↓
3. In the long run, iD
returns to old level,
RD
shifts back, go
to point 3 and get
Exchange Rate
Overshooting
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17. © 2005 Pearson Education
Canada Inc. 19-17
Why Exchange Rate Volatility?
1. Expectations of Eet+1 fluctuate
2. Exchange rate overshooting