THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 539

A rise in the expected future exchange rate, E e t*1 , shifts the demand curveto the right and causes an appreciation of the domestic currency.. Using the same reasoning, a fall in the e

A rise in the expected future exchange rate, E e t*1 , shifts the demand curve

to the right and causes an appreciation of the domestic currency Using the same reasoning, a fall in the expected future exchange rate, E e

t*1 , shifts the demand curve to the left and causes a depreciation of the currency.

Earlier in the chapter we discussed the determinants of the exchange rate in the long run: the relative price level, relative trade barriers, import and export demand, and relative productivity (refer to Table 19-1) These four factors influ-ence the expected future exchange rate The theory of purchasing power parity suggests that if a higher Canadian price level relative to the foreign price level is expected to persist, the dollar will depreciate in the long run A higher expected relative Canadian price level should thus have a tendency to lower , lower the relative expected return on dollar assets, shift the demand curve to the left, the lower the current exchange rate

Similarly, the other long-run determinants of the exchange rate can influence the relative expected return on dollar assets and the current exchange rate Briefly, the following changes, all of which increase the demand for domestic goods rela-tive to foreign goods, will raise : (1) expectations of a fall in the Canadian price level relative to the foreign price level; (2) expectations of higher Canadian trade barriers relative to foreign trade barriers; (3) expectations of lower Canadian import demand; (4) expectations of higher foreign demand for Canadian exports; and (5) expectations of higher Canadian productivity relative to foreign productiv-ity By increasing , all of these changes increase the relative expected return

on dollar assets, shift the demand curve to the right, and cause an appreciation of the domestic currency, the dollar

E e

t + 1

E e

t + 1

E e

t + 1

C H A P T E R 1 9 The Foreign Exchange Market 507

F I G U R E 1 9 - 6 Response to an Increase in the Expected Future Exchange Rate,

When the expected future exchange rate increases, the relative expected return on domestic (dollar) assets rises and the demand curve shifts to the right The equilibrium exchange rate rises fromE1toE2.

E

t *1 e

S

(euros/$)

Quantity of Dollar Assets

E1

E2

1 2