Money banking and the financial system 1e by hubbard and OBrien chapter 08

The Market for Foreign ExchangeC H A P T E R 8 LEARNING OBJECTIVES After studying this chapter, you should be able to: 8.1 8.2 8.3 Explain the difference between nominal and real exchang

R GLENN

HUBBARD

ANTHONY PATRICKO’BRIEN

Money, Banking, and the Financial System

The Market for Foreign Exchange

C H A P T E R 8

LEARNING OBJECTIVES

After studying this chapter, you should be able to:

8.1 8.2 8.3

Explain the difference between nominal and real exchange rates Explain how markets for foreign exchange operate

Explain how exchange rates are determined in the long run

8.4 Use a demand and supply model to explain how exchange rates

are determined in the short run

WHY WOULD THE U.S FEDERAL RESERVE LEND DOLLARS TO

FOREIGN CENTRAL BANKS?

• The world of international finance has become highly interconnected The Federal Reserve can no longer ignore how its policies affect other countries or how events in other countries affect the U.S economy

• During the financial crisis of 2007–2009, the Federal Reserve

established dollar liquidity swap lines with foreign central banks, which

facilitated the exchange of dollars for an equivalent amount of foreign currency and allowed foreign banks to make dollar loans

• The increased volume of transactions across countries makes

fluctuations in exchange rates an important concern of policymakers

• An Inside Look at Policy on page 244 discusses the impact of the

European debt crisis of 2010 on the demand for the U.S dollar

C H A P T E R 8

The Market for Foreign Exchange

Key Issue and Question

Issue: During the 2007–2009 financial crisis, exchange rates proved

to be particularly volatile, and the Federal Reserve and other central

banks took coordinated policy actions to help stabilize the

international financial system

Question: Why did the value of the U.S dollar soar during the height

of the financial crisis?

8.1 Learning

Objective

Explain the difference between nominal and real exchange rates

Nominal exchange rate The price of one currency in terms of another

currency; also called the exchange rate.

another currency

currency

• When individuals or firms in the United States import or export goods or

make investments in other countries, they need to convert dollars into

foreign currencies

• Fluctuations in the exchange rate between the dollar and foreign currencies

affect the prices that U.S consumers pay for foreign imports

Exchange Rates and Trade

Making the Connection

What’s the Most Important Factor in Determining Sony’s Profits?

• In the long run, Sony’s profitability depends on its ability to develop

innovative new products, produce them at a low cost, and market them well

to consumers

• In the short run, Sony’s profits depend on the prices it charges relative to the prices its competitors charge for comparable products

• Since Sony sells most of its goods outside of Japan, fluctuations in

exchange rates will affect its foreign currency prices

• Sony estimates that an appreciation of the yen from ¥95 = $1 to ¥85 = $1

reduces the firm’s profits by about ¥10 billion

• Not surprisingly, Sony CEO Howard Stringer and the top managers of other

Japanese firms continue to explore ways of cushioning the impact of

fluctuations in the value of the yen on the profitability of their firms

Exchange Rates and Trade

Figure 8.1

Foreign-Exchange Cross Rates

Foreign-exchange rates can be expressed as either U.S dollars per unit of foreign currency

or as units of foreign currency per U.S dollar.

Reading across the rows, we have the direct quotations, while reading down the columns,

we have the indirect quotations.

For example, the second entry in the U.S row shows that the exchange rate on this day was

$1.2927 per euro (€) The last entry in the U.S Dollar column shows that the exchange rate can also be expressed as €0.7736 per dollar •

Exchange Rates and Trade

Is It Dollars per Yen or Yen per Dollar?

• Exchange rates quoted as units of domestic currency per unit of foreign

currency are referred to as direct quotations Indirect quotations express

exchange rates as units of foreign currency per unit of domestic currency

Figure 8.2

Fluctuations in Exchange Rates, 2000–2010

The panels show fluctuations in the exchange rates between the United States dollar and the yen, the Canadian dollar, and the euro Because we are measuring the exchange rate

on the vertical axis as dollars per unit of foreign currency, an increase in the exchange rate represents a depreciation of the dollar and an appreciation of the other currency •

Exchange Rates and Trade

Nominal Exchange Rates versus Real Exchange Rates

be exchanged for goods and services in another country

• We use the real exchange rate when we are interested in knowing how

much of another country’s goods and services you can buy with a U.S

dollar For example, the real exchange rate between the dollar and the

pound in terms of Big Macs is:

• Similarly, we can derive the real exchange rate between the dollar and the

pound using the nominal exchange rate and the price levels in each country:

Exchange Rates and Trade

rate) exchange (nominal

rate exchange pound

per Dollars London

in Macs Big

of price Pound

York New

in Macs Big

of price Dollar



rate)exchange

(nominalrate

exchangepound

per Dollarsindex

priceBritish

indexprice

consumer U.S



8.2 Learning

Objective

Explain how markets for foreign exchange operate

Foreign-Exchange Markets

currencies are traded

• If you want to buy foreign stocks or bonds, you must convert U.S dollars into the appropriate currency

• The large commercial banks are called market makers because they are

willing to buy and sell the major currencies at any time

• Most foreign-exchange trading takes place among commercial banks located

in London, New York, and Tokyo, with secondary centers in Hong Kong,

Singapore, and Zurich

• With daily trading in the trillions of dollars, the foreign-exchange market is

one of the largest financial markets in the world Participants include

investment portfolio managers and central banks

Forward and Futures Contracts in Foreign Exchange

• In the foreign-exchange market, spot market transactions involve an

exchange of currencies or bank deposits immediately (subject to a two-day

settlement period) at the current exchange rate

• In forward transactions, traders agree today to a forward contract to

exchange currencies or bank deposits on a specific future date at an

exchange rate known as the forward rate

• Futures contracts in foreign exchange also exist They are traded on

exchanges, such as the CBOT, and are standardized in terms of quantity

and settlement date The exchange reduces counterparty risk, which in turn

reduces default risk

• In foreign exchange markets, the amount of trading in forward contracts is at least 10 times greater than the amount of trading in futures contracts

• Call and put options contracts are also available on foreign exchange.

Foreign-Exchange Markets

Exchange-Rate Risk, Hedging, and Speculating

fluctuations in exchange rates

• The forward rate reflects what traders in the forward market expect the spot

exchange rate between the dollar and pound to be in 90 days, so it may not

equal the current spot rate

• To hedge against a fall in the value of the pound, a firm sells pounds in the

forward market; to hedge against a rise in the value of the pound, a firm

buys pounds in the forward market

• A hedger uses derivatives markets to reduce risk, while a speculator uses

derivatives markets to place a bet on the future value of a currency

• Firms and investors can also use options contracts to hedge or to speculate

• The disadvantage of speculating with options contracts is that their prices

are higher than are the prices of forward contracts

Foreign-Exchange Markets

Making the Connection

Can Speculators Drive Down the Value of a Currency?

• In early 2010, a controversy erupted over whether the managers of hedge

funds were conspiring to earn billions of dollars by driving down the price of

the euro

• In February 2010, the managers of four hedge funds met in New York City to discuss whether it would be profitable to use derivatives to bet that the value

of the euro would fall

• The U.S Department of Justice thought that their actions might be illegal

and opened an investigation The fund managers claimed that they were just exchanging ideas on an investment opportunity rather than conspiring to

take actions that were intended to drive down the value of the euro in

exchange for the dollar

• But, as we will see, exchange rates among major currencies such as the

euro and the dollar are determined by factors that a few hedge fund

managers probably can’t affect, however large those funds

Foreign-Exchange Markets

8.3 Learning

Objective

Explain how exchange rates are determined in the long run

Exchange Rates in the Long Run

should sell for the same price everywhere

The Law of One Price and the Theory of Purchasing Power Parity

move to equalize the purchasing power of different currencies

• In the context of international trade, the law of one price is the basis for the

theory of purchasing power parity (PPP)

• In other words, in the long run, exchange rates should be at a level that

makes it possible to buy the same amount of goods and services with the

equivalent amount of any country’s currency

The Law of One Price and the Theory of Purchasing Power Parity

• Once the exchange rate reflects the purchasing power of the two currencies, the opportunity for arbitrage profits is eliminated This mechanism appears to guarantee that exchange rates will be at their PPP levels

• PPP makes an important prediction about movements in exchange rates in

the long run: If one country has a higher inflation rate than another country,

the currency of the high-inflation country will depreciate relative to the

currency of the low-inflation country

• Real exchange rate between the dollar and the pound =

Exchange Rates in the Long Run

rate) exchange

(nominal rate

exchange pound

per Dollars index

price consumer British

index price

consumer U.S.



The Law of One Price and the Theory of Purchasing Power Parity

• We can rearrange terms to arrive at an expression for the nominal exchange rate in terms of the real exchange rate and the price levels in the two

countries:

• If prices in the United States increase on average faster than prices in

Great Britain, then to maintain PPP, the value of the dollar will have to

depreciate relative to the value of the pound

Exchange Rates in the Long Run

rate exchange Real

index price

consumer British

index price

consumer U.S.

pound per

Dollars





Is PPP a Complete Theory of Exchange Rates?

1 Not all products can be traded internationally.

2 Products are differentiated.

3 Governments impose barriers to trade.

imported

• Three real-world complications keep purchasing power parity from being

a complete explanation of exchange rates:

Exchange Rates in the Long Run

Solved Problem 8.3

Should Big Macs Have the Same Price Everywhere?

The Economist magazine tracks the

prices of the McDonald’s Big Mac

hamburger in countries around the

world

The following table shows the price

of Big Macs in the United States and

in six other countries, along with the

exchange rate between that country’s

currency and the U.S dollar

a Explain whether the statistics in the table are consistent with the theory

of purchasing power parity

b Explain whether your results in part (a) mean that arbitrage profits exist

in the market for Big Macs

Exchange Rates in the Long Run

Solved Problem 8.3

Should Big Macs Have the Same Price Everywhere?

Solving the Problem

Step 1 Review the chapter material.

Step 2 Answer part (a) by determining whether the theory of purchasing power

parity applies to Big Macs.

We can convert the price of a Big Mac in a given country to its price in dollars For

example, in the case of Japan: ¥330/(¥93.2/$) = $3.54.

Exchange Rates in the Long Run

Solved Problem 8.3

Should Big Macs Have the Same Price Everywhere?

Solving the Problem

Step 3 Answer part (b) by explaining whether arbitrage profits exist in the

market for Big Macs.

Exchange Rates in the Long Run

It is not possible to make arbitrage profits by buying low-price Big Macs in one country and selling them in another The theory of purchasing power parity

does not provide a complete explanation of exchange rates because many

goods—such as Big Macs—cannot be traded internationally

8.4 Learning

Objective

Use a demand and supply model to explain how exchange rates are

determined in the short run

A Demand and Supply Model of Short-Run Movements in Exchange Rates

A Demand and Supply Model of Exchange Rates

• By assuming that price levels are constant, our model will determine both the

equilibrium nominal exchange rate and the equilibrium real exchange rate

• The demand for U.S dollars represents the demand by households and

firms outside the United States for U.S goods and U.S financial assets

• The supply of dollars in exchange for yen is determined by the willingness of households and firms that own dollars to exchange them for yen

A Demand and Supply Model of Exchange Rates

So, the demand curve for dollars in exchange for yen is downward sloping

The higher the exchange rate, the more yen households or firms will receive in exchange for dollars and the larger the quantity of dollars supplied The supply curve of dollars in exchange for yen is upward sloping because the quantity of dollars supplied will increase as the exchange rate increases.

A Demand and Supply Model of Short-Run Movements in Exchange Rates

Shifts in the Demand and Supply for Foreign Exchange

Figure 8.4 (1 of 2)

The Effect of Changes

in the Demand and Supply for Dollars

Panel (a) illustrates the effect of an increase in the demand for dollars in exchange for yen.

The demand curve for dollars shifts to the right, causing the equilibrium exchange rate to

increase from ¥80 = $1

to ¥85 = $1 and the equilibrium quantity of dollars traded to

increase from Dollars1 to Dollars2.

A Demand and Supply Model of Short-Run Movements in Exchange Rates

Shifts in the Demand and Supply for Foreign Exchange

Figure 8.4 (2 of 2)

The Effect of Changes

in the Demand and Supply for Dollars

Panel (b) illustrates the effect of an increase in the supply of dollars in

exchange for yen.

The supply curve for dollars in exchange for yen shifts to the right, causing the equilibrium exchange rate to

decrease from ¥80 = $1 to

¥75 = $1 and the equilibrium quantity of dollars traded to increase from Dollars1 to Dollars2.•

A Demand and Supply Model of Short-Run Movements in Exchange Rates

The “Flight to Quality” during the Financial Crisis

Figure 8.5

Movements in the Trade-Weighted Exchange Rate of the U.S Dollar

The increase in the value of the dollar during the late 1990s, as shown in the figure, was driven by strong demand from foreign investors for U.S stocks and bonds, particularly

U.S Treasury securities Something similar happened during the financial crisis of 2007– 2009: As many foreign investors sought a safe haven in U.S Treasury securities, the

demand for dollars increased.

A Demand and Supply Model of Short-Run Movements in Exchange Rates