THE FOREIGN EXCHANGE MARKET The price of one currency in terms of the other is called the exchange rate.

It is defined as the number of domestic currency units that are necessary to buy one unit of foreign currency, e.g., KD 0.300 to buy US$ 1. What are Foreign Exchange Rates. There are two kinds of foreign exchange transactions;

Spot Transactions: involve the immediate exchange of currencies ( it may take two days for
the exchange to take place ), based on the spot exchange rate.

Forward Transactions: involve the exchange of currencies at some specified future date; 30,
60, 90 days,.etc., based on the ( current ) forward exchange rate. Changes in Exchange Rates. When a currency increases in value, it has appreciated, e.g., if e ( KD, $ ) = KD 0.300 = $ 1, where e ( KD, $ ) = the exchange rate of dollars in KD. If the exchange rate changed to KD 0.250 = $ 1. The value of KD vis-a-vis the dollar increased. When a currency increases in value it experiences appreciation. When a countrys currency appreciates ( rises in value to other currencies ), the countrys goods abroad become more expensive and foreign goods in the country become cheaper. If the exchange rate changed to Changed to KD 0.350 = $ 1. The value of KD vis-a-vis the dollar decreased. When a currency increases in value it undergoes depreciation. When a countrys currency depreciates, its goods abroad become cheaper, while foreign goods in that country become more expensive. Exchange Rates in the Long Run. The Theory of Purchasing Power Parity. States that exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries. Factors that Affect Exchange Rates in the Long Run.

Relative Price levels.

When the prices of domestic goods rise ( relative to foreign goods ), the demand for them falls and the domestic currency tends to depreciate, and vice versa. In the long run a rise in the countrys price level ( relative to foreign price levels ) causes its currency to depreciate, while a fall in the countrys relative price level causes its currency to appreciate.

Tariffs and Quotas.

Barriers to free trade such as tariffs and quotas can affect the exchange rate. Tariffs and quotas cause a countrys currency to appreciate relative in the long run.

Preference for Domestic Versus Foreign Goods.

Increased demand for a countrys exports causes its currency to appreciate in the long run, while increased demand for imports causes its currency to depreciate .

Productivity
In the long run, as a country becomes more productive relative to other countries, its currency appreciates.

Exchange Rates in the Short Run.

We understood that exchange rates in the long run is determined by purchasing power parity,
however, in the short run exchange rates may exhibit large changes from day to day.

The key to understand short-run behavior of exchange rates is to recognize that exchange rate
is the price of domestic bank deposits ( i.e., denominated in domestic currency ) in terms of foreign bank deposits ( i.e., denominated in the foreign currency ). Hence exchange rate in the short run will be determined using the asset market approach.

Comparing Expected Returns on Domestic and Foreign Deposits.

Suppose that KD deposits have a interest rate

, while US $ deposits interest rate is . To compare the expected returns on KD deposits and US$ deposits we must convert the returns into the currency investors use.

Expected return on deposits is the nominal interest rate plus expected depreciation (
), i.e. the expected return on domestic deposits equals;

while the expected return on foreign ( $ ) deposits is;

hence the relative return ( the difference between expected return on domestic deposits and foreign deposits ) is;

Interest Parity Condition. Since foreign bank deposits and domestic bank deposits have similar risk and liquidity and because there are few impediments to capital mobility, it is reasonable to assume that the deposits are perfect substitutes. Under these conditions, if the expected return on domestic deposits is above that on foreign deposits both national and foreign investors will want to hold

KD deposits, and vice versa. For existing supplies of both KD deposits and $ deposits to be held, it must therefore be true that there is no difference in the expected returns, that is the relative expected return must equal zero, i.e.,

; ( expected returns in terms of KD )

This equation is called the INTEREST PARITY CONDITION, and it states that the domestic interest rate equals the foreign interest rate plus the expected appreciation ( depreciation ) of the domestic currency. Hence;

if domestic interest rate is above the foreign interest rate, this means that there is a positive
expected appreciation of the foreign currency which compensates for lower foreign interest rate.

Given our assumption that domestic and foreign bank deposits are perfect substitutes, the
interest parity condition is an equilibrium condition for the foreign exchange market. Equilibrium in the Foreign Exchange Market. To see how the interest parity equilibrium condition works in determining the exchange rate let us examine how the expected returns on $ and KD deposits change as the current exchange rate changes.

Expected Return on Foreign Deposits.

Equilibrium in foreign exchange market will be determined by the intersection of the schedules for the expected return on $ deposits and expected return on KD deposits. As shown in the following figure. figure

The expected return on $ slopes upward, i.e., as the exchange rate E rises, the expected return on $ deposits rises. A higher current exchange rate means a greater expected appreciation of the

foreign currency in the future, which increases the expected return on foreign deposits in terms of KD.

Expected Return on KD deposits.

The expected return on KD deposits is always interest rate on KD deposits no matter what the exchange rate is.

Equilibrium.
The intersection of the schedules for the expected return on KD deposits and the expected return on $ deposits is equilibrium in the exchange market, i.e.,

At equilibrium exchange rate the interest parity condition is satisfied because the expected returns on KD and $ deposits are equal.

Explaining Changes in Exchange Rates. Shifts in the Expected-Return Schedule for Foreign Deposits. Factors that shift this schedule are the foreign interest rate, and the expected future exchange rate.

Changes in the Foreign Interest Rate.

If interest on foreign deposits increases, the expected return on these deposits must also increase. Hence at a given exchange rate, the increase in foreign interest rate leads to a rightward shift in the expected return schedule for foreign deposits. The outcome is a depreciation of KD. Alternatively we recognize that the increase on expected return on $ deposits at the original equilibrium exchange rate resulting from the rise in foreign interest rate means that people will want to buy dollars and sell KDs, so the value of KD must fall. Figure

Conclusion: An increase in the foreign interest rate shifts the expected return schedule for foreign deposits to the right and causes the domestic currency to depreciate, and vice versa.

Changes in the Expected Future Exchange Rate.

Any factor that causes the expected future exchange rate to fall decreases the expected appreciation of KD and hence raises the expected appreciation of the $. The result is a higher expected return on $ deposits to the right and leads to a decline in the exchange rate. Conclusion: a rise in the expected future exchange rate shifts the expected return schedule for foreign deposits to the left and causes a depreciation of KD, a fall in the expected exchange rate shifts the expected return schedule for foreign deposits to the right and causes an appreciation of KD. Shifts in the Expected Return Schedule for Domestic Deposits. Expected return on domestic deposits is the domestic interest rate.

Changes in the Domestic Interest Rate.

A rise in the domestic interest rate raised the expected return on KD deposits, shifts in the expected return on domestic deposits to the right, and leads to a rise in the exchange rate. Figure

Conclusion: a rise in the domestic interest rate shifts the expected return schedule for domestic deposits to the right and causes an appreciation of the domestic currency; a fall in domestic interest rate shifts the expected return schedule for domestic deposits to the left and causes a depreciation of the domestic currency. BACK TO PAGE