Topic 9.

Exchange rates and the

foreign exchange market

9.1 and 9.2. Some definitions

9.3. Equilibrium in the foreign exchange market: An asset approach
9.4. The purchasing power parity
References:
Krugman, P.R., Obstfeld, M. and M.J. Melitz (2015): International Economics: Theory and Policy.
Tenth Edition (Global Edition). Pearson, chapter 14, pages 374-383, 389-403 and 408-410,
chapter 16, pages 445-449 and 455-462.

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 9.1. and 9.2. SOME DEFINITIONS.
Definition of exchange rate (E):
Price of one currency in terms of another
The exchange rate (E) can be expressed in two ways (to illustrate the theory of
Topic 9 we use two currencies, the euro and the dollar):
E$/€ = 1,09 [ 1,09 $ per 1 €]
E€/$ = 0.92 [ 0.92 € per 1 $]
Mathematically (one is the inverse of the other one):
E$/€ =1/E€/$ and E€/$ =1/E$/€
One important role of exchange rates:
Compare prices in different currencies. An example: The price of a pair of jeans is
50$ in the US and 45€ in Europe. Where is it cheaper? (two ways to get to the
same answer):
you
have
to All prices in €: (P$US)×E€/$= 50×0.92=46€. Hence, it is cheaper in Europe (45€).
obtai
n the
same
All prices in $: (P€Europe)×E$/€= 45×1,09 =49.05$. Hence, it is cheaper in Europe
in
both
(in the US the price is 50$). number of dollars thath corresponds to each euro

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 Changes in exchange rates (E): Agreements between government establishes the rates: they come form
agreements of governments.
Under a fixed exchange rates system (where it is the Governments through agreements that
establish the exchange rates between currencies; world exchange rate system until 1973):
one currencie losses value in terms of another, when done by government agreements.
There eas a central currence (dollar, whcih has a
Devaluation: one currency looses value in terms of another. correspandace with gold; central currency with a value in
Revaluation: one currency gains value in terms of another. gold). Establishing every currency with respect to the
dollarm and also between them.
one currency is devaluated,w hile the other one revaluated
Under a flexible (or floating) exchange rates system (where it is the equilibrium of the Foreign
Exchange Market that determines the exchange rates between currencies; world exchange rate
system since 1973):
Governments are not agreeing the exchange rates, but they hve a lot of power (making policies, purchase currencies,
expectations to reaction of people) and the reaction of people to affect the equilibrium in the market. The determination
of exchange rates is in the market where people exchange currencies, is called the Foreign Exchange rate Market.
Depreciation: one currency looses value in terms of another.
Appreciation: one currency gains value in terms of another.
The names depend on the exchange rate system (which in turn depends on how the exchange
rates are established) but, beyond this, for a currency, the meaning of Devaluation is equivalent to
that of Depreciation (and Revaluation equivalent to that of Appreciation).
Examples:
Devaluation/Depreciation of the € against the $: If the exchange rate E€/$=0.92 (number of € per $)
changes to E’€/$=1.25 (number of € per $), the € is loosing value against the $ since in the second case
you will need to pay more € to purchase one $. It is the same as saying that the $ gains value against the
€ (the $ is Revaluated/Appreciated against the €). euro has lost value
Revaluation/Appreciation of the € against the $: If the exchange rate E€/$=0.92 (number of € per $)
changes to E’€/$=0.75 (number of € per $), the € is gaining value against the $ since in the second case
you will need to pay less € to purchase one $. The $ is Devaluated/Depreciated against the €.

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 type of bussiness in which coe people (arbitrageurs) check the litltle difference ebetween exchange rates between the different
countries and you see where is it a little bit cheaper to purchase dollars with euroes, and then you get to the country where
dollars are more high valued. Yu purchase where it is cheaper and sell in the most expensive and get the profir. Private profit
activity, but for society they guarantee this differential dissapear and they exploit the difference thaht equalize the price of
currencies. They equalize proces int he world, bc it's a business from them, they get the difference.
The Foreign Exchange Market:
It is not a unique market, it is composed of many financial centres in the world where Commercial
Banks, non-Banking financial institutions, Insurance Companies, Central Banks, and Multinationals,
sell and buy currencies in large quantities. It works 24 hours and it is very well connected through
internet.
This good connexion and transmission of information between financial centres allows performing
a business called Arbitrage , which is the process of a simultaneous purchase and sale
of currencies in two or more Foreign Exchange Markets with an objective to make profits by
capitalizing on the exchange-rate differentials in various markets. The relevant role of this business
is contributing to the equalization of exchange rates in thewhent
different
here's anForeign
exhange ofExchange Markets
currencies is odne in
immediatly,
the world. If one currency is cheap in a market in termsand ofin another, arbitrageurs
this market meanst purchase
2 days the most),a nd youthe
exchange at the current equilibrium in the market (SPOT
currency in this market and simultaneously sell the currencyexhange
whererate,it and
is more expensive.
the exchange rate is spot exchange rate
is the current equilibrium exhange rate in the market for this
Main types of transactions in the Foreign Exchange Market:exhange.
“Spot” transactions: Transactions to purchase/sale currencies with immediate delivery (two days
maximum) and at the current market exchange rate (known as "Spot" exchange rate).
“Forward” transactions: Transactions to purchase/sale currencies with delayed delivery and at an
exchange rate agreed in the contract for the future exchange of currencies (“Forward” exchange
rate: exchange rate at which an agent agrees to exchange one currency for another at a future
date). Agents that need a particular currency in the future are interested in “Forward” contracts to
avoid the risk of what is going to happen in the future with exchange rates (they agree today in a
contract the exchange rate that will be applied to them in the future).
distingished bc echange of currencies is not immediate, it's at some future date, people do it today (Agreement, contract) in which
they agree an amout of the future peiord currency and at which exchange rate. Is it profitable to import????????? is it profitable=??? 4
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know Rochina
for certaincy the futurecost of puchasing dollars. (Froward exchange rate)
 9.3. EQUILIBRIUM IN THE FOREIGN EXCHANGE
MARKET: An asset approach.
We are going to explain this equilibrium in 3 ways:
Intuitively, its mathematical expression and its graphic representation.
Assets approach: to be able to prove to show the equilirbium of exchange rate, to show this equilibrium, we'll consider investing in currencies and
money as a n asset. People can invest in the asset, coming in bank depossits, people obtain money by investinf in bank depossits. Asset approach:
considering money an asset where people can invest consider the ecahnge rates. Intiutiely, mathematically and graphical representation.
 Intuitively: We consider money as an asset in which investors can
invest. In particular, in our analysis investors can invest in Bank deposits
in different countries (or economic areas) with different currencies. To
get the equilibrium of exchange rates for two currencies, for example
the € and the $, we consider the case of investors that are Europeans
and are deciding where to invest their money, either in Bank deposits in
Europe in € or in Bank deposits in the US in $. Investors will compare
rates of return (profitability) from both investments and they will be
indifferent only when the rates of return from both investments in Bank
deposits are identical. At this time, the Foreign Exchange Market for
these two currencies is in equilibrium and their equilibrium exchange
rate is determined.
Returns of investment are the same than returns of intevesting in euros, when investors are indifferent: profitability rates thath they get same
profitability in € and $. Moving money from one to another. The important thing here, we'll move this condition into a mathematical expression.

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

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Therefore, the equilibrium condition in the Foreign Exchange Market is obtained
when the two previous rates of return are the same (this condition is well-
known as the INTEREST PARITY CONDITION):
 Et€/$
+1
- Et€/$  Et€/$
+1

r€ r$ + 
=  →
= r€ r$ + t − 1
 Et E €/$
 €/$ 
The left-hand side is the rate of return on investments in Bank deposits in € and the
right-hand side the rate of return on investments in Bank deposits in $. Notice that
the rate of return on Bank deposits in $ for European investors depends positively on
the interest rate in the US, r$ , and the value of the exchange rate Et+1€/$ in the future
(period t+1), when European investors will recover the investment and the rate of
return (profitability) on their investment. The higher Et+1€/$ (that is, the weaker the €
and, hence, the stronger the $) the more profitable for them to invest their money in
the US since doing this they will receive $ in period t+1. Differently, the rate of return
on Bank deposits in $ for European investors depends negatively on the present value
(period t) of the exchange rate, Et€/$ , since in period t if they decide to invest in $
what they want is a strong € (the lower Et€/$ , the better, since this means that with
less € they can buy the $ they need to invest in the United States in $).

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The INTEREST PARITY CONDITION has two versions that depend on the uncertainty
in the future value of the exchange rate that exists when investors take the decision
about where inverting their money:
 The Uncovered INTEREST PARITY CONDITION: when investors decide where to
invest their money using expectations about what is going to be the exchange rate in
period t+1 (Et+1€/$ ). The exchange rate in the future is in principle an unknown
variable for the investors deciding at period t.
 The Covered INTEREST PARITY CONDITION: when investors decide where to
invest their money knowing with certainty the value of the exchange rate that will be
applied to them in the future (period t+1). How can this be possible? Because they
have agreed today (period t) in a “Forward” contract which is going to be the
“Forward” exchange rate that is going to be applied to them in the future (period
t+1). In this way, when taking their decisions (period t) they are covered from the
risk of what is going to happen with the exchange rate in the future. In the
uncovered case, they assume this risk when deciding.
In the graphic representation of the equilibrium we work with the most common
version of the INTEREST PARITY CONDITION that is the Uncovered one (the one
that works with expectations) and which is simply known as the INTEREST
PARITY CONDITION.

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 Before starting with the graphic representation of the equilibrium (or Interest Parity
Condition):

 Et€/$
+1
- Et€/$  Et€/$
+1

r€ r$ + 
=  →
= r€ r$ + t − 1
 E t  E €/$
 €/$ 
VERY RELEVANT TO NOTICE THE FOLLOWING:
1. For making the analysis more intuitive for you I have assumed that the investors deciding
where to invest their money where Europeans. But in fact, once we have obtained the
mathematical expression of the INTEREST PARITY CONTIDITON (IPC), this is of wider
applicability (this means that we do not need to know whether investors are Europeans,
from the US or from somewhere else).
2. The IPC is in fact a mathematical approximation of a non-linear expression (but we work
with its mathematical approximation). Due to this, we can either use the expression as it is
written before (using the € as the reference currency) or as written in the following way
(using the $ as the reference currency):
 E$/€
t +1
- E$/€
t
 E$/€
t +1

r$ r€ + 
=  →
= r$ r€ + t − 1
 Et E$/€
 $/€ 
This other way of writing the IPC can be intuitively understood from the point of view of
American investors instead of Europeans (although we know that it is not necessary to know
where investors are from to apply the IPC).

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  Graphic representation of the equilibrium in the Foreign
Exchange Market (graphic representation of the Interest Parity
Condition, IPC). We use the € as the reference currency:
Exchange rate:
Et€/$
Return on € deposits = r€

Et€/$
+1

r€ = r$ + −1
Et€/$
Et,1€/$

Expected return on $ deposits =

Et€/$
+1

= r$ + −1
E t
€/$

r€ Rates of return on Bank deposits

(the € as reference)
Equilibrium 1 is associated to the equilibrium exchange rate Et,1€/$ . The equilibrium is determined by 3
variables: r€, r$ and Et+1€/$ . Whenever one of these variables changes, the equilibrium changes (see next slides).
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 Example 1: Change in equilibrium 1 when the interest rate
on Bank deposits in € grows from r1€ to r2€ :
An increase in the € interest rate
(r€). makes the red line to move
outwards.
Et€/$
Now, at Et,1€/$ , the expected
return for deposits in $ (blue line) is Return on € deposits
lower than the return for deposits
in € (red line). How much lower?
The horizontal distance from point
1 to 1´. Et,1€/$ is not anymore the
equilibrium when the red line has Et,1€/$
moved. equil.1 1’
This profitability differential in Et,2€/$ equil.2
favour of € deposits makes Expected return
investors start purchasing € (and on $ deposits
selling $). This makes the €
appreciate against the $, that is the
equilibrium exchange rate drops r1€ r2€ Rates of return on
until equilibrium 2. Bank deposits
In the new equilibrium of the market, equil.2, the equil. exchange (the € as reference)
rate is smaller, what means that to purchase one $ investors need less €.

María Rochina 11
 Example 2: Change in equilibrium 1 when the interest rate
on Bank deposits in $ grows from r1$ to r2$ :
An increase in the $ interest rate
(r$) makes the blue line to move
outwards. Et€/$ r$
Now, at Et,1€/$ , the expected
return for deposits in $ (blue line) is Return on € deposits
higher than the return for deposits
in € (the red line). How much
higher? The horizontal distance Et,2€/$ equil.2
from point 1 to 1´. Et,1€/$ is not
anymore the equilibrium when the Et,1€/$ 1’
blue line has moved. equil.1 Expected return
This profitability differential in on $ deposits
favour of $ deposits makes
investors start purchasing $ (and
selling €). This makes the €
depreciate against the $, that is the
equilibrium exchange rate goes up r€ Rates of return on
until equilibrium 2. Bank deposits
In the new equilibrium of the market, equil.2, the equil. exchange (the € as reference)
rate is higher, what means that to purchase one $ investors need more €.

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 Example 3: Change in equilibrium 1 when the expected
exchange rate for period t+1 (future), Et+1€/$ , increases ( ):
An increase in the expected value of
Et+1€/$ makes the blue line to move
outwards. Et€/$ Et+1€/$
Now, at Et,1€/$ , the expected return Return on € deposits
for deposits in $ (blue line) is higher
than the return for deposits in € (the
red line). How much higher? The t,2
horizontal distance from point 1 to E €/$ equil.2
1´. Et,1€/$ is not anymore the
equilibrium when the blue line has Et,1€/$ 1’
moved. equil.1 Expected return
on $ deposits
This profitability differential in favour
of $ deposits makes investors start
purchasing $ (and selling €). This
makes the € depreciate against the
$, that is the equilibrium exchange
rate goes up until equilibrium 2. r€ Rates of return on
Bank deposits
In the new equilibrium of the market, equil.2, the equil. exchange (the € as reference)
rate is higher, what means that to purchase one $ investors need more €.

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 TWO RELEVANT THINGS TO NOTICE:

1. We have seen previously 3 examples of changes in the equilibrium in

the Foreign Exchange Rates market. Notice that we can have 3 more
examples if instead of increasing the value of r€, r$ or Et+1€/$ , we
decrease their values.

1. In numerical exercises of the IPC, we use this equation to solve it for

anything unknown, that is r€, r$, Et+1€/$ , or Et€/$ . However, in its graphic
representation what we get in the equilibrium is the value of the
equilibrium exchange rate that is in the current time (period t) in the
market, and this is the variable Et€/$ (the variable that in the
mathematical expression of the IPC appears in the denominator):

Et€/$
+1

=r€ r$ + −1
E t
€/$

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 9.4. THE PURCHASING POWER PARITY (PPP):
Exchange rates in the long-term.
 Some economic theories try to explain the long-term values ​of exchange rates,
unlike the Interest Parity Condition, which determines the current equilibrium
in the Foreign Exchange Market.
 These economic theories for the long-term determination of the value and
evolution of exchange rates started by a theory called The Law of One Price
(LOP):
According to the LOP, in competitive markets, with no transportation costs
and barriers to trade (such as tariffs, etc.), that is, if there is free trade,
identical goods sold in different countries must be sold at the same
price if expressed in terms of the same currency.
Mathematically, being PiUS in $ and PiEU in € the prices of good “i” in the US and in the
EU, respectively, it should be true by the LOP the following:
P i
Pi = Pi ⋅ E ⇒E = EU
EU US €/$ €/$ Pi
US
That is, the exchange rate €/$ is obtained as the one that guarantees that a good “i”
identical in the two markets has exactly the same price when expressed in the same
currency (in our formula we have expressed it in €).

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 The second step in these economic theories for the long-term determination of
exchange rates is what is called The absolute Purchasing Power Parity (aPPP).
One of the critical points of the Law of One Price was the multiplicity of exchange
rates we could obtain through the previous formula. Notice that there can be many
goods “i” identical in the two countries, and from each of them we can isolate a
different exchange rate E€/$. To solve this problem, the aPPP is defined for a basket
of goods and services that can be used to define the purchasing power of money in
both countries (or economic areas with different currencies). Hence, the aPPP says
that if there is free trade, the price of the entire basket of goods and
services in the two countries must be the same if it is expressed in the
same currency.
Mathematically, being PUSbasket in $ and PEUbasket in € the prices of the “basket” in the US and
in the EU, respectively, it should be true by the aPPP the following:
Pbasket
P basket
=P basket
⋅E ⇒E = EU
EU US €/$ €/$ Pbasket
US
That is, the unique exchange rate €/$ is obtained as the one that guarantees that
the price of the “basket” is identical in the two markets when expressed in the
same currency (in our formula we have expressed it in €).
If the E€/$ is determined by the aPPP, it guarantees that the purchasing power of money
is the same in the two countries. You can see this through an example: if the basket is worth
100 $ in the US and the exchange rate that comes out of the previous formula is applied, you
get exactly the number of € necessary to buy the same basket in the EU.

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 The third step in these economic theories for the long-term determination of exchange
rates is what is called The relative Purchasing Power Parity (rPPP). It has been
verified with real data if the aPPP is fulfilled, and many times it is not. On the contrary,
what is fulfilled with real data to a greater extent is the rPPP. The rPPP, rather than
relating the absolute values ​of prices to the absolute value of the exchange rate, it
relates the percentage changes in prices to the percentage change in the exchange
rate over time. According to this theory, variations over time of the exchange rate
between two currencies obey to prices growth rates differentials, that is, obey to the
differential in inflation rates.
The mathematical formula for the rPPP is as follows: ˆ =P
E ˆ −Pˆ = Π −Π
€ /$ EU US EU US

where the symbol ^ means the percentage change of a given variable over a period of
time, P is a price index and its percentage change coincides with the inflation rate (the
symbol Π).
This mathematical formula of the rPPP indicates that the currency of the area with
higher inflation is going to suffer a depreciation (the opposite for the other
currency, an appreciation).
Example: the inflation rate from period t to t+1 in the EU is 10% and the inflation rate
during the same period in the US is 3%. How is going to change the exchange rate €/$
during this period? Eˆ € /$ = 10% − 3% =
7% . In a year time you have to pay 7% more € to
purchase a $ (that is, the € suffers a 7% depreciation, and the $ suffers a 7%
appreciation).

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