The Economics of Money, Banking, and
Financial Markets
Twelfth Edition, Global Edition
Topic 7 (Chapter 18)
The Foreign Exchange
Market
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Learning Objectives
• LO1: Explain how the foreign exchange market operates
• LO2: Determine factors affecting exchange rate in the long
run
• LO3: Determine factors affecting exchange rate in the
short run using the asset market approach
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1. Foreign Exchange Market Operations
• Exchange rate: price of one currency in terms of another
– Quotation: Direct vs Indirect quotation
→ Indirect quotation: unit of foreign currency per 1 unit of domestic
currency (Et)
• Foreign exchange market: where the trading of
currencies and bank deposits denominated in particular
currencies takes place.
• Spot transaction: immediate (two-day) exchange of bank
deposits (at spot exchange rate, S).
• Forward transaction: the exchange of bank deposits at
some specified future date (at Forward exchange rate, F)
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Table 1: Exchange rate of USD and major currencies
18/01/2023
Source: tradingeconomics.com
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Table 2:
Exchange rate
of Vietnam
dong as of
18/01/2023
Copyright © 2019 Pearson Education, Ltd. Source: vietcombank.com
Table 3: EUR/USD Forward Rates
as of Jan 18, 2023
Source: fxempire.com
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1. Foreign Exchange Market Operations
• Appreciation: a currency rises in value relative to another
currency
• Depreciation: a currency falls in value relative to another
currency
• When a country’s currency appreciates, the country’s
goods become more expensive to foreigners and foreign
goods in that country become less expensive to domestic
economic agents.
• Traded over-the-counter market mainly banks
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1. Foreign Exchange Market Operations
• Foreign currencies are traded over-the-counter with a
network of dealers.
• Dealers use telephone and computer to contact and ready
to buy and sell currencies and deposits denominated in
foreign currencies.
• The foreign exchange market is very competitive, it
functions similar to a centralized market.
• The volume in this market is colossal, exceeding $5 trillion
per day.
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2. Exchange rate in the long run:
Purchasing power parity (PPP)
• The law of one price: states that the exchange rate between
any two countries’ currencies is such that a basket of goods
and services, wherever it is produced, costs the same in both
countries
Exchange rate (f/d) = Foreign price level / Domestic price level
• Example: a basket of goods in the United States costs $100.
The same basket costs VND 2,300,000 in Vietnam. The
exchange rate between VND and USD should be
VND23,000 per dollar. Given exchange rate of VND23,000/$,
the basket of goods in Vietnam would cost $100, the same
as in the US.
• What happen if the exchange rate is VND25,000/$?
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2. Exchange rate in the long run:
Purchasing power parity (PPP)
• Key PPP insight: If a country’s price level rises relative to
another’s by a certain percentage, then its currency
should depreciate by the same percentage.
• Example: Suppose that the price level in Japan rises by
10%, while the price level in the United States does not
change. What will be the new exchange rate if PPP holds?
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2. Exchange rate in the long run:
Real Exchange Rate
• Real exchange rate: the rate at which domestic goods
can be exchanged for foreign goods. PPP predicts that
real exchange rate is always equal to 1
Domestic price of domestic goods
Real exchange rate =
Domestic price of foreign goods
• Example: Consider a basket of goods in New York worth
$50; meanwhile, the same basket of goods is worth ¥7500
in Tokyo. The nominal exchange rate is ¥100/$. How
much dollar does it cost to buy a basket of goods in
Tokyo? What is the real exchange rate?
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Application:
Burgernomics - Big Macs and PPP
• Since 1986, The Economist magazine has published the
Big Mac index as a “light- hearted guide to whether
currencies are at their ‘correct’ level based on the theory of
purchasing power parity.”
• Big Macs are sold by McDonald’s are sold in 56 different
regions and countries, then uses these prices to compare
the exchange rate implied by PPP and the Big Mac index.
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Application:
Burgernomics: Big Macs and PPP
%over/undervaluation
• A Big Mac in US costs $4.93 (=(Actual-Implied)/Implied)
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2. Exchange rate in the long run: PPP
limitations
There are three reasons why the theory of PPP does not
fully explain.
1. PPP theory does not take into account that many goods
and services are non-tradable.
2. Similar goods typically are not identical in both countries.
3. There are barriers to trade.
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2. Exchange rate in the long run:
Determinants of long-run exchange rate
• The basic rule: Anything that increases the demand for
domestically produced goods relative to foreign traded
goods tends to appreciates domestic currency.
→ If a factor increases the demand for domestic goods
relative to foreign goods, the domestic currency will
appreciate; and vice versa.
– Relative price levels
– Trade barriers
– Preferences for domestic versus foreign goods
– Productivity
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Summary Table 1: Determinants of long-run
exchange rate
Factor Change in Factor Response of the
Exchange Rate, E*
Domestic price level† ↑ ↓
Trade barriers† ↑ ↑
Import demand ↑ ↓
Export demand ↑ ↑
Productivity† ↑ ↑
*Units of foreign currency per dollar: ↑ indicates domestic currency appreciation; ↓, depreciation.
†Relative to other countries.
Note: Only increases (↑) in the factors are shown; the effects of decreases in the variables on the exchange rate are the
opposite of those indicated in the “Response” column.
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3. Exchange Rates in the Short Run: Asset
market approach
• An exchange rate is the price of domestic (dollar) assets in
terms of foreign assets
• Supply curve for domestic assets
– Assume amount of domestic assets is fixed (supply
curve is vertical)
• Demand curve for domestic assets
– Most important determinant is the relative expected
return of domestic assets
– At lower current values of the dollar (everything else
equal), the quantity demanded of dollar assets is
higher
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Figure 2 Equilibrium in the Foreign
Exchange Market
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20
3. Exchange Rates in the Short Run: Asset
market approach
▪ Expected return on domestic assets equals
domestic interest rate
▪ Expected return on foreign assets equals
foreign interest rates minus the expected
change in the value of domestic currency.
▪ Interest parity condition states that expected
returns on domestic assets and foreign assets
must be equal
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21
3. Exchange Rates in the Short Run: Asset
market approach
▪ The domestic interest rate equals the foreign interest
rate minus the expected change of the domestic
currency’s value.
E e
− Et
i D
=i F
− t +1
Et
• The equilibrium condition for the foreign exchange
market is reached when the interest parity condition
holds.
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3. Exchange Rates in the Short Run: Asset
market approach
• Relative expected return on domestic assets
E e
− Et
=i D
−i F
+ t +1
Et
• Shifts in the demand for domestic assets
– Domestic interest rate
– Foreign interest rate
– Changes in the expected future exchange rate
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Figure 3 Response to an Increase in the
Domestic Interest Rate, iD
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Figure 4 Response to an Increase in the
Foreign Interest Rate, iF
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Figure 5 Response to an Increase in the
Expected Future Exchange Rate, Eet+1
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Summary Table 2 Factors That Shift the Demand Curve
for Domestic Assets and Affect the Exchange Rate
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Application: Effects of Changes in Interest
Rates on the Equilibrium Exchange Rate
• Changes in Interest Rates
– When domestic real interest rates rise, the domestic
currency appreciates.
– When domestic interest rates rise due to an expected
increase in inflation, the domestic currency
depreciates.
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Figure 6 Effect of a Rise in the Domestic Interest Rate
As a Result of an Increase in Expected Inflation
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Application: The Global Financial Crisis
and the Dollar
• With the start of the global financial crisis in August 2007,
the dollar began an accelerated decline in value, falling by
9% against the euro until mid-July of 2008. After hitting an
all-time low against the euro on July 11, the value of the
dollar suddenly shot upward, by over 20% against the euro
by the end of October. What is the relationship between
the global financial crisis and these large swings in the
value of the dollar?
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Application: The Global Financial Crisis
and the Dollar
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Application: Brexit and the British Pound
• As noted in the introduction, the Brexit vote in the United
Kingdom on June 23, 2016, led to nearly a 10%
depreciation in the British pound, from $1.48 to the pound
on June 23, just before the vote, to $1.36 per pound on
June 24. What explains the large one-day decline in the
exchange rate for the pound?
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Application: Brexit and the British Pound
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THE 2022 CASE: The strong USD
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INTERVENTION IN THE FOREIGN
EXCHANGE MARKET
• Central banks regularly engage in international financial
transactions, the purchase and sale of their currencies,
called foreign exchange interventions, to influence
exchange rates
• International reserves: central bank’s holdings of assets
denominated in a foreign currency
• A central bank’s purchase (sale) of domestic currency and
corresponding sale (purchase) of foreign assets in the
foreign exchange market leads to an equal decline
(increase) in its international reserves and the monetary
base.
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INTERVENTION IN THE FOREIGN
EXCHANGE MARKET
• Unsterilized intervention: central bank allows the
purchase or sale of domestic currency to have an effect on
the monetary base (and thus, money supply).
– If domestic currency is bought and foreign assets are
sold → fall in international reserves, fall in the money
supply, and appreciation of the domestic currency
– If domestic currency is sold and foreign assets are
purchased → rise in international reserves, rise in the
money supply, and depreciation of the domestic
currency.
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INTERVENTION IN THE FOREIGN
EXCHANGE MARKET
• Sterilized intervention: A foreign exchange intervention
with an offsetting open market operation that leaves the
monetary base (and thus, money supply) unchanged.
– Has almost no effect on the exchange rate (the money
supply unchanged, interest rates unaffected).
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Summary
• Foreign exchange market operations
• The law of one price and Purchasing power parity
• Factors affecting exchange rate in the long run: relative
price level, trade barriers, preferences for domestic and
foreign goods, productivity.
• Factors affecting exchange rate in the short run: domestic
interest rate, foreign interest rate, expected future
exchange rate.
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