Exchange Rates. MBMM Lecture Petar Stankov. 09 Dec P. Stankov (CERGE-EI) Lecture Dec.
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1 Exchange Rates MBMM Lecture Petar Stankov 09 Dec P. Stankov (CERGE-EI) Lecture Dec / 11
2 Outline 1 What Are Foreign Exchange Rates? 2 How Is the Foreign Exchange Rate Determined? 3 Equilibrium: The Interest Rate Parity Condition P. Stankov (CERGE-EI) Lecture Dec / 11
3 The Foreign Exchange Market What is a foreign exchange market? Denition: A foreign exchange market A market where funds are converted from one currency to another Why do rms and citizen need this conversion? to transfer funds from one country to another for safety reasons Denition: A foreign exchange rate A price of one currency in terms of another P. Stankov (CERGE-EI) Lecture Dec / 11
4 The Foreign Exchange Market - Graphs What is the Euro-Dollar exchange rate for ? P. Stankov (CERGE-EI) Lecture Dec / 11
5 The Foreign Exchange Market - Graphs How is the US dollar moving in terms of other currencies? Why do we care? What do these graphs mean? What happens when the Euro becomes expensive? For citizens, and for rms... P. Stankov (CERGE-EI) Lecture Dec / 11
6 How Does the Foreign Exchange Market Work? An over-the-counter market How does the exchange market work: If you want 20 e, go to the exchange oce. P. Stankov (CERGE-EI) Lecture Dec / 11
7 How Does the Foreign Exchange Market Work? An over-the-counter market How does the exchange market work: If you want 20 e, go to the exchange oce. If you want 20 mln. e, go to the bank, open an account in CZK, P. Stankov (CERGE-EI) Lecture Dec / 11
8 How Does the Foreign Exchange Market Work? An over-the-counter market How does the exchange market work: If you want 20 e, go to the exchange oce. If you want 20 mln. e, go to the bank, open an account in CZK, and ask the bank to trade for you. P. Stankov (CERGE-EI) Lecture Dec / 11
9 How Does the Foreign Exchange Market Work? An over-the-counter market How does the exchange market work: If you want 20 e, go to the exchange oce. If you want 20 mln. e, go to the bank, open an account in CZK, and ask the bank to trade for you. The bank trades over-the-counter with other banks, and buys the 20 mln for you. P. Stankov (CERGE-EI) Lecture Dec / 11
10 How Does the Foreign Exchange Market Work? An over-the-counter market How does the exchange market work: If you want 20 e, go to the exchange oce. If you want 20 mln. e, go to the bank, open an account in CZK, and ask the bank to trade for you. The bank trades over-the-counter with other banks, and buys the 20 mln for you. You go to Italy and buy furniture, invest in real estate, buy a factory, etc. P. Stankov (CERGE-EI) Lecture Dec / 11
11 How Is the Foreign Exchange Rate Determined? Four main factors for demand shifts What shifts demand for domestic/foreign goods? 1 Price levels in CR (or US) and in EU 2 Home bias in consumption 3 Productivity (cost) improvement 4 Taris and quotas P. Stankov (CERGE-EI) Lecture Dec / 11
12 How Is the Foreign Exchange Rate Determined? Four main factors for demand shifts What shifts demand for domestic/foreign goods? 1 Price levels in CR (or US) and in EU 2 Home bias in consumption 3 Productivity (cost) improvement 4 Taris and quotas Common factor: demand for domestic/foreign goods P. Stankov (CERGE-EI) Lecture Dec / 11
13 Factors Determining the Changes in Exchange Rates The long-run perspective P. Stankov (CERGE-EI) Lecture Dec / 11
14 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y P. Stankov (CERGE-EI) Lecture Dec / 11
15 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe P. Stankov (CERGE-EI) Lecture Dec / 11
16 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe Suppose Assets in US yield i US, and Assets in Europe yield i EU. P. Stankov (CERGE-EI) Lecture Dec / 11
17 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe Suppose Assets in US yield i US, and Assets in Europe yield i EU. Suppose further i US = 7%, i EU = 5%. P. Stankov (CERGE-EI) Lecture Dec / 11
18 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe Suppose Assets in US yield i US, and Assets in Europe yield i EU. Suppose further i US = 7%, i EU = 5%. Is this information enough to make a decision which assets to buy? P. Stankov (CERGE-EI) Lecture Dec / 11
19 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe Suppose Assets in US yield i US, and Assets in Europe yield i EU. Suppose further i US = 7%, i EU = 5%. Is this information enough to make a decision which assets to buy? Suppose US $ is expected to depreciate by 3%. EReturn US =? Formally: EReturn US = i US i EU + P. Stankov (CERGE-EI) Lecture Dec / 11
20 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe Suppose Assets in US yield i US, and Assets in Europe yield i EU. Suppose further i US = 7%, i EU = 5%. Is this information enough to make a decision which assets to buy? Suppose US $ is expected to depreciate by 3%. EReturn US =? Formally: EReturn US = i US i EU + E t+1 E t E t P. Stankov (CERGE-EI) Lecture Dec / 11
21 Factors Determining the Changes in Exchange Rates Special attention to expected returns on assets Recall the exchange rate transmission channel of monetary policy: M s i r E NX Y Example: Assets in US Vs. Assets in Europe Suppose Assets in US yield i US, and Assets in Europe yield i EU. Suppose further i US = 7%, i EU = 5%. Is this information enough to make a decision which assets to buy? Suppose US $ is expected to depreciate by 3%. EReturn US =? Formally: What happens when EReturn US? EReturn US = i US i EU + E t+1 E t E t P. Stankov (CERGE-EI) Lecture Dec / 11
22 The Interest Rate Parity Condition Recall: EReturn US = i US i EU + P. Stankov (CERGE-EI) Lecture Dec / 11
23 The Interest Rate Parity Condition Recall: EReturn US = i US i EU + E t+1 E t E t P. Stankov (CERGE-EI) Lecture Dec / 11
24 The Interest Rate Parity Condition Recall: EReturn US = i US i EU + E t+1 E t E t Set EReturn US = 0. The Interest Rate Parity Condition i US = i EU E t+1 E t E t This condition determines equilibrium on the foreign exchange market. P. Stankov (CERGE-EI) Lecture Dec / 11
25 Equilibrium on the Foreign Exchange Market A graphical illustration P. Stankov (CERGE-EI) Lecture Dec / 11
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