Book Title
International Economics: Theory and Policy 9th Edition

978-0132146654 Chapter 14 Lecture Notes

December 18, 2019
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach    69
Chapter 14
Exchange Rates and the Foreign Exchange Market:
An Asset Approach
.1 Chapter Organization
Exchange Rates and International Transactions
  Domestic and Foreign Prices
  Exchange Rates and Relative Prices
The Foreign Exchange Market
  The Actors
  Characteristics of the Market
  Spot Rates and Forward Rates
  Foreign Exchange Swaps
  Futures and Options
The Demand for Foreign Currency Assets
  Assets and Asset Returns
  Box: Nondeliverable Forward Exchange Trading in Asia
  Risk and Liquidity
  Interest Rates
  Exchange Rates and Asset Returns
  A Simple Rule
  Return, Risk, and Liquidity in the Foreign Exchange Market
Equilibrium in the Foreign Exchange Market
  Interest Parity: The Basic Equilibrium Condition
  How Changes in the Current Exchange Rate Affect Expected Returns
  The Equilibrium Exchange Rate
Interest Rates, Expectations, and Equilibrium
  The Effect of Changing Interest Rates on the Current Exchange Rate
  The Effect of Changing Expectations on the Current Exchange Rate
  Case Study: What Explains the Carry Trade?
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
70  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
APPENDIX TO CHAPTER 14: Forward Exchange Rates and Covered Interest Parity
Chapter Overview
The purpose of this chapter is to show the importance of the exchange rate in translating foreign prices into
domestic values as well as to begin the presentation of exchange rate determination. Central to the
treatment of exchange rate determination is the insight that exchange rates are determined in the same way
as other asset prices. The chapter begins by describing how the relative prices of different countries’ goods
are affected by exchange rate changes. This discussion illustrates the central importance of exchange rates
for cross-border economic linkages. The determination of the level of the exchange rate is modeled in
the context of the exchange rate’s role as the relative price of foreign and domestic currencies, using the
uncovered interest parity relationship.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach    71
The euro is used often in examples. Some students may not be familiar with the currency or aware of
which countries use it; a brief discussion may be warranted. A full treatment of EMU and the theories
surrounding currency unification appears in Chapter 20.
The description of the foreign exchange market stresses the involvement of large organizations (commercial
banks, corporations, nonbank financial institutions, and central banks) and the highly integrated nature
of the market. The nature of the foreign exchange market ensures that arbitrage occurs quickly, so that
common rates are offered worldwide. A comparison of the trading volume in foreign exchange markets to
that in other markets is useful to underscore how quickly price arbitrage occurs and equilibrium is restored.
Forward foreign exchange trading, foreign exchange futures contracts, and foreign exchange options play
an important part in currency market activity. The use of these financial instruments to eliminate short-run
exchange rate risk is described.
The explanation of exchange rate determination in this chapter emphasizes the modern view that exchange
rates move to equilibrate asset markets. The foreign exchange demand and supply curves that introduce
exchange rate determination in most undergraduate texts are not found here. Instead, there is a discussion
of asset pricing and the determination of expected rates of return on assets denominated in different
Students may already be familiar with the distinction between real and nominal returns. The text demonstrates
that nominal returns are sufficient for comparing the attractiveness of different assets. There is a brief
description of the role played by risk and liquidity in asset demand, but these considerations are not
pursued in this chapter. (The role of risk is taken up again in Chapter 18.)
Substantial space is devoted to the topic of comparing expected returns on assets denominated in domestic
and foreign currency. The text identifies two parts of the expected return on a foreign currency asset
(measured in domestic currency terms): the interest payment and the change in the value of the foreign
currency relative to the domestic currency over the period in which the asset is held. The expected return
on a foreign asset is calculated as a function of the current exchange rate for given expected values of the
future exchange rate and the foreign interest rate.
The absence of risk and liquidity considerations implies that the expected returns on all assets traded in the
foreign exchange market must be equal. It is thus a short step from calculations of expected returns on foreign
assets to the interest parity condition. The foreign exchange market is shown to be in equilibrium only when
the interest parity condition holds. Thus, for given interest rates and given expectations about future exchange
rates, interest parity determines the current equilibrium exchange rate. The interest parity diagram introduced
here is instrumental in later chapters in which a more general model is presented. Since a command of this
interest parity diagram is an important building block for future work, we recommend drills that employ
this diagram.
The result that a dollar appreciation makes foreign currency assets more attractive may appear
counterintuitive to students—why does a stronger dollar reduce the expected return on dollar assets? The
key to explaining this point is that, under the static expectations and constant interest rates assumptions, a
dollar appreciation today implies a greater future dollar depreciation; so, an American investor can expect
to gain not only the foreign interest payment but also the extra return due to the dollar’s additional future
depreciation. The following diagram illustrates this point. In this diagram, the exchange rate at time t 1 is
expected to be equal to E. If the exchange rate at time t is also E, then expected depreciation is 0. If, however,
the exchange rate depreciates at time t to E then it must appreciate to reach E at time t 1. If the exchange
rate appreciates today to E then it must depreciate to reach E at time t 1. Thus, under static
expectations, a depreciation today implies an expected appreciation and vice versa.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley
72  Krugman/Obstfeld/Melitz •   International Economics: Theory & Policy, Ninth Edition
Figure 14-1
This pedagogical tool can be employed to provide some further intuition behind the interest parity
relationship. Suppose that the domestic and foreign interest rates are equal. Interest parity then requires
that the expected depreciation is equal to zero and that the exchange rate today and next period is equal
to E. If the domestic interest rate rises, people will want to hold more domestic currency deposits. The
resulting increased demand for domestic currency drives up the price of domestic currency, causing the
exchange rate to appreciate. How long will this continue? The answer is that the appreciation of the
domestic currency continues until the expected depreciation that is a consequence of the domestic
currency’s appreciation today just offsets the interest differential.
The text presents exercises on the effects of changes in interest rates and of changes in expectations of
the future exchange rate. These exercises can help develop students’ intuition. For example, the initial
result of a rise in U.S. interest rates is a higher demand for dollar-denominated assets and thus an increase
in the price of the dollar. This dollar appreciation is large enough that the subsequent expected dollar
depreciation just equalizes the expected return on foreign currency assets (measured in dollar terms) and
the higher dollar interest rate.
The chapter concludes with a case study looking at a situation in which interest rate parity may not hold:
the carry trade. In a carry trade, investors borrow money in low-interest currencies and buy
high-interest-rate currencies, often earning profits over long periods of time. However, this transaction
carries an element of risk as the high-interest-rate currency may experience an abrupt crash in value. The
case study discusses a popular carry trade in which investors borrowed low-interest-rate Japanese yen to
purchase high-interest-rate Australian dollars. Investors earned high returns until 2008, when the Australian
dollar abruptly crashed, losing 40 percent of its value. This was an especially large loss as the crash
occurred amidst a financial crisis in which liquidity was highly valued. Thus, when we factor in this
additional risk of the carry trade, interest rate parity may still hold.
The Appendix describes the covered interest parity relationship and applies it to explain the determination
of forward rates under risk neutrality as well as the high correlation between movements in spot and
forward rates.
© 2012 Pearson Education, Inc. Publishing as Addison-Wesley