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Chapter 8
The Market for Foreign Exchange
Brief Chapter Summary and Learning Objectives
8.1 Exchange Rates and Trade (pages 225–229)
Explain the difference between nominal and real exchange rates.
Foreign exchange rates can be expressed as either U.S. dollars per unit of foreign currency or as
units of foreign currency per U.S. dollar.
The nominal exchange rate is the price of one country’s currency in terms of another country’s
currency.
The real exchange rate measures the rate at which goods and services in one country can be
exchanged for goods and services in another country.
8.2 Foreign-Exchange Markets (pages 230–234)
Explain how markets for foreign exchange operate.
Currencies trade in foreign-exchange markets involve both spot transactions and future
transactions.
A hedger uses derivatives markets to reduce risk, while a speculator uses derivatives markets to
place a bet on the future value of a currency.
8.3 Exchange Rates in the Long Run (pages 234–238)
Explain how exchange rates are determined in the long run.
The theory of purchasing power parity (PPP) holds that exchange rates move to equalize the
purchasing power of different currencies.
A key implication of PPP is that countries with relatively high inflation rates are likely to see
their currencies depreciate relative to the currencies of countries with low inflation rates.
PPP does not hold exactly, particularly in the short run, for a variety of reasons including not all
goods can be traded internationally, products are differentiated, and governments impose trade
barriers.
8.4 A Demand and Supply Model of Short-Run Movements in Exchange Rates (pages 238–246)
Use a demand and supply model to explain how exchange rates are determined in the short run.
The demand for U.S. dollars represents the demand by households and firms outside of the
United States for U.S. goods and U.S. financial assets. The supply of U.S. dollars in exchange
for a foreign currency is determined by the willingness of households and firms that own U.S.
dollars to exchange them for the foreign currency.
Anything that increases the willingness of foreign households and firms to buy U.S. goods or
U.S. assets will cause the demand curve for dollars to shift to the right, whereas anything that
increases the willingness of households and firms in the United States to buy foreign goods or
assets will cause the supply curve for dollars to shift to the right.
The interest-rate parity condition holds that differences in interest rates on similar bonds in
different countries reflect expectations of future changes in exchange rates.
Key Terms
Appreciation An increase in the value of a
currency in exchange for another currency.
Depreciation A decrease in the value of a
currency in exchange for another currency.
Exchange-rate risk The risk that a firm will
suffer losses because of fluctuations in exchange
rates.
Foreign-exchange market An over-the-counter
market where international currencies are traded.
Interest-rate parity condition The proposition
Nominal exchange rate The price of one
currency in terms of another currency; also
called the exchange rate.
Quota A limit a government imposes on the
quantity of a good that can be imported.
Real exchange rate The rate at which goods
and services in one country can be exchanged
for goods and services in another country.
Tariff A tax a government imposes on imports.
Theory of purchasing power parity (PPP)
that differences in interest rates on similar bonds
in different countries reflect expectations of
future changes in exchange rates.
Law of one price The fundamental economic
idea that identical products should sell for the
same price everywhere.
The theory that exchange rates move to equalize
the purchasing power of different currencies.
Chapter Outline
Teaching Tips
Many students are intrigued by questions of foreign exchange. Those students who closely follow the
financial news are familiar with discussions about the strength of the dollar. Some are confused as to
whether references to the “declining value of the dollar” refer to declines in the domestic purchasing
power of the dollar or to declines in the exchange value of the dollar.
One of the strengths of this text is that the exchange rates are discussed in an early chapter. The chapter
provides clear definitions of basic concepts, such as the real exchange rate and purchasing power parity,
and provides a simple demand and supply model of exchange rate determination. The chapter concludes
with a discussion of the interest-rate parity condition, which is linked to the discussion of Fed policy
found in the chapter opener.
Is Ben Bernanke Responsible for Japanese Firms Moving to the United States?
The increase in the value of the Japanese yen following the financial crisis made it less profitable for
Japanese firms to export products to the United States. As a result, several firms shifted production to the
United States so that both their revenues and their costs would be in dollars. This move insulated these
Japanese firms from the effects of changes in exchange rates. What led to the rising value of the yen?
The rise was likely due in part to U.S. monetary policy, which pushed some interest rates close to zero,
reducing the demand for dollars relative to the demand for the currencies of other countries.
8.1 Exchange Rates and Trade (pages 225–229)
Learning Objective: Explain the difference between nominal and real exchange rate.
The nominal exchange rate is the price of one country’s currency in terms of another country’s
currency. An increase in the value of one country’s currency in exchange for another country’s
currency
is called an appreciation, while a decrease is called a depreciation. Fluctuations in the exchange
rate between the dollar and foreign currencies affect the prices that U.S. consumers pay for foreign
imports.
A. Is It Dollars per Yen or Yen per Dollar?
Foreign exchange rates can be expressed as either U.S. dollars per unit of foreign currency or as
units of foreign currency per U.S. dollar.
B. Nominal Exchange Rates versus Real Exchange Rates
When we are interested in the relative purchasing power of two countries’ currencies, we use
the real exchange rate, which measures the rate at which goods and services in one country can
be exchanged for goods and services in another country. The following is the expression for the
real exchange rate in terms of the nominal exchange rate and the price levels in each country:
Real exchange rate between the dollar and the foreign currency
❑
❑
In this equation, the nominal exchange rate is measured as dollars per foreign currency.
Teaching Tips
Have students read and discuss the Making the Connection, “What’s the Most Important Factor
in Determining Sony’s Profits?” on page 226. Students typically do not think about the role that
exchange rates play in the profitability of U.S. and foreign firms competing in the U.S. market.
This Making the Connection provides material for a good class discussion of this issue. The
discussion should include the different ways that Sony and other multinational corporations are
affected by fluctuations in exchange rates.
8.2 Foreign-Exchange Markets (pages 230–234)
Learning Objective: Explain how markets for foreign exchange operate.
As with other prices, exchange rates are determined by the forces of demand and supply.
Currencies are traded in foreign-exchange markets around the world.
A. Forward and Futures Contracts in Foreign Exchange
In the foreign-exchange market, spot market transactions involve an exchange of currencies or
bank deposits immediately (subject to a two-day settlement period) at the current exchange
rate. In forward transactions, traders agree today to a forward contract in which they commit to
exchanging currencies or bank deposits at a specific future date at an exchange rate known as
the forward rate. Futures contracts in foreign exchange also exist.
B. Exchange-Rate Risk, Hedging, and Speculating
Exchange-rate risk is the risk that a firm will suffer losses because of fluctuations in exchange
rates. Companies can hedge, or reduce, the exchange-rate risk they face by entering into a forward
contract–or, more likely, having a bank carry out the forward transaction for a fee. A hedger
uses derivatives markets to reduce risk, while a speculator uses derivatives markets to place a
bet on the future value of a currency. Compared with futures contracts, options contracts have the
advantage to hedgers that if the price moves in the opposite direction to the one being hedged
against, the hedger can decline to exercise the option and instead can gain from the favorable
price movement. A speculator who believed that the value of a currency was likely to rise more
than expected would buy calls, while a speculator who believed that the value of a currency
was likely to fall more than expected would buy puts.
8.3 Exchange Rates in the Long Run (pages 234–238)
Learning Objective: Explain how exchange rates are determined in the long run.
A. Law of One Price and the Theory of Purchasing Power Parity
The law of one price states that identical products should sell for the same price everywhere. In
the context of international trade, the law of one price is the basis for the theory of purchasing
power parity (PPP), which holds that exchange rates move to equalize the purchasing power of
different currencies. PPP predicts that if one country has a higher inflation rate than another
country, then the currency of the high-inflation country will depreciate relative to the currency
of
the low-inflation country.
B. Is PPP a Complete Theory of Exchange Rates?
Though PPP provides some useful insights, it doesn’t always hold true, particularly in the short
run. Some reasons include the fact that not all goods are traded internationally, products are
differentiated, and governments impose trade barriers. So, prices are not always equalized
across countries.
8.4 A Demand and Supply Model of Short-Run Movements in Exchange Rates
(pages 238–246)
Learning Objective: Use a demand and supply model to explain how exchange rates are determined
in the short run.
A. A Demand and Supply Model of Exchange Rates
The demand for U.S. dollars represents the demand by households and firms outside of the
United States for U.S. goods and U.S. financial assets, while the supply of dollars in exchange
for foreign currency is determined by the willingness of households and firms that own U.S.
dollars to exchange them for the foreign currency. The demand curve for dollars in exchange
for foreign currency is downward sloping because the quantity of dollars demanded will
increase as the exchange rate declines. Similarly, the supply curve for dollars is upward sloping
because the quantity of dollars supplied will increase as the exchange rate increases.
B. Shifts in the Demand and Supply for Foreign Exchange
Anything, other than a change in the exchange rate, that increases the willingness of foreign
households and firms to buy U.S. goods or U.S. assets will cause the demand curve for dollars
to shift to the right, whereas anything that increases the willingness of Americans to buy
foreign goods or assets will cause the supply curve for dollars to shift to the right. Changes in
relative interest rates can also affect the supply and demand for foreign exchange. For example,
if interest rates in the United States rise relative to interest rates in other countries, the demand
for U.S. dollars will increase as foreign investors exchange their currencies for dollars in order
to purchase U.S. financial assets. An increase in the demand for U.S. dollars leads to an
appreciation of the dollar, while an increase in the supply of dollars leads to a depreciation of
the dollar.
C. The “Flight to Quality” During the Financial Crisis
During times of international economic crisis, many foreign investors may engage in a “flight
to quality” in which they purchase assets denominated in U.S. dollars, particularly U.S.
Treasury securities, because they appear to be safe investments.
D. The Interest-Rate Parity Condition
On a typical day, more than 95% of the demand for foreign exchange is the result of a desire by
investors to buy foreign financial assets. International financial investment involves
exchange-rate risk. The interest-rate parity condition holds that differences in interest rates on
similar bonds in different countries reflect expectations of future changes in exchange rates. In
practice, interest-rate parity may not hold because of: (1) The differences among bonds with
respect to default risk and liquidity; (2) the transactions costs involved in buying foreign
financial assets; and (3) the exchange-rate risk involved in investing in a foreign financial asset.
Teaching Tips
Use of the section, “The Flight to Quality During the Financial Crisis” on pages 241-242, to illustrate the
global nature of the financial system. Have students discuss how changes in risk perceptions resulted in
major movements of financial flows, causing significant changes in the value of currency during the
financial crisis of 2007-2009.
