Chapter 14
Exchange Rates and the Foreign Exchange Market:
An Asset Approach
■ Chapter Organization
Exchange Rates and International Transactions.
Domestic and Foreign Prices.
Exchange Rates and Relative Prices.
The Foreign Exchange Market.
The Actors.
Box: Exchange Rates, Auto Prices, and Currency Wars.
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: Offshore Currency Markets: The Case of the Chinese Yuan.
Risk and Liquidity.
Interest Rates.
Exchange Rates and Asset Returns.
A Simple Rule.
Return, Risk, and Liquidity in the Foreign Exchange Market.
90 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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?
Summary
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.
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 21.
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
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 91
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
currencies.
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.
Because 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
92 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
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.
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
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 93
abruptly crashed, losing 40% 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.
94 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
■ Answers to Textbook Problems
1. At an exchange rate of 1.05 $ per euro, a 5 euro bratwurst costs 1.05$/euro × 5 euros = $5.25. Thus,
the bratwurst in Munich is $1.25 more expensive than the hot dog in Boston. The relative price is
2. If it were cheaper to buy Israeli shekels with Swiss francs that were purchased with dollars than to
directly buy shekels with dollars, then people would act upon this arbitrage opportunity. The demand
for Swiss francs from people who hold dollars would rise, causing the Swiss franc to rise in value
against the dollar. The Swiss franc would appreciate against the dollar until the price of a shekel
4. When the yen depreciates versus the dollar, costs to a Japanese firm that imports petroleum will rise.
This depresses its profits. On the other hand, that firm will be able to export more to the United States
96 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Eleventh Edition
8. If market traders learn that the dollar interest rate will soon fall, they also revise upward their
expectation of the dollar’s future depreciation in the foreign exchange market. Given the current
9. The analysis will be parallel to that in the text. As shown in the accompanying diagrams, a movement
down the vertical axis in the new graph, however, is interpreted as a euro appreciation and dollar
In the second case, the expected appreciation of the dollar raises the euro return on an American asset
e
R
e
R
10. a. If the Federal Reserve pushed interest rates down, with an unchanged expected future exchange
rate, the dollar would depreciate (note that the article uses the term “downward pressure” to mean
b. The “disruptive” effects of a recession make dollar holdings more risky. Risky assets must offer
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 97
© 2018 Pearson Education, Inc.
assets. This extra compensation may be in the form of a bigger expected appreciation of the
currency in which the asset is held. Given the expected future value of the exchange rate, a bigger
expected appreciation is obtained by a more depreciated exchange rate today. Thus, a recession
that is disruptive and makes dollar assets more risky will cause a depreciation of the dollar.
11. The euro is less risky for you. When the rest of your wealth falls, the euro tends to appreciate,
12. The chapter states that most foreign exchange transactions between banks (which accounts for the
vast majority of foreign exchange transactions) involve exchanges of foreign currencies for U.S.
dollars, even when the ultimate transaction involves the sale of one nondollar currency for another
13. The interest rate parity condition tells us that interest rates and exchange rates are directly linked. As
interest rates become more volatile, so too will exchange rates. For example, suppose that the
European Central Bank actively limits fluctuations in euro interest rates while the Federal Reserve
does not intervene to keep dollar interest rates stable. Interest rate parity states that:
€ € €
− = −
US EU $/ $/ $/
( )/
e
R R E E E
If the left-hand side of this equation becomes more volatile, then so too must the right-hand side.
Assuming that expectations remain unchanged, then this increase in volatility will be reflected in
higher variablility of the exchange rate.
