Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
Chapter 14 (3)
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: 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?
Summary
APPENDIX TO CHAPTER 14 (3): Forward Exchange Rates and Covered Interest Parity
76 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
◼ 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 20(9).
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
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[7].)
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.
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 77
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.
Figure 14(3)-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.
78 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth 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
3. Take for example the exchange rate between the Argentine peso, the US dollar, the euro, and the
British pound. One dollar is worth 5.3015 pesos, while a euro is worth 7.0089 pesos. To rule out
triangular arbitrage, we need to see how many pesos you would get if you first bought euros with
We need to say that triangular arbitrage is “approximately” ruled out for several reasons. First,
rounding error means that there may be some small discrepancies between the direct and indirect
4. A depreciation of Chinese yuan makes the import more expensive. Since the demand for oil is
inelastic, China needs to import oil from the oil exporting countries. This leads to spending more on
5. The dollar rates of return are as follows:
c. There are two parts to this return. One is the loss involved due to the appreciation of the dollar;
the dollar appreciation is ($1.38 − $1.50)/$1.50 = −0.08. The other part of the return is the interest
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 79
6. Note here that the ordering of the returns of the three assets is the same whether we calculate real or
nominal returns.
a. The real return on the house would be 25 percent − 10 percent = 15 percent. This return could
also be calculated
by first finding the portion of the $50,000 nominal increase in the house’s price due to inflation
7. The expected rate of MYR depreciation against the euro is (3.15- 3.00)/3.00 =0.05 or 5% per year.
The expected gain to Volkswagen, if there is no change in exchange rate, was = 700,000 × 0.05 =
35,000 euro.
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 exchange rate
and interest rates, there is thus a rise in the expected dollar return on euro deposits from
EU,1
e
R
to
EU,2
e
R
. At the current exchange rate of E1, the dollar return on a European asset exceeds the dollar
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
depreciation rather than the reverse. Also, the horizontal axis now measures the euro interest rate.
80 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
The two diagrams below show the effects of an increase in European interest rates and an increase in
the expected future exchange rate in terms of euros per dollar. In the first case, an increase in European
interest rates raises the euro return on a European asset above the euro return on an American asset.
This will cause the exchange rate to fall (euro appreciation, dollar depreciation) from E1 to E2.
In the second case, the expected appreciation of the dollar raises the euro return on an American asset
from
e
US,1
R
to
US,2 .
e
R
At the current exchange rate, American assets pay a higher euro return and the
exchange rate must rise (euro depreciation, dollar appreciation) to restore interest rate parity.
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
pressure for the dollar to depreciate). If there is a “soft landing,” and the Federal Reserve does
not lower interest rates, then this dollar depreciation will not occur.
b. The “disruptive” effects of a recession make dollar holdings more risky. Risky assets must offer
some extra compensation such that people willingly hold them as opposed to other, less risky
assets. This extra compensation may be in the form of a bigger expected appreciation of the
11. If the Japanese yen gives 15% interest rate against 10% interest rate of euro deposits, people will
prefer to hold Japanese yen deposits as it gives more return. However, a depreciation of 10%
Japanese yen would give 5% more return on the euro deposits. No rational consumer will prefer to
hold Japanese Yen. The holders of yen will try to sell it for the euro deposits. This would increase
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 nondollar
currency. This central role of the dollar makes it a vehicle currency in international transactions. The
reason the dollar serves as a vehicle currency is that it is the most liquid of currencies because it is
easy to find people willing to trade foreign currencies for dollars. The greater liquidity of the dollar as
compared to, say, the Mexican peso, means that people are more willing to hold the dollar than the
peso, and thus, dollar deposits can offer a lower interest rate, for any expected rate of depreciation
against a third currency, than peso deposits for the same rate of depreciation against that third currency.
Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 81
As the world capital market becomes increasingly integrated, the liquidity advantages of holding
dollar deposits as opposed to euro deposits will probably diminish. The euro represents an economy
13. The expected depreciation rate of yen is (2.4 – 2)/2 = 0.2 or 20%
The expected rate of return from rupee deposits will be 0.05 + (2.4 – 2)/2 = 0.25
14. A tax on interest earnings and capital gains leaves the interest parity condition the same because all
its components are multiplied by one less the tax rate to obtain after-tax returns. If capital gains are
15. A devaluation of the exchange rate will make export cheaper for the foreign nationals and the import
16. The value should have gone down as there is no more need to engage in intra-EU foreign currency
trading. This represents the predicted transaction cost savings stemming from the euro. At the same
17. If the dollar depreciated, all else being equal, we would expect outsourcing to diminish. If, as the
problem states, much of the outsourcing is an attempt to move production to locations that are relatively
cheaper, then the United States becomes relatively cheap when the dollar depreciates. Although it
may not be as cheap a destination as some other locations, at the margin, labor costs in the United
States will have become relatively cheaper, making some firms choose to retain production at home.
For example, we could say that the labor costs of producing a computer in Malaysia is $220 and the
82 Krugman/Obstfeld/Melitz • International Economics: Theory & Policy, Tenth Edition
18. They key here is to compute the return on the carry trade by accounting for not only the difference
between Korean and American interest rates, but also the percentage change in the value of the
Korean won against the dollar. The risk of the carry trade is that the won might depreciate against the
dollar, thus negating the higher interest rate paid on Korean bonds. Using data from Jan 2009 through
Oct 2013, a carry trade described in this problem would have the following cumulative return:
19. As per the question, a currency depreciation benefits exporters and hurts consumers by raising the
cost of living. Exporters tend to have more influence with the government for two reasons. First,
there are fewer exporters than there are consumers, so the gains from a currency depreciation are
much more heavily concentrated than the losses. As a result, each individual exporter will put forth
more effort in lobbying the government than each individual consumer. Second, exporters are much
