Exchange Rates and the Foreign Exchange Market:

An Asset Approach

To Accompany International Economics: Theory and Policy, Sixth Editio

by Paul R. Krugman and Maurice Obstfeld
 Introduction
 Exchange rates are important because they enable us
to translate different counties’ prices into comparable
terms.
 Exchange rates are determined in the same way as
other asset prices.
 The general goal of this chapter is to show:
• How exchange rates are determined
• The role of exchange rates in international trade

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 Exchange Rates and
International Transactions
 An exchange rate can be quoted in two ways:
• Direct
– The price of the foreign currency in terms of dollars
• Indirect
– The price of dollars in terms of the foreign currency

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 Exchange Rates and
International Transactions
Table 13-1: Exchange Rate Quotations

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 Exchange Rates and
International Transactions
 Domestic and Foreign Prices
• If we know the exchange rate between two countries’
currencies, we can compute the price of one country’s
exports in terms of the other country’s money.
– Example: The dollar price of a £50 sweater with a dollar
exchange rate of $1.50 per pound is (1.50 $/£) x (£50) =
$75.

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 Exchange Rates and
International Transactions
• Two types of changes in exchange rates:
– Depreciation of home country’s currency
– A rise in the home currency prices of a foreign currency
– It makes home goods cheaper for foreigners and foreign goods
more expensive for domestic residents.
– Appreciation of home country’s currency
– A fall in the home price of a foreign currency
– It makes home goods more expensive for foreigners and
foreign goods cheaper for domestic residents.

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 Exchange Rates and
International Transactions
 Exchange Rates and Relative Prices
• Import and export demands are influenced by relative
prices.
• Appreciation of a country’s currency:
– Raises the relative price of its exports
– Lowers the relative price of its imports
• Depreciation of a country’s currency:
– Lowers the relative price of its exports
– Raises the relative price of its imports

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 Exchange Rates and
International Transactions
Table 13-2: $/£ Exchange Rates and the Relative Price of American
Designer Jeans and British Sweaters

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 The Foreign Exchange Market
 Exchange rates are determined in the foreign
exchange market.
• The market in which international currency trades take
place
 The Actors
• The major participants in the foreign exchange market
are:
– Commercial banks
– International corporations
– Nonbank financial institutions
– Central banks

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 Exchange Rates and
International Transactions
• Interbank trading
– Foreign currency trading among banks
– It accounts for most of the activity in the foreign
exchange market.

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 Exchange Rates and
International Transactions
 Characteristics of the Market
• The worldwide volume of foreign exchange trading is
enormous, and it has ballooned in recent years.
• New technologies, such as Internet links, are used
among the major foreign exchange trading centers
(London, New York, Tokyo, Frankfurt, and
Singapore).
• The integration of financial centers implies that there
can be no significant arbitrage.
– The process of buying a currency cheap and selling it
dear.
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 Exchange Rates and
International Transactions
• Vehicle currency
– A currency that is widely used to denominate
international contracts made by parties who do not
reside in the country that issues the vehicle currency.
– Example: In 2001, around 90% of transactions between banks
involved exchanges of foreign currencies for U.S. dollars.

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 Exchange Rates and
International Transactions
 Spot Rates and Forward Rates
• Spot exchange rates
– Apply to exchange currencies “on the spot”
• Forward exchange rates
– Apply to exchange currencies on some future date at a
prenegotiated exchange rate
• Forward and spot exchange rates, while not necessarily
equal, do move closely together.

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 Exchange Rates and
International Transactions
 Foreign Exchange Swaps
• Spot sales of a currency combined with a forward
repurchase of the currency.
• They make up a significant proportion of all foreign
exchange trading.

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 Exchange Rates and
International Transactions
 Futures and Options
• Futures contract
– The buyer buys a promise that a specified amount of
foreign currency will be delivered on a specified date in
the future.
• Foreign exchange option
– The owner has the right to buy or sell a specified
amount of foreign currency at a specified price at any
time up to a specified expiration date.

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 The Demand for
Foreign Currency Assets
 The demand for a foreign currency bank deposit is
influenced by the same considerations that influence
the demand for any other asset.
 Assets and Asset Returns
• Defining Asset Returns
– The percentage increase in value an asset offers over
some time period.
• The Real Rate of Return
– The rate of return computed by measuring asset values
in terms of some broad representative basket of products
that savers regularly purchase.

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 The Demand for
Foreign Currency Assets
 Risk and Liquidity
• Savers care about two main characteristics of an asset
other than its return:
– Risk
– The variability it contributes to savers’ wealth
– Liquidity
– The ease with which it can be sold or exchanged for goods

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 The Demand for
Foreign Currency Assets
 Interest Rates
• Market participants need two pieces of information in
order to compare returns on different deposits:
– How the money values of the deposits will change
– How exchange rates will change
• A currency’s interest rate is the amount of that
currency an individual can earn by lending a unit of
the currency for a year.
– Example: At a dollar interest rate of 10% per year, the
lender of $1 receives $1.10 at the end of the year.

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 The Demand for
Foreign Currency Assets
 Exchange Rates and Asset Returns
• The returns on deposits traded in the foreign exchange
market depend on interest rates and expected exchange
rate changes.
• In order to decide whether to buy a euro or a dollar
deposit, one must calculate the dollar return on a euro
deposit.

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 The Demand for
Foreign Currency Assets
 Return, Risk, and Liquidity in the Foreign Exchange
Market
• The demand for foreign currency assets depends not
only on returns but on risk and liquidity.
– There is no consensus among economists about the
importance of risk in the foreign exchange market.
– Most of the market participants that are influenced by
liquidity factors are involved in international trade.
– Payments connected with international trade make up a very
small fraction of total foreign exchange transactions.
• Therefore, we ignore the risk and liquidity motives for
holding foreign currencies.
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 Summary
 Exchange rates play a role in spending decisions
because they enable us to translate different
countries’ prices into comparable terms.
 A depreciation (appreciation) of a country’s currency
against foreign currencies makes its exports cheaper
(more expensive) and its imports more expensive
(cheaper).
 Exchange rates are determined in the foreign
exchange market.

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 Summary
 An important category of foreign exchange trading is
forward trading.
 The exchange rate is most appropriately thought of as
being an asset price itself.
 The returns on deposits traded in the foreign
exchange market depend on interest rates and
expected exchange rate changes.

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 Summary
 Equilibrium in the foreign exchange market requires
interest parity.
• For given interest rates and a given expectation of the
future exchange rate, the interest parity condition tells
us the current equilibrium exchange rate.
 A rise in dollar (euro) interest rates causes the dollar
to appreciate (depreciate) against the euro.
 Today’s exchange rate is altered by changes in its
expected future level.

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