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Problem Set: Exchange Rates: International Economics

The key points are: 1) At the initial equilibrium (Point 1), the interest rate parity condition holds - the expected return on dollar and euro deposits is equal when measured in dollars. 2) Then, expectations shift such that investors expect a bigger depreciation of the euro in the future. This reduces the expected dollar return from euro deposits. 3) For interest rate parity to be restored, the euro must depreciate against the dollar to a new exchange rate E2$/€. This increases the expected dollar return from euro deposits back to the level of dollar deposits. So in summary, a change in expectations about the future exchange rate causes a shift in the interest rate parity curve, which is restored

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Lucia Yuste Moreira
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49 views

Problem Set: Exchange Rates: International Economics

The key points are: 1) At the initial equilibrium (Point 1), the interest rate parity condition holds - the expected return on dollar and euro deposits is equal when measured in dollars. 2) Then, expectations shift such that investors expect a bigger depreciation of the euro in the future. This reduces the expected dollar return from euro deposits. 3) For interest rate parity to be restored, the euro must depreciate against the dollar to a new exchange rate E2$/€. This increases the expected dollar return from euro deposits back to the level of dollar deposits. So in summary, a change in expectations about the future exchange rate causes a shift in the interest rate parity curve, which is restored

Uploaded by

Lucia Yuste Moreira
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
You are on page 1/ 16

INTERNATIONAL ECONOMICS:

ECONOMIC INTEGRATION

Problem Set: Exchange rates


Plan for today

i. Review of the interest parity condition

ii. Problem Set: Exchange rates


The Demand of Currency Deposits

 The demand for a foreign currency bank deposit is influenced by the


same considerations as for other assets:
 An asset´s value depends on its expected future purchasing power
 Participants in the foreign exchange market prefer to hold those
assets yielding the highest expected rate of return.
 To compare the rate of return on a deposit in domestic currency with
the rate of return on a deposit in foreign currency, consider:

 the interest rate for the foreign currency deposit.

 the expected rate of appreciation or depreciation of the foreign currency


relative to the domestic currency.
The Demand of Currency Deposits. Example

 Suppose the interest rate on a dollar deposit is 2%.


 Suppose the interest rate on a euro deposit is 4%.
 Q: Does a euro deposit yield a higher expected rate of return?
Depends on the expected rate of appreciation or depreciation of currency
 Suppose today the exchange rate is $1/€1, and the expected rate one year in the
future is $0.97/€1.
 $100 can be exchanged today for €100.
 These €100 will yield €104 after one year.
 These €104 are expected to be worth $0.97/€1 x €104 = $100.88 in one year.
The Demand of Currency Deposits. Example
 The rate of return in terms of dollars from investing in euro deposits is
($100.88 – $100)/$100 = 0.88%.

 We simplify the analysis by saying that the dollar rate of return on euro
deposits approximately equals
 the interest rate on euro deposits
 plus the expected rate of appreciation of euro
 4% + –3% = 1% ≈ 0.88%

 Let’s compare this rate of return with the rate of return from a dollar deposit.
 The rate of return is simply the interest rate.
 After 1 year the $100 is expected to yield $102:
($102 – $100)/$100 = 2%

 The euro deposit has a lower expected rate of return: thus, all investors
should be willing to make dollar deposits and none should be willing to hold
euro deposits.
 Will be an excess supply of euro assets and an excess demand of dollar assets.
That will lead to a euro depreciation against the dollar until the expected rate
of return is equalized
The Demand of Currency Deposits
 We are on equilibrium in the foreign exchange market when
deposits of all currencies offer the same expected rate of return
(the interest parity condition holds)

R$ = R€ + (Ee$/€ – E$/€)/E$/€

expected rate interest rate expected current


of return = on euro exchange rate exchange rate
interest rate on deposits
dollar deposits
expected rate of
appreciation of the euro
against the dollar

expected rate of return on euro deposits


Q: At Case 1,will investors prefer to have deposits in dollars, euros, or will they be indifferent?
Investors always prefer to hold deposits of currencies offering the highest expected return
Case 1: implies that if the expected return on euro deposits is 4 percent lower than that on dollar
deposits (6% vs 10%).
No one will be willing to continue holding euro deposits, and holders of euro deposits will be trying to
sell them for dollar deposits. Excess supply of euro deposits and an excess demand for dollar deposits.
Not equilibrium: the euro will depreciate against the dollar as investors all try to shift their funds
Q: At Case 2,will investors prefer to have deposits in dollars, euros, or will they be indifferent?
Investors always prefer to hold deposits of currencies offering the highest expected return
Case 2: deposits of all currencies offer the same expected rate of return.
The interest parity condition holds!
There no excess supply of some type of deposit and no excess demand for another.
We are on equilibrium in the foreign exchange market
Investors always prefer to hold deposits of currencies offering the highest expected return
Case 3: implies that if the expected return on euro deposits is 4 percent higher than that on dollar
deposits (14% vs 10%).
No one will be willing to continue holding dollar deposits, and holders of dollar deposits will be trying
to sell them for euro deposits. Excess supply of dollar deposits and an excess demand for euro deposits.
Not equilibrium: the euro will appreciate against the dollar as investors all try to shift their funds
Q: At Case 4,will investors prefer to have deposits in dollars, euros, or will they be indifferent?
Investors always prefer to hold deposits of currencies offering the highest expected return
Case 4: the expected return on euro deposits is 2 percent lower than that on dollar deposits (8% vs
10%).
No one will be willing to continue holding euro deposits, and holders of euro deposits will be trying to
sell them for dollar deposits. Excess supply of euro deposits and an excess demand for dollar deposits.
Not equilibrium: the euro will depreciate against the dollar as investors all try to shift their funds
Problem Set: Exchange rates

So, at equilibrium in the foreign exchange market requires interest rate parity

R$ = 2%
R€ = 4%

0.02 0.04 ? 0
Problem Set: Exchange rates

Exchange rates always adjust to maintain interest parity


R$, the return on dollar deposits measured in
terms of dollars

Fall in euro The expected return on euro deposits,


Interest rate measured in terms of dollars

11 Response: At a given expected future


exchange rate and interest rate, a more
2 appreciated euro implies less future
appreciation (or more depreciation) and
a lower expected return in dollars
Problem Set: Exchange rates

Exchange rates always adjust to maintain interest parity


Point 1: Initial equilibrium
Them investors expect a bigger
depreciation of the euro in the future:
Expectation that At the initial exchange rate E1$/€
the euro will
depreciate a rise in the expected depreciation of the euro
reduced the expected dollar return on euro
1 deposits.The curve shift leftward

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