The Demand for Foreign Currency Assets

• Foreign Currency Assets (FCA) refer to

financial assets that are denominated in
currencies other than the home currency of the
holder. These assets can range from cash
reserves, bank deposits, bonds, stocks, and
other financial instruments.

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Asset Type Description

Cash or savings in foreign
Cash reserves and deposits in
currencies, often held in foreign
foreign banks
accounts or abroad.
Bonds issued by foreign
Foreign government bonds governments, denominated in
the issuer's home currency.
Equities or bonds issued by
Foreign corporate stocks and foreign corporations, priced in
bonds the corporation's home
currency.
International reserve assets
created by the IMF,
Special Drawing Rights (SDRs) representing a claim to
currency held by IMF member
countries
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The Demand for Foreign Currency Assets

Determinants of Demand for Foreign Currency Assets
1. Interest Rate Differentials
2. Exchange Rate Expectations
3. Inflation Rates
4. Political and Economic Stability
5. Liquidity and Accessibility
6. Speculation
Impact of Foreign Currency Demand on Exchange Rates
• Higher demand for a foreign currency leads to an appreciation
of that currency relative to the domestic currency.
• Conversely, a decline in demand weakens the foreign currency.
Central banks and policymakers monitor these fluctuations to
stabilize their economies and prevent excessive volatility.
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 Interest Parity Condition & Rate of Return
• The Interest Parity Condition (IPC) is a fundamental principle in international
finance that explains how interest rates and exchange rates interact in
determining the expected returns on foreign and domestic assets. It ensures that
investors cannot earn risk-free profits (arbitrage) by shifting funds between
currencies.
• Interest Parity Condition (IPC): states that the expected rate of return on
domestic and foreign currency assets should be equal when adjusted for
exchange rate changes.
• There are two main forms of interest parity:
• Covered Interest Parity (CIP): Applies when investors use forward contracts to
hedge against exchange rate risk. The formula𝐹 is:
1+𝑟𝑑=( 1+ 𝑟𝑓 ) ∗
𝑆
• where:
rd= domestic interest rate
rf= foreign interest rate
F= forward exchange rate (domestic per unit of foreign)
S = spot exchange rate
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• Uncovered Interest Parity (UIP): Applies when

investors do not hedge against exchange rate
risk and instead rely on expected exchange rate
changes. The formula is:
1+

• If UIP holds, investors cannot earn extra returns

from interest rate differences unless they
correctly predict exchange rate movements.
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Rate of Return on Foreign Currency Assets
• Investors compare the rate of return on domestic and foreign assets before
deciding where to invest. The return on foreign currency assets depends on:
1. Foreign Interest Rate: A higher foreign interest rate increases the
attractiveness of foreign deposits.
2. Expected Exchange Rate Changes: If the foreign currency is expected to
appreciate, investors may earn additional returns when converting back to
their domestic currency.
• The effective rate of return on a foreign asset is:
)

• where the second term represents the expected capital gain or loss from
exchange rate movements.
• If the effective return on foreign assets is higher than domestic returns,
investors shift capital to foreign markets, increasing demand for foreign
currency and affecting exchange rates.
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Implications of Interest Parity and Rate of Return

• Exchange Rate Movements: If a country offers
higher interest rates, its currency tends to
appreciate due to increased capital inflows.
• Monetary Policy Impact: Central banks
influence exchange rates and capital flows by
adjusting interest rates.
• Risk Considerations: Investors assess political
and economic risks before engaging in foreign
currency investments.
 Exchange Rate and Rate of Return
• The relationship between exchange rates and rates of return is fundamental in
international finance. Investors compare returns on domestic and foreign assets,
considering interest rates and expected exchange rate changes to maximize their
returns.
Rate of Return on Foreign Currency Assets
• Investors in foreign currency assets earn returns from:
1. Foreign Interest Rate– The nominal return earned on a foreign deposit or bond.
2. Expected Exchange Rate Change - The potential gain or loss due to exchange
rate fluctuations.

• Investors compare this return with the domestic interest rate. If the return on
foreign currency assets is higher, investors will prefer foreign assets, increasing
demand for foreign currency and affecting exchange rates.
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Exchange Rate Adjustments and Capital Flows:
If foreign assets offer higher returns, investors move funds abroad,
leading to:
• Increased demand for foreign currency → Foreign currency
appreciates
• Depreciation of domestic currency
If domestic assets offer higher returns, investors keep funds domestically,
leading to:
• Increased demand for domestic currency → Domestic currency
appreciates
• Depreciation of foreign currency
This dynamic ensures that the interest parity condition (IPC) holds in the
absence of arbitrage opportunities.
 Linking Money, Interest Rate, and Exchange Rate
The relationship between money supply, interest rates, and exchange rates is crucial in
macroeconomics and international finance. Central banks control the money supply, which
influences interest rates and, in turn, affects exchange rates through capital flows and investor
expectations.
1. Money Supply and Interest Rates
The supply of money is managed by a country's central bank (e.g., the Federal Reserve in the
U.S., the ECB in Europe). Changes in the money supply affect interest rates through the liquidity
effect:
Increase in Money Supply → More liquidity → Lower interest rates
Decrease in Money Supply → Less liquidity → Higher interest rates
Lower interest rates encourage borrowing and investment but can also lead to currency
depreciation as investors seek higher returns elsewhere.
2. Interest Rates and Exchange Rates
Interest rates influence exchange rates through capital flows. Investors prefer assets with higher
returns, so differences in interest rates drive currency demand:
Higher Domestic Interest Rates → Attract capital inflows → Higher demand for domestic
currency → Appreciation
Lower Domestic Interest Rates → Capital outflows → Reduced demand for domestic currency →
Depreciation
This effect aligns with the interest parity condition (IPC), ensuring that expected returns are
balanced across currencies.
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3. Money Supply, Inflation, and Exchange Rate Movements
Expanding the money supply can lead to inflation, reducing the real
value of a currency. The link is:
Higher Money Supply → Lower Interest Rates → Higher Inflation →
Currency Depreciation
Lower Money Supply → Higher Interest Rates → Lower Inflation →
Currency Appreciation
In the long run, purchasing power parity (PPP) suggests that currencies
adjust based on inflation differentials. If a country has persistently higher
inflation, its currency tends to weaken.
4. Short-Run vs. Long-Run Effects
Short-Run: Changes in money supply primarily affect interest rates and
capital flows, impacting exchange rates through speculative movements.
Long-Run: Persistent monetary expansion leads to inflation and
depreciation, aligning exchange rates with real purchasing power.
 2.3. Monetary Approach to Exchange Rates
 This approach uses monetary factors to predict how
exchange rates adjust in the long run.
 It uses the absolute version of PPP.
 It assumes that prices adjust in the long run.
 In particular, price levels adjust to equate real (aggregate)
money supply with real (aggregate) money demand. This
implies:
PUS = M s US/L (R$, YUS)
PEU = M s EU/L (R€, YEU)
 To the degree that PPP holds and to the degree that prices adjust
to equate real money supply with real money demand, we have
the following prediction:

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 Cont.
• The exchange rate is determined in the long run by prices, which
are determined by the relative supply of money across countries
and the relative real demand of money across countries.
Predictions about changes in:
1. Money supply: a permanent rise in the domestic money supply
 Causes a proportional increase in the domestic price level,
 Causing a proportional depreciation in the domestic currency (through PPP).
 Same prediction as long run model without PPP

2. Interest rates: a rise in the domestic interest rate

 Lowers domestic money demand,
 Increasing the domestic price level,
 Causing a proportional depreciation of the domestic currency (through PPP).

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 Cont.
3. Output level: a rise in the domestic output level
 Raises domestic money demand,
 Decreasing the domestic price level,
 Causing a proportional appreciation of the domestic currency (through PPP).

 All 3 changes affect money supply or money demand, thereby causing

prices to adjust to maintain equilibrium in the money market, thereby
causing exchange rates to adjust to maintain PPP.
 A change in the level of the money supply results in a change in the price
level.
 A change in the money supply growth rate results in a change in the
growth rate of prices (inflation).
 Other things equal, a constant growth rate in the money supply results in a persistent
growth rate in prices (persistent inflation) at the same constant rate.
 Inflation does not affect the productive capacity of the economy and real income from
production in the long run.
 Inflation, however, does affect nominal interest rates. How?

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 Cont….
 According to the Quantity Theory, the money supply of
a country is proportional to its nominal income.
 Let Y be real GDP, P be the price level, and Ms be the
money supply. Then
M = kPY  P = M/kY
where k (=1/V) is the average holding period for money.
 Then for a foreign country,
Mf = kf Pf Yf  Pf = Mf / kf Yf
 We can examine the relationship between prices in two
countries:
(P/Pf ) = (M/Mf )(kf /k)(Yf /Y)

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 We can then combine this with PPP to write:
e = P/Pf = (M/Mf )(kf /k)(Yf /Y), also note that a 1%
change in (M/Mf ), (kf /k), or (Yf /Y) leads to a 1%
change in e .
 This leads us to extend PPP to a more general monetary
approach to exchange rate determination.
 These approaches focus on exchange rates as the result
of supply and demand for money at home and abroad.
 It is an equilibrium, supply and demand approach.
 Money supply and demand operate through the linkage
of prices and inflation rates.

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 All else equal, the spot exchange rate is raised by:
 A rise in the domestic money supply relative to the
foreign money supply,
 A rise in the domestic price level relative to the
foreign one, or
 A rise in foreign real GDP relative to domestic real
GDP.
 A rise in foreign velocity, or equivalently a decline in
the domestic k, relative to foreign velocity or k, e.g.,
as the result of a change in the domestic payments
system.

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 Monetary Approach: Policy
Prescriptions
• If a foreign country wanted to raise its exchange
rate, it could do so by:
– Decreasing its money supply
– Causing disinflation
• Reducing its money supply would raise domestic
interest rates and slow the domestic economy.
Eventually output would recover, but prices
would decline (Pf ) as a result of fewer dollars
(Mf ).

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