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Forex Market Equilibrium

1) The document discusses equilibrium in the foreign exchange market. It states that equilibrium occurs when the demand for foreign exchange equals the supply of foreign exchange, or when net exports equal net capital outflows. 2) It explains how exchange rates affect the relative prices of exports and imports, with currency depreciation making exports cheaper and imports more expensive. 3) The concept of rate of return is introduced, including how expected returns should be compared to actual inflation-adjusted returns and how returns on foreign investments depend on interest rates and exchange rate changes. 4) Equilibrium in the forex market equalizes expected returns on foreign deposits with domestic deposit rates, taking into account interest rates and expected future exchange rates.

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Vishnu Venugopal
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201 views11 pages

Forex Market Equilibrium

1) The document discusses equilibrium in the foreign exchange market. It states that equilibrium occurs when the demand for foreign exchange equals the supply of foreign exchange, or when net exports equal net capital outflows. 2) It explains how exchange rates affect the relative prices of exports and imports, with currency depreciation making exports cheaper and imports more expensive. 3) The concept of rate of return is introduced, including how expected returns should be compared to actual inflation-adjusted returns and how returns on foreign investments depend on interest rates and exchange rate changes. 4) Equilibrium in the forex market equalizes expected returns on foreign deposits with domestic deposit rates, taking into account interest rates and expected future exchange rates.

Uploaded by

Vishnu Venugopal
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
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Forex Market Equilibrium

Capital Flows
 Demand and supply of forex ($):
D$ = M + CO, S$=X+CI

 Equilibrium
M + CO = X + CI X – M = CO – CI
NX = NCO = NFA

NCO > 0 net foreign asset will increase

 CAD = M – X = NCI

CAD > 0 M>X Negative NX financed by selling Home


asset to foreigners

Sunandan Ghosh, CDS, 2013 2


Exchange Rates and Relative Prices
 Exports will fetch foreign exchange and imports will require
foreign exchange.

 1 US car costs $25,000 12,50,000 INR in India given Re/$ = 50

 If Re/$ depreciates to 55 the car will cost 1,25,000 INR more

 If Re/$ appreciates to 45 the car will cost 1,25,000 INR less

 From the exporters point of view, if home currency appreciates


then relative price of export increases and relative price of
export falls if home currency depreciates.

 Hence, China’s policy to peg Yuan at a lower level helps China to


have a CA in terms of lower export prices.

Sunandan Ghosh, CDS, 2013 3


Rate of Return
 Savings foregoing current consumption for future
consumption

 The benefit from this current sacrifice is the rate of return to


such savings

 Example: You have Rs. 2000 to save and you buy shares of two
companies (BSNL and M&M) investing Rs. 1000 in each. After
one year you earn Rs. 1100 from M&M shares (includes change
in stock prices and dividends) positive 10% rate of return.
Now, you earn Rs. 950 from BSNL stocks negative 5% rate of
return. Overall rate of return from your portfolio = positive 2.5%

 This is nominal rate of return.

Sunandan Ghosh, CDS, 2013 4


Rate of Return (Continued)
 What if there is inflation in this one year?

 What is the real rate of return on your investment?

 Suppose there is 2.5% overall inflation during this year your


real rate of return is = 0.

 That is, you had expected some positive rate of return one year
ago but did not expect such rate of return being exactly offset by
inflation.

 So, there is a difference in expected and real rates of return.

 Investment/Savings decision is taken by the former.

Sunandan Ghosh, CDS, 2013 5


Rate of Return (Continued)
 Another important factor that plays a big role is interest
rate of the currency.

 Interest rate on INR is = the return that you get by


depositing that Rs. 2000 in bank for one year (you are in
fact lending to the bank) and such rate is fixed given some
rate offered by the bank at the date of your deposit.

 Now, what if you invest in foreign asset, say dollar bonds or


euro deposits instead of investing your savings of Rs. 2000
in shares of Indian companies or depositing that sum of
money in an Indian bank for one year?

Sunandan Ghosh, CDS, 2013 6


Rate of Return (Continued)
 Suppose you have two options – buying dollar bonds that give
5% rate of return vis-á-vis euro deposit giving 6% rate of return.

 Presently, $1 = Rs. 50 and €1 = Rs. 65

 Therefore, price of 1 unit of dollar bond is Rs. 50 and that of euro


deposit is Rs. 65

 Suppose you expect both $ and € to appreciate vis-a-vis INR by


5% and 6% respectively

 Indian bank offers flat 11% return

 Where will you invest?

Sunandan Ghosh, CDS, 2013 7


Rate of Return (Continued)
 The rate of return on foreign deposit is approximately the
foreign interest rate plus the rate of depreciation of INR with
respect to the foreign currency.

 Let, the interest rate on foreign deposit is R, the present


exchange rate be E and the expected exchange rate after one year
be Ee.
Ee E
 Therefore, rate of depreciation of home currency is
e
E
E E
 Hence, rate of return on your investment is R
E
 Now compare between rates of returns from dollar bond, euro
deposit and deposit in home bank.

Sunandan Ghosh, CDS, 2013 8


Equilibrium in Forex Market
 Interest Parity Condition:
Ee E
R r
E
where, r is the rate of return from home deposit

 Equilibrium is obtained at the intersection of the expected return


on foreign deposit curve and return on home deposit.

 How is expected return on foreign deposit related to exchange


rate that actually prevails initially?

 We have a negative relationship.

Sunandan Ghosh, CDS, 2013 9


Equilibrium in Forex Market

Sunandan Ghosh, CDS, 2013 10


Forward Exchange Rate & Equilibrium
 You want a specified return and hence, avoid the uncertainty
arising from exchange rate volatility

 You opt for forward exchange rate

 Let the forward exchange rate be F, then, the return will be


approximately equal to
F E
R r
E
 Such that we have Ee = F. (Check Figure 13.1 of Krugman-
Obstfeld)

 This is covered interest parity condition.

Sunandan Ghosh, CDS, 2013 11

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