THE FOREIGN

EXCHANGE MARKET

Chapter: 18
Nhóm: 3
Thành
viên:
Nguyễn Thị Thu Thủy
Nguyễn Thúy Duyên
Trần Bảo Minh
Đoàn Ngọc Anh
Lâm Quốc Vinh

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18.1 FOREIGN EXCHANGE MARKET

What Are Foreign Exchange Rates?

Term Definition Example

Exchange Rate the price of one currency in If the exchange rate for the
terms of another currency USD is 23,865.00
Vietnamese dong that means
that each USD that is
purchased will cost 23,865.00
Vietnamese dong.

Foreign Exchange Market a market in which one in the market for Vietnamese
currency is exchanged for dong, the Vietnamese dong is
another currency being bought and sold, and is
being paid for using another
currency, such as the USD.

Exchange rate: currency 1/ currency 2

currency 1 : base currency
currency 2: quoted currency/ counter currency

Direct quotation: 1 foreign currency = X domestic currency

Indirect quotation: 1 domestic currency = X foreign currency

There are 2 kinds of exchange rate transactions:

Spot Transaction price for a commodity being The exchange rate at which
traded immediately (within the transaction is done is
two-day) (exchange “on the called the spot exchange rate
spot”)

Forward Transaction is the settlement price of a The exchange rate at which the
transaction that will not take transaction is done is called the
place until a specified future forward exchange rate
date

Appreciation: is when the value of a currency increases relative to another currency; VND appreciates
when you need more of another currency to buy a single unit of VND currency.

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Depreciation: is when the value of a currency decreases relative to another currency; VND currency
depreciates when you need less of another currency to buy a single unit of VND currency.

Why Are Exchange Rates Important?

Country’s currency appreciates ⇒ the country’s goods become more expensive ⇒ foreign goods
become cheaper.
Conversely, when a country’s currency depreciates ⇒ domestic goods become cheaper ⇒
foreign goods become more expensive.

How Is Foreign Exchange Traded?

- The foreign exchange market is an over-the-counter market wherein most trades
involve the buying and selling of bank deposits denominated in different currencies
- We pay a higher price for foreign currency—than the exchange rates quoted in the
newspaper.

18.2 EXCHANGE RATES IN THE LONG RUN

Like the price of any other goods in free market, exchange rate determined by the interaction of
supply and demand. We need to know how to determine exchange rate in 2 terms: long- run and
short-run. First, we examine exchange rate in long-run and uses its determinants to comprehend
exchange rate in short-run.

Theory of Purchasing Power Parity

This is a theory to determine the exchange rate. It states that currency that any 2 countries use to
exchange is a basket of goods and services, and the cost of the basket is the same in both countries.

-Another way to explain, Purchasing Power Parity is based on the concept of real
exchange rate, the rate of exchanging domestic goods for foreign goods.

- The real exchange rate is the price of domestic goods relative to the price of foreign goods
denominated in the domestic currency.

- The real exchange rate indicates whether a currency is relatively cheap or not.

- PPP predicts that in the long run that the real exchange rate is always equal to 1.0 because PPP
theory assumes that purchasing power does not change between 2 countries => the exchange rate is
equal 1.0

What happens if one country’s price level changes relative to another’s?

--> If one country’s price level rises relative to another’s by a certain percentage, then the
other country’s currency appreciates, its currency should depreciate by the same percentage.

For example, VND is domestic currency and USD is foreign currency (1 VND = 0.00005 USD; indirect),
Vietnam’s price level rises 20% => the price of VN’s basket rises 20% from 100,000VND to
120,000VND but the price of US basket stay the same as 5$. => Exchange rate decreased from 0.00005 to
0.0000417 (decreased 20%) => VND currency now depreciated 20% and USD appreciated 20%.

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 --> one currency’s appreciation is the other currency’s depreciation

Evidence on Purchasing Power Parity

PPP measures the exchange by using relative price levels. It does predict the actual exchange rate in
the long run but can’t predict the changes of actual exchange rate in the short-run.

Why the Theory of Purchasing Power Parity Cannot Fully Explain

Exchange Rates
1. PPP theory does not take into account that many goods and services are nontradable
→seem as not traded across borders
2. Similar goods typically are not identical in both countries
3. There are barriers to trade
+ Transportation Costs
+ Tariff
+ Quotas

PPP Does Not Hold Exactly, But It Has Predictive Power

Using Big Mac prices
exchange rate: X U.S dollars = 1 local currency
● price of big mac in domestic is A
● price of big mac foreign is B
exchange rate now is seem as A/B → B is high so exchange rate is low

Departures from PPP: Overvaluations and Undervaluations

PPP often departs substantially (chênh lệch đáng kể) from the actual exchange rate
- Big mac is nontradable

The Big Mac index tell us how big the discrepancy ( mức độ chênh lệch) is between the actual
exchange rate and the exchange rate implied by PPP
● When a country’s goods and services are expensive relative to other countries’,
we say that its currency is overvalued in terms of purchasing power parity
● When a country’s goods and services are cheap relative to other countries,

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 currency of that country is undervalued in terms of purchasing power parity

Compare real exchange rates to see how the local currency (foreign) is priced
real exchange rate = price of basket goods domestic / price of basket goods of foreign
= 1 purchasing power parity
< 1 overvalued
> 1 undervalued

Factors That Affect Exchange Rates in the Long Run

In the long run, four major factors affect the exchange rate:
+ relative price levels
+ trade barriers
+ preferences for domestic versus foreign goods
+ productivity.
Increases the demand for domestically produced goods⇒ appreciate the domestic currency and vice versa

Relative Price Levels

- prices of domestic goods rise→demand for domestic goods falls→domestic currency
tends to depreciate
- prices of foreign goods rise →prices of domestic goods to fall→ demand for domestic goods
increases→ domestic currency tend to appreciate

Trade Barriers
Free trade such as tariffs and quotas for import goods increase —> foreign goods become
expensive → increase the demand for domestic goods —> domestic currency appreciate

Preferences for Domestic Versus Foreign Goods

Increased demand for a country’s exports causes its currency to appreciate in the long run;
conversely, increased demand for imports causes the domestic currency to depreciate.

Productivity
Higher productivity→ decline in the price of domestically produced traded goods→ increase
demand for domestic goods → domestic currency appreciate

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18.3 EXCHANGE RATES IN THE SHORT RUN: A
SUPPLY AND DEMAND ANALYSIS
We used the more modern asset market approach here which emphasizes stocks of assets rather than
the flows of exports and imports over short periods (because export & import transactions are small
relative to the amounts of domestic & foreign assets held at any given time)

Supply Curve for Domestic Assets

We treat Vietnam as the home country, so domestic assets are denominated in VND, and foreign
assets are denominated in USD
Because the quantity of VND assets is primarily the quantity of bank deposits, bonds, and equities in
Vietnam, for all practical purposes we can take this amount as fixed WRT the exchange rate
=> Supply curve is vertical

Demand Curve for Domestic Assets

Notes: the books is using indirect quotation (1 domestic currency = X foreign currency)
*Because the books treat exchange rate = foreign/ domestic, which refers to X foreign per
domestic, or 1 domestic = X foreign

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There are 2 explanation why demand curve slope downward:

1. The concept of demand curve for this chapter is not the same as the normal demand curve
with normal goods, it is based on the concept of future expected exchange rate (Et+1), which
we assume Et+1 is constant and above EA, and we compare current exchange rate (Et) with
Et+1.
If (Et) lower than (Et+1) => people expect the exchange rate in the future is higher=> expected
value of money will rise => people will want to hold more currency at (E t) => Qd at (Et)
higher than Qd at (Et+1).
The higher the gap between (Et) and (Et+1) => the larger the Qd between (Et) and (Et+1)
Like in the picture, the gap between (Et) and (Et+1) increases from EA to EC. => Qd will
increase from EA to EC => Demand curve downward sloping.
2. Exchange rate increases --> 1 unit of domestic currency can be exchanged for more foreign
currency → domestic goods are more expensive relative to foreign goods --> demand for
foreign goods increases → people need more foreign currency which needs less domestic
currency -> quantity of demand for domestic assets decline

Equilibrium in the Foreign Exchange Market

- If Et > E*, Qs > Qd, a condition of excess supply, means that people want to sell domestic
assets than want to buy them -> the value of domestic will fall until it reach the equilibrium
- If Et < E*, Qs < Qd, a condition of excess demand, means that people want to buy domestic
assets than want to sell them -> the value of domestic will rise until it reach the equilibrium

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18.4 EXPLAINING CHANGES IN EXCHANGE RATES

Because we assume that the amount of domestic currency is fixed, the S curve is vertical at a given
quantity and does not shift. Hence, we need to examine only those factors that shift the D curve to
explain how exchange rates change over time

Shifts in the Demand for Domestic Assets

We continue examine shifts in the demand curve based on the concept of relative expected return

Domestic Interest Rate (iD)

Suppose the domestic currency pay an interest rate of i D, when the domestic interest rate on domestic
assets rises -> the return on it increases relative to the return on foreign assets -> people want to hold
more domestic assets => Demand increases and shifts right.

=> An increase in the domestic interest rate iD shifts the demand curve for domestic
assets D to the right -> exchange rate rises -> causes the domestic currency to
appreciate

Foreign Interest Rate (iF)

Suppose foreign assets pay an interest rate of iF, when the foreign interest rate iF rises, the return on
foreign assets rises relative to the return on domestic assets -> the relative expected return on
domestic assets falls -> people want to hold fewer domestic assets => Demand decreases and shifts
left

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=> An increase in the foreign interest rate iF make demand for domestic assets
decrease, thus shifts the demand curve D to the left -> lower exchange rate -> causes
the domestic currency to depreciate

Changes in the Expected Future Exchange Rate (Et+1)

Because the demand for domestic assets depends on the future resale price, higher relative expected
return on domestic assets -> increases the demand for domestic assets -> Demand curve shifts right
& vice versa

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=> A rise in the expected future exchange rate Ee t + 1 shifts the demand curve to the
right -> exchange rate rises -> causes an appreciation of the domestic currency

Four factors that affect Et+1 which then affect the shifting in the D curve:
1. The relative price level
When the relative price level is higher -> prices of domestic goods rise → demand for
domestic goods falls → demand curve shifts left -> lower exchange rate -> domestic currency
tends to depreciate
2. Relative trade barrier
Free trade such as tariffs and quotas for import goods increase —> foreign goods become
expensive → increase the demand for domestic goods —> demand curve shifts right ->
higher exchange rate -> domestic currency appreciate
3. Import and export demand
Increased demand for a country’s exports -> demand for domestic goods increase -> demand
curve shifts right -> exchange rate increases -> domestic currency appreciate in the long run
& vice versa
4. Relative productivity
Higher productivity→ decline in the price of domestically produced traded goods increase
demand for domestic goods → demand curve shifts right -> exchange rate increases ->
domestic currency appreciate.

Application
Effects of Changes in Interest Rates on the Equilibrium Exchange Rate

Analyse base on Fisher Equation:

Nominal domestic interest rate rise due to 2 reasons: real interest rate or expected
inflation rise. => we have 2 scenarios:

1. Real interest rate rise => increase in demand, shift right => exchange rate increase
=> domestic currency is appreciated.

2. Expected inflation rise => has the same effect as rise in price level => decrease in
demand, shift left => Exchange rate decrease => domestic currency now is depreciated. (although
interest rate rise leads to a rise in value but this negative effect of expected inflation
outweighs it).

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The Global Financial Crisis and the Dollar

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Effect of the Global Financial Crisis mainly hit the US first => FED has to lower their interest to
fight with that, while other countries haven't been affected by the Financial Crisis so they keep their
interest rate.=> US depreciate (D1 to D2).

After some time, other countries now have been affected by the Crisis => lower interest rate
=> Demand for US assets increase. One more reason is that ppl at the time now believe US treasury
securities are the safest => US demand increases more aggressively => US dollar appreciated (D2 to
D3).

Brexit and the British Pound

When British exit => no entry to the “one market” of the European Union => creating (erecting)
the trade barriers for export => demand decreases shift right => lower exchange rate => British
pound now depreciated.

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