Chapter 13 the Foreign Exchange Market

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Chapter 13
The Foreign Exchange Market
Foreign Exchange Market What are Foreign Exchange Rates? Following the Financial News: Foreign Exchange Rates Why are Exchange Rates Important? How is Foreign Exchange Traded? Exchange Rates in the Long Run Law of One Price Theory of Purchasing Power Parity Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates Factors That Affect Exchange Rates in the Long Run Exchange Rates in the Short Run Comparing Expected Returns on Domestic and Foreign Deposits Interest Parity Condition Demand Curve for Domestic Assets Supply Curve for Domestic Assets Equilibrium in the Foreign Exchange Market Explaining Changes in Exchange Rates Shift in the Demand for Domestic Assets Case: Changes in the Equilibrium Exchange Rate: Two Examples Changes in Interest Rates Changes in the Money Supply Exchange Rate Overshooting Case: Why are Exchange Rates So Volatile? Case: The Dollar and Interest Rates, 1973–2007 Case: The Euro’s First Nine Years Case: Reading the Wall Street Journal: The “Foreign Exchange” Column Following the Financial News: The “Currency Trading” Column The Practicing Manager: Profiting from Foreign Exchange Forecasts

Overview and Teaching Tips
Chapter 13 explains behavior in the foreign exchange market by using a modern asset-market approach to exchange rate determination. This asset-market approach is now the dominant method of analyzing exchange rate movements in the literature and it has major advantages over the more conventional treatment of the foreign exchange market typically found in financial markets and institutions textbooks.

Chapter 13

The Foreign Exchange Market


As the first case in the chapter indicates, the asset-market approach, in contrast to earlier approaches emphasizing import and export demand, can be used to explain a feature of the foreign exchange market that has received much attention in the press in recent years: the high volatility of exchange rates. This phenomenon is not well explained by the earlier flow approach because it does not predict that exchange rates should be highly volatile. The asset-market approach is developed in several steps. First, the long-run determinants of the exchange rate are laid out, and then the information about the long-run determinants is embedded in a model of the short-run determination of exchange rates. The key idea that must be transmitted to the student is that the demand for domestic currency (say dollar) assets is determined by the relative expected return on these assets. To help students achieve an intuitive grasp of how the relative expected return on domestic assets, and hence the demand curve shifts, tell them to put themselves in the shoes of an investor who is thinking about putting his or her money into foreign or domestic assets. When a factor changes, have them ask themselves whether at the same exchange rate, they would earn a higher expected return on domestic assets—if so, the demand curve has shifted to the right. This kind of thinking will help them manipulate the demand curve so they can predict which way the exchange rate changes. Several summary tables in the chapter should help students master the material, and I have found that using them in class helps greatly in clarifying the discussion. The six cases in the chapter on the effect of interest rates and money growth on the exchange rate, why exchange rates are so volatile, the relationship between the value of the dollar and interest rates from 1973–2007, the Euro’s first nine years, reading the foreign exchange column in the Wall Street Journal, and how financial institutions use foreign exchange forecasts to increase profits, all can be used in class to show students that the material they have learned has practical uses. In teaching my class, I again bring the previous day’s Wall Street Journal Foreign Exchange column into class and then conduct a case discussion along the lines of the “Case: the Wall...
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