Copyright 2012 Pearson Education. All rights reserved. Chapter 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach Copyright 2012 Pearson Education. All rights reserved. 14-2 Preview The basics of exchange rates Exchange rates and the prices of goods The foreign exchange markets The demand of currency and other assets A model of foreign exchange markets role of interest rates on currency deposits role of expectations of exchange rates Copyright 2012 Pearson Education. All rights reserved. 14-3 Definitions of Exchange Rates Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency. How much can be exchanged for one dollar? 89.40/$ How much can be exchanged for one yen? $0.011185/ Exchange rates allow us to denominate the cost or price of a good or service in a common currency. How much does a Nissan cost? 2,500,000 Or, 2,500,000 x $0.011185/ = $27,962.50 Copyright 2012 Pearson Education. All rights reserved. 14-4 Table 14-1: Exchange Rate Quotations Copyright 2012 Pearson Education. All rights reserved. 14-5 Depreciation and Appreciation Depreciation is a decrease in the value of a currency relative to another currency. A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency. $1/ $1.20/ means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable. The euro has appreciated relative to the dollar: it is now more valuable. Copyright 2012 Pearson Education. All rights reserved. 14-6 Depreciation and Appreciation (cont.) Appreciation is an increase in the value of a currency relative to another currency. An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency. $1/ $0.90/ means that the dollar has appreciated relative to the euro. It now takes only $0.90 to buy one euro, so that the dollar is more valuable. The euro has depreciated relative to the dollar: it is now less valuable. Copyright 2012 Pearson Education. All rights reserved. 14-7 Depreciation and Appreciation (cont.) A depreciated currency is less valuable, and therefore it can buy fewer foreign produced goods that are denominated in foreign currency. A Nissan costs 2,500,000 = $25,000 at $0.010/ becomes more expensive $27,962.50 at $0.011185/ A depreciated currency means that imports are more expensive and domestically produced goods and exports are less expensive. A depreciated currency lowers the price of exports relative to the price of imports. Copyright 2012 Pearson Education. All rights reserved. 14-8 Depreciation and Appreciation (cont.) An appreciated currency is more valuable, and therefore it can buy more foreign produced goods that are denominated in foreign currency. A Nissan costs 2,500,000 = $27,962.50 at $0.011185/ becomes less expensive $25,000 at $0.010/ An appreciated currency means that imports are less expensive and domestically produced goods and exports are more expensive. An appreciated currency raises the price of exports relative to the price of imports. Copyright 2012 Pearson Education. All rights reserved. 14-9 Table 14-2: $/ Exchange Rates and the Relative Price of American Designer Jeans and British Sweaters Copyright 2012 Pearson Education. All rights reserved. 14-10 Foreign Exchange Markets The set of markets where foreign currencies and other assets are exchanged for domestic ones Institutions buy and sell deposits of currencies or other assets for investment purposes. The daily volume of foreign exchange transactions was $4.0 trillion in April 2010 up from $500 billion in 1989. Most transactions (85% in April 2010) exchange foreign currencies for U.S. dollars. Copyright 2012 Pearson Education. All rights reserved. 14-11 Foreign Exchange Markets The participants: 1.Commercial banks and other depository institutions: transactions involve buying/selling of deposits in different currencies for investment purposes. 2.Non-bank financial institutions (mutual funds, hedge funds, securities firms, insurance companies, pension funds) may buy/sell foreign assets for investment. 3.Non-financial businesses conduct foreign currency transactions to buy/sell goods, services and assets. 4.Central banks: conduct official international reserves transactions. Copyright 2012 Pearson Education. All rights reserved. 14-12 Foreign Exchange Markets (cont.) Buying and selling in the foreign exchange market are dominated by commercial and investment banks. Inter-bank transactions of deposits in foreign currencies occur in amounts $1 million or more per transaction. Central banks sometimes intervene, but the direct effects of their transactions are small and transitory in many countries. Copyright