University:
California State University, Northridge
Course:
ECON 405 | International Trade
Academic year:

2024
Views:

118

Pages:

10
Author:

estorrii16i

Topic 7 Exchange Rates and the Foreign Exchange Market: An Asset Approach Part 3 The Equilibrium Exchange Rate • Exchange rates always adjust to maintain interest parity. • Assuming R$ , R€ , and Ee$/€ are all given, Figure 3 shows how the equilibrium exchange rate is determined. • The equilibrium exchange rate occurs at point 1 where returns on dollar and euro deposits are equal. • Why will exchange rates settle at point 1? • Consider how exchange rates would adjust if they are initially at point 2 or point 3 instead. 13-43 The Equilibrium Exchange Rate (cont.) • At point 2, the return on dollar deposits is greater than the return on euro deposits. • There is an excess demand for dollar deposits (and an excess supply of euro deposits) which causes the dollar to appreciate against the euro. • The dollar will appreciate (and the euro will depreciate) until interest parity is achieved. • Recall that an appreciation of the dollar lowers the euro deposit’s current dollar cost, making euro deposits more attractive. 13-44 The Equilibrium Exchange Rate (cont.) • At point 3, the return on euro deposits is greater than the return on dollar deposits. • There is an excess demand for euro deposits (and an excess supply of dollar deposits) which causes the dollar to depreciate against the euro. • The dollar will depreciate (and the euro will appreciate) until interest parity is achieved. • Recall that a depreciation of the dollar raises the euro deposit’s current dollar cost, making euro deposits less attractive. 13-45 Fig. 3: Determination of the Equilibrium $/€ Exchange Rate Equilibrium occurs at point 1 where returns are equal. At point 2, there is an excess demand for dollar deposits which causes the dollar to appreciate. At point 3, there is an excess supply of dollar deposits which causes the dollar to depreciate. $↑ $↓ R€2 R€3 The Effect of Changing Interest Rates on Equilibrium Exchange Rates • An increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits. • This leads to an appreciation of the currency. ♦ Higher interest rates on dollar deposits causes the dollar to appreciate. ♦ Higher interest rates on euro deposits causes the dollar to depreciate. 13-47 Fig. 4: Effect of a Rise in the Dollar Interest Rate A rise in U.S. interest rates shifts the dollar return line outward. ↑i $↑ The return on dollar deposits is now higher than the return on euro deposits (point 1 to point 1’). There is an excess demand for dollar deposits (and an excess supply of euro deposits) so the dollar must appreciate for interest parity to hold (point 1’ to point 2). Point 2 is the new equilibrium. Fig. 5: Effect of a Rise in the Euro Interest Rate A rise in euro interest rates shifts the expected euro return curve outward. The return on euro deposits is now higher than the return on dollar deposits (point 1 to point 1’). There is an excess demand for euro deposits so the dollar must depreciate (point 1’ to point 2). Point 2 is the new equilibrium. $↓ 1’ R€ The Effect of an Expected Appreciation of the Euro • If people expect the euro to appreciate in the future, then euro deposits will pay in valuable euros, so that these future euros will be able to buy more dollars and more dollardenominated goods. ♦ The expected rate of return on euro deposits therefore increases. ♦ An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy). ♦ An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy). 13-50 Fig. 6: Effect of an Expected Rise of the Euro A rise in the expected future value of the euro shifts the expected euro return curve outward. Euro is expected Euro is to expected rise to rise $↓ $↓ The return on euro deposits is now higher than the return on dollar deposits (point 1 to point 1’). There is an excess demand for euro deposits so the dollar must depreciate (point 1’ to point 2). Point 2 is the new equilibrium. 1’ R€