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

2024
Views:

442

Pages:

19
Author:

Kody Downs

Topic 7 Exchange Rates and the Foreign Exchange Market: An Asset Approach Part 2 The Demand for Currency Deposits • What influences the demand for (willingness to buy) deposits denominated in domestic or foreign currency? • Demand for bank deposits is influenced by the same factors that influence the demand for any other asset. ♦ Namely, what is the expected real rate of return? 13-25 The Demand for Currency Deposits (cont.) • Rate of return: the percentage change in value that an asset offers over some time period. ♦ The annual return for $100 savings deposit with an interest rate of 2% is $100 x 1.02 = $102, so that the rate of return = ($102 - $100)/$100 = 2%. 13-26 The Demand for Currency Deposits (cont.) • Real rate of return: inflation-adjusted rate of return, ♦ represents the additional amount of goods and services that can be purchased with earnings from the asset. ♦ The real rate of return for the above savings deposit when inflation is 1.5% is: 2% – 1.5% = 0.5%. After accounting for the rise in the prices of goods and services, the asset can purchase 0.5% more goods and services after 1 year. • If the inflation rate is 0% then (nominal) rates of return = real rates of return. 13-27 The Demand for Currency Deposits (cont.) • Risk of holding assets also influences decisions about whether to buy them. • Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets. • For now, we assume that all bank deposits have the same level of risk and liquidity, regardless of their currency denomination. 13-28 The Demand for Currency Deposits (cont.) • We therefore say that investors are primarily concerned about the rates of return on currency deposits. • Rates of return that investors expect to earn are determined by: ♦ interest rates that the deposits earn ♦ expectations about the currency’s appreciation or depreciation against other currencies 13-29 The Demand for Currency Deposits (cont.) • A currency deposit’s interest rate is the amount of that currency an individual can earn by lending a unit of the currency for one year. • The rate of return for a deposit in domestic currency is the interest rate that the deposit earns. • To compare the rate of return on a deposit in domestic currency with one in foreign currency, consider ♦ the interest rate for the foreign currency deposit ♦ the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency 13-30 The Demand for Currency Deposits (cont.) • Suppose the interest rate on a dollar deposit is 10% and the interest rate on a euro deposit is 5%. • Suppose today’s exchange rate is $1.10/€, and the expected rate in one year is $1.165/€. • Does a dollar deposit yield a higher expected rate of return? ♦ $100 can be exchanged today for €90.91. ♦ These €90.91 will yield €95.45 after one year. ♦ These €95.45 are expected to be worth $1.165/€ x €95.45 = $111.20 in one year. 13-31 The Demand for Currency Deposits (cont.) • The rate of return in terms of dollars from investing in euro deposits is ($111.20-$100)/$100 = 11.2%. • Let’s compare this rate of return with the rate of return from a dollar deposit. ♦ The rate of return is simply the interest rate. ♦ After 1 year the $100 is expected to yield $110: ($110-$100)/$100 = 10% • The dollar deposit has a lower expected rate of return. 13-32 The Demand for Currency Deposits (cont.) • Note that the expected rate of appreciation of the euro was = ($1.165-$1.10)/$1.10 = 5.9% • Simplify this analysis by saying that the dollar rate of return on euro deposits roughly equals ♦ the interest rate on euro deposits ♦ plus the expected rate of appreciation of the euro against the dollar ♦ 5% + 5.9% = 10.9% ≈ 11% ♦ R€ + (Ee$/€ - E$/€)/E$/€ 13-33 The Demand for Currency Deposits (cont.) • The difference in the rate of return on dollar deposits and euro deposits is • R$ - (R€ + (Ee$/€ - E$/€)/E$/€ ) = R$ expected rate of return = interest rate on dollar deposits - R€ interest rate on euro deposits - (Ee$/€ - E$/€)/E$/€ expected exchange rate current exchange rate expected rate of appreciation of the euro expected rate of return on euro deposits 13-34 Table 2: Comparing Dollar Rates of Return on Dollar and Euro Deposits Case 1: interest difference in favor of dollar deposits is 4% and no change in the exchange rate is expected; so dollar deposits provide 4% higher returns. Case 2: interest difference in favor of dollar deposits is 4%, but the euro is expected to appreciate by 4%; so dollar and euro deposits provide equal returns. Case 3: interest difference in favor of dollar deposits is 4%, but the euro is expected to appreciate by 8%; so euro deposits provide 4% higher returns. Case 4: interest difference in favor of euro deposits is 2%, but the euro is expected to depreciate by 4%, so dollar deposits provide 2% higher returns. Model of Foreign Exchange Markets • We use the ♦ demand for (rate of return on) dollar deposits ♦ and the demand for (rate of return on) foreign currency deposits to construct a model of foreign exchange markets. • This model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity. ♦ Interest parity implies that deposits in all currencies are equally desirable assets. 13-36 Model of Foreign Exchange Markets (cont.) • Interest parity says: R$ = R€ + (Ee$/€ - E$/€)/E$/€ • Why should this condition hold? Suppose it didn’t. ♦ Suppose R$ > R€ + (Ee$/€ - E$/€)/E$/€ ♦ Then no investor would want to hold euro deposits, driving down the demand and price of euros. ♦ Then all investors would want to hold dollar deposits, driving up the demand and price of dollars. ♦ The dollar would appreciate and the euro would depreciate, increasing the right-hand side until equality was achieved: R$ > R€ + (Ee$/€ - E$/€)/E$/€ 13-37 Model of Foreign Exchange Markets (cont.) • (Assuming interest rates and future exchange rates are unchanged) how do changes in the current exchange rate affect the expected rate of return on foreign currency deposits? • Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Why? ♦ When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return on foreign currency deposits. 13-38 Model of Foreign Exchange Markets (cont.) • Appreciation of the domestic currency today raises the expected return on foreign currency deposits. Why? ♦ When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby raising the expected rate of return on foreign currency deposits. 13-39 Model of Foreign Exchange Markets (cont.) • Table 3 shows the dollar return on euro deposits for various levels of today’s $/€ exchange rate, always assuming that the expected future exchange rate remains fixed at $1.05/€ and the euro interest rate is fixed at 5%. ♦ A rise in today’s exchange rate (a depreciation of the dollar) always lowers the expected dollar return on euro deposits. ♦ A fall in today’s exchange rate (an appreciation of the dollar) always raises this return. 13-40 Table 3: Today’s Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee$/€ = $1.05 per Euro If today’s exchange rate is $1.00/€, then the expected appreciation of the euro is 5%. The return on euro deposits is 10% = 5% (expected euro appreciation) + 5% (interest on euro deposits). If the dollar depreciates so today’s exchange rate is $1.03/€, then the expected appreciation of the euro is 1.9%. The return on euro deposits is now 6.9% = 1.9% (expected euro appreciation) + 5% (interest on euro deposits). Thus, a depreciation of today’s dollar lowers the dollar returns to euro deposits. Fig. 2: Relation Between the Current Exchange Rate and the Expected Dollar Return on Euro Deposits This is a graph of columns 1 and 4 from Table 3. It shows how expected dollar returns on euro deposits vary with the current $/€ exchange rate.

Exchange Rates and the Foreign Exchange, Part 2

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