In mid-80s, lots of Americans traveled to Europe. Why? The US dollar was at an all-time high in 1985. When the dollar is strong, foreign travel is cheap.  Strong dollar makes all foreign goods and services seem cheap to Americans.  Since the mid-80s, the dollar has weakened, foreign currency has appreciated, and more foreigners have traveled to the U.S.

See graphs page 152.  Exchange rates of foreign currencies vs. the U.S. dollar.  When the line on the graph increases, the foreign currency is getting stronger and the $ is getting weaker.

Even though Americans found it cheap to travel to Europe in the mid-1980s, U.S. mfg./export sector was complaining to the Reagan administration that the dollar was too strong?  (See graphs on page 152, Swiss Franc, German mark and Japanese were at all-time lows in mid-80s, meaning the $ was at an all-time high.) Why? Stronger dollar means weaker foreign currencies. Our export sector suffered from the strong dollar. Exports fell because U.S. goods were expensive overseas.

Illustrates some of the concern about the value of the dollar.  Do we want a strong dollar or weak dollar?  Depends - there are winners and losers either way.

In this chapter we study "international money", the foreign exchange market and exchange rates, to understand how monetary policy affects the value of the dollar not only domestically, but affects the value of the dollar in foreign exchange markets as well.  By affecting the value of the dollar in the foreign exchange market, monetary policy affects the economy by affecting the relative price of domestic and foreign goods, affecting the export and import sectors, as well as the financial markets.  Exports and imports are each more than $1T/year, or more than 10% (each) of GDP ($10T).  Many U.S. companies have more than 50% of sales overseas: Coca-Cola, GM, Microsoft, etc., so exchange rates have a very significant impact on U.S. companies and the U.S. economy.


The exchange rate is just the price of one currency in terms of another currency.  Currency markets are the world's largest financial market - over $1T ($1000B) is traded daily vs. $10-15B traded daily in the entire US equity market.  Foreign exchange market operates daily around the clock - 24/7.  There is not a physical location or exchange (like NYSE) for currency trading, it is more like NASDAQ, an over-the-counter network of currency traders, most large banks, linked by telephone and computer.  Trading is usually in transactions of $1m or more per trade, at the wholesale level.

Trading in the foreign exchange market is mainly to facilitate international trade and international investment - the buying and selling of foreign goods, services and financial assets.  Think of the three functions of money - unit of account, medium of exchange and store of value.   Foreign goods are usually priced in foreign currency - German wine/beer is priced in euros for example.  The unit of account is the euro, the medium of exchange is the euro.  American liquor distributors need euros to buy the German wine/beer.  Also, American investors may consider the euro a better store of value than the US dollar.  They could buy a CD from a German bank denominated in euros, instead of putting money in a U.S. bank.  Or American investors want to buy stock of a company in UK, Brazil or Turkey. They need foreign currency to buy foreign assets.

What determines the value of the dollar (or Yen, Euro or pound) in foreign currency markets? ______________________________________

Note: Exchange rates can be quoted two ways:

e = ¥ / $, or the Foreign Currency per U.S $.  When e gets bigger (100 to 120), dollar gets stronger, appreciates in value (and the Yen depreciates).  $1 will buy more foreign currency, or it takes more Yen to buy a $1.  When e gets smaller (100 to 80), dollar gets weaker, depreciates in value (and the Yen appreciates).  $1 will buy fewer Yen, or it takes fewer Yen to buy a $1.  Just like a price of $2/gallon of gasoline, when the P gets bigger the value (price) of gas increases (it's in the denominator), when P gets smaller the value (price) of gas decreases.

e = $ / £ (British pound), or the U.S. $ equivalent, or U.S. Dollars per national currency unit.  When this e gets bigger, the £ get stronger (appreciates) and the dollar gets weaker (depreciates), because it takes more dollars to buy a £.  When e gets smaller, the £ depreciates and the dollar gets stronger.  It costs less for us, in U.S. $, to buy a pound.

1. When e (ex-rate) gets bigger, the currency in the DENOMINATOR gets stronger (appreciates).
2. When e (ex-rate) gets smaller, the currency in the DENOMINATOR gets weaker (depreciates).
3. Since the ex-rate is just a ratio of two currencies, when one ($) gets stronger, the other (£) gets weaker.

Two Types of Exchange Rates:
1. Spot Rates (e or E) - Buyer and Seller agree on P (ex-rate) and Q for immediate delivery (within two days).
2. Forward rates (F) - Buyer and Seller agree on P (ex-rate) and Q for delivery in the future - 1 month, 3 month, 6 months or more in the future.

Forward rates are considered a forecast of the future spot ex-rate, and tell us whether currency traders expect a currency to appreciate (strengthen) or depreciate (weaken) in the future.  Market forces determine both spot and forward rates. Why might forward rates be accurate, unbiased predictors of future spot rates?

Note: When a currency is expected to appreciate, it sells at a FORWARD PREMIUM (%), and when it is expected to depreciate, it sells at a FORWARD DISCOUNT (%).  For example:  1) If the  e = ¥100/$ and the 1 year F =  ¥105/$, the dollar is selling a 5% FORWARD PREMIUM: (105-100) / 100, and is expected to appreciate by 5% over the next year.   2) If the  e = ¥100/$ and the 1 year F =  ¥95/$, the dollar is selling a 5% FORWARD DISCOUNT: (95-100) / 100, and is expected to depreciate by 5% over the next year.

Example: see WSJ handout and page 154.  Over the next 6 months (12 months) is the $ expected to appreciate or depreciate?  By what percent?

$ vs. British pound?
$ vs. Canadian $?
$ vs. Franc?
$ vs. Mark?
$ vs. Yen?
$ vs. SF

Note: SDR - unit of account, no medium of exchange.

Who uses spot rates and forward rates?  Why are ex-rates important?

Ex-rates affect the relative prices of domestic and foreign goods.  The dollar price of foreign goods to an American depends on two factors: the price of foreign goods in foreign currency (unit of account), and the exchange rate between the foreign currency and dollars.

Example: Suppose a bottle of French wine is priced in France at 1000 Euros.  If the e = $1/€, the cost to an American is €1000 x ($1 / €) = $1000.
Conclusion: __________________ .  If the Euro appreciates ($ depreciates), will the French wine be more or less expensive? __________________ Proof:  if  e = $1.20 / €, the cost to an American is €1000  x ($1.20 / € ) = $1200.  If the Euro depreciates ($ appreciates), will the French wine be more expensive or less? __________ Proof: if  e = $.80 / €, the cost to an American is €1000  x ($.80 / €) = $800.  Therefore, the price could fluctuate between $800-$1200, depending on currency movements.

POINT: if the dollar is strong (weak), French wine is cheaper (more expensive) for an American.  The value of the $ in relation to the € will affect the price of foreign goods for an American.  When the dollars appreciates, foreign goods/assets/services are CHEAPER.  When the dollar depreciates, foreign goods/assets/services are MORE EXPENSIVE.

SUMMARY of the Advantages/Disadvantages of a Strong/Weak Currency:

1. Strong dollar = Weak foreign currency:

a. Advantages: foreign goods and services are cheap, including foreign travel.  Helps the import sector of the economy, companies that sell foreign goods (Toyota dealers).  Helps U.S. companies buying foreign inputs.  Helps U.S. consumers - imports are cheaper.

b. Disadvantages: U.S. exports are expensive, including tourism in U.S.  Hurts the export sector, companies that sell abroad, makes them less competitive. Hurts the import-competing sector - GM, for example (Toyotas from Japan are now cheaper).  Domestic goods are less competitive overseas and here, because strong $ = weak foreign currency.

2. Weak dollar  = Strong foreign currency:

a. Advantages: Helps the U.S. export sector.  Our goods and services are cheap overseas, including tourism in US.  Helps the import-competing sector like GM, domestic goods are more competitive (Toyotas made in Japan are more expensive).

b. Disadvantages: Hurts the import sector of the economy (BMW and Toyota dealers).  Hurts US companies buying foreign inputs (50% of imports are inputs and NOT finished goods).  Hurts U.S. consumers - imports are more expensive, e.g. oil, coffee, bananas, German wine and beer, foreign travel, diamonds, for example.

The examples above illustrate CURRENCY RISK - the possibility of an adverse exchange rate movement.  Currency risk is an important consideration for almost all  businesses because 1) most companies either buy foreign inputs or sell their output in other countries, 2) exchange rates are unpredictable and 3) contracts for purchases (imports, foreign inputs) and sales (export) are made far in advance.  If a contract is stated in a foreign currency, one party is exposed to currency risk.

Example:  U.S. computer manufacturer (importer) agrees by contract to buy computer parts in 6 months from a firm in Japan for  ¥100,000 /unit.  If the ex-rate  ¥100 /$ in 6 months, the parts cost $1000.  If the ex-rate is ¥80 / $ ($ weakens) the price is $1250/unit.  Currency risk for the importer is that the dollar might depreciate over the next six months, meaning that it becomes more expensive to buy  ¥ and more expensive to buy the foreign import.

Risk can work both ways: if the ex-rate is 125¥ / $ (dollar appreciates, Yen depreciates) in 6 months, the cost is only $800.  In this case, the dollar got stronger, so it became cheaper to buy Yen, and the foreign product (priced in a fixed amount of Yen) became cheaper.  Ex-rate volatility (currency risk) means the cost of parts could range between $800-1250 over the next 6 months for the U.S. manufacturer.  Imagine if you were building a house, it would be complete in 6 months, and the range for the final cost was between $80,000-125,000!  RISK FOR THE IMPORTER: They have to buy Yen 6 months from now to buy the imported product, they are worried that the $ will get weaker, making it more expensive to buy the foreign product.  If you have to pay a fixed amount of foreign currency in the future, you are worried about your domestic currency getting weaker in the future because it will cost you more money in dollars to buy the import.

Example:  U.S. Exporter agrees in a contract to sell beef to a buyer in Japan for  ¥500 / lb. in 6 months.  If the e =  ¥100 / $, the U.S. exporter receives $5/lb.  If e = ¥80 / $, (dollar weakens, Yen strengthens), the exporter gets $6.25/lb.  If e = 125Yen/$ (dollar strengthens, Yen weakens) he gets $4/lb.  Range for the sales revenue is between $4.00-6.25/lb.  Currency risk for the exporter is that the Yen could weaken over the next six months, dollar strengthen.  RISK FOR EXPORTER: They are receiving a fixed amount of foreign currency in the future, they are worried about the foreign currency getting weaker in the future, meaning fewer dollars in the future for the sale of the exported product.

What can importers/exporter do about currency risk?
1. Negotiate the contract in domestic currency ($).
2. Wait and see. Take the risk of using spot market at time of delivery, and hope for a favorable ex-rate movement.
3. Lock in a forward ex-rate today with a forward contract, either for the entire amount (full hedge) or for a portion of the total (partial hedge).

Example: Importer needs to buy Yen in six months.  He/she can buy Yen forward today at the 6 month forward rate, and lock in a guaranteed ex-rate now for when the contract is due in 6 months.  Locking in an ex-rate locks in a cost of the imported product in US dollars.  If they will need  ¥10m, they can buy ¥10m forward (full hedge) or just ¥5m for example (partial hedge).

Exporter will receive ¥  in six months, and convert into (sell for) US dollars.  They can sell Yen forward now at the 6 month forward rate.  Lock in a guaranteed ex-rate, and thereby lock in a fixed amount of revenue in US dollars.  Full hedge or partial, sell ¥10m forward, or just  ¥5m forward.

Forward rates and forward contracts for currency allow companies doing intl. business to manage, control and predict costs and revenues by hedging to reduce or eliminate currency risk.

EXCHANGE RATES IN THE LONG RUN: What determines Ex-rates?

Basically, the Supply and Demand for currency determines ex-rates, market forces, like any commodity or asset.  We first look at ex-rates in the long-run (LR) and then ex-rates in the short-run (SR).

LAW OF ONE PRICE (LOP): starting point for understanding ex-rates in the LR.  Also called the "price equalization principle": for homogeneous, identical goods, the price of the commodity should be the same (equalize) throughout the world, especially when barriers to trade, transactions costs and transportation costs are low.  Says that foreign prices (Pf ), domestic prices (Pd) and ex-rates (e) are linked through the Law of One Price which says: Pd ($) = e * Pf (£) , where e = $ / £.   LOP says that similar products should sell for the same price in both countries, after converting the foreign price into dollars.

Example: Price of gold in U.S. = $260 (Pd) , Price of gold in Canada = C$400 (Pf) and e = $0.65 / C$.

LOP holds: $260 = ($.65/C$)  x  C$400, says that gold sells for the same price ($260/ounce) in both the U.S. and Canada, after converting the foreign price into $.  The price of gold should equalize around the world and sell for about the same price everywhere: $260/ounce.  What if somewhere in the world, P < $260/oz, what would happen?  What if somewhere in the world, P > $260, what would happen?  ARBITRAGE: Riskless profits from exploiting price discrepancies.

Example: What if gold was cheaper in Canada than in US?  In U.S., P=$260 and in Canada, P = $255? [Pd ($) > e * Pf (C$)] Two effects:

1) People would _________ gold in Canada, __________ gold in U.S.  Price in Canada would __________ and price in U.S. would _____________.

2) People would first buy __________ to buy Canadian gold, and would also sell _________ to buy Canadian dollars.  Can $ would ________, US $ would ________,
ex-rate ($/C$) would ___________.

Law of One Price would be restored, through an adjustment in gold prices here and in Canada, and through an adjustment in the ex-rate.

Law of One Price holds most strongly for: homogeneous, traded goods like commodities such as: gold, silver, wheat, steel, copper, oil, aluminum, cotton, etc. and financial assets like Treasury securities, bank CDs, etc. In fact, most of the currency trading is for financial transactions, not commodities.

Also Law of One Price assumes frictionless trading.  If we introduce frictions like tariffs, taxes, transportation costs, commissions, shipping, insurance, etc., the Law of One Price may not always hold.  Also, many goods and services may be non-tradeable items like haircuts and golf lessons.  Law of One Price is a starting point for ex-rates, illustrates one aspect of how international trade affects ex-rates.

PURCHASING POWER PARITY (PPP): PPP is another way to understand how ex-rates are determined.  PPP is the LOP applied to the general price level of two countries.

PPP:  Pd  =  e *  Pf,

where Pd is the domestic price level (CPIUS) and Pf is the foreign price level (CPIF).

or e = Pd  /  Pf.

PPP therefore says that the ex-rate will change to reflect changes in the relative price levels in two countries.  If Pd >  Pf , the domestic price level (Pd) increases more than the price level of another country (Pf ), e ($/£) will therefore increase, and the foreign currency (£) will appreciate, and the domestic currency ($) will depreciate relative to the foreign currency.  Reason:  If our price level (U.S.) increases MORE than the foreign price level (U.K.), what does it imply about the supply of dollars relative to pounds?___________________________

Converting to percentage changes, PPP also implies that % e = % Pd - % Pf , or % e = INFus - INFf.  Ex-rate movements (% e) are linked to the country's relative inflation rates (INFus vs. INFf).  When INFus > INFuk, the dollar will __________ and the pound will ____________.  When INFuk > INFus  the dollar will __________ and the pound will ____________.    See handout.

Does PPP hold?  Not always, and not perfectly.  However, we can say that when Pd (INFus) > Pf (INFuk), the dollar should weaken in general, relative to the pound, even if the change in the ex-rate is not exactly equal to the difference in inflation.

Example:  PPP explains the general direction of the ex-rate movement, but not the exact amount of change - see page 157.  Between 1973-1999, the British price level increased by 85% compared to US (INFuk > INFus), and as a result the dollar got stronger (e = £ / $ in this case instead of vice-versa) and the pound got weaker.  However, the $ only appreciated by 45% instead of the full 85%, so the dollar was undervalued and the pound was overvalued, according to PPP. And between 1985 and 1987, the British price level was rising compared to US, predicting that the dollar should appreciate, when the dollar actually depreciated by 40%.

Why doesn't PPP explain ex-rate movements?

1. Assumes goods in both countries are identical or are perfect substitutes.  OK for steel, but what about American vs. Japanese cars?  Is a Chevy the equivalent of a Toyota?  No, so the prices don't have to equalize.  If the Law of One Price doesn't hold, then PPP can't hold.  According to PPP, if the price of Toyotas goes up relative to Chevys, the Yen should depreciate and the dollar should appreciate. (Pd = e Pf) Pf goes up, e should go down. Doesn't always happen that way, since Toyotas and Chevys are not identical, homogenous, perfect substitutes.  PPP also assumes that the price index (CPI) is identical in both countries, which it isn't.

2. Not all goods and services get traded - restaurant meals, haircuts, golf lessons, etc. (services) are not traded goods.  If these services go up in price, or down in price, it will affect the domestic price level, but it doesn't necessarily affect the ex-rate.  Also, there are trade barriers (tariffs and quotas), transportation costs, transactions costs.


Reasoning: Anything that increases demand for domestic goods will appreciate the dollar.  Anything that increases demand for foreign goods will appreciate the foreign currency and depreciate the dollar.

1. Relative Price Levels - PPP. In the long run, a rise in a country's price level causes its currency to depreciate. A fall in price level causes appreciation. MS increases, price level increases, inflation increases, currency depreciates. Relative supply of currency determines its value - at least on the supply side of the equation.  Or if prices rise in the U.S. (CPI goes up), foreign goods become more competitive (cheaper), increasing demand for foreign currency and appreciating the foreign currency, depreciating the dollar.  (see formula, where e = $ / £)

2. Tariffs and quotas - Barriers to trade cause a country's currency to appreciate in the long run.  Increasing domestic trade barriers (raising tariffs on foreign products) reduces demand for foreign products (imports) relative to domestic products, which reduces the demand for foreign currency, reduces the value of foreign currency, increases the value of domestic currency.  Reducing trade barriers, lowering tariffs, would increase demand for imports, increase demand for foreign currency, appreciate foreign currency relative to the dollar.

3. Preferences for Domestic vs. Foreign Goods - Increased demand for domestic products (exports) puts upward pressure on domestic currency, dollar appreciates. Increased demand for foreign products (imports) puts upward pressure on foreign currency, causing domestic currency ($) to depreciate.

4. Productivity - Increases in U.S. productivity causes an increased demand for our products internationally (exports), because U.S. costs of production are lower, domestic firms are more efficient/competitive, so firms can lower price and still increase profits.  Increases demand for U.S. products, increases the demand U.S. dollar, leads to an appreciation of the $.

See page 159 for a summary.  E =   ¥ / $ in this case, so an upward arrow means that the dollar is getting STRONGER.   SUMMARY: Dollar appreciates when: a) tariffs on imports go up, b) demand for U.S. products (exports) goes up, or c) U.S. productivity increases because in each case demand for U.S. products goes UP.  Dollar depreciates when a) U.S. prices increase in general (CPI) or b) when demand for foreign products (imports) goes up, because in both cases demand for foreign goods has gone UP.


The four factors outlined above describe ex-rate determination in the LR, the long run trends in currency movements, appreciating and depreciating over the LR.  However, ex-rates can be very volatile and change daily, so we need to understand what factors affect the short run (SR) volatility of foreign exchange.

Ex-rates in the SR are determined more by the demand for foreign and domestic financial assets than the demand for imports and exports of goods/services.  Annual foreign exchange transactions in U.S. ($60T) are more than 25x greater than the annual total volume of international trade in U.S. ($2T),  so ex-rate determination is determined much more by demand for financial assets than by export/import demand discussed above (LR factors).

Capital mobility - There are now few restrictions on international capital mobility, and financial markets are international - international credit markets, bond markets, stock markets, etc.  Bank deposits and treasury securities are considered perfect substitutes by international investors and they can now just shop the world credit and capital markets for the highest rate of return.  For example, capital mobility allows a life insurance company/pension funds with millions of dollars to shop the world financial markets for the highest rate of return, they are not restricted to domestic markets anymore.  Likewise, foreign investors can easily invest in the U.S. market, buy U.S. stocks, Treasury securities, corporate bonds, make deposits in U.S. banks, buy CDs here, money market instruments, etc.  Capital mobility assumes that investment capital is internationally mobile, and capital flows to those countries and markets that offer the highest expected rates of returns.

Capital mobility, along with the Theory of Asset Demand, gives us insight into ex-rate determination in SR.  The demand for domestic (dollar) assets and the demand for foreign (Euro, pound) assets is largely determined by the expected returns on those assets.  When the expected return for U.S. assets (ius) is high relative to the expected return for foreign assets (if), the demand for U.S. assets will be high, and so will the demand for dollars.   Therefore, it is the demand for domestic and foreign assets that creates demand for foreign currency (or the dollar), which then determines the value of foreign exchange in SR.

Reason: to take advantage of high interest rates in U.S. (U.K.), you first have to buy dollars (pounds).   Also, we assume realistically that many financial assets are perfect (or very close) substitutes: Treasury securities, bank CDs, etc.

For example, you have $10m to invest in Treasury securities, so you consider 10 year government debt (T-bonds) issued by New Zealand, UK, Japan, Canada, Germany, Switzerland, Norway, etc., because they are all risk-free T-bonds.   Or you consider, short term one year bank CDs in those same countries.   What do you base your decision on when considering these alternative investments in different countries?  ___________________  and ___________________ .

Rate of return on a 1 year foreign investment to a U.S. investor has two components:

1) if = One year interest rate (nominal interest rate) on the foreign asset.

2) (F - E) / E = Expected rate of appreciation (%) or depreciation (%) of the foreign currency over the next year, where F = forward ex-rate and E = spot ex-rate

a) E = $1.50/£ and F360 = $1.605/£.  Pound is expected to appreciate by 7% over the next year.

b) E = $1.50/£ and F360 = $1.395/£.  Pound is expected to depreciate by 7% over the next year.

You are really making two investments: 1) you are investing in the foreign asset ( if) and 2) you are "investing" in the foreign currency £ (%F).  For example, assume the one year foreign interest rate in UK (if)  = 10%, you get a 10% guaranteed nominal return for the next year.  If the pound appreciates by 7% versus the dollar, you get an additional return of 7%, for a total dollar return of 17%.  The UK government paid you 10% nominal return, and you benefited over the next year by holding a foreign currency that appreciated by 7% relative to the dollar.

Investment process: You take $ and buy £ to buy the UK T-bill.  After one year you get your proceeds in £ in UK and sell the pounds for $.  Since the pound is 7% stronger than it was a year ago, you gained an additional 7% by holding a pound-denominated asset because the pound got stronger by 7%.

If the British pound depreciates by 7% over the next year, you lose 7% on your total return and you end up with 10% (nominal rate) MINUS 7% (depreciation of the pound), for a total dollar return of 3% (10% - 7% = 3%).   POINT: When investing in a foreign asset, you GAIN when the foreign currency APPRECIATES, and you LOSE when the foreign currency DEPRECIATES.


ius =  if  +   (F - E)  /  E

i = Nominal return on foreign asset for period t

ius = Nominal return on domestic asset for period t

where the domestic asset and foreign asset are perfect or close substitutes (T-bills, bank CDs, etc.)

E = spot ex-rate

F = forward ex-rate for period t

(F - E) / E  = % Appreciation (or % Depreciation) of the Foreign Currency over the relevant period.

ius = Effective dollar return to US investor for an investment in a foreign country

Interest Parity implies that: ( ius - if ) =  (F - E) / E meaning that:
For similar assets in two different countries, the difference in nominal interest rates reflects the expected change in the ex-rate.

Example: Interest rates for 1 year Tbills in US are 8%, 1 year interest rates in Germany are 6%, and 1 year interest rates in Canada are 10%.

US vs. Germany:  8% (US)  =  6% (Germany) + 2% (Appreciation of DM)

Parity condition implies equality of returns in both countries after taking into account the appreciation or depreciation of the foreign currency.  You can get an 8% dollar return in the U.S. or an effective 8% dollar return in Germany (6% nominal + 2% appreciation).


(8%  - 6%) = +2% Appreciation of the German mark.

The difference in 1 year nominal interest rates between US and Germany (+2%) reflects an expected appreciation of the DM of 2% over the next year.  A U.S. investor will get an effective 8 percent return in either country, after taking into account the change in foreign currency.  (For a German investor, they can get 6% in Germany, or an 8% nominal dollar return in U.S. MINUS a -2% depreciation of the dollar for a 6% return in either country.)

US vs. Canada: 8% (U.S.) = 10% (Canada) - 2% (Depreciation of the C$).


( 8 - 10%) = -2% Depreciation of the C$.

A U.S. investor will get a dollar return of 8% in the U.S., or a 10% return in Canada MINUS -2% depreciation of the Canadian dollar, for an effective dollar return of 8%.  Or the difference in nominal interest rates (-2%) reflects an expected depreciation of the foreign currency, the C$.

If bank deposits are perfect substitutes and there is international capital mobility, and there are active forward markets for foreign currency, interest rate parity has to hold.  Reason: you can cover yourself with a forward contract.

Covered return = you invest in a foreign country and sell the foreign currency forward to get your dollars back, to get a guaranteed dollar return.  If covered returns in one country are higher than the interest rate parity condition, investment will take place to restore the parity (equality) condition.

Example: Assume 1 year T-bill rates in U.S. are 6%, and 1 year T-bill rates in U.K. are 9%, and the E = $1.50/£.  According to Interest Rate Parity, the difference in ex-rates (6 - 9% = -3%) means that the pound is expected to DEPRECIATE by -3%.  The effective dollar return should be 6% in either country (6% in US = 6% in UK (9 - 3%)).  If the pound is expected to deprecate by 3% relative to the $, interest rate have to be 3% higher in UK, otherwise nobody would invest there.  U.S. investors need to be compensated for the 3% depreciation of the foreign currency.  If the pound depreciates by 3%, then F should be equal to: $1.50 - 3% = $1.455/£.

What if interest rate parity does NOT hold and F = 1.47/£.  What would happen?

1) Calculate the Forward Premium/Discount: (F - E) / E = (1.47 - 1.50) / 1.50 = -.02 or -2%.

2) Calculate the Effective Return for a U.S. investor in UK = 9 - 2% = 7% (UK) vs. 6% (US).

3) Since returns are higher in UK versus US, what would investors do?

Buy ___________ to buy ___________ and sell ________________

4. What happens to bond prices, interest rates in UK?

5) What would happen to the ex-rate (E) for the pound?

Assume that after trading, interest rate UK = 8.5%, E = $1.5077/£ and F = $1.47/£.  Now the forward discount (F - E / E) for the pound is -2.5%, so the Effective Return for US investor = (8.5% - 2.5%) = 6% and Interest Rate Parity is restored.  Adjustment in the ex-rate helps restore IRP.

What if interest rates were 6% in U.S., and 9% in UK, E = $1.50/£ and F = $1.44/£.

Forward Discount = (1.44 - 1.50) / 1.50 =

Effective Covered Return for US investor in UK =

What would happen to US bond prices, interest rates and the value of the dollar and E?


1. For assets that are perfect substitutes (Tbills, CDs) domestic interest rate equals the foreign interest rate PLUS a forward premium (or MINUS a forward discount) of the foreign currency.
2. If domestic interest rates (15%) are higher than the foreign interest rate (10%), the foreign currency is expected to appreciate (by +5%).  Foreign currency should be selling at a forward premium (of +5%).
3. If domestic interest rates (10%) are lower than the foreign interest rate (15%), the foreign currency is expected to depreciate (by -5%).  Foreign currency should be selling at a forward discount of (of -5%).
4. In equilibrium, the effective dollar return should be the same (parity) in both countries.
5. Differences in nominal interest rates should reflect the expected depreciation or appreciation of the foreign currency, which should be reflected in a forward discount or premium.
6. Interest rates, ex-rates and forward rates are all inter-related, and adjust to restore interest rate parity.
7. Demand for foreign and domestic assets affects the determination of ex-rates.


Now we have shown that:
1. Demand for international trade creates demand for foreign exchange.
2. Demand for foreign assets creates demand for foreign exchange.
3. Ex-rates change and fluctuate daily due to changes in demand for foreign currency.

Several other factors to consider (p. 168-171), including nominal versus real (again).  Remember from the Fisher equation: R = r + INFe, so when domestic nominal interest rates (R) go up it could be because: a) U.S. real rates have gone up or b) because U.S. expected inflation has gone up.  Using that we conclude:

1. When domestic real rates (r) rise (relative to r in other countries), U.S. attracts foreign investment, leading to an appreciation of the dollar.

2. When U.S. nominal rates (R), due to an increase in expected inflation in U.S., the dollar will depreciate.  (Inflation = depreciation of the currency).

3. An increase in the domestic money supply (increase in dollars), causes the domestic currency to depreciate.  Example: If E= $1.50/ £ and M1 in the U.S. doubles, and M1 in UK stays the same, the dollar would be worth half as much and the new E = _______________.


See page 169 for a summary of the factors that affect the expected ex-rate, taking into account the discussion above (remember that interest rates are forward looking, e.g. a 1 year interest rates imply a one year future time horizon):

1. Domestic interest rates rise, due to an increase in real interest rate (r), dollar appreciates.
2. Foreign interest rates rise, due to an increase in real interest rates, dollar depreciates, £ appreciates.
1a. Domestic interest rates rise, due to an increase in INFe, dollar depreciates.
2a. Foreign interest rates rise, due to an increase in INFe, £ depreciates and dollar appreciates.

Factors 3-7 are the same as on page 159.

3. Expected domestic price level goes up, foreign goods are cheaper, demand for £ goes up, foreign currency appreciates, dollar depreciates.  (Also, higher U.S. INFe leads to depreciation of $)

4. Expected increase in trade barriers (higher tariffs), leads to decreased demand for £, depreciation of foreign currency, $ appreciates.

5. Expected import demand increases, higher demand for £, foreign currency appreciates, $ falls.

6. Expected export demand increases, higher demand for $, $ appreciates.

7. Expected U.S. productivity increases, U.S. goods are more competitive, increased demand for $ appreciates the dollar.


Why are ex-rates so volatile? When we went off fixed ex-rates in 1973, economists thought that ex-rates would be fairly stable under a flexible ex-rate system. Turns out that floating ex-rates are fairly volatile, change daily.  Remember that one of the functions of money is as an asset, store of value, especially interest bearing liquid assets in M2 and M3, such as money market instruments, CDs, bank deposits, etc.  Looking at international money as a financial asset (store of value), and using an asset market approach, we would expect ex-rate volatility, just like any financial asset, including stocks, etc.

Ex-rates are volatile because there are so many factors affect ex-rates:

MS in US vs. foreign, current and expected
Monetary policy in U.S. and monetary policy in other countries
Foreign vs. domestic price levels and inflation, current and expected
Foreign vs. domestic int rates, both nominal and real, current and expected
Foreign and domestic trade policy (tariffs and quotas), current and expected.
Foreign and domestic export and import demand, changes in taste, preferences, demographics, etc.
Productivity advances
Other financial markets - stock markets in U.S. and other countries
Possible changes in tax treatment, other fiscal policies (trade policy)
Political factors (U.S. presidential election, which party is in power might affect either future fiscal policy or monetary policy)
Political uncertainty, international climate, wars, etc.

As any of these factors change, ex-rates change on a daily basis, leading to volatility.  Important point: earlier models of ex-rates focused on goods market (intl. trade), didn't account for the important role of a) financial assets and b) expectations in ex-rate determination.  Now that we have both active spot markets for foreign exchange and active forward markets for foreign exchange, ex-rates reflect not only current conditions but forward ex-rates reflect expectations of the currency values in the future.

Ex-rate volatility implies Currency Risk for exporters, importers, international investors, etc.   Many hedging alternatives (derivatives) exist to control and manage currency risk: forward contracts, currency futures contracts, currency options, etc.  We look at futures markets in Chapter 13.

Interest Rates and Ex-Rates.

See page 174.  Plot of Nominal, Real Int Rates vs. Exchange Rate of $. (Value of dollar vs. a basket of foreign currencies). The dollar's value follows the real rate of interest much more closely than the nominal rate.

1970s: real int rates were falling in U.S., and nominal interest rates were rising.  What happened to the dollar?

Early to mid-1980s: real int rates were rising, and nominal interest rates were falling.  What happened to the dollar?

Point: Value of the dollar follows real interest rates more closely than nominal. Real variables matters.  Falling real interest rates explain why the dollar was weak in the 70s, and rising real rates explain why the dollar was strong in the 80s, nominal int rates don't.


1. One year zero coupon treasury securities are selling for $952.38 in the U.S. and for £930.23 in the U.K. (assume 1000 face value, round interest rates to two
decimal places).  The current ex-rate is $1.58/£.
a. calculate the one year nominal returns in the U.S. and in the U.K.

b. If interest rate parity holds, should the pound be selling at a forward discount or premium?

c. based on your answer, calculate the expected one year forward ex-rate.

d. If interest rate parity does not hold and the actual forward rate is $1.5563/£, compare your rate of return in the U.S. versus the U.K. for a U.S. investor.  For the U.K. investment , assume that you would use a forward contract to cover ex-rate risk.

e. If the actual forward rate is $1.5563/£, and given the one year interest rates from part a, what would happen to bond prices and interest rates in the U.S. and U.K. to
restore interest rate parity?