lecture2 - Outline Exchange Rates Foreign exchange market...

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Outline Exchange Rates Foreign exchange market Asset approach to exchange rates Interest parity condition Empirical tests Covered interest parity
Exchange Rates The (spot) exchange rate (E) is price of one currency in terms of another for immediate trade (on the spot). The conventional way of reporting this in economics is home currency per unit of foreign. In the U.S. this is \$ per unit foreign currency. – Example, yesterday E\$/€ = 1.21 \$/€, called direct (“American”) terms – Sometimes you will hear quoted the other way around, often called indirect (“European”) terms. E.g., 0.82 €/\$. Exchange rates are important for trade because they allow you to compare the cost of imports to that of domestic goods in common terms. Example: You visit Rome and see an Armani suit for €1000. What is that in US currency? Consider units: you want to convert € to \$ so you need to multiply by an exchange rate expressed in \$/€ (check: multiply units and cancel). €1000 * 1.21 \$/€ = \$1210

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Appreciations and depreciations Our definition of E = home per unit foreign currency (\$/€) Definition can make it confusing to talk about changes in E, called appreciations and depreciations. – Appreciation: increase in value of the given (home) currency relative to another. – Depreciation: decrease in value of the given (home) currency relative to another . Say the \$/€ rate changed from 1.21 to 1.50. Now how much would the suit would cost in \$ terms? – Dollars are not buying as many euros now, so the dollar has depreciated or weakened (against the euro). If E\$/€ rises we say that the dollar has depreciated (€ has appreciated) If E\$/€ falls we say that the dollar has appreciated (€ has depreciated)
The foreign exchange market: actors Commercial banks : a company has a bank debit its account, change into foreign currency, and make payment by depositing in its foreign bank. Inter-bank trading : bank enters foreign exchange market to execute multiple trades—very large transactions. Corporations : some corporations enter market directly. Increasingly common. Non-bank financial institutions : Deregulation allows them to compete in the market. E.g. pension funds. Central banks : sometimes intervene to increase or decrease the supply of their currency or purposefully affect E. – Official interventions are relatively small, because there is so much private money involved. Is central bank a big enough player to affect E?

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The foreign exchange market: character Volume is enormous: over a trillion dollars a day. – US GDP is about \$10 trillion in the whole year. Concentrated in certain key financial cities: where? – London largest, also NY, Tokyo, Frankfurt and Singapore.
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lecture2 - Outline Exchange Rates Foreign exchange market...

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