Please enable JavaScript.
Coggle requires JavaScript to display documents.
The Foreign Exchange Market - Coggle Diagram
The Foreign Exchange
Market
Foreign Exchange Market Operations
Exchange rate
: price of one currency in terms of another
Direct
Indirec
Foreign exchange market
: where the trading of currencies and bank deposits denominated in particular currencies takes place.
Spot transaction
: immediate (two-day) exchange of bank
deposits (at spot exchange rate, S).
Forward transaction
: the exchange of bank deposits at
some specified future date (at Forward exchange rate, F)
Appreciation
: a currency rises in value relative to another
currency
Depreciation
: a currency falls in value relative to another
currency
Exchange rate in the long run
Purchasing power parity (PPP)
The law of one price
: states that the exchange rate between any two countries’ currencies is such that a basket of goods and services, wherever it is produced, costs the same in both countries
Exchange rate (f/d) = Foreign price level / Domestic price level
Key PPP insight
: If a country’s price level rises relative to another’s by a certain percentage, then its currency should depreciate by the same percentage
Real Exchange Rate
Domestic price of domestic good/ Domestic price of foreign good
PPP
limitations
PPP theory does not take into account that many goods
and services are non-tradable.
Similar goods typically are not identical in both countries
There are barriers to trade
Determinants of long-run exchange rate
Anything that increases the demand for domestically produced goods relative to foreign traded goods tends to appreciates domestic currency
Relative price levels
Trade barriers
Preferences for domestic versus foreign goods
Productivity
Exchange Rates in the Short Run
Asset
market approach
An exchange rate is the price of domestic (dollar) assets in
terms of foreign assets
Supply curve
for domestic assets
– Assume amount of domestic assets is fixed
Demand curve
for domestic assets
– Most important determinant is the relative expected return of domestic assets
– At lower current values of the dollar (everything else equal), the quantity demanded of dollar assets is higher
Shifts in the demand
for domestic assets
Domestic interest rate
Foreign interest rate
Changes in the expected future exchange rate
