Financial Markets and Institutions (2-downloads)

country becomes more productive relative to other countries, its currency

appreciates.

1

Our long-run theory of exchange rate behavior is summarized in Table 15.1. We

use the convention that the exchange rate E is quoted so that an appreciation of

the currency corresponds to a rise in the exchange rate. In the case of the United

States, this means that we are quoting the exchange rate as units of foreign currency

per dollar (say, yen per dollar).

2

Exchange Rates in the Short Run: A Supply and

Demand Analysis

We have developed a theory of the long-run behavior of exchange rates. However,

because factors driving long-run changes in exchange rates move slowly over time,

if we are to understand why exchange rates exhibit such large changes (sometimes

several percent) from day to day, we must develop a supply-and-demand analysis of

how current exchange rates (spot exchange rates) are determined in the short run.

The key to understanding the short-run behavior of exchange rates is to recog-

nize that an exchange rate is the price of domestic assets (bank deposits, bonds, equi-

ties, etc., denominated in the domestic currency) in terms of foreign assets (similar

1

A country might be so small that a change in productivity or the preferences for domestic or foreign

goods would have no effect on prices of these goods relative to foreign goods. In this case, changes in

productivity or changes in preferences for domestic or foreign goods affect the country’s income but

will not necessarily affect the value of the currency. In our analysis, we are assuming that these factors

can affect relative prices and consequently the exchange rate

2

Exchange rates can be quoted either as units of foreign currency per domestic currency or as units of

domestic currency per foreign currency. In professional writing, many economists quote exchange rates

as units of domestic currency per foreign currency so that an appreciation of the domestic currency is

portrayed as a fall in the exchange rate. The opposite convention is used in the text here, because it is

more intuitive to think of an appreciation of the domestic currency as a rise in the exchange rate.

TA B L E   1 5 . 1

Summary Factors That Affect Exchange Rates in the Long Run

S U M M A R Y