Financial Markets and Institutions (2-downloads)

Reading the Wall Street Journal: The

“Currency Trading” Column

Now that we have an understanding of how exchange rates are determined, we can

use our analysis to understand discussions about developments in the foreign

exchange market reported in the financial press.

Every day, the Wall Street Journal reports on developments in the foreign

exchange market on the previous business day in its “Currency Trading” column,

an example of which is presented in the Following the Financial News box, “The

‘Currency Trading’ Column.” The column states that the dollar fell against the euro

after the Federal Reserve renewed its commitment to ultralow interest rates as it

turned more cautious on the U.S. economic recovery. Our analysis of the foreign

exchange market explains why this development led to a weaker dollar.

The weaker economy and the Fed’s commitment to keep interest rates low lower

the expected return on dollar assets in the future. Therefore, traders in the currency

markets will expect that in the future the relative expected return for dollar assets

will be lower and, as a result, there will be a smaller quantity of dollar assets

demanded at each exchange rate. Thus, they expect that in the future the demand

curve for dollar assets will shift to the left, as in Figure 15.5, and the dollar will depre-

ciate in the future. Because currency traders expect a lower future exchange rate for

the dollar, the expected appreciation of the dollar falls today. This lowers the

expected return for dollar assets relative to foreign assets now, which causes the

demand for dollar assets to decline and causes the current exchange rate to fall, as

in Figure 15.5.

The column also points out that the British pound appreciated because one mem-

ber of the Bank of England’s Monetary Policy Committee voted to raise interest rates.

Again this is what our analysis of the foreign exchange market predicts. The greater

likelihood of a rise in domestic (British) interest rates will lead traders to expect

the relative expected return for pound assets to be higher, thereby increasing the

quantity of pound assets demanded at each exchange rate, shifting the demand curve

to the right as in Figure 15.4, and causing the pound to appreciate in the future.

The higher expected future exchange rate for the pound raises the expected return

for pound assets, which causes the demand for pound assets to rise today and causes

the pound to appreciate as in Figure 15.4.

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