Wall Street Journal; an example is presented here. It is
Source: The Wall Street Journal ”Dollar Drops Against Euro; Pound Advances” by Bradley Davis. Copyright 2010 by DOW JONES &
COMPANY, INC. Reproduced with permission of DOW JONES & COMPANY, INC. via Copyright Clearance Center.
Chapter 15 The Foreign Exchange Market
367
financial institutions or economic forecasting firms. In predicting exchange rate move-
ments, forecasters look at the factors mentioned in this chapter. For example, if they
expect domestic real interest rates to rise, they will predict, in line with our analy-
sis, that the domestic currency will appreciate; conversely, if they expect domestic
inflation to increase, they will predict that the domestic currency will depreciate.
Managers of financial institutions, particularly those engaged in international
banking, rely on foreign exchange forecasts to make decisions about which assets
denominated in foreign currencies they should hold. For example, if a financial insti-
tution manager has a reliable forecast that the euro will appreciate in the future but
the yen will depreciate, the manager will want to sell off assets denominated in yen
and instead purchase assets denominated in euros. Alternatively, the manager might
instruct loan officers to make more loans denominated in euros and fewer loans
denominated in yen. Likewise, if the yen is forecast to appreciate and the euro to
depreciate, the manager would want to switch out of euro-denominated assets into
yen-denominated assets and would want to make more loans in yen and fewer in euros.
If the financial institution has a foreign exchange trading operation, a forecast
of an appreciation of the yen means that the financial institution manager should
tell foreign exchange traders to buy yen. If the forecast turns out to be correct, the
higher value of the yen means that the trader can sell the yen in the future and pocket
a tidy profit. If the euro is forecast to depreciate, the trader can sell euros and buy
them back in the future at a lower price if the forecast turns out to be correct, and
again the financial institution will make a profit.
Accurate foreign exchange rate forecasts can thus help a financial institution
manager generate substantial profits for the institution. Unfortunately, exchange rate
forecasters are no more or less accurate than other economic forecasters, and they
often make large errors. Reports on foreign exchange rate forecasts and how well
forecasters are doing appear from time to time in the Wall Street Journal and in
the trade magazine Euromoney.
S U M M A R Y
1. Foreign exchange rates (the price of one country’s
currency in terms of another’s) are important because
they affect the price of domestically produced goods
sold abroad and the cost of foreign goods bought
domestically.
2. The theory of purchasing power parity suggests that
long-run changes in the exchange rate between two
countries’ currencies are determined by changes in
the relative price levels in the two countries. Other
factors that affect exchange rates in the long run are
tariffs and quotas, import demand, export demand,
and productivity.
3. In the short run, exchange rates are determined by
changes in the relative expected return on domestic
assets, which cause the demand curve to shift. Any
factor that changes the relative expected return on
domestic assets will lead to changes in the exchange
rate. Such factors include changes in the interest rates
on domestic and foreign assets as well as changes in
any of the factors that affect the long-run exchange
rate and hence the expected future exchange rate.
4. The asset market approach to exchange rate deter-
mination can explain both the volatility of exchange
rates and the rise of the dollar in the 1980–1984
period and its subsequent fall.
5. Forecasts of foreign exchange rates are very valu-
able to managers of financial institutions because
these rates influence decisions about which assets
denominated in foreign currencies the institutions
should hold and what kinds of trades should be made
by their traders in the foreign exchange market.
368
Part 5 Financial Markets
K E Y T E R M S
appreciation, p. 346
capital mobility, p. 372
depreciation, p. 346
effective exchange rate index, p. 362
exchange rate, p. 344
foreign exchange market, p. 344
forward exchange rate, p. 346
forward transactions, p. 346
interest parity condition, p. 372
law of one price, p. 348
quotas, p. 351
real exchange rate, p. 349
spot exchange rate, p. 346
spot transactions, p. 346
tariffs, p. 351
theory of purchasing power parity
(PPP), p. 349
Q U E S T I O N S
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