Learning Objectives

• Explain supply and demand for exchange rates
• Define arbitrage
• Explain purchasing power parity's importance when comparing countries.

Expectations About Future Exchange Rates

One reason to demand a currency in the foreign exchange market' is the belief that the value of the currency is about to increase. One reason to supply a currency, that is, sell it in the foreign exchange market, is the expectation that the value of the currency is about to decline. For example, imagine that a leading business newspaper, runs an article predicting that the Mexican peso will appreciate in value. The likely effects of such an article are illustrated in Figure 15.6. Demand for the Mexican peso shifts to the right, from D₀ to D₁, as investors become eager to purchase pesos. Conversely, the supply of pesos shifts to the left, from S₀ to S₁, because investors will be less willing to give them up. The result is that the equilibrium exchange rate rises from 10 to 12 cents per peso, and the equilibrium exchange rate rises from 85 to 90 billion pesos as the equilibrium shifts from E₀ to E₁.

Figure 15.6 Exchange Rate Market for Mexican Peso Reacts to Expectations About Future Exchange Rates An announcement that the peso exchange rate is likely to strengthen in the future will lead to greater demand for the peso in the present from investors who wish to benefit from the appreciation. Similarly, it will make investors less likely to supply pesos to the foreign exchange market. Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate.

Figure 15.6 also illustrates some peculiar traits of supply and demand diagrams in the foreign exchange market. In contrast to all the other cases of supply and demand you have considered, in the foreign exchange market, supply and demand typically both move at the same time. Groups of participants in the foreign exchange market like firms and investors, include some who are buyers and some who are sellers. An expectation of a future shift in the exchange rate affects both buyers and sellers, that is, it affects both demand and supply for a currency.

The shifts in demand and supply curves both cause the exchange rate to shift in the same direction; in this example, they both make the peso exchange rate stronger. However, the shifts in demand and supply curves work in opposing directions on the quantity traded. In this example, the rising demand for pesos is causing the quantity to rise whereas the falling supply of pesos is causing quantity to fall. In this specific example, the result is a higher quantity. But in other cases, the result could be that quantity remains unchanged or declines.

This example also helps to explain why exchange rates often move quite substantially in a short period of a few weeks or months. When investors expect a country’s currency to strengthen in the future, they buy the currency and cause it to appreciate immediately. The appreciation of the currency can lead other investors to believe that future appreciation is likely and thus lead to even further appreciation. Similarly, a fear that a currency might weaken quickly leads to an actual weakening of the currency, which often reinforces the belief that the currency is going to weaken further. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.

Differences Across Countries in Rates of Return

The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in the United States as compared with Mexico. Thus, financial investments in the United States promise a higher return than they previously did. As a result, more investors will demand U.S. dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply U.S. dollars to foreign exchange markets. As shown in Figure 15.7, demand for the U.S. dollar will shift to the right, from D₀ to D₁, and supply will shift to the left, from S₀ to S₁. The new equilibrium E₁, will occur at an exchange rate of nine pesos per dollar and the same quantity of $8.5 billion. Thus, a higher interest rate or rate of return relative to other countries leads a nation’s currency to appreciate or strengthen and a lower interest rate relative to other countries leads a nation’s currency to depreciate or weaken. Because a nation’s central bank can use monetary policy to affect its interest rates, a central bank can also cause changes in exchange rates—a connection that will be discussed in more detail later in this chapter.

Figure 15.7 Exchange Rate Market for U.S. Dollars Reacts to Higher Interest Rates A higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the demand for dollars in the foreign exchange market shifts to the right, from D₀ to D₁ while the supply of dollars shifts to the left, from S₀ to S₁. The new equilibrium (E₁) has a higher exchange rate than does the original equilibrium (E₀), but in this example, the equilibrium quantity traded does not change.

Relative Inflation

If a country experiences a relatively high inflation rate in comparison to other economies, then the buying power of its currency is eroding, which will tend to discourage anyone from wanting to acquire or to hold the currency. Figure 15.8 shows an example based on an actual episode concerning the Mexican peso. In 1986–1987, Mexico experienced an inflation rate of more than 200 percent. Not surprisingly, as inflation dramatically decreased the purchasing power of the peso in Mexico, the exchange rate value of the peso declined as well. As shown in Figure 15.8, demand for the peso in foreign exchange markets decreased from D₀ to D₁, and supply of the peso increased from S₀ to S₁. The equilibrium exchange rate fell from $2.50 per peso at the original equilibrium (E₀) to $0.50 per peso at the new equilibrium (E₁). In this example, the quantity of pesos traded in foreign exchange markets remained the same even as the exchange rate shifted.

Figure 15.8 Exchange Rate Markets React to Higher Inflation If a currency is experiencing relatively high inflation, then its buying power is decreasing and international investors will be less eager to hold it. Thus, a rise in inflation in the Mexican peso would lead demand to shift from D₀ to D₁, and supply to increase from S₀ to S₁. Both movements in demand and supply would cause the currency to depreciate. The effect on the quantity traded is drawn here as a decrease, but in truth it could be an increase or no change, depending on the actual movements of demand and supply.

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Purchasing Power Parity

Over the long term, exchange rates must bear some relationship to the buying power of the currency in terms of goods that are internationally traded. If at a certain exchange rate it was much cheaper to buy internationally traded goods—such as oil, steel, computers, and cars—in one country than in another country, businesses would start buying in the cheap country, selling in other countries, and pocketing the profits.

For example, if a U.S. dollar is worth $1.60 in Canadian currency, then a car that sells for $20,000 in the United States should sell for $32,000 in Canada. If the price of cars in Canada was much lower than $32,000, then at least some U.S. car buyers would convert their U.S. dollars to Canadian dollars and buy their cars in Canada. If the price of cars was much higher than $32,000 in this example, then at least some Canadian buyers would convert their Canadian dollars to U.S. dollars and go to the United States to purchase their cars. This is known as arbitrage, the process of buying and selling goods or currencies across international borders at a profit. It may occur slowly, but over time, it will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries.

The exchange rate that equalizes the prices of internationally traded goods across countries is called the purchasing power parity (PPP) exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries on the basis of, detailed studies of the prices and quantities of internationally tradable goods.

The PPP exchange rate has two functions. First, PPP exchange rates are often used for international comparison of GDP and other economic statistics. Imagine that you are preparing a table showing the size of GDP in many countries in several recent years and, for ease of comparison, you are converting all the values into U.S. dollars. When you insert the value for Japan, you need to use a yen/dollar exchange rate. But should you use the market exchange rate or the PPP exchange rate? Market exchange rates bounce around. In the summer of 2008, the exchange rate was 108 yen per dollar, but in late 2009 the U.S. dollar exchange rate versus the yen was 90 yen per dollar. For simplicity, let’s say that Japan’s GDP was ¥500 trillion in both 2008 and 2009. If you use the market exchange rates, then Japan’s GDP will be $4.6 trillion in 2008 [i.e., ¥500 trillion /(¥108/dollar)] and $5.5 trillion in 2009 [i.e., ¥500 trillion /(¥90/dollar)].

Of course, it is not true that Japan’s economy increased enormously in 2009; in fact, Japan had a recession like much of the rest of the world. The misleading appearance of a booming Japanese economy occurs only because we used the market exchange rate, which often has short-term rises and falls. However, PPP exchange rates stay fairly constant and change only modestly, if at all, from year to year.

The second function of the PPP exchange rate is that exchanges rates will often get closer and closer to it as time passes. It is true that in the short and medium term, as exchange rates adjust to relative inflation rates, rates of return, and expectations about how interest rates and inflation will shift, the exchange rates will often move away from the PPP exchange rate for a time. But knowing the PPP will allow you to track and predict exchange rate relationships.