18 The Foreign Exchange

Market
Learning Objectives
18.1 Explain how Preview
O
the foreign exchange n June 23, 2016, the United Kingdom voted to leave the European Union. This
market works and why decision is referred to as Brexit (Britian Exit). Within a day the British pound
exchange rates are fell in value by 9% relative to the U.S. dollar.
important. The price of one currency in terms of another is called the exchange rate. As the
18.2 Identify the Brexit example suggests, exchange rates are highly volatile. The exchange rate affects
main factors that affect the economy and our daily lives because when the domestic currency becomes more
exchange rates in the valuable relative to foreign currencies, as the U.S. dollar did relative to the British
long run. pound after Brexit, foreign goods become cheaper for us, and domestic goods become
18.3 Draw the demand more expensive for foreigners. When our domestic currency falls in value, foreign
and supply curves for goods become more expensive for us, and our goods become cheaper for foreigners.
the foreign exchange Fluctuations in the exchange rate also affect both inflation and output and are an
market and interpret the important concern to monetary policymakers. When the domestic currency falls in
equilibrium in the value, the higher prices of imported goods feed directly into a higher price level and
market for foreign inflation. At the same time, a declining domestic currency, which makes domestic
exchange. goods cheaper for foreigners, increases the demand for domestic goods and leads to
18.4 List and illustrate higher production and output.
the factors that affect How are currencies traded? What drives fluctuations in exchange rates? Why are
the exchange rate in the exchange rates so volatile? We answer these questions by first examining the financial mar-
short run. ket in which currencies are traded. Next, we look at what affects exchange rates in the long
run. We then develop a supply and demand analysis to explain what determines exchange
rates in the short run. Finally, we use this supply and demand analysis to explain fluctua-
tions in the exchange rate resulting from events such as Brexit and the global financial crisis.

18.1 FOREIGN EXCHANGE MARKET

LO 18.1 Explain how the foreign exchange market works and why exchange rates are
important.

Most countries of the world have their own currencies: The United States has its
dollar; the European Monetary Union, its euro; Brazil, its real; and China, its yuan.
Trade between countries involves the mutual exchange of different currencies (or, more
typically, bank deposits denominated in different currencies). When an American firm
buys foreign goods, services, or financial assets, for example, U.S. dollars (typically,
bank deposits denominated in U.S. dollars) must be exchanged for foreign currency
(bank deposits denominated in the foreign currency).
468

M18B_MISH9481_13_GE_C18.indd 468 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 469

Following the Financial News Foreign Exchange Rates

Foreign exchange rates are published daily in news- ¥7.97 per euro. The first quote may be of more use
papers and on Internet sites such as [Link] to Chinese investors desirous to invest in Euro-area
.[Link]/data/currencies/. Exchange rates for a cur- countries or financial instruments; the second quote
rency are quoted in two ways: as the number of for- may be used, instead, by European investors seeking
eign currency units per unit of domestic currency, or to make investment in China.
as the number of domestic currency units per unit These quotes refer to the spot exchange rate, cor-
of foreign currency. Let’s consider the Chinese yuan responding to spot transactions. For transactions
as the domestic currency and the euro as the foreign taking place in the future (forward transactions), the
currency. On September 30, 2020, the yuan-euro forward exchange rate will be needed.
exchange rate was quoted as €0.12 per yuan or as

The trading of currencies and bank deposits denominated in particular currencies

takes place in the foreign exchange market. Transactions conducted in the foreign
exchange market determine the rates at which currencies are exchanged, which in turn
determine the cost of purchasing foreign goods and financial assets.

What Are Foreign Exchange Rates?

An exchange rate is the price of one currency in terms of another. There are two
kinds of exchange rate transactions. The predominant ones, called spot transactions,
involve the immediate (two-day) exchange of bank deposits. Forward transactions
involve the exchange of bank deposits at some specified future date. The spot exchange
rate is the exchange rate for the spot transaction, and the forward exchange rate is
the exchange rate for the forward transaction.
When a currency increases in value, it experiences appreciation; when it falls
in value, it undergoes depreciation. For example, on January 1, 1999, the euro was
worth 1.15 U.S. dollars (the dollar was worth €0.87); on September 30, 2020, the
euro was worth 1.17 U.S. dollars (the dollar was worth €0.85). Thus, over these 21
years, the euro slightly appreciated (against the dollar), while the dollar slightly
depreciated (against the euro). Note that the exchange rate underwent larger swings
between these two dates, reaching a low of 0.87 dollars per euro in October 2000,
and a high of 1.59 in July 2008. The rate of appreciation/depreciation is quite
easy to calculate: The rate of depreciation of the euro between 1999 and 2020 is:
11.17 - 1.152 >1.15 = - 0.017 or - 1.7%.

Why Are Exchange Rates Important?

Exchange rates are important because they affect the relative prices of domestic and for-
eign goods. The yen price of French goods to a Japanese is determined by the interac-
tion of two factors: the price of French goods in euros and the euro/yen exchange rate.
Suppose that Akari, a Japanese wine importer, decides to buy a bottle of 1961 (a
very good year) Château Lafite Rothschild to satisfy the needs of her Japanese customers.
If the price of one bottle of 1961 Château Lafite in France is €1,000 and the exchange

M18B_MISH9481_13_GE_C18.indd 469 01/07/2021 17:11

 470 PART 5 International Finance and Monetary Policy

rate is ¥124 to the euro, the wine will cost Akari ¥24,000 1 = €1,000 * ¥1242. Now
suppose that Akari delays her purchase by two months, at which time the euro has
appreciated (and, therefore, the yen has depreciated), reaching ¥150 to the euro. If the
domestic price of the bottle of Lafite Rothschild remains €1,000, its cost in yen will
increase to ¥150,000.
The same currency appreciation, however, makes foreign goods in France
less expensive. At an exchange rate of ¥124 per euro, a Yamaha motorbike price at
¥1,500,000 in Japan will cost Pierre, a French motorbike enthusiast, €12,096. If the
exchange rate increases to ¥150, the price paid for the Japanese motorbike by the
French consumer will decrease to €10,000.
Such reasoning leads to the following conclusion: When a country’s currency
appreciates (rises in value relative to other currencies), the country’s goods abroad
become more expensive, and foreign goods in that country become cheaper (holding
domestic prices constant in the two countries). Conversely, when a country’s currency
depreciates, its goods abroad become cheaper, and foreign goods in that country
become more expensive.
Depreciation of a currency makes it easier for domestic manufacturers to sell their
goods abroad and makes foreign goods less competitive in domestic markets. The
depreciation of the U.S. dollar from 2018 to 2020 helped U.S. industries sell more
goods, but it hurt American consumers because foreign goods were more expensive.
The prices of foreign goods such as French cheese and the cost of vacationing abroad
all rose as a result of the weak dollar.
In contrast, the appreciation of the U.S. dollar from 2016 to 2018 made goods and
services produced in the United States less competitive. However, the stronger dollar
was positive for American consumers because foreign goods like French cheese and
vacationing abroad were less expensive.

How Is Foreign Exchange Traded?

You cannot go to a centralized location to watch exchange rates being determined;
currencies are not traded on exchanges such as the New York Stock Exchange. Instead,
the foreign exchange market is organized as an over-the-counter market in which sev-
eral hundred dealers (mostly banks) stand ready to buy and sell deposits denominated in
foreign currencies. Because these dealers are in constant telephone and computer contact,
the market is very competitive; in effect, it functions no differently from a centralized market.
An important point to note is that although banks, companies, and governments
talk about buying and selling currencies in foreign exchange markets, they do not take
a fistful of dollar bills and sell them for British pound notes. Rather, most trades involve
the buying and selling of bank deposits denominated in different currencies. So when
we say that a bank is buying dollars in the foreign exchange market, what we actually
mean is that the bank is buying deposits denominated in dollars. The volume in this mar-
ket is colossal, exceeding $6 trillion per day.
Trades in the foreign exchange market consist of transactions in excess of $1 mil-
lion. The market that determines the exchange rates given in the Following the Finan-
cial News box is not the market in which we would buy foreign currency for a trip
abroad. Instead, we buy foreign currency in the retail market, from dealers such as
American Express or from banks. Because retail prices are higher than wholesale prices,
when we buy foreign exchange, we obtain fewer units of foreign currency per dollar—
that is, we pay a higher price for foreign currency—than the exchange rates quoted in
the newspaper.

M18B_MISH9481_13_GE_C18.indd 470 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 471

18.2 EXCHANGE RATES IN THE LONG RUN

LO 18.2 Identify the main factors that affect exchange rates in the long run.

Like the price of any good or asset in a free market, exchange rates are determined by
the interaction of supply and demand. To simplify our analysis of exchange rates in
a free market, we divide it into two parts. First, we examine how exchange rates are
determined in the long run; then we use our knowledge of the long-run determinants
of exchange rates to help us understand how they are determined in the short run.

Theory of Purchasing Power Parity

One of the most prominent theories of how exchange rates are determined is the the-
ory of purchasing power parity (PPP). It states that the exchange rate between any
two countries’ currencies is such that a basket of goods and services, wherever it is pro-
duced, costs the same in both countries.
Suppose that you are an Indian consumer, purchasing a basket of goods and ser-
vices in India that costs ₹100,000 (the symbol for the Indian rupee is ₹). The same bas-
ket of goods costs £1,000 in Great Britain. The theory of purchasing power parity says
that the exchange rate between the rupee and the pound is therefore £0.01 per rupee.
At this exchange rate, the basket of goods and services in India would cost £1,000
1 = ₹100,000 * £0.01 per rupee2, the same cost as in Great Britain. Similarly, the bas-
ket of goods and services would cost ₹100,000 in Great Britain 1 = £1,000 * ₹10 per
pound2 the same as in India.
What is the intuition behind purchasing power parity? Suppose the basket of goods
in Great Britain were shipped to India and there were no transportation costs or barri-
ers to trade. It would sell for the same rupee amount in India as it does in Great Britain.
Similarly, if the Indian basket of goods were shipped to Great Britain, it would cost the
same amount in pounds. Only an exchange rate of £0.01 per rupee ensures that the
prices are consistent across the two countries.
Another way of thinking about purchasing power parity is through a concept called
the real exchange rate, the rate at which domestic goods can be exchanged for foreign
goods. In effect, the real exchange rate is the price of domestic goods relative to the price of
foreign goods denominated in the domestic currency. For example, if a basket of goods in
Mumbai costs ₹50,000 while the same basket of goods in London costs ₹75,000 (because
the basket of goods costs £750 and the exchange rate is £0.01 per rupee), then the real
exchange rate is 0.66 1 = ₹50,000>₹75,0002. In our example, the real exchange rate is
below 1.0, indicating that it is cheaper to buy the basket of goods in India than in Great
Britain. The real exchange rate for the U.S. dollar is currently low against many other cur-
rencies, and this is why New York is overwhelmed by so many foreign tourists going on
shopping sprees. The real exchange rate indicates whether a currency is relatively cheap or
not. The theory of PPP can also be described in terms of the real exchange rate. PPP pre-
dicts that in the long run the real exchange rate is always equal to 1.0, so that the purchas-
ing power of the dollar is the same as that of other currencies, such as the yen or the euro.
What happens if one country’s price level changes relative to another’s? For exam-
ple, suppose that the price level in Great Britain rises by 10%, while the price level in
India does not change. As a result, the price of the basket in Great Britain has risen by
10% relative to the Indian price. Now the cost of the basket of goods and services in
Great Britain would rise by 10% to £1,100, while the price of the same basket in India
would remain ₹100,000. For the Indian and Great Britainian baskets of goods to cost

M18B_MISH9481_13_GE_C18.indd 471 01/07/2021 17:11

 472 PART 5 International Finance and Monetary Policy

Real-time data

Index
250
Relative Price
Levels (CPIUK /CPIUS)
200

150

Exchange Rate (£/ $)

100

1973 1983 1993 2003 2013 2023

FIGURE 1 Purchasing Power Parity, United States/United Kingdom, 1973–2020

(Index: March 1973 = 100.)
Over the whole period shown, the rise in the British price level relative to the U.S. price level is associated
with a rise in the value of the dollar, as predicted by PPP. However, the PPP relationship does not hold
over shorter periods.
Source: Federal Reserve Bank of St. Louis FRED database: [Link] [Link]
[Link]/series/CPIAUCNS; [Link]

the same, the exchange rate would have to change to £0.011 per rupee. Then the Indian
basket would cost £1,100 in Great Britain 1₹100,000 * £0.011 per rupee2 and the
British basket would cost ₹100,000 in India 1£1,100 pounds * ₹9.09 per pounds2.
Thus, according to the theory of PPP, if the price level in Great Britain rises 10% relative
to the Indian price level, the dollar appreciates by 10%.
Our India/Great Britain example demonstrates the key insight of the theory of PPP:
If one country’s price level rises relative to another’s by a certain percentage, then the
other country’s currency appreciates by the same percentage. Because one currency’s
appreciation is the other currency’s depreciation, there is an equivalent way of stating
this result: If a country’s price level rises relative to another’s by a certain percentage,
then its currency should depreciate by the same percentage.

Evidence on Purchasing Power Parity As our India/Great Britain example

demonstrates, the theory of PPP suggests that if one country’s price level rises relative
to another’s, its currency should depreciate (and the other country’s currency should
appreciate). As you can see in Figure 1, this prediction is borne out in the long run.
From 1973 to 2020, the British price level rose 75% relative to the U.S. price level, and
as the theory of PPP predicts, the dollar appreciated against the pound—by 95%, an
amount larger than the 75% increase predicted by PPP.
Yet, as the same figure indicates, PPP theory does a poor job of predicting
change in the exchange rate in the short run. From early 1985 to the end of 1987,
for example, the British price level rose relative to that of the United States. Instead
of appreciating, as predicted by PPP theory, the U.S. dollar actually depreciated by

M18B_MISH9481_13_GE_C18.indd 472 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 473

40% against the pound. So even though PPP theory provides some guidance as to
the long-run movement of exchange rates, it does not hold particularly well in the
short run.
What explains the PPP theory’s failure to predict well in the short run?

Why the Theory of Purchasing Power Parity Cannot Fully Explain

Exchange Rates There are three reasons why the theory of PPP does not fully
explain exchange rates in the short run.
1. PPP theory does not take into account that many goods and services (whose prices
are included in a measure of a country’s price level) are nontradable; that is, they
are not traded across borders. Housing, land, and services such as restaurant meals,
haircuts, and golf lessons are not traded goods. So even though the prices of these
items might rise, leading to a higher price level relative to another country’s, the
exchange rate would experience little direct effect.
2. Similar goods typically are not identical in both countries. For example, Japanese
Yamaha motorbikes are not the same as Italian Ducati motorbikes, and so their prices
do not have to be equal in one country. Yamahas can be more expensive relative to
Ducatis, and both Italians and Japanese will still purchase Yamahas. Furthermore a
rise in the price of Yamahas relative to Ducatis will not necessarily mean that the yen
must depreciate by the amount of the relative price increase of Yamahas over Ducatis.
3. There are barriers to trade. One barrier to trade is transportation costs, but these
costs have been declining dramatically over time. More important in today’s world
are government-imposed barriers to trade, such as tariffs, taxes on imported
goods, and quotas, restrictions on the quantity of goods that can be imported.
Imposition of a tariff or quota on an imported good can substantially raise its price
relative to the price it would have elsewhere. For example, the U.S. government
has recently imposed very high tariffs on a broad range of imported goods, includ-
ing steel and aluminum; as a result, the domestic price of those goods has risen
in the United States relative to that in other parts of the world --in particular, it is
estimated that following the imposition of such tariffs in 2018, the price of steel in
the United States was 50% higher than that in Europe. Similarly, countries such as
China have imposed tariffs on goods imported from the United States, such as pork
and soybean, making the price of soybean in China higher than in other countries.

A P P L I C AT I O N Burgernomics: Big Macs and PPP

Since 1986, The Economist magazine has published the Big Mac index as a “lighthearted
guide to whether currencies are at their ‘correct’ level based on the theory of purchasing
power parity.” Big Macs are sold by McDonald’s all around the world and are supposed
to taste the same wherever they are sold. The Economist collects prices (in the local cur-
rency) of Big Macs sold in more than 50 different regions and countries. It then uses
these prices to calculate both the exchange rate implied by PPP and the Big Mac index.
Table 1 reproduces a portion of The Economist’s Big Mac numbers originally published
in July 2020.
• Column (2) of Table 1 lists the local price of a Big Mac denominated in local
currency.
• Column (3) lists the actual exchange rate.

M18B_MISH9481_13_GE_C18.indd 473 01/07/2021 17:11

 474 PART 5 International Finance and Monetary Policy

TABLE 1 Big Mac Index, July 2020

(5)
(3) (4) Big Mac Index
Actual Exchange Exchange Rate (Percent difference
Rate Implied by PPP between actual
(2) (U.S. dollars (U.S. dollars exchange rate
(1) Local Price per unit of local per unit of local and implied PPP
Country of Big Mac currency) currency) exchange rate)
Canada 6.88 Canadian dollars 0.74 0.83 - 11.10%
China 21.70 yuan 0.14 0.26 - 45.70%
Euro area 4.31 euro 1.14 1.35 - 16.20%
Japan 390 yen 0.01 0.01 - 36.30%
United Kingdom 3.39 pounds sterling 1.27 1.69 - 25.10%
Switzerland 6.50 Swiss francs 1.06 0.88 - 20.90%

Source: The Economist, July 15, 2020: [Link]

• Column (4) provides the implied exchange rate if there is purchasing power parity
(that is, if the local price of the Big Mac when converted to dollars equals the dollar
price of the Big Mac in the United States, which was $5.71 at the time).
• Column (5) lists the Big Mac index, the percent difference between the actual and
implied exchange rates.
What conclusions can we draw from Table 1?

PPP Does Not Hold Exactly, But It Has Predictive Power Although the
Big Mac prices indicate that PPP does not hold exactly, PPP does help predict exchange
rates for the countries shown. According to PPP, when the Big Mac has a high price in
terms of local currency, then the exchange rate quoted in U.S. dollars per unit of local
currency should be low.
We see this relationship in the second and fourth columns of the table. Japan has
the highest Big Mac price in terms of the local currency (¥390), and it has the lowest
exchange rate, $0.0091 per yen. The United Kingdom has the lowest Big Mac price in
terms of the local currency (£3.39), and it has the highest exchange rate, $1.69 per
pound sterling.

Departures from PPP: Overvaluations and Undervaluations The

exchange rate implied by PPP often departs substantially from the actual exchange rate.
This should not be surprising given that Big Macs are nontradable. Think about bringing
a Big Mac from China to the United States. By the time you got it to the United States,
it would be disgusting and might even give you food poisoning. The Big Mac index tells
us how big the discrepancy is between the actual exchange rate and the exchange rate
implied by PPP.

M18B_MISH9481_13_GE_C18.indd 474 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 475

For example, the Big Mac index tells us that Switzerland has an actual exchange
rate that is 20.9% higher than the exchange rate implied by PPP. The price of a Big
Mac in Switzerland when converted into U.S. dollars using the actual exchange rate is
$7.86, which is 20.9% higher than the $5.71 paid to acquire the same product in the
United States.
When a country’s goods and services are expensive relative to other countries’, we
say that its currency is overvalued in terms of purchasing power parity.
In the sample of countries listed in Table 1, China has the largest percentage dif-
ference between the actual dollar/yuan exchange rate and the rate implied by PPP.
Indeed, the Big Mac index indicates that the actual exchange rate is 45.7% lower than
the exchange rate implied by PPP. A U.S. customer willing to fly to China to eat a Big
Mac could get one for the price of $2.61.
When a country’s goods and services are cheap relative to other countries’, as in
the case of China according to the Big Mac Index, we say that its currency (the yuan/
remninbi) is undervalued in terms of purchasing power parity. ◆

Factors That Affect Exchange Rates in the Long Run

In the long run, four major factors affect the exchange rate: relative price levels, trade
barriers, preferences for domestic versus foreign goods, and productivity. We exam-
ine how each of these factors affects the exchange rate while holding the other factors
constant.
The basic reasoning proceeds along the following lines: Anything that increases
the demand for domestically produced goods that are traded relative to foreign traded
goods tends to appreciate the domestic currency, because domestic goods will con-
tinue to sell well even when the value of the domestic currency is higher. Similarly,
anything that increases the demand for foreign goods relative to domestic goods tends
to depreciate the domestic currency, because domestic goods will continue to sell well
only if the value of the domestic currency is lower. In other words, if a factor increases
the demand for domestic goods relative to foreign goods, the domestic currency will
appreciate; if a factor decreases the relative demand for domestic goods, the domestic
currency will depreciate.

Relative Price Levels In line with PPP theory, when prices of domestic goods rise
(holding prices of foreign goods constant), the demand for domestic goods falls, and the
domestic currency tends to depreciate so that domestic goods can still sell well. By con-
trast, if prices of foreign goods rise, causing the relative prices of domestic goods to fall,
the demand for domestic goods increases, and the dollar tends to appreciate because
domestic goods will continue to sell well even with a higher value of the domestic
currency. In the long run, a rise in a country’s price level (relative to the foreign price
level) causes its currency to depreciate, and a fall in the country’s relative price level
causes its currency to appreciate.

Trade Barriers Barriers to free trade such as tariffs and quotas can affect the
exchange rate. Suppose India increases its tariff or puts a lower quota on British
machinery. These increases in trade barriers increase the demand for Indian machinery,
and the rupee tends to appreciate because Indian machinery will still sell well even

M18B_MISH9481_13_GE_C18.indd 475 01/07/2021 17:11

 476 PART 5 International Finance and Monetary Policy

SUMMARY TABLE 2
Factors That Affect Exchange Rates in the Long Run
Factor Change in Factor Response of the Exchange Rate, E*
Domestic price level† c T
Trade barriers† c c
Import demand c T
Export demand c c
Productivity† c c
*
Units of foreign currency per dollar: c indicates domestic currency appreciation; T, depreciation.
†
Relative to other countries.

Note: Only increases (c) in the factors are shown; the effects of decreases in the variables on the exchange rate are the opposite of those
indicated in the “Response” column.

with a higher value of the rupee with respect to the pound. Increasing trade barriers
causes a country’s currency to appreciate in the long run.

Preferences for Domestic Versus Foreign Goods If the British develop an

appetite for Indian goods—say Indian spices and garments—the increased demand for
Indian goods (exports, if we hold India as the domestic currency) tends to appreciate
the rupee because the Indian goods will continue to sell well even at a higher value of
the rupee. Likewise, if Indian consumers decide that they prefer British wool to the
Indian counterpart, the increased demand for British (imported) goods will depreciate
the rupee. Increased demand for a country’s exports causes its currency to appreciate
in the long run; conversely, increased demand for imports causes the domestic cur-
rency to depreciate.

Productivity When productivity in a country rises, it tends to rise in domestic

sectors that produce traded goods rather than nontraded goods. Higher productiv-
ity, therefore, is associated with a decline in the price of domestically produced traded
goods relative to foreign traded goods. As a result, the demand for domestic traded
goods rises, and the domestic currency tends to appreciate. If, however, a country’s
productivity lags behind that of other countries, its traded goods become relatively
more expensive, and the currency tends to depreciate. In the long run, as a country
becomes more productive relative to other countries, its currency appreciates.1
Our long-run theory of exchange rate behavior is summarized in Summary Table 2.
We use the convention that the exchange rate E is quoted such that an appreciation of
the domestic currency corresponds to a rise in the exchange rate. In the case of India,
for instance, this means that we are quoting the exchange rate as units of foreign cur-
rency, say, pound sterling, per rupee.2

1
A country might be so small that a change in productivity or the preferences for domestic or foreign goods
will have no effect on the 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 do not necessarily affect the
value of the currency. In our analysis, we are assuming that changes in productivity or preferences can affect rela-
tive prices and consequently the exchange rate.

M18B_MISH9481_13_GE_C18.indd 476 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 477

18.3 EXCHANGE RATES IN THE SHORT RUN:

A SUPPLY AND DEMAND ANALYSIS
LO 18.3 Draw the demand and supply curves for the foreign exchange market and
interpret the equilibrium in the market for foreign exchange.

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 percentage
points) from day to day, we must develop a supply and demand analysis that explains
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 recognize
that an exchange rate is the price of domestic assets (bank deposits, bonds, equities,
and so on, denominated in the domestic currency) in terms of foreign assets (similar
assets denominated in the foreign currency). Because the exchange rate is the price of
one asset in terms of another, the natural way to investigate the short-run determina-
tion of exchange rates is with a supply and demand analysis that uses an asset market
approach, which relies heavily on the theory of portfolio choice developed in Chapter 5.
As you will see, however, the long-run determinants of the exchange rate we have just
outlined also play an important part in the short-run asset market approach.
In the past, supply and demand approaches to exchange rate determination empha-
sized the role of import and export demand. The more modern asset market approach
used here emphasizes stocks of assets rather than the flows of exports and imports over
short periods because export and import transactions are small relative to the amounts
of domestic and foreign assets held at any given time. In many countries, the total value
of foreign transactions in any given year significantly exceeds the annual amount of
exports and imports. According to the most recent data released by the Bank for Inter-
national Settlements, in April 2019 the world’s total daily average of foreign exchange
transactions amounted to 6,595 billion U.S. dollars - even when focusing on spot trans-
actions only (thus excluding the massive amounts of derivative foreign exchanges), the
number (1,987 billion dollars), once multiplied by the number of trading days, is still
much greater than the annual value of the world’s total imports and exports (19,500
billion dollars in 2019 according to the United Nations).

Supply Curve for Domestic Assets

We start by discussing the supply curve. In this analysis we treat India as the home coun-
try, so domestic assets are denominated in rupees. For simplicity, we use pound sterling
to stand for any foreign country’s currency, so foreign assets are denominated in pound
sterling.
The quantity of rupee assets supplied is primarily the quantity of bank deposits,
bonds, and equities in India, and for all practical purposes we can take this amount as
fixed with respect to the exchange rate. The quantity supplied at any exchange rate is
the same, so the supply curve, S, is vertical, as shown in Figure 2.

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 domes-
tic 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 this text because it is more intuitive to think of an appreciation
of the domestic currency as a rise in the exchange rate.

M18B_MISH9481_13_GE_C18.indd 477 01/07/2021 17:11

 478 PART 5 International Finance and Monetary Policy

Mini-lecture

FIGURE 2
Exchange Rate, Et S
Equilibrium in the
(£/ )
Foreign Exchange
Market A Excess supply at EA
Equilibrium in the EA causes the value of
the rupee to fall.
foreign exchange
market occurs at
point B, the intersec-
tion of the demand B
E*
curve D and the
supply curve S at an
Excess demand
exchange rate of E*. at EC causes the
value of the
C
Ec rupee to rise.

Quantity of Rupee Assets

Demand Curve for Domestic Assets

The demand curve traces out the quantity of domestic (rupee) assets demanded at each
current exchange rate by holding everything else constant, particularly the expected
future value of the exchange rate. We write the current exchange rate (the spot exchange
rate) as Et and the expected exchange rate for the next period as E et + 1. As suggested
by the theory of portfolio choice, the most important determinant of the quantity of
domestic (rupee) assets demanded is the relative expected return on domestic assets.
Let’s see what happens as the current exchange rate Et falls.
Suppose we start at point A in Figure 2, where the current exchange rate is at EA. With
the future expected value of the exchange rate held constant at E et + 1, a lower value of the
current exchange rate—say, at E*—implies that the rupee is more likely to rise in value,
that is, appreciate. The greater the expected rise (appreciation) of the rupee, the higher is
the relative expected return on rupee (domestic) assets. According to the theory of port-
folio choice, because rupee assets are now more desirable to hold, the quantity of rupee
assets demanded will rise, as shown by point B in Figure 2. If the current exchange rate
falls even further to EC, there will be an even higher expected appreciation of the rupee, a
higher expected return, and therefore an even greater quantity of rupee assets demanded.
This effect is shown at point C at Figure 2. The resulting demand curve D, which connects
these points, is downward-sloping, indicating that at lower current values of the rupee
(everything else being equal), the quantity demanded of rupee assets is higher.
A numerical example may make this clearer. Suppose that the future expected
value of the rupee, E et + 1, is £0.02 per rupee, and EA is £0.015 per rupee, E* is £0.01
per rupee and EC is £0.005 per rupee. At EA where the actual exchange rate is £0.015
per rupee, the expected appreciation of the rupee is 33% (= (0.02 - 0.015)>0.015
= 0.33 = 33%). When the exchange rate drops to E* of £0.01 per rupee, the expected
appreciation is now a larger 10% (= (0.02 - 0.01)>0.01 = 1 = 100%), and so the
quantity of rupee assets demanded is higher. When the exchange rate declines even fur-
ther to EC of £0.005 per rupee, the expected appreciation of the rupee rises further to

M18B_MISH9481_13_GE_C18.indd 478 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 479

300% (= (0.02 - 0.005)>0.005 = 3 = 300%) and so the quantity demanded of rupee

assets is even higher.

Equilibrium in the Foreign Exchange Market

As in the usual supply and demand analysis, the market is in equilibrium when the
quantity of rupee assets demanded equals the quantity supplied. In Figure 2, equilib-
rium occurs at point B, the intersection of the demand and supply curves. At point B,
the exchange rate is E*.
Suppose the exchange rate is at EA, which is higher than the equilibrium exchange
rate of E*. As we can see in Figure 2, the quantity of rupee assets supplied is now
greater than the quantity demanded, a condition of excess supply. Given that more
people want to sell rupee assets than want to buy them, the value of the rupee will fall.
As long as the exchange rate remains above the equilibrium exchange rate, an excess
supply of rupee assets will continue to be available, and the rupee will fall in value until
it reaches the equilibrium exchange rate of E*.
Similarly, if the exchange rate is less than the equilibrium exchange rate at EC,
the quantity of rupee assets demanded will exceed the quantity supplied, a condition
of excess demand. Given that more people want to buy rupee assets than want to sell
them, the value of the rupee will rise until the excess demand disappears and the value
of the rupee is again at the equilibrium exchange rate of E*.

18.4 EXPLAINING CHANGES IN EXCHANGE RATES

LO 18.4 List and illustrate the factors that affect the exchange rate in the short run.

The supply and demand analysis of the foreign exchange market illustrates how and
why exchange rates change.3 We have simplified this analysis by assuming that the
amount of dollar assets is fixed: The supply curve is vertical at a given quantity and
does not shift. Under this assumption, we need to look at only those factors that shift
the demand curve for dollar assets to explain how exchange rates change over time.

Shifts in the Demand for Domestic Assets

As we have seen, the quantity of domestic (dollar) assets demanded depends on the
relative expected return on dollar assets. To see how the demand curve shifts, we need
to determine how the quantity demanded changes, holding the current exchange rate,
Et, constant, when other factors change.
For insight into the direction in which the demand curve will shift, suppose you
are an investor who is considering putting funds into domestic (dollar) assets. When a
factor changes, you must decide whether, at a given level of the current exchange rate
and holding all other variables constant, you would earn a higher or lower expected
return on dollar assets versus foreign assets. This decision will tell you whether you
want to hold more or fewer dollar assets and thus whether the quantity demanded will
increase or decrease at each level of the exchange rate. The direction of the change in

3
How and why exchange rates change can also be modeled using the interest parity condition, an important concept
in international finance that shows the relationships among domestic interest rates, foreign interest rates, and the
expected appreciation of domestic currency. The interest parity condition and how it explains the determination of
exchange rates is discussed in an appendix to this chapter found in MyLab Economics.

M18B_MISH9481_13_GE_C18.indd 479 01/07/2021 17:11

 480 PART 5 International Finance and Monetary Policy

Mini-lecture

FIGURE 3
Exchange Rate, Et S
Response to an (£/ )
Increase in the
Domestic Interest Step 2. leading
to a rise in the
Rate, iD 2 exchange rate.
When the domes- E2
tic interest rate iD
increases, the relative Step 1. A rise in the
expected return on domestic interest rate
domestic (rupee) 1 shifts the demand
E1
curve to the right . . .
assets increases and
the demand curve
shifts to the right.
The equilibrium
exchange rate rises
from E1 to E2.
D1 D2

Quantity of Rupee Assets

the quantity demanded at each exchange rate indicates which way the demand curve
will shift. In other words, if the relative expected return on dollar assets rises, holding
the current exchange rate constant, the demand curve will shift to the right. If the rela-
tive expected return falls, the demand curve will shift to the left.

Domestic Interest Rate, iD Suppose that dollar assets pay an interest rate of iD.
When the domestic interest rate on dollar assets iD rises, holding the current exchange
rate Et and everything else constant, the return on dollar assets increases relative to the
return on foreign assets, and so people will want to hold more dollar assets. The quan-
tity of dollar assets demanded increases at every value of the exchange rate, as shown by
the rightward shift of the demand curve from D1 to D2 in Figure 3. The new equilibrium
is reached at point 2, the intersection of D2 and S, and the equilibrium exchange rate
rises from E1 to E2. An increase in the domestic interest rate iD shifts the demand curve
for domestic assets D to the right and causes the domestic currency to appreciate (E c ).
Conversely, if iD falls, the relative expected return on dollar assets falls, the demand
curve shifts to the left, and the exchange rate falls. A decrease in the domestic interest
rate iD shifts the demand curve for domestic assets D to the left and causes the domes-
tic currency to depreciate (ET ).

Foreign Interest Rate, iF Suppose foreign assets pay an interest rate of iF. When
the foreign interest rate iF rises, holding the current exchange rate and everything else
constant, the return on foreign assets rises relative to the return on dollar assets. Thus
the relative expected return on dollar assets falls. Now people want to hold fewer dollar
assets, and the quantity demanded decreases at every value of the exchange rate. This
scenario is shown by the leftward shift of the demand curve from D1 to D2 in Figure 4.
The new equilibrium is reached at point 2, when the value of the dollar has fallen. Con-
versely, a decrease in iF raises the relative expected return on dollar assets, shifts the
demand curve to the right, and raises the exchange rate. To summarize, an increase in

M18B_MISH9481_13_GE_C18.indd 480 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 481

Mini-lecture

FIGURE 4
Step 1. A rise in the
Response to an foreign interest rate
Increase in the Exchange Rate, Et shifts the demand S
Foreign Interest (£/ ) curve to the left . . .
Rate, iF
When the foreign
interest rate iF
increases, the rela-
tive expected return 1
E1
on domestic (rupee)
assets falls and the
demand curve shifts
to the left. The equi- 2
librium exchange rate E2
falls from E1 to E2. Step 2. leading
to a fall in the
exchange rate. D2 D1

Quantity of Rupee Assets

the foreign interest rate iF shifts the demand curve D to the left and causes the domes-
tic currency to depreciate; a fall in the foreign interest rate iF shifts the demand curve
D to the right and causes the domestic currency to appreciate.

Changes in the Expected Future Exchange Rate, E et + 1 Expectations about

the future value of the exchange rate play an important role in shifting the current
demand curve because the demand for domestic assets, like that for any physical or
financial asset, depends on the future resale price. Given the current exchange rate
Et, any factor that causes the expected future exchange rate E et + 1 to rise increases the
expected appreciation of the dollar. The result is a higher relative expected return on
dollar assets, which increases the demand for dollar assets at every exchange rate,
thereby shifting the demand curve to the right from D1 to D2 in Figure 5. The equi-
librium exchange rate rises to point 2 at the intersection of the D2 and S curves. A rise
in the expected future exchange rate E et + 1 shifts the demand curve to the right and
causes an appreciation of the domestic currency. According to the same reasoning, a
fall in the expected future exchange rate E et + 1 shifts the demand curve to the left and
causes a depreciation of the currency.
Earlier in the chapter we discussed the determinants of the exchange rate in the
long run: the relative price level, relative trade barrier, import and export demand,
and relative productivity (refer to Summary Table 2). These four factors influence the
expected future exchange rate. The theory of purchasing power parity suggests that if a
higher American price level relative to the foreign price level is expected to persist, then
the dollar will depreciate in the long run. A higher expected relative American price
level should thus have a tendency to lower E et + 1, lower the relative expected return on
dollar assets, shift the demand curve to the left, and lower the current exchange rate.

M18B_MISH9481_13_GE_C18.indd 481 01/07/2021 17:11

 482 PART 5 International Finance and Monetary Policy

Mini-lecture

FIGURE 5
Exchange Rate, Et S
Response to an (£/ )
Increase in the
Expected Future Step 2. leading to a
Exchange Rate, 2 rise in the current
E et + 1 E2 exchange rate.

When the expected

future exchange rate Step 1. A rise in the
increases, the rela- expected future
tive expected return E1 1 exchange rate
on domestic (rupee) shifts the demand
assets rises and the curve to the right . . .
demand curve shifts
to the right. The equi-
librium exchange rate
rises from E1 to E2.
D1 D2

Quantity of Rupee Assets

Similarly, the other long-run determinants of the exchange rate can influence the
relative expected return on dollar assets and the current exchange rate. Briefly, the fol-
lowing changes, all of which increase the demand for domestic goods relative to foreign
goods, will raise E et + 1 : (1) expectations of a fall in the American price level relative to
the foreign price level; (2) expectations of higher American trade barriers relative to
foreign trade barriers; (3) expectations of lower American import demand; (4) expecta-
tions of higher foreign demand for American exports; and (5) expectations of higher
American productivity relative to foreign productivity. By increasing E et + 1, all of these
changes increase the relative expected return on dollar assets, shift the demand curve to
the right, and cause an appreciation of the domestic currency, the dollar.
The fact that exchange rates are so volatile is explained by the analysis here. Because
expected appreciation of the domestic currency affects the expected return on domestic
assets, expectations about the price level, inflation, trade barriers, productivity, import
demand, export demand, and monetary policy play important roles in determining the
exchange rate. When expectations about any of these variables change, as they do—
and often, at that—our analysis indicates that the expected return on domestic assets,
and therefore the exchange rate, will be immediately affected. Because expectations on
all these variables change with just about every bit of news that appears, it is not sur-
prising that the exchange rate is volatile.

Recap: Factors That Change the Exchange Rate

Summary Table 3 outlines all of the factors that shift the demand curve for domes-
tic assets and thereby cause the exchange rate to change. Shifts in the demand curve
occur when one factor changes, holding everything else constant, including the current

M18B_MISH9481_13_GE_C18.indd 482 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 483

SUMMARY TABLE 3
Factors That Shift the Demand Curve for Domestic Assets and Affect the Exchange Rate
Change in Quantity
Demanded of Domestic
Change in Assets at Each Response of
Factor Factor Exchange Rate Exchange Rate, Et
Domestic interest c c c Et S

rate, iD E2

E1

D1 D2
Dollar Assets

Foreign interest rate, c T T Et S

iF E1

E2
D2 D1
Dollar Assets

Expected domestic c T T Et S

price level* E1

E2
D2 D1
Dollar Assets

Expected trade c c c Et S

barriers* E2

E1

D1 D2
Dollar Assets

Expected import c T T Et S

demand E1

E2
D2 D1
Dollar Assets

Expected export c c c Et S

demand E2

E1

D1 D2
Dollar Assets

Expected c c c Et S

productivity* E2

E1

D1 D2
Dollar Assets

*
Relative to other countries.
Note: Only increases (c) in the factors are shown; the effects of decreases in the variables on the exchange rate are the opposite of
those indicated in the “Response” column.

M18B_MISH9481_13_GE_C18.indd 483 01/07/2021 17:11

 484 PART 5 International Finance and Monetary Policy

exchange rate. Again, the theory of portfolio choice asserts that changes in the relative
expected return on dollar assets are the source of shifts in the demand curve.
Let’s review what happens when each of the seven factors in Table 3 changes.
Remember that to understand the direction in which the demand curve will shift, we
must consider what happens to the relative expected return on dollar assets when the
factor changes. If the relative expected return rises, holding the current exchange
rate constant, the demand curve shifts to the right. If the relative expected return falls,
the demand curve shifts to the left.
1. When the interest rates on domestic assets iD rise, the expected return on dollar
assets rises at each exchange rate and so the quantity demanded increases. The
demand curve therefore shifts to the right, and the equilibrium exchange rate rises,
as shown in the first row of Table 3.
2. When the foreign interest rate iF rises, the return on foreign assets rises, and so
the relative expected return on dollar assets falls. The quantity demanded of dollar
assets then falls, the demand curve shifts to the left, and the exchange rate falls, as
shown in the second row of Table 3.
3. When the expected domestic price level rises relative to the foreign price level,
our analysis of the long-run determinants of the exchange rate indicates that the
value of the dollar will fall in the future. The expected return on dollar assets thus
falls, the quantity demanded declines, the demand curve shifts to the left, and the
exchange rate falls, as indicated in the third row of Table 3.
4. With higher expected trade barriers, the value of the dollar is higher in the long
run and the expected return on dollar assets is higher. The quantity demanded of
dollar assets thus rises, the demand curve shifts to the right, and the exchange rate
rises, as shown in the fourth row of Table 3.
5. When the expected import demand rises, we expect the exchange rate to depreciate
in the long run, so the expected return on dollar assets falls. The quantity demanded
of dollar assets at each value of the current exchange rate therefore falls, the demand
curve shifts to the left, and the exchange rate falls, as shown in the fifth row of Table 3.
6. When the expected export demand rises, the exchange rate is expected to appreciate
in the long run. Thus the expected return on dollar assets rises, the demand curve
shifts to the right, and the exchange rate rises, as indicated in the sixth row of Table 3.
7. When expected domestic productivity rises, the exchange rate is expected to appre-
ciate in the long run, so the expected return on domestic assets rises. The quantity
demanded at each exchange rate therefore rises, the demand curve shifts to the
right, and the exchange rate rises, as shown in the seventh row of Table 3.

A P P L I C AT I O N Effects of Changes in Interest Rates on

the Equilibrium Exchange Rate
Our analysis has revealed the factors that affect the value of the equilibrium exchange
rate. Now we use this analysis to take a closer look at the response of the exchange rate
to changes in interest rates and money growth.
Changes in domestic interest rates iD are often cited as a major factor affecting
exchange rates. For example, we see headlines in the financial press like this one:
“Dollar Recovers as Interest Rates Edge Upward.” But is the positive correlation sug-
gested in this headline true in every case?

M18B_MISH9481_13_GE_C18.indd 484 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 485

Mini-lecture

FIGURE 6
Effect of a Rise Step 1. A fall in
the domestic real
in the Domestic interest as a result
Interest Rate of an increase in
as a Result of Exchange Rate, Et
expected inflation
S
an Increase in shifts the demand
(£/ ) curve to the left . . .
Expected Inflation
Because a rise in
domestic expected
inflation leads to a
decline in expected 1
dollar appreciation E1
that is larger than
the increase in the
domestic interest
rate, the relative E2 2
expected return
Step 2. leading
on domestic to a fall in the
(rupee) assets falls. exchange rate.
The demand curve D2 D1
shifts to the left,
and the equilibrium
exchange rate falls
from E1 to E2. Quantity of Rupee Assets

Not necessarily, because to analyze the effects of interest rate changes, we must
carefully distinguish the sources of the changes. The Fisher equation (Chapter 4) states
that a nominal interest rate such as iD equals the real interest rate plus expected infla-
tion: i = ir + pe. The Fisher equation thus indicates that the interest rate iD can change
for two reasons: Either the real interest rate ir changes or the expected inflation rate pe
changes. The effect on the exchange rate is quite different, depending on which of these
two factors is the source of the change in the nominal interest rate.
Suppose the domestic real interest rate increases, so that the nominal interest rate
iD rises while expected inflation remains unchanged. In this case, it is reasonable to
assume that the expected appreciation of the dollar will be unchanged because expected
inflation is unchanged. In this case, the increase in iD increases the relative expected
return on dollar assets, raises the quantity of dollar assets demanded at each level of the
exchange rate, and shifts the demand curve to the right. We end up with the situation
depicted in Figure 3, which analyzes an increase in iD, holding everything else constant.
Our model of the foreign exchange market produces the following result: When domes-
tic real interest rates rise, the domestic currency appreciates.
When the nominal interest rate rises because of an increase in expected inflation,
we get a different result from the one shown in Figure 3. The rise in expected domestic
inflation leads to a decline in the expected appreciation of the dollar, which is typically
found to be larger than the increase in the domestic interest rate iD. As a result, at any
given exchange rate, the relative expected return on domestic (dollar) assets falls, the
demand curve shifts to the left, and the exchange rate falls from E1 to E2, as shown in
Figure 6. Our analysis leads to this conclusion: When domestic interest rates rise due
to an expected increase in inflation, the domestic currency depreciates.

M18B_MISH9481_13_GE_C18.indd 485 01/07/2021 17:11

 486 PART 5 International Finance and Monetary Policy

Because this result is completely different from the result that is obtained when the
rise in the domestic interest rate is associated with a higher real interest rate, we must
always distinguish between real and nominal measures when analyzing the effects of
interest rates on exchange rates.

A P P L I C AT I O N The Global Financial Crisis and the Dollar

With the start of the global financial crisis in August 2007, the dollar began an acceler-
ated decline in value, falling by 9% against the euro until mid-July of 2008. After hit-
ting an all-time low against the euro on July 11, the value of the dollar suddenly shot
upward, by over 20% against the euro by the end of October. What is the relationship
between the global financial crisis and these large swings in the value of the dollar?
Supply and demand analysis of what happened to the dollar is illustrated in Figure 7.
Because we are analyzing what happened to the value of the dollar, we are again treating

Mini-lecture

Exchange Rate, Et S
(euros/$) Step 4. Leading to a
rise in the exchange
rate to 0.78 euro per
dollar by the end of
3 October 2008.
0.78

Step 3. The spread of the financial crisis to

1 Europe led to lower European interest rates,
0.73
which increased the relative expected return
Step 2. Leading to on dollar assets, and along with a “flight to
a fall in the quality” into U.S. Treasury securities, shifted
exchange rate to the demand curve to the right, …
0.63 euro per dollar
by April 2008.
2
0.63

D2 D1 D3

Step 1. The financial crisis in the U.S. Quantity of Dollar Assets

led to lower interest rates, leading to a
decline in the relative expected return
on dollar assets, shifting the demand
curve to the left, …

FIGURE 7 Global Financial Crisis and the Dollar

The financial crisis in the United States led to lower interest rates, leading to a decline in the relative
expected return on dollar assets, which shifted the demand curve to the left and lowered the exchange
rate to 0.63 euro per dollar by April 2008. The spread of the global financial crisis to Europe led to
lower European interest rates, which increased the relative expected return of dollar assets, and along
with a “flight to quality” to U.S. Treasury securities, shifted the demand curve to the right and raised the
exchange rate to 0.78 euro per dollar by the end of October 2008.

M18B_MISH9481_13_GE_C18.indd 486 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 487

the U.S. dollar as the domestic currency. The exchange rate on the vertical axis in the
diagram is therefore quoted as euros per U.S. dollar, so a rise in the exchange rate is an
appreciation of the dollar. The horizontal axis is the quantity of U.S. (dollar) assets. In
August 2007 before the crisis started, the exchange rate for the dollar was 0.73 euro per
dollar at equilibrium point 1.
During 2007, the negative effects of the financial crisis on economic activity were
mostly confined to the United States. The Federal Reserve acted aggressively to lower
interest rates to counter the contractionary effects, decreasing the federal funds rate tar-
get by 325 basis points from September 2007 to April 2008. In contrast, other central
banks like the ECB did not see the need to lower interest rates, particularly because
high energy prices had led to a surge in inflation. The relative expected return on dollar
assets thus declined, shifting the demand curve for dollar assets to the left in Figure 7,
from D1 to D2.. The equilibrium moved from point 1 in August 2007 to point 2 in April
2008, leading to a decline in the equilibrium exchange rate to 0.63 euro per dollar. Our
analysis of the foreign exchange market thus explains why the early phase of the global
financial crisis led to a decline in the value of the dollar.
We now turn to the rise in the value of the dollar. Starting in the summer of
2008, the effects of the global financial crisis on economic activity began to spread
more widely throughout the world. The European Central Bank started to cut interest
rates, with the expectation that further rate cuts would follow, as indeed did occur. The
expected decline in foreign interest rates then increased the relative expected return
on dollar assets, leading to a rightward shift in the demand curve from D2 to D3, with
the equilibrium moving to point 3 where the dollar rose to 0.78 euro per dollar by the
end of October 2008. Another factor driving the dollar upward was the “flight to qual-
ity” that occurred when the global financial crisis reached a particularly virulent stage
in September and October. Both Americans and foreigners now wanted to put their
money into the safest assets possible: U.S. Treasury securities. The resulting increase in
the demand for dollar assets provided an additional reason for the demand curve for
dollar assets to shift out to the right, thereby helping to produce a sharp appreciation
of the dollar. ◆

A P P L I C AT I O N Brexit and the British Pound

As noted in the introduction, the Brexit vote in the United Kingdom on June 23, 2016,
led to nearly a 10% depreciation in the British pound, from $1.48 to the pound on June
23, just before the vote, to $1.36 per pound on June 24. What explains the large one-
day decline in the exchange rate for the pound?
Here we use our supply and demand analysis of the foreign exchange market in
Figure 8 to answer this question. Because we are analyzing what happened to the value
of the British pound, we are treating the pound as the domestic currency and thus are
looking at the supply of and demand for pounds. The exchange rate on the vertical axis
in the figure is therefore quoted as U.S. dollars per pound, so a rise in the exchange rate
is an appreciation of the pound. The horizontal axis is the quantity of British pound
assets. On June 23, right before the Brexit vote, the initial equilibrium was at point 1,
with the equilibrium exchange rate for the pound at $1.48 per pound.

M18B_MISH9481_13_GE_C18.indd 487 01/07/2021 17:11

 488 PART 5 International Finance and Monetary Policy

Mini-lecture

FIGURE 8
Exchange Rate, Et S
Brexit and the ($/£)
British Pound
The Brexit vote low-
ered the expected
return on British Step 1. The Brexit vote
pound assets, which lowered the expected future
shifted the demand exchange rate, shifting the
curve to the left and $1.48 1 demand curve to the left, …
lowered the exchange
rate to $1.36 per
pound. 2
$1.36
Step 2. Leading to
a decline in the
exchange rate to
$1.36 per pound.
D2 D1

Quantity of Pound Assets

The Brexit vote would result in the United Kingdom no longer having access to the
“one market” of the European Union, thereby likely erecting significant trade barriers
to the export of British goods and services, especially financial services, which is one of
Britain’s most important industries. With higher expected European Union trade barriers,
the demand for British goods and services would fall in the future, so the expected value of
the pound would be lower in the future. The relative expected return on British (pound)
assets therefore fell, and so the quantity demanded of pound assets declined at any given
exchange rate, shifting the demand curve for pound assets to the left. The result was the
sharp fall in the equilibrium exchange rate for the British pound to $1.36 per pound. ◆

SUMMARY
1. Foreign exchange rates (the price of one country’s cur- 3. In the short run, exchange rates are determined by
rency in terms of another’s) are important because they changes in the relative expected return on domestic
affect the price of domestically produced goods sold assets, which cause the demand curve to shift. Any fac-
abroad and the cost of foreign goods bought tor that changes the relative expected return on domes-
domestically. tic assets will lead to changes in the exchange rate. Such
2. The theory of purchasing power parity suggests that factors include changes in the interest rates on domestic
long-run changes in the exchange rate between the and foreign assets, as well as changes in any of the fac-
currencies of two countries are determined by changes tors that affect the long-run exchange rate and hence
in the relative price levels in the two countries. Other the expected future exchange rate.
factors that affect exchange rates in the long run are 4. The asset market approach to exchange rate determina-
tariffs and quotas, import demand, export demand, and tion can explain the changes in the value of the dollar
productivity. during the global financial crisis, and the sharp decline
in the value of the British pound after the Brexit vote.

M18B_MISH9481_13_GE_C18.indd 488 01/07/2021 17:11

 CHAPTER 18 The Foreign Exchange Market 489

KEY TERMS
appreciation, p. 469 forward transaction, p. 469 spot transaction, p. 469
depreciation, p. 469 nontradable, p. 473 tariffs, p. 473
exchange rate, p. 469 quotas, p. 473 theory of purchasing power parity
foreign exchange market, p. 469 real exchange rate, p. 471 (PPP), p. 471
forward exchange rate, p. 469 spot exchange rate, p. 469

QUESTIONS
1. Suppose you are a Japanese customer considering buy- 10. If the Indian government unexpectedly announces that
ing a bottle of French wine. If the euro appreciates by it will be imposing higher tariffs on foreign goods one
15% with respect to the yen, are you more or less likely year from now, what will happen to the value of the
to buy a bottle of French wine rather than, say, sake? Indian rupee today?
2. “A country is always worse off when its currency is 11. If nominal interest rates in America rise but real interest
weak (falls in value).” Is this statement true, false, or rates fall, predict what will happen to the U.S. dollar
uncertain? Explain your answer. exchange rate.
3. When the Indian rupee depreciates, what happens to 12. If European car companies make a breakthrough in
exports and imports in India? battery technology that will greatly increase the speed,
4. If the British price level rises by 5% relative to the reliability and autonomy of electric cars, what will
price level in India, what does the theory of purchas- happen to the euro exchange rate?
ing power parity predict will happen to the value of the 13. If Mexicans go on a spending spree and buy twice as
British pounds in terms of rupees? much French perfume and twice as many Japanese TVs,
5. If the demand for a country’s exports falls at the same English sweaters, Swiss watches, and bottles of Italian
time that tariffs on imports are raised, will the country’s wine, what will happen to the value of the Mexican
currency tend to appreciate or depreciate in the long run? peso?
6. When the Federal Reserve conducts an expansionary 14. Through the summer and fall of 2008, as the global
monetary policy, what happens to the money supply? financial crisis began to take hold, international finan-
How does this affect the supply of dollar assets? cial institutions and sovereign wealth funds significantly
7. From 2009 to 2011, the economies of Australia and increased their purchases of U.S. Treasury securities as
Switzerland suffered relatively mild effects from the a safe haven investment. How should this have affected
global financial crisis. At the same time, many countries U.S. dollar exchange rates?
in the euro area were hit hard by high unemployment 15. In the Spring of 2020, the European Central Bank
and burdened with unsustainably high government announced a package of emergency measures designed
debts. How should this have affected the euro/Swiss to combat the economic impact of the Covid-19 pan-
franc and euro/Australian dollar exchange rates? demic, comprising, inter alia, a pandemic emergency
8. In the mid to late 1970s, the yen appreciated in value purchase program bound to further decrease long-term
relative to the dollar, even though Japan’s inflation rate interest rates in the euro area. What effect could have
was higher than America’s. How can this be explained such a policy have on the euro exchange rate?
by improvements in the productivity of Japanese indus- 16. On June 23, 2016, voters in the United Kingdom voted
try relative to U.S. industry? to leave the European Union. From June 16 to June 23,
9. Suppose the president of the United States announces 2016, the exchange rate between the British pound
a new set of reforms that includes a new anti-inflation and the U.S. dollar increased from 1.41 dollars per
program. Assuming the announcement is believed by pound to 1.48 dollars per pound. What can you say
the public, what will happen to the exchange rate on about market expectations regarding the result of the
the U.S. dollar? referendum?

M18B_MISH9481_13_GE_C18.indd 489 01/07/2021 17:11

 490 PART 5 International Finance and Monetary Policy

APPLIED PROBLEMS
17. A German sports car is selling for €65,000. What is the year, given PPP, what is the expected exchange rate in
dollar price in the United States for the German car if one year?
the exchange rate is 0.80 euro per dollar? 22. If the price level recently increased by 19% in England
18. If the Canadian dollar to U.S. dollar exchange rate is while falling by 6% in the Canada, by how much must
1.24, and the British pound to U.S. dollar exchange rate the exchange rate change if PPP holds? Assume that the
is 0.68, what must be the Canadian dollar to British current exchange rate is 0.58 pound per dollar.
pound exchange rate? For Problems 23–25, use a graph of the foreign exchange
19. The New Zealand dollar to U.S. dollar exchange rate market for dollars to illustrate the effects described in each
is 1.38, and the British pound to U.S. dollar exchange problem.
rate is 0.65. If you find that the British pound to New 23. If expected inflation drops in Europe, so that interest
Zealand dollar is trading at 0.5, what would be the risk- rates fall there, what will happen to the exchange rate
less profit per U.S. dollar invested? on the U.S. dollar?
20. In 1999, the euro was trading at $0.90 per euro. If 24. If the European Central Bank decides to pursue a con-
the euro is now trading at $1.18 per euro, what is the tractionary monetary policy to fight inflation, what will
percentage change in the euro’s value? Is this an appre- happen to the value of the U.S. dollar?
ciation or depreciation? 25. If a strike takes place in France, making it harder to buy
21. The Mexican peso is trading at 11 pesos per dollar. French goods, what will happen to the value of the U.S.
If the expected U.S. inflation rate is 1% while the dollar?
expected Mexican inflation rate is 15% over the next

DATA ANALYSIS PROBLEMS

The Problems update with real-time data in MyLab Economics on the daily three-month London Interbank Offer Rate, or
and are available for practice or instructor assignment. LIBOR, for the United States dollar (USD3MTD156N), euro
1. Real-time Data Analysis Go to the St. Louis Federal (EUR3MTD156N), British pound (GBP3MTD156N), and
Reserve FRED database, and find data on the exchange rate Japanese yen (JPY3MTD156N). LIBOR is a measure of inter-
of U.S. dollars per British pound (DEXUSUK). A Mini Coo- est rates denominated in each country’s respective currency.
per can be purchased in London, England, for £17,865 or a. Calculate the difference between the LIBOR
in Boston, United States, for $23,495. rate in the United States and the LIBOR
a. Use the most recent exchange rate available rates in the three other countries using the
to calculate the real exchange rate of the data from one year ago and the most recent
London Mini per Boston Mini. data available.
b. Based on your answer to part (a), are Mini b. Based on the changes in interest rate dif-
Coopers relatively more expensive in Boston ferentials, do you expect the dollar to
or in London? depreciate or appreciate against the other
c. What price in British pounds would make currencies?
the Mini Cooper equally expensive in both c. Report the percentage change in the
locations, all else being equal? exchange rates over the past year. Are the
results you predicted in part (b) consistent
2. Real-time Data Analysis Go to the St. Louis Federal
with the actual exchange rate behavior?
Reserve FRED database, and find data on the daily dollar
exchange rates for the euro (DEXUSEU), British pound
(DEXUSUK), and Japanese yen (DEXJPUS). Also find data

M18B_MISH9481_13_GE_C18.indd 490 01/07/2021 17:11