Exchange Rates and the
Foreign Exchange Market:
An Asset Approach
In the first years of the millennium, Americans flocked to Paris to enjoy French
cuisine while shopping for designer clothing and other specialties. When
measured in terms of dollars, prices in France were so much lower than they
had been a few years before that a shopper’s savings could offset the cost of an
airplane ticket from New York or Chicago. Five years later, however, the prices of
French goods again looked high to Americans. What economic forces made the
dollar prices of French goods swing so widely? One major factor was a sharp fall
in the dollar price of France’s currency after 1998, followed by an equally sharp
rise starting in 2002.
The price of one currency in terms of another is called an exchange rate. At
4 P.M. London time on November 30, 2010, you would have needed 1.3018
dollars to buy one unit of the European currency, the euro, so the dollar’s
exchange rate against the euro was $1.3018 per euro. Because of their strong
influence on the current account and other macroeconomic variables, exchange
rates are among the most important prices in an open economy.
Because an exchange rate, the price of one country’s money in terms of another’s,
is also an asset price, the principles governing the behavior of other asset
prices also govern the behavior of exchange rates. As you will recall from
Chapter 13, the defining characteristic of an asset is that it is a form of wealth, a
way of transferring purchasing power from the present into the future. The price
that an asset commands today is therefore directly related to the purchasing
power over goods and services that buyers expect it to yield in the future.
Similarly, today’s dollar/euro exchange rate is closely tied to people’s expectations
about the future level of that rate. Just as the price of Google stock rises immediately
upon favorable news about Google’s future prospects, so do exchange
rates respond immediately to any news concerning future currency values.
Our general goals in this chapter are to understand the role of exchange rates in
international trade and to understand how exchange rates are determined. To begin,
we first learn how exchange rates allow us to compare the prices of different
countries’ goods and services. Next we describe the international asset market in
which currencies are traded and show how equilibrium exchange rates are determined
in that market. A final section underlines our asset market approach by
showing how today’s exchange rate responds to changes in the expected future
values of exchange rates.
LEARNING GOALS
After reading this chapter, you will be able to:
• Relate exchange rate changes to changes in the relative prices of countries’
exports.
• Describe the structure and functions of the foreign exchange market.
• Use exchange rates to calculate and compare returns on assets denominated
in different currencies.
• Apply the interest parity condition to find equilibrium exchange rates.
• Find the effects of interest rates and expectation shifts on exchange rates.
Foreign Exchange Market:
An Asset Approach
In the first years of the millennium, Americans flocked to Paris to enjoy French
cuisine while shopping for designer clothing and other specialties. When
measured in terms of dollars, prices in France were so much lower than they
had been a few years before that a shopper’s savings could offset the cost of an
airplane ticket from New York or Chicago. Five years later, however, the prices of
French goods again looked high to Americans. What economic forces made the
dollar prices of French goods swing so widely? One major factor was a sharp fall
in the dollar price of France’s currency after 1998, followed by an equally sharp
rise starting in 2002.
The price of one currency in terms of another is called an exchange rate. At
4 P.M. London time on November 30, 2010, you would have needed 1.3018
dollars to buy one unit of the European currency, the euro, so the dollar’s
exchange rate against the euro was $1.3018 per euro. Because of their strong
influence on the current account and other macroeconomic variables, exchange
rates are among the most important prices in an open economy.
Because an exchange rate, the price of one country’s money in terms of another’s,
is also an asset price, the principles governing the behavior of other asset
prices also govern the behavior of exchange rates. As you will recall from
Chapter 13, the defining characteristic of an asset is that it is a form of wealth, a
way of transferring purchasing power from the present into the future. The price
that an asset commands today is therefore directly related to the purchasing
power over goods and services that buyers expect it to yield in the future.
Similarly, today’s dollar/euro exchange rate is closely tied to people’s expectations
about the future level of that rate. Just as the price of Google stock rises immediately
upon favorable news about Google’s future prospects, so do exchange
rates respond immediately to any news concerning future currency values.
Our general goals in this chapter are to understand the role of exchange rates in
international trade and to understand how exchange rates are determined. To begin,
we first learn how exchange rates allow us to compare the prices of different
countries’ goods and services. Next we describe the international asset market in
which currencies are traded and show how equilibrium exchange rates are determined
in that market. A final section underlines our asset market approach by
showing how today’s exchange rate responds to changes in the expected future
values of exchange rates.
LEARNING GOALS
After reading this chapter, you will be able to:
• Relate exchange rate changes to changes in the relative prices of countries’
exports.
• Describe the structure and functions of the foreign exchange market.
• Use exchange rates to calculate and compare returns on assets denominated
in different currencies.
• Apply the interest parity condition to find equilibrium exchange rates.
• Find the effects of interest rates and expectation shifts on exchange rates.
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