Interest Rates, Expectations, and Equilibrium
Having seen how exchange rates are determined by interest parity, we now take a look at
how current exchange rates are affected by changes in interest rates and in expectations
about the future, the two factors we held constant in our previous discussions. We will see
E$/€
E 1 $/€
3
E$/€
1 ,
E$/€
3
E$/€
E 1 $/€
2
E$/€
1 ,
E$/€
1 ;
E$/€
2
Return on
dollar deposits
2
1
3
Exchange rate,
E$/€
Expected return
on euro deposits
Rates of return
(in dollar terms)
R$
E$/€
2
E$/€
1
E$/€
3
Figure 14-4
Determination of the Equilibrium
Dollar/Euro Exchange Rate
Equilibrium in the foreign exchange market is
at point 1, where the expected dollar returns
on dollar and euro deposits are equal.
8We could have developed our diagram from the perspective of Europe, with the euro/dollar exchange rate
the vertical axis, a schedule vertical at indicate the euro return on euro deposits, and a downward-
sloping schedule showing how the euro return on dollar deposits varies with An exercise at the end of
the chapter asks you to show that this alternative way of looking at equilibrium in the foreign exchange market
gives the same answers as the method used here in the text.
E€/$.
R€ E$/€ (=1/E$/€)
342 PART THREE Exchange Rates and Open-Economy Macroeconomics
Dollar return
2
1 1'
Exchange rate,
E$/€
Expected
euro return
Rates of return
(in dollar terms)
E$/€
E$/€
1
2
R$
1 R$
2
Figure 14-5
Effect of a Rise in the Dollar Interest Rate
A rise in the interest rate offered by dollar
deposits from to causes the dollar to
appreciate from (point 1) to E$/€ (point 2).
E 2 $/€
1
R$
R 2 $
1
that the exchange rate (which is the relative price of two assets) responds to factors that
alter the expected rates of return on those two assets.
The Effect of Changing Interest Rates
on the Current Exchange Rate
We often read in the newspaper that the dollar is strong because U.S. interest rates are high
or that it is falling because U.S. interest rates are falling. Can these statements be
explained using our analysis of the foreign exchange market?
To answer this question we again turn to a diagram. Figure 14-5 shows a rise in the
interest rate on dollars, from to as a rightward shift of the vertical dollar deposits
return schedule. At the initial exchange rate the expected return on dollar deposits is
now higher than that on euro deposits by an amount equal to the distance between points 1
and As we have seen, this difference causes the dollar to appreciate to (point 2).
Because there has been no change in the euro interest rate or in the expected future
exchange rate, the dollar’s appreciation today raises the expected dollar return on euro
deposits by increasing the rate at which the dollar is expected to depreciate in the future.
Figure 14-6 shows the effect of a rise in the euro interest rate . This change causes
the downward-sloping schedule (which measures the expected dollar return on euro
deposits) to shift rightward. (To see why, ask yourself how a rise in the euro interest rate
alters the dollar return on euro deposits, given the current exchange rate and the expected
future rate.)
At the initial exchange rate the expected depreciation rate of the dollar is the
same as before the rise in so the expected return on euro deposits now exceeds that on
dollar deposits. The dollar/euro exchange rate rises (from to ) to eliminate the
excess supply of dollar assets at point 1. As before, the dollar’s depreciation against the
euro eliminates the excess supply of dollar assets by lowering the expected dollar rate of
return on euro deposits. A rise in European interest rates therefore leads to a depreciation
E$/€
E 2 $/€
1
R€,
E$/€
1 ,
R€
E$/€
1oe. 2
E$/€
1 ,
R$
R 2, $
1
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 343
of the dollar against the euro or, looked at from the European perspective, an appreciation
of the euro against the dollar.
Our discussion shows that, all else equal, an increase in the interest paid on deposits of
a currency causes that currency to appreciate against foreign currencies.
Before we conclude that the newspaper account of the effect of interest rates on
exchange rates is correct, we must remember that our assumption of a constant expected
future exchange rate often is unrealistic. In many cases, a change in interest rates will
be accompanied by a change in the expected future exchange rate. This change in the
expected future exchange rate will depend, in turn, on the economic causes of the interest
rate change. We compare different possible relationships between interest rates and
expected future exchange rates in Chapter 16. Keep in mind for now that in the real world,
we cannot predict how a given interest rate change will alter exchange rates unless we
know why the interest rate is changing.
The Effect of Changing Expectations
on the Current Exchange Rate
Figure 14-6 may also be used to study the effect on today’s exchange rate of a rise in the
expected future dollar/euro exchange rate,
Given today’s exchange rate, a rise in the expected future price of euros in terms of
dollars raises the dollar’s expected depreciation rate. For example, if today’s exchange rate
is per euro and the rate expected to prevail in a year is per euro, the expected
depreciation rate of the dollar against the euro is if the expected
future exchange rate now rises to per euro, the expected depreciation rate also rises, to
Because a rise in the expected depreciation rate of the dollar raises the expected dollar
return on euro deposits, the downward-sloping schedule shifts to the right, as in Figure 14-6.
At the initial exchange rate E$/€, there is now an excess supply of dollar deposits: Euro
1
(1.06 - 1.00)/1.00 = 0.06.
$1.06
(1.05 - 1.00)/1.00 = 0.05;
$1.00 $1.05
E$/€
e .
2
1
Exchange rate,
E$/€
Rates of return
(in dollar terms)
R$
Rise in euro
interest rate
E$/€
E$/€
1
2
Dollar return
Expected
euro return
Figure 14-6
Effect of a Rise in the Euro Interest Rate
A rise in the interest rate paid by euro
deposits causes the dollar to depreciate
from (point 1) to (point 2). (This
figure also describes the effect of a rise in
the expected future $/€ exchange rate.)
E$/€
E 2 $/€
1
344 PART THREE Exchange Rates and Open-Economy Macroeconomics
deposits offer a higher expected rate of return (measured in dollar terms) than do dollar deposits.
The dollar therefore depreciates against the euro until equilibrium is reached at point 2.
We conclude that, all else equal, a rise in the expected future exchange rate causes a
rise in the current exchange rate. Similarly, a fall in the expected future exchange rate
causes a fall in the current exchange rate.
Case Study
What Explains the Carry Trade?
Over much of the 2000s, Japanese yen interest rates were close to zero (as Figure 14-2
shows) while Australia’s interest rates were comfortably positive, climbing to over
7 percent per year by the spring of 2008.
While it might therefore have appeared attractive
to borrow yen and invest the proceeds
in Australian dollar bonds, the interest parity
condition implies that such a strategy should
not be systematically profitable: On average,
shouldn’t the interest advantage of Australian
dollars be wiped out by relative appreciation
of the yen?
Nonetheless, market actors ranging from
Japanese housewives to sophisticated hedge
funds did in fact pursue this strategy, investing billions in Australian dollars and driving
that currency’s value up, rather than down, against the yen. More generally,
international investors frequently borrow low-interest currencies (called “funding” currencies)
and buy high-interest currencies (called “investment” currencies), with results
that can be profitable over long periods. This activity is called the carry trade, and
while it is generally impossible to document the extent of carry trade positions accurately,
they can become very large when sizable international interest differentials open
up. Is the prevalence of the carry trade evidence that interest parity is wrong?
The honest answer is that while interest parity does not hold exactly in practice—in
part because of the risk and liquidity factors mentioned above—economists are still
working hard to understand if the carry trade requires additional explanation. Their
work is likely to throw further light on the functioning of foreign exchange markets in
particular and financial markets in general.
One important hazard of the carry trade is that investment currencies (the high-interest
currencies that carry traders target) may experience abrupt crashes. Figure 14-7
illustrates this feature of foreign exchange markets, comparing the cumulative return to
investing in yen bonds and in Australian dollar bonds over different investment
horizons, with the initial investment being made at the start of 2003. As you can see,
the yen investment yields next to nothing, whereas Australian dollars pay off handsomely,
not only because of a high interest rate but because the yen tended to fall
against the Australian dollar through the summer of 2008. But in 2008 the Australian
dollar crashed against the yen, falling in price from yen to only yen between
July and December. As Figure 14-7 shows, this crash did not wipe out the gains to the
carry trade strategy entirely—if the strategy had been initiated early enough! Of course,
anyone who got into the business late, for example, in 2007, did very poorly indeed.
Conversely, anyone savvy enough to unwind the strategy in June 2008 would have
¥104 ¥61
¥100
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 345
50
75
100
125
150
175
200
225
2003 2004 2005 2006 2007 2008 2009 2010
Investment return
Australian dollar
Japanese yen
Figure 14-7
Cumulative Total Investment Return in Australian Dollar Compared to Japanese Yen, 2003–2010
The Australian dollar-yen carry trade has been profitable on average but is subject to sudden large reversals,
as in 2008.
Source: Exchange rates and three-month treasury yields from Global Financial Data.
9If crashes are independent events over time, the probability that a crash does not occur over five years is (0.9)5.
Therefore, the probability that a crash does occur in the five-year period is 1(0.9)5
10See Markus K. Brunnermeier, Stefan Nagel, and Lasse H. Pedersen, “Carry Trades and Currency Crashes,”
NBER Macroeconomics Annual 23 (2008), pp. 313–347. These findings are consistent with the apparently greater
empirical success of the interest parity condition over relatively long periods, as documented by Menzie Chinn,
“The (Partial) Rehabilitation of Interest Rate Parity in the Floating Rate Era: Longer Horizons, Alternative
Expectations, and Emerging Markets,” Journal of International Money and Finance 25 (February 2006), pp. 7–21.
doubled his or her money in five and a half years. The carry trade is obviously a very
risky business.
We can gain some insight into this pattern by imagining that investors expect a gradual
1 percent annual appreciation of the Australian dollar to occur with high probability
(say, 90 percent) and a big 40 percent depreciation to occur with a 10 percent probability.
Then the expected appreciation rate of the Australian dollar is:
The negative expected appreciation rate means that the yen is actually expected to
appreciate on average against the Australian dollar. Moreover, the probability of a crash
occurring in the first five years of the investment is only
percent, less than fifty-fifty.9 The resulting pattern of cumulative returns could easily look
much like the one shown in Figure 14-7. Calculations like these are suggestive, and
although they are unlikely to explain the full magnitude of carry trade returns, researchers
have found that investment currencies are particularly subject to abrupt crashes, and funding
currencies to abrupt appreciations.10
1 - (0.9)5 = 1- 0.59 = 41
Expected appreciation = (0.9) * 1 - (0.1) * 40 = -3.1 percent per year.
346 PART THREE Exchange Rates and Open-Economy Macroeconomics
SUMMARY
1. An exchange rate is the price of one country’s currency in terms of another country’s
currency. Exchange rates play a role in spending decisions because they enable us to
translate different countries’ prices into comparable terms. All else equal, a depreciation
of a country’s currency against foreign currencies (a rise in the home currency
prices of foreign currencies) makes its exports cheaper and its imports more expensive.
An appreciation of its currency (a fall in the home currency prices of foreign currencies)
makes its exports more expensive and its imports cheaper.
2. Exchange rates are determined in the foreign exchange market. The major participants
in that market are commercial banks, international corporations, nonbank financial institutions,
and national central banks. Commercial banks play a pivotal role in the market
because they facilitate the exchange of interest-bearing bank deposits, which make
up the bulk of foreign exchange trading. Even though foreign exchange trading takes
place in many financial centers around the world, modern communication technology
links those centers together into a single market that is open 24 hours a day. An important
category of foreign exchange trading is forward trading, in which parties agree to
exchange currencies on some future date at a prenegotiated exchange rate. In contrast,
spot trades are settled immediately.
3. Because the exchange rate is the relative price of two assets, it is most appropriately
thought of as being an asset price itself. The basic principle of asset pricing is that an
asset’s current value depends on its expected future purchasing power. In evaluating an
asset, savers look at the expected rate of return it offers, that is, the rate at which the
value of an investment in the asset is expected to rise over time. It is possible to measure
an asset’s expected rate of return in different ways, each depending on the units in
which the asset’s value is measured. Savers care about an asset’s expected real rate of
Complementary explanations based on risk and liquidity considerations have also
been advanced. Often, abrupt currency movements occur during financial crises, which
are situations in which other wealth is being lost and liquid cash is particularly valuable.
In such circumstances, large losses on carry trade positions are extra painful and
may force traders to sell other assets they own at a loss.11We will say much more about
crises in later chapters, but we note for now that the Australian dollar collapse of late
2008 occurred in the midst of a severe global financial crisis.
When big carry trade positions emerge, the government officials responsible for international
economic policies often lose sleep. In their early phase, carry trade dynamics
will drive investment currencies higher as investors pile in and build up ever-larger
exposures to a sudden depreciation of the investment currency. This makes the crash
bigger when it occurs, as wrong-footed investors all scramble to repay their funding
loans. The result is greater exchange rate volatility in general, as well as the possibility
of big trader losses with negative repercussions in stock markets, bond markets, and
markets for interbank loans.
11See Brunnermeier et al., ibid., as well as A. Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski, and
Sergio T. Rebelo, “Do Peso Problems Explain the Returns to the Carry Trade?” Working Paper 14054, National
Bureau of Economic Research, June 2008.
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 347
return, the rate at which its value expressed in terms of a representative output basket
is expected to rise.
4. When relative asset returns are relevant, as in the foreign exchange market, it is
appropriate to compare expected changes in assets’ currency values, provided those
values are expressed in the same currency. If risk and liquidity factors do not strongly
influence the demands for foreign currency assets, participants in the foreign
exchange market always prefer to hold those assets yielding the highest expected rate
of return.
5. The returns on deposits traded in the foreign exchange market depend on interest rates
and expected exchange rate changes. To compare the expected rates of return offered
by dollar and euro deposits, for example, the return on euro deposits must be expressed
in dollar terms by adding to the euro interest rate the expected rate of depreciation of
the dollar against the euro (or rate of appreciation of the euro against the dollar) over
the deposit’s holding period.
6. Equilibrium in the foreign exchange market requires interest parity; that is, deposits of
all currencies must offer the same expected rate of return when returns are measured in
comparable terms.
7. For given interest rates and a given expectation of the future exchange rate, the interest
parity condition tells us the current equilibrium exchange rate. When the expected
dollar return on euro deposits exceeds that on dollar deposits, for example, the dollar
immediately depreciates against the euro. Other things equal, a dollar depreciation
today reduces the expected dollar return on euro deposits by reducing the depreciation
rate of the dollar against the euro expected for the future. Similarly, when the expected
return on euro deposits is below that on dollar deposits, the dollar must immediately
appreciate against the euro. Other things equal, a current appreciation of the dollar
makes euro deposits more attractive by increasing the dollar’s expected future depreciation
against the European currency.
8. All else equal, a rise in dollar interest rates causes the dollar to appreciate against the
euro while a rise in euro interest rates causes the dollar to depreciate against the euro.
Today’s exchange rate is also altered by changes in its expected future level. If there
is a rise in the expected future level of the dollar/euro rate, for example, then at
unchanged interest rates, today’s dollar/euro exchange rate will also rise.
Having seen how exchange rates are determined by interest parity, we now take a look at
how current exchange rates are affected by changes in interest rates and in expectations
about the future, the two factors we held constant in our previous discussions. We will see
E$/€
E 1 $/€
3
E$/€
1 ,
E$/€
3
E$/€
E 1 $/€
2
E$/€
1 ,
E$/€
1 ;
E$/€
2
Return on
dollar deposits
2
1
3
Exchange rate,
E$/€
Expected return
on euro deposits
Rates of return
(in dollar terms)
R$
E$/€
2
E$/€
1
E$/€
3
Figure 14-4
Determination of the Equilibrium
Dollar/Euro Exchange Rate
Equilibrium in the foreign exchange market is
at point 1, where the expected dollar returns
on dollar and euro deposits are equal.
8We could have developed our diagram from the perspective of Europe, with the euro/dollar exchange rate
the vertical axis, a schedule vertical at indicate the euro return on euro deposits, and a downward-
sloping schedule showing how the euro return on dollar deposits varies with An exercise at the end of
the chapter asks you to show that this alternative way of looking at equilibrium in the foreign exchange market
gives the same answers as the method used here in the text.
E€/$.
R€ E$/€ (=1/E$/€)
342 PART THREE Exchange Rates and Open-Economy Macroeconomics
Dollar return
2
1 1'
Exchange rate,
E$/€
Expected
euro return
Rates of return
(in dollar terms)
E$/€
E$/€
1
2
R$
1 R$
2
Figure 14-5
Effect of a Rise in the Dollar Interest Rate
A rise in the interest rate offered by dollar
deposits from to causes the dollar to
appreciate from (point 1) to E$/€ (point 2).
E 2 $/€
1
R$
R 2 $
1
that the exchange rate (which is the relative price of two assets) responds to factors that
alter the expected rates of return on those two assets.
The Effect of Changing Interest Rates
on the Current Exchange Rate
We often read in the newspaper that the dollar is strong because U.S. interest rates are high
or that it is falling because U.S. interest rates are falling. Can these statements be
explained using our analysis of the foreign exchange market?
To answer this question we again turn to a diagram. Figure 14-5 shows a rise in the
interest rate on dollars, from to as a rightward shift of the vertical dollar deposits
return schedule. At the initial exchange rate the expected return on dollar deposits is
now higher than that on euro deposits by an amount equal to the distance between points 1
and As we have seen, this difference causes the dollar to appreciate to (point 2).
Because there has been no change in the euro interest rate or in the expected future
exchange rate, the dollar’s appreciation today raises the expected dollar return on euro
deposits by increasing the rate at which the dollar is expected to depreciate in the future.
Figure 14-6 shows the effect of a rise in the euro interest rate . This change causes
the downward-sloping schedule (which measures the expected dollar return on euro
deposits) to shift rightward. (To see why, ask yourself how a rise in the euro interest rate
alters the dollar return on euro deposits, given the current exchange rate and the expected
future rate.)
At the initial exchange rate the expected depreciation rate of the dollar is the
same as before the rise in so the expected return on euro deposits now exceeds that on
dollar deposits. The dollar/euro exchange rate rises (from to ) to eliminate the
excess supply of dollar assets at point 1. As before, the dollar’s depreciation against the
euro eliminates the excess supply of dollar assets by lowering the expected dollar rate of
return on euro deposits. A rise in European interest rates therefore leads to a depreciation
E$/€
E 2 $/€
1
R€,
E$/€
1 ,
R€
E$/€
1oe. 2
E$/€
1 ,
R$
R 2, $
1
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 343
of the dollar against the euro or, looked at from the European perspective, an appreciation
of the euro against the dollar.
Our discussion shows that, all else equal, an increase in the interest paid on deposits of
a currency causes that currency to appreciate against foreign currencies.
Before we conclude that the newspaper account of the effect of interest rates on
exchange rates is correct, we must remember that our assumption of a constant expected
future exchange rate often is unrealistic. In many cases, a change in interest rates will
be accompanied by a change in the expected future exchange rate. This change in the
expected future exchange rate will depend, in turn, on the economic causes of the interest
rate change. We compare different possible relationships between interest rates and
expected future exchange rates in Chapter 16. Keep in mind for now that in the real world,
we cannot predict how a given interest rate change will alter exchange rates unless we
know why the interest rate is changing.
The Effect of Changing Expectations
on the Current Exchange Rate
Figure 14-6 may also be used to study the effect on today’s exchange rate of a rise in the
expected future dollar/euro exchange rate,
Given today’s exchange rate, a rise in the expected future price of euros in terms of
dollars raises the dollar’s expected depreciation rate. For example, if today’s exchange rate
is per euro and the rate expected to prevail in a year is per euro, the expected
depreciation rate of the dollar against the euro is if the expected
future exchange rate now rises to per euro, the expected depreciation rate also rises, to
Because a rise in the expected depreciation rate of the dollar raises the expected dollar
return on euro deposits, the downward-sloping schedule shifts to the right, as in Figure 14-6.
At the initial exchange rate E$/€, there is now an excess supply of dollar deposits: Euro
1
(1.06 - 1.00)/1.00 = 0.06.
$1.06
(1.05 - 1.00)/1.00 = 0.05;
$1.00 $1.05
E$/€
e .
2
1
Exchange rate,
E$/€
Rates of return
(in dollar terms)
R$
Rise in euro
interest rate
E$/€
E$/€
1
2
Dollar return
Expected
euro return
Figure 14-6
Effect of a Rise in the Euro Interest Rate
A rise in the interest rate paid by euro
deposits causes the dollar to depreciate
from (point 1) to (point 2). (This
figure also describes the effect of a rise in
the expected future $/€ exchange rate.)
E$/€
E 2 $/€
1
344 PART THREE Exchange Rates and Open-Economy Macroeconomics
deposits offer a higher expected rate of return (measured in dollar terms) than do dollar deposits.
The dollar therefore depreciates against the euro until equilibrium is reached at point 2.
We conclude that, all else equal, a rise in the expected future exchange rate causes a
rise in the current exchange rate. Similarly, a fall in the expected future exchange rate
causes a fall in the current exchange rate.
Case Study
What Explains the Carry Trade?
Over much of the 2000s, Japanese yen interest rates were close to zero (as Figure 14-2
shows) while Australia’s interest rates were comfortably positive, climbing to over
7 percent per year by the spring of 2008.
While it might therefore have appeared attractive
to borrow yen and invest the proceeds
in Australian dollar bonds, the interest parity
condition implies that such a strategy should
not be systematically profitable: On average,
shouldn’t the interest advantage of Australian
dollars be wiped out by relative appreciation
of the yen?
Nonetheless, market actors ranging from
Japanese housewives to sophisticated hedge
funds did in fact pursue this strategy, investing billions in Australian dollars and driving
that currency’s value up, rather than down, against the yen. More generally,
international investors frequently borrow low-interest currencies (called “funding” currencies)
and buy high-interest currencies (called “investment” currencies), with results
that can be profitable over long periods. This activity is called the carry trade, and
while it is generally impossible to document the extent of carry trade positions accurately,
they can become very large when sizable international interest differentials open
up. Is the prevalence of the carry trade evidence that interest parity is wrong?
The honest answer is that while interest parity does not hold exactly in practice—in
part because of the risk and liquidity factors mentioned above—economists are still
working hard to understand if the carry trade requires additional explanation. Their
work is likely to throw further light on the functioning of foreign exchange markets in
particular and financial markets in general.
One important hazard of the carry trade is that investment currencies (the high-interest
currencies that carry traders target) may experience abrupt crashes. Figure 14-7
illustrates this feature of foreign exchange markets, comparing the cumulative return to
investing in yen bonds and in Australian dollar bonds over different investment
horizons, with the initial investment being made at the start of 2003. As you can see,
the yen investment yields next to nothing, whereas Australian dollars pay off handsomely,
not only because of a high interest rate but because the yen tended to fall
against the Australian dollar through the summer of 2008. But in 2008 the Australian
dollar crashed against the yen, falling in price from yen to only yen between
July and December. As Figure 14-7 shows, this crash did not wipe out the gains to the
carry trade strategy entirely—if the strategy had been initiated early enough! Of course,
anyone who got into the business late, for example, in 2007, did very poorly indeed.
Conversely, anyone savvy enough to unwind the strategy in June 2008 would have
¥104 ¥61
¥100
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 345
50
75
100
125
150
175
200
225
2003 2004 2005 2006 2007 2008 2009 2010
Investment return
Australian dollar
Japanese yen
Figure 14-7
Cumulative Total Investment Return in Australian Dollar Compared to Japanese Yen, 2003–2010
The Australian dollar-yen carry trade has been profitable on average but is subject to sudden large reversals,
as in 2008.
Source: Exchange rates and three-month treasury yields from Global Financial Data.
9If crashes are independent events over time, the probability that a crash does not occur over five years is (0.9)5.
Therefore, the probability that a crash does occur in the five-year period is 1(0.9)5
10See Markus K. Brunnermeier, Stefan Nagel, and Lasse H. Pedersen, “Carry Trades and Currency Crashes,”
NBER Macroeconomics Annual 23 (2008), pp. 313–347. These findings are consistent with the apparently greater
empirical success of the interest parity condition over relatively long periods, as documented by Menzie Chinn,
“The (Partial) Rehabilitation of Interest Rate Parity in the Floating Rate Era: Longer Horizons, Alternative
Expectations, and Emerging Markets,” Journal of International Money and Finance 25 (February 2006), pp. 7–21.
doubled his or her money in five and a half years. The carry trade is obviously a very
risky business.
We can gain some insight into this pattern by imagining that investors expect a gradual
1 percent annual appreciation of the Australian dollar to occur with high probability
(say, 90 percent) and a big 40 percent depreciation to occur with a 10 percent probability.
Then the expected appreciation rate of the Australian dollar is:
The negative expected appreciation rate means that the yen is actually expected to
appreciate on average against the Australian dollar. Moreover, the probability of a crash
occurring in the first five years of the investment is only
percent, less than fifty-fifty.9 The resulting pattern of cumulative returns could easily look
much like the one shown in Figure 14-7. Calculations like these are suggestive, and
although they are unlikely to explain the full magnitude of carry trade returns, researchers
have found that investment currencies are particularly subject to abrupt crashes, and funding
currencies to abrupt appreciations.10
1 - (0.9)5 = 1- 0.59 = 41
Expected appreciation = (0.9) * 1 - (0.1) * 40 = -3.1 percent per year.
346 PART THREE Exchange Rates and Open-Economy Macroeconomics
SUMMARY
1. An exchange rate is the price of one country’s currency in terms of another country’s
currency. Exchange rates play a role in spending decisions because they enable us to
translate different countries’ prices into comparable terms. All else equal, a depreciation
of a country’s currency against foreign currencies (a rise in the home currency
prices of foreign currencies) makes its exports cheaper and its imports more expensive.
An appreciation of its currency (a fall in the home currency prices of foreign currencies)
makes its exports more expensive and its imports cheaper.
2. Exchange rates are determined in the foreign exchange market. The major participants
in that market are commercial banks, international corporations, nonbank financial institutions,
and national central banks. Commercial banks play a pivotal role in the market
because they facilitate the exchange of interest-bearing bank deposits, which make
up the bulk of foreign exchange trading. Even though foreign exchange trading takes
place in many financial centers around the world, modern communication technology
links those centers together into a single market that is open 24 hours a day. An important
category of foreign exchange trading is forward trading, in which parties agree to
exchange currencies on some future date at a prenegotiated exchange rate. In contrast,
spot trades are settled immediately.
3. Because the exchange rate is the relative price of two assets, it is most appropriately
thought of as being an asset price itself. The basic principle of asset pricing is that an
asset’s current value depends on its expected future purchasing power. In evaluating an
asset, savers look at the expected rate of return it offers, that is, the rate at which the
value of an investment in the asset is expected to rise over time. It is possible to measure
an asset’s expected rate of return in different ways, each depending on the units in
which the asset’s value is measured. Savers care about an asset’s expected real rate of
Complementary explanations based on risk and liquidity considerations have also
been advanced. Often, abrupt currency movements occur during financial crises, which
are situations in which other wealth is being lost and liquid cash is particularly valuable.
In such circumstances, large losses on carry trade positions are extra painful and
may force traders to sell other assets they own at a loss.11We will say much more about
crises in later chapters, but we note for now that the Australian dollar collapse of late
2008 occurred in the midst of a severe global financial crisis.
When big carry trade positions emerge, the government officials responsible for international
economic policies often lose sleep. In their early phase, carry trade dynamics
will drive investment currencies higher as investors pile in and build up ever-larger
exposures to a sudden depreciation of the investment currency. This makes the crash
bigger when it occurs, as wrong-footed investors all scramble to repay their funding
loans. The result is greater exchange rate volatility in general, as well as the possibility
of big trader losses with negative repercussions in stock markets, bond markets, and
markets for interbank loans.
11See Brunnermeier et al., ibid., as well as A. Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski, and
Sergio T. Rebelo, “Do Peso Problems Explain the Returns to the Carry Trade?” Working Paper 14054, National
Bureau of Economic Research, June 2008.
CHAPTER 14 Exchange Rates and the Foreign Exchange Market: An Asset Approach 347
return, the rate at which its value expressed in terms of a representative output basket
is expected to rise.
4. When relative asset returns are relevant, as in the foreign exchange market, it is
appropriate to compare expected changes in assets’ currency values, provided those
values are expressed in the same currency. If risk and liquidity factors do not strongly
influence the demands for foreign currency assets, participants in the foreign
exchange market always prefer to hold those assets yielding the highest expected rate
of return.
5. The returns on deposits traded in the foreign exchange market depend on interest rates
and expected exchange rate changes. To compare the expected rates of return offered
by dollar and euro deposits, for example, the return on euro deposits must be expressed
in dollar terms by adding to the euro interest rate the expected rate of depreciation of
the dollar against the euro (or rate of appreciation of the euro against the dollar) over
the deposit’s holding period.
6. Equilibrium in the foreign exchange market requires interest parity; that is, deposits of
all currencies must offer the same expected rate of return when returns are measured in
comparable terms.
7. For given interest rates and a given expectation of the future exchange rate, the interest
parity condition tells us the current equilibrium exchange rate. When the expected
dollar return on euro deposits exceeds that on dollar deposits, for example, the dollar
immediately depreciates against the euro. Other things equal, a dollar depreciation
today reduces the expected dollar return on euro deposits by reducing the depreciation
rate of the dollar against the euro expected for the future. Similarly, when the expected
return on euro deposits is below that on dollar deposits, the dollar must immediately
appreciate against the euro. Other things equal, a current appreciation of the dollar
makes euro deposits more attractive by increasing the dollar’s expected future depreciation
against the European currency.
8. All else equal, a rise in dollar interest rates causes the dollar to appreciate against the
euro while a rise in euro interest rates causes the dollar to depreciate against the euro.
Today’s exchange rate is also altered by changes in its expected future level. If there
is a rise in the expected future level of the dollar/euro rate, for example, then at
unchanged interest rates, today’s dollar/euro exchange rate will also rise.
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