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EXCHANGE
MARKET AND
EXCHANGE RATES
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
Today’s global economy characterized by
high degree of international capital mobility.
Hence investors can buy financial assets
denominated in many different currencies in
many markets around the world.
Would a situation in which investors could
earn a higher expected return from buying
Japanese rather than U.S. assets persist for a
long time?
What would the opportunity for traders to
make profits result into?
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
If the Japanese assets have a higher
expected rate of return than the U.S. assets.
Traders around the world will recognize a
chance to make a profit by selling U.S. assets
and buying Japanese assets.
What effects do these buying and selling
transactions have on the expected return?
FOREIGN-EXCHANGE MARKET
EQUILIBRIUM
As traders and investors sell dollar-
denominated assets and buy yen-
denominated assets.
This increases demand for yen.
10
5 R < Rf
R = Rf
10
0
R > Rf
97
1.9% 5%
9.8%
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN DOMESTIC REAL INTEREST
RATES
Interest rate is sum of real interest rate and
expected rate of inflation.
We assume expected inflation is kept
constant.
An increase in the domestic interest rates
increases expected rate of return on
domestic assets.
This shifts the R curve from R to R towards
0 1
right.
This indicates a rise in exchange rate, that
means the domestic currency will appreciate.
EXCHANGE RATE FLUCTUATIONS:
CHANGES IN DOMESTIC REAL INTEREST
RATES
Alternately if the domestic real interest rates
fall, it will lead to shifting of expected real
rate of return towards left.
This would result in falling of exchange rates.