Lecture 12
EXCHANGE RATES: THE ASSET MARKET APPROACH

Main idea

• In the short run, exchange-rate movements can be explained using the Interest Parity Condition.

• Suppose interest rates in the U.S. and Japan are different. Which will yield a higher return -- investing in the U.S. money market or the Japanese money market?

1. Assumptions

• There is perfect capital mobility between the U.S. and Japan
• There are no taxes on interest income

2. Notation

r_US = Interest rate in the U.S. money market
r_J = Interest rate in the Japanese money market
E = Spot exchange rate, in $/yen
E^e = Expected future exchange rate, in $/yen

3. Returns on deposits in two countries

• Dollar return on dollar deposits = Interest rate in the U.S.

• Expected dollar return on yen deposits = Interest rate in Japan + Expected rate of dollar depreciation
• As E increases, the expected dollar return on yen deposits decreases: Why?
  A current depreciation of the dollar makes the "expected future depreciation" smaller, ceteris paribus.

• Plot dollar returns in each case vs. the spot exchange rate (E on the vertical axis)

4. Equation signifying interest parity

5. Analysis

• Given: (a) Interest rate in the U.S., (b) Interest rate in Japan, (c) Expected exchange rate one year hence

• Obtain the eqbm (spot) exchange rate
  • Increase in the U.S. interest rate lowers E (why?)

  • Increase in the Japanese interest rate raises E (why?)

  • Increase in the expected rate of depreciation of the dollar raises E (why?)

5.1 Question

• Under a system of fixed exchange rates and perfect capital mobility, what is the relationship between the interest rates in the two countries?

6. Why the interest parity condition may not hold

• Is capital freely mobile?

• Does either government impose taxes on interest income?