The Foreign Exchange Market 435

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Preview 435

Foreign Exchange Market 435

What Are Foreign Exchange Rates? 436

Following the Financial News Foreign Exchange Rates 437

Why Are Exchange Rates Important? 438

How Is Foreign Exchange Traded? 438

Exchange Rates in the Long Run 439

Law of One Price 439

Theory of Purchasing Power Parity 439

Why the Theory of Purchasing Power Parity Cannot Fully Explain Exchange Rates 440

Factors That Affect Rates in the Long Run 441

Exchange Rates in the Short Run 443

Comparing Expected Returns on Domestic and Foreign Deposits 443

Interest Parity Condition 445

Equilibrium in the Foreign Exchange Market 446

Explaining Changes in Exchange Rates 448

Shifts in the Expected-Return Schedule for Foreign Deposits 448

Shifts in the Expected-Return Schedule for Domestic Deposits 450

Application Changes in the Equilibrium Exchange Rate: Two Examples 452

Changes in Interest Rates 452

Changes in the Money Supply 453

Exchange Rate Overshooting 453

Application Why Are Exchange Rates So Volatile? 455

Application The Dollar and Interest Rates, 1973-2002 455

Application The Euro's First Four Years 457

Application Reading the Wall Street Journal: The "Currency Trading" Column .457

Following the Financial News The "Currency Trading" Column 458

Summary, Key Terms, Questions and Problems, and Web Exercises 459

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