Chapter 29: Problem 15

Does an expectation of a stronger exchange rate in the future affect the exchange rate in the present? If so, how?

Short Answer

Expert verified

In conclusion, expectations of a stronger exchange rate in the future do affect the present exchange rate through the concept of Interest Rate Parity (IRP). When there is a positive expectation of the domestic currency strengthening in the future, domestic interest rates are higher than foreign interest rates. This attracts investors to the domestic market, increasing demand for the domestic currency and causing it to appreciate in value. Consequently, the future expectation of a stronger exchange rate leads to a stronger exchange rate in the present.

Step by step solution

1. Understanding Interest Rate Parity (IRP)

: Interest rate parity is a major concept in international finance. It states that the difference in interest rates between two countries is equal to the percentage difference in their exchange rates. When IRP holds, investors are indifferent between investing in the domestic or foreign market because they get the same return on both investments. IRP can be represented as: \(1 + i_d = (1 + i_f) \times (1 + \Delta e)\) where: - \(i_d\) = domestic interest rate - \(i_f\) = foreign interest rate - \(\Delta e\) = expected percentage change in the exchange rate

2. Expecting a Stronger Exchange Rate in the Future

: When people expect a stronger exchange rate in the future, this means they expect a greater value of the domestic currency compared to the foreign currency. In other words, the expected change in the exchange rate, \(\Delta e\), will be positive.

3. Examining the Effect on Interest Rates

: If people expect the domestic currency to strengthen in the future (positive \(\Delta e\)), the interest rate parity equation can be rearranged to solve for the domestic interest rate, \(i_d\): \(i_d = (1 + i_f)(1 + \Delta e) - 1\) Since, the expected change in the exchange rate \(\Delta e\) is positive, this means that the domestic interest rate, \(i_d\), will be higher than the foreign interest rate, \(i_f\).

4. Domestic Currency Appreciates

: When domestic interest rates are higher than those of foreign countries, investors will be attracted to the domestic market, increasing the demand for the domestic currency. As a result, the domestic currency appreciates in value, which means the present exchange rate increases.

5. Conclusion

: In conclusion, expectations of a stronger exchange rate in the future do affect the present exchange rate. Specifically, when people expect the domestic currency to strengthen in the future, domestic interest rates will be higher compared to foreign interest rates according to the Interest Rate Parity. This higher interest rate attracts investors, increasing the demand for the domestic currency. As demand increases, the present exchange rate appreciates. Thus, the future expectation of a stronger exchange rate, when considering Interest Rate Parity, leads to a stronger exchange rate in the present.