Question

Suppose R$ > R€ + (E_($/€)^e – E$/€)/E$/€. Explain how the foreign exchange market will get into equilibrium in this situation. (Hint: Do investors prefer holding dollar deposits or euro deposits? How will their actions affect E$/€?)

Answer 1

In our given case, we are provided with the equation   > R€ + (E_($/€)^e – E$/€)/E€.

There are different factors which influence the trading of Forex(foreign Exchange) which are mainly risk of holding assets, liquidity of assests, expected return on holding asset and substitutability of that asset.

The foreign exchange market will be in equilibrium when deposits of all currencies offer the same expected rate of return known as interest parity. Interest parity implies that deposits in all currencies are deemed equally desirable assets if they offer the same expected rate of return. This condition should hold in case it doesn't and $/R$ > R€ + (E_($/€)^e – E$/€)/E€. Then no investor would want to hold euro deposits, driving down the demand for and relative price of euros. All investors would want to hold dollar deposits, driving up the demand for and relative price of dollars. The dollar would appreciate and the euro would depreciate, increasing the right side of equation (given the expected future exchange rate Ee$/€ ) until equality was achieved. We know that return on dollar deposits' curve will be vertical and expected return on euro deposits' curve will be downward sloping (you can assume some values with same expected return and form a table to see the real changes in the equation). At intersection point of both curves(1 in image attached), return on dollar deposits is equal to return on euro deposits and interest parity condition is satisfying. Any deviation in these interest rates will lead to fluctuate in the market and demand of respective deposits in foreign exchange market.

As mentioned in image,to the left of return of dollar deposits' curve, we have less demad of euro deposits and to the right of return of dollar deposits curve , we have less demand of dollar deposits. In our given equation we are at point 2.

To reach an equilibrium,we have 2 ways which are as follows:

• Fall in interest rate of Dollar return which will move return on dollar deposits curve to leftwards. A fall in interest rate of dollar will lead to depreciation of dollar and appreciation of euro. This will lead to less holding of dollar deposits and more demand of euro deposits.
• Rise in Euro interest rate which moves expected euro return upwards and interest the dollar return curve at higher point on same return on dollar deposits curve. This will lead to change in expectations of people in near future. As euro interest rate is increasing, people will expect an appreciation in euro holding and demand euro holding.

I have attached an image for better understanding.