We now use what we have learned about the demand for foreign currency assets to describe how exchange rates are determined. We will show that the exchange rate at which the market settles is the one that makes market participants content to hold existing supplies of deposits of all currencies. When market participants willingly hold the existing supplies of deposits of all currencies, we say that the foreign exchange market is in equilibrium.
The description of exchange rate determination given in this section is only a first step: A full explanation of the exchange rate’s current level can be given only after we examine how participants in the foreign exchange market form their expectations about the exchange rates they expect to prevail in the future. The next two chapters look at the factors that influence expectations of future exchange rates. For now, however, we will take expected future exchange rates as given.
The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any two currencies are equal when measured in the same currency is called the interest parity condition. It implies that potential holders of foreign currency deposits view them all as equally desirable assets, provided their expected rates of return are the same.
Let’s see why the foreign exchange market is in equilibrium only when the interest parity condition holds. Suppose the dollar interest rate is 10 percent and the euro interest rate is 6 percent, but that the dollar is expected to depreciate against the euro at an 8 percent rate over a year. (This is case 3 in Table 14-3.) In the circumstances described, the expected rate of return on euro deposits would be 4 percent per year higher than that on dollar deposits. We assumed at the end of the last section that individuals always prefer to hold deposits of currencies offering the highest expected return. This implies that if the expected return on euro deposits is 4 percent greater than that on dollar deposits, no one will be willing to continue holding dollar deposits, and holders of dollar deposits will be trying to sell them for euro deposits. There will therefore be an excess supply of dollar deposits and an excess demand for euro deposits in the foreign exchange market.
As a contrasting example, suppose that dollar deposits again offer a 10 percent interest rate but euro deposits offer a 12 percent rate and the dollar is expected to appreciate against the euro by 4 percent over the coming year. (This is case 4 in Table 14-3.) Now the return on dollar deposits is 2 percent higher. In this case no one would demand euro deposits, so they would be in excess supply and dollar deposits would be in excess demand.
When, however, the dollar interest rate is 10 percent, the euro interest rate is 6 percent, and the dollar’s expected depreciation rate against the euro is 4 percent, dollar and euro deposits offer the same rate of return and participants in the foreign exchange market are equally willing to hold either. (This is case 2 in Table 14-3.)
Only when all expected rates of return are equal—that is, when the interest parity condition holds—is there no excess supply of some type of deposit and no excess demand for another. The foreign exchange market is in equilibrium when no type of deposit is in excess demand or excess supply. We can therefore say that the foreign exchange market is in equilibrium when, and only when, the interest parity condition holds.
To represent interest parity between dollar and euro deposits symbolically, we use expression (14-1), which shows the difference between the two assets’ expected rates of return measured in dollars. The expected rates of return are equal when
You probably suspect that when dollar deposits offer a higher return than euro deposits, the dollar will appreciate against the euro as investors all try to shift their funds into dollars. Conversely, the dollar should depreciate against the euro when it is euro deposits that initially offer the higher return. This intuition is exactly correct. To understand the mechanism at work, however, we must take a careful look at how exchange rate changes like these help to maintain equilibrium in the foreign exchange market.