The Effect of Changes in the Expected Exchange Rate on the Spot Exchange Rate

Suppose that the FOREX is initially in equilibrium such that S_£ = D_£ at the exchange rate E¹. Now suppose investors suddenly raise their expected future exchange rate, E^e_$/£. This means that if investors had expected the £ to appreciate, they now expect it to appreciate more. Likewise, if investors had expected the $ to depreciate they now expect it to depreciate more. Also, if they had expected the £ to depreciate, they now expect it to depreciate less. Likewise, if they had expected the dollar to appreciate they now expect it to appreciate less.

This change might occur because new information is released. For example the British Central Bank might release information that suggest an increase chance that the £ will rise in value in the future.

The increase in the expected exchange rate raises the rate of return on British assets, RoR_£, which, at the original exchange rate causes the rate of return on British assets to exceed the rate of return on US assets, RoR_£ > RoR_$. This will raise the demand for £ on the FOREX as US investors seek the higher average return on British assets. It will also lower the supply of British £s by British investors who decide to invest at home rather than abroad. Thus in terms of the graph, D_£ shifts right (black to red) while S_£ shifts left (black to red). The equilibrium exchange rate rises to E². This means that the increase in the expected exchange rate, E^e_$/£, causes a £ appreciation and a $ depreciation.

This is a case of self-fulfilling expectations. If investors suddenly think the £ will appreciate more in the future and if they act upon that belief, then the £ will begin to rise in the present hence fulfilling their expectations.

As the exchange rate rises RoR_£ falls since . RoR_£ continues to fall until the interest parity condition, RoR_$ = RoR_£, again holds.

International Finance Theory and Policy - Chapter 20-6: Last Updated on 12/31/05