Asset Approach to Exchange Rate Determination

#### Finance 20-3

The interest parity condition can be used to develop a model of exchange rate determination. That is, investor behavior in asset markets which generates interest parity can also explain why the exchange rate may rise and fall in response to market changes.

The first step is to reinterpret the rate of return calculation described above in more general (aggregate) terms. Thus instead of using the interest rate on a one year CD, we will interpret the interest rates in the two countries as the average interest rates currently prevailing. Similarly, we will imagine that the expected exchange rate is the average expectation across many different individual investors. The rates of return then are the average expected rates of return on a wide variety of assets between the two countries.

Next we imagine that investors trade currencies in the foreign exchange market. Each day some investors come to a market ready to supply a currency in exchange for another while others come to demand currency in exchange for another.

Consider the market for British pounds(£) in New York depicted in the adjoining diagram. We measure the supply and demand of £s along the horizontal axis and the price of £s (i.e. the exchange rate E\$/£) on the vertical axis. Let S£ represent the supply of £s in exchange for dollars at all different exchange rates that might prevail. The supply is generally by British investors who demand dollars to purchase dollar denominated assets. However, supply of £s might also come from US investors who decide to convert previously acquired £ currency. Let D£ the demand for £s in exchange for dollars at all different exchange rates that might prevail. The demand is generally by US investors who supply dollars to purchase £ denominated assets. Of course, demand might also come from British investors who decide to convert previously purchased dollars. Recall that which implies that as E\$/£ rises RoR£ falls. This means that British investors would seek to supply more £s at higher £ values but US investors would demand fewer £s at higher £ values. This explains why the supply curve slopes upward and the demand curve slopes downward.

The intersection of supply and demand specifies the equilibrium exchange rate, E1, and the quantity of £s, Q1, traded in the market.