Adding Exchange Rates to the Equation
Lets take stock of where we are now since we are very close to linking everything together. We started by understanding how banking loans add to the money supply in the economy. We then looked at the various sectors that contribute to this loans or funds market. We looked at the demand and supply curve for funds that depict the relationship between funds, interest rates and the equilibrium rate of interest. We then studied how the shifts in behaviour of each sector such as households, firms and governments cause shifts in the demand or supply curve that impacts interest rates. Factors such as consumer confidence in the economy, tax policies, demographics, ease of credit availability etc cause a shift in the demand or supply curve and therefore the equilibrium rate. We then introduced the concept of YTM, HPY and HPY for foreign assets, which is a function of both interest rates and exchange rates so that we know what foreign investor fund flows are seeking. We mentioned foreign flows seek the highest comparative risk for the lowest comparative return.
We then introduced net lending or investments by foreigners to our supply curve. We saw the effect local economic events such as government defects have on the demand curve causing the demand curve to shift right raising interest rates. The rise in interest rates makes domestic investments more attractive and thereby increases net foreign investments. We now have a clear picture of the funds market, economic entities, economic and other factors and interest rates.
So far we have totally ignored exchange rates in our analysis of net investments by foreigners focusing only on interest rates. However when discussing HPY we mentioned that the HPY on foreign assets is a function of yields on the asset as well as yields on the exchange rate change.
When foreigners invest abroad they do so by selling their currency and exchanging for the foreign currency in the Foreign Exchange markets. So there is a relationship between the funds market and the exchange rate market. To take the example of the US, if interest rates rise in the US making dollar investments more attractive than the ROW, foreign funds flow will into the US. These funds will first need to enter the exchange rate market where the ROW would sell foreign currencies for the dollar. The buying of dollars increases the dollar rate against other currencies making the dollar stronger. A stronger dollar in turn changes the expected HPY yield of the dollar asset as we have seen that the return on the asset is a function of interest rates as well as exchange rate yields.
Lets examine these relationships in more detail next.