determining exchange rates

8/9/2019 determining exchange rates

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Lecture 3Lecture 3

International FinanceInternational Finance

ECON 243ECON 243 Summer I, 2005Summer I, 2005Prof. Steve CunninghamProf. Steve Cunningham


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1993 1994 1995 1996 1997

Exchange rate componentsExchange rate components

Yens trade-

weighted

exchange value

Fundamentally

driven long-run

equilibrium pathFundamentally

driven medium-run

cyclical path

Technically driven

short-run

overshooting path

Fundamental

equilibrium path


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What Determines Exchange Rates?What Determines Exchange Rates?

Short runShort run (hours, days, months)(hours, days, months) related torelated to

financial transfers because of the speed of thesefinancial transfers because of the speed of these

transactions. Therefore:transactions. Therefore:

Asset Market ApproachAsset Market Approach: differences in real interest rates,: differences in real interest rates,hence our interest in:hence our interest in:

Covered Interest DifferentialsCovered Interest Differentials

Uncovered Interest DifferentialsUncovered Interest Differentials

Shifting expectations of future exchange ratesShifting expectations of future exchange rates

Medium runMedium run (years)(years)

Economic cycles (Income differentials)Economic cycles (Income differentials)


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Interest Rate DifferentialsInterest Rate Differentials

Short term real interest rate differentialsShort term real interest rate differentials

influence international capital movementsinfluence international capital movements

Real interest rate is nominal minus inflationReal interest rate is nominal minus inflation

Low short term rates lead to less demandLow short term rates lead to less demand

for the currency and depreciationfor the currency and depreciation

High rates lead to greater demand for theHigh rates lead to greater demand for the

currency and appreciationcurrency and appreciation


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30 35 40 45 50 55 60 65 70

Millions of Euros

Impact of interest rate differentialsImpact of interest rate differentials

Dollars

per Euro

S0

A

D0

.80

.75

B

D1

S1


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Market expectationsMarket expectations

As with stock markets, foreign exchangeAs with stock markets, foreign exchange

markets react quickly to news or evenmarkets react quickly to news or even

rumors that point to future changesrumors that point to future changes

affecting ratesaffecting rates

Future expectations can be selfFuture expectations can be self--fulfilling;fulfilling;

speculative bubbles can start without anyspeculative bubbles can start without any

real information but can become selfreal information but can become selfsustaining for a whilesustaining for a while


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Determining Exchange RatesDetermining Exchange Rates (Continued)(Continued)

Long runLong run (many years)(many years) -- movements ofmovements of

goods, services, investment, influenced by:goods, services, investment, influenced by:

Inflation rates (relative prices:Inflation rates (relative prices:

Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)

LongLong--term investment profitabilityterm investment profitability

Consumer tastesConsumer tastes

LongLong--term real GDP growth ratesterm real GDP growth rates ProductivityProductivity

Trade policyTrade policy


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Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)some historysome history

The theory of PPP has been around as long as paperThe theory of PPP has been around as long as paper

money. It is one of the oldest theories of exchange ratemoney. It is one of the oldest theories of exchange rate

determination. Hence we present it first.determination. Hence we present it first.

It was discussed in 16It was discussed in 16thth Century Spain, for example.Century Spain, for example.

It was last resurrected by Gustav Cassel in the periodIt was last resurrected by Gustav Cassel in the period

between WWI and WWII. He used it in discussions of howbetween WWI and WWII. He used it in discussions of how

much European countries would have to either changemuch European countries would have to either change

their exchange rates or their domestic price levels, giventheir exchange rates or their domestic price levels, given

that WWI had changed the relative prices in the countriesthat WWI had changed the relative prices in the countries(causing different inflation rates in the countries).(causing different inflation rates in the countries).

It is based on theIt is based on the Law Of One Price (LOOP)Law Of One Price (LOOP)..


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Law of One Price (LOOP)Law of One Price (LOOP)

TheThe law of one pricelaw of one price is:is:

In a competitive market, if two goodsIn a competitive market, if two goods

are identical, then they should sell forare identical, then they should sell for

the same price.the same price.

If the two goods were in the same place and bothIf the two goods were in the same place and both

available to customers, then customers wouldavailable to customers, then customers would

always choose the cheaper of the two goods,always choose the cheaper of the two goods,forcing the sellers of the more expensive one toforcing the sellers of the more expensive one to

lower their price.lower their price.


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ArbitrageArbitrage

If the two goods were not in the sameIf the two goods were not in the same

market (place), thenmarket (place), then arbitragearbitrage wouldwould

operate to equalize the prices.operate to equalize the prices.

ArbitrageArbitrage is the process of buying or sellingis the process of buying or selling

something in order to exploit a pricesomething in order to exploit a price

differential so as to make a riskless profit.differential so as to make a riskless profit.

Arbitrageurs seek to find and exploit priceArbitrageurs seek to find and exploit pricedifferentials between markets (across space).differentials between markets (across space).

Arbitrageurs seek to carry goods across markets.Arbitrageurs seek to carry goods across markets.


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SpeculationSpeculation

If the two goods were not being demanded at theIf the two goods were not being demanded at the

same time, and the good was storable, thensame time, and the good was storable, then

speculationspeculation would tend to equalize prices.would tend to equalize prices.

SpeculationSpeculation is the holding of a good or security inis the holding of a good or security inthe hope of profiting from a future rise in price.the hope of profiting from a future rise in price.

Speculators arbitrage across time. Speculators carrySpeculators arbitrage across time. Speculators carry

the goods across time.the goods across time.

Because no one really knows the future, speculation isBecause no one really knows the future, speculation isinherently risky. (Spatial) arbitrage is not.inherently risky. (Spatial) arbitrage is not.


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Deviations from LOOPDeviations from LOOP

Carrying (storage) costsCarrying (storage) costs reduce the profits fromreduce the profits fromspeculation, andspeculation, and

Transportation costsTransportation costs reduce the profits fromreduce the profits fromarbitrage.arbitrage.

Transactions costsTransactions costs are other costs associated with aare other costs associated with atransaction, over and above the cost of the goodtransaction, over and above the cost of the goodwhich actually changes hands. These also reducewhich actually changes hands. These also reducethe profits associated with arbitrage andthe profits associated with arbitrage andspeculation.speculation.

All three of these can result in deviations from theAll three of these can result in deviations from theLOOP.LOOP.


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International LOOPInternational LOOP

Transportation costs can be significant.Transportation costs can be significant.

Legal barriers and tariffs may exist.Legal barriers and tariffs may exist.

Some goods are not traded internationally. TheseSome goods are not traded internationally. These

are goods for which interare goods for which inter--regional priceregional pricedifferentials cannot be eliminated by arbitrage.differentials cannot be eliminated by arbitrage.

Examples ofExamples ofnontradeable goodsnontradeable goods are:are:

HousesHouses

Medical servicesMedical services

Goods that are not available in all countriesGoods that are not available in all countries

Goods that do not survive transportationGoods that do not survive transportation


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International LOOPInternational LOOP (Continued)(Continued)

When we add the complication of (flexible)When we add the complication of (flexible)

exchange rates, we have to restate the lawexchange rates, we have to restate the law

of one price for international trade:of one price for international trade:

In a competitive market, similarIn a competitive market, similar

goods in different countries shouldgoods in different countries should

sell for the same price when the pricessell for the same price when the prices

are stated in the same currency.are stated in the same currency.

In effect, this means that we have to apply the exchange

rate to translate the prices of the goods to a common

currency. After doing so, the prices should be equal.


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International LOOPInternational LOOP (Continued)(Continued)

Thus ifThus if ppdd is the domestic price andis the domestic price and ppff is theis the

foreign price of the same good, andforeign price of the same good, and ee is theis the

spot price of the foreign currency in thespot price of the foreign currency in the

domestic currency, thendomestic currency, thenppdd = e= e ppff

andand

epepff/ p/ pdd = 1 and= 1 and e = pe = pdd / p/ pff But is this true?But is this true?

Big Mac Index (Next Slide)Big Mac Index (Next Slide)


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Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)

Extending the LOOP, ifExtending the LOOP, if PPdd is the domestic priceis the domestic pricelevel andlevel and PPff is the foreign price level,is the foreign price level,

Q = ePQ = ePff/ P/ Pddis called theis called the real exchange ratereal exchange rate whereaswhereas rrss is calledis called

thethe nominal exchange ratenominal exchange rate..

If PPP holds, thenIf PPP holds, then QQ = 1= 1andand e = Pe = Pd /d /PPff..

This is referred to asThis is referred to as absolute purchasing powerabsolute purchasing powerparityparity..

Restated: The general level of prices, whenRestated: The general level of prices, whenconverted to a common currency, will be the sameconverted to a common currency, will be the samein every country.in every country.


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Q: Empirical EvidenceQ: Empirical Evidence

CountryCountry QQ

United KingdomUnited Kingdom 0.960.96

CanadaCanada 1.301.30

JapanJapan 0.780.78

GermanyGermany 1.001.00

SwedenSweden 0.890.89

NorwayNorway 0.890.89

KoreaKorea 1.961.96

MexicoMexico 1.721.72

ChinaChina 4.764.76

IndiaIndia 5.265.26


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PPPPPP (Continued)(Continued)

This is a simpleThis is a simple monetary model of the exchange ratemonetary model of the exchange rate..

Strictly speaking, it does not depend upon the LOOP.Strictly speaking, it does not depend upon the LOOP.

We have ignored transactions costs, transportationWe have ignored transactions costs, transportation

costs, carrying costs, tariffs, nontraded goods, etc.costs, carrying costs, tariffs, nontraded goods, etc. We have ignored the problem that not all markets areWe have ignored the problem that not all markets are

competitive.competitive.

We have ignored the problem of different weights inWe have ignored the problem of different weights in

computing the price levels of the countries involved.computing the price levels of the countries involved.


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This is an extension of the LOOP. At least on averageThis is an extension of the LOOP. At least on average

(maybe?) goods should cost the same in all countries (aside(maybe?) goods should cost the same in all countries (aside

from tariffs, transportation costs, etc.).from tariffs, transportation costs, etc.).

If this is true, then exchange rates must adjust to makeIf this is true, then exchange rates must adjust to make

prices equal across countries, at least over the long run.prices equal across countries, at least over the long run.

This isThis is LONG RUNLONG RUN because it does not consider that pricebecause it does not consider that price

rigidities exist that make price adjustments sometimes slow.rigidities exist that make price adjustments sometimes slow.

If two countries have different inflation rates, exchangeIf two countries have different inflation rates, exchange

rates will tend to move in opposite directions to keep pricesrates will tend to move in opposite directions to keep pricesthe same.the same.


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This leads to proposition known asThis leads to proposition known as Relative PPPRelative PPP::

The percentage change in the exchange rateThe percentage change in the exchange rate

between two currencies over any period equalsbetween two currencies over any period equals

the difference between the percentage changesthe difference between the percentage changesin national price levels.in national price levels.

This amounts to:

rate of appreciation of the foreign currency = d f,

which implies that an increase in the domestic inflation

rate will raise the spot exchange rate proportionately.


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PPP and Interest ParityPPP and Interest Parity

Notice that interest parity is essentially anNotice that interest parity is essentially anextension of relative PPP.extension of relative PPP.

Interest is the price of borrowing, and interestInterest is the price of borrowing, and interestparity arguments (covered interest parity andparity arguments (covered interest parity anduncovered interest parity) argue that changes inuncovered interest parity) argue that changes inthese special prices will cause adjustments in thethese special prices will cause adjustments in theexchange rate.exchange rate.

A major difference between interest parity andA major difference between interest parity and

PPP is that interest parity is related to financialPPP is that interest parity is related to financialassets whose prices adjust very quickly, and thatassets whose prices adjust very quickly, and thathave substantially lower transactions costs,have substantially lower transactions costs,transportation costs, etc.transportation costs, etc.


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Empirical EvidenceEmpirical Evidence

PPP predictsPPP predicts fairly wellfairly well, both in absolute and, both in absolute and

relative form, at the level ofrelative form, at the level ofone heavily tradedone heavily traded

commoditycommodity for which the governments involved dofor which the governments involved do

not interfere with trade. (wheat, gold, etc.)not interfere with trade. (wheat, gold, etc.) Thus for something like wheat LOOP is a pretty goodThus for something like wheat LOOP is a pretty good

approximation.approximation.

PPP predicts onlyPPP predicts only moderately wellmoderately well at the level ofat the level of

allall tradedtraded goods. We run into a variety ofgoods. We run into a variety ofproblems, including barriers to trade,problems, including barriers to trade,

noncompetitive markets, and index construction.noncompetitive markets, and index construction.


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Empirical EvidenceEmpirical Evidence (Continued)(Continued)

PPP predictsPPP predicts poorlypoorly at the level ofat the level ofall productsall products inin

an economy. (Using CPI, GDP deflators, etc.)an economy. (Using CPI, GDP deflators, etc.)

PPP predictsPPP predicts better over the long runbetter over the long run than thethan the

short run.short run. According to Froot and Rogoff (1995), for majorAccording to Froot and Rogoff (1995), for major

industrialized countries it takes about four years onindustrialized countries it takes about four years on

average for a deviation from PPP to be reduced byaverage for a deviation from PPP to be reduced by

half.half.

PPP has its worst problems withPPP has its worst problems with nontradednontraded goods.goods.


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Relative PPP: Evidence (1)Relative PPP: Evidence (1)


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Relative PPP: Evidence (2)Relative PPP: Evidence (2)


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PPP: As LongPPP: As Long--Run Tendency (1)Run Tendency (1)


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PPP: As LongPPP: As Long--Run Tendency (2)Run Tendency (2)


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Monetary Approach:Monetary Approach:

Quantity TheoryQuantity Theory

According to the Quantity Theory, the moneyAccording to the Quantity Theory, the money

supply of a country is proportional to its nominalsupply of a country is proportional to its nominal

income.income.

LetLet YY be real GDP,be real GDP, PP be the price level, andbe the price level, and MMss

bebethe money supply. Thenthe money supply. Then

M = kPYM = kPY

wherewhere kk (=1/(=1/V)V) is the average holding period foris the average holding period for

money.money. Then for a foreign country,Then for a foreign country,

MMff= k= kffPPffYYff ..


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Quantity TheoryQuantity Theory

Using the Quantity Theory, we can examine the relationshipUsing the Quantity Theory, we can examine the relationship

between prices in two countries:between prices in two countries:

(P/P(P/Pff) = (M/M) = (M/Mff)(k)(kff/k)(Y/k)(Yff /Y)/Y)

We can then combine this with PPP to write:We can then combine this with PPP to write:

e = P/Pe = P/Pff= (M/M= (M/Mff)(k)(kff/k)(Y/k)(Yff/Y)/Y)

Also note that a 1% change inAlso note that a 1% change in (M/M(M/Mff), (k), (kff/k),/k), oror (Y(Yff/Y)/Y) leadsleads

to a 1% change into a 1% change in rrss .. We say that the elasticity of each ofWe say that the elasticity of each ofthese terms is one.these terms is one.

This leads us to extend PPP to a more general monetaryThis leads us to extend PPP to a more general monetary

approach to exchange rate determination.approach to exchange rate determination.


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Monetary approachMonetary approach

These approaches focus on exchange rates as the result ofThese approaches focus on exchange rates as the result of

supply and demand for money at home and abroad. It issupply and demand for money at home and abroad. It is

an equilibrium, supply and demand approach.an equilibrium, supply and demand approach.

Money supply and demand operate through the linkageMoney supply and demand operate through the linkage

of prices and inflation rates.of prices and inflation rates.

All else equal,All else equal, the spot exchange rate is raised bythe spot exchange rate is raised by::

A rise in the domestic money supply relative to the foreign moneyA rise in the domestic money supply relative to the foreign money

supply,supply,

A rise in the domestic price level relative to the foreign one, orA rise in the domestic price level relative to the foreign one, or A rise in foreign real GDP relative to domestic real GDP.A rise in foreign real GDP relative to domestic real GDP.

A rise in domestic velocity, or equivalently a decline in theA rise in domestic velocity, or equivalently a decline in the

domesticdomestic k,k, relative to domestic velocity orrelative to domestic velocity or kk, e.g., as the result of a, e.g., as the result of a

change in the domestic payments systemchange in the domestic payments system


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Policy PrescriptionsPolicy Prescriptions

If a foreign country wanted to raise itsIf a foreign country wanted to raise itsexchange rate (relative to the dollar), itexchange rate (relative to the dollar), itcould do so by:could do so by:

Decreasing its money supplyDecreasing its money supply Causing disinflationCausing disinflation

Reducing its money supply would raiseReducing its money supply would raisedomestic interest rates and slow the domesticdomestic interest rates and slow the domestic

economy. Eventually output would recover,economy. Eventually output would recover,but prices would declinebut prices would decline (P(Pffqq))as a result ofas a result offewer dollarsfewer dollars (M(Mffqq).).


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Real income differentialsReal income differentials

A country with faster economic growth thanA country with faster economic growth than

the rest of the world will have athe rest of the world will have a

depreciating currency (other things beingdepreciating currency (other things being

equal)equal) Imports rise faster than exportsImports rise faster than exports

Real income changes can also reflect otherReal income changes can also reflect other

processes, which might lead to rising exportsprocesses, which might lead to rising exports


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0 5 10 15 20 25 30 35 40

Millions of Pounds

Impact of real income differentialsImpact of real income differentials

Dollars

per PoundS0

A

D0

1.60

1.50

D1


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Next: ShorterNext: Shorter--RunRun

AssetAsset--markets approachmarkets approach

Currencies are a kind of financial asset thatCurrencies are a kind of financial asset that

are part of asset portfolios held by investorsare part of asset portfolios held by investors

Short run exchange rate changes are causedShort run exchange rate changes are caused

by shifts in the kind and location of financialby shifts in the kind and location of financial

assets investors want to holdassets investors want to hold

Investors shift between assets based onInvestors shift between assets based on

market expectations for expected returnsmarket expectations for expected returns

Documents

determining exchange rates