Download What Is the Equilibrium Exchange Rate?

Macroeconomic Policy Analysis
in Low Income Countries
Lecture 3:
The Exchange Rate
By Dr. Mark Ellyne
1
Goals of the Lecture
Know what factors the exchange rate
affects
Understand factors that determine
the exchange rate
Understand purchasing power parity
(PPP)
Recognize implications of alternative
exchange rate regimes
2
Measuring the
Nominal Exchange Rate
Nominal bilateral rate:
local currency(lc)/foreign currency(fc)
↑ = depreciation of lc
or
foreign currency/local currency
↑ = appreciation of lc
3
Short-Run vs Long-Run
4
Foreign Exchange Market Operations
Authorised Dealers (Banks, and others)
are licensed to buy and sell foreign
exchange.
What are the sources and uses of foreign
exchange?
Why does the price move?
5
How do the Authorities
Affect the Rate
The central bank is usually the marginal
supplier/purchaser of foreign exchange in
the interbank foreign exchange market.
Buying/selling foreign exchange affects
the central bank’s NFA or foreign
reserves.
6
Foreign Reserves and Exchange Rate
What is the relationship between the
exchange rate and the level of foreign
reserves?
7
What Impact
Does the Exchange Rate
Have on the Economy?
8
Prices & Inflation Effect
Domestic price level is a weighted sum of
prices for tradables (adjusted by exchange
rate) and nontradables
P = α Pnt + (1-α) [NER*Pt]
Pnt = Price of nontradables
Pt = Price of tradables (foreign currency)
Depreciation can cause Inflation
9
Trade Balance Effect
The relative price of imports/exports.
A depreciation makes exports
cheaper and imports more expensive.
Effect on trade balance depends on
Marshall-Lerner conditions
The equilibrium exchange rate is the
value that creates a sustainable
current account balance.
10
Marshal Lerner
Conditions
For a real depreciation (%∆RER↑)
to raise net exports,
the quantity of exports must
increase and quantity of imports
must decline (quantity effect), by
more than the exchange rate
depreciates (price effect).
11
Timing and J Curve Effect
Because prices adjust faster than quantities, the
immediate effect of a depreciation is usually a
decrease in net exports (larger trade deficit).
After people can adjust to the new prices, the
trade balance may will get better if the MarshallLerner conditions were met.
Net
Exports
Time
12
Wealth Effect
Foreign exchange is an alternative asset
class and provides a store of value.
Depreciation hurts those holding a large
share of their wealth in foreign exchange.
13
Income Effect
The exchange rate affects the income of
the foreign trade (private) sector more
than the domestic sector.
The government’s income is affected by
the exchange rate to the extent that its
foreign flows are not balanced (i.e.,
grants+loans-debt service ≠ 0).
14
Terms Of Trade (Income) Effect
Improved TOT (Px/Pm ) raises the real income of the country
Y = C + I + QX*PX – QIM*PM
If PX/PM
QX buys more imports
This usually creates a RER appreciation
15
The Long-Run Equilibrium
Exchange Rate and
Purchasing Power Parity
16
Law of One Price
The Law of one price
P = e Pf
In the absence of trade barriers,
transportation costs and tariffs, competition
will equalize the price of identical goods
across countries, when prices are expressed
in a common currency
e = local/foreign currency; increase=depreciation
17
Absolute Purchasing Power Parity
 Purchasing power parity refers to the amount
of domestic currency needed to purchase an
(approximately) equivalent basket of goods in
a foreign country.
 Why is the $ PPP GDP of a low income
country usually higher than the actual $ GDP?
 Which measure is better?
18
Absolute Purchasing Power Parity
 If the actual cost of the basket of goods is not
specified, we use the CPI of the basket.
NER = K P/Pf
What is K?
NER (e) = local/foreign currency; increase=depreciation
19
Estimating Absolute PPP
If the actual cost of the basket of goods is
not specified, we use the CPI of the basket:
NER = K P/Pf
What is K?
Log(NER) = log(K)+ log(P/Pf)
e = local/foreign currency; increase=depreciation
20
Estimating PPP
NER = K P/Pf
Log(NER) = log(K)+ log(P/Pf) + ɛ
Series are not stationary, but are they
‘cointegrated’
If ɛ is random and normally distributed, the
series are cointegrated.
Else, can use Johanson method to identify
long-run cointegration between series.
21
Dynamic PPP
If PPP holds in terms of levels, NER = K P/Pf
Then it holds in terms of changes:
Δ%NER = Δ%K + Δ%P - Δ%Pf
Δ%NER = 0 + π - πf
The change in nominal exchange rate
equals the inflation differential.
22
Does PPP Hold?
 Tends to be a long-run phenomena after taking
account of transportation costs and tax/tariff
differentials.
 Tends to be true for traded goods as opposed to
non-traded goods
 Not necessarily true in short-run owing to shortterm trends in interest rates, TOT, BOP shocks,
…
 May change due to relative productivity shift
23
Price of Tradables vs. Nontradable
Balassa-Samuelson Effect – As
countries develop, productivity in the
traded sector grows faster than in the
nontradable sector, resulting in falling
prices for tradable goods and…
Penn Effect – The relative price of
nontradables tends to be more expensive
in high income countries.
24
What is The Real Exchange Rate?
The real exchange rate is the ratio of relative
prices of two countries,
shown in one currency
RERSA$ = (CPI_US in Rand)/(CPI_SA)
= (Rand/$*CPI_US)/CPI_SA
RER = NER*(Pf/PSA)
= (NER*Pf)/Pd
RER is foreign price of local currency
Up = depreciation
25
The Real Exchange Rate
The RER is equally the price adjusted
nominal exchange rate.
RER = NER*(Pf/Pd)
RER
𝑙𝑐 𝑃𝑓
= ∗ 𝑑
𝑓𝑐 𝑃
𝑙𝑐 𝑓𝑐
= 𝑑/ 𝑓
𝑃
𝑃
The RER is an index in the same units as
the NER (lc/fc)
↑ = depreciation of lc
26
PPP and the RER
RER = NER*(Pf/P)
NERPPP=K*(P/Pf)
If PPP always holds, then the RER is
constant (=K)
Check for mean reversion (stationarity of
RER) to decide if PPP holds.
 However, PPP only tends to hold over
longer periods
27
Calculate the RER
RER = (R/US$)*(CPI_US/CPI_SA)
Plot
and test for stationarity
Using Dickey Fuller Test
28
Jan-12
Sep-11
May-11
Jan-11
Sep-10
May-10
Jan-10
Sep-09
May-09
Jan-09
Sep-08
May-08
Jan-08
Sep-07
May-07
Jan-07
Sep-06
May-06
Jan-06
Sep-05
May-05
Jan-05
Sep-04
May-04
8.00
Jan-04
Sep-03
May-03
Jan-03
4.00
Sep-02
May-02
Jan-02
South Africa RER-ZAR/$
RER
NE
14.00
13.00
12.00
12.00
11.00
10.00
10.00
Rand/US$
9.00
6.00
8.00
7.00
Real
Rand/Doll
6.00
2.00
5.00
0.00
4.00
29
Is the RER (R/$) Stationary?
Dickey Fuller Test
Random Walk:
Y t = Y t -1 + Єt
Y t - Y t -1 = Єt
30
Why Does the RER Vary?
 Short term changes in demand:
– interest rates
– Terms of trade movements
– Current account balance swings
 Long-term shifts
– productivity changes
– changes in economy (e.g. discovery of oil)
31
What is the ‘Effective’ Exchange
Rate?
=The exchange rate in terms of a basket of
partner country currencies
∑ wi JNERri = index fc/basket of lc
NERi = foreign currency/local currencyi
JNER1 = index of NERi
wi = trade weight of country i
32
The Real Effective Exchange Rate?
=The real exchange rate in terms of a basket
of partner country currencies
∑ wi JRERri = index fc/basket of lc
RERi = foreign currency/local currencyi
JRER1 = index of RERi
wi = trade weight of country i
Compiled by IMF
33
IMF REER and NEER
IMF REER compiled as
foreign/domestic currency
So = appreciation
As opposed to
NER in local/foreign currency
Beware of definition
34
IMF REER & NEER
REER & NEER in foreign/local, up=apprec
REER = NEER (CPI_local/CPI_for)
REER = NEER * Relative Price Index (RPI)
What makes REER move?
35
South Africa: REER and NEER
(IMF data, down = depreciation)
36
Is the SA REER Stationary?
REER
140
130
120
110
100
90
80
70
1970
1975
1980
1985
1990
1995
2000
2005
2010
37
REER_SA Stationary
H0: The series is nonstationary
1. It may be nonstationary
2. It may be stationary around a trend
(which is a little like non-stationary)
3. It may be stationary excluding a “break”
38
Non-Stationary (Excluding Trend)
Null Hypothesis: REER has a unit root
Exogenous: Constant
Lag Length: 0 (Automatic - based on SIC, maxlag=9)
Augmented Dickey-Fuller test statistic
Test critical values:
1% level
5% level
10% level
t-Statistic
Prob.*
-2.011787
-3.588509
-2.929734
-2.603064
0.2809
*MacKinnon (1996) one-sided p-values.
Augmented Dickey-Fuller Test Equation
Dependent Variable: D(REER)
Method: Least Squares
Date: 08/03/15 Time: 12:53
Sample (adjusted): 1971 2014
Included observations: 44 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
REER(-1)
C
-0.203254
19.75779
0.101032
10.17140
-2.011787
1.942485
0.0507
0.0588
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)
0.087894
0.066177
8.056847
2726.337
-153.2168
4.047287
0.050687
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
-0.558477
8.337444
7.055311
7.136410
7.085386
1.596141
39
Approx. Stationary Around a Trend
Null Hypothesis: REER has a unit root
Exogenous: Constant, Linear Trend
Lag Length: 1 (Automatic - based on SIC, maxlag=9)
Augmented Dickey-Fuller test statistic
Test critical values:
1% level
5% level
10% level
t-Statistic
Prob.*
-3.388732
-4.186481
-3.518090
-3.189732
0.0663
*MacKinnon (1996) one-sided p-values.
Augmented Dickey-Fuller Test Equation
Dependent Variable: D(REER)
Method: Least Squares
Date: 08/03/15 Time: 12:47
Sample (adjusted): 1972 2014
Included observations: 43 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
REER(-1)
D(REER(-1))
C
@TREND("1970")
-0.410549
0.313855
46.12632
-0.240946
0.121151
0.152689
13.66669
0.109989
-3.388732
2.055519
3.375090
-2.190635
0.0016
0.0466
0.0017
0.0345
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
0.240936
0.182546
7.626696
2268.493
-146.2763
4.126344
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
-0.575045
8.435382
6.989595
7.153427
7.050011
1.960378
40
Stationary with a Break (1983)
Null Hypothesis: REER has a unit root
Trend Specification: Intercept only
Break Specification: Intercept only
Break Type: Innovational outlier
Break Date: 1983
Break Selection: Minimize Dickey-Fuller t-statistic
Lag Length: 1 (Automatic - based on Schwarz information criterion,
maxlag=9)
Augmented Dickey-Fuller test statistic
Test critical values:
1% level
5% level
10% level
t-Statistic
Prob.*
-4.496008
-4.949133
-4.443649
-4.193627
0.0438
*Vogelsang (1993) asymptotic one-sided p-values.
Augmented Dickey-Fuller Test Equation
Dependent Variable: REER
Method: Least Squares
Date: 08/03/15 Time: 12:48
Sample (adjusted): 1972 2014
Included observations: 43 after adjustments
Variable
Coefficient
Std. Error
t-Statistic
Prob.
REER(-1)
D(REER(-1))
C
INCPTBREAK
BREAKDUM
0.550613
0.346306
48.16501
-5.852726
28.81833
0.099952
0.136294
10.58930
2.468542
7.348666
5.508749
2.540882
4.548460
-2.370924
3.921574
0.0000
0.0153
0.0001
0.0229
0.0004
R-squared
Adjusted R-squared
S.E. of regression
Sum squared resid
Log likelihood
F-statistic
Prob(F-statistic)
0.745982
0.719243
6.713566
1712.735
-140.2343
27.89890
0.000000
Mean dependent var
S.D. dependent var
Akaike info criterion
Schwarz criterion
Hannan-Quinn criter.
Durbin-Watson stat
99.29179
12.67033
6.755082
6.959872
6.830602
1.678314
41
Zambia: Why Are NER and RER
Moving in Opposite Directions?
15,000
160
10,000
Foreign/local currency
Up = Appreciation
5,000
3,500
2,500
140
NEER
120
REER
1,500
1,000
100
500
350
250
80
150
60
100
50
40
90
92
94
96
98
00
REER_ZAM
02
04
06
08
10
12
NEER_ZAM
42
Check What Is Moving the RER
RER = NER(R/$)[PSA/Pusa]
Is RER moving because of
NER or relative prices?
NER may move due to international
supply/demand (CAB)
Relative prices likely to move due to
domestic factors (Competitiveness)
• XR – measured in domestic/foreign currency; up=depreciation
44
RER Appreciation Due to
Domestic Factors
A real appreciation owing to domestic
conditions (eg. inflation) implies:
 Higher relative inflation without offsetting
adjustment of nominal exchange rate;
 Exports become more expensive, imports
less expensive, so trade balance worsens;
 Exports less competitive;
 Worsening trade balance usually means
loss of reserves
e.g., fixed NER with high inflation
45
RER Appreciation Due to
International Factors
owing to external factors
(e.g. TOT increase):
 Nominal exchange rate appreciates from
rise in world export prices;
 Exports not necessarily less competitive;
 Increase in real national income;
 Reduction in inflation;
 Upward pressure on reserves
46
How to Project the NER
No-Policy-Change Scenario: Assume that
the RER is constant in the future:
RER = NER*Pf/Pd
The expected NER is then:
NERt+1 = RER*Pd/Pft+1
Or
%ΔNER = %ΔRER+%ΔPd -%ΔPf
47
Projecting the Exchange Rate
 In the absence of specific knowledge, we will
assume a constant RER under a no-policychange scenario.
%ΔRER = %ΔNER - %ΔRPI = 0
%ΔNER = %ΔRPI
%ΔNER = (%ΔCPIcountry – %ΔCPIpartner)
RER = Index, local/forex, increase is depreciation
NER = Index, local/forex, increase is depreciation
Relative Price Index = CPIcountry/CPIpartner
Dr. M Ellyne – Macro Policy Analysis
48
Projecting the Exchange Rate
%ΔRER = 0
%ΔNER = %ΔRPI
= πhome– πpartner
The nominal rate moves by the inflation
differential.
RER = Index, local/forex, decrease is appreciation
NER = Index, local/forex, decrease is appreciation
Relative Price Index = CPIcountry/CPIpartner
Dr. M Ellyne – Macro Policy Analysis
49
What is the Dutch Disease?
When a single export good is plentiful,
easily produced, and in high (world)
demand, it can lead to a real appreciation
of the exchange rate and to an elimination
of the previous exports of traditional
goods.
E.g., oil in Nigeria eventually replaced
exports of agricultural goods.
50
The Dutch Disease
E.g., oil in Nigeria eventually replaced
exports of agricultural goods.
We can say that Angola today suffers from
the DD because their domestic prices look
very expensive in rand.
PN/PT
51
What Is the Equilibrium
Exchange Rate?
Value at which there is no pressure to
change.
Underlying value toward which the rate
moves in the absence of shocks.
Long-run equilibrium rate is compatible with
internal (full employment) and external
balance (CAB=sustainable capital flows).
Misalignment occurs when short-run rate
deviates from long-run equilibrium.
52
Alternative Methods of Identifying
the Equilibrium Exchange Rate
1. Purchasing power parity (PPP) approach
2. Equilibrium RER Estimation
3. External sustainability approach – the
exchange rate which balances the current
account
4. The exchange rate that balance the
demand for foreign assets (capital
account)
54
The Exchange Rate and Rates of Return An alternative Asset Approach
55
Domestic vs Foreign Assets
Compare asset earnings in a single
currency
Arbitrage: If it is possible to earn more
interest in a comparable bond in SA than
in the USA then money should flow into
SA and affect the expected future
exchange rate to offset that interest
differential
56
Covered Interest Parity (CIP)
Convert 1 Rand to US$ and
invest at ius =1/St*(1+ius)
Convert back to Rand at forward rate,
F: =1/St*(1+ius)*Ft
This should be equal to
investing in Rand at iza
1/St*(1+ius)*Ft ≈ (1+iza)
Spot and Forward in Rand/$
57
Testing Covered Interest Parity
IF:
Ft/St ≈ (1+it)/(1+ift)
Log(F) – log(S) = log(1+it)- log(1+ift)
f
s
i
if
THEN:
f- s = a + b (i – if)
Test if a=0 and b=1
Evidence holds
Forward premium=interest rate differential
S and F in domestic/foreign currency
Applicable to open capital markets where assets are perfect substitutes
58
Uncovered Interest Rate Parity
The interest rate differential similarly influences the future spot
rate:
E{S}/S = (1+i)/(1+if)
Or
E {%∆St+1} ≈ it - ift
Expected % change in XR = interest rate differential
And if markets are efficient:
Et {XRt+1} = XRt+1 = Ft + εt
S in domestic/foreign currency
59
Testing UIP
Under rational expectations:
E {%∆St+1} = ∆St+1
E {%∆St+1} = it - ift = ∆St+1
Then:
∆St+1 = a + b (i – if)
Test if a=0 and b=1
Evidence does not support
60
UIP Does Not Necessarily Hold
Infinite number of factors can come into
play that determine the future exchange
rate.
Interest differential is predominately used
for setting the forward rate used by banks.
Forward rate is estimator of future actual
rate.
61
The Exchange Rate and
Interest Rate Policy
E{St+1}/St -1 = i – if
If the domestic interest rate is raised, does
St+1 or St move?
S=NER in domestic/foreign currency = R/$
Decrease = appreciation
62
Exchange Rate Regimes
Fixed (to another currency)
.
.
.
(Independently) Floating
63
Fixed Exchange Rate Regimes
 A Fixed exchange rate between a
country's currency and an "anchor
currency,"
 Automatic convertibility guaranteed
by central bank
 A long-term commitment to the peg
64
How to Hold a Peg?
At equilibrium, the foreign exchange
inflows cover the foreign exchange outflow
at the fixed exchange rate
What happens if a shock temporarily
raises the demand for foreign exchange?
Where does the extra foreign exchange
come from?
65
Implications of Peg
Rate remains fixed but no control over the
level of foreign reserves (NFA) changes.
i.e., Central Bank loses control over
money supply.
66
Implications of Floating Rate
Free float – Central bank controls money
supply or the interest rate and does not
intervene in foreign exchange market, i.e.,
does not buy or sell foreign reserves.
Managed float with no predetermined
path – Central Bank may intervene in
foreign exchange market, but no exchange
rate target.
70
Declared Exchange Rate Regimes2011
No. of independent currencies – 13
Currency Boards – 12
Pegged – 43
Crawl like peg - 15
Managed float - 35
Independent float – 31
Source: IMF AREAER, 2011
71
How Convertible are Currencies?
When IMF member countries accept
Article VIII it means that they allow free
convertibility of their currency for current
account transactions—not necessarily
for capital account transactions.
72
Impossible Trinity
In an environment of free capital mobility,
it is either possible to maintain a fixed
exchange rate or an independent
monetary policy, but not both.
73
Given Capital Mobility?
If the exchange rate is fixed to a partner
currency (like Namibia), can you change
your interest rate to manage the domestic
economy?
74
Policy Choice for
Inflation Control
Capital Mobility
Independent
Monetary Policy, r
or
Fixed
Exchange
Rate, NER
Inflation control
75
Alternative Policy Anchors
Inflation Targeting means using the
interest rate to fight inflation, while leaving
the exchange rate to float.
alternatively
Fixing the exchange rate to a low inflation
partner currency locks in the inflation to
that of the partner and requires similar
interest rates.
76
Can we set the interest rate
and exchange rate?
In a centrally planned economy with a
closed capital account and the current
account mostly under government control
(for imports and exports), it could be
possible to set your own exchange rate
and own interest rates since the interest
will not affect capital flows. (e.g. former
USSR)
77
Question?
Does capital mobility exist (de facto not de
jure)? Or
Can you effectively close the capital
account (except for transactions
specifically permitted by the government)?
78
What Are Exchange Controls
Payment restrictions (for foreign
exchange) on current account and/or
capital account transactions
Aimed at residents and/or
nonresidents
Aimed at inflows and/or outflows
79
Reviving Capital Controls
to Manage Crises
IMF has recently expressed concerns
about orderly liberalisation of capital
controls by systemically important
emerging markets, like China and India.
Fund embraces “Capital Flow Measures,”
including capital controls and prudential
measures on a temporary basis, to
dampen the impact of capital flows.
80
You Should Know
Understand factor affecting the exchange
rate
Understand what factors the exchange
rate affects
Be able to estimate the future PPP rate
Know the difference between fixed and
floating regimes
81