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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