Download S t

Chapter 18
Exchange Rate Determination I:
Prices and the Real Exchange Rate
Chapter 19
Exchange Rate Determination II:
Nominal Exchange Rates and Currency
Crises
Exchange Rate Crises & Hong Kong
 HK Dollars, as currency, is printed by money center
banks Standard Chartered, HSBC, and, now, Bank of
China.
 During the 1970’s, the banks faced little limitation on
money creation. In July of 1982, the HK dollar was
depreciating at a rate of 7.7% per year.
 In 1983, Britain and the People’s Republic were
engaged in talks about the terms on which Hong
Kong would be returned to China. Responding to
news from these talks, currency traders unloaded
there HK dollar positions.
 As a response, the Hong Kong dollar depreciated
rapidly. By September 1983, the HK dollar was
depreciating at a rate of 65% per year.
Policy Response: Currency Board
 The government announced that Hong Kong would
switch to a currency board system.
 A currency board is an arrangement whereby a
country can only issue domestic currency if it backed
up by central bank holdings of a specific foreign
currency.
 To give permission to a money center bank to print
7.8 HK dollars, the government would have to
acquire US$1.
 This has been the monetary policy of Hong Kong
ever since.
Objectives
 Define the real exchange rate and purchasing
power parity.
 Explain why inflation in Hong Kong differs
from the US.
 Demonstrate that the capital account is the
negative of the current account.
 Use interest differentials to price exchange
rate futures.
 Define uncovered interest parity and explain
exchange rate fluctuations.
Bilateral Exchange Rate
 Bilateral Exchange
Rate is the exchange
rate of one countries’
currency vs. another’s.
 Exchange rates can be
written in two ways
which are inverses of
each other.

Definition 1 The price of
foreign currency in terms
of domestic currency (the
# of domestic currency
units needed to purchase
1 unit of foreign currency)


HK$7.8 per 1 US$
Definition 2 The price of
domestic currency in
terms of foreign currency
(the # of foreign currency
units needed to purchase
1 unit of domestic
currency.

US$.128 per 1 HK$
Terminology
 Typically, a bilateral
exchange rate is reported as
the # of units of the currency
with the lower value per unit
of the currency of the higher
value.
 Examples
 HK$7.8 per 1 US$
 ¥120.14 per 1 US$
 US1.53 per 1 ₤
 An appreciation of a
currency is an increase in
the value of a currency.
 A depreciation is a decrease
in value.
 A depreciation would
increase the exchange rate
by Definition 1.
 Ex. A movement of HK$7.8
to HK$10 per US is a
depreciation.
 A depreciation would
decrease the exchange rate
by Definition 2.
 Ex. A movement of US$.127
to US$.1 would be a
depreciation of HK dollar.
Exchange Rates
 HK has a fixed bilateral exchange rate with the US.
HK Exchange Fund (the currency board operated by
HKMA) will buy or sell HK$ at a fixed exchange rate.
No one will ever buy for more or sell for less.
 Effective Exchange Rate is a weighted average of a
country’s bilateral exchange rates [weights are by
share of trade].
 HK effective exchange rate fluctuates since US dollar
fluctuates relative to important HK trading partners
such as Japan, Germany, etc.
HK Effective Exchange Rate
122
Index (100 in 1990)
120
118
116
114
112
110
108
1998
1999
2000
2001
Effective Exchange Rate HK
2002
Real Exchange Rate
 Real exchange rates are the price of domestic goods relative to
the price of foreign goods. In other words, real exchange rates
are the # of foreign goods that must be given up to obtain 1
domestic good.
 A foreigner compares the price of their foreign goods with the
price of our domestic goods.
 To buy 1 foreign good, he must pay PF foreign currency units
where PF ≡ Foreign price level.
 To buy 1 domestic good, he must pay P domestic currency
units, but he must pay Nominal Exchange Rate × P. (using
Definition 2).
P
 Define
E  Nominal Exchange Rate×
PF
 Real exchange rate can be calculated on a bilateral basis or an
index basis.
HK: US Real Exchange Rate
.22
.20
.18
.16
.14
.12
.10
.08
.06
1980
1985
1990
Real Exchange Rate
1995
2000
US$ per HK$
Law of One Price (LoOP)
 Arbitrage should insure
that identical goods
should sell for the same
price in different
markets.
 For easily transportable,
standardized goods
sold in highly
competitive markets
(such as gold), LoOP
holds.

1.
2.
3.
4.
Why doesn’t LoOP hold for
most goods?
Transport Costs – Large costs
of moving goods may keep
arbitrage from working.
Non-traded Goods – Some
goods, such as real estate,
have near infinite transport
prices.
Pricing-to-Market – Firms with
market power may find it
optimizing to charge different
prices in different markets.
Tariffs & Taxes – Imported
goods may face additional
taxes
Purchasing Power Parity (PPP)
 PPP theory says LoOP applies to all markets.
 Define relative prices of foreign goods
F
P
XP 
P
 Absolute PPP says that the real exchange
rate is always E = 1 or the Def. 2 of the
Nominal exchange rate = XP
 Relative PPP says that the growth rate of the
real exchange rate is zero
g
EXCHANGE RATE
  F 
Does PPP Hold?
 Does Absolute or Relative PPP hold?
 In short run, NO. Exchange rates are much more
volatile than inflation rates.
 In long run for countries with similar levels of
development, PPP holds.

Example. Twenty year averages for OECD countries.
 Rapidly developing countries typically see long-term
real exchange rate appreciations

Hong Kong has had much faster inflation than the US
over the life of the exchange rate peg.
Long Run
Average Annual
Inflation Differential
with the US
8.00
I t al y
6.00
NZ
4.00
UK
2.00
0.00
-4.00
-2.00
Canada
Denmar k
Swi t z. 0.00 Ger many 2.00
-2.00
Fr ance
4.00
6.00
NL
Japan
-4.00
-6.00
A v e r a g e A n n u a l D e p r e c i a t i o n ( %) A g a i n s t t h e U S $
8.00
Rich Countries are more expensive
than poor countries.
 Many types of services have unchanging technology
(like haircuts) or inherently limited supply (like real
estate).
 Most technology advances occur in traded goods
sector.
 As a country grows wealthier and more
technologically advanced, the countries residents will
pay more for real estate or services.
 If traded goods have roughly equal prices across
countries, but a countries non-traded goods start to
become more expensive as it develops, the overall
relative price of its goods will increase.
XP vs. Exchange Rate
Year 2000
Indonesia
Hong Kong
China
Japan
Macau
Singapore
Philippines
Indonesia
Exchange
Rate
XP
0.128
0.150
0.121
0.522
0.009
0.006
0.125
0.203
0.580
0.724
0.023
0.091
0.022
0.130
Real
Exchange
Rate
0.858
0.231
1.448
0.613
0.801
0.249
0.171
Philippines
Singapore
Macau
Japan
China
Hong Kong
0
0.2
0.4
0.6
0.8
1
Real Exchange Rate w/ USA
1.2
1.4
1.6
Current Account
 The current account is, conceptually, the amount of
income earned overseas less the amount of income
earned by foreigners from the domestic economies.
Current Account =
Balance on Goods
(Goods Exports-Goods
Imports)
+ Balance on Services
(Services ExportsServices Imports)
+ Net Investment
Income
(Investment Income
Earned Overseas –
Investment Income
Paid to Foreigners)
+Net Transfers
(Donations from
Overseas)
Capital & Financial Account
 The capital account (more accurately the capital &
financial account) records capital inflows into the
country. The account includes the financial account,
the capital account, and change in reserve assets.
Capital
&
Capital
Account
Financial
+ Financial
Account →
Account
=
+ Change in
Reserve Assets
(Debt Forgiveness, Patents)
Direct Investment
(FDI of Foreign Companies – FDI by
Domestic Companies)
+ Portfolio
Investment
(Domestic Securities Purchases by
Foreigners – Foreign Securities
Purchases by Domestic Residents)
+ Other Investments
(Deposits in Domestic Banks by
Foreigners – Deposits in Foreign
Banks by Domestic Residents)
-Accumulation of Foreign Exchange
Reserves
Hong Kong Current Account &
Capital Account 2001
Net
Goods
Services
Income
Current Transfers
Current Account
Capital Account
Direct Investment
Portfolio Investment
Financial Derivatives
Other Investment
Change in Reserves
Capital &Financial
Account
Credit
-64970
133468
41175
-13878
95795
 Hong Kong had a
Debit
1488982
323087
384595
4719
2201383
1553952
189619
343420
18597
2105588
96 million dollar
current account
surplus in 2001.
 Hong Kong had a
-9155
97 million dollar
Into HK
Abroad
96948
185424
88476
capital & financial
Foreign Holdings Holdings of
of Hong Kong
Foreign Assets
account deficit.
Assets
-322045
-9054
312992  The difference is
39640
-100507
-140147
133783
-327414
-461197
reserve assets.
-36530
-97359
Net Savings = Net Exports
 Capital Account = I – S
 Current Account = EX – IM
S=Y–C–G
 Y = C + I + G + EX – IM → Y – C – G = I + EX-IM
S = I + EX – IM → S – I = EX - IM
 Net Capital Outflows = Goods Outflows
 When an economy provides more goods to the world
economy than it receives in return it will have extra
foreign funds. These will be used to acquire foreign
assets.
Real Exchange Rate and Net Exports

An increase in the real exchange rate has counter-veiling
effects on net exports.
1.
The value/price of a given amount of export goods will rise
relative to a given amount of import goods when domestic
goods increase in relative price.

When relative price of domestic goods increases, the
domestic economy will export fewer goods and import
more goods.
In very short run, the first effect will dominate.
In medium to long run, the second effect tends to dominate.
2.


An economy exports 100 apples at price of $1 each and
imports 100 oranges at price of $1. Net exports are zero. If
price of apples goes to $2, then net exports will increase to
100.
Equilibrium Net Exports
E
S-I
E*
NX
Real Exchange Rate Determination
 The real exchange rate, in the medium run, is
determined by the position of savings and
investment.
 Shortfalls in domestic savings result in high real
exchange rates and low net exports
Event
S - I / NX
E
Government
Deficits
←
↑
Productivity
Boom
←
↑
Domestic Funds Shortfall
S-I’
E
S-I
E**
NX
Nominal Exchange Rate
 Quantities of funds exchanged in foreign
currency markets far exceed the currency
needed for goods trade. Most currency
trading is for asset trading or portfolio holding
purposes.
 Exchange rates are more volatile than goods
prices and quantities.
 In the short run, currencies behave like
financial assets with volatility like financial
markets.
Spot vs. Forward Markets

1.
2.
Two basic markets for
foreign exchange.
Spot Markets – In spot
markets, traders agree on
terms/rates for currency
trades with immediate
delivery (within 48 hours).
Forward Markets – In
forward markets, traders
agree on terms/rates for
currency trades at some
specified future date
(usually 30, 90 or 180 days)
 Define St as the (Definition
1) exchange rate for
currency for immediate
trade.
 Define Ft as the exchange
rate for delivery at a date on
period in the future.
Covered Interest Parity

An investor has $1 for saving. Consider two
investment strategies:
1.
2.
Invest $1 in a domestic bond with interest rate 1+i.
Use $1 to buy 1/St foreign dollars in spot markets.
Invest 1/St in foreign bonds at interest rate 1+i*.
Agree on a forward contract to sell (1+i*)/St foreign
currency for Ft (1  it* ) domestic dollars.
St
Arbitrage implies that the two strategies will have the
same pay-off.
Ft
*
1  it 

St
(1  it )
This implies a forward price. Ft  St  1  it
1  it*
Uncovered Interest Parity
 Forward prices should equal the market’s
expectation of future spot rate.

If traders think the price of foreign currency >
Ft, then why agree to deliver it at that price. If
traders think the price of foreign currency < Ft,
why agree to pay that price.
 This should imply a term for exchange rate
parity
1  it

StE1  Ft  St 
F 
1

i
t 

Implications
 We observe that different countries have
different interest rates.
 UIRP suggests that countries with high
interest rates are expected to have their
currency depreciate.

The only reason not to buy bonds in a high
interest economy is that you expect the value
of the currency to drop.
Exchange Rate Determination
 UIRP Creates a
financial market theory
of exchange rate
determination
 Graph expected returns
from investing in
domestic and foreign
currency.
 Exchange Rate
equalizes the two
returns.
Invest in
Domestic
Bonds
1+it
Invest in
Foreign
Bonds
 StE1 
F
(1

i
t )


S
t 

Equilibrium Exchange Rate
1+i
St
S*
 StE1 
F
(1

i
t )


S
t 

Return
Exchange Rate Determination

1.
•
2.
•
Implications:
Given future exchange
rates, a rise in domestic
interest rates or a fall in
interest rates will lead to
an appreciation.
A temporary increase
in domestic interest
rates will lead to
appreciation.
A rise in the future value of
the currency will increase
the current value.
Current exchange rate
depends on whole path
of future interest rates.
Event
Exchange
Rate
Temporary
i→
St ↓
Temporary
iF →
St ↑
St+1 ↑
St ↑
Rise in Domestic Interest Rates
1+i
St
S*
1+i’
 StE1 
F
(1

i
t )


S
t 

S**
Return
Contradiction and Dynamics
 If domestic bond yields
 Is this a contradiction?
are higher than foreign
yields, we should
expect a depreciation of
domestic currency over
the life of bond.
 A temporary increase in
domestic yields leads to
a domestic currency
appreciation.
 No, the domestic
currency will
immediately appreciate
and subsequently
depreciate back to the
original position.
Time Path: Temporary Rise in
Domestic Interest Rates
S
i
time
Rise in Foreign Interest Rates or
Future Depreciation
1+i
St
S***
S*
 StE1 
F
(1

i
)
t


St 

Return
Time Path: Temporary Rise in
Foreign Interest Rates
S
iF
time
Permanent Rise In Interest Rate
 Expected Inflation rises permanently leading
to a persistent rise in the interest rate.
 This should also lead to a permanent
increase in the rate of depreciation of the
currency. These two affects cancel out on
current exchange rate.
Time Path: Permanent Rise in Domestic
Interest Rates Due to Inflation
S
i
time
Expansionary Monetary Policy
 Expansionary monetary policy will generate
an immediate liquidity effect reducing
exchange rates.
 But it will lead to high future inflation and
exchange rate depreciation and high future
interest rates.
Time Path: Liquidity Effect &
Fischer Effect
S
i
time
UIRP & Exchange Rate Volatility
 Using UIRP we can write the
exchange rate as a function
of the future series of
exchange rate differentials.
 Since forecasts of future
variables may be volatile and
subject to optimism and
pessimism, this may explain
a large degree of exchange
rate volatility.
1  it 1
1  itF
S

St  2
St 
St 1 , t 1
1  it 1
1  it
F
St  2
1  itF

St 3 ,...
1  it
1  itF 1  itF1 1  itF 2 1  itF3
St 



 .....StLR ,
1  it 1  it 1 1  it  2 1  it 3
Is UIRP true
 On average, UIRP does not hold. High
interest rate countries do not see their
countries currencies deteriorate.
 On average, buying bonds in high interest
rate countries generates high average
returns.
 Why don’t investors take advantage of these
opportunities?

Investors perceive these countries as having
some risk of an exchange rate depreciation
and investors are risk averse.
Risk Adjusted UIRP
 We might assume that there is a risk premium
(either positive or negative) for investing in
foreign bonds relative to investing in domestic
bonds. 1  it  rpt  St 1  (1  it )
St
 A temporary increase in the risk premium on
foreign asset will lead to an appreciation of
the domestic currency.
Thai Interest Rates and the Dollar/Baht
Rate
.32
.28
.24
.20
16
.16
12
.12
8
4
0
1990
1992
1994
1996
1998
2000
HK$: Baht
Thai Baht Time Deposit Rate - 1Year
HK$ Time Deposits - 1 year
Costs of Exchange Rate Volatility
 Volatile exchange rates generate income risk
for firms that export goods. This may
eliminate some benefits of international trade.
 Volatile exchange rates generate liability risk
for firms that borrow foreign currency to
finance investment projects. This is especially
significant for firms in emerging markets.
Means to Fix Exchange Rate
 Currency Board: Government/central bank commit to
buy or sell foreign currency at a fixed exchange rate.
This fixes the exchange rate at that level (example:
Hong Kong).
 Dollarization: The economy abandons a national
currency and uses some foreign currency for all
transactions (example: Panama).
 Currency Area: A number of countries choose to
jointly adopt the same currency (example: Euroland).
 Exchange Rate Peg: Central bank buys and sells
foreign currency in foreign currency markets to
manipulate exchange rate.
Exchange Rate Systems
 Impossible Trinity: There are a menu of
three policy goals, among which a
government can choose at most two.
1.
2.
3.
Free International Capital Flows
Fixed Exchange Rates
Free Interest Rate/Monetary Policy
 If a country, like HK, chooses 1) and 2) then
domestic interest rates must equal foreign
interest rates.
Fixed Exchange Rates/Free Capital
Movements
 If there are free capital flows, then UIRP
holds.
 A permanent fixed exchange rate St = St+1
implies i = iF.
 If currencies have constant relative value
over time, then investing in bonds
denominated in either one should be
equivalent so interest rates should be
equivalent.
HK vs. US Interest Rates
12
10
8
6
4
2
0
1992
1994
1996
Exchange Fund Yields
1998
2000
2002
US Treasury Bill Yields
HK & US Interest Rates
 HK and US interest rates have tracked each
other closely since the imposition of the
currency board.
 When US interest rates rise, HK interest rates
must also rise to keep bondholders from
selling their HK dollar bonds.
 Major exception was in the period
immediately following the handover when risk
premium was applied to HK bonds (rp < 0).