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MBA34 Managerial Excellence Exchange rate economics The firm and its environment - Francesco Giavazzi Copyright SDACopyright Bocconi 2004 SDA Bocconi 2006 1 The exchange rate, a confusing concept • The euro - one of many currencies – Each currency linked by a rate of exchange to the other n-1 currencies in the world. Exchange rates are in the first instance bilateral • We may also compute the “average” rate of a currency with currencies of trading partners – This is the effective exchange rate • A currency is also an asset, a way to store wealth. The value of a currency tomorrow is not the same as the value of that currency tomorrow set of today. – The spot rate between two currencies is not the same as their forward rate • And the rate at which two currencies are exchanged is not the same as the exchange rate that measures the purchasing power of a given currency in terms of goods in the domestic country and in a foreign country – Nominal rates are not the same as real rates Copyright SDA Bocconi 2004 2 Euro Effective Exchange Rate is Trade weighted, use amount of trade to weight bilateral Xrates 4% Singapore Dollar 4% Danish Krone 2% Norw egian Krone 2% Canadian Dollar 1% Australian Dollar 25% US Dollar 4% Hong Kong Dollar 5% Korean Won 6% Sw edish Krona 9% Sw iss Franc 15% Japanese Yen Copyright SDA Bocconi 2004 24% Pound Sterling 3 Euro effective exchange rate Yearly averages, from daily data 135.0 130.0 125.0 120.0 115.0 110.0 105.0 100.0 1999 2000 2001 2002 2003 2004 2005 2006 2008 2007 95.0 Estimates and assumptions1 Since 1999, the Euro has appreciated by some 25% or so on average with respect to the other currencies 4 Copyright SDA Bocconi 2004 Source: Oecd Economic Outlook, June 2008 US$ effective exchange rate 2% Brazilian Real 2% Thai Baht 2% Australian Dollar 3% Malaysian 2% Sw iss Franc Ringgitt 3% Hong Kong Dollar 1% Indonesian Rupiah 1% Philippine Peso 19% Canadian Dollar 3% Singapore dollar 4% Korean Won 4% Taiw anese Dollar 5% Pound Sterling 9% Mexican Peso 7% Chinese Yuan Copyright SDA Bocconi 2004 18% Euro 16% Japanese Yen 5 Two ways of appreciating the euro appreciation with respect to US$ 1. How many euros to buy a dollar? Or: Yearly averages, from daily data 1.200 1.100 1.000 0.900 0.800 0.700 0.600 2007 1999 1999 2001 2002 2003 2004 2005 2006 2008 Estimates and assumptions1 Since 2001, the Euro has appreciated by some 40% or so with respect to the US dollar Copyright SDA Bocconi 2004 Source: Oecd Economic Outlook, June 2008 6 …. 2. How many dollars to buy a euro? (Daily data) 1.3 $/Euro 1.15 1 0.85 0.7 06/12/19 23/06/20 09/01/20 28/07/20 13/02/20 01/09/20 20/03/20 06/10/20 23/04/20 09/11/20 99 00 01 01 02 02 03 03 04 04 Copyright SDA Bocconi 2004 7 Appreciation/depreciation of nominal Xrates • Appreciation of €: rise in value of €, so €1 buys more foreign currency – 1.10 US$/€ in 1999 to 1.35 US$/€ in 2008 • Depreciation of €: decline in value of €, so €1 buys less foreign currency – 1.10 US$/€ in 1999 to 1.00 US$/€ in 2000 Copyright SDA Bocconi 2004 8 Real Exchange Rate is a measure of competitiveness (the nominal exchange rate is not) € Domestic Price Level Real Rate = Nominal Rate x Foreign Price Level $/€ $ Note that the real rate is unit-less To measure the real Xrate, we may also employ the ratio between labor costs Copyright SDA Bocconi 2004 9 If Law of One Price holds, real rate =1 Law of One Price: The price of identical commodities, once converted in the same currency, is the same no matter where the commodities are sold • LOP • (Nominal rate) x (domestic price of bananas) = Foreign price of bananas • LOP Based on idea of arbitrage • If LOP holds real rate =1 Copyright SDA Bocconi 2004 10 Yet the Law of One Price doesn’t hold • Transportation costs – US/Japan prices imply distance of 43 million miles. • Border effects (tariffs, non-tradables, etc.) Copyright SDA Bocconi 2004 11 Estimated transport cost for global trade: between 2 and 8% Copyright SDA Bocconi 2004 12 If LOP doesn’t hold, … Euro vs dollar: Real and nominal exchange rates 130.0 125.0 120.0 115.0 110.0 105.0 100.0 1999 2000 2001 2002 2003 Real rate 2004 2005 2006 2007 Nominal rate .. changes in nominal exchange rates go hand in hand with changes in real rates, hence in competitiveness Copyright SDA Bocconi 2004 13 Yet LOP is almost right over longer horizons Inflation and currency depreciation - Five Year Window Currency Depreciation (% pa) 30 23 17 10 3 -3 -10 -20 Copyright SDA Bocconi 2004 -10 0 Inflation Differential 10 20 30 14 Inflation and Currency Depreciation Twenty Year Window 12 Currency Depreciation (% pa) 9 6 3 0 -3 -6 -10 Copyright SDA Bocconi 2004 -5 Inflation Differential 0 5 10 15 15 To understand what makes real rates change year by year we need to understand some Trade Accounting • Current account – Records net transactions in goods and services – Exports - Imports • Capital account – Records net transactions in assets – Net Saving Copyright SDA Bocconi 2004 16 Current Account The sum of • Exports – Imports (=trade balance) – Goods – Services • Investment income and dividends from abroad (bond income and stock dividends) • Net transfers from abroad (foreign aid) Copyright SDA Bocconi 2004 17 Capital Account The balance of foreign trade in assets • Capital transfers (debt forgiveness) • Financial account – Direct investment – Portfolio investment – Other investment • Reserve Assets – A country has a “balance of payments problem” if Financial account and reserves do not provide enough foreign currency to cover Current account deficits) (Plus: Errors and omissions – Fudge factor) Copyright SDA Bocconi 2004 18 Trade Accounts PS (private saving) = GDP + NIFA (net income from abroad) – C – T AND GDP = C + I + G + (X – M) X – M = T – G + PS – I – NIFA X–M= S (national saving)– I – NIFA Copyright SDA Bocconi 2004 19 Trade Accounts X – M + NIFA = S – I Net Exports = Current Account Surplus Copyright SDA Bocconi 2004 Net Saving = Capital Account Deficit 20 The U.S. and euro area balance of payments in 2005 Current account and transfers Goods and services Income revenue Transfers Capital account* Other investments, including portfolio investment Direct investment Foreign exchange reserves Statistical discrepancies Copyright SDA Bocconi 2004 UNITED STATES % GDP $Bn -6.4% -792 -717 11 -86 6,3% 785 EURO ZONE % GDP €Bn -0.4% -29 90 -53 -66 0.6% 40 870 101 -185 7 176 -155 19 -11 0.1% -0.2% 21 Net foreign positions of the United States, euro zone and Japan 40% 30% 20% % of GDP Japan 10% 0% Eurozone -10% USA -20% -30% 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 Copyright SDA Bocconi 2004 22 Trade accounts and the real exchange rate What mechanism ensures that net savings always equals the trade balance in equilibrium? In short, it is the adjustment in the real exchange rate - The real rate does NOT affect the net saving curve (it is thus vertical with respect to the real rate) - Instead a real depreciation of the dollar (in terms of the euro) improves the trade balance and the current account (US goods become cheaper) – As the real rate goes down (depreciation of the $) net exports up, trade balance and current account improves – Net exports curve negatively sloped with respect to the real rate Copyright SDA Bocconi 2004 23 Net Export Market Real Exchange Rate S-I €/$ E0 E1 X – M + NIFA Net Exports Increase in net savings reduces real X rate Copyright SDA Bocconi 2004 24 Net Export Market Real Exchange Rate S-I ₤/$ E0 E1 X – M + NIFA Net Exports Decrease in net savings increases real exchange rate Copyright SDA Bocconi 2004 25 Real Exchange Rate Movements • Decrease in Net Savings – Causes • Decrease in private savings • Increase in investment spending • Fiscal Deficit – Effect • Real exchange rate appreciates (dollars buy more of other currencies) • Increases current account deficit • Examples: US under Reagan, Germany after reunification Copyright SDA Bocconi 2004 26 Copyright SDA Bocconi 2004 27 Summing up so far • Definitions of exchange rates: real vs nominal • Law of one price – Goods should sell at the same price everywhere • PPP – Real exchange rate = 1 • Trade accounts and the real exchange rate Copyright SDA Bocconi 2004 28 Exchange rate regimes Currency board ŌDollarizationÕ, ŌeuroizationÕ Low flexibility Monetary union Hard pegs Copyright SDA Bocconi 2004 Fixed exchange rate Crawling peg Soft peg with fluctuation band High flexibility Managed float Free float Intermediate regimes 29 Exchange rates and asset markets Key concepts • Covered Interest Parity • Uncovered Interest Parity • Spot and Forward Exchange Rates • Global Capital Markets Copyright SDA Bocconi 2004 30 Nominal Exchange Rates • Spot market: price for immediate delivery of one currency for another • Forward market: exchange rate fixed today for future delivery of currency Copyright SDA Bocconi 2004 31 Covered Interest Parity (CIP) $100 Copyright SDA Bocconi 2004 Stay in US $100(1+ius) 32 Covered Interest Parity $100 10900¥ Convert to Yen at Spot Rate 109¥/$ Convert to $ at Forward Rate 108¥/$ 10900(1+iJapan)¥ Copyright SDA Bocconi 2004 $101(1+iJapan) 33 Covered Interest Parity $100 Stay in US Con vert to Yen 10900¥ at Spot Rate Convert to $ 109 at Forward ¥/$ Rate 108¥/$ 10900(1+iJapan)¥ Copyright SDA Bocconi 2004 $100(1+ius) Must be same rate of return $101(1+iJapan) 34 Covered Interest Parity Con $100 vert to Yen at Spot 10900¥ Rate 109 ¥/$ $101(1+iJapan) = $100(1+ius) (1 i Japan ) Forward Rate(Yen / $) US (1 i ) Spot Rate(Yen / $) 10900(1+iJapan)¥ Copyright SDA Bocconi 2004 35 CIP (1 i ) Forward Rate(Yen / $) US (1 i ) Spot Rate(Yen / $) Japan US i + forward premium = Copyright SDA Bocconi 2004 J i 36 CIP • Japanese interest rate > US interest rate – Forward rate > Spot rate – Dollar expected to appreciate with respect to the yen • Japanese interest rate < US interest rate – Forward rate < Spot rate – Dollar expected to depreciate • Sum: dollar depreciates if US interest rate exceeds Japanese interest rate Copyright SDA Bocconi 2004 37 Uncovered Interest Parity (UIP) Investors don’t protect themselves against exchange rate movements. They wait before converting dollars in yen at future spot rate • Use expected future spot rate. • May earn more or less than expected (1 i ) Expected Future Spot (Yen / $) US (1 i ) Spot Rate(Yen / $) Japan • Taking expectations as given, we can use UIP to determine the current level of the exchange rate Copyright SDA Bocconi 2004 38 Current exchange rate (¥/$) UIP and the Exchange Rate (for Se(1) given) iJ S*(0) Return on yen account Return on dollar account: given Se(1), the higher the current Spot rate, the lower the return iUS + [Se(1)-S(0)]/S(0) Rate of Return Copyright SDA Bocconi 2004 39 Current exchange rate (¥/$) UIP and the Exchange Rate iJ iUS + [Se(1)-S(0)]/S(0) Rate of Return As interest rate in Japan goes up, $ depreciates Copyright SDA Bocconi 2004 40 Current exchange rate (¥/$) UIP and the Exchange Rate iJ iUS + [Se(1)-S(0)]/S(0) Rate of Return As interest rate in Japan goes down, $ appreciates Copyright SDA Bocconi 2004 41 UIP and the Exchange Rate If expectations of future rates are fixed • Spot market depreciation of dollar – Rise in Japanese interest rates – Fall in US interest rates – Expectation of future dollar depreciation • Spot market appreciation of the dollar – Fall in Japanese interest rates – Increase in US interest rates – Expectation of future Yen depreciation Copyright SDA Bocconi 2004 42 Risk Averse Investors • So far, we’ve neglected risk • Risk averse investors require risk premium to hold risky assets US interest Rate + Expected Dollar Appreciation = Japanese Interest Rate + Risk Premium If positive, US is perceived as riskier than Japan. If negative, US is perceived as safer than Japan. Copyright SDA Bocconi 2004 43 Decrease in risk premium Current exchange rate (¥/$) iJ $ appreciates Copyright SDA Bocconi 2004 iUS + $ appreciation – Risk Premium Rate of Return 44 Difficulties with UIP • Does perform well in forecasting forward exchange rate – High interest rate currencies tend to appreciate • Incorporation of risk is not enough to explain volatility – Risk premium is not correlated with interest rate differentials – Not large enough to account for volatility • Exchange rates appear to be not highly correlated with macroeconomic variables Copyright SDA Bocconi 2004 45 Home country bias • Diversification says balance portfolio in home and foreign assets • Domestic savers tend to buy domestic assets • Why? – Capital controls – Measurement problems – Asymmetric information Copyright SDA Bocconi 2004 46 International financial integration, 1870-200 average abs value of current accounts in % of GDP Avg abs. value of current account in % of GDP 6 5 4 3 2 1 -0 4 20 00 -9 4 19 90 -8 4 19 80 -7 4 19 70 -6 4 19 60 -5 4 19 50 -4 4 19 40 -3 4 19 30 -2 4 19 20 -1 4 19 10 -0 4 19 00 -9 4 18 90 -8 4 18 80 18 70 -7 4 0 Sources: Taylor (1996), FERI. Copyright SDA Bocconi 2004 47 Summing up • CIP • UIP – Relation to interest rate movements – Relation to exchange rate movements – Role of risk aversion • Global capital market puzzles Copyright SDA Bocconi 2004 48