Download Long Run Exchange Rate Determination

Lecture 3
International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
Exchange rate components
Yen’s tradeweighted
exchange value
Technically driven
short-run
overshooting path
Fundamental
equilibrium path
Fundamentally
driven long-run
equilibrium path
Fundamentally
driven medium-run
cyclical path
1993
1994
1995
1996
1997
What Determines Exchange Rates?

Short run (hours, days, months) – related to
financial transfers because of the speed of these
transactions. Therefore:

Asset Market Approach: differences in real interest rates,
hence our interest in:
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Covered Interest Differentials
Uncovered Interest Differentials
Shifting expectations of future exchange rates
Medium run (years)

Economic cycles (Income differentials)
Interest Rate Differentials

Short term real interest rate differentials
influence international capital movements

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Real interest rate is nominal minus inflation
Low short term rates lead to less demand
for the currency and depreciation
High rates lead to greater demand for the
currency and appreciation
Impact of interest rate differentials
Dollars
per Euro
S1
S0
B
.80
.75
A
D1
D0
30
35
40
45
50
55
Millions of Euros
60
65
70
Market expectations

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As with stock markets, foreign exchange
markets react quickly to news or even
rumors that point to future changes
affecting rates
Future expectations can be self-fulfilling;
speculative bubbles can start without any
real information but can become self
sustaining for a while
Determining Exchange Rates (Continued)
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Long run (many years) - movements of
goods, services, investment, influenced by:
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Inflation rates (relative prices:
Purchasing Power Parity (PPP)
Long-term investment profitability
Consumer tastes
Long-term real GDP growth rates
Productivity
Trade policy
Purchasing Power Parity (PPP)
—some history
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The theory of PPP has been around as long as paper
money. It is one of the oldest theories of exchange rate
determination. Hence we present it first.
It was discussed in 16th Century Spain, for example.
It was last resurrected by Gustav Cassel in the period
between WWI and WWII. He used it in discussions of how
much European countries would have to either change
their exchange rates or their domestic price levels, given
that WWI had changed the relative prices in the countries
(causing different inflation rates in the countries).
It is based on the Law Of One Price (LOOP).
Law of One Price (LOOP)

The law of one price is:
“In a competitive market, if two goods
are identical, then they should sell for
the same price.”
 If the two goods were in the same place and both
available to customers, then customers would
always choose the cheaper of the two goods,
forcing the sellers of the more expensive one to
lower their price.
Arbitrage

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If the two goods were not in the same
market (place), then arbitrage would
operate to equalize the prices.
Arbitrage is the process of buying or selling
something in order to exploit a price
differential so as to make a riskless profit.

Arbitrageurs seek to find and exploit price
differentials between markets (across space).
Arbitrageurs seek to carry goods across markets.
Speculation

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If the two goods were not being demanded at the
same time, and the good was storable, then
speculation would tend to equalize prices.
Speculation is the holding of a good or security in
the hope of profiting from a future rise in price.

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Speculators “arbitrage” across time. Speculators “carry”
the goods across time.
Because no one really knows the future, speculation is
inherently risky. (Spatial) arbitrage is not.
Deviations from LOOP
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Carrying (storage) costs reduce the profits from
speculation, and
Transportation costs reduce the profits from
arbitrage.
Transactions costs are other costs associated with a
transaction, over and above the cost of the good
which actually changes hands. These also reduce
the profits associated with arbitrage and
speculation.
All three of these can result in deviations from the
LOOP.
International LOOP
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Transportation costs can be significant.
Legal barriers and tariffs may exist.
Some goods are not traded internationally. These
are goods for which inter-regional price
differentials cannot be eliminated by arbitrage.
Examples of nontradeable “goods” are:
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Houses
Medical services
Goods that are not available in all countries
Goods that do not survive transportation
International LOOP (Continued)
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When we add the complication of (flexible)
exchange rates, we have to restate the law
of one price for international trade:
“In a competitive market, similar
goods in different countries should
sell for the same price when the prices
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.
International LOOP (Continued)
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Thus if pd is the domestic price and pf is the
foreign price of the same good, and e is the
spot price of the foreign currency in the
domestic currency, then
and
pd = e pf
epf / pd = 1 and e = pd / pf
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But is this true?
Big Mac Index (Next Slide)
Purchasing Power Parity (PPP)
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Extending the LOOP, if Pd is the domestic price
level and Pf is the foreign price level,
Q = ePf / Pd
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is called the real exchange rate whereas rs is called
the nominal exchange rate.
If PPP holds, then Q = 1 and e = Pd / Pf.
This is referred to as absolute purchasing power
parity.
Restated: The general level of prices, when
converted to a common currency, will be the same
in every country.
Q: Empirical Evidence
Country
Q
United Kingdom
Canada
Japan
Germany
Sweden
Norway
Korea
Mexico
China
India
0.96
1.30
0.78
1.00
0.89
0.89
1.96
1.72
4.76
5.26
PPP (Continued)
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This is a simple monetary model of the exchange rate.
Strictly speaking, it does not depend upon the LOOP.
We have ignored transactions costs, transportation
costs, carrying costs, tariffs, nontraded goods, etc.
We have ignored the problem that not all markets are
competitive.
We have ignored the problem of different weights in
computing the price levels of the countries involved.
PPP (Continued)
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This is an extension of the LOOP. At least on average
(maybe?) goods should cost the same in all countries (aside
from tariffs, transportation costs, etc.).
If this is true, then exchange rates must adjust to make
prices equal across countries, at least over the long run.
This is LONG RUN because it does not consider that price
rigidities exist that make price adjustments sometimes slow.
If two countries have different inflation rates, exchange
rates will tend to move in opposite directions to keep prices
the same.
PPP (Continued)
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This leads to proposition known as Relative PPP:
“The percentage change in the exchange rate
between two currencies over any period equals
the difference between the percentage changes
in national price levels.”
This amounts to:
rate of appreciation of the foreign currency = πd – πf ,
which implies that an increase in the domestic inflation
rate will raise the spot exchange rate proportionately.
PPP and Interest Parity
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Notice that interest parity is essentially an
extension of relative PPP.
Interest is the price of borrowing, and interest
parity arguments (covered interest parity and
uncovered interest parity) argue that changes in
these special prices will cause adjustments in the
exchange rate.
A major difference between interest parity and
PPP is that interest parity is related to financial
assets whose prices adjust very quickly, and that
have substantially lower transactions costs,
transportation costs, etc.
Empirical Evidence
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PPP predicts fairly well, both in absolute and
relative form, at the level of one heavily traded
commodity for which the governments involved do
not interfere with trade. (wheat, gold, etc.)
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Thus for something like wheat LOOP is a pretty good
approximation.
PPP predicts only moderately well at the level of
all traded goods. We run into a variety of
problems, including barriers to trade,
noncompetitive markets, and index construction.
Empirical Evidence (Continued)
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PPP predicts poorly at the level of all products in
an economy. (Using CPI, GDP deflators, etc.)
PPP predicts better over the long run than the
short run.
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According to Froot and Rogoff (1995), for major
industrialized countries it takes about four years on
average for a deviation from PPP to be reduced by
half.
PPP has its worst problems with nontraded goods.
Relative PPP: Evidence (1)
Relative PPP: Evidence (2)
PPP: As Long-Run Tendency (1)
PPP: As Long-Run Tendency (2)
Monetary Approach:
Quantity Theory
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According to the Quantity Theory, the money
supply of a country is proportional to its nominal
income.
Let Y be real GDP, P be the price level, and Ms be
the money supply. Then
M = kPY
where k (=1/V) is the average holding period for

money.
Then for a foreign country,
Mf = kf Pf Yf .
Monetary Approach:
Quantity Theory

Using the Quantity Theory, we can examine the relationship
between prices in two countries:
(P/Pf ) = (M/Mf )(kf /k)(Yf /Y)
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We can then combine this with PPP to write:
e = P/Pf = (M/Mf )(kf /k)(Yf /Y)
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Also note that a 1% change in (M/Mf ), (kf /k), or (Yf /Y) leads
to a 1% change in rs . We say that the elasticity of each of
these terms is one.
This leads us to extend PPP to a more general monetary
approach to exchange rate determination.
Monetary approach
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These approaches focus on exchange rates as the result of
supply and demand for money at home and abroad. It is
an equilibrium, supply and demand approach.
Money supply and demand operate through the linkage
of prices and inflation rates.
All else equal, the spot exchange rate is raised by:
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A rise in the domestic money supply relative to the foreign money
supply,
A 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 domestic velocity, or equivalently a decline in the
domestic k, relative to domestic velocity or k, e.g., as the result of a
change in the domestic payments system
Monetary Approach:
Policy Prescriptions
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If a foreign country wanted to raise its
exchange rate (relative to the dollar), it
could do so by:
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Decreasing its money supply
Causing disinflation
Reducing its money supply would raise
domestic interest rates and slow the domestic
economy. Eventually output would recover,
but prices would decline (Pf )as a result of
fewer dollars (Mf ).
Monetary Approach:
Real income differentials

A country with faster economic growth than
the rest of the world will have a
depreciating currency (other things being
equal)
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Imports rise faster than exports
Real income changes can also reflect other
processes, which might lead to rising exports
Impact of real income differentials
Dollars
per Pound
S0
1.60
1.50
A
D1
D0
0
5
10
15
20
25
Millions of Pounds
30
35
40
Next: Shorter-Run—
Asset-markets approach
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Currencies are a kind of financial asset that
are part of asset portfolios held by investors
Short run exchange rate changes are caused
by shifts in the kind and location of financial
assets investors want to hold
Investors shift between assets based on
market expectations for expected returns