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Exchange Rate Topics Chapter 35 Real Exchange Rate Real Exchange Rate • A country’s real exchange rate is the relative cost of that country’s good when compared to foreign goods when measured in domestic currency PtUS St REX t St HOME Pt PPPt • Numerator: # of domestic currency units needed to by the # of foreign currency units needed to buy 1 foreign good. • Denominator: # of domestic currency units needed to buy Purchasing Power Parity • An currency achieves a PPP exchange rate when the cost of purchasing foreign goods equals domestic goods S = PPP, REX = 1. • Absolute PPP – REX = 1 • Relative PPP gREX = gS +[πUS – π] = 0 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. Long Run: Developed Economies Source: IFS 1975-1995 PORTUGAL ITALY SPAIN SWEDEN UNITED KINGDOM AUSTRALIA FRANCE CANADA BELGIUM GERMANY NETHERLANDS JAPAN -4.00% -2.00% 0.00% Inflation Differential 2.00% 4.00% Exchange Rate Depreciation 6.00% 8.00% Over-valued/Under-valued • When the cost of purchasing foreign goods is – relatively high, S > PPP and a currency is said to be undervalued. – relatively low, S < PPP and a currency is said to be overvalued. •Is HK$ overvalued in 2008? Calculate Real Exchange Rate • Calculate Pt – Get PPPReference from World Bank, U Penn etc. – Convert CPI to World Bank Reference Year Dollars for Domestic and Foreign Economy CPI CPI t Pt PPPReference CPI Reference PtUSA CPI tUSA USA CPI Reference Example • HK: PPP in 2005 was 5.69 meaning goods that cost $1 in the US cost HK$5.69 in HK. • But prices (and exchange rates) have changed since then. CPI USA HK 2005 196.400 100.3 2008 219.086 109.1 PPP 2005 1 5.69 S 2008 7.8 REX • What is REX in HK? • Is HK$ over or undervalued. 2008 US HK P 1.115509 1.087737 S 7.8 PPP 5.548338 Relative PPP • In the long-run, we expect prices to converge through arbitrage trade (i.e. exporters should ship goods from a cheap market to an expensive one, until prices equalize across markets). • The average growth rate of the exchange rate should be equal to the inflation differentials. S HOME US $ gt t t Long Run: Developed Economies Source: IFS 1975-1995 PORTUGAL ITALY SPAIN SWEDEN UNITED KINGDOM AUSTRALIA FRANCE CANADA BELGIUM GERMANY NETHERLANDS JAPAN -4.00% -2.00% 0.00% Inflation Differential 2.00% 4.00% Exchange Rate Depreciation 6.00% 8.00% Hong Kong’s Exchange Rate Regime Clearing Accounts Reserves • May 2005 Under the strong-side Convertibility Undertaking, the HKMA undertakes to buy US dollars from licensed banks at 7.75. Under the weak-side Convertibility Undertaking, the HKMA undertakes to sell US dollars at 7.85. US Monetary Policy Causes US Interest Rates Go Down Relative Demand for US$ Goes Down S Supply Supply' 1 S=7.8 Excess Supply of US Dollars S** Demand Demand ' Passive Forex Intervention Money Supply i Money Agents want more Hong Kong dollars and excess supply of US dollars at exchange rate. Supply’ i* i** Rather than sell US dollars at falling prices, sell to HKMA at Strong Side price 1 Money Demand 2 M HKMA purchase of forex increases M and reduces i. Convertibility Undertaking Stabilizes Forex Demand and Supply Curves Automatically S Supply Supply' 1 S=7.8 Excess Supply of US Dollars S** Demand Demand ' Iron Triangle of International Finance Open to International Capital Flows Monetary Policy that Controls The Interest Rate Pick 2 items from this menu Fixed Exchange Rates Advanced Topic Uncovered Interest Parity Exchange Rate Depreciation • Exchange Rate: S - # of domestic currency units purchased for 1 US$. • An increase in S is a depreciation and a decrease in S is an appreciation. • Depreciation Rate St 1 St St 1 t 1 St St Saving It is January 1st, and you have HK$1000 to save for 1 year. You can put it into: 1. Put it into a domestic currency bank account at an interest rate i. 2. a foreign currency bank account at interest rate iF. Payoff to strategy #2 • Strategy two has three parts. 1. Buy foreign exchange at spot rate S01/01 to get {HK$1000/ S01/01} US dollars. 2. Put {S01/01 × HK$1000} into bank account. After 1 year get US$(1+iF)×{HK$1000/S01/01 } 3. Convert these funds into US at exchange rate prevailing in 1 year. (1 i F ) S12 / 31 HK $1000 S01/ 01 Uncovered Interest Parity • If (1 i F ) S12 / 31 > 1+i, deposit funds S01/ 01 then deposit in US$ account. F (1 i ) S12 / 31 • If < 1+i, deposit funds S01/ 01 then deposit in HK$ account. • Then in equilibrium (1 i F S01/ 01 ) 1 i S12 / 31 Interest Rate Parity • The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rate would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. F • Approximately i i 12 / 31 Fixed Exchange Rate • If the central bank undertakes to keep the exchange rate fixed and that is a credible undertaking, then 0. t 1 • If the relative values of currency are fixed, then funds will flow out of the domestic currency if domestic interest rates are too low and flow into domestic currency if interest rates are too high. i = iF Learning Outcome • Calculate the real exchange rate and judge whether the domestic currency is over or undervalued.