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Exchange Rates
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Issues
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What drives foreign exchange (FX) rates?
Exchange rate regimes
Speculative attacks on currencies
Financial crisis
International Monetary Fund
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Why did the Japanese Yen strengthen
from 350 to about 100 from 1970 to 1995?
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Why has the U.S. Dollar fallen in value since 2001?
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What led to the 1997 South East Asian Currency Crisis?
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Exchange Rates (Feb 12, 2003)
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Law of One Price
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Using the market exchange rate to price goods in a common currency, the Law of
One Price asserts that similar goods cost the same independent of the country in
which they are purchased.
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Let P denote the domestic price of a basked of goods in units of domestic currency
and P* denote the foreign price of a basket of goods in units of foreign currency,
then the law of one price implies
E = P*/P
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An example:
– Suppose the price of a TV in Japan is ¥10,000 and suppose the price of the
same TV in the U.S is $90
– The law of one price implies that the exchange rate should equal ¥10,000/$90 =
111.11 ¥ / $
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Implication of the Law of One Price
E P P

E P P
*
t 1
t
t 1
t 1
*
t
t
• Changes in exchange rates reflect relative inflation differentials across
countries:
Change in Exchange rate = Foreign inflation rate – Domestic inflation rate
• If goods prices rise faster in the U.S relative to that in Japan, then the Yen
should appreciate in value relative to the dollar: the Yen/Dollar exchange rate
should decline, as one Dollar buys fewer Yen
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Nominal Exchange Rates and Inflation Differentials
45 degree line
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U.S. Consumer Price Index
Why has the U.S. Dollar risen in value during the recent recession?
Deflation during the recent recession caused the U.S. Dollar to rise in value
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Short Run Inflation effect on FX
when inflation is high and variable
Quarterly inflation and depreciation in Brazil, 1990–1997
High inflation in Brazil led to its currency falling in value .
As inflation ended, the currency stabilized immediately.
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Interest Rates and Exchange Rates:
Uncovered Exchange Rate Parity
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Strategy 1
Invest 1$ in the US risk-less asset.
Payoff at year end: [1+Rt]$
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Strategy 2
Convert 1 dollar to receive Et ¥ today.
Invest in a Japanese risk-less asset.
Payoff at year end Et[1+Rt*] ¥.
Convert to dollars at the end of the
year, receiving : Et [1+Rt*]/Et+1$.
Uncovered Exchange Rate Parity
1+Rt = Et [1+Rt*]/Expected(Et+1)
or
[Expected(Et+1)-Et]/Et = Rt* - Rt
Expected change in the exchange rate is equal to the nominal interest rate differential.
A country with a high interest rate has an exchange rate that is expected to depreciate.
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Exchange Rates and Interest Rates
45 degree line
Countries with high nominal interest rates have, typically,
seen a fall in the value of their currency
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Real Exchange Rate
• The real exchange rate, e, is the quantity of foreign goods that one can
receive in exchange for one unit of the domestic good:
e = E P/P*
• P = domestic consumer price index (i.e., CPI)
• The real exchange rate can be thought of as the inflation-adjusted nominal
exchange rate
• When the real exchange rate for the domestic currency increases
– Domestic residents receive more foreign goods per unit of the
domestic good
– Domestic residents have an incentive to buy more foreign goods
relative to domestic goods
• Law of One Price implies the Real Exchange Rate e = 1
Real Exchange Rate
Example
• Suppose a hamburger costs $2 in the U.S. and costs
¥1100 in Japan
• Current nominal exchange rate is 110 yen per dollar,
what is the hamburger rate of exchange?
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$2 buys one hamburger in the US
Or, $2 buys ¥220
¥220 buys .2 = 220/1100 hamburgers in Japan
You can exchange one U.S. hamburger for 0.20 hamburgers in Japan
Suppose the dollar appreciates to 140 Yen/USD. The hamburger rate of
exchange is [140*2/1100]=0.25
Real Exchange Rates and Per-capita Real Income
United States
Source: Obstfeld and Rogoff, Foundations of International Economics, MIT Press, 1996
Non-traded Goods
and the Law of One Price
• Goods are traded goods or non-traded goods
– Most goods have a significant non-traded component
– Value of local distribution
– Value of service to sell the good
• The law of one price holds only for traded goods
E = P*_traded/P_traded
• Non-traded goods are cheap in poor countries:
– Lower demand for local inputs in fixed supply (land)
– Cheap unskilled labor as primary input into production
• Inflation can be high due to high inflation in non-traded goods
Hong Kong’s Inflation in the Face of High Growth and a Fixed Exchange Rate
China’s Inflation in the Face of High Growth and a Fixed Exchange Rate
The New York Times, June 11, 2010
China Inflation Rises to a 19-Month High
Consumer prices prices rose at their fastest rate in 19 months …
Japan’s Real Exchange Rate
Japanese real exchange rate rose from 1973 to 1995
Purchasing Power Parity adjusted GDP
PPP real GDP is adjusted for the cost of living (the real exchange rate)
country
market GDP
PPP GDP
United States
14.430
14.430
European Union
16.180
14.510
China
4.814
8.789
Japan
5.108
4.137
India
1.095
3.560
Russia
1.232
2.116
Brazil
1.490
2.025
Botswana
0.011
0.026
Big Mac Index
• Begin with Big Mac price in local currency
• Big Mac price in dollars is the Big Mac price
in local currency converted into dollars at the
market exchange rate
• Implied PPP of the dollar is what the
exchange rate would have to be for the Big Mac
price in dollars to equal that of the U.S.
• Actual dollar exchange rate is the current
market exchange rate
• Under/over valuation against the dollar,
calculated as:
(PPP - Exchange Rate)
---------------------------------- x 100
Exchange Rate
The Big Mac theory of the exchange rate
asserts that the value of the domestic
currency should be expected to rise if it is
undervalued per above, and to fall if
overvalued. Does this make sense?
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Exchange Rates and Short-Run Fluctuations
in the Real Interest Rate
• A rise in real interest rates relative to that of other countries
leads to an inflow of capital and a demand for financial assets.
• The rise in demand for assets leads to a rise in the demand for
that country’s currency, as foreign investors purchase
domestic currency to purchase domestic assets.
• The rise in the demand for currency leads to a short-run rise in
its value; i.e., the (real) exchange rate.
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Macro News and Exchange Rates
(Short Run Movements in Currency Values)
Higher than expected
inflation
Law of one price
effect will drive
currency value down
Higher than expected
real GDP growth
Better investment
opportunities will attract
foreign capital.
Higher than expected
Federal Funds rate
• In developed countries
this typically increases the
real interest rate, and
hence attracts foreign
capital.
• In emerging economies a
rise in the short term rate,
typically is due to a rise in
expected inflation =>
currency will fall in value.
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Key Message
• Economies with relative high real GDP growth
will see the value of their currencies rise
• High inflation leads to a fall in the value of the
currency
• High interest rates due to high real rates will
lead to a rise in the value of the currency.
• High interest rates due to high inflation will
lead to a fall in the value of the currency
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Fixed Exchange Rates
Country on a fixed exchange rate regime fixes its currency
value relative to that of another country
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Et is a constant, so Et /Et+1=1
Consequently, Et[1+Rt*]/Et+1 = 1+Rt*
So, arbitrage ensures equality of nominal interest rates: Rt = Rt*
Main economic implication:
A country that pursues a fixed exchange rate cannot pursue an
independent monetary policy
• Note that nominal interest rates must be the same, but with movements
in the real exchange rate, inflation rates can differ (as we have already
seen)
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Bretton-Woods: Fixed Exchange Rate Regime
between Europe, Japan, and the US from 1947 to 1973
• Under Bretton-Woods, Europe/Japan was tied to the US Dollar and the Dollar was tied to gold
• In the early 70s Nixon printed more currency, which landed up in European Central Banks
• European Central Banks preferred to hold gold than dollars
• Nixon refused to convert dollars to gold, which led to the collapse of Bretton-Woods
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The Euro
• Following Bretton-Woods, Europe continue to fix exchange rates to the
German mark
• The Euro was introduced as a common currency amongst 16 European
countries: unit of account as of Jan. 1, 1999, currency in circulation as of
Jan. 1, 2002
• The Euro has the highest value of banknotes and currency in the world
• Benefits:
– Lower exchange rate volatility
– Greater mobility of capital
– Inherit credibility of the Euro
• Costs:
– None of the 16 countries have independent monetary policy
– UK, Denmark and Sweden have not joined the Euro, partly to maintain
an independent monetary policy
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Fixed Exchange Rates
and Speculative Attacks
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Historically, many countries pegged their currency to the U.S. Dollar as an
attempt to commit to a prudent monetary policy
Speculative attacks are an outcome of inconsistency between the fiscal policy
and the fixed rate of exchange. Why?
Uncontrolled government budget deficits and the necessity of monetization
lead to a collapse of the fixed exchange rate regime
Speculative Attack:
– Borrow the foreign currency
– Exchange into Dollars at the official exchange rate
– Invest in a domestic bond
– Foreign Central Bank loses large amounts of dollar reserves and is forced
to abandon the pegged currency value, similar to a bank run
– Cash in some of the domestic bonds to pay the foreign debt
In the end, attempts at fixed exchange rate regimes led to repeated financial
crises, hence they are not widely used today
The only source of long-term credibility is a prudent fiscal policy
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Examples of Speculative Attacks
• UK Pound, 09/1992
• Mexican Peso, 12/94
• Thai Baht and Malaysian Ringgit, 08/97 (The South East
Asian Currency Crises)
• Brazilian Real, 02/99
• Turkey, Argentina, 2001
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exchange rates
national currency per dollar
Financial Crisis in the 90’s
Mexico
Thailand
Russia
Argentina
Jan90Dec90Dec91 Dec92Dec93 Dec94Dec95 Dec96Dec97 Dec98 Dec99Dec00 Dec01
Dec02
months
Time series of recent collapse
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Financial Crisis in South East Asia
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South-East Asian Crisis
Return to capital is falling well before the crisis in 1997
Note return to capital is reciprocal of Incremental capital-output ratio
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Non-Performing Loans in South-East Asia (1997)
Banks are in trouble
Percentage of all loans
Percentage of GDP
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30
25
20
15
10
5
Singapore
Philipines
Malaysia
South
Korea
Indonesia
Thailand
0
Moreover, banks borrowed internationally in dollars and loaned in domestic
currency, making the entire banking sector vulnerable to an exchange rate crises
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Non-Performing Loans in South-East Asia (1997)
Percentage of government revenues
Singapore
Philipines
Malaysia
South Korea
Indonesia
Thailand
180
160
140
120
100
80
60
40
20
0
Non-performing loans if covered by the government are a huge liability.
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Mexican Currency Crises
Central bank lost about $10B in defending the currency. The rise in the
nominal and real interest rates squelched GDP growth. Current account
reversal due to collapse in investment.
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• The Brazilian government introduced a 3-year, $80 billion package of
spending cuts and tax increases today in an effort to restore the
country’s flagging credibility in world markets …
• Investor’s reacted warily, and said the measures did not go as far as
they hoped in making structural changes to permanently reduce
Brazil’s burgeoning budget deficit, which is now running at 7% of
GNP.
• Jorge Mariscal, chief investment strategist for Latin America of
Goldman Sachs, said, “It’s a step in the right direction, but if you think
of Brazil climbing up a wall of disbelief, this is just a few inches up.”
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Key Message
• Inconsistencies between the official exchange rate and the
fiscal policy of the government lead to speculative attacks
• Managed exchange rate regimes are susceptible to very
dramatic changes in exchange rates
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International Monetary Fund
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Created in 1944, initially 45 members, now 186 countries
Objective to stabilize the world financial system
International lender of last resort
Impose austerity measures as a condition of receiving loans: the Washington
Consensus (10 points)
– Reduce budget deficits
– Encourage spending on education, health, and infrastructure
– Broaden tax base and lower marginal tax rates
– Market determined interest rates
– Market determined exchange rates
– Free trade
– Encourage foreign direct investment
– Privatize state enterprises
– Deregulation
– Secure property rights
Poor track record: focus now on second-generation reforms
– Productivity-boosting reforms (efficiency)
– Higher quality institutions
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