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Lecture 6: Exchange
Rate Theory
Based on Sloman Chapter 24
Definitions of the Exchange Rate
E
pf
pd
 1.49
Price of £1 is 1.49 Euros (Euros per pound)
pd E  p f
Price of good in UK= price on continent by exchange rate
Definitions of the Exchange Rate
pd
e
 £0.67
pf
Price in £ (pennies) of 1Euro – .67 per Euro
pd  ep f
e= Domestic price of foreign currency
Price of good in UK = price of foreign currency multiplied
by the price of good abroad
But what determines ER
E
pf
pd
Trade equalises prices of tradable good
Once local prices are determined e is
determined.
Conversely, if world prices and
exchange rate is determined then local
prices are determined
What determines Prices
• Some people
argue that prices
are determined by
money supply
• P.Y= MV
• GNP=must be paid
for
• GNP= Money by
the time it
changes hands
PY  MV
MV
P
Y
What determines Prices
• If so exchange
rate is determined
by ratio of prices
M fVf
E
pf
pd
Yf

M dVd
Yd
M f V f Yd

M dVd Y f
What determines Prices
M fVf
E
pf
pd
Yf

M dVd
Yd
M f V f Yd

M dVd Y f
• So if increase Md, prices up, E goes
down (a depreciation, worth less)
• If Velocity rises) money goes around
faster, prices up, depreciation
• If Income rises (prices fall!!!), E up
pd
3.28
 PPP ER 
 1.06
pf
2.90
• Big Mac Index
•
Burgernomics is based on the theory of purchasingpower parity, the notion that a dollar should buy the
same amount in all countries. Thus in the long run,
the exchange rate between two countries should
move towards the rate that equalises the prices of an
identical basket of goods and services in each
country. Our "basket" is a McDonald's Big Mac,
which is produced in about 120 countries. The Big
Mac PPP is the exchange rate that would mean
hamburgers cost the same in America as abroad.
Comparing actual exchange rates with PPPs
indicates whether a currency is under- or overvalued.
• http://www.economist.com/markets/bigmac/index.cf
m
Purchasing Power Parity
e
pf
pd
• Tradeable goods prices are equal
– Need to exclude transport costs,
– Looking only at the purely tradable
component -have to discount fact that
property prices in London are the same as in
Skye ( NON-TRADABLE GOODS)
– Labour costs – e.g. Hair cuts in Budapest v
Birmingham
Alternative Theory
– Interest rate parity
e
pf
pd
• If I invest money in UK expect same return as
invest in France
• So Interest rates have to be the same
• But not.
• SO if invest in UK interest rate +movement on
ER = return in France.
• So if irf =3% and iruk=5% then
3% =5%-depreciation of 2%
Alternative Theory
– Interest rate parity
• So if irf =3% and iruk=5% then
3% =5%-depreciation of 2%
So can put £1 in UK bank at £1.05
OR buy Euro at .67 per Euro=1.492537
Get 3% =1.5372313
Sell at 0.683009= 1.5372313*0.683009
=1.05
So ir reflect EXPECTED depreciation
At start - 0.67
At end 0.683009
So price of Euro rises (worth less) at end of period
• These explanations imply government
can control the ER
• Do I believe?
• ER as a random variable?
• OK lets focus in ER as something
deterministic driven either by trade or
finance flows.
• Can government manipulate the ER and
why?
Exchange rate E = Price in Euros of 1£
The exchange rate as a price for the demand and supply
of domestic currency
S1
Supply – sell £ to buy
Forex for imports or
foreign investment –
Higher E means buy
more abroad
er1
Demand – Foreigners
buy £ to buy exports
or inward investment
D1
O
Quantity of £s
Adjustment of the exchange rate to a shift in demand
and supply
Exchange rate
S1
S2
UK ER fates fall,
EU up switch to
Euros – S of £
shifts out
er1
Depreciation
er2
D2
O
Quantity of £s
D1
Adjustment of the exchange rate to a shift in demand
and supply
Exchange rate
S1
S2
Fall in demand for UK
exports
er1
Depreciation
er2
D2
O
Quantity of £s
D1
Adjustment of the exchange rate to a shift in demand
and supply
Exchange rate
S1
er1
D1
O
Quantity of £s
Adjustment of the exchange rate to a shift in demand
and supply
S3
S1
Exchange rate
er3
er1
D3
D1
O
Quantity of £s
Adjustment of the exchange rate to a shift in demand
and supply
S3
S1
Exchange rate
er3
Appreciation
er1
D3
D1
O
Quantity of £s
• With a floating Exchange Rate the price
of £ changes in response to S & D.
• What will happen to Balance of
Payments?
• Fluctuations in E ensure the value of
imports always equals value of exports
so Balance of payments always in
balance
Fixed Exchange Rate and Balance of Payments deficit
Exchange rate
This creates
external imbalance:
i.e. currency flow deficit
r1
S1 by UK
S2 by UK
Fixed
exchange rate
D by overseas
residents
O
Quantity of £s
Fixed Exchange Rate and Balance of payments surplus
Exchange rate
S by UK
Fixed rate
D2
D from abroad
O
Quantity of £s
UK balance of payments as % of GDP: 1980–2000
3
2
1
0
-1
-2
-3
-4
-5
-6
1980
1982
Source: Datastream
1984
1986
1988
1990
1992
1994
1996
1998
2000
UK balance of payments as % of GDP: 1980–2000
3
2
1
0
Current
account
-1
-2
-3
-4
-5
-6
1980
1982
Source: Datastream
1984
1986
1988
1990
1992
1994
1996
1998
2000
UK balance of payments as % of GDP: 1980–2000
3
2
1
0
Current
account
-1
-2
-3
Trade in goods
-4
-5
-6
1980
1982
Source: Datastream
1984
1986
1988
1990
1992
1994
1996
1998
2000
$ / £ exchange rate: 1976-99
$/£
Index
1990=100
$2.40
150
$2.20
140
$2.00
130
120
$1.80
110
$1.60
100
$1.40
90
$1.20
80
$1.00
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
70
$ / £ exchange rate: 1976-99
$/£
Index
1990=100
$2.40
150
$2.20
140
$2.00
130
120
$1.80
110
$1.60
100
$1.40
90
$1.20
80
$1.00
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
70
$ / £ exchange rate and £ exchange rate index: 1976-99
$/£
Index
1990=100
$2.40
150
$2.20
140
$2.00
130
120
$1.80
110
$1.60
100
$1.40
90
$1.20
80
$1.00
1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998
70
Exchange rate indices
averages for each period (1995 = 100)
1970-3
1974-7 1978-81 1982-5
1986-9
1990-3
1994-6
1997-9
USA
61
58
57
80
77
86
101
121
Japan
17
19
25
30
51
64
94
88
Germany
36
44
53
58
71
82
97
97
UK
163
122
118
113
106
107
102
124
Italy
256
181
134
112
113
118
106
113
Source: Sloman based on data in European Economy Statistical Annex (Commission of the European Union)
The crawling peg within exchange rate bands
Exchange rate
$1.60
$1.40
O
No
intervention
Source: Sloman
Central bank
buys domestic
currency
No
intervention
Central bank
sells domestic
currency
No
intervention
Time
If Government changes ER –depreciation- imports
become more expensive (shift in)
S2 (Epf)
Price in £
S of imports
So imports fall
helping deficit - but
cost more hurting
deficit
r1
Demand for Imports
O
Quantity
If Government changes ER –depreciation- and
Exports become competitive (shift out)
Price in £
S of Exports
Exports rise
helping deficit
r1
D2 (pd/E)
Demand for Exports
O
r1
S2
(Epf)
S of imports
Price in £
Price in £
If Government changes –depreciates imports become more
expensive (shift in) and Exports become competitive (shift
out)
r1
Demand for Imports
O
S of Exports
D2
(pd/E)
Demand for Exports
O
Argument is that sales of exports and lower imports outweigh
additional expense of remaining imports – SO BOP Better
But dedpreciation – import tax (tarrif) and export subsidy
EXCHANGE RATE SYSTEMS IN PRACTICE
• UK experience of dirty floating
– first oil crisis and its aftermath
– second oil crisis and the rise in monetarism
– effects of growing US budget and trade deficits in the
1980s
– the 1985 exchange crisis
– joining and leaving the ERM
– experience since leaving ERM
 fluctuations in the pound
 exchange rate consequences of targeting the
inflation rate
• The volatility of exchange rates