Download Lecture #8

Exchange Rate Determination(4)
Real Factor Approach
Dr. J. D. Han
King’s College
U.W. O.
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1. Recall that S and D of FOREX affect FX
Rates through International Trade
FOREX Supply
• International Trade
»
Impacts
Export
FOREXDemand
Imports
FX rate down FX rate up
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2. Real Factor Analysis:
Beyond Nominal Factor Theory of
Purchasing Power Parity
•
FOREX rate is negatively related to Current Account (surplus)
of the Balance of Payment
•
Current Account of BP is positively correlated with the
Relative Demand for Domestic Product to (Demand for)
Foreign Product.
•
It is affected by the Relative Price Level, which is in turn set
by relative monetary condition <- “Nominal Factors”
•
Besides, what are the Real factors that affect the relative
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international demand?
1) Real Factor Analysis focuses on the real factors
affecting the Supply and Demand of Products
(1) Supply Side
‘Technical Innovation’
-> Cost down, and (non-monetary, but real) Price down
–> Exports = Demand for Domestic Products up
-> Current Account up
-> Supply of FX up
-> Price of FX down
(2) Demand Side
‘International Demand Switch’ to, or ‘International Substitution’ of
Domestic Products
-> Current Account up
-> Supply of FX up
-> Price of FX or FOREX rate down
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2) Principle
“Any real factors that favorably affect
the Current Account of Balance Payment
(EX-IM ) will lead to appreciation of
Domestic Currency and depreciation of
FOREX” (FOREX rate falls).
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3) Examples
eg1) Technical Innovation in a Canadian
export industry will lower the cost and the
price of exports. As more exports bring in
more FOREX, E will fall.
eg2) Unfavorable tax system and labor
movement will raise the production cost of
the Canadian export industry. Then………
eg3) An increase in the international demand
for oil sand from Canada will lead to a fall
of FOREX rate in Canada.
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3. Nominal FOREX versus
Real FOREX rates
• Nominal (Foreign) Exchange rate or
FOREX = E or S (spot)
• Real FOREX rate ‘q’
= E / (P/Pf) = S / (P/Pf)
= E Pf/P = S Pf /P
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• A falling ‘q’ real exchange rate is a
reflection of an Increasing International
Competitiveness.
• A falling ‘q’ means that the FOREX
depreciates, and the domestic currency
appreciates.
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*Caution: The Direction of
Causality
• A falling ‘q’ means that the foreign currency
becomes cheaper and the domestic currency
becomes more expensive.
• The falling ‘q’ is the reflection of the Country’s
goods becoming more competitive.
• The falling ‘q’ now may cause the country’s
goods less competitive a little, but not enough to
offset the initial rise in competitiveness.
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• In the case where real factors work in
addition to nominal factor(money, and price
level), the changes in FOREX rate cannot
be fully explained by nominal factors, such
as money supply and relative price level.
• Thus, not only nominal FOREX (S or E)
changes but also ‘q’ changes as well.
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4. Case Study I: Japan
FOREX Changes in Japan of the 1970-80s :
Nominal versus Real Factors
Background:
-Japanese Yen became strong: for the Japanese, FX rate
fell
- S fell more than P/ Pf fell; ‘q’ fell as well.
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1) Facts: Data of Japanese FOREX Rate
Trends of P/Pf and E in Japan
P/Pf
E=S
‘76
‘87
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2) Analysis:
(1) Nominal Factor
- The appreciation of the Japanese Yen, or the
falling E or S can be only partially explained by
P/Pf as PPP suggests.
- Japanese price level was relatively stable compared
to the U.S. price level
because Japanese monetary policy was relatively
conservative compared to the U.S. monetary
policy.
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(2) There is a large part of the falling E,
which cannot be explained by PPP:
These are the real factors that change ‘q’.
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We can infer that
q = (actual E) / (P / Pf ) fell
as E fell more than P/ Pf fell
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*Now use ‘q’ to explain the whole story:
(i) Nominal Factors affecting the Price Level:
Relative Overall Price Ratio between Japan and U.S. (P
/ Pf) fell due to relatively conservative monetary policy
in Japan.
-> International Demand for Japanese Goods up
-> S or E in Japan down
However, P/Pf is not enough to explain the changes in
E or S.
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(ii) Real Factors affecting the Price Level: Overall Average
Prices do not change very much.
• Suppose that In Japan, there are two sectors of industry:
Tradables and Non-Tradables
• The overall price level in Japan is the weighted average of
the prices of the two sectors:
P = 0.5 PT + 0.5 PNT (in simpliest form)
• Technical Innovation happens only to Tradables industry
- Due to Technical Innovations, Japanese Tradable becomes
cheaper. Due to Technical Backwardness, Japanese Nontradable becomes more expensive:
-> The Overall Japanese Price Level (P) stays relatively stable
while the Japanese Tradable Good Price Level (PT ) falls.
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(iii) Real Factors affecting the Prices of Tadables, and
Trade: FOREX rate or E falls
• Japanese Tradable goods have price competitiveness
edge over Foreign-produced Tradable goods.
<- Trade depends on PT/ PT of Foreign Country, not P/Pf.
International Substitution from foreign Tradable
goods to domestic tradable goods
-> Trade surplus for Japan
-> Excess Demand for Japanese currency
(Excess Supply of foreign currency)
-> Nominal FOREX rate falls additionally in Japan
beyond what PPP dictates.
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(iv) Real FOREX rate or q falls:
• E falls more than P / Pf .
• q = E / (P/ P f ) falls as well.
-> a falling real exchange rate reflects a rising
international competitiveness
<- a falling real exchange rate raises Japanese
imports but does not fully offset the initial rise in
competitiveness.
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(v) PPP worked for Tradable Goods Prices
only, not for the Overall Price Level:
• E PT f / PT = 1 for Tradable Goods
• E P f / P << 1 for overall price level
Here, q(<<1) is a reflection of an increasing
competitiveness of Japanese export goods.
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5. Case study of Canada
1) Facts
• Between 1975-1990s
-E continued to rise (against Canadian dollars)
-Nominal factors: Money supply increased faster in
Canada than in U.S.
-Real factors: Canadian productivity lagged behind
the U.S. productivity
• Between 2001-2003
- e continues to fall
- capital flows from U.S. : A higher interest rate in
Canada than in the U.S.
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- may reflect improving real factors
*Data: US-Canadian FOREX Rates of the 1970s to
2001.
In fact, PPP was not
exactly correct
If PPP had been
correct
E
q
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*2) Analysis: Explaining with ‘q’
•It is true that the Canadian monetary policy was
more liberal than the U.S. monetary policy up to the
1990s: This explains the general rise of P and E.
•Theoretically, E and Pcanada /P us should have gone up
proportionally. Yet, E went up faster than P/Pf
•Canada- inflation differentials between U.S. and
Canada could not fully explain the changes in the
nominal FX.
•This suggests that a substantial part of FOREX
fluctuations between Canada and US is caused by ‘real
factors’.
•What have caused the real FX rate to change, or
deviate from unit(one)?
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What is the real factor against
Canada?
• Relatively lower productivity, and
• Speed of innovation
-> Demand for Canadian goods falls
-> Exchange rates rises more than PPP
suggests.
-> ‘q’ rises as part of ‘the
equilibriating/corrective forces’, which
tries to increase the exports and thus to
restore the equilibrium.
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3) One More Application: “Canada
should use U.S. Dollars?”
• Pros
1.No conversion/transactions
cost
2. Eliminated FOREX Risks
3. Monetary Discipline for
Canada
• Cons
1. Most FX transactions
were in a large amount
and do not carry a
large percentage of
conversion costs
2. Recently developed
hedging has already
reduced FOREX risks
substantially
3. Not much gains for
Canada for now
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*“How would the elimination of FX rates between
the two countries affect the Canadian Economy?”
• The same currency means no floating
FOREX rates.
• The same currency means the same
monetary policies and the same rate of
inflation for the two country (as PPP says).
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-If the changes in the Canada-US exchange rate had
reflected inflation differentials, then the adoption
of the common currency would have nominal
impacts only.
• In fact, the floating FOREX rates did have other
function(s), the adoption of the common currency
and thus the virtual fixed exchange rates would
hinder the very function of the floating FOREX
rates
- Canada needs the floating FX rate system, which
presupposes its own currency.
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*Suppose Real Adverse Shocks for Canada, not
U.S. : eg) Canada is hit with a lower productivity;
The demand for the Canadian goods fall.
Under Fixed FX system
Either
•
Labor demand falls; and
•
thus Wages fall
•
Prices fall
•
Demand for the Canadian
goods may rise back
Or
If wages do not fall,
•
Actual exports fall;
•
Unemployment rises.
Under Flexible FX system
The FOREX rates will take the first
beating (Option II);
The resulting depreciation of the
domestic currency substantially
restores the demand for the
Canadian goods;
The changes in Income will be mild.
*M. Friedman: “Changing the setting of the clock” is easier; Option II is
better and easier for adjustment than Option I.
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