Download Exchange Rate Dynamics

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(P or M) 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) What are ‘Real Factors’ which affect supply and
demand for trade?
(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
Foreign Currency” (FX rate or ‘S’ 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 versus Real FX rates
• Nominal FX rate: E or S
• Real FX rate: ‘q’
q = S / (P/Pf)
= S Pf/P
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• Under PPP where S is set by all nominal
factors such as P or M, q =1 at all times.
• When real factors are at work on S, ‘q’ may
not be equal to one.
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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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• A nominal factor affects S and P at the same
time to the same degree.
- thus,‘q’ does NOT change.
• A real factor may affect S and P differently.
- thus, ‘q’ change.
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• In the case where real factors work in
addition to nominal factor(money, and price
level), the changes in FX rate cannot be
fully explained by nominal factors, such as
money supply and relative price level.
• Thus, nominal FX (S or E) changes and ‘q’
changes as well.
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For example,
• Domestic ‘technical innovation’ leads to an increase in
supply of manufactured/tradable goods and their falling
prices.
• However, the overall price level of the domestic country
may not fall much as technical innovation may not happen
in some industries such as services and the price level is an
average of manufactured goods and services.
• The international demand for tradable goods increases .
As supply of FX rises, FX rate falls.
• Thus q = S Pf/P falls.
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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 = S / (P / Pf ) falls
as S falls more than P/ Pf falls
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*Now use ‘q’ to explain the whole story:
(i) Nominal Factors affecting the Price Level:
relatively conservative monetary policy in Japan
-> P/Pf fell.
-> S in Japan fell according to the Purchasing Power Parity
Theorem.
* However, if this is all that has happened, S and P/Pf move by
the same amount, and thus ‘q’ would not have changed.
However, P/Pf is not enough to explain the changes in S.
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(ii) Real Factors: The Overall Average Prices do not change
very much while the price of a specific sector directly
related to the real factors change a lot.
• Suppose that In Japan, there are two sectors of industry: Tradable and
Non-Tradable industries.
• 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 Tradable industry
- Due to Technical Innovations, Japanese Tradable goods become
cheaper. Due to Technical Backwardness, Japanese Non-tradable
goods become more expensive:
-> The Overall Price Level (P) stays relatively stable while Tradable Good
Price(PT ) falls significantly.
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(iii) Real Factors affecting the Prices of Tradable
goods: FX rate falls
• Japanese Tradable goods become more
internationally competitive
• Trade depends on the relative prices of tradable
goods between domestic and foreign country PT/ PT
of Foreign Country, not the overall relative prices 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 FX rate falls additionally in Japan beyond what PPP
dictates.
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(iv) Real FX rate or q falls:
• S falls more than P / Pf .
• q = S / (P/ P f ) falls as well.
-> a falling real exchange rate reflects a rising international
competitiveness; This is called ‘Real Appreciation of
Domestic Currency”
<- a falling real exchange rate has a unfavorable reaction,
decreasing Japanese exports and increasing Japanese
imports. However, this secondary reaction may 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:
• S PT f / PT = 1 for Tradable Goods
• S 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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6. Case Study of China:
A good topic for your assignment
• P/Pf
• S
• q
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*Confusing Use of S and q by
some other authors
• Just like the case of direct versus indirect
quotation of S, there are two different
definition of q.
• Our way is right
• The other use of q (= 1/S P/Pf) is only for
convenience.
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