EXCHANGE RATES

• “I’ve watched year in and year out as companies have shut down and people have lost their jobs because China has not played by the same rules, in part by holding down artificially the value of their currency,” Mitt Romney 2012

• Exchange Rate: S - # of domestic currency units purchased for 1 US$.

• An increase in S is a depreciation of domestic currency and a decrease in S is an appreciation.

Exchange Rates

What level should it be?

Link

Interest Parity

1(1 ) (1 )F tt t

t

Si iS

Saving

It is January 1st, and you have D$1000 to save for 1 year. You can put it into:

1. 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 St to get {D$1000/St} F

dollars. 2. Put {D$1000/St} F dollars into F bank account. After 1 year

get F$(1+iF)×{D$1000/St }

3. Convert these funds into F$ at exchange rate prevailing at end of year. 1(1 )

$1000F

t

t

i SD

S

Uncovered Interest Parity

• If , deposit funds then deposit in

F$ account.• If , deposit funds then deposit in

D$ account. • Then in equilibrium

1(1 )1

Ft

t

i Si

S

1(1 )1

Ft

t

i Si

S

1 (1 ) 1t F

t

Si i

S

Interest Rate Parity• The only reason people would be willing to hold a US$

account when US interest rates were lower than domestic interest rates 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.

• Approximately

11

t tF F St t t t

t

S Si i i g

S

Three Reasons UIRP might not hold1. Future exchange rates are risky, uncovered interest

parity does not account for risk.A. Interest Parity Works for Forward Prices

Forward Price for currency delivered at t+1

2. Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons.

3. Currency controls

{ }1

11

t tFt tt

iF Si

{ }1 :t

tF

Supply and Demand Model

Why do exchange rates change?• Relative values of two currency determined by supply and

demand by traders of the two currencies.

Unlike textbook, we will describe a model of domestic country’s forex market in which US$ is vehicle currency

Link

• Price of US$: S is the price of US$ in terms of DCU.

From Interest Parity• People trade currencies to engage in foreign trade and

international investment.• Expected (Investment) Profit:

• Of Domestic Investors in Foreign Economy

• Of Foreign Investors in Domestic Economy

1 (1 )Ftt

t

S iS

11t

tt

S iS

Consider the spot foreign exchange market. • Supply of US$: People who want to acquire DCU to buy

domestic goods or assets.Substitution Effects When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency.

• Expected Profit Effect - e.g. Expensive US$ magnifies returns on domestic accounts

• Exports Effect – Expensive US$ reduces the attractiveness of exports.

11t

tt

S iS

• Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment.

Substitution Effects: When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises

• Expected Profit Effect - e.g. Cheap US$ magnifies returns on foreign accounts

• Imports Effect – Cheap US$ reduces the competitiveness of imports.

1 (1 )Ftt

t

S iS

Supply and Demand in Forex Mkt

S

Demand

Supply

Forex Turnover

BoP > 0

BoP < 0

Equilibrium in the Forex Market

• Gap between supply and demand of US$ is the Balance of Payments.

• Two types of Forex Markets• Floating: Forces of supply and demand equilibrate

markets.• Fixed: Gov’t/Central Bank buys excess foreign

currency in market.

Equilibrium with Floating Rates

S

Demand

Supply

S*

Forex Purchas

S

S

⓪

Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods

S Supply

Demand

S*

Supply'

S**Domestic Currency Appreciates

⓪

①

Increase in Desired Capital Outflows by Domestic Investors/

Desired Purchases of Foreign GoodsS

Supply Demand

S*

Demand '

S** Domestic Currency Depreciates

⓪

①

Fixed Exchange Rate: Weak Currency Target

S

Demand

Supply

Forex Turnover

BoP > 0

STGT

Gov’t Buys Excess Supply US$

Fixed Exchange Rate: Strong Currency Target

S

Demand

Supply

Forex Turnover

BoP < 0

STGT

Gov’t Buys Excess DCU

Exchange Rate Regimes

Monetary Authorities

Fixed ExchangeRates

constantly maintain the external value of the currency.

Crawling Peg adjusts currency periodically in small amounts at a fixed rate or in response to changes in selective indicators.

Managed Floating attempt to influence the exchange rate without having a specific exchange rate path or target. Indicators for managing the rate are broadly judgmental.

De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks

I nflation targeting framework

Other

U.S. dollar (66) Composite (15)

Other (7)

_ (44)

_ (33)

Hong Kong SAR

BangladeshMongoliaSri LankaVietnamChina

Cambodia Singapore Indonesia MalaysiaLao P.D.R. Vanuatu Thailand PakistanMyanmar India

Korea JapanPhilippines

Independently floating (40)

Other conventional fixed peg arrangement (68)

Managed floating with no pre-determined path for the exchange rate (44)

Crawling peg (8)

Exchange rate arrangement (Number of countries)

Monetary Policy Framework

Exchange rate anchor

Currency board arrangement (13)

Brunei

Balance of Payments Crisis

• Basic asymmetry between weak and strong currency target.

• Weak target: Govt has infinite amount of domestic currency and can always maintain.

• Strong target: Govt has finite amount of foreign currency and may face a balance of payments crisis.

• BoP crisis: Gov’t must borrow funds from abroad or allow a weakening of the currency.

China Forex Market: Excess Supply of US

• Trade Surplus: Chinese exporters bringing cash home can sell foreign currency at policy rate to SAFE.

• Capital & Currency Controls: Non-trivial to move money into China and even harder to move it out. Govt policies to encourage FDI inflows and discourage portfolio outflows.

• Exchange Rate Policy: Crawling Peg

China Forex : Supply and Demand less sensitive to exchange rate or interest differentials.

S Supply

Demand

STGT

Link

• China State Administration Foreign Exchange Safe through 2011 has accumulated large quantities of foreign reserve assets.

Link

Foreign Currency InterventionSterilized vs. UnsterilizedTwo ways of financing interventions• Foreign currency purchase:

• Central bank purchases foreign currency• Unsterilized: Create additional domestic currency liquidity• Sterilized: Borrow domestic currency from banks, govt, selling

bonds. • Foreign currency sale

• Central bank sells foreign currency• Unsterilized: Withdraw domestic currency liquidity• Sterilized: Repay domestic currency loans.

Exchange Rates are Volatile!

Future Exchange Rate Level• If people’s expectation of the future exchange rate indicates a future depreciation, this will reduce the expected returns on investing in the domestic economy at any given interest rate.

• This will increase demand for US$ and reduce supply.

• An expected depreciation leads to a current depreciation!

Expectation of St+1 Increases

S

Supply Demand

S*

Supply'

Demand '

S**

Domestic Currency Depreciates1

2

REAL EXCHANGE RATES & TRADE BALANCE

Real Exchange Rate: Measure of Competitiveness

• We can measure the competitive pricing of home goods.

• 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 1 domestic good

Ft

t t HOMEt

PRER S

P

Benchmark: PPP• The first theory of exchange rates was Purchasing

Power Parity – Arbitrage should insure the price of goods was equalized across countries

1HOME USt t t tPPP P S P RER

•Is PPP true? Not in short run. Trade arbitrage does not work that fast. How about long run?

Exchange Rate MisalignmentOver-valuation/Undervaluation of Currency

• Exchange rate misalignment: when price of currency differs from relative prices of goods making domestic goods relatively cheap/competitive or relatively expensive/uncompetitive

Overvalued/Uncompetitive

S <

Undervalued/Competitive

S >

HOME

FP

P

HOME

FP

P

Is the Currency Undervalued or Overvalued?

• When RER is weak (i.e. when currency is undervalued), domestic exports are competitive on global markets while foreign imports may be less attractive.

• For any pair of currencies, it is easy to observe the exchange rate, but what is the relative price we should consider when thinking about the competitiveness of currency?

Effective Exchange Rate Indices• IMF constructs effective exchange rate indices both nominal and

real. • Indices are constructed so the growth rate of the index is equal

to a weighted average of bilateral appreciation rates

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201190.000

95.000

100.000

105.000

110.000

115.000

120.000

125.000

130.000

China, Real Effective Exchange Rate, CPI Based, 2005 = 100

How about the long run?

Competitiveness & Current Account

IMF Data Mapper

RELATIVE PRICES

Market Basket Index?• Construct an international market basket of goods

produced and purchased around the world. For country j, PPPj could be the relative price of the market basket relative to price of the market basket in US$.

• Problem: Judging the cost of living by the cost of the international market basket may not be fair if customers in the local market can buy the types of goods which are cheaper at home.

PPP: Purchasing Power Parities

• PPP is the relative price of goods in one country measured in its own currency compared to the price of a reference country.

• Example: If Big Macs were k and cost HK$18.90 in HK and US$3.71 in USA, then

hom 5.0943 $ $BigMac

eBigMacUSA

p HK USp

• Major project to compare prices internationally implemented by the World Bank with the help of UN and national statistical agencies.

• ICP has been implemented by UN Statistical Office since 1968.

Link

Relative Prices

kjv

1. Divide expenditures into k = 1,..,K (in 2005, K = 155) “basic heading” categories of goods.

2. All j = 1,..J countries (in 2005, J = 146) report total expenditure in domestic currency of all k categories.

3. Sample prices of representative goods from each category in each country.

4. Construct average of those prices (relative to “anchor” economy) for each country j basic heading type of good k .

homk k

e USAp p

PPP XrateClassification Name 20051101 Food and non-alcoholic beverages 8.81547906 7.781102 Alcoholic beverages and tobacco 10.1680743 7.781103 Clothing and footwear 6.11435997 7.781104 Housing, water, electricity, gas and other fuels 9.09847987 7.781105 Furnishings, household equipment and household maintenance 7.61334163 7.781106 Health 2.9312812 7.781107 Transport 9.40016616 7.781108 Communication 6.83789147 7.781109 Recreation and culture 5.24897067 7.781110 Education 3.25951882 7.781111 Restaurants and hotels 8.98215569 7.781112 Miscellaneous goods and services 5.61784877 7.781501 Machinery and equipment 7.5934365 7.781502 Construction 4.15019416 7.78

Hong Kong PPP per Category

WDI provides PPP data for many countries using US$ as anchor currency

International Comparison Project

PPP in Anchor Currency.4. Define quantity of good of type k valued

5. Calculate price of j’s market basket in j’s prices relative to price of j’s market basket in anchor country prices.

kk j

kjj

vq

p

1 2$

1 2

1 2 2

1 2 2

...

...

Kj j jAC

j Kj j j

j j j

US US US

v v vPPP

v v v

p p pp p p

Numerator in j currency, denominator in US$

• Conceptually PPP is the cost of the goods purchased by consumers in their country relative to the cost of those same goods in US$ terms.

1 1 2 2

1 1 2 2

...

...

K Kj j j j j j

j K KUSA j USA j USA j

p q p q p qPPP

p q p q p q

GDP in Intl$

GDP per capita, PPP (current international $)2005

Hong Kong SAR, China $35,677.92China $4,114.57India $2,299.76Indonesia $3,216.81Malaysia $11,754.53Korea, Rep. $22,783.27Thailand $6,750.94Singapore $45,374.24

• PPP’s are used to construct comparable measures of GDP for multiple countries by converting them into international dollars.

$US jj

j

GDPGDP

PPP

Per capita GDP in international dollars is headline way of comparing living standards.

World Development Indicators

World Development Indicators

PPP 2010

PPP PPP/XR XR REXChina 3.946 0.583 6.770 1.716Hong Kong 5.345 0.688 7.769 1.453Korea 827.346 0.716 1156.061 1.397Japan 111.389 1.269 87.780 0.788Singapore 1.040 0.763 1.364 1.311

World Development Indicators

• Developing countries tend to be relatively cheap with PPP’s being lower than exchange rates.

• OECD countries tend to have more similar price structures, though they tend to be relatively more expensive.

• High income, non-OECD countries tend to be relatively cheap.

• Compare values measured in different currencies using the PPP and exchange rate method.

0 10000 20000 30000 40000 50000 60000 70000 800000

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

1.8

PPP conversion factor (GDP) to market exchange rate ratio

GDP per Capita (PPP, 2005)

PPP/

S

World Development Indicators

GDP in US$ by Conversion Method

2005 GDP per Capita

$0

$1,000

$2,000

$3,000

$4,000

$5,000

$6,000

$7,000

Low income Lower middleincome

Middle income Upper middleincome

US/

Intl$

Exchange Rate PPP

2005 GDP per Capita

0

5000

10000

15000

20000

25000

30000

35000

40000

High income: OECD High income: nonOECD

US/

Intl$

Exchange Rate PPP

World Development Indicators

Is China the Biggest Economy in the World?

• Discuss Subramanian Link

Learning Outcomes Students should be able to:• Use interest differentials to calculate expected depreciation rate

under UIRP. • Use the Supply-Demand model of the forex model to explain the

effect of international trade conditions on the exchange rate.• Compare values measured in different currencies using the PPP

and exchange rate method