Lecture 3Lecture 3

International FinanceInternational Finance

ECON 243 – Summer I, 2005ECON 243 – Summer I, 2005

Prof. Steve CunninghamProf. Steve Cunningham

1993 1994 1995 1996 1997

Exchange rate Exchange rate componentscomponents

Yen’s trade-weighted exchange

value

Fundamentally driven long-

run equilibrium

path

Fundamentally driven medium-run cyclical path

Technically driven short-run

overshooting path Fundamental

equilibrium path

What Determines Exchange What Determines Exchange Rates?Rates?

Short runShort run (hours, days, months) – related (hours, days, months) – related to financial transfers because of the to financial transfers because of the speed of these transactions. Therefore:speed of these transactions. Therefore: Asset Market ApproachAsset Market Approach: differences in real : differences in real

interest rates, hence our interest in:interest rates, hence our interest in: Covered Interest DifferentialsCovered Interest Differentials Uncovered Interest DifferentialsUncovered Interest Differentials

Shifting expectations of future exchange ratesShifting expectations of future exchange rates Medium runMedium run (years) (years)

Economic cycles (Income differentials)Economic cycles (Income differentials)

Interest Rate DifferentialsInterest Rate Differentials Short term real interest rate Short term real interest rate

differentials influence international differentials influence international capital movementscapital movements Real interest rate is nominal minus Real interest rate is nominal minus

inflationinflation Low short term rates lead to less Low short term rates lead to less

demand for the currency and demand for the currency and depreciationdepreciation

High rates lead to greater demand High rates lead to greater demand for the currency and appreciationfor the currency and appreciation

30 35 40 45 50 55 60 65 70

Millions of Euros

Impact of interest rate Impact of interest rate differentialsdifferentials

Dollars per Euro

S0

A

D0

.80

.75

B

D1

S1

Market expectationsMarket expectations As with stock markets, foreign As with stock markets, foreign

exchange markets react quickly to exchange markets react quickly to news or even rumors that point to news or even rumors that point to future changes affecting ratesfuture changes affecting rates

Future expectations can be self-Future expectations can be self-fulfilling; speculative bubbles can fulfilling; speculative bubbles can start without any real information start without any real information but can become self sustaining for a but can become self sustaining for a whilewhile

Determining Exchange Rates Determining Exchange Rates (Continued)(Continued)

Long runLong run (many years) - movements of (many years) - movements of goods, services, investment, influenced goods, services, investment, influenced by:by: Inflation rates (relative prices: Inflation rates (relative prices:

Purchasing Power Parity Purchasing Power Parity (PPP)(PPP)

Long-term investment profitabilityLong-term investment profitability Consumer tastesConsumer tastes Long-term real GDP growth ratesLong-term real GDP growth rates ProductivityProductivity Trade policyTrade policy

Purchasing Power Parity (PPP)Purchasing Power Parity (PPP)——some historysome history

The theory of PPP has been around as long as paper The theory of PPP has been around as long as paper money. It is one of the oldest theories of exchange money. It is one of the oldest theories of exchange rate determination. Hence we present it first.rate determination. Hence we present it first.

It was discussed in 16It was discussed in 16thth Century Spain, for example. Century Spain, for example. It was last resurrected by Gustav Cassel in the It was last resurrected by Gustav Cassel in the

period between WWI and WWII. He used it in period between WWI and WWII. He used it in discussions of how much European countries would discussions of how much European countries would have to either change their exchange rates or their have to either change their exchange rates or their domestic price levels, given that WWI had changed domestic price levels, given that WWI had changed the relative prices in the countries (causing the relative prices in the countries (causing different inflation rates in the countries).different inflation rates in the countries).

It is based on the It is based on the Law Of One Price (LOOP)Law Of One Price (LOOP)..

Law of One Price (LOOP)Law of One Price (LOOP) The The law of one pricelaw of one price is: is:

““In a competitive market, if two goods In a competitive market, if two goods are identical, then they should sell for are identical, then they should sell for the same price.”the same price.”

If the two goods were in the same place If the two goods were in the same place and both available to customers, then and both available to customers, then customers would always choose the customers would always choose the cheaper of the two goods, forcing the cheaper of the two goods, forcing the sellers of the more expensive one to sellers of the more expensive one to lower their price.lower their price.

ArbitrageArbitrage If the two goods were not in the same If the two goods were not in the same

market (place), then market (place), then arbitragearbitrage would would operate to equalize the prices.operate to equalize the prices.

ArbitrageArbitrage is the process of buying or is the process of buying or selling something in order to exploit a selling something in order to exploit a price differential so as to make a price differential so as to make a riskless profit.riskless profit. Arbitrageurs seek to find and exploit price Arbitrageurs seek to find and exploit price

differentials between markets (across differentials between markets (across space). Arbitrageurs seek to carry goods space). Arbitrageurs seek to carry goods across markets.across markets.

SpeculationSpeculation If the two goods were not being If the two goods were not being

demanded at the same time, and the demanded at the same time, and the good was storable, then good was storable, then speculationspeculation would tend to equalize prices.would tend to equalize prices.

SpeculationSpeculation is the holding of a good or is the holding of a good or security in the hope of profiting from a security in the hope of profiting from a future rise in price. future rise in price. Speculators “arbitrage” across time. Speculators “arbitrage” across time.

Speculators “carry” the goods across time.Speculators “carry” the goods across time. Because no one really knows the future, Because no one really knows the future,

speculation is inherently risky. (Spatial) speculation is inherently risky. (Spatial) arbitrage is not.arbitrage is not.

Deviations from LOOPDeviations from LOOP Carrying (storage) costsCarrying (storage) costs reduce the profits reduce the profits

from speculation, andfrom speculation, and Transportation costsTransportation costs reduce the profits reduce the profits

from arbitrage.from arbitrage. Transactions costsTransactions costs are other costs are other costs

associated with a transaction, over and associated with a transaction, over and above the cost of the good which actually above the cost of the good which actually changes hands. These also reduce the changes hands. These also reduce the profits associated with arbitrage and profits associated with arbitrage and speculation.speculation.

All three of these can result in deviations All three of these can result in deviations from the LOOP.from the LOOP.

International LOOPInternational LOOP Transportation costs can be significant.Transportation costs can be significant. Legal barriers and tariffs may exist.Legal barriers and tariffs may exist. Some goods are not traded Some goods are not traded

internationally. These are goods for which internationally. These are goods for which inter-regional price differentials cannot inter-regional price differentials cannot be eliminated by arbitrage. Examples of be eliminated by arbitrage. Examples of nontradeable “goods”nontradeable “goods” are: are: HousesHouses Medical servicesMedical services Goods that are not available in all countriesGoods that are not available in all countries Goods that do not survive transportationGoods that do not survive transportation

International LOOP International LOOP (Continued)(Continued)

When we add the complication of (flexible) When we add the complication of (flexible) exchange rates, we have to restate the exchange rates, we have to restate the law of one price for international trade:law of one price for international trade:

““In a competitive market, similar In a competitive market, similar goods in different countries should goods in different countries should sell for the same price when the prices sell for the same price when the prices are stated in the same currency.”are stated in the same currency.”

In effect, this means that we have to apply the exchange rate to translate the prices of the goods to a common currency. After doing so, the prices should be equal.

International LOOP International LOOP (Continued)(Continued)

Thus if Thus if ppdd is the domestic price and is the domestic price and ppff is the foreign price of the same good, is the foreign price of the same good, and and e e is the spot price of the foreign is the spot price of the foreign currency in the domestic currency, currency in the domestic currency, thenthen ppdd = e = e ppff

andand epepff / p / pdd = 1 and = 1 and e = pe = pd d / p/ pff

But is this true?But is this true? Big Mac Index (Next Slide)Big Mac Index (Next Slide)

Purchasing Power Parity Purchasing Power Parity (PPP)(PPP)

Extending the LOOP, if Extending the LOOP, if PPdd is the domestic is the domestic price level and price level and PPff is the foreign price level, is the foreign price level,

Q = ePQ = ePf f / P/ Pdd is called the is called the real exchange ratereal exchange rate whereas whereas rrss is called the is called the nominal exchange ratenominal exchange rate..

If PPP holds, thenIf PPP holds, then QQ = 1 = 1 and and e = Pe = Pd / d / PPff.. This is referred to as This is referred to as absolute purchasing absolute purchasing

power paritypower parity.. Restated: The general level of prices, Restated: The general level of prices,

when converted to a common currency, when converted to a common currency, will be the same in every country.will be the same in every country.

Q: Empirical EvidenceQ: Empirical Evidence

CountryCountry QQUnited KingdomUnited Kingdom 0.960.96

CanadaCanada 1.301.30

JapanJapan 0.780.78

GermanyGermany 1.001.00

SwedenSweden 0.890.89

NorwayNorway 0.890.89

KoreaKorea 1.961.96

MexicoMexico 1.721.72

ChinaChina 4.764.76

IndiaIndia 5.265.26

PPP PPP (Continued)(Continued)

This is a simple This is a simple monetary model of the monetary model of the exchange rateexchange rate..

Strictly speaking, it does not depend upon the Strictly speaking, it does not depend upon the LOOP.LOOP.

We have ignored transactions costs, We have ignored transactions costs, transportation costs, carrying costs, tariffs, transportation costs, carrying costs, tariffs, nontraded goods, etc.nontraded goods, etc.

We have ignored the problem that not all We have ignored the problem that not all markets are competitive.markets are competitive.

We have ignored the problem of different We have ignored the problem of different weights in computing the price levels of the weights in computing the price levels of the countries involved.countries involved.

PPP PPP (Continued)(Continued)

This is an extension of the LOOP. At least on This is an extension of the LOOP. At least on average (maybe?) goods should cost the same average (maybe?) goods should cost the same in all countries (aside from tariffs, transportation in all countries (aside from tariffs, transportation costs, etc.).costs, etc.).

If this is true, then exchange rates must adjust If this is true, then exchange rates must adjust to make prices equal across countries, at least to make prices equal across countries, at least over the long run.over the long run.

This is This is LONG RUNLONG RUN because it does not consider because it does not consider that price rigidities exist that make price that price rigidities exist that make price adjustments sometimes slow.adjustments sometimes slow.

If two countries have different inflation rates, If two countries have different inflation rates, exchange rates will tend to move in opposite exchange rates will tend to move in opposite directions to keep prices the same.directions to keep prices the same.

PPP PPP (Continued)(Continued)

This leads to proposition known as This leads to proposition known as Relative PPPRelative PPP::

““The percentage change in the exchange rate The percentage change in the exchange rate between two currencies over any period equals between two currencies over any period equals the difference between the percentage changes the difference between the percentage changes in national price levels.”in national price levels.”

This amounts to: rate of appreciation of the foreign currency = πd – πf ,

which implies that an increase in the domestic inflation rate will raise the spot exchange rate proportionately.

PPP and Interest ParityPPP and Interest Parity Notice that interest parity is essentially an Notice that interest parity is essentially an

extension of relative PPP.extension of relative PPP. Interest is the price of borrowing, and Interest is the price of borrowing, and

interest parity arguments (covered interest interest parity arguments (covered interest parity and uncovered interest parity) argue parity and uncovered interest parity) argue that changes in these special prices will that changes in these special prices will cause adjustments in the exchange rate.cause adjustments in the exchange rate.

A major difference between interest parity A major difference between interest parity and PPP is that interest parity is related to and PPP is that interest parity is related to financial assets whose prices adjust very financial assets whose prices adjust very quickly, and that have substantially lower quickly, and that have substantially lower transactions costs, transportation costs, transactions costs, transportation costs, etc. etc.

Empirical EvidenceEmpirical Evidence PPP predicts PPP predicts fairly wellfairly well, both in absolute , both in absolute

and relative form, at the level of and relative form, at the level of one one heavily traded commodityheavily traded commodity for which the for which the governments involved do not interfere with governments involved do not interfere with trade. (wheat, gold, etc.)trade. (wheat, gold, etc.) Thus for something like wheat LOOP is a pretty Thus for something like wheat LOOP is a pretty

good approximation.good approximation. PPP predicts only PPP predicts only moderately wellmoderately well at the at the

level of level of allall tradedtraded goods. We run into a goods. We run into a variety of problems, including barriers to variety of problems, including barriers to trade, noncompetitive markets, and index trade, noncompetitive markets, and index construction.construction.

Empirical Evidence Empirical Evidence (Continued)(Continued)

PPP predicts PPP predicts poorlypoorly at the level of at the level of all all productsproducts in an economy. (Using CPI, GDP in an economy. (Using CPI, GDP deflators, etc.)deflators, etc.)

PPP predicts PPP predicts better over the long runbetter over the long run than than the short run.the short run. According to Froot and Rogoff (1995), for According to Froot and Rogoff (1995), for

major industrialized countries it takes about major industrialized countries it takes about four years on average for a deviation from four years on average for a deviation from PPP to be reduced by half. PPP to be reduced by half.

PPP has its worst problems with PPP has its worst problems with nontradednontraded goods. goods.

Relative PPP: Evidence (1)Relative PPP: Evidence (1)

Relative PPP: Evidence (2)Relative PPP: Evidence (2)

PPP: As Long-Run PPP: As Long-Run Tendency (1)Tendency (1)

PPP: As Long-Run PPP: As Long-Run Tendency (2)Tendency (2)

Monetary Approach:Monetary Approach:

Quantity TheoryQuantity Theory

According to the Quantity Theory, the According to the Quantity Theory, the money supply of a country is proportional money supply of a country is proportional to its nominal income.to its nominal income.

Let Let YY be real GDP, be real GDP, P P be the price level, be the price level, and and MMss be the money supply. Thenbe the money supply. Then M = kPYM = kPYwhere where kk (=1/ (=1/V) V) is the average holding is the average holding period for money.period for money.

Then for a foreign country,Then for a foreign country, MMff = k = kf f PPf f YYff . .

Monetary Approach:Monetary Approach:

Quantity TheoryQuantity Theory Using the Quantity Theory, we can examine the Using the Quantity Theory, we can examine the

relationship between prices in two countries:relationship between prices in two countries:

(P/P(P/Pff ) = (M/M ) = (M/Mf f )(k)(kff /k)(Y /k)(Yff /Y) /Y)

We can then combine this with PPP to write:We can then combine this with PPP to write:

e = P/Pe = P/Pff = (M/M = (M/Mf f )(k)(kff /k)(Y /k)(Yff /Y) /Y)

Also note that a 1% change in Also note that a 1% change in (M/M(M/Mf f ), (k), (kff /k), /k), or or (Y(Yff /Y) /Y) leads to a 1% change in leads to a 1% change in rrss . . We say that the elasticity We say that the elasticity of each of these terms is one.of each of these terms is one.

This leads us to extend PPP to a more general This leads us to extend PPP to a more general monetary approach to exchange rate determination.monetary approach to exchange rate determination.

Monetary approachMonetary approach These approaches focus on exchange rates as the These approaches focus on exchange rates as the

result of supply and demand for money at home and result of supply and demand for money at home and abroad. It is an equilibrium, supply and demand abroad. It is an equilibrium, supply and demand approach.approach.

Money supply and demand operate through the Money supply and demand operate through the linkage of prices and inflation rates.linkage of prices and inflation rates.

All else equal, All else equal, the spot exchange rate is raised bythe spot exchange rate is raised by:: A rise in the domestic money supply relative to the foreign A rise in the domestic money supply relative to the foreign

money supply,money supply, A rise in the domestic price level relative to the foreign one, A rise in the domestic price level relative to the foreign one,

oror A rise in foreign real GDP relative to domestic real GDP.A rise in foreign real GDP relative to domestic real GDP. A rise in domestic velocity, or equivalently a decline in the A rise in domestic velocity, or equivalently a decline in the

domestic domestic k, k, relative to domestic velocity or relative to domestic velocity or kk, e.g., as the , e.g., as the result of a change in the domestic payments systemresult of a change in the domestic payments system

Monetary Approach:Monetary Approach:

Policy PrescriptionsPolicy Prescriptions If a foreign country wanted to raise If a foreign country wanted to raise

its exchange rate (relative to the its exchange rate (relative to the dollar), it could do so by:dollar), it could do so by: Decreasing its money supplyDecreasing its money supply Causing disinflationCausing disinflation

Reducing its money supply would Reducing its money supply would raise domestic interest rates and slow raise domestic interest rates and slow the domestic economy. Eventually the domestic economy. Eventually output would recover, but prices output would recover, but prices would decline would decline (P(Pff ))as a result of fewer as a result of fewer dollars dollars (M(Mff ).).

Monetary Approach:Monetary Approach:

Real income differentialsReal income differentials

A country with faster economic A country with faster economic growth than the rest of the world growth than the rest of the world will have a depreciating currency will have a depreciating currency (other things being equal)(other things being equal) Imports rise faster than exportsImports rise faster than exports

Real income changes can also Real income changes can also reflect other processes, which reflect other processes, which might lead to rising exportsmight lead to rising exports

0 5 10 15 20 25 30 35 40

Millions of Pounds

Impact of real income Impact of real income differentialsdifferentials

Dollars per

Pound

S0

A

D0

1.60

1.50

D1

Next: Shorter-Run—Next: Shorter-Run—

Asset-markets approachAsset-markets approach

Currencies are a kind of financial Currencies are a kind of financial asset that are part of asset portfolios asset that are part of asset portfolios held by investorsheld by investors

Short run exchange rate changes are Short run exchange rate changes are caused by shifts in the kind and caused by shifts in the kind and location of financial assets investors location of financial assets investors want to holdwant to hold

Investors shift between assets based Investors shift between assets based on market expectations for expected on market expectations for expected returnsreturns