Transcript Slide 1

Exchange Rates
Real Exchange Rates
Real Exchange Rate
• A country’s real exchange rate is the relative cost
of that country’s good when compared to foreign
goods when measured in domestic currency
PtUS
St
rext  St  HOME 
Pt
PPPt
• 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
Purchasing Power Parity
• An currency achieves a PPP exchange
rate when the cost of purchasing foreign
goods equals domestic goods S = PPP,
REX = 1.
• Absolute PPP – e = 1
• Relative PPP ge = gS +[πUS – π] = 0
Does PPP Hold?
• Does Absolute or Relative PPP hold?
• In short run, NO. Exchange rates are much more
volatile than inflation rates.
• In long run for countries with similar levels of
development, PPP holds.
– Example. Twenty year averages for OECD countries.
Long Run: Developed Economies
Source: IFS 1975-1995
PORTUGAL
ITALY
SPAIN
SWEDEN
UNITED KINGDOM
AUSTRALIA
FRANCE
CANADA
BELGIUM
GERMANY
NETHERLANDS
JAPAN
-4.00%
-2.00%
0.00%
Inflation Differential
2.00%
4.00%
Exchange Rate Depreciation
6.00%
8.00%
Does PPP Hold?
• Does Absolute or Relative PPP hold?
• In short run, NO. Exchange rates are much more
volatile than inflation rates.
• In long run for countries with similar levels of
development, PPP holds.
– Example. Twenty year averages for OECD countries.
Long Run: Developed Economies
Source: IFS 1975-1995
PORTUGAL
ITALY
SPAIN
SWEDEN
UNITED KINGDOM
AUSTRALIA
FRANCE
CANADA
BELGIUM
GERMANY
NETHERLANDS
JAPAN
-4.00%
-2.00%
0.00%
Inflation Differential
2.00%
4.00%
Exchange Rate Depreciation
6.00%
8.00%
Over-valued/Under-valued
• When the cost of purchasing foreign
goods is
– relatively high, S > PPP and a currency is said
to be undervalued.
– relatively low, S < PPP and a currency is said
to be overvalued.
•Is HK$ overvalued in 2008?
Calculate Real Exchange Rate
• Calculate Pt
– Get PPPReference from World Bank, U Penn etc.
– Convert CPI to World Bank Reference Year
Dollars for Domestic and Foreign Economy
CPI
CPIt
Pt  PPPReference 
CPI Reference
USA
CPI
t
PtUSA 
USA
CPI Reference
Example
• HK: PPP in 2005 was
5.69 meaning goods
that cost $1 in the US
cost HK$5.69 in HK.
• But prices (and
exchange rates) have
changed since then.
CPI
USA
HK
2005 196.400
100.3
2008 219.086
109.1
PPP
2005
1
5.69
S
2008
7.8
REX
• What is REX in HK?
• Is HK$ over or
undervalued.
2008 US
HK
P
1.115509 1.087737
S
7.8
PPP
5.548338
Exchange Rate Model
Exchange Rates are Volatile
Jan-06
Jan-04
Jan-02
Jan-00
Jan-98
Jan-96
Jan-94
Jan-92
Jan-90
Jan-88
Jan-86
280.00
260.00
240.00
220.00
200.00
180.00
160.00
140.00
120.00
100.00
80.00
Jan-84
Yen per Dollar
Yen-Dollar Rate
Interest Parity
Saving
It is January 1st, and you have D$1000 to
save for 1 year. You can put it into:
1. Put it into 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 S01/01 to get
{D$1000/S01/01} US dollars.
2. Put {S01/01 × D$1000} into bank account. After
1 year get US$(1+iF)×{D$1000/S01/01 }
3. Convert these funds into US at exchange rate
prevailing in 1 year.
(1  i F )  S12/31
 D$1000
S01/01
Uncovered Interest Parity
• If
(1  i F )  S12/31
> 1+i, deposit funds
S01/01
then deposit in US$ account.
F
(1

i
)  S12/31 < 1+i, deposit funds
• If
S01/01
then deposit in HK$ account.
• Then in equilibrium
(1  i
F
S01/01

)
1  i
S12/31
Interest Rate Parity
• The only reason people would be willing to
hold a US$ account when US interest rates
were lower than domestic interest rate
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
S
S
i i
F


12/31
S01/01
01/01

Are Exchange Rate Differentials a
Good Predictor of Exchange Rate
Movements
• In short-term, no.
• Estimate equation, should see β0 =0 β1 =1
SM 1/01  SM /01  
SM /01
JPN
USA



i

i

0
1
M /01
M /01    t
• Estimate using Japanese monthly data
SM 1/01  SM /01  .614 .161 
SM /01
(.161)
(.160)
JPN
USA

i

i
1  M /01
M /01 
Why the failure?
Two Reasons
1. Future exchange rates are risky,
uncovered interest parity does not
account for risk.
2. Domestic and foreign currency not
perfect substitutes. People like to hold
currency for liquidity reasons.
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.
• People trade currencies to engage in
foreign trade and international investment.
• Monetary policy is a prime driver of
exchange rates.
– And vice versa, Some economies structure
monetary policy around exchange rate.
Forex Market: Supply & Demand
Consider the spot foreign exchange market.
• Price of US$: S is the price of US$ in terms of DCU.
• Supply of US$: Foreign people who want to acquire
DCU to buy domestic goods or assets.
– When US$ becomes expensive, domestic goods
or assets get cheap and foreign investors are
attracted to domestic currency.
• Demand for US$: Domestic people who want to
acquire US$ for foreign purchases or overseas
investment.
– When US$ get cheap, US$ goods or assets get
cheap and demand for US$ rises
Equilibrium in Forex Market
Supply Equals Demand
S
Supply
1
S*
Demand
Increase in Desired Capital Outflows by
Domestic Investors/
Desired Purchases of Foreign Goods
S
S**
2
S*
1
Supply
Domestic
Currency
Depreciates
Demand '
Demand
Increase in Desired Capital Inflows by
Foreign Investors/
Desired Purchases of Domestic Goods
S
Supply
Supply'
Domestic
Currency
Appreciates
1
S*
S**
2
Demand
US Monetary Policy Causes
US$ Interest Rates Go Up
Relative Demand for US$ Goes Up
S
2
S**
S*
1
Domestic
Currency
Depreciates
Supply'
Supply
Demand '
Demand
Domestic Monetary Policy Causes
D.C. Interest Rates Go Up
Relative Demand for US$ Goes Down
S
Supply
Supply'
1
S*
Domestic
Currency
Appreciates
S**
2
Demand
Demand '
Monetary Policy & Exchange Rates
• The central impact of the foreign currency
intervention is on domestic interest rates.
• Monetary policy that shifts domestic interest
rates will also shift exchange rates
regardless of whether it occurs through
currency intervention, OMO, or some other
change in quantity of bank reserves.
• Monetary policy that does not shift interest
rates will not shift exchange rates.
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
2
S**
S*
1
Domestic
Currency
Depreciates
Supply'
Supply
Demand '
Demand
Hong Kong’s Exchange Rate
Regime
Clearing Accounts Reserves
• May 2005 Under the strong-side Convertibility
Undertaking, the HKMA undertakes to buy US
dollars from licensed banks at 7.75. Under the
weak-side Convertibility Undertaking, the HKMA
undertakes to sell US dollars at 7.85.
US Monetary Policy Causes
US Interest Rates Go Down, Strengthening
Pressure on HK$
S
Supply
Supply'
1
S=7.8
Excess Supply
of US Dollars
S**
Demand
Demand '
Hong Kong Interbank Market:
HIBOR higher than US interest rate.
iHIBOR
i*
S
S'
Banks
convert US$
to Clearing
Balances to
take
advantage
of higher
interest
rates in
Hong Kong
1
2
iUSA
D
Reserve Accounts
Convertibility Undertaking Stabilizes Forex
Demand and Supply Curves Automatically
R
Supply
Supply'
1
S=7.8
Excess Supply
of US Dollars
S**
Demand
Demand '
Fixed Exchange Rate
• If the central bank undertakes to keep the
exchange rate fixed and that is a credible
undertaking, then  St 1  .St 
E

St
0

• If the relative values of currency are fixed,
then funds will flow out of the domestic
currency if domestic interest rates are too
low and flow into domestic currency if
interest rates are too high.
i = iF
Fed Funds
HIBOR
Jun-04
Jun-03
Jun-02
Jun-01
Jun-00
Jun-99
Jun-98
Jun-97
Jun-96
Jun-95
Jun-94
Jun-93
Jun-92
Jun-91
Jun-90
Jun-89
Jun-88
Jun-87
Jun-86
%
HIBOR vs. Fed Funds Rate
Interbank Rates
20
18
16
14
12
10
8
6
4
2
0
Loss of Credibility
• A fixed exchange rate will lose credibility if
people come to believe that the central bank will:
– devalue the currency, (ie. raise S in the future)
– revalue the currency (ie. reduce S in the future)
• If market expects an exchange rate change,
commercial banks will adjust comparison rate for
the expectations of devaluation.
HIBOR
t
i
i
FF
t
 St 1  St  
E

S
t


Iron Triangle of International
Finance
Open to
International
Capital Flows
Monetary
Policy that
Controls The
Interest Rate
Pick 2 items from this menu
Fixed
Exchange
Rates
Managed Floating
Foreign Currency Intervention
• Foreign currency purchase:
– Central bank purchases foreign currency
– Credit reserve accounts of counterparty commercial bank
– More reserves pushes down interest rates
• Increases demand for and reduces supply of US$ in
forex market
• Foreign currency sale
–
–
–
–
Central bank sells foreign currency
Debit reserve accounts of purchasing bank
Less reserves pushes up interest rates
Reduces demand for and increases supply of US$ in
forex market
IMF Exchange Rate Classification
60
50
40
30
20
10
0
No Currency
Currency
Board
Fixed
Exchange
Rate
Band
Crawling
Peg
Managed
Float
Source http://www.imf.org/external/np/mfd/er/2008/eng/0408.htm
Free Float
Excess Demand for Foreign Currency
1. Domestic
Currency Faces
Depreciation
Pressure
S
1
S*
Supply
Demand '
Demand
Foreign Currency Intervention
Managed Floating: Sale
• Foreign Central Bank raises interest rate
• Domestic Forex rate weakens
• Domestic Central Bank sells forex directly
increasing supply of forex.
• Forex Purchase also reduces domestic
money supply and increases domestic
interest rates.
• This helps to keep domestic forex rate from
weakening.
Forex Sale
Supply
S
1
S*
2
Supply'
1. Central Bank
does Forex
Sale
maintaining
Exchange
Rate Stability
2. Shrinking
money
Demand supply and
higher
domestic
Demand '
interest rates
Excess Supply of Foreign Currency
1. Domestic
Currency Faces
Appreciation
S
S*
1
Supply
Demand
Foreign Currency Intervention
Managed Floating: Purchase
• Foreign Central Bank cuts interest rate
• Domestic Forex rate strengthens
• Domestic Central Bank purchases forex
directly increasing demand for forex.
• Forex Purchase also expands domestic
money supply and reduces domestic interest
rates.
• This helps to keep domestic forex rate from
strengthening.
Forex Purchase
S
2
S*
Supply'
Supply
1
1. Central Bank
does Forex
Purchase
maintaining
Exchange
Rate Stability
2. Growing
money
supply and
Demand ' lower
domestic
interest rates
Demand
Sterilized Intervention
• Sterilized intervention occurs when the
central bank engages in a foreign
exchange market intervention combined
with an offsetting open market operation
which leaves the monetary base
unchanged.
• When the government conducts a foreign
currency intervention but maintains a fixed
interest rate target, passive transactions
will automatically sterilize.
Sterilized Interventions
• Sterilized interventions will not affect the
domestic interest rate. However, they may
create a very liquid currency market which
temporarily affects the exchange rate.
• Most empirical studies find that sterilized
interventions have little effect on exchange
rates in even the medium run.
Learning Outcomes
Students should be able to:
• Use the Exchange Rate method and the
PPP method to convert nominal values into
other currencies.
• Use the exchange rate, PPP, and CPI to
calculate the real exchange rate and use
inflation differentials and exchange rate to
calculate real exchange rate growth.
• Use interest differentials to calculate
expected depreciation rate under UIRP.
Learning Outcomes Pt. 2
• Use the Supply-Demand model of the
forex model to explain:
– the effect of international trade conditions on
the exchange rate.
– the impact of interest rates and other financial
market conditions on exchange rates.
– Government policy efforts to stabilize the
exchange rate under fixed exchange rates
and managed floating