Transcript International Dimensions

Open Economy: Purchasing
Power Parity
Learning Objectives
• Understand the difference between nominal and
real exchange rates.
• Understand the differences between fixed
exchange rate systems and flexible exchange rate
systems.
• Understand how the theory of purchasing power
parity explains the determination of interest rates.
• Understand how the theory of interest rate parity
explains the determination of interest rates.
Exchange Rates
• An exchange rate is the price of one
currency in terms of another.
• Exchange rates are important because
exports, imports and all international
financial transactions are affected by the
prices at which currencies exchange for one
another.
Nominal Exchange Rate
• Nominal exchange rate: the relative price of
the currency of two countries.
– e = yen/dollar = 120/1 = 120
• One dollar buys 120 yen
– e = dollar/yen = 1/120 = 0.0083
• 120 yen buy 0.0083 dollars.
Real Exchange Rate
• Real exchange rate is re = e x PUSA /PJ
– The real exchange rate can be expressed as:
• re = (Y/PJ)/($/PUSA) = Y/$ x (PUSA/PJ)
where
•
•
•
•
Y =
$ =
PUSA =
PJ =
Yen
Dollars
Price level in the USA
Price level in Japan
Exchange Rate Systems
• Fixed Exchange Rates
– A fixed exchange rate system is one in which
exchange rates are set at officially determined
levels and are changed only by direct
governmental action.
Fixed Exchange Rate Definitions
• When the value of a currency in terms of
another is fixed by the government,
– Devaluation: a reduction in the official value of
a currency.
– Revaluation: an increase in the official value of
a currency.
Fixed Exchange Rates
• In a system of fixed exchange rates, the central
bank must be prepared to offset imbalances in
both demand and supply by government sales
or purchases of foreign exchange.
• Each country’s central bank must intervene in
the foreign exchange market to prevent that
country’s exchange rate from going outside a
narrow band on either side of its par value.
Fixed Exchange Rates: Example
• Let the exchange value of the Hong Kong
dollar be set such that it is overvalued
relative to its current market value.
– Hong Kong must drive up the value of the HK$
by using its foreign reserves to buy the HK$ in
the world market .
Fixed Exchange Rates: Example
• Let the exchange value of the Hong Kong
dollar be set such that it is undervalued
relative to its current market value.
– Hong Kong must drive down the value of the
HK$ by selling them in the world market, thus
gaining foreign reserves.
Fixed Exchange Rate: Example
$/HK$
$/HK$
S
Market
S
Loss of Reserves
Peg
Peg
Gain of Reserves
Market
D
D
0
Q
Overvalued
0
Q
Undervalued
Fixed Exchange Rates:
Advantage
• Advantage:
– Less uncertainty in the near future about
exchange rates.
• Developing countries use fixed exchange rates so
that the rest of the world will be willing to hold
their currencies.
Fixed Exchange Rates:
Disadvantages
• Disadvantages:
– Requires large amounts of currency reserves.
– May require difficult macroeconomic policy
adjustments and a loss of control of domestic
economic policy.
– Can be used to promote an inefficient pattern of
trade and specialization.
Exchange Rate Systems
• Flexible Exchange Rates
– A flexible exchange rate system is one in which
exchange rates are determined by conditions of
supply and demand in the foreign exchange
market.
– Flexible exchange rate systems are also known
as floating exchange rate systems
Flexible Exchange Rate Definitions
• When the value of a currency in terms of
another is determined by the market,
– Appreciation: an increase in a country’s
exchange rate due to a change in demand and/or
supply.
– Depreciation: a decrease in a country’s
exchange rate due to a change in demand and/or
supply.
Flexible Exchange Rates: Example
c/$
S$
If supply of dollars exceeds
demand, the dollar depreciates
and the euro appreciates.
If demand for dollars exceeds
supply, the dollar appreciates
and the euro depreciates.
D$
0
Q1
Qeq
Q2
Q
Flexible Exchange Rates:
Advantages and Disadvantages
• Advantages:
– Exchange rates re-equilibrate automatically.
– Promote a globally efficient pattern of
production specialization and international
trade.
• Disadvantages:
– Market volatility.
– Increase transactions costs associated with
dealing with foreign currency.
Exchange Rate Determination: Long
Run
• In the long run, exchange rates can be
explained with the concept of purchasing
power parity (PPP).
– Purchasing power parity states that if
international arbitrage is possible, the price of
a good in one nation should be the same as
the price of the same good in another nation,
adjusted for the exchange rate.
PPP: Simple Example
• Assume that the U.S. and Canada produce
identical bushels of wheat and that the
exchange rate is $1.00 Canadian for $1.00
USA.
• Let the price of wheat in Canada be $3/bushel
and the price of wheat in the USA be
$2.50/bushel.
• What will happen?
PPP: Example
• Canadians will buy U.S. wheat. In order to do
this, they must first buy U.S. dollars.
– Supply of Canadian dollars in the global
marketplace increases.
– Demand for U.S. dollars in the global
marketplace increases
• The Canadian dollar depreciates and the U.S
dollar appreciates.
PPP: Simple Example
• In the long run, these transactions bring
about a single price for U.S. and Canadian
wheat.
• Conclusion:
– A rise in the price level puts downward
pressure on a currency.
– A fall in the price level puts upward pressure
on a currency.
Why PPP Works Poorly in the
Short Run
• PPF Assumptions:
– All goods are identical in both countries.
– All goods and services are traded across
borders.
– Both countries have similar levels of
productivity.
– Consumers do not prefer one country’s goods
over another’s.
– No tariffs or quotas.
Exchange Rate Determination: Short
Run
• The modern asset market approach to explain
exchange rate determination emphasizes
financial flows.
• In the short run, decisions to hold domestic or
foreign assets play a more important role than
trade.
Exchange Rate Determination:
Interest Rate Parity
• Interest rate parity says that the higher
domestic real rates of interest are relative to
foreign real interest rates, the higher will be
the value of the domestic currency, other
things remaining the same.
Interest Rate Parity: Assumptions
• Foreign and U.S. deposits have similar risk and
liquidity characteristics.
• There are few impediments to capital mobility.
– Foreigners can easily purchase American assets
and Americans can easily purchase foreign assets.
• Therefore, foreign and American assets are
perfect substitutes.
Expected Return
• Demand for dollar assets vis a vis foreign
assets depends on the relative expected
return on the assets.
– A higher expected return on dollar assets
relative to foreign assets results in a higher
demand for dollar assets.
– A higher expected return on foreign assets
relative to dollar assets results in a higher
demand for foreign assets.
Relative Expected Return:
Foreign Perspective
• The relative expected return on dollar assets
held by a foreigner depends on the
difference between the domestic and
foreign interest rates and the expected
change in the exchange rate of the dollar.
Relative Expected Return: Example
• RETE = iusa – if + /\e$/e$
– If iusa = 10%, if = 5%, and /\e$/e$ = 5%, the
relative expected return from the foreign
perspective on the USA asset is 10%.
– If iusa = 10% , if = 5%, and /\e$/e$ is – 5%, the
relative expected return from the foreign
perspective on the USA asset is 0%.
Interest Rate Parity Condition
• For existing supplies of both dollar and
foreign assets to be held, it must be true that
there is no difference in their expected
returns.
– The relative expected return must equal zero.
• Relative RETE = id – if + /\e$/e$ = 0
id = if – /\e$ /e$
Interest Rate Parity Condition:
Implications
• If the domestic rate is below the foreign
interest rate, positive expected appreciation of
the domestic currency is expected.
• The expected appreciation compensates for the
lower domestic interest rate.
• 8% = 10% – x
Interest Rate Parity Condition:
Implications
• If the domestic rate is above the foreign
interest rate, positive expected appreciation of
the foreign currency is expected.
– Positive expected appreciation of the foreign
currency equals negative expected appreciation of
the domestic currency.
– The expected appreciation compensates for the
lower foreign interest rate.
• 10% = 8% – x
Interest Rate Parity: Example
• Assume that U.S. interest rates are higher than
those in other countries.
• The high rates of return on U.S. financial
assets attract foreign buyers.
– In order to buy U.S. financial assets, foreigners
must first buy dollars.
• The demand for dollars increases in the global marketplace
and the dollar appreciates.
• The supply of the foreign currency increases in the global
marketplace and it depreciates.
Determinants of the Exchange Rate:
Summary Table
An Increase in
Change in the
Exchange Rate
Reason
Domestic output
Fall
Demand for imports
& supply of dollars rise
Demand for domestic
exports & dollars rises
Demand for goods and
dollars rises.
Foreign output
Rise
ROW demand for domestic
goods
Rise
Real domestic interest rate
Rise
Demand for dollars rises
Foreign interest rate
Fall
Supply of dollars rises
Expected value of the
dollar
Rise
Demand for dollars rises