Transcript Document

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 Rates
• 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.
What level should it be?
Link
Interest Parity
(1  i ) 
F
t
St 1
St
 (1  it )
Saving
It is January 1st, and you have D$1000 to
save for 1 year. You can put it into:
a domestic currency bank account at an
interest rate i.
2. a foreign currency bank account at interest
rate iF.
1.
Payoff to strategy #2
•
Strategy two has three parts.
1.
Buy foreign exchange at spot rate St to get {D$1000/St} F
dollars.
Put {D$1000/St} F dollars into F bank account. After 1
year get F$(1+iF)×{D$1000/St }
Convert these funds into F$ at exchange rate prevailing at
end of year.
F
2.
3.
(1  i )  St 1
St
 D$1000
Uncovered Interest Parity
• If
(1  i F )  St 1
St
F$ account.
F
(1

i
)  St 1
• If
St
 1  i , deposit funds then deposit in
 1 i
D$ account.
• Then in equilibrium
, deposit funds then deposit in
St 1  (1  i F )  1  i
St
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
it  i
F
t
St 1  St  F

S

i g
St
t
t 1
Three Reasons UIRP might not hold
Future exchange rates are risky, uncovered interest
parity does not account for risk.
1.
Interest Parity Works for Forward Prices
A.
{t }
t 1
F
{t }
t 1
F
2.
3.
 St 
: Forward Price for currency delivered at t+1
1  it
1 i
F
t
Domestic and foreign currency not perfect substitutes.
People like to hold currency for liquidity reasons.
Currency controls
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
• Price of US$: S is the price of US$ in terms of DCU.
Link
From Interest Parity
• People trade currencies to engage in foreign trade and
international investment.
• Expected (Investment) Profit:
• Of Domestic Investors in Foreign Economy
St 1
St
 (1  itF )
• Of Foreign Investors in Domestic Economy
St
St 1
 1  it
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
St
St 1
 1  it
• Exports Effect – Expensive US$ reduces the attractiveness
of exports.
• 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
St 1
St
 (1  itF )
• Imports Effect – Cheap US$ reduces the
competitiveness of imports.
Supply and Demand in Forex Mkt
S
Supply
BoP > 0
BoP < 0
Demand
Forex Turnover
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
Supply
S
⓪
S*
S
Demand
Forex
Purchas
Increase in Desired Capital Inflows by Foreign Investors/
Desired Purchases of Domestic Goods
S
Supply
Supply'
⓪
S*
S**
①
Domestic Currency
Appreciates
Demand
Increase in Desired Capital Outflows by Domestic Investors/
Desired Purchases of Foreign Goods
S
S**
①
S*
Domestic Currency
Depreciates
⓪
Supply
Demand
Demand '
Fixed Exchange Rate: Weak Currency Target
S
Gov’t Buys Excess Supply US$
Supply
STGT
BoP > 0
Demand
Forex Turnover
Fixed Exchange Rate: Strong Currency Target
S
Supply
BoP < 0
STGT
Gov’t Buys Excess DCU
Demand
Forex Turnover
Exchange Rate Regimes
Monetary Authorities
Fixed Exchange
Rates
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
Exchange rate
arrangement
(Number of
countries)
Monetary Policy Framework
Exchange rate anchor
U.S. dollar (66)
Currency board
arrangement (13)
Hong Kong SAR
Other conventional
fixed peg
arrangement (68)
Bangladesh
Mongolia
Sri Lanka
Vietnam
China
Crawling peg (8)
Managed floating
Cambodia
with no preLao P.D.R.
determined path for Myanmar
the exchange
rate (44)
Independently
floating (40)
Composite
(15)
Singapore
Vanuatu
Inflation
targeting
framework
Other
(7)
Brunei
_
(44)
Other
_
(33)
Indonesia
Thailand
Malaysia
Pakistan
India
Korea
Philippines
Japan
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
STGT
Demand
Link
• China State Administration Foreign Exchange Safe through 2011 has
accumulated large quantities of foreign reserve assets.
Link
Foreign Currency Intervention
Sterilized vs. Unsterilized
Two 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
2
S**
S*
1
Domestic
Currency
Depreciates
Supply'
Supply
Demand
Demand '
REAL EXCHANGE RATES &
TRADE BALANCE
Real Exchange Rate: Measure of
Competitiveness
• We can measure the competitive pricing of home
goods.
F
Pt
RERt  St  HOME
Pt
• 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
Benchmark: PPP
• The first theory of exchange rates was Purchasing
Power Parity – Arbitrage should insure the price of
goods was equalized across countries
PPP  Pt HOME  St  PtUS  RERt  1
•Is PPP true? Not in short run. Trade arbitrage does
not work that fast. How about long run?
Exchange Rate Misalignment
Over-valuation/Undervaluation of Currency
Overvalued/
Uncompetitive
Undervalued/
Competitive
S < P HOME
S > P HOME
PF
PF
• Exchange rate misalignment: when price of currency differs
from relative prices of goods making domestic goods
relatively cheap/competitive or relatively
expensive/uncompetitive
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
China, Real Effective Exchange Rate,
CPI Based, 2005 = 100
130.000
125.000
120.000
115.000
110.000
How about the
long run?
105.000
100.000
95.000
90.000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
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
BigMac
US$3.71 in USA, then
phom e
BigMac
USA
p
 5.0943 HK $ US $
Link
• 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.
Relative Prices
1.
2.
Divide expenditures into k = 1,..,K (in 2005, K =
155) “basic heading” categories of goods.
All j = 1,..J countries (in 2005, J = 146) report
total expenditure in domestic currency of all k
k
categories.
v
j
3.
4.
Sample prices of representative goods from each
category in each country.
Construct average of those prices (relative to
“anchor” economy) for each country j basic
heading type of good k .
k
k
phome pUSA
WDI provides PPP data for many countries
using US$ as anchor currency
International Comparison Project
Hong Kong PPP per Category
PPP
Xrate
Classification Name
2005
1101 Food and non-alcoholic beverages
8.81547906
1102 Alcoholic beverages and tobacco
10.1680743
1103 Clothing and footwear
6.11435997
1104 Housing, water, electricity, gas and other fuels
9.09847987
1105 Furnishings, household equipment and household maintenance 7.61334163
1106 Health
2.9312812
1107 Transport
9.40016616
1108 Communication
6.83789147
1109 Recreation and culture
5.24897067
1110 Education
3.25951882
1111 Restaurants and hotels
8.98215569
1112 Miscellaneous goods and services
5.61784877
1501 Machinery and equipment
7.5934365
1502 Construction
4.15019416
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
7.78
PPP in Anchor Currency.
4.
Define quantity of good of type k valued
q 
k
j
5.
v
k
j
Calculate price of j’s market basket in j’s prices relative to
price of j’s market basket in anchor country prices.
v1j  v 2j  ...  v Kj
PPPjAC $ 
v1j
1
j
p
1
pUS

v 2j
p
2
j
2
pUS
 ... 
v Kj
p 2j
2
pUS
Numerator in j currency, denominator in US$
p kj
• 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.
PPPj 
p q  p q  ...  p q
1
USA
p
1 1
j j
1
j
2
j
q  p
2
USA
2
j
K
j
K
j
K
USA
 q  ...  p
2
j
q
K
j
GDP in Intl$
• PPP’s are used to construct comparable measures of GDP for
multiple countries by converting them into international dollars.
US $
j
GDP

GDPj
PPPj
Per capita GDP in
GDP per capita, PPP (current international $)
2005
international dollars is Hong Kong SAR, China
$35,677.92
headline way of
China
$4,114.57
India
$2,299.76
comparing living
Indonesia
$3,216.81
Malaysia
$11,754.53
standards.
World Development Indicators
Korea, Rep.
Thailand
Singapore
$22,783.27
$6,750.94
$45,374.24
World Development Indicators
PPP 2010
PPP
China
Hong Kong
Korea
Japan
Singapore
PPP/XR XR
REX
3.946
0.583
6.770
1.716
5.345
0.688
7.769
1.453
827.346
0.716 1156.061
1.397
111.389
1.269
87.780
0.788
1.040
0.763
1.364
1.311
World Development Indicators
• Developing countries tend to be relatively cheap with
PPP’s being lower than exchange rates.
• OECD countries tend to have more similar price
structures, though they tend to be relatively more
expensive.
• High income, non-OECD countries tend to be
relatively cheap.
• Compare values measured in different currencies using
the PPP and exchange rate method.
PPP conversion factor (GDP) to market exchange rate ratio
1.8
1.6
1.4
1.2
PPP/S
1
0.8
0.6
0.4
0.2
0
0
10000
20000
30000
40000
GDP per Capita (PPP, 2005)
World Development Indicators
50000
60000
70000
80000
GDP in US$ by Conversion Method
2005 GDP per Capita
2005 GDP per Capita
40000
$6,000
35000
$5,000
30000
25000
$4,000
US/Intl$
US/Intl$
World Development Indicators
$7,000
$3,000
20000
15000
$2,000
10000
$1,000
5000
$0
Low income
Lower middle
income
Middle income
Exchange Rate
PPP
Upper middle
income
0
High income: OECD
High income: nonOECD
Exchange Rate
PPP
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