Exchange Rate DeterminationII Trade Approach

1
Exchange Rate Determination(II)Trade Approach

• Dr. J. D. Han
• Kings College
• U.W. O.

2
(Key Question)1.What causes exchange rates to
fluctuate?2. How do you predict exchange rates
(and their changes)?3. What is the correct
exchange rate?4.What are the benefits of having
exchange rates as opposed to not having ones
(using the big countrys currency)?
3

Overview Revisited Three Theories There are
three theories which link the economic
fundamental to FOREX rate

• Focusing on International Investment and Interest
  Rate
• - Interest Parity Theorem
• Exchange rates depend on Interest Rate
  Differentials

• International Trade and Price Level
• -Purchasing Power Parity
• Exchange rates depend on relative price ratio or
  inflation differentials

• International Trade and Real Factors
• - Real Exchange Rate Analysis
• Real FOREX rate changes due to real factors such
  as Innovations

4
Links FOREX Rates to the relative price levels of
the two countries in International Trade.
3. International Trades perspective

• E P domestic / P foreign
• Pin down the cause of changes in Price Level to
  Nominal Factor (Money Supply) - Purchasing Power
  Parity
• Pin down the cause of Price Level changes to Real
  Factors - Real Exchange Rate Analysis

5
What changes the Price Levels?

• 1) Nominal Factor such as Money Supply
• E changes when Money Supply changes at
  different rates in the two countries - Purchaing
  Power Parity Theory of FOREX rate
• 2) Real Factors such as Demand and Supply of
  Trade Goods(Tradables)
• Excess Supply lowers P domestic, and E
• Excess Supply can happen due to i) innovation
  on the supply side and/or ii) suppressed demand
• - Real Exchange Rate Analysis of FOREX Rate

6
4. Purchasing Power Parity

• 1) It says
• Under a certain set of conditions,
• Exchange Rate is determined in such a way
  that a unit of a certain currency should, through
  the conversion using the exchange rate, fetch the
  same amount of goods in the foreign country as it
  would in the domestic countries
• A currency should have the same
  purchasing power everywhere in the world..

7
2) PPP comes from Law of One Price for One
Good

• In the long-run, a merchandise should have the
  same price, in a currency, everywhere in the
  world through arbitrage of international trade.

8
3) Under what set of conditions does Purchasing
Power Parity hold?

• No changes in Real Factors, or Supply/ Demand for
  domestic/foreign goods other things being
  equal(ceteris paribus)
• In the Long Run equilibrium situation
• For tradables not for non-tradables
• Works best with free trade or no barrier to
  trade
• Price Measurement should be correct
• .

9
4) Empirical Evidence of PPP

• Big Mac Index Mixed
• Non-Tradable Goods Not working
• Tradable Goods working well
• All goods Mixed

10
(1) A widely cited evidence for/against PPP
Big Mac Index

• FOREX rates calculated on the basis of the local
  currency prices of a Big Mac across countries
• PPP A Big Mac Meal might cost the same after
  currency conversion whatever country it might be
  sold in and in whatever currency it might be sold
  in.
• Idea Cdn 2.60 buys a Big Mac in Canada in
  U.S., a Big Mac costs U.S. 2. The correct FOREX
  rate for one U.S. dollar in Canadian dollars
  should be Cdn / US _____.

11

• Updated Big Mac Index
• http//www.licenseenews.com/news/news188.html
  
• Mixed Evidence for/against PPP
• The actual FOREX rates differ significantly from
  the Big Mac Index
• -Why?
• Recall PPP presupposes Free Trade.
• PPP works for Tradable Goods only, and
• in the long-run only

12

• In contrast, there is no reason why a price of
  non-tradable good should have the same price in
  two different countries unless the production
  factors are completely mobile between the two
  countries.
• Eg) A steak dinner costs U.S. 50 in New York. An
  equally good steak costs _____ Yuan in China.

13
5) Two Versions of PPP

• Absolute PPP
• Level
• P E Pf
• E P/Pf
• E Pf / P 1

• Relative PPP
• Percentage Changes
• ?P ? E ?Pf
• ? E ?P - ?Pf
• p pf

14
Visual Image of PPP in time-series data
If PPP holds, then in the data we should see

• E Pf /P 1

• P/ Pf and

time
e move together
15
5. Monetary Theory relates Price Level to
Monetary Theory and Growth

• FOREX rate
• Relative Value of Two Currencies Relative
  Worth of Two Monies Relative Inverse of Price
  Levels Relative Money Supplies (M)
• - Relative Real Economic Perfomance/Growth
  (y)
• Relative Stability of Monetary
  Situations(V)
• between domestic and foreign countries

16

Formally by using Quantity Equation of Exchange,
we can show that Price Level is determined by
Three FactorsMoney supply, Economic Growth Rate,
and Velocity of Circulation

• Absolute PPP

Mf Vf Pf yfPf Mf Vf/yf
M V P yP M V/y
e P/Pf (M V/y)/ (Mf Vf//yf ) if we assume
V Vf 1 for now e (M / y) / (Mf /yf )
17
Relative PPP De DP - D Pf - (1) DP
D M - D y ( D V) - (2) DPf D Mf -
D yf ( D Vf ) - (3) Pluging (2) and (3)
into (1) , we get D e (D M- D Mf ) -
(D y - D yf )
18
6. Relation between Inflation and Domestic
Monetary Theory

• Fundamentally speaking, a Change in FX rate
  depends mainly on Relative Speeds of Money
  Creation by two governments.

19

• The proof needs three links
• Uncovered International Parity Theorem
• (International) Fisher equation
• Quantity equation of exchange

20
Step 1

• Fisher Equation
• Nominal Interest rate Real Interest Rate
  Expected Rate of Inflation
• i r p e, where ? Pe p e
• if rf p ef
• Interest Differential comes mainly from Inflation
  Differential
• i - if (r rf ) p e - p ef

21
(No Transcript)
22
Step 2 Monetary Theory of Quantity Equation of
Exchange

• Money supply mainly determines Price Level M V
  P yMf Vf P f yf
• Speed of money creation mainly determines
  Inflation Rate?P ? M - ? y ?V ?Pf
  ? Mf - ? yf ?Vf

23
Step 3Fisher Equation Quantity Equation of
Exchange

• Combining the above two equations, we get ? e
  
• p e - p ef , if r rf 0
• ? M- ? Mf
• - (? y - ?yf), if ?V - ?Vf 0.
• FOREX rate depends mainly on Money Supply
  conditions.

24

• Note Precisely speaking, FOREX rates are
  determined by i) the difference in money creation
  (between the domestic and the foreign countries)
  and ii) the difference in economic growth.

25
FOREX and Monetary Policy

• Country with an Easy Monetary Policy faces a High
  Exchange Rate
• Easy Monetary Policies
• A Large Quantity of Money
• Low Value of Money
• High Price of A Foreign Currency in that
  Domestic Money
• High FOREX Rate

26
Summary LR Nominal Factors

• Purchasing Power Parity says Exchange rates are
  determined by Inflation differential
• Uncovered Interest Parity says that Exchange rate
  changes for Interest Rate Differentials.
• International Fisher Effect says that Interest
  Rate Differential comes from Inflation
  Differential.
• Monetary Theory, such as, Quantity Equation of
  Exchange says Inflation Differential comes mainly
  from the difference in money creation (between
  the domestic and the foreign countries).
• (along with difference in economic growth).