Exchange Rate DynamicsI

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Exchange Rate Dynamics(I)

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

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(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)?
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Definition of Exchange Rates1) European
Quotation Price of a unit of Foreign Currency
in terms of Domestic Currency eg) The
representative FOREX rate in Canada Canadian
X / US 11.31 as of Jan. 20042) American
Quotation foreign currency price of a unit of
domestic currencyeg)0.76 Cdn 1 buys US
0.76
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Exchage Rates Relative Value of Foreign
Currency to Domestic Currency

• For instance, the representative FOREX rate for
  Canada is 1.3 for the U.S. dollar.
• FOREX rate 1.3
• Value of US 1/ Value of Canadian 1
• US 1 is 1.3 times as valuable as Cdn 1

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2. What is the correct FOREX rate?Equilibrium
versus Disequilibrium

• Is there an equilibrium long-run FOREX rate which
  correctly reflect the economy-wide and market
  fundamentals?The actual FOREX rate may differ
  from this equilibrium FOREX rate for a
  short-term, but eventually the actual FOREX rate
  should gravitate to the equilibrium value.
• Is the currently observed FOREX rate an
  equilibrium or a disequilibrium?

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3. Three Aspects of Theories There are three
theories which link the economic fundamental to a
Long-run equilibrium exchange rate

• Monetary Theory,
• Quantity Equation of Exchanges
• relates inflation/price differentials to
  international differences in monetary policy and
  economic growth

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

• International Investment
• - Uncovered Interest Parity Theorem
• Exchange rates depend on Interest Rate
  Differentials
• - International Fisher Effect
• Exchange rates depend on Inflation Differentials

• Real Factor Analysis
• Real FOREX rate changes due to Innovations

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Links FOREX Rates to the economic and market
fundamentals in International Trade
4. International Trades perspective

• Short-run Disequilibrium
• Exports pushes FX rate up,
• Imports pushes FX rates down.
• Long-Run Equilibrium
• Purchasing Power Parity

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1) Purchasing Power Parity 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..

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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

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

• No changes in Supply or Demand for
  domestic/foreign goods other things being
  equal(ceteris paribus)
• In the Long Run equilibrium situation
• With tradable
• Works best with free trade
• .

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4) Empirical Evidence of PPP

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

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(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 _____.

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

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• 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 hair cut costs U.S. 25 in New York. An
  equally good hair cost costs 25 Yuan in Beijing.
  
• The PPP might dictate the FOREX rate of 1Yuan for
  U.S. ___.
• In fact, the actual FOREX rate is the opposite.

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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

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

• P/ e Pf 1

• P/ Pf and

time
e move together
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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

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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 )
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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 )
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6. International Investment

• International Investment Perspectives
• Disequilibrium
• Money moves to a higher return
• Capital Flows
• Equilibrium
• Money earns the same real rate of return
• No Capital Flows

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1) Uncovered Interest Parity TheoremInternationa
l Fisher Effect

• At Equilibrium (No Capital Movement),
• i if (ee - e)/ e
• if ?ee
• ? ee i - if
• The expected changes in exchange rate is equal
  to the interest rate differential

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2) Covered Interest Rate Parity Theorem

• ( 1 i) F/e (1 if )
• (F- e)/ e i i f
• Forward Premium or discount is equal to the
  interest rate differential

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3) Unbiased-Forward-Rate Theory

• e e F
• The expected future spot rate is the same as
  the forward rate
• (ee e)/e (F e)/e
• ? ee (F- e)/ e
• The expected change in the spot rate is equal
  to the forward premium or discount

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7. 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.

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

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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

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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

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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.

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• 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.

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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

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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).

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8. Real Factors

• What are the real factors that affect FOREX
  rates?
• Real means the opposite to Nominal or
  Monetary
• Trade
• Supply of and demand for domestic versus
  foreign goods (tradable goods)
• Price competitiveness
• Innovation and Productivities
• Investment conditions risk factors, business
  prospect

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2) Real Factors affect International Trade
and Investment

• Real Shocks to Supply Demand
• International Trade Export Imports
  
• International Investment K Inflows K Outflows
• _______________
• FX rate6 FX rate 5

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3) Real factors affect FX rates

• Nominal FOREX rate or e
• Real FOREX rate or q when Real factors do not
  affect Price Level as much as they affect Nominal
  FOREX rate
• eg) e Pf/ P q.