Session 13.

Exchange Rates

Exchange Rates in the Long Run

The law of one price
Deviations of the law of one price
Exchange rates, productivity and inflation
Short Run: Currencies as Assets
Interest parity conditions
Putting everything together: monetary policy, interest rates and exchange
rates

Are foreign exchange markets efficient? The $/€ exchange rate from 1975 to
2022

Macroeconomics in the Global Economy

 Nominal and Real Exchange Rates

Nominal Exchange rate

Relative price of the currencies of two countries
How many units of foreign currency one can buy with one unit of
domestic currency

Real exchange rate

How many foreign goods one can buy with one unit of a domestic good

e% P

eR – real exchange rate

e" = '
P
eN – nominal exchange rate
P – price of a domestic good (basket of goods)
PF – price of a foreign good (basket of goods)

Macroeconomics in the Global Economy

 Theory #1: Arbitrage ensures that prices
are equal across countries (PPP)

Macroeconomics in the Global Economy

 Law of one Price

If all goods were subject to perfect arbitrage then the real exchange rate would always be
equal to 1. This theory implies that the nominal exchange rate will be simply the ratio of the
prices in the two countries:

&
" %
! ! = !1! ! =
%
[Let’s check: iPhone, Big Mac, haircuts]

Macroeconomics in the Global Economy

 Law of one Price?

Macroeconomics in the Global Economy

 Theory #1: Arbitrage ensures that prices
are equal across countries (PPP).

Theory #2: Law of one price does not hold. Two reasons:

1. Taxes, barriers to trade, transportation costs.

2. Arbitrage only applies to some goods (those that are

easily tradable).

“Modified PPP” theory.

Macroeconomics in the Global Economy

 Productivity and the
Real Exchange Rate
Arbitrage does not apply to all goods and services. There are goods that
are not traded and where arbitrage is not possible. But their prices across
countries are still determined by economic forces. Here is the argument:

1. Prices of tradables are roughly the same around the world because of
arbitrage (think of an iPhone).
2. Within a country, prices of traded goods (iPhone) and non-traded
goods (haircuts) are linked through their relative productivity.
3. The real exchange rate will depend on the relative productivity of the
two countries.
4. The nominal exchange rate will depend on the real exchange rate and
monetary policy (i.e. inflation).

Macroeconomics in the Global Economy

 Productivity and Exchange Rates

Example: two countries differ on their GDP per capita because of their productivity on
the trade sector (realistic assumption).
Number of hours Spain Germany
required to (low GDP per Capita) (high GDP per Capita)
Spain Germany
Produce a car 2000 1000
Produce/Serve a Big Mac 0.2 0.2

Price of a car is the same in both countries because of arbitrage: 20,000 Euros

Wage in Germany: 20 euros/hour

Wage in Spain: 10 euros/hour
Price of a Big Mac in Germany: 4 euros
Price of a Big Mac in Spain: 2 euros

Real exchange rate is below one Price level is lower in Spain than in Germany.

Macroeconomics in the Global Economy

 Productivity and Exchange Rates

Imagine a scenario where productivity in Spain increases due to convergence

(Session 3).
Wages and therefore prices of non-tradables in Spain will increase and the
real exchange rate will appreciate.

%
" ! &
! = '
&
Because Spain and Germany share a currency, this can happen only through
a high inflation in Spain (eN=1). But this is not macroeconomic inflation, this
is “good” inflation.

Macroeconomics in the Global Economy

 Productivity and Exchange Rates

Change countries: China (low GDP per capita) versus the US (high GDP per
capita). Real exchange rate lower than one as well (China’s price level lower
than the US).
Imagine a scenario where productivity in China increases relative to the US
due to convergence (Session 4).
Wages and therefore prices of non-tradables in China will increase and the
real exchange rate will appreciate.
%
" ! &
! = '
&
But now there is a nominal exchange rate so there are two options: higher
inflation in China or nominal appreciation (or a combination of both).
Who decides which one will happen? Central Bank
Can we see a nominal depreciation: yes if inflation is too high

Macroeconomics in the Global Economy

 Managing the Exchange Rate when
Productivity is Growing Fast: Singapore
SGD managed against a basket of currencies.
Pre-announced appreciation of the exchange rate (“fixed” exchange rate)
Slope of appreciation ensures real exchange rate appreciation without the
need for high inflation (“Since 1981, monetary policy in Singapore has been
centred on the management of the exchange rate. The primary objective has been to
promote price stability as a sound basis for sustainable economic growth.”)
Slope is revised depending on economic conditions. Bands are allowed to
provide some flexibility.
%
" ! &
! = '
&
Source: https://www.mas.gov.sg/-/media/MAS/Monetary-Policy-and-Economics/Monetary-Policy/MP-
Framework/Singapores-Exchange-Ratebased-Monetary-Policy.pdf

Macroeconomics in the Global Economy

 Fixed Exchange Rates (a Reminder)

Fixed exchange rates means a commitment by central bank to buy and sell unlimited
amounts of its currency at a “fixed” price.

When pressure to appreciate: sell local currency, buy foreign currency/reserves

When pressure to depreciate: by local currency with foreign reserves

Fixed exchange rates à central bank hands are tied

For example:
• Increase liquidity, lower interest rate à capital outflow and pressure to depreciate
• Need to buy back local currency at fixed price à reduce liquidity, higher interest rate
• [back to where we started]

Macroeconomics in the Global Economy

 Real Exchange Rate for Countries with Different
Productivity Levels
Rich countries generally have higher prices (i.e. a higher real exchange rate).

1.2

United States
1 United Kingdom Netherlands
Price Level Relative to US

Germany

0.8 France
Korea
China
Czech Republic
0.6
South Africa Mexico
Namibia Bulgaria
Poland
Russia
0.4 Thailand Serbia
Pakistan Turkey
Ukraine Paraguay
Indonesia
0.2

0
0 0.2 0.4 0.6 0.8 1 1.2
GDP per Capita Relative to US (PPP)

Data from Year 2021

Macroeconomics in the Global Economy

 Real Exchange Rate for Countries with Similar
Productivity Growth
Real exchange rate will remain constant. Therefore:
% change in Nominal Exchange Rate = Foreign inflation - Domestic inflation

Percentage 10
change
9
in nominal
exchange 8 South Africa
rate 7
6 Depreciation
5 Italy relative to
U.S. dollar
4 New Zealand
Australia Spain
3 Sweden
Ireland
2 Canada
1 France UK
Belgium
0
-1 Appreciation
Germany Netherlands
-2 relative to
Switzerland U.S. dollar
-3 Japan
-4
-3 -2 -1 0 1 2 3 4 5 6 7 8
Source: Mankiw (Fig.5.13). Averages for 1972-2000.
Inflation differential
Macroeconomics in the Global Economy
 Exchange Rates for Countries with Different
Productivity Growth
Productivity growth in Japan in the period 1976-1996 outpaced that of the U.S. This led to
an increase in the price level in Japan relative to the U.S. This is what we call a real exchange
rate appreciation.

440 Productivity and Exchange Rates: Japan vs. US

390
340
Index 1960=100

290
240
190
140
90
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000

Relative Productivity (Japan/US) Real Exchange Rate (Japan/US)

Macroeconomics in the Global Economy

 Exchange Rates for Countries with Different
Productivity Growth
The real appreciation in Japan happened through a nominal appreciation of the
exchange rate (because Bank of Japan choose an inflation rate similar to the US). In
1960 one US dollar could buy 360 Yen, by the late 1990s the nominal exchange rate
had appreciated to about 100-110 Yen/$.

Macroeconomics in the Global Economy

 The Law of One Price (PPP) and Exchange Rates
Exchange rates follow PPP estimates in the long run but substantial short-
term volatility persists
Australia (AUD/USD) UK (GBP/USD)
2.1 0.85

1.9 0.8

1.7 0.75

0.7
1.5
0.65
1.3
0.6
1.1
0.55
0.9
0.5
0.7
0.45
0.5 0.4
1980 1985 1990 1995 2000 2005 2010 2015 2020 1980 1985 1990 1995 2000 2005 2010 2015 2020

Nominal Exchange Rate PPP-Implied Exchange Rate

Nominal Exchange Rate PPP-Implied Exchange Rate

Macroeconomics in the Global Economy

 Theory #1: Arbitrage ensures that prices
are equal across countries (PPP).

Theory #2: Law of one price does not hold. Two reasons:

1. Taxes, barriers to trade, transportation costs.

2. Arbitrage only applies to some goods (those that are easily

tradable).

Theory #3: Currencies are assets and exchange rates represent their
prices. Let’s use asset pricing to think about exchange rates.

Macroeconomics in the Global Economy

 Exchange Rates as Asset Prices

Stylized Fact #1: Exchange rates are extremely volatile

Stylized Fact #2: Volume on foreign exchange markets is very large (i.e. capital
flows dominate foreign exchange markets).

Daily Turnover Foreign Exchange Markets

8000
7000
6000
Billions USD

5000
4000
3000
2000
1000
0
1986 1989 1992 1995 1998 2001 2004 2007 2010 2013 2016 2019 2022

Macroeconomics in the Global Economy

 Exchange Rates as Asset Prices
v In the short run, think about currencies as assets. Deposits in different currencies
represents different assets. The returns on these deposits will be affected by
exchange rate movements.

v A sudden increase in interest rates in one country will lead to a capital inflow and
an appreciation of the currency. News on interest rates determine change in
exchange rates.

v But be careful: the above theory does not say that countries with higher interest
rates should have appreciating currencies. Quite the contrary: arbitrage ensures that
returns are equalized across currencies and countries with higher interest rates
have depreciating currencies.

v It is only the news on changes in monetary policy that makes exchange rates
move up when interest rates go up.

Macroeconomics in the Global Economy

 Adjustment following monetary expansion

Money
Nominal Exchange Rate
1. In the long run the exchange
depreciates by an amount equal to the
Time 0 increase in the price level (PPP)
Time

Interest rates

Time 0 Time 0
Time
Time

Prices
3. On impact, the nominal exchange
rate depreciates. It does so up to the
point where the future appreciation
Time 0 Time matches the difference in interest rates
and leads towards the new PPP long-
run value. There is a unique value
today that satisfies these two
conditions. Intuitively, the exchange
rate depreciations because lower
interest rates trigger a capital outflow
(the IS-LM model).
Macroeconomics in the Global Economy
2. During the period where
interest rates are lower (and
there are no news) the exchange
rate appreciates to ensure that
there are no excess returns
(“arbitrage” in capital markets).
The appreciation happens at a
rate which is equal to the
difference in interest rates.
 2017. Euro
Are Foreign Exchange Markets Efficient? strengthens on
surprising growth
USD per EUR Exchange Rate (recovery from
1.75 two recessions)
1980. US Federal Reserve What is the “right” value? PPP? (OECD Estimate)
raises interest rates to stop
1.55
inflation while new
president (Reagan) engages
1.35 in large budget deficits

1.15

0.95
March 2015.
Goldman Sachs
0.75 1999. Euro is born at 1.17 $. predicts Euro will
Market pessimism follows hit parity in 6
months
0.55
Jan-75 May-78 Sep-81 Jan-85 May-88 Sep-91 Jan-95 May-98 Sep-01 Jan-05 May-08 Sep-11 Jan-15 May-18 Sep-21

In the past, Central Banks have intervened when the currency moved “too far” from its fundamental
value as it happened in September 1985 (Plaza Accord), February 1987 (Louvre Accord) and the
interventions of November 2000 to stop the fall in the Euro.

Macroeconomics in the Global Economy

 Magnifying the Real Size of News
November 15th 2006, Financial Times, front page:

“Euro Tumbles – French Premier Dominique de Villepin sent

the Euro tumbling against the dollar after making a call for
greater collaboration among Euro-zone authorities on
managing the exchange rate … Gavin Friend, strategist at
Commerzbank, said that he was surprised at the currency’s
market reaction, given that there was little Mr Villepin could
do about the strength of the Euro other than lobby the ECB”

Nov 10th Nov 13th Nov 14th Nov 15th Nov 16th Nov 17th Nov 29th
1.278 1.285 1.285 1.282 1.281 1.282 1.315

Macroeconomics in the Global Economy

 Can the theory explain the data?
The USD/EUR Exchange Rate

What works:
1. Long term trend shows depreciating USD (because of higher inflation).
2. Some episodes of fast US growth and high interest rates (the early 80’s
led to an appreciating USD.
What cannot be explained:
1. The exchange rate is too volatile.
2. The link between interest rates and exchange rates is too weak. The spot
rate is a better prediction than the interest rate differential.
3. Some short-term trends cannot be explained by any consistent economic
theory.
4. There are too many episodes where the exchange rate appreciates (or
depreciates) continuously over a long period of time. This is only possible
if there is a continuous flow of news about monetary policy that always
go in the same direction (very unlikely).
Macroeconomics in the Global Economy
 Summary: What Do We Know about Exchange Rates?
1. In the long run, exchange rates are determined by arbitrage of tradable goods. There is a long-
run equilibrium value of the nominal exchange rate implied by arbitrage and the actual nominal
exchange rate fluctuates around it.
2. In the long run, we can describe movements in nominal exchange rates as reflecting differences
in inflation rates (adjusted for productivity changes).
3. In the short run, we think of exchange rates as asset prices. Interest rate determine the evolution
of nominal exchange rates in the short run. An unexpected increase in the interest rate, leads to
immediate appreciation of the currency. Once the interest rate has gone up, higher interest rates
predict depreciation of the currency. The reason is arbitrage. Make the distinction between an
“increase in interest rates” vs. “higher interest rates”.
4. Empirically, nominal exchange rates are much more volatile than any of the macroeconomic
fundamentals and even the ‘overshooting’ result cannot explain why exchange rates are so
volatile.
5. Be aware that the ‘theories’ that explain exchange rate movements are much more ex-post
rationalization than tested hypothesis. Only way to anticipate changes in the exchange rate is if
you are good at guessing what the theory of the day will be.

Macroeconomics in the Global Economy