Globalization and Financial Markets

Part I: Exchange Rates

HEC Paris
Fall 2023
 Plan of the Exchange Rate Part
1. Introduction: Exchange rate concepts and language
2. Long-run relationships (PPP & competitiveness of
countries)
3. Arbitrage in the exchange rate market
4. Monetary policy and exchange rate behavior
5. Modern models of exchange rates
6. Forecasting exchange rates
7. Different exchange rate regimes and their economic impact
1. Exchange rate concepts and language
What we want to understand: CHF/USD,
1973-2013.
 East Asian crisis: some exchange rate
movements (1st Jan 1997 = 1), $ per currency
1,1

0,9

0,8

0,7

0,6

0,5

0,4
11-Mar-1997 19-Jun-1997 27-Sep-1997 5-Jan-1998 15-Apr-1998 24-Jul-1998 1-Nov-1998

Korean Won Malaysian Ringgit Thai Baht

 Properties of exchange rates

• May be very volatile in the short run

– Changes more than 50% of value within a year
– Even for developed, rich and stable countries (e.g. Switzerland)
changes can be of the order of 25%.
– Currency crises may occur (puzzling!)

• There might be long-term trends: this is not a random walk

in the long-run.
 Why are exchange rates important?

• Relative rates (prices) between two currencies

– Affect the relative prices of foreign competitors’ goods and services

– Important for valuing proceeds from exports or investments and
importing or borrowing costs;
– Volatility introducing risk;
– Directly impact inflation, monetary policy and monetary conditions in
many countries
– A huge financial market in itself: exchange rates as assets
 Controlling prices? Exchange rate systems

• Floating
– The exchange rate is determined in the exchange rate market freely

• Fixed (at least for some time)

– There is a fixed exchange rate maintained by the central bank (ready
to buy and sell any quantity of the domestic currency).
– Hard (currency board) or soft peg; against one or a basket of
currencies
– Requires maintenance of foreign currency reserves

• Mixed

• De iure vs. de facto regimes

 Why such exchange rate systems?

We’ll discuss it more later.

• Floating
– Allows for domestic monetary policy & free capital flows.

• Fixed (at least for some time)

– Stabilizes the external price but disallows active monetary policy
(under free capital flows)
– Risk of a change of the regime (speculative attack)

• Mixed
– Interventions when needed ("dirty float") or customized to a problem
at hand (e.g. disinflation & crawling peg)
 (De facto) Exchange rate arrangements:
examples

No separate legal tender Ecuador, El Salvador, Kosovo, Montenegro, Panama

Currency board Djibouti, Hong Kong, Bosnia and Herzegovina, Bulgaria
Conventional peg Saudi Arabia, Denmark, WAEMU and CEMAC countries
Stabilized arrangement Morocco, Croatia, Serbia, Vietnam, Iran
Crawling peg Honduras, Nicaragua, Botswana
Crawl-like arrangement Bangladesh, Bangladesh, Tunisia, Singapore
Other managed arrangement China, Argentina, Kenya, Pakistan
Floating Hungary, Switzerland, Phillipines, India, Brazil, South Africa
Free-floating Australia, Canada, Mexico,Japan, Poland, Sweden, UK, USA, EU

Source: IMF, AREAR 2020 11

Example behavior of the exchange rate in
base regimes
St St

central parity

t t
Hard peg Conventional peg with bounds
St St

t t
Crawling peg Free floating
 Quoting nominal exchange rates
• As a price of a unit of another currency, for example 1.07
USD per 1 EUR denoted 1.07 USD/EUR (this is the one we
shall adopt)

• But, sometimes you will find quotes like 1 EUR = 1.07 USD
which are described as EURUSD = 1.07

• Quotation and the typical order which currency is first

depends on the source, on the market = so watch out for
definitions!
• In our preferred notation, quotes with the currency with the
lower unit price coming first historically* are more popular (so,
for example 158 JPY/EUR instead of 0.0063 EUR/JPY).

*: Typically EUR was more expensive than the USD, so convention USD/EUR.
 Language of exchange rate changes

• Suppose currently the CHF/EUR nominal rate is at 2 (or

EUR/CHF at 0.5)

– If the rate increases to 2.5 CHF/EUR then the Swiss Franc

depreciates (or is devalued by the central bank if it was a fixed rate)

– If it changes to 1.5 CHF/EUR then the Swiss Franc appreciates (or is

revalued if a fixed rate)

– At the same time, the Euro would respectively appreciate (to 0.4
EUR/CHF) or depreciate (to 0.667 EUR/CHF) to the Swiss Franc.
 A detour: How to look at exchange rate
changes (I)
• Suppose currently the CHF/EUR nominal rate is at 2 and the
rate increases to 2.5 CHF/EUR.
• What is the percentage change?
– If you use the CHF/EUR as a base you would conclude that the Swiss
Franc depreciated by (2.5 – 2)/2*100%= 25%

– If you used the quote EUR/CHF as a base though, the change would
point to a 20% appreciation of the Euro (0.4-0.5)/0.5*100%= (- 20%)

– So which one is correct? The base seems to matter! (Siegel’s paradox)

– Market convention: depends on the base currency. For example,

MXP/USD will be measured in terms of changes vis-à-vis the U.S. dollar.

– Dollar- or euro-denominated returns: the qualifier is important.

 A detour: How to look at exchange rate
changes (II)
• An alternative way of representing exchange rates is through
their logarithms (used also in research).

– Now ln(2) = 0.6931 in CHF/EUR terms

– while in EUR/CHF terms ln(0.5) = ln(1/2) = -ln(2) = -0.6931
– If CHF/EUR increases to ln(2.5) = 0.9163 or in EUR/CHF terms
decreases to -0.9163 the change in log-terms is approximately

ln(2.5) – ln(2) = ln (2.5/2) ≈ 0.22

so a 22% depreciation of the Franc or appreciation of the Euro no

matter which way you look at it.

• This is why we shall adopt the logarithmic notation to avoid

confusion!
 Nominal effective exchange rates

• There are many bilateral exchange rates for each country.

• For a given country, its exchange rate may within a time
period depreciate against some and appreciate vs. others.
• Effective exchange rates give an answer to what occurs on
average.
– An index
– “N” bilateral exchange rates are weighted

𝑁 𝜔𝑗,𝑡
𝑆𝑗,𝑡
𝑋𝑡 = 𝑋𝑡−1 × ෍
𝑆𝑗,𝑡−1
𝑗=1
Where w are weights (trade-based, competition-based etc.)

• We will deal typically with bilateral exchange rates.

Nominal effective exchange rates: did the
pound depreciate or appreciate?

Source: FT
 Nominal vs. real exchange rates

• Nominal exchange rate

– The price of a currency in terms of another one (nominal)
• Real exchange rate (RER)
– “real” in the sense that is deflated by some real world product or
good (for example wages, CPI…)
– Allows for relative comparisons about what is cheap or expensive
across countries.
• Distinction similar to that of nominal and real GDP, but the
comparison is now cross-country.
– Typically understood as a comparison vis-à-vis the rest of the world
conditions (multilateral or “effective” RER)
– Or vis-à-vis one particular currency (e.g. the U.S. dollar) – a
“bilateral” RER
2. The exchange rate market and
exchange rates in the long run
What we want to understand: CHF/USD,
1973-2013.
In search of fundamentals in other financial markets:
Business cycles, S&P 500 price and earnings

Source: Robert Schiller, http://www.econ.yale.edu/~shiller/data.htm

 Plan

1. Purchasing power parity (PPP) theory.

2. The Real Exchange Rate based on PPP approaches.
3. Applications:
- Consequences of overvaluation
- The Euro zone and current accounts
- Fixed exchange rate regime and overvaluation
- The “Dutch disease”
4. The Harrod-Balassa-Samuelson (H-B-S) effect
What we want to understand: CHF/USD,
1973-2013.
 Purchasing Power Parity
• „Absolute” version of the PPP
– Based on the Law of One Price: a commodity should sell
everywhere for the same price everywhere (measured in the same
currency). Arbitrage in the goods market works.

P = SeP*
where P is the price level in country 1 (say “home”), P* is the price
level in country 2, and the Se is the equilibrium exchange rate
(country 1 currency per country 2 currency)
So Se = P / P*

In logarithmic terms (let ln(P) = p etc.):

se = p - p*
 Mechanisms: goods/services arbitrage
Suppose that SP* > P

• Home goods are cheaper than the foreign ones at the current
market rate S.

1. Excess demand for home currency -> appreciation of S (fall

in S)

2. Excess demand for home goods: increase in prices P,

decrease in prices P*

 Continues until equilibrium condition is restored and

trade imbalances mitigated.
 Deviations from the PPP 1973-2019

British pound vs. U.S. dollar French franc (Euro) vs. U.S. dollar

Source: Penn World Tables, 10.1

 “Relative” Purchasing Power Parity

• The “absolute” version may not always hold (for example, b/c
existing tax differences…) or we need to work with price indices

• „Relative” version: the change in the exchange rate between

periods (t, t+1) is equal to the change in the price levels

pt+1 - pt = set+1 - set + p*t+1 – p*t

 Absolute PPP implies the relative PPP (but not the other way around).
 “Relative” Purchasing Power Parity (II)

• Interpretation: The change in the exchange rate has to be equal

in the difference in the change in the price levels (a.k.a.
inflation) between countries.

• Or: the country’s currency will depreciate if it has a higher

inflation rate.

Dset,t+1= pt,t+1 – p*t,t+1

 PPP evidence

Source: Feenstra and Taylor, 2012

Similar forces: offshoring and the working
of the law of one price
 Labor costs in different countries
(relative to the U.S.,manufacturing), 2009
Labor costs + productivity (relative to the
U.S.,), 2009
Effective labor costs (cost/productivity)
(relative to the U.S.), 2009
 In general you get what you pay for...

Source: Irwin 2009.

 Failures of the PPP

• Transport costs
• Trade barriers
• The presence of nontraded goods
• Prices of traded goods include also some nontraded
services
• Incomparable baskets of goods
• Stickiness of prices
• Measurement errors: a price level is an index
• Local tastes, different wealth levels (that affect
consumption) etc.
• Poorer countries have lower prices for nontradables
(Balassa-Samuelson, Bhagwati)
 Taking stock

• A Law of one price theory of equilibrium exchange rates

• International arbitrage a powerful balancing tool
– Arbitrage in goods & services directly by consumers
– But also firms in terms of production site / procurement choices.
• “Offshoring” driven by cost differences: temporary phenomenon
• Operating channels:
– Excess demand for « undervalued » currencies (fast adjustment
channel) given an imbalance
– Price adjustments (wages…): slow adjustment
– Both forces work until the imbalance is adjusted
• Barriers & frictions (tariffs, transport costs…) that prevent full
adjustment
Real exchange rates, over- and
undervaluation
 REWIND: Nominal vs. real exchange rates

• Nominal exchange rate

– The price of a currency in terms of another one (nominal)
• Real exchange rate (RER)
– “real” in the sense that is deflated by some real world products or
good (for example labor)
• Distinction similar to that of nominal and real GDP, but the
comparison is now cross-country.
– Typically understood as a comparison vis-à-vis the rest of the world
conditions (multilateral or “effective” RER)
– Or vis-à-vis one particular currency (e.g. the U.S. dollar) – a
“bilateral” RER
 Real exchange rates: why do we care?

• Helps to determine where the nominal exchange rate

should be if some (reasonable) condition is met; for
example, after correcting for price differentials, current
account imbalances etc.
• A tool to depict competitiveness of a country and a possible
direction in which the nominal exchange rate will go in the
long run
– large deviations from the “equilibrium” value will cannot be sustained
– An overvalued exchange rate will depreciate in the long run while an
undervalued one will appreciate
• The latent or underlying exchange rate that economic
agents watch (so very important for fixed exchange rates to
determine the credibility of the system).
 Real exchange rates: what should be the
metric?
• CPI-based RER:

RER = S × (P* / P)

Sanity checks:
• Is RER = 1 always? When is RER = 1?

• Suppose CPI inflation is the same in two countries. What

should happen to the RER between them if S is constant?

There are many other concepts. We will return to that.

 Language of exchange rate changes ctd.
• Similarly to nominal exchange rates, we can talk of real
exchange rate depreciation or appreciation.

• If the measure of the real exchange rate we use is based on

PPP so that RER = SP*/P:
– If the RER increases then the currency depreciates in real terms
– If the RER decreases then we have an appreciation

• The nominal and real exchange rates move in the same

direction!

• Short-term (when goods prices don’t change) nominal

exchange rate movements (S) impact RER in the same way.
– Short term movements in the RER are driven by S
 Over/undervaluation

• Considered relative to the real exchange rate that should be

obtained in equilibrium (depends on the real exchange rate
concept).

• If we use the PPP concept with CPI (RER = SP* / P)

RER > 1 : undervaluation
RER < 1 : overvaluation

• An overvalued exchange rate should depreciate while an

undervalued rate should appreciate in the long run, restoring
equilibrium.
 Deviations from the PPP 1973-2019

British pound vs. U.S. dollar French franc (Euro) vs. U.S. dollar

Source: Penn World Tables, 10.1

 Mechanisms: goods arbitrage

• Suppose that RER > 1 or SP* > P

• Home goods are cheaper than the foreign ones

1. Excess demand for home currency -> appreciation of S

2. Excess demand for home goods: increase in prices P,

decrease in prices P*
 Caution about over/undervaluation

• The same country may have an undervalued currency when

RER in PPP (CPI-deflated) terms is considered, but for
example an overvalued one if RER based on ULC (unit labor
costs) in manufacturing.

• Other caveat: the Harrod-Balassa-Samuelson effect (we’ll

discuss shortly)

⟶ one should be careful to use the concept that “matters” for

tradable goods.
Stylized example: Consequences of overvaluation
• Suppose that there are
– A firm in Silverina and the USA with an identical technology making an
identical product A. Labor the only factor of production.
– No markups (pricing at marginal cost).
– the price level and in particular wages in the two countries are the same
– Wages per hour in the local currency @10 pesos and 10 USD
respectively, the productivity of labor is the same, requiring 1 labor-hour
per unit of product A.
– but the exchange rate is 0.8 peso/USD.

• In this context, if this is the only good produced in the two

countries, is the peso overvalued relatively to the U.S. dollar?

• Yes.
 Consequences of overvaluation (II)

• What does it imply for the prices of product A (assume no

margins) in different countries?

U.S. dollar price Silverina peso price

US firm 10 8
Silverina firm 12.5 10

• What will happen?

• When a currency is overvalued we speak of a “loss of (price)
competitiveness”.
• When a currency appreciates, imports become cheaper while
the exports of our countries’ firms more expensive! More
details in
• Question about the margins and pass through.
the
materials
 Back of the envelope calculation: effect of
barriers on sales
• Sales* (as a fraction of benchmark) as a function of trade cost
barriers (exchange rates, tariffs, transport costs etc.), assuming
a 1-to-1 pass through.

Industry markup
overvaluation 5% 10% 20%
0% 1.00 1.00 1.00
5% 0.38 0.61 0.78
10% 0.15 0.39 0.62
20% 0.03 0.16 0.40

• * - based on a standard monopolistic competition model with a

love-of-variety utility More
details in
the
materials
 Who is hurt/helped by overvaluation?
(examples to think about)

• Low margin companies/industries

• Companies/industries in markets with high foreign

penetration.

• Exporters with a local cost base vs. Producers for the local
market basing on imported intermediates

• Foreign currency borrowers that produce for the local market

• Consumers of imported products (oil, drugs…)

 Question

• So what will happen if the RER is overvalued for a prolonged

period of time?

• … in a country with a fixed exchange rate regime?

 Real exchange rates:
Application to the Euro zone and country
current accounts
 ULC-based PPP
• Idea: if technology is the same, and the prices of different
factors of production (capital, materials, etc.) are similar,
differences in the labor cost will drive final prices.
• EU as an example? But – ideal conditions don’t hold even
within countries (e.g. debate about different minimum wage
across French regions)

• ULC-based RER:

RER = S × (P* / P) ≈ S × (MC* / MC) ≈ S × (w* / w)

• Evolution of average wages w (also productivity adjusted)

relatively easy to follow.
Portugal: RER CPI and ULC based; Q1 99 =1
 Some Eurozone countries: Real ULC, index,
2000 = 100

Source: Eurostat
 Questions
• Individual countries’ RER trajectories are behaving differently.

• What should we expect? For a country with an appreciating

real exchange rate, in comparison with a depreciating one,
– Export growth should be lower
– Import growth would be faster
– External borrowing could appear more attractive in the short run

TB = Ex – Im
CA = TB + NINV + NUT

• The trade balance and the current account could deteriorate.

 Some Eurozone countries: TB balance

Source: Eurostat
 Some Eurozone countries: CA balance

Source: Eurostat
 Some Eurozone countries: Export
performance

Source: World Bank

 Question

• So what will happen if the RER is overvalued for a prolonged

period of time?

• … in a country with a fixed exchange rate regime without firm

support from favorable outside actors like the ECB?
 Application:
Real exchange rate overvaluation and
subsequent currency crisis
Brazil in 1998
Brazil: real exchange rate 1990-2006
Brazil CA and NIIP 1990-2006
 ja

1
1,2
1,4
1,6
1,8
2
2,2
nv
-
fé 97
vr
m -97
ar
s-
9
av 7
r-
m 97
ai
-9
ju 7
in
-9
ju 7
il
ao -97
ût
-
se 97
pt
-9
oc 7
t-9
no 7
v-
9
dé 7
c-
ja 97
nv
-
fé 98
vr
m -98
ar
s-
9
av 8
r-9
m 8
ai
-9
ju 8
in
-9
ju 8
il
ao -98
ût
-
se 98
pt
-9
oc 8
t-9
no 8

Real/USD exchange rate

v-
9
dé 8
c-
ja 98
nv
-
fé 99
vr
m -99
ar
s-
9
av 9
BRL/USD exchange rate

r-
m 99
ai
-9
ju 9
in
-9
ju 9
il
ao -99
ût
-
se 99
pt
-9
oc 9
t-9
no 9
v-
9
dé 9
c-
99
 Narrative
• Brazil kept a crawling peg regime in a period when they were trying
to disinflate their economy.
• They weren’t successful, and the real BRL/USD exchange rate
appreciated through time as the rate of the crawl (devaluation did
not keep up with inflation. Assuming Dp* close to zero, if Ds < Dp
Drer = Ds + Dp* - Dp < 0
• The appreciation of the RER led Brazilian firms to lose price
competitiveness; as a consequence their CA deteriorated and was
heavily negative throughout the years (implying borrowing from the
rest of the world).
• This continued borrowing increased Brazilian liabilities wrt ROW
(NINP) and structurally altered their CA: they needed to pay much
higher interest and dividends to foreigners (NINV in the CA), and
needed a much higher trade balance (TB) surplus to tilt CA to zero.
• The regime is abandoned Jan 1999 and a huge depreciation
followed.
Memo: CA = TB + NINV + NUT; we’ll discuss this later.
 Application: The “Dutch Disease” and the
real effects of exchange rates
• Three sectors: a nontradable and two tradable sectors.
• One tradable sector is booming (for example, a discovery of some
valuable resource). The other one is “lagging”.
Effects:
• Resource movement effect (direct demand for labor)
• Spending effect (increased wealth raises prices of the non-traded
goods, wages rise)
Implications:
• Leads to a real exchange rate appreciation.
• The competitiveness of the “lagging” sector is hindered.
Examples:
Oil: The Netherlands, Norway, Mexico 1970s, Venezuela in 2000s,
Nigeria, Azerbaijan, Algeria, Chile (copper).
 Emerging countries:
The Harrod-Balassa-Samuelson effect
 A bit of PPP philosophy

• Why can we define a meaningful equilibrium exchange

rate using PPP theory?
• What matters is arbitrage: agents can react if goods
prices across countries are different when priced in the
same currency.
– Law of one price holds: prices of tradeable (arbitrageable) goods
should be the same in all countries
• In the presence of nontraded goods, the overall (e.g. CPI
indexes) may give different RER readings than those
based on only tradeable (arbitrageable) goods.
• This will be a problem if there are systematic differences
between nontraded prices across countries.
 Example

What really matters:

PT = Se PT*

where PT are prices of tradable goods

 Example

Suppose PCPI = (PT)b(PNT)(1-b)

WLOG, normalize 1 = PT* = PT, and S = Se so that

RERT = S(PT*/ PT) = 1

but PNT < P*NT

then
1= RERT < RERCPI
So the exchange rate calculated according to CPI indexes
will appear undervalued.
 The Balassa-Samuelson effect: panel of
Log of price ratio
countries

Source: PWT 9.0, Feenstra et al. (2015)

 Emerging markets: the “pure” PPP is not valid

• “Stylized” fact: The price levels are systematically lower in

poorer countries.
• The PPP approach based on CPI would point to a consistent
undervaluation of their exchange rates.
Also, typically, RERPPI < RERCPI
• Is there a systematic pattern in the differences?
– A productivity explanation
– But also others: capital-labor ratio explanation, different tastes
• Typically referred to as the Harrod-Balassa-Samuelson
effect
– A static and dynamic view. More
details in
the
materials
 The “static” HBS effect
A simple model.

• A tradable (T) and a nontradable (NT) sector.

• Perfect competition (then prices = cost).

• Elastic labor supply: people choose careers (sectors) that

bring them highest wage. Wages will equalize across
sectors.

• No unemployment.
 The “static” HBS effect
• For simplicity, Cobb-Douglas production function.

• Cost minimization gives, for example in the T sector (similar

in the NT)

• Then, with perfect competition, cost = price

where G is a constant
 The “static” HBS effect
• Let b be the weight of tradable goods. Set pT = 1 and then
the price level is
• The price level ratio between two countries is

• Assume that ANT=A*NT. Then

• If AT < A*T, w < w*, r* < r then P < P*

• Suppose S=1. Then, if RERPPI defined over tradable goods
RERPPI = 1 < RERCPI
 Intuition: the HBS forces

• HBS effect: the relative wages set by the relative productivity

in the tradable sector.

Since pT = 1 in both countries and suppose r=r* (if free capital

flows) from the cost functions

w = w* × (AT / A*T)(1/(1-a))
So that w < w*.
 In general you get what you pay for...

Source: Irwin 2009.

 Intuition: the K/L differences

• K/L ratio lower in emerging countries:

(1) higher productivity of capital ceteris paribus
(2) higher marginal product of capital
(3) higher rate of return on capital r > r*
(4) At the same time w < w*
(5) Requires frictions in international capital flows
 GDP per capita (2011 USD) vs. return to capital, 2014

Source: PWT 9.0

 The “dynamic” HBS effect (I)
• Local services (nontradables) are assumed to be much more
labor intensive than manufacturing (tradables).
• Then the home country will face an appreciation of the real
exchange rate measured by the PPP CPI measure if the
difference in growth of productivity in tradables exceeds that
in nontradables.

• Typically the case in fast growing emerging economies.

 The “dynamic” HBS effect (II)
• Suppose productivity in an emerging market increases constantly relative to
a developed country: the real exchange rate (CPI terms) will constantly
appreciate.
• This effect has to be taken into account while forecasting the evolution of the
real exchange rate of emerging markets (we care about the one in tradables)
• Appreciation that does not imply overvaluation
• Changes in the price index (aka inflation) from nonmonetary sources!

RERCPI

1
RERT

t
 The Balassa-Samuelson effect: Poland vs.
US, 1990-2007
70% 40%

38%

60% 36%

34%

50% 32%

30%

40% 28%

26%

30% 24%

22%

20% 20%

2004
1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2005

2006
Undervaluation of the currency (%)
Productivity (right hand side)
Source: Penn World Tables
 Conclusion
• Exchange rates of countries in which productivity grows
quickly may experience real exchange rate appreciation as
measured by the PPP based on CPI which does not imply a
dangerous overvaluation of the exchange rate according to
PPP based on PPI.

• The problem may be in disentangling whether appreciation is

taking place or not if data is not good.

• For developing countries, even a mild appreciation of the

currency perceived by the market as unjustified can lead to a
financial crisis.
 Conclusions of the PPP approach

The PPP should hold

- In the long run
- For tradeable goods (commodities, manufacturing)
- For countries that are similar economically (same stage of
development, economic structure etc.)

It is a benchmark that can serve as a first approximation

where the exchange rate should be in comparison where
it currently is.

If there is a severe overvaluation: a correction could be in

place?
Other equilibrium exchange rate concepts
Other equilibrium real exchange rate concepts

To study “over” and “under” - valuation

Many theories that go beyond the simple PPP:
• Fundamental Equilibrium Exchange Rate (FEER): taking the current
account imbalances
• Behavioral Equilibrium Exchange Rate (BEER)
• Asset market approach: cross-country holdings of currency, bonds,
stocks and other assets matter
• Macroeconomic balance approach: various macroeconomic quantities
need to be in balance for the exchange rate to be in equilibrium.

Problem: the data allowing to estimate these quantities

comes with a significant time lapse, and typically too few time
points to properly evaluate the exchange rate model so that it
can be useful.
 Concepts you should know by now

• Nominal and real exchange rates

• devaluation/depreciation, revaluation/appreciation
• Law of One Price
• Purchasing Power Parity (PPP) – « absolute » and
« relative »
• overvaluation/undervaluation of the exchange rate
• unit labor cost
• Harrod-Balassa-Samuelson effect
• terms of trade
 Important formulas

• Equilibrium exchange rate according to PPP

Se = P/P*, in logs se = p - p*

• Change in the (log-) exchange implied by the PPP between

times t and t+1 (to use over long periods):

Dset,t+1= pt,t+1 – p*t,t+1

 Recap: Real exchange rates --
different prices as a base
Measures indicate deviations from some benchmark

• CPI-based:
RERCPI = S × (P* / P)

• Traded good-based
RERT = S × (PT* / PT)

• ULC-based
RERULC = S × (w* / w) ≈ S × (MC* / MC)
 Summary

The real exchange rate helps to track whether a currency is

over- or undervalued

In the long run:

• An overvalued exchange rate will depreciate
• An undervalued exchange rate will appreciate

This is because either there will be

• An adjustment in the nominal exchange rate due to the
working of demand / supply for the currency
• An adjustment in the relative prices of the two countries
3. Arbitrage in the exchange market
 Plan

1. (Uncovered) Interest Rate Parity (UIP)

2. The covered Interest Rate Parity and the forward rate

3. The carry trade & risk premia in the exchange rate

market

92
Implications of arbitrage in financial markets
• Idea: returns on same financial assets matter in determining the
price of the currency and should be the same in any two countries.
• Relevant only if there are free capital flows, no transaction
costs and no restrictions in banking

Home
Y Y(1+i)

time
t t+1
Foreign Y/St (Y(1+i*)/St)Et(St+1)

• So I want
𝑌
Y 1+𝑖 = 1 + 𝑖 ∗ 𝐸𝑡 (𝑆𝑡+1 )
𝑆𝑡
ln 1 + 𝑖 = ln 𝐸𝑡 (𝑆𝑡+1 ) − ln 𝑆𝑡 + ln 1 + 𝑖 ∗
𝑖 ≈ 𝐸𝑡 𝑠𝑡+1 − 𝑠𝑡 + 𝑖 ∗
Where (s) S is the (log of the) spot exchange rate.
 The Interest Rate Parity (IRP)

• To make investors equally happy, the change in the

exchange rate should be therefore given by

∗
∆𝑠𝑡,𝑡+1 = 𝑖𝑡,𝑡+1 − 𝑖𝑡,𝑡+1

• If the interest rate in one country is higher, the currency

of that country should depreciate in the future!
• Investors want to have the same rate of return on their
assets irrespective of the currency of denomination
• In frictionless markets, arbitrage works. If there are
higher returns expected in one country, capital flows
there.
 “Uncovered” interest rate parity

Expected rate:

i = (Etst+1 - st) + i*

return on Expected return on

home bonds currency return foreign bonds

where "E" here is the expectations operator at time t.

 Question

Should I use the Interest Rate Parity (IRP) to forecast

exchange rate changes?

Answer:

It’s not that simple!

 Problems with the interest rate parity as a
forecasting tool (I)
• Which variables are here exogenous?

• The relationship tells us what the change in the

exchange rate should be between the spot (today) rate
and some value of the exchange rate in the future.

• The problem is whether, if there is a change in the

exchange rate required, it is the spot rate that should
adjust or the expected future exchange rate!

• We cannot measure expectations about exchange rates!

 Problems with the interest rate parity as a
forecasting tool (II)
• Suppose that there is a shock (new information is
available) so that suddenly i > i*

• If the expectation about the future exchange rate stays

constant (for example, the interest rate differential is not
due to expected inflation differentials) then the spot rate
needs to appreciate!

• If the market expects a future depreciation of the

currency that is equal to the one required by the IRP,
than there is no effect on the spot exchange rate.
 Application: fixed exchange rates, free
capital flows and interest rates
• With a fixed exchange rate, it has to be the case in a
credible regime that
Etst+1 = st
• Therefore, the interest rate parity (free capital flows and
arbitrage!) implies that
i = i*
• The domestic interest rate has to be equal to the foreign
interest rate. There is no independent monetary policy!
• Inflation has to be exactly the same as in the foreign
country if the real interest rate is the same in both
countries.
• Otherwise, capital will flow out!
Interest rates in the Eurozone and Denmark
 Application: Rate hike in a country
• On Oct 7, 2021, the Polish central bank increased its base
rate from 0.1 to 0.5%

• This made liquid Polish assets more attractive in the eyes of

investors as they offered higher yield.

• What do you believe should be a response of the PLN/USD

exchange rate?
PLN/USD rate that day
USD/EUR rate on Sep 21, 2022 (Fed Funds
increased by 0.75% @2pm)
 Application: Bad news about U.S. PMI

• On Oct 1, 2019 the ISM index (purchasing managers’

survey) measuring economic activity of the manufacturing
sector came with an unexpectedly low reading of 47.8,
indicating an ongoing contraction of the U.S. manufacturing.

• This raised fears that there will be a recession in the U.S.

• What do you believe should be a response of main interest

rates and the USD/EUR exchange rate?
The U.S. 2-year T-govt yield
The exchange rate (USD/EUR)
 How to reconcile the IRP with the PPP?

• What is the nominal interest rate?

Interest =
real remuneration of capital + compensation for inflation

Assume that the real interest rate rr is equal across countries.

• If i = pt+1 - pt + r and i* = p*t+1 – p*t + r

then
∗ ∗
∆𝑠𝑡,𝑡+1 = 𝑖𝑡,𝑡+1 − 𝑖𝑡,𝑡+1 = 𝜋𝑡,𝑡+1 − 𝜋𝑡,𝑡+1

• So, there is (theoretically) a close relation with PPP (aka

the Fisher effect).
 The Fisher effect in data

Source: Feenstra and Taylor, 2012

 Terms of trade

• A measure how the prices of exported goods change in

comparison to imported goods
• A deterioration of the terms of trade says that the countries
exports become worse foreign currency earners.
• If there is a prolonged period of terms of trade fall, the
country might find itself in balance of payments imbalance.
• This may be especially true if the country is a primary good
exporter without other diversified export goods.

• But careful: quick productivity gains in a major sector may

lead to terms of trade deterioration as well.
 Intuition
Terms of trade

TOT = Pexports / Pimports

If Poil ↑ then Pexports ↑,

there is excess demand for Canadian Dollars
S↓
CAD appreciates to USD.
Why did the Euro depreciate so much to
USD in 2022?
The U.S. dollar and Euro 2013-
2022
The U.S. dollar and Euro 2013-
2022
 Why did the Euro depreciate?

• Enduring belief (fulfilled in the first half of 2022) that the

FED will raise interest rates faster than the ECB

• Terms of trade deterioration of the Euro zone, improvement

for the U.S. and a resulting Euro zone trade deficit
– As a result of high oil/gas prices (Euro zone net importer)
– Leading to a lower demand for euros and
– higher demand for dollars.
Covered interest rate parity & hedging
 Hedging exchange rate risk:
Covered interest rate parity
- Forward rate:

Ft+1 = (1+ i) / (1+ i*) St

- The forward rate is just a quotation based on the

difference of interest rates and the spot rate.
- A product that is standardly offered by banks.
- You can lock in the future exchange rate at which you
would want to liquidate your investment/trade flow.

- It does NOT reflect any expectations about the

exchange rate per se.
 How the forward rate is "locked" in

• Suppose that you have some flow Y (say an importer is

going to pay you) in three months time in a foreign currency
and that you do not want to face currency risk.
• You can go to the bank that will quote you a "forward" rate
so that your exchange rate for this particular transaction will
be fixed and completely unrelated with the exchange rate
that will occur in the market in three months time.
• What operations does the bank do to assure you this rate in
the future? How does it construct the transactions?
• It acts just like making arbitrage using the interest rate parity
condition.
 What the bank does
Home convert to
pay XSt(1+i) to
country XSt
the customer

Foreign
country

borrow X repay X(1+i*)

and obtain Y

t t+1 time

We have X(1+i*) = Y so the customer obtains YSt(1+i)/(1+i*) = YFt+1

In log-terms: i - i* + st = ft+1
 The forward premium

- The difference between the forward and the spot rate is

called the forward premium:

Ft+1 / St

- If there is a difference between the forward premium and

the market interest rate differential
(1 + i) / (1 + i*)

then there are arbitrage opportunities

 Covered interest rate parity and capital flow
restrictions

Source: Feenstra and Taylor, 2012

The carry trade and risk premia
 The carry trade
• You borrow and sell a currency that has a low rate of return
to purchase a currency that has a high returns in some liquid
financial assets
• After some investment horizon, the assets in the high-
yielding currency are sold, and the debt in the (“funding”
currency) repaid.
• The strategy is risky as the speculator is exposed towards
adverse movements of exchange rates
– runs counter to the IRP intuition!
• Often becomes a widely used strategy for “hot money”. The
funding currencies: low domestic interest rates induced by
loose monetary policy (hence in the recent years: the “yen”
or the “dollar” carry trades). The investment currencies: high-
yielding emerging markets.
 The carry trade in the 2000s

Interest rates

Returns from Returns of

Funding Investment appreciation carry trades Investment countries

U.S. Dollar 3.4 10.2 1.1 7.9 Brazil, Mexico, Canada

Euro 3.2 7.4 1 5.2 Iceland, Poland, Czech Rep.

Japanese Australia, Korea, New
Yen 0.1 5.3 5.2 10.7 Zealand

Source: McKinnon 2013

 Carry trade and emerging economies: how
to think about it through the lens of IRP?
• The real return to capital in emerging markets can be high.
• There can be a premium for the volatility of the local
currency
– Monthly coefficient of variation of the floating exchange rates vs. the
U.S. dollar for 2005-2014: OECD countries: 10.8%, nonOECD 14.5%
– “peso” problem for fixed rates.
• Emerging markets have typically shallow financial markets.
Large flows may affect dramatically prices of financial
instruments… and change the domestic interest rates
• There are typically more restrictions on flows and borrowing
in the local currency.
Carry trade from the Euro zone on the PLN:
3-month returns (annualized)
 Risk premia in exchange rate markets (I)

Related to currency valuation (currency premium)

– Excess returns on average when times are good; High negative

returns in « bad » times.

– Linked assets in the view of the asset pricing theories may command
a premium depending on the extent of their covariance with other
assets (or the market portfolio used by investors).

129
 Risk premia in exchange rate markets (II)

On main assets denominated in a particular currency

(especially on an emerging country/developing country cross):

– interest rate parity will not hold because the « assets » of the two
countries are not of the same risk class (differences in the risk of
default)

– Exchange rate risk: there may be a flight from the currency etc.

– Political risk: convertibility issues, sovereign default risk

– Counterparty risk: the banks operating in the country may have a

high risk of not fulfilling contracts.

130
 The risk premium and IRP

i = Est+1 - st + i* - r

where r>0 is the risk premium on the foreign currency.

• But: r is not directly observable, may be time-varying.

• Could be deduced in a non-credible fixed exchange rate
regime (the « peso » problem).
 Concepts you should know by now

• uncovered interest rate parity

• covered interest rate parity
• a forward contract
• the carry trade
• risk premia in the exchange market
 Important formulas

• The UIRP relationship

i = Etst+1 - st + i*

…and the implied exchange rate change

∗
∆𝑠𝑡,𝑡+1 = 𝑖𝑡,𝑡+1 − 𝑖𝑡,𝑡+1

• Forward rate
ft+1 = i - i* + st
 4. Short run behavior of the exchange
rate market: the role of money, prices,
and interest rates
We make a small country assumption:
the developments in the home country cannot change the
conditions in the world markets

More
details in
your
materials
 Monetary policy in an open economy
Quick refresher on how interest rates are determined and
how they are intertwined with exchange rates.
The determination of the short-term
interest rate
Short term interest rate comovement
 %

ja

10
15
20
25
30
35
40
45
50
nv
-
fé 97
vr
m -9
ar 7
s-
9
av 7
r-9
m 7
ai
-
ju 97
in
-9
ju 7
il-
ao 97
ût
se -97
pt
-9
oc 7
t-
no 97
v-
dé 97
c
ja -97
nv
fé -98
v
m r-9
ar 8
s-
9
av 8
r-9
m 8
ai
-

SELIC
ju 98
in
-9
ju 8
il-
ao 98

date
ût
se -98
pt
-9
oc 8
t-
no 98
v-
dé 98
c

Change in reserves
ja -98
nv
fé -99
v
m r-9
ar 9
s-
9
av 9
r-9
m 9
ai
-
ju 99
in
-9
ju 9
il-
ao 99
ût
intervention: Brazil 1998-1999

se -99
pt
-9
oc 9
t-
Interest rate defense + unsterilized

no 99
v-
dé 99
c-
99
0
5000

-5000
10000
15000

-25000
-20000
-15000
-10000

USD bn
 ja

1
1,2
1,4
1,6
1,8
2
2,2
nv
-
fé 97
vr
m -97
ar
s-
9
av 7
r-
m 97
ai
-9
ju 7
in
-9
ju 7
il
ao -97
ût
-
se 97
pt
-9
oc 7
t-9
no 7
v-
9
dé 7
c-
ja 97
nv
-
fé 98
vr
m -98
ar
s-
9
av 8
r-9
m 8
ai
-9
ju 8
in
-9
ju 8
il
ao -98
ût
rate

-
se 98
pt
-9
oc 8
t-9
no 8

Real/USD exchange rate

v-
9
dé 8
c-
ja 98
nv
-
fé 99
vr
m -99
ar
s-
9
av 9
r-
m 99
ai
-9
ju 9
in
-9
ju 9
il
ao -99
ût
-
se 99
pt
-9
oc 9
t-9
Brazilian Real (currency) /USD exchange

no 9
v-
9
dé 9
c-
99
 Application: Bad news about U.S. PMI
• On Oct 1, 2019 the ISM index (purchasing managers’
survey) measuring economic activity of the manufacturing
sector came with an unexpectedly low reading of 47.8,
indicating an ongoing contraction of the U.S. manufacturing.

• This raised fears that there will be a recession in the U.S.

• What would our models predict for the behavior of the

interest rates in the short run?
The U.S. 2-year T-govt yield
The exchange rate (USD/EUR)
Adding output changes (AA-AD model)

We maintain the assumption of fixed prices

(and the short run).
 Aggregate demand in a closed economy
Aggregate D=Y
demand

AD = C+ I + G

Slope of the consumption function = 0.6

0.6 = marginal propensity to consume = c1
1

Autonomous
consumption, c0

Current income
(output), Y
191
 Open economy: adding Net exports

NX = exports - imports

• Exports (X): foreign demand

• Imports (I): domestic final and intermediate demand.

• Assume: Marginal propensity to import (m) the fraction of Y spent on
foreign goods.

• NX
• Important for small/emerging countries
• Specialization of economies means relying on foreign demand for sales
and foreign supply for consumption.
• Exchange rates, tariffs play an important role
• Great Depression: competitive devaluations, tariff hikes (Smoot-Hawley)
• In interdependent economies cross-border spillovers of national
192
policies (e.g. subsidies for car purchases in 2008-2009).
 AD and the multiplier revisited

AD = Y = c0 + c1(1-t)Y + I + G + X – m0 – m1Y

• Saving, taxation and imports are referred to as "leakages" from

the circular flow of income.

• Some autonomous level of imports (e.g. necessities) m0

• Out of current income:

• (1-c1)(1-t)Y saved
• (tY) goes directly to the government as taxes
• (mY) spent on goods/services from abroad

• Reduction in the multiplier!

193
Smaller multiplier = flatter AD curve
 Aggregate demand in an open economy
Aggregate D=Y
demand

AD = C+ I + G + NX

Autonomous
consumption, c0

Current income
(output), Y
194
 Net exports and exchange rates
• Exports (X):

S ↑ ⟹ foreign demand ↑

• Imports (I):

if S ↑ ⟹ home demand for foreign products/services ↓

Then S ↑ ⟹ NX ↑

• A depreciation of the home exchange rate increases NX.

• Assumption for what follows: NX = TB = CA

(usually there are more items in the CA than that – we discuss that later)
195
 A multiplier effect of currency depreciation
Aggregate D=Y
demand

AD = C+ I + G + CA(S2,…)

AD = C+ I + G + CA(S1,…)

Autonomous
consumption, c0

Current income
(output), Y
196
“beggar thy neighbor” policy!
 The DD curve
Exchange rate S

DD1 DD2

S2

S1

Y1 Y2 Current income
(output), Y
197
DD may shift e.g. with changes in G
 Deriving the Asset Market equilibrium

rates of return

Expected return
on Euro deposits
i2

2
i1
L'(r,Y2)

3 1
L(r,Y1)

Exchange rate S S1 S2 M/P Real money holdings

 The AA curve
Exchange rate S

S1

S2
AA

Y1 Y2 Current income
(output), Y
200
 The short run equilibrium
Exchange rate S DD

S1

AA

Current income
Y1
(output), Y
201
 Temporary fiscal policy expansion
Exchange rate S DD1
DD2

S1

S2

AA

Current income
Y1 Y2
(output), Y
202
 Temporary monetary policy expansion
Exchange rate S DD

S2

S1
AA2

AA1

Current income
Y1 Y2
(output), Y
203
 Models with flexible prices

Prices are at least somewhat flexible also in the short-run

equilibrium!
The monetary model of exchange rates
 Intuition for the monetary model (I)

- Suppose that the output growth in two countries is same

over long horizons

- Excess money supply (growth of m – m*) will translate

into higher prices over long time periods

- So, a country with a higher monetary growth should

experience a depreciation of the exchange rate.
 Intuition for the monetary model (II)

- Suppose that money growth in two countries is same over

long horizons

- Faster GDP growth in one country (growth of y – y*) will

translate into lower prices over long time periods

- So, a country with a higher growth should experience an

appreciation of the exchange rate.
 Monetary model: long term evidence

Source: Feenstra and Taylor, 2012

Monetary policy with Taylor rules and
exchange rates
 A monetary model with a Taylor rule
• Taylor (1993) rule: the CB changes the short-run interest
rate responding to changes in inflation and the output
gap.

it = r + a + bpt + f(pt-pgt)+ cytgap + git-1

where
it is the targeted interest rate,
r is the natural rate of interest,
pt is inflation,
pgt is targeted inflation,
ytgap the output gap while
it-1 represents gradualism in monetary policy.
Output gap
Taylor rule example: US (with “core” inflation)
 A monetary model with a Taylor rule

• CBs in “small open economies” are going to react also to

changes in the exchange rates because these (coupled
with capital flows) may fuel inflation

it = r + a + bpt + f(pt-pgt)+ cytgap + git-1 + dqt

where qt is the real exchange rate.

 A Taylor rule in a SOE
The “qt” part in the rule:

qt = st + p*t - pt

• The CB increases the nominal interest rate if the

exchange rate depreciates from its PPP value (so when
the RER depreciates and q goes up).

• Conversely, if the exchange rate appreciates, the CB

would lower the interest rates.
“Floating” exchange rates under a Taylor rule
• Under Taylor rule-operating central banks, an
(unexpected) increase in inflation in a country may lead
to an appreciation of its exchange rate.

• Logic:
– the CB will increase the interest rate to combat inflation
(immediately or in the nearest future);
– This will induce a need for the exchange rate to depreciate more
on the transition path than what would be warranted in the
inflation phase-out
– Which requires an instantaneous appreciation of the exchange
rate at the news of inflation
– This effect should be stronger the better the CB has a reputation
of fighting inflation.
• Complex modelling and dynamics (with gradualism, RER
and inflation feedbacks).
Reaction of the Swedish krona to an
unexpectedly high inflation

Source: FT, Sep 12. 2017

Surprise: USD/EUR on July 12, 2023 @8:30AM ET:
U.S. y/y inflation dropped from 4% (May) to 3%
 A simple recipe for understanding the
behaviour of the exchange rate market
1. What is the exact shock? What does it change precisely: Y? i? i*?
M? P?

2. Is there a change to the expectations of the future exchange rate?

3. What is the exchange rate regime (floating, fixed)?

4. In case there is a change to the expected future exchange rate -

what does UIRP imply for the adjustment of the exchange rate? Is
the exchange rate going to appreciate, depreciate, remain
unchanged over the period of adjustment?

5. What happens as a result to the spot exchange rate?

6. Forecasting exchange rates
CHF/USD, 1973-2013.
 Forecasting exchange rates

Meese and Rogoff (1983): classic models (based on

“fundamentals”) are unable to predict the exchange rates
better than the random walk*.

Many studies reached the same conclusion even after

changing the econometric methods, models or samples.

* - or the prediction cannot be greatly improved upon

 The random walk prediction
Assumptions:
• The (log) exchange rate s is a Brownian motion.
• Innovations et ~ N(0, s2) are white noise.
st+1 = st + et

Then the expected rate at some time t+1

Etst+1 = st

Expectation
operator Time period
s for the logarithm
of the exchange rate
Expected rate at some time t+1 = exchange rate NOW!
CHF/USD, 1973-2013 and the Swiss/US
price levels
 Forecasting exchange rates (II)

For developed countries with floating regimes – rule of thumb:

• Up to 2 years horizon: the random walk cannot be beaten*
• More than 2 years: the Purchasing Power Parity model
can beat any other model

For fixed exchange rates: theoretically they should be fixed

forever, but will they be always so?

* - or the prediction cannot be greatly improved upon

 PPP-based prediction in practice
• Absolute model (small period t -> t+1)
st+1= a + b(pt+1 – p*t+1) + et

• Relative model:
Dst,t+1= a + b(pt,t+1 – p*t,t+1) + et

• Error-correction models:
Dst,t+1= a + b[st – (pt – p*t)] + et

• Error-correction models and relative PPP:

Dst,t+1= a + b1[st – (pt – p*t)] + b2(pt,t+1 – p*t,t+1) + et

• Problem: you need to work often with forecasts of future

prices or inflation that may be imprecise by themselves!
 What does the theory tell us?

• Absolute and the relative models

a=0
b=1

• Error-correction models:
a=0

But b ? Unclear: measures the speed of correction.

CHF/USD, 1973-2013 and the Swiss/US
price levels

“deviation” from PPP

(unscaled)

relative inflation
 PPP-based prediction in practice: case of
the error-correction model
The change in the log-exchange rate:

Dst,t+1= a + b1[st – (pt – p*t)] + b2(pt,t+1 – p*t,t+1) + et

Misalignment Expected inflation

of the exchange rate over the forecasted
in PPP terms period

• Estimate the above model

• Form predictions of future inflation

• Calculate the forecasted change

 Practical issues while using PPP

• For the PPP in the “absolute” version, pick a basket of similar

goods.
– CPI or PPI based indexes?
– Tradeable/nontradeable goods...

• For the relative PPP, it is crucial when you pick the reference
date. Try the date when you believe there was an
“equilibrium”.

• A popular measure: manufacturing unit labor costs (ULC)

based PPP