FUQINTRD 683W: Global Markets and Institutions

Exchange Rates

1
 Questions
• What drives foreign exchange (FX) rates?

• Exchange rate regimes

• Speculative attacks on currencies

• Financial crisis

• International Monetary Fund

2
 Why did the Japanese Yen strengthen
from 350 to about 100 from 1970 to 1995?

3
 Why did the U.S. Dollar:
rise until 2001, fall till 2008, and rise thereafter?

4
What led to the 1997 South East Asian Currency Crisis?

ASIAN
FINANCIAL CRISIS
5
Exchange Rates (April 16, 2013)

6
 Law of One Price
• Using the market exchange rate to price goods in a common currency, the Law of
One Price asserts that similar goods cost the same independent of the country in
which they are purchased.

• P = domestic price of a basked of goods in units of domestic currency

• P* denote the foreign price of a basket of goods in units of foreign currency
• E = foreign currency per unit of domestic currency

• Law of one price implies

E = P*/P
• I.e., it a good costs twice as much foreign currency as domestic currency, then 1 unit
of domestic currency should be exchanged for 2 units of foreign currency

• An example:
– TV in Japan costs ¥50,000
– same TV in the U.S costs $500
– Law of one price: E should equal ¥50,000/$500 = 100 ¥ / $ so that $500 can be exchanged
for ¥50,000
7
 Exchange rate

• An exchange rate is the value of one nation's

currency versus the currency of another nation or
economic zone. For example, how many NZ
dollars does it take to buy one US dollar
• Current rate ~ 1.5 ( this means you need to pay 1.5
NZD to get one USD)
 The Exchange Rate

• Exchange rate policy comes in two flavours:

– Fixed exchange rates
• For example China.
– Floating exchange rates
• New Zealand and the USA.
– There are also regions---well a region---in a somewhat unusual
hybrid position.
• The Euro is a fixed exchange rate between members, but a floating
rate with respect to all other countries.
• Before discussing the mechanics of exchange rates, we
need to talk about why people trade currencies.
 The Exchange Rate

• The exchange rate is the key price that determines

the cost of:
– Our exports to foreign consumers,
– Foreign goods to domestic consumers.
• As a result, the exchange rate is the key price in
determining the Current Account balance.
 The Exchange Rate

• The exchange rate is the central price in these

adjustments.
• Before discussing the exchange rate, it is worth
considering others ways in which the Balance of
Payments can adjust (normally to a balanced
Current Account)
 The Exchange Rate

• Currently, 1NZD purchases 0.67USD.

– If the number of USD that we receive falls, then the New Zealand
Dollar is said to be depreciating.
– If the number of USD that we receive increases, then the New
Zealand Dollar is said to be appreciating.
• A depreciating domestic currency is good for producers:
– Our goods become cheaper for foreign consumers.
• But bad for consumers:
– Imported goods become more expensive.
 Exchange Rate Mechanisms

• As noted above, exchange rates come in two basic

forms: fixed and floating.
• Our discussion of the operation of the foreign
exchange market is based on:
– Demand for New Zealand Dollars from
• Foreigners wanting to buy goods from us, and
• Foreigners wanting to buy assets from us.
– Supply of New Zealand Dollars from
• New Zealanders wanting to buy foreign-made goods, and,
• New Zealanders wanting to buy assets from foreigners.
The Mechanics of Fixed Exchange Rates

• Shifts in the demand for and supply of a currency naturally

lead to changes in its value (the exchange rate).
• In order to maintain a fixed exchange rate, the central bank
needs to stand ready to match any shifts in the for demand
or supply of the domestic currency.
• Doing so requires
– Significant foreign currency reserves if the currency
would normally be depreciating,
– A willingness to print money if the currency would be
appreciating.
The Mechanics of Fixed Exchange Rates

• If the currency would be depreciating it is because there

are too many NZD relative to USD in the forex market:
– The Reserve Bank would need to provide the additional
USD from its reserves.
• If the currency would be appreciating it is because there
are too few NZD relative to USD in the forex market:
– The Reserve Bank would need to print new NZD to
maintain the fixed value of the NZD.
• An alternative is for maintaining fixed exchange rates is to
limit access to forex markets.
The Mechanics of Floating Exchange Rates

• Much easier: any imbalance results in the

exchange rate changing.
– Long-run trade deficits tend to result in the
currency depreciating.
– Depreciation vs Devaluation
– Appreciation vs Revaluation
 Real and Nominal Exchange Rates

• The distinction between real and nominal can be

applied to exchange rates.
• As noted, a depreciating currency is generally seen
as good for exporters and the Current Account
balance.
• But, as with interest rates, it is the real exchange
rate that matters, not the nominal rate.
 Real and Nominal Exchange Rates -
Example
• Suppose the Yen to Dollar exchange rate is 100 to
1 (i.e. 100 yen purchase 1 dollar), and a locally
made calculator costs,
– 900 yen in Japan, 900/100 = 9
– 10 dollars in the USA.
• Americans would import calculators from Japan at
a cost of 9 dollars each.
 Real and Nominal Exchange Rates -
Example
• Now suppose the dollar depreciates by 20%, so
that the exchange rate is 80 to 1 (the dollar buys
20% fewer yen). As a result:
– Japanese calculators now cost 900/80 = $11.25 in the
USA,
– American calculators cost 10 × 80 = 800 yen in Japan.
• The depreciation in the US dollar has reversed the
direction of the trade flows.
 Real and Nominal Exchange Rates -
Example
• The nominal depreciation in the dollar could be
more than offset by higher inflation in the USA.
– Suppose inflation is 0% in Japan and 30% in the USA.
– The cost of the American calculator would be 10 × 1.3 ×
80 = 1040 yen in Japan.
– The cost of the Japanese calculator would be 11.25 dollars
in the USA.
• We are back to the original direction of trade, despite
the large nominal depreciation in the US dollar.
 Real and Nominal Exchange Rates -
Example
• Despite the depreciation in the nominal value of
the dollar,
• The real value of the dollar rose.
• The result hinged on the size of the nominal
depreciation relative to the difference in the
inflation rates.
 The Real Exchange Rate

• The
  change in the real exchange rate for any two
countries is approximated by:

Where D is Domestic and F is foreign.

 Implication of the Law of One Price
E P P * *

 t 1 t 1 t

E P P
t t 1 t

• Changes in exchange rates reflect relative inflation differentials across

countries:

Change in Exchange rate = Foreign inflation rate – Domestic inflation rate

• If goods prices rise faster in the U.S relative to that in Japan, then the Yen
should appreciate in value relative to the dollar: the Yen/Dollar exchange rate
should decline, as one Dollar buys fewer Yen

23
Nominal Exchange Rates and Inflation Differentials

45 degree line

24
Quarterly inflation and currency depreciation in Brazil, 1990–1997

High inflation in Brazil led to its currency falling in value .

As inflation ended, the currency stabilized immediately.
25
 Interest Rates, Exchange Rates and Uncovered Interest Rate Parity

Strategy 1
• Invest 1$ in the US risk-less asset.
• Payoff at year end: [1+Rt]$
Strategy 2
• Convert 1 dollar to receive Et ¥ today.
• Invest in a Japanese risk-less asset.
Payoff at year end Et[1+Rt*] ¥.
• Convert to dollars at the end of the
year, receiving : Et [1+Rt*]/Et+1$.

Uncovered Interest Rate Parity (UIP)

Expected change in the exchange rate is equal
to the nominal interest rate differential.
1+Rt = Et [1+Rt*]/Expected(Et+1)
or A country with a high interest rate has an
exchange rate that is expected to depreciate.
[Expected(Et+1)-Et]/Et = Rt* - Rt

Carry Trade: Borrow from low interest rate country and invest in high interest rate country.
Average profit should be zero. But this strategy actually earns a profit (perhaps infrequent large losses).

26
 Exchange Rates and Interest Rates

45 degree line

Countries with high nominal interest rates have, typically,

seen a fall in the value of their currency 27
 Real Exchange Rate
• The real exchange rate, e, is the quantity of foreign goods that one can
receive in exchange for one unit of the domestic good:

e = E P/P*

• P = domestic consumer price index (i.e., CPI)

• The real exchange rate can be thought of as the inflation-adjusted nominal

exchange rate

• When the real exchange rate for the domestic currency increases
– Domestic residents receive more foreign goods per unit of the
domestic good
– Domestic residents have an incentive to buy more foreign goods
relative to domestic goods

• Law of One Price implies the Real Exchange Rate e = 1

 Real Exchange Rate
Example
• Cost of hamburger
– $2 in the U.S.
– ¥220 in Japan

• Nominal exchange rate

– 100 yen per dollar

• Hamburger real exchange rate

– $2 buys one hamburger in the U.S.
– Or buys ¥200 yen
– ¥200 purchases .9 of a burger in Japan
– U.S./Japan hamburger real exchange rate = .9

• Law of one price (implied PPP value of dollar)

– Exchange rate should be 110 yen per dollar
– $2 convert to ¥220 yen, which is one burger in Japan
 Big Mac Index
• Begin with Big Mac price in local currency

• Big Mac price in dollars is the Big Mac price in

local currency converted into dollars at the market
exchange rate

• Implied PPP of the dollar is what the exchange rate

would have to be for the Big Mac price in dollars to
equal that of the U.S.

• Actual dollar exchange rate is the current market

exchange rate

• Under/over valuation against the dollar, calculated

as:

(PPP - Exchange Rate)        

---------------------------------- x 100
Exchange Rate

The Big Mac theory of the exchange rate asserts that

the value of the domestic currency should be expected
to rise if it is undervalued per above, and to fall if
overvalued. Does this make sense?
         
30
Real Exchange Rates for a Broad Basked of Goods
Real Exchange Rates and Per-capita Real Income

United States

Source: Obstfeld and Rogoff, Foundations of International Economics, MIT Press, 1996
Prices for Big Mac is Higher in Rich Countries
 Non-Traded Goods
and the Law of One Price
• Goods are traded goods or non-traded goods
– Most goods have a significant non-traded component
– Value of local distribution
– Value of service to sell the good

• The law of one price holds only for traded goods

E = P*_traded/P_traded

• Non-traded goods are cheap in poor countries:

– Lower demand for local inputs in fixed supply (land)
– Cheap unskilled labor as primary input into production

• Inflation can be high due to high inflation in non-traded goods

Hong Kong’s Inflation in the Face of High Growth and a Fixed Exchange Rate
China’s Inflation in the Face of High Growth and a Fixed Exchange Rate
China’s Inflation in the Face of High Growth and a Fixed Exchange Rate
 Japan’s Real Exchange Rate

Japanese real exchange rate rose from 1973 to 1995

 Purchasing Power Parity adjusted GDP
PPP real GDP is adjusted for the cost of living (the real exchange rate)
2015 (Trillion dollars)

country market GDP PPP GDP

United States 17.947 17.947
European Union 16.220 19.205
China 10.982 19.392
Japan 4.124 4.830
India 2.090 7.965
Russia 1.324 3.717
Brazil 1.772 3.192
Botswana 0.013 0.035
 Exchange Rates and Real Interest Rate:
Short-Run Fluctuations
• A rise in real interest rates relative to that of other countries leads to an
inflow of capital and a demand for financial assets.

• The rise in demand for assets leads to a rise in the demand for that
country’s currency, as foreign investors purchase domestic currency to
purchase domestic assets.

• The rise in the demand for currency leads to a short-run rise in its value;
i.e., the (real) exchange rate.

41
 Macro News and Exchange Rates
(Short Run Movements in Currency Values)

Higher than expected Higher than expected real Higher than expected
inflation GDP growth Federal Funds rate

Law of one price Better investment • Increases real interest

effect will drive
currency value down
opportunities will attract rate and attracts foreign
foreign capital. savings
• Signals strong economy
by the Federal Reserve
• Lowers inflation
expectations

42
 Key Message

• Economies with relative high real GDP growth will see the value of
their currencies rise

• High inflation leads to a fall in the value of the currency

• High interest rates due to high real rates will lead to a rise in the value
of the currency.

• High interest rates due to high inflation will lead to a fall in the value
of the currency

43
 Fixed Exchange Rates
Country on a fixed exchange rate regime fixes its currency
value relative to that of another country

• Et is a constant, so Et /Et+1=1
• Consequently, Et[1+Rt*]/Et+1 = 1+Rt*
• So, arbitrage ensures equality of nominal interest rates: Rt = Rt*
• Main economic implication:

A country that pursues a fixed exchange rate cannot pursue an

independent monetary policy

• Note that nominal interest rates must be the same, but with movements
in the real exchange rate, inflation rates can differ (as we have already
seen) 44
 Bretton-Woods: Fixed Exchange Rate Regime
between Europe, Japan, and the US from 1947 to 1973

• Under Bretton-Woods, Europe/Japan was tied to the US Dollar and the Dollar was tied to gold
• In the early 70s Nixon printed more currency, which landed up in European Central Banks
• European Central Banks preferred to hold gold than dollars
• Nixon refused to convert dollars to gold, which led to the collapse of Bretton-Woods
45
 The Euro
• Following Bretton-Woods, Europe pegged exchange rates to German
mark

• The Euro was introduced as a common currency amongst 16 European

countries: unit of account as of Jan. 1, 1999, currency in circulation as of
Jan. 1, 2002

• Benefits:
– Lower exchange rate volatility
– Greater mobility of capital
– Inherit credibility of the Euro

• Costs:
– None of the 16 countries have independent monetary policy
– UK, Denmark and Sweden have not joined the Euro, partly to maintain an independent
monetary policy

46
 Fixed Exchange Rates
and Speculative Attacks
• Historically, many countries pegged their currency to the U.S. Dollar as an
attempt to commit to a prudent monetary policy
• Speculative attacks are an outcome of inconsistency between the fiscal policy
and the fixed rate of exchange. Why?
• Uncontrolled government budget deficits and the necessity of monetization
lead to a collapse of the fixed exchange rate regime
• Speculative Attack:
– Borrow the foreign currency
– Exchange into Dollars at the official exchange rate
– Invest in a domestic bond
– Foreign Central Bank loses large amounts of dollar reserves and is forced to
abandon the pegged currency value, similar to a bank run
– Cash in some of the domestic bonds to pay the foreign debt
• In the end, attempts at fixed exchange rate regimes led to repeated financial
crises, hence they are not widely used today
• The only source of long-term credibility is a prudent fiscal policy
47
 Examples of Speculative Attacks
• UK Pound, 09/1992

• Mexican Peso, 12/94

• Thai Baht and Malaysian Ringgit, 08/97 (The South East Asian
Currency Crises)

• Brazilian Real, 02/99

• Turkey, Argentina, 2001

48
national currency per dollar
Financial Crisis in the 90’s
exchange rates

Mexico

Thailand
Russia

Argentina

Jan90Dec90 Dec91 Dec92 Dec93 Dec94 Dec95 Dec96 Dec97 Dec98 Dec99 Dec00 Dec01Dec02
months
Time series of recent collapse
49
Financial Crisis in South East Asia

50
 Non-Performing Loans in South-East Asia (1997)
Banks are in trouble
Percentage of all loans Percentage of GDP

35
30
25
20
15
10
5
0
Thailand

Indonesia

Korea
South

Malaysia

Philipines

Singapore
Moreover, banks borrowed internationally in dollars and loaned in domestic
currency, making the entire banking sector vulnerable to an exchange rate crises
51
 Non-Performing Loans in South-East Asia (1997)

Percentage of government revenues

180
160
140
120
100
80
60
40
20
0
Thailand

Indonesia

South Korea

Malaysia

Philipines

Singapore
Non-performing loans if covered by the government are a huge liability.

52
 Mexican Currency Crises

Central bank lost about $10B in defending the currency. The rise in the
nominal and real interest rates squelched GDP growth. Current account
reversal due to collapse in investment.
53
• The Brazilian government introduced a 3-year, $80 billion package of
spending cuts and tax increases today in an effort to restore the
country’s flagging credibility in world markets …

• Investor’s reacted warily, and said the measures did not go as far as
they hoped in making structural changes to permanently reduce
Brazil’s burgeoning budget deficit, which is now running at 7% of
GNP.

• Jorge Mariscal, chief investment strategist for Latin America of

Goldman Sachs, said, “It’s a step in the right direction, but if you think
of Brazil climbing up a wall of disbelief, this is just a few inches up.”

54
55
 Key Message

• Inconsistencies between the official exchange rate and the

fiscal policy of the government lead to speculative attacks

• Managed exchange rate regimes are susceptible to very

dramatic changes in exchange rates

56
 International Monetary Fund
• Created in 1944, initially 45 members, now 186 countries
• Objective to stabilize the world financial system
• International lender of last resort
• Impose austerity measures as a condition of receiving loans: the Washington
Consensus (10 points)
– Reduce budget deficits
– Encourage spending on education, health, and infrastructure
– Broaden tax base and lower marginal tax rates
– Market determined interest rates
– Market determined exchange rates
– Free trade
– Encourage foreign direct investment
– Privatize state enterprises
– Deregulation
– Secure property rights
• Poor track record: focus now on second-generation reforms
– Productivity-boosting reforms (efficiency)
– Higher quality institutions

57