Description
The presentation includes detail the economies of exchange rates along with how it works and also purchasing power parity.
Economics of Exchange Rates
Introduction
Exchange rates are very complex and the result of many different forces In this lecture we will look at just a few of those forces which affect exchange rates in the long run Specifically we will examine the impact of prices, inflation rates and interest rates on exchange rates. We will also examine fixed and flexible exchange rates and the advantages of each
Purchasing Power Parity
PPP is one of the fundamental building blocks of exchange rate theory It doesn’t provide a full theory but it helps us understand part of the picture and points the way to a deeper theory The concept is also extremely important in measuring GDP and comparing the GDP of different countries.
Law of One Price
The basis for the purchasing power parity theory is the law of one price which simply states that the same good will have the same price in different markets Obviously this will only hold true given certain assumptions about free trade between the markets, competitive markets and zero transport costs Another way of stating the law is that arbitrage opportunities are quickly eliminated For example suppose 1 dollar= 40 rupees and a shirt costs 10 dollars in the US. The law of one price says that the shirt will cost 400 rupees in India. If this were not true there would be arbitrage opportunities given our assumptions Though simple, the law of one price has deep implications for the operations of financial markets
Purchasing Power Parity
The PPP theory states that the exchange rate between two countries’ currencies equals the ratio of their price levels. In a sense it is an extension of the law of one price applied to the entire price level of a country’s economy If the law of one price applies to every good in the representative commodity basket then PPP automatically holds true
Absolute and Relative PPP
Absolute PPP is a theory of the level of exchange rates whereas Relative PPP is a theory about the changes in exchange rates. Relative PPP says that changes in exchange rates between two countries depends on the difference between their inflation rates. E.g. If US inflation rate is 2% and Indian inflation rate is 6%, Relative PPP predicts that the Indian rupee will depreciate by 4% relative to the US dollar. Similarly if the Japanese inflation rate is 1% and the European inflation rates is 3%, Relative PPP predicts that the yen will appreciate 2% relative to the euro.
Empirical Evidence for PPP
The empirical evidence for both versions of the PPP theory are weak. To test absolute PPP, economists measure the price of a broad commodity of goods after adjusting for quality differences. Contrary to theory the price of this basket vary sharply across countries Relative PPP fares a little better but once again contradicts the evidence in that relative inflation rates offer only a poor guide to exchange rate movements. PPP fares particularly badly in the era of flexible exchange rates since 1973
Reasons for failure of PPP
Trade barriers: For the law of one price to hold goods should be freely tradable Transport costs: drive wedges between prices of goods in different countries Non-tradable goods: In extreme cases goods cannot be traded at all: e.g. many services Imperfect Competition and price discrimination Different tax structures Differences in measurement of price levels
PPP and GDP measurements
GDP statistics are sometimes used to compare economic activity in different countries You need a way of converting GDP figures from one country to another One way of doing this is through market exchange rates. However as we have seen market exchange rates don’t reflect purchasing power in different countries You need to create another measure which reflects purchasing power parity. Thus you often see GDP statistics measured in PPP
Per capita Income
Country India Nominal 800 PPP 3,750
China
Brazil Russia Japan Germany
2,000
5,700 6,850 34,200 35,200
7,600
9,100 12,100 32,650 31,100
US
44,000
43,400
Source: IMF (the numbers are approximate)
Importance of PPP
For developing countries in particular PPP measures of GDP are significantly different from conventional measures Whenever you see a GDP measure you should always try to find out how it is measured For rich countries PPP makes less of a difference. But relatively speaking some rich countries like the US do better than countries like Japan. This reflects the relatively cheaper land in the US and more efficient non-tradable sector
Fisher Effect
The Fisher effect links expected inflation rates with interest rates It states that a rise in a country’s expected inflation rate will lead to an equal rise in the interest rates of its currency deposits Eg. If Indian interest rates are 8% and expected inflation rises from 4% to 6%, interest rates will also rise to 10%
Interest Parity
The interest parity condition says that foreign exchange market will be in equilibrium when the deposits of all currencies offer the same expected return If this condition doesn’t hold true then there will be arbitrage opportunities which will cause the exchange rates to move until parity is restored
Example
Suppose the dollar interest rate is 8% and the yen rate is 4% but the dollar is expected to depreciate against the yen at 6% per year. The return on yen deposits will be 2% higher which will lead to excess demand for the yen Alternatively suppose the dollar interest rate is 8% and the yen interest rate is 10% but the dollar is expected to appreciate by 4%.Now the dollar deposits will earn a higher return and there will be excess demand for dollars Clearly in equilibrium deposits in both currencies should earn the same return. Mathematically:
R$ ? RY ? ( E
e $ /Y
? E$ / Y ) / E$ / Y
Exchange Rates Regimes
There have been many currency arrangements over the last few centuries Broadly speaking they can be divided into three: Fixed exchange rates Flexible exchange rates Managed Floats (hybrid) Each system has its strengths and weaknesses
Fixed Exchange Rates
The government fixes the exchange rate either with an important reference currency or a basket of currencies The exchange rate doesn’t fluctuate according to demand and supply. Instead the central bank intervenes in the foreign exchange market to maintain the fixed rate In addition foreign exchange controls may be used to allocate foreign exchange
Advantages
A fixed exchange rate reduces exchange risk and the disruptions caused by sudden exchange rate movements By anchoring itself to a more reputable currency, the government can commit to following a sound monetary policy This in turn will ideally lead to lower interest rates
Problems
A fixed exchange rate will make monetary policy less effective especially if you have free capital flows A fixed exchange rate will make the currency vulnerable to a speculative attack. E.g. ERM crisis in 1992 and the attack on the British pound A fixed exchange rate may encourage too much borrowing in foreign-currency debt E.g. East Asian crisis Any rationing of foreign exchange can lead to inefficiency and corruption A fixed rate based on a reserve currency may give that country an unfair advantage (e.g. Bretton Woods system)
Flexible Exchange Rates
In a flexible exchange rate, the exchange rate is set by demand and supply in the foreign exchange markets There is no intervention by the central bank or government Some of the factors that affect the exchange rate include: a) Its attractiveness as an investment destination b) Its current account deficit
Benefits
The main benefit of a flexible exchange rate is that it preserves the freedom of the central bank to conduct monetary policy In fact under flexible exchange rates monetary policy will be extra effective because of the effect of capital movements on the exchange rate E.g. Suppose a government wants stimulate the economy, it will lower interest rates which will lead to a currency depreciation which will add further to total demand (how?) Flexible rates also eliminate the inefficiencies associated with exchange controls Flexible rates should lead to a faster adjustment to economic shocks
Problems
Flexible exchange rates add to volatility and increase transaction costs for international business Foreign exchange markets may tend to overreact and move beyond fundamentals The flexibility may tempt policy makers to create more inflationary policies Developing countries may have to pay an excessive exchange premium for international capital Exchange rate appreciation may lead to an uncompetitive manufacturing sector E.g. Dutch disease
Managed Float
This is a flexible exchange rate where the government may intervene in order prevent the exchange rate from excessive volatility In order to succeed a central bank will need a high credibility and adequate foreign exchange reserves Exchange rates may become influenced by domestic political lobbying
Impossible Trinity
Any country can have only two of the following three attributes: A fixed exchange rate Free capital flows Independent monetary policy In other words policy makers have to choose to drop at least one of the three. Alternatively they may achieve a partial combination of all three
Indian policy
In practice India has tried to choose a hybrid policy which tries to avoid the hard choices of the trinity India has a managed float and the RBI does intervene. For example preventing exchange rate from appreciating too much and hurting exporters India is not fully open to capital flows While India does try to maintain an independent monetary policy, it is not the only tool in controlling inflation. Fiscal policy and direct controls are also important.
Conclusion
Both fixed and flexible exchange rates have their strengths and weaknesses. Governments have to choose the best rate regime according to their policy goals and resources and keeping in mind the fundamental constraints of the impossible trinity
doc_699996872.ppt
The presentation includes detail the economies of exchange rates along with how it works and also purchasing power parity.
Economics of Exchange Rates
Introduction
Exchange rates are very complex and the result of many different forces In this lecture we will look at just a few of those forces which affect exchange rates in the long run Specifically we will examine the impact of prices, inflation rates and interest rates on exchange rates. We will also examine fixed and flexible exchange rates and the advantages of each
Purchasing Power Parity
PPP is one of the fundamental building blocks of exchange rate theory It doesn’t provide a full theory but it helps us understand part of the picture and points the way to a deeper theory The concept is also extremely important in measuring GDP and comparing the GDP of different countries.
Law of One Price
The basis for the purchasing power parity theory is the law of one price which simply states that the same good will have the same price in different markets Obviously this will only hold true given certain assumptions about free trade between the markets, competitive markets and zero transport costs Another way of stating the law is that arbitrage opportunities are quickly eliminated For example suppose 1 dollar= 40 rupees and a shirt costs 10 dollars in the US. The law of one price says that the shirt will cost 400 rupees in India. If this were not true there would be arbitrage opportunities given our assumptions Though simple, the law of one price has deep implications for the operations of financial markets
Purchasing Power Parity
The PPP theory states that the exchange rate between two countries’ currencies equals the ratio of their price levels. In a sense it is an extension of the law of one price applied to the entire price level of a country’s economy If the law of one price applies to every good in the representative commodity basket then PPP automatically holds true
Absolute and Relative PPP
Absolute PPP is a theory of the level of exchange rates whereas Relative PPP is a theory about the changes in exchange rates. Relative PPP says that changes in exchange rates between two countries depends on the difference between their inflation rates. E.g. If US inflation rate is 2% and Indian inflation rate is 6%, Relative PPP predicts that the Indian rupee will depreciate by 4% relative to the US dollar. Similarly if the Japanese inflation rate is 1% and the European inflation rates is 3%, Relative PPP predicts that the yen will appreciate 2% relative to the euro.
Empirical Evidence for PPP
The empirical evidence for both versions of the PPP theory are weak. To test absolute PPP, economists measure the price of a broad commodity of goods after adjusting for quality differences. Contrary to theory the price of this basket vary sharply across countries Relative PPP fares a little better but once again contradicts the evidence in that relative inflation rates offer only a poor guide to exchange rate movements. PPP fares particularly badly in the era of flexible exchange rates since 1973
Reasons for failure of PPP
Trade barriers: For the law of one price to hold goods should be freely tradable Transport costs: drive wedges between prices of goods in different countries Non-tradable goods: In extreme cases goods cannot be traded at all: e.g. many services Imperfect Competition and price discrimination Different tax structures Differences in measurement of price levels
PPP and GDP measurements
GDP statistics are sometimes used to compare economic activity in different countries You need a way of converting GDP figures from one country to another One way of doing this is through market exchange rates. However as we have seen market exchange rates don’t reflect purchasing power in different countries You need to create another measure which reflects purchasing power parity. Thus you often see GDP statistics measured in PPP
Per capita Income
Country India Nominal 800 PPP 3,750
China
Brazil Russia Japan Germany
2,000
5,700 6,850 34,200 35,200
7,600
9,100 12,100 32,650 31,100
US
44,000
43,400
Source: IMF (the numbers are approximate)
Importance of PPP
For developing countries in particular PPP measures of GDP are significantly different from conventional measures Whenever you see a GDP measure you should always try to find out how it is measured For rich countries PPP makes less of a difference. But relatively speaking some rich countries like the US do better than countries like Japan. This reflects the relatively cheaper land in the US and more efficient non-tradable sector
Fisher Effect
The Fisher effect links expected inflation rates with interest rates It states that a rise in a country’s expected inflation rate will lead to an equal rise in the interest rates of its currency deposits Eg. If Indian interest rates are 8% and expected inflation rises from 4% to 6%, interest rates will also rise to 10%
Interest Parity
The interest parity condition says that foreign exchange market will be in equilibrium when the deposits of all currencies offer the same expected return If this condition doesn’t hold true then there will be arbitrage opportunities which will cause the exchange rates to move until parity is restored
Example
Suppose the dollar interest rate is 8% and the yen rate is 4% but the dollar is expected to depreciate against the yen at 6% per year. The return on yen deposits will be 2% higher which will lead to excess demand for the yen Alternatively suppose the dollar interest rate is 8% and the yen interest rate is 10% but the dollar is expected to appreciate by 4%.Now the dollar deposits will earn a higher return and there will be excess demand for dollars Clearly in equilibrium deposits in both currencies should earn the same return. Mathematically:
R$ ? RY ? ( E
e $ /Y
? E$ / Y ) / E$ / Y
Exchange Rates Regimes
There have been many currency arrangements over the last few centuries Broadly speaking they can be divided into three: Fixed exchange rates Flexible exchange rates Managed Floats (hybrid) Each system has its strengths and weaknesses
Fixed Exchange Rates
The government fixes the exchange rate either with an important reference currency or a basket of currencies The exchange rate doesn’t fluctuate according to demand and supply. Instead the central bank intervenes in the foreign exchange market to maintain the fixed rate In addition foreign exchange controls may be used to allocate foreign exchange
Advantages
A fixed exchange rate reduces exchange risk and the disruptions caused by sudden exchange rate movements By anchoring itself to a more reputable currency, the government can commit to following a sound monetary policy This in turn will ideally lead to lower interest rates
Problems
A fixed exchange rate will make monetary policy less effective especially if you have free capital flows A fixed exchange rate will make the currency vulnerable to a speculative attack. E.g. ERM crisis in 1992 and the attack on the British pound A fixed exchange rate may encourage too much borrowing in foreign-currency debt E.g. East Asian crisis Any rationing of foreign exchange can lead to inefficiency and corruption A fixed rate based on a reserve currency may give that country an unfair advantage (e.g. Bretton Woods system)
Flexible Exchange Rates
In a flexible exchange rate, the exchange rate is set by demand and supply in the foreign exchange markets There is no intervention by the central bank or government Some of the factors that affect the exchange rate include: a) Its attractiveness as an investment destination b) Its current account deficit
Benefits
The main benefit of a flexible exchange rate is that it preserves the freedom of the central bank to conduct monetary policy In fact under flexible exchange rates monetary policy will be extra effective because of the effect of capital movements on the exchange rate E.g. Suppose a government wants stimulate the economy, it will lower interest rates which will lead to a currency depreciation which will add further to total demand (how?) Flexible rates also eliminate the inefficiencies associated with exchange controls Flexible rates should lead to a faster adjustment to economic shocks
Problems
Flexible exchange rates add to volatility and increase transaction costs for international business Foreign exchange markets may tend to overreact and move beyond fundamentals The flexibility may tempt policy makers to create more inflationary policies Developing countries may have to pay an excessive exchange premium for international capital Exchange rate appreciation may lead to an uncompetitive manufacturing sector E.g. Dutch disease
Managed Float
This is a flexible exchange rate where the government may intervene in order prevent the exchange rate from excessive volatility In order to succeed a central bank will need a high credibility and adequate foreign exchange reserves Exchange rates may become influenced by domestic political lobbying
Impossible Trinity
Any country can have only two of the following three attributes: A fixed exchange rate Free capital flows Independent monetary policy In other words policy makers have to choose to drop at least one of the three. Alternatively they may achieve a partial combination of all three
Indian policy
In practice India has tried to choose a hybrid policy which tries to avoid the hard choices of the trinity India has a managed float and the RBI does intervene. For example preventing exchange rate from appreciating too much and hurting exporters India is not fully open to capital flows While India does try to maintain an independent monetary policy, it is not the only tool in controlling inflation. Fiscal policy and direct controls are also important.
Conclusion
Both fixed and flexible exchange rates have their strengths and weaknesses. Governments have to choose the best rate regime according to their policy goals and resources and keeping in mind the fundamental constraints of the impossible trinity
doc_699996872.ppt