Lecture 6: Exchange Rate Theory

Based on Sloman Chapter 24

Lecture 6: Exchange Rate Theory

Based on Sloman Chapter 24

Definitions of the Exchange RateDefinitions of the Exchange Rate

49.1d

f

p

pE

Price of good in UK= price on continent by exchange rate

fd pEp

Price of £1 is 1.49 Euros (Euros per pound)

Definitions of the Exchange RateDefinitions of the Exchange Rate

67.0£f

d

p

pe

e= Domestic price of foreign currency

Price of good in UK = price of foreign currency multiplied by the price of good abroad

fd epp Price in £ (pennies) of 1Euro – .67 per Euro

But what determines ERBut what determines ER

d

f

p

pE

Trade equalises prices of tradable good

Once local prices are determined e is determined.

Conversely, if world prices and exchange rate is determined then local

prices are determined

What determines PricesWhat determines Prices

• Some people argue that prices are determined by money supply

• P.Y= MV

• GNP=must be paid for

• GNP= Money by the time it changes hands

• Some people argue that prices are determined by money supply

• P.Y= MV

• GNP=must be paid for

• GNP= Money by the time it changes hands

Y

MVP

MVPY

What determines PricesWhat determines Prices

• If so exchange rate is determined by ratio of prices

• If so exchange rate is determined by ratio of prices

d

f

p

pE

d

dd

f

ff

YVM

Y

VM

f

d

dd

ff

Y

Y

VM

VM

What determines PricesWhat determines Prices

• So if increase Md, prices up, E goes down (a depreciation, worth less)

• If Velocity rises) money goes around faster, prices up, depreciation

• If Income rises (prices fall!!!), E up

• So if increase Md, prices up, E goes down (a depreciation, worth less)

• If Velocity rises) money goes around faster, prices up, depreciation

• If Income rises (prices fall!!!), E up

d

f

p

pE

d

dd

f

ff

YVM

Y

VM

f

d

dd

ff

Y

Y

VM

VM

• Big Mac Index•

Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.

• http://www.economist.com/markets/bigmac/index.cfm

• Big Mac Index•

Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.

• http://www.economist.com/markets/bigmac/index.cfm

06.190.2

28.3 ERPPP

p

p

f

d

Purchasing Power ParityPurchasing Power Parity

• Tradeable goods prices are equal

– Need to exclude transport costs,

– Looking only at the purely tradable component -have to discount fact that property prices in London are the same as in Skye ( NON-TRADABLE GOODS)

– Labour costs – e.g. Hair cuts in Budapest v Birmingham

• Tradeable goods prices are equal

– Need to exclude transport costs,

– Looking only at the purely tradable component -have to discount fact that property prices in London are the same as in Skye ( NON-TRADABLE GOODS)

– Labour costs – e.g. Hair cuts in Budapest v Birmingham

d

f

p

pe

Alternative Theory – Interest rate parityAlternative Theory – Interest rate parity

• If I invest money in UK expect same return as invest in France

• So Interest rates have to be the same

• But not.

• SO if invest in UK interest rate +movement on ER = return in France.

• So if irf =3% and iruk=5% then

3% =5%-depreciation of 2%

• If I invest money in UK expect same return as invest in France

• So Interest rates have to be the same

• But not.

• SO if invest in UK interest rate +movement on ER = return in France.

• So if irf =3% and iruk=5% then

3% =5%-depreciation of 2%

d

f

p

pe

Alternative Theory – Interest rate parityAlternative Theory – Interest rate parity

• So if irf =3% and iruk=5% then

3% =5%-depreciation of 2%

So can put £1 in UK bank at £1.05OR buy Euro at .67 per Euro=1.492537

Get 3% =1.5372313

Sell at 0.683009= 1.5372313*0.683009

=1.05

• So if irf =3% and iruk=5% then

3% =5%-depreciation of 2%

So can put £1 in UK bank at £1.05OR buy Euro at .67 per Euro=1.492537

Get 3% =1.5372313

Sell at 0.683009= 1.5372313*0.683009

=1.05

So ir reflect EXPECTED depreciationSo ir reflect EXPECTED depreciation

At start - 0.67

At end 0.683009

So price of Euro rises (worth less) at end of period

• These explanations imply government can control the ER

• Do I believe?

• ER as a random variable?

• OK lets focus in ER as something deterministic driven either by trade or finance flows.

• Can government manipulate the ER and why?

• These explanations imply government can control the ER

• Do I believe?

• ER as a random variable?

• OK lets focus in ER as something deterministic driven either by trade or finance flows.

• Can government manipulate the ER and why?

The exchange rate as a price for the demand and supply of domestic currency

The exchange rate as a price for the demand and supply of domestic currency

O

Exc

ha

nge

ra

te E

= P

rice

in E

uro

s o

f 1£

Quantity of £s

S1

D1

er1

Supply – sell £ to buy Forex for imports or foreign investment – Higher E means buy more abroad

Demand – Foreigners buy £ to buy exports or inward investment

O

Exc

ha

nge

ra

te

Quantity of £s

S1

D1

er1

er2

S2

D2

Adjustment of the exchange rate to a shift in demand and supply

Adjustment of the exchange rate to a shift in demand and supply

DepreciationUK ER fates fall, EU up switch to Euros – S of £ shifts out

O

Exc

ha

nge

ra

te

Quantity of £s

S1

D1

er1

er2

S2

D2

Depreciation

Adjustment of the exchange rate to a shift in demand and supply

Adjustment of the exchange rate to a shift in demand and supply

Fall in demand for UK exports

O

Exc

ha

nge

ra

te

Quantity of £s

S1

D1

er1

Adjustment of the exchange rate to a shift in demand and supply

Adjustment of the exchange rate to a shift in demand and supply

O

Exc

ha

nge

ra

te

Quantity of £s

S1

D1

er1

S3

D3

er3

Adjustment of the exchange rate to a shift in demand and supply

Adjustment of the exchange rate to a shift in demand and supply

O

Exc

ha

nge

ra

te

Quantity of £s

S1

D1

er1

S3

D3

er3

Appreciation

Adjustment of the exchange rate to a shift in demand and supply

Adjustment of the exchange rate to a shift in demand and supply

• With a floating Exchange Rate the price of £ changes in response to S & D.

• What will happen to Balance of Payments?

• Fluctuations in E ensure the value of imports always equals value of exports so Balance of payments always in balance

• With a floating Exchange Rate the price of £ changes in response to S & D.

• What will happen to Balance of Payments?

• Fluctuations in E ensure the value of imports always equals value of exports so Balance of payments always in balance

O

Exc

ha

nge

ra

te

Quantity of £s

S1 by UK

D by overseasresidents

r1 Fixedexchange rate

S2 by UK

This createsexternal imbalance:

i.e. currency flow deficit

Fixed Exchange Rate and Balance of Payments deficitFixed Exchange Rate and Balance of Payments deficit

Fixed Exchange Rate and Balance of payments surplusFixed Exchange Rate and Balance of payments surplus

O

Exc

ha

nge

ra

te

Quantity of £s

S by UK

D from abroad

Fixed rate

D2

-6

-5

-4

-3

-2

-1

0

1

2

3

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

UK balance of payments as % of GDP: 1980–2000UK balance of payments as % of GDP: 1980–2000

Source: Datastream

-6

-5

-4

-3

-2

-1

0

1

2

3

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

UK balance of payments as % of GDP: 1980–2000UK balance of payments as % of GDP: 1980–2000

Currentaccount

Source: Datastream

-6

-5

-4

-3

-2

-1

0

1

2

3

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

UK balance of payments as % of GDP: 1980–2000UK balance of payments as % of GDP: 1980–2000

Currentaccount

Trade in goods

Source: Datastream

$ / £ exchange rate: 1976-99$ / £ exchange rate: 1976-99

$ / £Index

1990=100

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

$2.40

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

70

80

90

100

110

120

130

140

150

$ / £ exchange rate: 1976-99$ / £ exchange rate: 1976-99

$ / £Index

1990=100

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

$2.40

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

70

80

90

100

110

120

130

140

150

$1.00

$1.20

$1.40

$1.60

$1.80

$2.00

$2.20

$2.40

1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998

70

80

90

100

110

120

130

140

150

$ / £ exchange rate and £ exchange rate index: 1976-99$ / £ exchange rate and £ exchange rate index: 1976-99

$ / £Index

1990=100

Exchange rate indicesExchange rate indicesaverages for each period (1995 = 100)averages for each period (1995 = 100)

Exchange rate indicesExchange rate indicesaverages for each period (1995 = 100)averages for each period (1995 = 100)

Source: Sloman based on data in European Economy Statistical Annex (Commission of the European Union)

The crawling peg within exchange rate bandsThe crawling peg within exchange rate bands

O

Exc

ha

nge

ra

te

Nointervention

Central bankbuys domestic

currency

Nointervention

Central banksells domestic

currency

Nointervention

$1.60

$1.40

Time

Source: Sloman

Quantity

If Government changes ER –depreciation- imports If Government changes ER –depreciation- imports become more expensive (shift in)become more expensive (shift in)

O

Pri

ce

in £

S of imports

Demand for Imports

r1

S2 (Epf)

So imports fall helping deficit - but cost more hurting deficit

If Government changes ER –depreciation- and If Government changes ER –depreciation- and Exports become competitive (shift out)Exports become competitive (shift out)

O

Pri

ce

in £

S of Exports

Demand for Exports

r1

D2 (pd/E)

Exports rise helping deficit

If Government changes –depreciates imports become more If Government changes –depreciates imports become more expensive (shift in) and Exports become competitive (shift expensive (shift in) and Exports become competitive (shift

out)out)

O

Pri

ce

in £

S of imports

Demand for Imports

r1

S2

(Epf)

OP

ric

e in

£ S of Exports

Demand for Exports

r1

D2

(pd/E)

Argument is that sales of exports and lower imports outweigh additional expense of remaining imports – SO BOP Better

But dedpreciation – import tax (tarrif) and export subsidy

• UK experience of dirty floatingUK experience of dirty floating

– first oil crisis and its aftermathfirst oil crisis and its aftermath

– second oil crisis and the rise in monetarismsecond oil crisis and the rise in monetarism

– effects of growing US budget and trade deficits in the effects of growing US budget and trade deficits in the 1980s1980s

– the 1985 exchange crisisthe 1985 exchange crisis

– joining and leaving the ERMjoining and leaving the ERM

– experience since leaving ERMexperience since leaving ERM fluctuations in the poundfluctuations in the poundexchange rate consequences of targeting the exchange rate consequences of targeting the

inflation rateinflation rate

• The volatility of exchange ratesThe volatility of exchange rates

• UK experience of dirty floatingUK experience of dirty floating

– first oil crisis and its aftermathfirst oil crisis and its aftermath

– second oil crisis and the rise in monetarismsecond oil crisis and the rise in monetarism

– effects of growing US budget and trade deficits in the effects of growing US budget and trade deficits in the 1980s1980s

– the 1985 exchange crisisthe 1985 exchange crisis

– joining and leaving the ERMjoining and leaving the ERM

– experience since leaving ERMexperience since leaving ERM fluctuations in the poundfluctuations in the poundexchange rate consequences of targeting the exchange rate consequences of targeting the

inflation rateinflation rate

• The volatility of exchange ratesThe volatility of exchange rates

EXCHANGE RATE SYSTEMS IN PRACTICEEXCHANGE RATE SYSTEMS IN PRACTICE