Business Economics: Exchange Rates

Michael Kitson

Reading
MANKIW, N.G., MACROECONOMICS Worth 5th edition 2003, BS 540, Chapter 5

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Structure
Nominal and real exchange rates Trade accounts Exchange rate adjustment Exchange rate regimes

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Exchange Rate
Nominal Price of one currency in terms of another currency (bilateral) Effective Average exchange rate over several other currencies
Trade weighted When averaging, use amount

of trade to weight the currency

Real Purchasing power of a currency

Price of currency adjusted for cross-country differences in prices of goods and service
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Euro Effective Exchange Rate

2% Norw egian Krone 2% Canadian Dollar 1% Australian Dollar 25% US Dollar

4% Singapore Dollar 4% Danish Krone 4% Hong Kong Dollar 5% Korean Won 6% Sw edish Krona

9% Sw iss Franc 15% Japanese Yen 24% Pound Sterling

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Dollar effective exchange rate

2% Brazilian Real 2% Thai Baht 2% Australian Dollar 3% Malaysian 2% Sw iss Franc Ringgitt 3% Hong Kong Dollar 1% Indonesian Rupiah 1% Philippine Peso 19% Canadian Dollar

3% Singapore dollar 4% Korean Won 4% Taiw anese Dollar

18% Euro

5% Pound Sterling 9% Mexican Peso 7% Chinese Yuan

16% Japanese Yen

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Real Exchange Rate

$
Domestic Price Level Real Rate = Nominal Rate x Foreign Price Level

/$

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Nominal and Real US exchange rate (Broad Index)

140

120

100

80

60

Real Rate
40

20

Nominal Rate

0 1970

1975

1980

1985

1990

1995

2000

2005

2010

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Law of One Price

Identical commodities sell at same price no matter where they are sold
Big Mac index

Implies real rate = 1 (or 100 if using an index) Based on idea of arbitrage

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Purchasing Power Parity

US Price Level Real Rate = Nominal Rate (/$) x

UK Price Level

Real Rate = 1

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The Limits of the Law of One Price

Transportation costs Border effects (tariffs, non-tradeables, etc.) Goods prices are sticky, nominal exchange rates arent
Pricing to market Exchange rate pass-through
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Estimated transport cost for global trade

Price differences between US and Canadian Cities.

Big Mac Index

Source: The Economist

Purchasing Power Parity

country Australia Canada France Germany Italy Japan Korea Mexico New Zealand Poland Switzerland United Kingdom

Actual Exchange Rate against the US Dollar

1.3598 1.301 0.8054 0.8054 0.8054 108.193 1145.32 11.286 1.5087 3.6576 1.2435 0.5462

PPP exchange rate against the US Dollar

1.385574266 1.258882765 0.951198456 0.954961439 0.912754646 148.0400132 840.21304 8.127764356 1.4310269 2.18587589 1.883798671 0.663639115

Actual and PPP exchange rates against the dollar in 2004

The number of units of local currency per US dollar

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Trade Accounts
Current account (X)- (M)
Records net transactions in goods and services Exports Imports Income and transfers from abroad

Capital account (NIFA)

Records net transactions in assets Net Saving
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Current Account
Exports Imports
Goods Services

Investment income and dividends Net transfers

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Capital Account
Capital transfers Financial account
Direct investment Portfolio investment Other investment Reserve Assets

Errors and omissions

Fudge factor
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World Current account balances 2006 (% of GDP)

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UK Balance of Trade in Goods

Balance of exports minus imports of goods at current prices, billion
10 0 -10 -20 -30 -40 -50 -60 -70 -80 -90 80 82 84 86 88 90 92 94 96 98 00 02 04 06
10 0 -10 -20 -30 -40 -50 -60 -70 -80 -90

GBP (billions)

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Source: Reuters EcoWin

billions

UK Balance of Trade in Services

Balance of exports minus imports of services, current prices, billion
40
40

35

35

30

30

25
GBP (billions)

25

20

20

15

15

10

10

0 80

82

84

86

88

90

92

94

96

98

00

02

04

06

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Source: Reuters EcoWin

billions

Components of the UK Balance of Payments

Annual balances for each component, billion
50
50

25

Trade in Services

25

0
Billion (billions)

Investment income Transfers

-25

Current account

-25

-50

Trade in Goods

-50

-75

-75

-100
97 98 99 00 01 02 03 04 05 06 07

-100

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Source: Reuters EcoWin

billions

Lowering the exchange rate to improve external balance

Devaluation (fixed exchange rates)/Depreciation (floating exchange rates) Success depends on:
Firms pricing strategies Price elasticities of demand (Marshall Lerner condition) Sufficient capacity (supply elasticities)

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Consequences of devaluation or depreciation

In the short-run there may be a deterioration in trade performance due to the J curve effect In the medium-run, a devaluation may increase competitiveness and aggregate demand (given that prices and wages adjust slowly). In the long run, a devaluation may not have to have much effect on the economy (if prices and wages have adjusted upwards returning the real exchange rate back to its initial position).

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Exchange Rate Regimes

Flexible
Fixed Managed

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Flexible Exchange Rates

Suppose there are only two countries, the UK and the US. For UK residents the exchange rate is the number of dollars that can be obtained for each unit of sterling.
The US (UK) demand for pounds sterling (dollars) stems from US (UK) residents and institutions who wish to buy goods made in the UK (US) or UK (US) assets.
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Flexible Exchange Rates

$ per S

Assume an initial exchange rate of 1 = $1.50. There are rumours that the UK is going to increase interest rates Investing in the UK would now be more attractive and demand for would rise

1.75 1.50

Shortage

D1 D

Q1

Q3

Q2

Quantity on ForEx Markets

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Fixed Exchange Rates

$ per S

B
Fixed Rate

A C
D1

D2
Q1 Michael Kitson

D Quantity on ForEx Markets

Fixed or Flexible Exchange rates?

The case for Flexible: Exchange rate changes need to compensate for inflation differences - (PPP) principle Exchange rates need to compensate for shocks The case against Fixed Policy makers do not know the equilibrium value Vulnerable to crises

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Fixed or Flexible Exchange rates?

The case for fixed (or the case against flexible):
Overshooting Uncertainty and instability

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Monetary and fiscal policy under floating exchange rates

Monetary policy is strong
eg: reducing the rate of interest depreciates the exchange rate

Fiscal policy is weak

eg increasing government expenditure appreciates the exchange rate

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Monetary and fiscal policy under fixed exchange rates

Monetary policy is ineffective
the money supply must adjust to ensure that the exchange rate stays stays at its announced level

Fiscal policy is strong

a fiscal expansion generates an additional monetary expansion

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Exchange Rates: the importance of asset markets and speculation

Historically exchange rates were influenced by trade flows More recently exchange rates have become more influenced by interest rates and asset prices Growing importance of speculation and herding behaviour Expectations: not what you think but what others think
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Foreign exchange market turnover, 1988 2007 ($billions)

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The Bank of Englands Exchange Rate Forecast and the Outturn

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Keynes on Speculation
"Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not the faces which he himself finds the prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of viewIt is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree when we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees." Keynes, J. M. (1936) The General Theory of Employment, Interest and Money. p156.
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Summary
Exchange rates
Nominal, effective and real

Exchange rate regimes

Fixed, Flexible (or managed)

What determines exchange rates?

Trade flows Financial flows Speculation and Herding behaviour

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