Open economy cont..

Inflation and Exchange rates: The

implications of macroeconomic
instability for emerging financial
markets

1
Outline
• Theory about inflation and loss of currency value
or exchange rate depreciation (or devaluation)
• Magnitude and impact of inflation in EFMs
• What causes inflation?
• How to control inflation: Fixing the exchange
rate?
• Impact of inflation on debt markets
• Impact of inflation on foreign exchange markets

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Preliminary
S (exchange rate): number of domestic currency per unit of
foreign currency. e.g. £0.5/$: 0.5 pounds for one dollar.
↑S: The value of £ ↓ against $ (depreciation): more pounds
needed for $1. e.g. from £0.5/$ to £0.7/$, £ depreciate by
0.2 against $.
Floating ex. rate : S is determined in the FOREX market, e.g.
£0.5/$ or £0.7/$ .
Fixed ex. rate: e.g. S=£0.5/$ fixed by Central Bank (CB)
intervention through buying and selling at fixed rate in
FOREX market
e.g. due to ↑ import, demand for £ ↓ in FOREX, there is a
pressure that the value of £ falls.
 CB needs to intervene by buying £ with foreign reserves in
FOREX causing to increase the demand for £ to maintain
the rate at £0.5/$.
 CB needs foreign reserves $ to sustain the fixed rate
system. 3
Loss of currency value: internal
and external factors
Inflation erodes internal (domestic) value of
currency
• Does £1 today have the same purchasing power,
e.g. one year later?
• What if less? (What if more?)
Devaluation (or depreciation) erodes external
(international) value of currency
• Does £1 today buy the same amount of $, e.g.
one year later?
• What if less? (What if more?)
Inflation and the exchange rate are closely related
through the Purchasing Power Parity (PPP)
theory.
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 Purchasing power parity (PPP)
X  S  ( PFC / PDC )
X: real exchange rate
S: nominal (spot) exchange rate (DC per unit of FC)
PFC : foreign country price level
PDC : domestic country price level

If purchasing power parity holds then the real exchange rate is constant,
i.e. x = constant, and S should move in line with the change in relative
prices. E.g. if PDC increases S should increase (devaluation) if PFC
increase S should decrease (appreciation) to maintain X constant.

If PPP holds the nominal exchange rate movement is equal to the inflation
rate differential between home and abroad. 5
Purchasing power parity (PPP)
PPP is based on the law of one price (LOP) which
states that the real price of an individual good
must be the same in all countries: if LOP then on
aggregate (across all goods) PPP should hold.

Under PPP, nominal exchange rate movements

should exactly offset any inflation differential
between the two countries (see Appendix I)

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Law of One Price (LOP)
• The law of one price simply says that the
same good in different competitive markets
must sell for the same price, when
transportation costs and barriers between
markets are not important.
– Why? Suppose the price of pizza at one restaurant is
$20, while the price of the same pizza at a similar
restaurant across the street is $40.
– What do you predict to happen?
– Many people would buy the $20 pizza, few would buy
$40.
PPP is LOP aggregated across the economy (applied to
aggregate price indices)
Purchasing Power Parity (PPP)
• PPP theory comes in 2 forms:
• Absolute PPP: purchasing power parity implies that
X=1, so that the Exchange rate equal price levels
across countries (e.g. US and EU).
S$/€ = PUS/PEU
• Relative PPP: Here X= constant, so that changes in
exchange rates equal changes in prices (inflation)
between two periods:
(S$/€,t - S$/€, t –1)/S$/€, t –1 = US, t - EU, t
where t = inflation rate from period t-1 to t
(see Appendix I)
There is a Macro-Monetary Theory linking
PPP with Exchange Rate which states that:

• To the degree that PPP holds and to the degree

that prices adjust to equate real money supply
with real money demand (i.e. equilibrium in the
money market), then we have the following
prediction: The exchange rate is determined in
the long run by prices, which are determined by
the relative supply of money across countries
and the relative real demand of money across
countries.
• See Krugman and Obstfeld, International
Economics, Ch. 16
Implications of the Macro-Monetary Theory
of Exchange Rate
Gives the following predictions about changes in:
1. Money supply: a permanent rise in the domestic
money supply
– causes a proportional increase in the domestic price level,
– causing a proportional depreciation in the domestic
currency (through PPP).
– same prediction as long run model without PPP
2. Interest rates: a rise in the domestic interest rate
– lowers domestic money demand,
– increasing the domestic price level,
– causing a proportional depreciation of the domestic
currency (through PPP).

15-10
Does PPP hold in practice?
Evidence supports PPP theory as long run (but not
short run) phenomenon.
• An empirical study supports long run PPP for the
period of 25 years with IFS data.
• Mean depreciation against US$ is correlated with
the mean inflation relative to US inflation.
• Relative PPP holds in the long run but not in the
short run, where exchange rate changes
respond to relative expected inflation rates (see
Appendix I)
• In short run, exchange rates volatility can occur
suddenly due to market sentiments and
expected future exchange rate (see Appendix II)
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Magnitude of inflation in EFMs
Annual inflation rate over 1970-95 (using annual
data of 98 emerging countries):
Mean 14.7% Median 11.0%
Standard Deviation (SD) 13.3%
• SD is similar to Mean: implying volatility.
• Median is below Mean: there are less low-
inflation countries than high-inflation ones.
It is empirically supported that higher mean and
volatility of inflation leads to slow economic
growth, especially when inflation is above 10%
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Inflation in EFMs (cont.)
Mean inflation in overlapping 10 year periods.
1970-79 13.3% 1976-85 15.3%
1980-89 15.7% 1986-95 15.4%
1970s: High inflation in both developing and
industrial countries due to oil price shocks
1980s and 1990s: Inflation continued to be high in
EFMs it came under control in industrial
countries due to tight monetary policies*
2000s: High inflation observed in e.g. Venezuela,
Ecuador, Uruguay, Turkey, Zimbabwe and
Lebanon, while it is controlled in e.g. Saudi
Arabia, Bahrain, Niger, Korea
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Impact of inflation on capital markets
• If inflation is high and uncertain, real interest
rates are low and uncertain so capital allocations
are distorted (investors are deterred).
• Uncertainty implies investors add risk premium
in rates of return thus requiring higher returns
– Risk premium raises the cost of capital and
depresses investment.
• Inflation increases capital gains taxation in real
terms*.
– Investors become reluctant to sell capital
assets which impedes the liquidity of capital
markets
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Causes of inflation: Cost push or demand pull?
Milton Friedman argued that inflation is a
monetary phenomenon – i.e. higher money
growth generates demand and causes inflation
Cost push inflation implies that an increase in
inputs such as oil or imported materials cause
higher rate of inflation
In general, both demand and cost push (supply)
factors are empirically supported worldwide.
Emerging countries’ specific features include:
• Monetising debt implying higher money growth.
Money growth is used as a means of paying for
government expenditure where taxation is
insufficient.
Such fiscal deficits imply money growth,
hence higher inflation in Emerging 15
markets.
Fiscal Deficits and Monetisation in EFM
Fiscal deficits are caused by excess of govt.
expenditure over revenue: In EFMs
• Underdeveloped taxation generates less
revenue than in developed economies*
• More subsidies to projects, regions and
groups as incentives raise deficit further
• SOEs requires expenditure (privatization
mitigates fiscal deficits)
Next question is how a budget deficit is
financed.
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Fiscal Deficits and Monetary Growth

Three options:
1. Use international reserves: but reserves are
limited, so used as a temporary solution
2. Borrow by issuing bonds: this is also limited,
besides risk-premium may be required from
borrowing abroad*
3. Monetize the deficit**: This is equivalent to
printing money to pay for the deficit.

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Sequence of monetization
Government sells bonds (e.g. £1m) to the Central Bank
(CB)
 CB pays £1m for the bonds by crediting the
government’s account
 Government writes checks £1m to pay for its purchases
 The seller collects £1m from the check
The money supply is effectively expanded by £1m.

Without increase in the quantity of goods,

monetizing the deficit leads to inflation.

If the PPP holds, the exchange rates increases (recall as

PDC increases S increase), i.e. depreciation. This leads to
a further inflation as import goods become more
expensive.
**
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Inflation is a tax which raises govt revenue
Formally,
Deficit = ∆M = (∆M/M) x M = πM
M: monetary base= currency plus bank reserves at CB
(∆M/M) is associated with the rate of inflation (π), which is
the tax rate
Deficit is monetised being expressed as change in
monetary base, ∆M, this in turn implies that tax is
imposed on monetary base, πM.
The inflation tax πM is what pays for the deficit.

By dividing through by the price level P, what will happen?

Deficit/P = ∆ (M/P) = (∆M/M) x M/P = π(M/P)
Real value of deficit falls as P increases: Inflation erodes
the real value of govt debt, so is a tax on private sector19
Unanticipated inflation tax:
Assume an investor requires 4% real interest rate and
inflation is expected to be 6%. 10% nominal return will
satisfy the investor.
Suppose there is a surprise inflation of 15%. A negative
real return of 5% (real value loss) is generated. The
amount equivalent to 5% is an unanticipated inflation
tax.

Monetization is costless and effective.

It causes less political protest than increasing taxes
Therefore, inflation is endemic in most EFMs
Example: Monetization of Brazilian deficits during
1970s led to high inflation, even before actual
monetization. Following PPP theory, exchange
rate depreciated.
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How to control inflation
• Inflation indexing is often used for price stability
– Government bonds, bank deposits, wages or pension
funds come with built-in adjustment to the rate of
inflation.
– However, it raises the government’s cost of wages,
interest, causing deficits worse in the next periods
• Indexing therefore often leads to further
inflation.
– For example, in Chile due to indexing inflation rose
from 20% in 1971 to 505% in 1974 with zero deficits
Evidence suggests that reducing the fiscal deficit
(e.g. through privatization) is the strong case for
lowering inflation 21
Fixing exchange rate to control
inflation
Inflation causes depreciation, but depreciation also
causes inflation*. Fixing the exchange rate
breaks this two-way link.
There are several ways to fix the exchange rate:
anchoring; currency board; pegging and
exchange rate band**
Many EFM governments seek to control inflation by
anchoring (fixing) the value of their currencies to
stronger currencies (e.g US$)
– Thus monetising fiscal deficit becomes theoretically
impossible since there is no local currency to print.
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• In a currency board system, local currency is
fully backed by reserves of a strong currency
(e.g. US$, DM or UK£)**: the two currencies are
perfect substitutes.
– local currency is only issued under limited
circumstances and only in the presence of reserves of
external currency
– It exerts a contractionary effect, hence countries
must be ready for severe recession***.
• Majority of EFM governments in 1990s adopted
‘pegging’ to the strong currency
– Currency is bought or sold to keep its value close to
some stated value
– It requires international reserves and fiscal policies

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• The crawling peg is a variant on the currency
peg that accommodates differences in inflation.
– Pegged exchange rates move slowly in response to
local inflation relative to inflation in the strong
currency

Advantage of pegging: imposes some discipline

and credibility in controlling inflation.
Disadvantages of pegging:
• Limits the scope of monetary policy
• Makes a country vulnerable to economic shocks
taking place in the strong currency country
• Prone to speculative attacks: if the currency is
perceived to be weak, speculators sell the
currency and force devaluation.

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• Trading band is a soft form of pegging
– A country declares a sustainable level of
exchange rate and defend a band of e.g. 10%
around it
– If the value of currency falls (rises) to the
bottom (above) of the band, the CB
intervenes by buying (selling) currency
– Russia and Indonesia adopted the band
system in mid 1990s.

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To summarise

• Floating exchange rates are volatile and

can increase inflation variability
• Many EFMs governments attempt to fix
their currency to a strong external
currency with a view to controlling
inflation.
• The system works only when fiscal deficits
are small, and country has international
reserves and capital controls to defend the
exchange rate
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Impact of inflation on debt markets

Expected inflation raises (i) nominal interest

rates, (ii) shorten the long maturities (iii)
reduces the available loans.

Real interest rate (r) is defined

1+ r = (1+ i )/(1+ π )
i = nominal interest rate
Π = rate of inflation

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From 1+ r = (1+ i )/(1+ π ), derive nominal
interest rate with the expected future inflation
πe, instead of actual inflation π.
1+ i = (1+r)(1+ πe) ≈ 1 + r + πe
and i = r + πe
If take account of inflation risk premium (m):
future inflation may be higher than expected.
1+ i = (1+r)(1+ πe)(1+m) ≈ 1 + r + πe +m
and i = r + πe + m
Expected inflation raises nominal interest
rates.

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Inflation risk premium:
• The magnitude of the risk premium m depends
on the variability of inflation.
• Given that inflation variability is highly correlated
with the level of inflation, the risk premium is
higher in EFMs than DE.
• e.g. UK during 1992-97, the risk premium was
0.7% p.a.
• Israel during 1984-92, the risk premium was
45.6% p.a.

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Expected inflation
ii) Expected inflation shortens the maximum term
for which investors lend at a fixed interest rate.
iii) Expected inflation de-motivates investors to
lend as inflation risk increases. This decrease
available loans.

Impact of expected inflation on debt market is to

contribute to financial repression.

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Impact of inflation on Foreign
Exchange Market (exchange rate)
The effect of inflation is to make exchange rates
substantially volatile.
– Investors incorporate their estimates of future
inflation into foreign exchange rates

The impact of inflation is to depress the forward

foreign exchange rates due to the presence of
inflation risk premium. (See more in detail
below)

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Do EFM banks benefit or lose from
inflation? (optional)
With higher rate of inflation, money is spent
more quickly *. This increases the number
of monetary transactions.

The quantity of money in transition from

one account to another grows: FLOAT.
The FLOAT is an interest-free source of
funding.
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A banking sector flush with interest –free
source of funds.
• Banks lend to the private sector with a
high inflation risk premium.
• Banks earn more risk-free returns by
investing government bonds.

EFM banks may benefit from inflation.

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Relative PPP (Appendix I)
Recall PPP: X = S (PFC/PDC)
Relative PPP is defined as
S1=S0(1+πFC)/(1+ π DC)
S0: spot exchange rate at the start of the period (a
number of FC/DC)
S1: spot exchange rate at the end of the period.
π : Inflation rate over the period.
Nominal exchange rate movements should exactly
offset any inflation differential between the two
countries.
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Fp/$=Sp/$(1+ πpe)(1+mp)/(1+ π$e) is close to
the relative PPP: S1=S0(1+πFC)/(1+ π DC)
except the presence of risk premium
The risk premium biases the forward rate away
from the expected future exchange rate
predicted by the relative PPP.
The higher the risk premium, the higher the
forward rate.
The value of pesos is depressed against $ in the
forward rates with the inflation risk premium.

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Covered Interest parity (Appendix II)
Spot exchange rates, forward exchange rates and
interest rates are linked by the interest rate
parity relation. Supposes weaker currency
‘pesos’ and stronger currency ‘US$’
Fp/$=Sp/$(1+ip)/(1+i$)
where S and F are the spot and forward exchange
rates (a number of pesos/$).
• The equation implies that forward exchange
rates are the consequence of interest rate
differentials in the two countries.

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Decompose the nominal interest rates into
real interest rates, future expected
inflation and inflation risk premium, then
Fp/$=Sp/$(1+ip)/(1+i$)
=Sp/$(1+rp)(1+ πpe)(1+mp)/(1+r$)(1+
π$e)
Inflation risk premium is attached only to
weaker currency
If we assume that real interest rates for
both countries are the same, then
Fp/$=Sp/$(1+ πpe)(1+mp)/(1+ π$e)
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