Exchange Rate Dynamics: Synthesized

1. Exchange Rate Dynamics:Synthesized Dr. J. D. Han King’s College U.W. O.

2. 1.What causes exchange rates to fluctuate?2. How do you predict exchange rates (and their changes)?3. What is the ‘correct exchange rate’?4.What are the benefits of having exchange rates as opposed to not having ones (using the big country’s currency)? (Key Question)

3. 1)European QuotationDomestic currency price of a unit of Foreign Currency2)American quotation One unit of domestic currency (=USD) fetches so many Foreign CurrenciesFor example) US FOREX quotation USD/CAD =1.4234 at 3:00 pm, January 25, 2016 It means that 1 US dollar fetches 1.4234 Canadian dollars.Note: here “/” in the American quotation is not division sign, but conversion sign between a pair of currencies: from left(base currency=1) to right (counter currency= how many?).Note: American FOREX rate is our (Canadian) FOREX rate in European quotation. “To get one U.S. dollar, Canadians need 1.4234 Canadian dollars; 1.4234 CAN/ 1 USD = 1.4234 and here “/” is division sign. For an example, refer to one of our practice question. 1. Definition of Foreign Exchange Rates(FOREX or FX rates):

4. * Bid/Ask Spread in FOREX rate You buy FOREX at (Dealers) Ask Rate; and You sell FOREX at (Dealer’s) Bid Rate. Your selling Rate < Your buying Rate Thus Bid rate < Ask Price.

5. Still, another way of looking at the FOREX Rates = Relative Value of Foreign Currency to Domestic Currency For instance, the representative FOREX rate for Canada is 1.4234 for the U.S. dollar (January 25, 2016). FOREX rate “1.4234” = Value of US $1/ Value of Canadian $1 = US $1 is 1.4234 times as valuable as Cadian $1

6. Arbitrage and Triangle Exchange Rates -If the FOREX market is efficient, Arbitrage will ensure that Triangle Exchange Rates works: A:B = x; B: C = y, the A:C = x times y. -The Efficient Market (hypothesis) means no information delay and no barriers to Arbitrage. • EMH may not work in the short-run A room for Triangle Arbitrage in FOREX market(=profitable transactions among three currencies for the failure of the triangle exchange rate): eg) ‘Day Trading’ • EMH does not work even for an extended short-run if there is persistent structural rigidity or distortion: eg) (unsustainable) Peg between 2 currencies only.

7. Example: HK Dollars between U.S. Dollar and Chinese Yuan • http://www.wsj.com/articles/hong-kong-dollar-drops-sharply-on-china-fears-1452791598 • Here is the Excel Table for FOREX rates among HKD, USD, and CNY on December 1, 2015, and then use the Excel table next. 1)Find the Arbitrage for a FOREX Dealer 2)Which FOREX rate(s) would change in which direction (Up or Down)? –FOREX Expectations 3)When would the FOREX Arbitrage stop? – What is the Equilibrium FOREX rate between U.S. dollar and HK dollar?

8. *Post Graduate Studies to be a FOREX dealer? University of Reading, UK may be one to consider http://www.icmacentre.ac.uk/about-us/dealing-rooms-and-facilities The International Capital Market Association center at U of Reading has the largest non-investment bank dealing room in the world.

9. 2. What is the correct FOREX rate?: Three Major Theories of (long-run) equilibrium FOREX rate determination Is there an equilibrium FOREX rate which correctly reflect the economy-wide and market fundamentals?The actual FOREX rate may differ from this equilibrium FOREX rate for a short-term, but eventually the actual FOREX rate should gravitate to the equilibrium value. There are three theories which link the economic fundamental to a specific equilibrium exchange rate • International Trade SR-> X-M up causes FOREX down LR->Purchasing Power Parity Theory relative P up and FOREX up) International Investment/Capital Flows Interest Parity Theorem MS up causes Interest Rate down ->FOREX up • Real Factor Analysis ->Productivity up causes FOREX down

10. 3. First Theory: International Trade’s perspective 1) Short-run Changes in Disequilibrium -just D S or D of FOREX leads to D E2) Long-run Equilibrium (Purchasing Power Parity Theory)% D E = %D P - % D Pf

11. 1) Short-run Disequilibrium -Suppose that there occurs a sudden decrease in International Demand for major Domestic Goods, From the viewpoint of Trade, trade surplus X-M <0 means an Excess Demand of FOREX. -FOREX rate as the price of FOREX will bear the upward pressure. -Under the Flexible FOREX rate system, the FOREX rate will rise. <-X-M may rise, if not fully, in the short-run due to ‘Cushioning Effect’ if Marshall Lerner holds. <-The cushioning effect will wear out in the Long-run as J curve and Pass-through applies here. -Under the Fixed FOREX system, the government has to defuse/remove the upward pressure on FOREX rate by creating Supply for FOREX. It has to sell FOREX for Domestic Currency. Money Supply (among the private sector) will gradually fall, and therefore the Price Level will gradually fall as well (deflation). This makes Exports cheaper. In the long-run, X-M will rise.

12. Recall that Recall, from Chapter 13, that in the ‘Above-the-line BP’, - Supply of FOREX comes from Exports(X) and Capital Inflows(CI): S(X, CI) - Demand of FOREX comes from Imports(M) and Capital Outflows(CO): D(M, CO) -S-D is ‘spontaneous (above-the-line) Balance of Payment. S and D will determine the Price of FOREX or FOREX Rates (S* , e, or E*) S-D >0, then Excess Supply of Foreign Currency pushes FOREX rate DOWN; S-D <0, then Excess Demand for FOREX pushes its price UP.

13. Recall Price of FOREX or E S of FOREX comes from (X or/and Capital Inflows): S(X, CI) D of FOREX comes from (M or/and Capital Outflows): D(M, CO) S or D for FOREX

14. If a country(Canada) gets a decreased World Demand for its major outputs(crude oil): S’ (X’, CI) S (X, CI) E’ E D (M, CO) If World demand for this country’s exports X falls; Less exports means less Supply of FOREX(S to S’), FOREX rate or E rises to E’. -> Domestic Currency depreciates and Foreign Currency appreciates

15. Path from one Equilibrium to another Eq. in FOREX market:Short-Run Over-Reacting/Turbulences E’ E E S or D of FOREX Time The circled part is Over-shooting: in the transitional period, FOREX rate deviates from the L-R equilibrium rate E’. Here, overshooting happens due to different adjustment speeds in the FX market Price (agile) and the FOREX Quantity ( initially no change in X or M and thus no change in S or D of FOREX, as is suggested by the J Curve argument, and then slow moving later ). This means no horizontal movement at first.

16. *If an exogenous change in Demand for Domestic Goods is not repeated, the process back to the Long-run starts with compensating variations:

17. **Question • What if there occurs sustained Technical Innovations from the fundamentals of the domestic economy? What will happen to X, and S over time? Would you please illustrate them by using the same graph as in Slide #14?

18. 2) Purchasing Power Parity says • ‘In the Long-RunFree Market equilibrium’, FOREX Rate is determined in such a way that a unit of a certain currency should, through the conversion using the exchange rate, fetch the same amount of goods in the foreign country through conversion as it would in the domestic countries; -> “A currency should have the same purchasing power everywhere in the world” = “A merchandise should have the same price, denominated in one common currency, everywhere in the world”. ->“ Law of One Price for One Good” -> The conversion ratio between the common currency price and the domestic/local currency price is L-R Equilibrium local FOREX rate.

19. Two Versions of PPP • Absolute PPP “Level” Domestic Price in Domestic Currency: P Foreign Price in foreign currency): Pf Foreign Price in domestic currency): E Pf Law of One price for One Good: P = E Pf E Pf / P = 1 E = P/ Pf at L-R eq. • Relative PPP “Percentage Changes” Δ%P = Δ% E + Δ%Pf Δ% E = Δ%P - Δ%Pf Δ% E = π – πf in the L-R eq.

20. What does it mean by ‘Long-Run’?: When and where does Purchasing Power Parity hold? i)Long-Run, and ii)with freeTrade Flows ->Works if the merchandise/good is tradable ->Works best when the merchandise/good is freely tradable: Even if its price of a tradable good is temporarily higher in a country in another, free trade will eventually eliminate the difference in the long-run.

21. According to the above, FOREX rates changes • In response to Changes in the Relative Price Level of Domestic to Foreign Countries. -> E rises against the country who price level goes up. • In response to Inflation Differential between Domestic and Foreign Countries. -> E goes up for the country with a higher rate of inflation -> A Higher inflation country experiences Depreciation of its own Currency.

22. Visual Image of PPP in time-series data If PPP holds, then in the data we should see: • If P/ Pf looks like this, time E must move this way if PPP holds. E Pf /P = 1

23. * What determines the value of a currency in a country? Formally by using Quantity Equation of Exchange, we can show that Price Level is determined by Three Factors:Money Supply, Real National Income, and Velocity of Circulation, M V = P y P = (M) (1/y ) (V)

24. Let’s examine it through Monetarists’ Theory: Quantity Equation of Exchange tells us that in the long-run money supply determines the price level. Monetarists Theory Quanty Equation of Exchange says M V = P yP = M 1/y V = MV /y Again Monetarists theory says Mf Vf = Pf yfPf = Mf 1/yf Vf = Mf Vf /yf PPP E = P/Pf = (M V/y V) / (Mf Vf /yf) =( M/ Mf ) (yf/y ) (V/Vf) -Thus FOREX rate E is related to Relative Ratio ofMoney Supplies(+); to an Inverse of Economic Growth(-); and to Velocity of Money(+) -“Relatively Expansionary Monetary Policy, a relatively Weak Economic/Income Growth, a relatively High Velocity of Money leads to a High E or a weak value of Domestic Currency”.

25. Combining Purchasing Power Parityof % DE= % D P - % DPfwith The Monetarists’ Theory of Inflation of %D P = %D M - %D y + %D V for domestic country and% DPf = %D Mf - %D yf+ %D Vf for foreign country,we get %D E = (%D M- % DMf ) - (%D y - %D yf ) + (% DV -%D V For a relative PPP, it means: • A percentage change in Exchange rates is positively related the differences in Money Creation Speed, the inverse of Economic Growth Rates, and velocities. • The speedier Money creation, the lower economic growth and the higher the velocity of money, the higher of the percentage of depreciation of domestic currency. *Questions: Why has Japan experienced a falling E (=stronger Yen) in the 1970-80s? Explain it with the above equation to a certain, if not all, extent.

26. *Empirical Evidence: “Big Mac Index”(click here) FOREX rates calculated on the basis of the local currency prices of a big mac across countries PPP: A Big Mac Meal might cost the same after the currency conversion whatever country it might be sold in and in whatever currency it might be sold in. Reality: The deviation of actual FOREX rate and the PPP-based FOREX rate reflects Over- or Under-valuation of a currency.

27. *Numerical Example of PPP (absolute form)

28. Solution:

29. ** Not-So-Counter Example: Non-tradable goods In contrast, when it comes to non-tradable/local goods, their prices may not be the same in two different countries unless their major production factors are completely mobile between the two countries. eg) A hair cut costs U.S. $28 in New York. An equally good hair cost costs 76 Yuan in Beijing. https://www.expatistan.com/price/men-haircut/beijing http://www.angieslist.com/articles/how-much-does-haircut-cost.htm • The PPP might dictate the FOREX rate of 1Yuan for U.S.___. • In fact, the actual FOREX rate is ____ on Jan. 18, 2016. eg) Three bedroom house osts so much on average in Japan while the comparable one costs a lot less on average in Canada. as we cannot trade Land, and construction workers between Japan and Canada

30. *** Empirical Evidence revisited: Does PPP fully explain exchange rate fluctuations? • In all cases, PPP should works for Tradable Goods only: E PTf/PT =1 • The PPP may not work for E Pf/P using the prices of all goods, Tradables and Non-tradables. • How to reconcile the above two conflicting evidence? • This leads us to the next discussion: There must be something else than Price Level, Money or Nominal Factor that affect FOREX rates.

31. 4. Second Theory: Real Factors • What are the real factors that affect FOREX rates? -Supply of and demand for currencies -Supply of and demand for domestic versus foreign goods -Productivities of Tradable Goods due to Technical Innovations -Price competitiveness of Exports Industry

32. 2) Real ROREX rate: E Pf /P = q • The above q is called “Real Exchange Rate”, or • “Relative Price Level” , or • (of the Foreign Country to the Domestic Country) • “ (Inverse of) International Price

33. 3) When does ‘q’ meander in the long –run? • ‘q’ may deviate from 1 in the short-run even if PPP holds – Disequilibrium/Dynamic/Compensating Variations/Overshooting ; “Trivial issues” • ‘q’ may meander in the long-run if there is some structural/endogenous/fundamental/intrinsic/real force at a constant work in the economy beyond what the Purchasing Power Parity suggests.

34. Illustration of a change in E and q • Innovation in Tradable Goods Industry only:  Domestic Tradable goods have price competitiveness edge over Foreign-produced Tradable goods.  International Substitution from foreign Tradable goods to domestic tradable goods  Trade surplus for domestic country  Excess Demand for domestic currency (Excess Supply of foreign currency)  E falls.  q falls even if overall price ratio Pf/P is stable.

35. Real Factors, Productivity, Industrial Duality Model: Two different industrial sectors have varying productivity. One has a high productivity progress and the other has a low one. • Suppose that in one country, there are two sectors of industry: Tradable and Non-Tradable industries. • The overall price level is the weighted average of the prices of the two sectors: P = 0.5 PT + 0.5 PNT (in simpliest form) • Technical Innovation happens only to Tradable industry - Due to Technical Innovations, domestic Tradable goods become cheaper. Due to Technical Backwardness, domestic Non-tradable goods become more expensive: -> The Overall Price Level (P) stays relatively stable while Tradable Good Price(PT ) falls significantly. - International Arbitrage of Goods pushes Demand for domestically-produced Tradable goods. This leads to an increased demand for Yen. - In Japan, its FORE or E falls, and the domestic currency appreciates.

36. 4)Empirical Studies of PPP #2: Technical Innovations and Japanese Foreign Exchange Rates (1) Facts: FOREX Changes in Japan of the 1970-80s : Nominal Factors of PPP, versus Real Factors -Japanese Yen became strong: for the Japanese, FOREX rate fell sharply more than PPP can explain. Some other force must be at work. - E fell more than P/ Pf fell, and thus ‘q’ was not constant but fell as well.

37. (2) Analysis of Japanese FOREX rates of 70s to 80s: (i) Nominal Factor - The appreciation of the Japanese Yen, or the falling E or S can be only partially explained by P/Pf as PPP suggests. • It is true that the Japanese price level was relatively stable compared to the U.S. price level because Japanese monetary policy was relatively conservative compared to the U.S. monetary policy. Thus P/Pf fells. - P/Pf did not fall so much as to justify PPP.

38. Trends of P/Pf and actual E in Japan: What can explain the difference between the two? P/Pf (PPP predicted E) actual E ‘76 ‘87

39. (ii) There is a large part of the fallingE, which cannot be explained by PPP:(iii) These are the real factors that change ‘q’.q = E /(P/ Pf ) ‘meandered’ in the long-run as E fell more than P/ Pf fell.(iv) what was pulling down E(value of USD in Japanese currency)?

40. (v)Technical Innovation in Tradable good industry leads to a higher value of Yen: • Japanese Tradable goods become more internationally competitive • Trade depends on the relative prices of tradable goods between domestic and foreign country PT/ PT f, not the overall relative prices P/Pf. • International Substitution of demand to Japanese domestic tradable goods leads to -> Trade surplus for Japan; -> Excess Demand for Japanese currency (Excess Supply of foreign currency); and thus -> Nominal FOREX rate fell in Japan beyond what PPP dictated. -Note here that it is trade (of tradable goods) that affects E.

41. (vi) Real FX rate or q fells: • E fell more than P / Pf . • Thus, q = E / (P/ P f ) fell as well. -> This falling real exchange rate reflects the underlying international competitiveness; This is called ‘Real Appreciation of Domestic Currency”

42. (vii) PPP worked for Tradable Goods Prices only, not for the Overall Price Level: • Inside E PTf / PT = 1 for Tradable Goods, and PT fell sharply, PTf / PT rose sharply, and as a result E fell sharply. • Outside it looks that the overall price ratio P f / P did not change very much, and the sharply falling E made E P f / P << 1 for overall price level. Here, q(<<1) is a reflection of an increasing competitiveness of Japanese export goods: Even if the Japanese Yen becomes very expensive, its exports are still strong and increasing. Usually, the external value of domestic currency goes up; its exports become more expensive; and its exports fall. Here, exports rise despite the currency’s strong external value.

43. Summary of Japanese E of the 1970s to 80s: 1) Changes in Nominal Exchange Rates or E %D E can be only partially explained by (% DP- % DPf ) or (%D M- % DMf)- (%Dy - %D yf) 2) For the difference between %D E and (% DP- % DPf ), Real Exchange Rates or q changes/’meanders’. • This difference can be explained by changes in real exchange rates: • For Tradable goods, E PT f/ PT = 1 in L. R. without any failure • endogenous Technical Innovation or continuous Productivity Increase lowers PT and raise PNT (thus overall P does not change much). • Lower PT ; X Up, E Down - “Despite Yen’s appreciation, X UP, UP and UP”; this contrasts with the usual case where domestic currency appreciation leads to X down. • And this is repeated over and over as Technical Innovation may be endogenous.

44. ***Empirical Studies of PPP #3: U.S.-Canada Productivity Gap and FOREX Rates • Period 1: Between 1975-1990s -E continued to rise (Value of Canadian dollars kept falling) -Nominal factors: Money supply increased faster in Canada than in U.S. -Real factors: Canadian productivity in tradable good industry lagged behind the U.S. counterpart. • Period 2: Between 2001-2003 • E started falling • Mainly, disequilibrium capital flows from U.S. • May also reflect some improving real factors such as Productivity in the Canadian tradable good industry. • Period 3: Between 2003-2014 • E sharply fell • Mainly, disequilibrium/exogenous increase in U.S. demand for Canadian X(of oil) • A rapidly rising CAN value severely affected the exports of Canadian manufacturing sector. • Canadian manufacturing good industry with only a high Productivity survived. • Period 4: Between 2014- Present • E sharply rises with over-shooting • Due to disequilibrium/exogenous decrease in U.S. demand for Canadian X(of oil) • A low CAN value may continue to help/nurture the surviving Canadian manufacturing sector with more profits to be invested for a further productivity growth.

45. (1)Facts • Between 1975-1990s -E continued to rise (against Canadian dollars) -Nominal factors: Money supply increased faster in Canada than in U.S. -Real factors: Canadian productivity lagged behind the U.S. productivity • Between 2001-2003 • e continues to fall • capital flows from U.S. : A higher interest rate in Canada than in the U.S. • may reflect improving real factors

46. US-Canadian FOREX Rates during Period 1 of 1970s to 2001; Canadian currency had real depreciation in the 1970s-80s. In reality, PPP did not exactly hold. If PPP had been correct, E E q q

47. (2) Analysis: Explaining the change in ‘q’ during Period 1 • Absolute Version of PPP: It is true that the Canadian monetary policy was more liberal than the U.S. monetary policy up to the 1990s: This explains the general rise of P and E. • Theoretically, according to PPP, E and PCanada /P us or P/Pf should have gone up proportionally. Yet, E went up faster than P/Pf • Relative Version of PPP: Canada- inflation differentials between U.S. and Canada could not fully explain the changes in the nominal FX. • This suggests that a substantial part of FOREX fluctuations between Canada and US is caused by ‘real factors’. • What have caused the real FOREX rate to change, or deviate from unit(one)?

48. What was the real factor against Canada’s currency value in Period 1? • Relatively lower productivity, and • Low Speed of Technical innovation -> Demand for Canadian goods fell over time; Less Demand for CAN. -> FOREX rate rose more than PPP suggested. -> In Canada, ‘q’ went up as part of ‘the equilibrating/corrective forces’, which tried to increase the exports and thus to restore the equilibrium.-> This was the real depreciation of the Canadian currency.

49. What was the real factor against Canada’s currency value in Periods 2 and 3? • Suddenly Increased Demand for Canadian Oil and Resources, and • Investment and Innovation in Canadian energy industry -> Demand for Canadian goods rose over time; More Demand for CAN. -> FOREX rate fell more than PPP suggested. -> In Canada, ‘q’ went down as the real depreciation of the Canadian currency reflected the competitiveness of Canadian energy industry-> This made too dear(expensive) the exports of the Canadian manufacturing industry in light of their steadily improving quality. -> In other words, Canadian energy industry became competitive Tradable industry, and Canadian manufacturing industry became non-competitive tradable industry -> Alberta rose and Ontario sinked.

50. *“How about eliminating FOREX rates between the two countries that affect the Canadian Economy?” • The common currency means no floating FOREX rates. • The same currency means the same monetary policies and the same rate of inflation for the two country (as PPP says).