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Exchange Rates

Exchange Rates. Issues. What drives foreign exchange (FX) rates? Exchange rate regimes Speculative attacks on currencies Financial crisis International Monetary Fund. Why did the Japanese Yen strengthen from 350 to about 100 from 1970 to 1995?.

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Exchange Rates

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  1. Exchange Rates

  2. Issues • What drives foreign exchange (FX) rates? • Exchange rate regimes • Speculative attacks on currencies • Financial crisis • International Monetary Fund

  3. Why did the Japanese Yen strengthen from 350 to about 100 from 1970 to 1995?

  4. Why has the U.S. Dollar fallen in value since 2001?

  5. What led to the 1997 South East Asian Currency Crisis?

  6. Exchange Rates (Feb 12, 2003)

  7. Law of One Price • Using the market exchange rate to price goods in a common currency, the Law of One Price asserts that similar goods cost the same independent of the country in which they are purchased. • Let P denote the domestic price of a basked of goods in units of domestic currency and P* denote the foreign price of a basket of goods in units of foreign currency, then the law of one price implies E = P*/P • An example: • Suppose the price of a TV in Japan is ¥10,000 and suppose the price of the same TV in the U.S is $90 • The law of one price implies that the exchange rate should equal ¥10,000/$90 = 111.11 ¥ / $

  8. Implication of the Law of One Price • Changes in exchange rates reflect relative inflation differentials across countries: Change in Exchange rate = Foreign inflation rate – Domestic inflation rate • If goods prices rise faster in the U.S relative to that in Japan, then the Yen should appreciate in value relative to the dollar: the Yen/Dollar exchange rate should decline, as one Dollar buys fewer Yen

  9. Nominal Exchange Rates and Inflation Differentials 45 degree line

  10. U.S. Consumer Price Index Why has the U.S. Dollar risen in value during the recent recession? Deflation during the recent recession caused the U.S. Dollar to rise in value

  11. Quarterly inflation and depreciation in Brazil, 1990–1997 Short Run Inflation effect on FX when inflation is high and variable High inflation in Brazil led to its currency falling in value . As inflation ended, the currency stabilized immediately.

  12. Strategy 1 Invest 1$ in the US risk-less asset. Payoff at year end: [1+Rt]$ Strategy 2 Convert 1 dollar to receive Et ¥ today. Invest in a Japanese risk-less asset. Payoff at year end Et[1+Rt*] ¥. Convert to dollars at the end of the year, receiving : Et [1+Rt*]/Et+1$. Interest Rates and Exchange Rates:Uncovered Exchange Rate Parity • Uncovered Exchange Rate Parity • 1+Rt = Et [1+Rt*]/Expected(Et+1) • or • [Expected(Et+1)-Et]/Et = Rt* - Rt • Expected change in the exchange rate is equal to the nominal interest rate differential. • A country with a high interest rate has an exchange rate that is expected to depreciate.

  13. Exchange Rates and Interest Rates 45 degree line Countries with high nominal interest rates have, typically, seen a fall in the value of their currency

  14. Real Exchange Rate • The real exchange rate, e, is the quantity of foreign goods that one can receive in exchange for one unit of the domestic good: e = E P/P* • P = domestic consumer price index (i.e., CPI) • The real exchange rate can be thought of as the inflation-adjusted nominal exchange rate • When the real exchange rate for the domestic currency increases • Domestic residents receive more foreign goods per unit of the domestic good • Domestic residents have an incentive to buy more foreign goods relative to domestic goods • Law of One Price implies the Real Exchange Rate e = 1

  15. Real Exchange RateExample • Suppose a hamburger costs $2 in the U.S. and costs ¥1100 in Japan • Current nominal exchange rate is 110 yen per dollar, what is the hamburger rate of exchange? • $2 buys one hamburger in the US • Or, $2 buys ¥220 • ¥220 buys .2 = 220/1100 hamburgers in Japan • You can exchange one U.S. hamburger for 0.20 hamburgers in Japan • Suppose the dollar appreciates to 140 Yen/USD. The hamburger rate of exchange is [140*2/1100]=0.25

  16. Real Exchange Rates and Per-capita Real Income United States Source: Obstfeld and Rogoff, Foundations of International Economics, MIT Press, 1996

  17. Non-traded Goodsand the Law of One Price • Goods are traded goods or non-traded goods • Most goods have a significant non-traded component • Value of local distribution • Value of service to sell the good • The law of one price holds only for traded goods E = P*_traded/P_traded • Non-traded goods are cheap in poor countries: • Lower demand for local inputs in fixed supply (land) • Cheap unskilled labor as primary input into production • Inflation can be high due to high inflation in non-traded goods

  18. Hong Kong’s Inflation in the Face of High Growth and a Fixed Exchange Rate

  19. China’s Inflation in the Face of High Growth and a Fixed Exchange Rate The New York Times, June 11, 2010 China Inflation Rises to a 19-Month High Consumer prices prices rose at their fastest rate in 19 months …

  20. Japan’s Real Exchange Rate Japanese real exchange rate rose from 1973 to 1995

  21. Purchasing Power Parity adjusted GDP PPP real GDP is adjusted for the cost of living (the real exchange rate)

  22. The Hamburger Standard (based on July, 2007 BigMac Prices) Big Mac Index • Begin with Big Mac price in local currency • Big Mac price in dollars is the Big Mac price in local currency converted into dollars at the market exchange rate • Implied PPP of the dollar is what the exchange rate would have to be for the Big Mac price in dollars to equal that of the U.S. • Actual dollar exchange rate is the current market exchange rate • Under/over valuation against the dollar, calculated as: • (PPP - Exchange Rate)         ---------------------------------- x 100Exchange Rate • The Big Mac theory of the exchange rate asserts that the value of the domestic currency should be expected to rise if it is undervalued per above, and to fall if overvalued. Does this make sense?

  23. Exchange Rates and Short-Run Fluctuations in the Real Interest Rate • A rise in real interest rates relative to that of other countries leads to an inflow of capital and a demand for financial assets. • The rise in demand for assets leads to a rise in the demand for that country’s currency, as foreign investors purchase domestic currency to purchase domestic assets. • The rise in the demand for currency leads to a short-run rise in its value; i.e., the (real) exchange rate.

  24. Macro News and Exchange Rates(Short Run Movements in Currency Values) Higher than expected inflation Higher than expected real GDP growth Higher than expected Federal Funds rate Law of one price effect will drive currency value down Better investment opportunities will attract foreign capital. • In developed countries this typically increases the real interest rate, and hence attracts foreign capital. • In emerging economies a rise in the short term rate, typically is due to a rise in expected inflation => currency will fall in value.

  25. Key Message • Economies with relative high real GDP growth will see the value of their currencies rise • High inflation leads to a fall in the value of the currency • High interest rates due to high real rates will lead to a rise in the value of the currency. • High interest rates due to high inflation will lead to a fall in the value of the currency

  26. Fixed Exchange Rates Country on a fixed exchange rate regime fixes its currency value relative to that of another country • Et is a constant, so Et /Et+1=1 • Consequently, Et[1+Rt*]/Et+1 = 1+Rt* • So, arbitrage ensures equality of nominal interest rates: Rt = Rt* • Main economic implication: A country that pursues a fixed exchange rate cannot pursue an independent monetary policy • Note that nominal interest rates must be the same, but with movements in the real exchange rate, inflation rates can differ (as we have already seen)

  27. Bretton-Woods: Fixed Exchange Rate Regime between Europe, Japan, and the US from 1947 to 1973 • Under Bretton-Woods, Europe/Japan was tied to the US Dollar and the Dollar was tied to gold • In the early 70s Nixon printed more currency, which landed up in European Central Banks • European Central Banks preferred to hold gold than dollars • Nixon refused to convert dollars to gold, which led to the collapse of Bretton-Woods

  28. The Euro • Following Bretton-Woods, Europe continue to fix exchange rates to the German mark • The Euro was introduced as a common currency amongst 16 European countries: unit of account as of Jan. 1, 1999, currency in circulation as of Jan. 1, 2002 • The Euro has the highest value of banknotes and currency in the world • Benefits: • Lower exchange rate volatility • Greater mobility of capital • Inherit credibility of the Euro • Costs: • None of the 16 countries have independent monetary policy • UK, Denmark and Sweden have not joined the Euro, partly to maintain an independent monetary policy

  29. Fixed Exchange Rates and Speculative Attacks • Historically, many countries pegged their currency to the U.S. Dollar as an attempt to commit to a prudent monetary policy • Speculative attacks are an outcome of inconsistency between the fiscal policy and the fixed rate of exchange. Why? • Uncontrolled government budget deficits and the necessity of monetization lead to a collapse of the fixed exchange rate regime • Speculative Attack: • Borrow the foreign currency • Exchange into Dollars at the official exchange rate • Invest in a domestic bond • Foreign Central Bank loses large amounts of dollar reserves and is forced to abandon the pegged currency value, similar to a bank run • Cash in some of the domestic bonds to pay the foreign debt • In the end, attempts at fixed exchange rate regimes led to repeated financial crises, hence they are not widely used today • The only source of long-term credibility is a prudent fiscal policy

  30. Examples of Speculative Attacks • UK Pound, 09/1992 • Mexican Peso, 12/94 • Thai Baht and Malaysian Ringgit, 08/97 (The South East Asian Currency Crises) • Brazilian Real, 02/99 • Turkey, Argentina, 2001

  31. Mexico Thailand Russia Argentina Financial Crisis in the 90’s

  32. Financial Crisis in South East Asia

  33. South-East Asian Crisis Return to capital is falling well before the crisis in 1997 Note return to capital is reciprocal of Incremental capital-output ratio

  34. Non-Performing Loans in South-East Asia (1997)Banks are in trouble Moreover, banks borrowed internationally in dollars and loaned in domestic currency, making the entire banking sector vulnerable to an exchange rate crises

  35. Non-Performing Loans in South-East Asia (1997) Non-performing loans if covered by the government are a huge liability.

  36. Mexican Currency Crises Central bank lost about $10B in defending the currency. The rise in the nominal and real interest rates squelched GDP growth. Current account reversal due to collapse in investment.

  37. The Brazilian government introduced a 3-year, $80 billion package of spending cuts and tax increases today in an effort to restore the country’s flagging credibility in world markets … • Investor’s reacted warily, and said the measures did not go as far as they hoped in making structural changes to permanently reduce Brazil’s burgeoning budget deficit, which is now running at 7% of GNP. • Jorge Mariscal, chief investment strategist for Latin America of Goldman Sachs, said, “It’s a step in the right direction, but if you think of Brazil climbing up a wall of disbelief, this is just a few inches up.”

  38. Key Message • Inconsistencies between the official exchange rate and the fiscal policy of the government lead to speculative attacks • Managed exchange rate regimes are susceptible to very dramatic changes in exchange rates

  39. International Monetary Fund • Created in 1944, initially 45 members, now 186 countries • Objective to stabilize the world financial system • International lender of last resort • Impose austerity measures as a condition of receiving loans: the Washington Consensus (10 points) • Reduce budget deficits • Encourage spending on education, health, and infrastructure • Broaden tax base and lower marginal tax rates • Market determined interest rates • Market determined exchange rates • Free trade • Encourage foreign direct investment • Privatize state enterprises • Deregulation • Secure property rights • Poor track record: focus now on second-generation reforms • Productivity-boosting reforms (efficiency) • Higher quality institutions

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