Chapter 18

1. Chapter 18 Exchange Rate Determination I: Prices and the Real Exchange Rate

2. Chapter 19 Exchange Rate Determination II: Nominal Exchange Rates and Currency Crises

3. Exchange Rate Crises & Hong Kong • HK Dollars, as currency, is printed by money center banks Standard Chartered, HSBC, and, now, Bank of China. • During the 1970’s, the banks faced little limitation on money creation. In July of 1982, the HK dollar was depreciating at a rate of 7.7% per year. • In 1983, Britain and the People’s Republic were engaged in talks about the terms on which Hong Kong would be returned to China. Responding to news from these talks, currency traders unloaded there HK dollar positions. • As a response, the Hong Kong dollar depreciated rapidly. By September 1983, the HK dollar was depreciating at a rate of 65% per year.

4. Policy Response: Currency Board • The government announced that Hong Kong would switch to a currency board system. • A currency board is an arrangement whereby a country can only issue domestic currency if it backed up by central bank holdings of a specific foreign currency. • To give permission to a money center bank to print 7.8 HK dollars, the government would have to acquire US$1. • This has been the monetary policy of Hong Kong ever since.

5. Objectives • Define the real exchange rate and purchasing power parity. • Explain why inflation in Hong Kong differs from the US. • Demonstrate that the capital account is the negative of the current account. • Use interest differentials to price exchange rate futures. • Define uncovered interest parity and explain exchange rate fluctuations.

6. Bilateral Exchange Rate • Bilateral Exchange Rate is the exchange rate of one countries’ currency vs. another’s. • Exchange rates can be written in two ways which are inverses of each other. • St Definition 1 The price of foreign currency in terms of domestic currency (the # of domestic currency units needed to purchase 1 unit of foreign currency) • St = HK$7.8 per 1 US$ • Zt Definition 2 The price of domestic currency in terms of foreign currency (the # of foreign currency units needed to purchase 1 unit of domestic currency). • Zt = US$.128 per 1 HK$

7. Terminology • Typically, a bilateral exchange rate is reported as the # of units of the currency with the lower value per unit of the currency of the higher value. • Examples • HK$7.8 per 1 US$ • ¥120.14 per 1 US$ • US1.53 per 1 ₤ • An appreciation of a currency is an increase in the value of a currency. • A depreciation is a decrease in value. • A depreciation would increase the exchange rate, St, by Definition 1. • Ex. A movement of HK$7.8 to HK$10 per US is a depreciation. • A depreciation would decrease the exchange rate, Zt, by Definition 2. • Ex. A movement of US$.127 to US$.1 would be a depreciation of HK dollar.

8. Exchange Rate Regimes • HK has a fixed bilateral exchange rate with the US. • HK Exchange Fund (the currency board operated by HKMA) stands ready to buy or sell unlimited amounts of HK$ at a fixed exchange rate HK$7.8:US$1. This policy fixes the market rate at this level. • No one will ever pay more for HK dollars than it costs to buy from the exchange fund. • No one will ever sell HK dollars for less than they could get from the exchange fund.

9. Most large, wealthy economies conduct monetary policy through open market operations and allow the exchange rate to be determined on a minute-by-minute basis in financial markets. These exchange rates are said to float. (Example: Canada, UK, USA, Euroland) Many smaller economies allow the exchange rates to float but occasionally buy or sell foreign currency to directly affect the exchange rate. Such exchange rates are called managed floats. (These are sometimes called dirty floats). Floating Exchange Rates

10. Effective Exchange Rates • Effective Exchange Rate is a weighted average of a country’s bilateral exchange rates relative to some base year. • The weight on the exchange rate with country j is the share of trade with country j. • Effective exchange rates are usually quoted in the form of Definition 2.

11. HK Effective Exchange Rate

12. A foreigner compares the price of their foreign goods with the price of our domestic goods. To buy 1 foreign good, he must pay PF foreign currency units where PF≡ Foreign price level. To buy 1 domestic good, he must pay P domestic currency units, but he must pay Z× P foreign currency units. Real exchange rates are the price of domestic goods relative to the price of foreign goods. In other words, real exchange rates are the # of foreign goods that must be given up to obtain 1 domestic good. Real exchange rate can be calculated on a bilateral basis or an index basis. Real Exchange Rate

13. HK: US Real Exchange Rate

14. Law of One Price (LoOP) • Arbitrage should insure that identical goods should sell for the same price in different markets. This is called the Law of One Price. • For easily transportable, standardized goods sold in highly competitive markets (such as gold), LoOP holds. • For most goods, that consumers buy and sell, LoOP does not hold across countries. • Example: A Big Mac cost PF = US$2.65 in New York. A Big Mac cost P = HK$11.20 in HK. Given an exchange rate Z = .128, the cost of a HK Big Mac in US$ is Z∙P = US$1.44.

15. Big Macs Around the World

16. Why doesn’t LoOP hold for most goods? • Transport Costs – Large costs of moving goods may keep arbitrage from working. • Non-traded Goods – Some goods, such as real estate, have near infinite transport prices. • Pricing-to-Market – Firms with market power may find it optimizing to charge different prices in different markets. • Tariffs & Taxes – Imported goods may face additional taxes

17. Purchasing Power Parity (PPP) • PPP theory says LoOP applies to all markets. • Define relative prices of foreign goods • Absolute PPP says that the real exchange rate is always E = 1 or Z = XP • Relative PPP says that the growth rate of the real exchange rate is zero

18. Does PPP Hold? • Does Absolute or Relative PPP hold? • In short run, NO. Exchange rates are much more volatile than inflation rates. • In long run for countries with similar levels of development, relative PPP holds. • Example. Twenty year averages for OECD countries. • Rapidly developing countries typically see long-term real exchange rate appreciations • Hong Kong has had much faster inflation than the US over the life of the exchange rate peg.

19. Long Run

20. Rich Countries are more expensive than poor countries. • Many types of services have unchanging technology (like haircuts) or inherently limited supply (like real estate). • Most technology advances occur in traded goods sector. • As a country grows wealthier and more technologically advanced, the countries residents will pay more for real estate or services. • If traded goods have roughly equal prices across countries, but a countries non-traded goods start to become more expensive as it develops, the overall relative price of its goods will increase.

21. XP vs. Exchange Rate

22. Converting GDP into Equivalent Units • GDP in different countries are measured in local currency units. To compare, we convert to common currency units, US dollars. • Two methods • Exchange Rate Conversion – Multiply by Z • PPP Conversion – Multiply by XP

23. Why do poor countries appear richer when PPP conversion is used. • Exchange rate conversion calculates the # of US dollars needed to buy the number of domestic currency units needed to buy the country’s GDP. • PPP conversion values the domestic goods at US dollar prices. • Since non-traded goods are cheap in poor countries (when calculated by exchange rate conversion), valuing them at US prices increases their relative value. • For poor countries, their goods are cheaper than their currency, because non-traded goods are relatively cheap.

24. Current Account • The current account is, conceptually, the amount of income earned overseas less the amount of income earned by foreigners from the domestic economies.

25. Capital & Financial Account • The capital account (more accurately the capital & financial account) records capital inflows into the country. The account includes the financial account, the capital account, and change in reserve assets.

26. Hong Kong Current Account & Capital Account 2001 • Hong Kong had a 96 billion dollar current account surplus in 2001. • Hong Kong had a 97 billion dollar capital & financial account deficit. • The difference is statistical or measurement error.

27. Net Savings = Net Exports • Capital Account = I – S • Current Account = EX – IM • S = Y – C – G • Y = C + I + G + EX – IM → Y – C – G = I + EX-IM S = I + EX – IM → S – I = EX - IM • Net Capital Outflows = Goods Outflows • When an economy provides more goods to the world economy than it receives in return it will have extra foreign funds. These will be used to acquire foreign assets.

28. Real Exchange Rate and Net Exports • An increase in the real exchange rate has counter-veiling effects on net exports. • The value/price of a given amount of export goods will rise relative to a given amount of import goods when domestic goods increase in relative price. • An economy exports 100 apples at price of $1 each and imports 100 oranges at price of $1. Net exports are zero. If price of apples goes to $2, then net exports will increase to 100. • When relative price of domestic goods increases, the domestic economy will export fewer goods and import more goods. • In very short run, the first effect will dominate. • In medium to long run, the second effect tends to dominate.

29. J-Curve: The dynamics of an exchange rate depreciation NX E time x

30. Equilibrium Real Exchange Rates E S-I E* NX

31. Real Exchange Rate Determination • The real exchange rate, in the medium run, is determined by the position of savings and investment. • Shortfalls in domestic savings result in high real exchange rates and low net exports. • High relative demand for domestic goods for reasons such as tariffs will result in high real exchange rates

32. Budget Deficit/Productivity Boom S-I’ E S-I E** NX

33. Tariffs E S-I E** NX’ E* NX

34. Nominal Exchange Rate • Quantities of funds exchanged in foreign currency markets far exceed the currency needed for goods trade. Most currency trading is for asset trading or portfolio holding purposes. • Exchange rates are more volatile than goods prices and quantities. • In the short run, currencies behave like financial assets with volatility like financial markets.

35. Two basic markets for foreign exchange. Spot Markets – In spot markets, traders agree on terms/rates for currency trades with immediate delivery (within 48 hours). Forward Markets – In forward markets, traders agree on terms/rates for currency trades at some specified future date (usually 30, 90 or 180 days) Define St as the (Definition 1) exchange rate for currency for immediate trade. Define Ftas the exchange rate for delivery at a date on period in the future. Spot vs. Forward Markets

36. Covered Interest Parity • An investor has $1 for saving. Consider two investment strategies: • Invest $1 in a domestic bond with interest rate 1+i. • Use $1 to buy 1/St foreign dollars in spot markets. Invest 1/Stin foreign bonds at interest rate 1+i*. Agree on a forward contract to sell (1+i*)/St foreign currency for domestic dollars. Arbitrage implies that the two strategies will have the same pay-off. • This implies a forward price.

37. We can price long term futures using long-term interest rates. Define as the yield on a domestic bond that matures in T periods and as the yield on a similar foreign bond. Example 1:The three month interest yield for HK is 1.18%. In Thailand, the 3 month yield is 1.5%. The current Baht-HK$ rate is 0.18263839. This implies a 3 month forward rate of Example 2: The 10 year interest yield in Thailand is 3.3352 while the 10 year yield in HK is 4.310. This implies a Forward Rates

38. Uncovered Interest Parity • Forward prices should equal the market’s expectation of future spot rate. • If traders think the price of foreign currency > Ft, then why agree to deliver it at that price. If traders think the price of foreign currency < Ft, why agree to pay that price. • This should imply a term for exchange rate parity

39. Implications • We observe that different countries have different interest rates. • UIRP suggests that countries with high interest rates are expected to have their currency depreciate. • One reason not to buy bonds in a high interest economy is that you expect the value of the currency to drop. • Interest rate differentials, by this logic, are the market’s prediction of future exchange rate growth:

40. Exchange Rate Determination • UIRP Creates a financial market theory of exchange rate determination • Graph expected returns from investing in domestic and foreign currency. • Exchange Rate equalizes the two returns.

41. Equilibrium Exchange Rate 1+i St S* Return

42. Exchange Rate Determination • Implications: • Given future exchange rates, a rise in domestic interest rates or a fall in interest rates will lead to an appreciation. • A temporary increase in domestic interest rates will lead to appreciation. • A rise in the future value of the currency will increase the current value. • Current exchange rate depends on whole path of future interest rates.

43. Rise in Domestic Interest Rates 1+i’ 1+i St S* S** Return

44. If domestic bond yields are higher than foreign yields, we should expect a depreciation of domestic currency over the life of bond. A temporary increase in domestic yields leads to a domestic currency appreciation. Is this a contradiction? No, the domestic currency will immediately appreciate and subsequently depreciate back to the original position. Contradiction and Dynamics

45. Time Path: Temporary Rise in Domestic Interest Rates S i X time

46. Rise in Foreign Interest Rates or Future Depreciation 1+i St S*** S* Return

47. Time Path: Temporary Rise in Foreign Interest Rates S iF time

48. Long-term Interest Differentials • Why might long-term nominal interest rates differ. • If relative PPP holds in the long-run, then a countries average expected depreciation rate over the long run should be a function of its inflation differential. • A country with higher average inflation should have a depreciating currency and higher average interest rates. • If long-term interest rates are the average of expected future interest rates, then countries with faster long-term inflation should have higher long-term interest rates.

49. UIRP & Exchange Rate Volatility • Using UIRP we can write the exchange rate as a function of the future series of exchange rate differentials. • Since forecasts of future variables may be volatile and subject to optimism and pessimism, this may explain a large degree of exchange rate volatility.

50. Is UIRP true • On average, UIRP does not hold. High interest rate countries do not see their countries currencies deteriorate. • On average, buying bonds in high interest rate countries generates high average returns. • Why don’t investors take advantage of these opportunities? • Investors perceive these countries as having some risk of an exchange rate depreciation and investors are risk averse.