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Currency Analysis with Fundamentals. Fundamental Analysis involves the use of data to assess the strength/weakness of a currency Economic Data GDP Employment.

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Presentation on theme: "Currency Analysis with Fundamentals. Fundamental Analysis involves the use of data to assess the strength/weakness of a currency Economic Data GDP Employment."— Presentation transcript:

1 Currency Analysis with Fundamentals

2 Fundamental Analysis involves the use of data to assess the strength/weakness of a currency Economic Data GDP Employment Prices Financial Data Interest Rates Asset Prices Demographic Data Population Growth Asset Prices International Data Trade Balance FDI Official Reserve Position International Data Trade Balance FDI Official Reserve Position

3 Trade Balances The trade balance approach focuses on a country’s current account. The trade balance approach focuses on a country’s current account. Exports = demand for a country’s currency Exports = demand for a country’s currency Imports = supply of a country’s currency Imports = supply of a country’s currency Trade deficit (surplus) countries should experience currency depreciations Trade deficit (surplus) countries should experience currency depreciations

4 Example: Bolivia (Bolivian Peso)

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6 The J-Curve Recall that currency demand/supply is based on foreign exchange expenditures Recall that currency demand/supply is based on foreign exchange expenditures If elasticities are low, then rising prices can actually increase expenditures If elasticities are low, then rising prices can actually increase expenditures Elasticities tend to increase over longer time horizons Elasticities tend to increase over longer time horizons Necessities (in particular, energy) have lower elasticities than luxuries Necessities (in particular, energy) have lower elasticities than luxuries

7 Balance of Payments The trade balance approach assumes that currency flows are due to purchases of goods/services alone. The trade balance approach assumes that currency flows are due to purchases of goods/services alone. The Capital & Financial Accounts keep track of net inflow of cash due to financial transactions (CA + KFA = 0) The Capital & Financial Accounts keep track of net inflow of cash due to financial transactions (CA + KFA = 0) Private Capital inflow: Purchases of domestic assets Private Capital inflow: Purchases of domestic assets Official Reserve Transactions: Acquisition of official reserve assets (between central banks) Official Reserve Transactions: Acquisition of official reserve assets (between central banks)

8 Example: Israel (Shekel)

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11 Balance of Payments Approach Adding the Capital account complicates the analysis: Adding the Capital account complicates the analysis: Remember, if a country is financing its trade deficit by selling its assets. These assets are claims to future payments Remember, if a country is financing its trade deficit by selling its assets. These assets are claims to future payments How big is “too big” How big is “too big” A country’s ability to repay its debts lies in in its ability to run future trade surpluses (or have a VERY cheap currency) A country’s ability to repay its debts lies in in its ability to run future trade surpluses (or have a VERY cheap currency)

12 Example Variable El Salvador Hungary GDP Growth 1.823.8 Capital Formation (% GDP) 15.9727.13 Illiteracy20.1.66 Debt Service 6.3537.5 Industry Value Added (% GDP) 29.433.7

13 Monetary Approach (Flexible Prices) The classical approach assumes that all prices are flexible and that all markets clear. The classical approach assumes that all prices are flexible and that all markets clear. Money markets take the lead Money markets take the lead Bond markets play a passive role. Bond markets play a passive role.

14 Capital Markets Classical theory assumes completely integrated capital markets Classical theory assumes completely integrated capital markets At the prevailing world interest rates, the trade balance is determined by At the prevailing world interest rates, the trade balance is determined by S – I – (G-T)

15 Monetary Policy & Capital Markets Money is ”Neutral” in classical theory. Therefore, Federal Reserve policy only influences the price level Money is ”Neutral” in classical theory. Therefore, Federal Reserve policy only influences the price level

16 Classical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account)

17 Classical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY

18 Classical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY For example, suppose that National Income is $8T. If the average household chooses to hold 10% of their income in the form of cash, what is aggregate money demand?

19 Classical Money Demand It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) It is assumed that households choose to hold a fraction of their nominal income in the form of cash (or a checking account) Money Demand = k* PY For example, suppose that National Income is $8T. If the average household chooses to hold 10% of their income in the form of cash, what is aggregate money demand? Money Demand = (.1)($8T) = $800B Money Demand = (.1)($8T) = $800B

20 Money Market Equilibrium The aggregate price level will adjust so that money supply equal money demand The aggregate price level will adjust so that money supply equal money demand

21 Money Market Equilibrium The aggregate price level will adjust so that money supply equal money demand The aggregate price level will adjust so that money supply equal money demand M = Money Demand = k*PY

22 Money Market Equilibrium The aggregate price level will adjust so that money supply equal money demand The aggregate price level will adjust so that money supply equal money demand M = Money Demand = k*PY Solving the above expression for price gives us Solving the above expression for price gives us P = M/(kY)

23 Money Demand and the Quantity Theory of Money An alternative way of expressing the previous expression is An alternative way of expressing the previous expression is MV = PY Where ‘V’ is the velocity of money (V = 1/k) This is known as quantity theory of money This is known as quantity theory of money

24 Implications of the Quantity Theory In the long run, velocity is relatively constant. Therefore, a country’s inflation rate is equal to In the long run, velocity is relatively constant. Therefore, a country’s inflation rate is equal to Inflation = Money Growth – Output Growth

25 Purchasing Power Parity Purchasing power parity (PPP) suggests that currencies should have the same purchasing power everywhere. Purchasing power parity (PPP) suggests that currencies should have the same purchasing power everywhere. P = eP* A more useful form of PPP is A more useful form of PPP is %Change in e = Inflation – Inflation* For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year. For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year.

26 Currency Fundamentals Begin with PPP Begin with PPP %Change in e = Inflation – Inflation*

27 Currency Fundamentals Begin with PPP Begin with PPP %Change in e = Inflation – Inflation* The Quantity theory gives us The Quantity theory gives us Inflation = Money Growth – Output Growth Inflation = Money Growth – Output Growth

28 Currency Fundamentals Begin with PPP Begin with PPP %Change in e = Inflation – Inflation* The Quantity theory gives us The Quantity theory gives us Inflation = Money Growth – Output Growth Therefore, we have Therefore, we have %change e = (Money Growth – Money Growth*) + ( Output Growth* - Output Growth)

29 Interest rate Parity Recall, integrated capital markets imply equal real rates of return across countries Recall, integrated capital markets imply equal real rates of return across countries r = r*

30 Interest rate Parity Recall, integrated capital markets imply equal real rates of return across countries Recall, integrated capital markets imply equal real rates of return across countries r = r* Purchasing Power Parity gives us Purchasing Power Parity gives us e = Inflation – Inflation*

31 Interest rate Parity Recall, integrated capital markets imply equal real rates of return across countries Recall, integrated capital markets imply equal real rates of return across countries r = r* Purchasing Power Parity gives us Purchasing Power Parity gives us e = Inflation – Inflation* Combining the two yields Combining the two yields i – i* = %change in e Assets should pay the same nominal return across countries

32 Example: Norway (Krone)

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35 The Importance of Relative Prices The fundamentals do quite well in explaining general trends, but are not so good at shorter term fluctuations The fundamentals do quite well in explaining general trends, but are not so good at shorter term fluctuations

36 Exchange Rates & the Fundamentals (JPY/USD)

37 Exchange Rates & the Fundamentals (GBP/USD)

38 The Importance of Relative Prices The fundamentals do quite well in explaining general trends, but are not so good at shorter term fluctuations The fundamentals do quite well in explaining general trends, but are not so good at shorter term fluctuations While impediments to trade (tariffs, transportation costs can be blamed for the failure of PPP) – movement in the real exchange rate While impediments to trade (tariffs, transportation costs can be blamed for the failure of PPP) – movement in the real exchange rate

39 Nominal/Real Exchange Rates

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42 The Importance of Relative Prices The fundamentals do quite well in explaining general trends, but are not so good at shorter term fluctuations The fundamentals do quite well in explaining general trends, but are not so good at shorter term fluctuations While impediments to trade (tariffs, transportation costs can be blamed for the failure of PPP) – movement in the real exchange rate While impediments to trade (tariffs, transportation costs can be blamed for the failure of PPP) – movement in the real exchange rate A more like solution is a real/appreciation caused by some relative price shift A more like solution is a real/appreciation caused by some relative price shift Terms of Trade Terms of Trade Non-Traded Goods Non-Traded Goods

43 Non Traded Goods Suppose that two countries have identical price indices Suppose that two countries have identical price indices P =.5(Goods) +.5(Services)

44 Non Traded Goods Suppose that two countries have identical price indices Suppose that two countries have identical price indices P =.5(Goods) +.5(Services) Suppose the domestic price of services increases Suppose the domestic price of services increases

45 Non Traded Goods Suppose that two countries have identical price indices Suppose that two countries have identical price indices P =.5(Goods) +.5(Services) Suppose the domestic price of services increases Suppose the domestic price of services increases The domestic price level rises by 10% The domestic price level rises by 10% No change in the nominal exchange rate is required No change in the nominal exchange rate is required A real appreciation of 10% occurs A real appreciation of 10% occurs

46 Non Traded Goods In the previous example, a 20% rise in the price of a non-traded good created a 10% real appreciation In the previous example, a 20% rise in the price of a non-traded good created a 10% real appreciation No change in nominal exchange rate No change in nominal exchange rate 10% rise in domestic price level 10% rise in domestic price level

47 Non Traded Goods In the previous example, a 20% rise in the price of a non-traded good created a 10% real appreciation In the previous example, a 20% rise in the price of a non-traded good created a 10% real appreciation No change in nominal exchange rate No change in nominal exchange rate 10% rise in domestic price level 10% rise in domestic price level This real appreciation could happen a number of different ways. For example This real appreciation could happen a number of different ways. For example 5% nominal appreciation 5% nominal appreciation 5% domestic price level increase 5% domestic price level increase

48 Terms of Trade Suppose that we have the US and Venezuela. Suppose that we have the US and Venezuela. P =.2(oil) +.8(manufactured goods) P =.2(oil) +.8(manufactured goods) P* =.4(oil) +.6(manufactured goods) P* =.4(oil) +.6(manufactured goods) Now, suppose oil prices rise by 10%. Now, suppose oil prices rise by 10%.

49 Terms of Trade Suppose that we have the US and Venezuela. Suppose that we have the US and Venezuela. P =.2(oil) +.8(manufactured goods) P =.2(oil) +.8(manufactured goods) P* =.4(oil) +.6(manufactured goods) P* =.4(oil) +.6(manufactured goods) Now, suppose oil prices rise by 10%. Now, suppose oil prices rise by 10%. The exchange rate is unchanged The exchange rate is unchanged P Rises by 2% P Rises by 2% P* rises by 4% P* rises by 4% A real depreciation of the dollar occurs A real depreciation of the dollar occurs

50 Terms of Trade The previous example gave us: The previous example gave us: The exchange rate is unchanged The exchange rate is unchanged P Rises by 2% P Rises by 2% P* rises by 4% P* rises by 4% A 2% real depreciation of the dollar occurs A 2% real depreciation of the dollar occurs However, any combination that adds up to a 2% real depreciation is possible. For example However, any combination that adds up to a 2% real depreciation is possible. For example A 2% nominal depreciation with no price changes. A 2% nominal depreciation with no price changes.

51 Terms of Trade It is generally assumed that a country’s exports will make up a larger share of its price index than imports. It is generally assumed that a country’s exports will make up a larger share of its price index than imports. Therefore, in the previous example, the US is an importer of oil, and an exporter of manufactured goods. Therefore, in the previous example, the US is an importer of oil, and an exporter of manufactured goods.

52 Terms of Trade The Terms of Trade is defined as the relative price of exports in terms of imports The Terms of Trade is defined as the relative price of exports in terms of imports In the previous example, the Terms of Trade for the US worsened causing a real depreciation of the $. In the previous example, the Terms of Trade for the US worsened causing a real depreciation of the $.

53 Oil Prices Year Price ($/Brl.) 1972$10.65 1973$11.58 1974$18.76 1978$18.66 1979$24.19 1980$37.85 1985$32.69 1986$16.61

54 Real $ Exchange Rate

55 Nominal $ Exchange Rate

56 Case Study: Mexico (Peso) Variable19981999200020012002 GDP Growth 5.033.626.56-.17.74 Capital Formation 24.3223.4523.4720.52NA Exports30.6930.7931.0327.34NA Imports32.8332.432.9729.68NA Inflation15.3715.2512.196.324.78 FDI (B) 11.912.514.224.7NA Terms of Trade 100.4102.32107.39NANA

57 Case Study: Mexico (Peso)

58 Case Study: India (Rupee) Variable19981999200020012002 GDP Growth 5.97.133.955.454.4 Capital Formation 21.3823.6622.5122.43NA Exports11.2211.7613.7913.2615.18 Imports12.9113.7214.5513.9516.1 Inflation7.883.854.523.474 FDI (B) 2.632.172.423.40NA Terms of Trade 108.7497.392.9NANA

59 Case Study: India (Rupee)

60 Case Study: Singapore (Dollar) Variable19981999200020012002 GDP Growth -.866.429.41-2.472.25 Capital Formation 32.3832.4432.3824.4320.62 ExportsNANANANANA ImportsNANANANANA Inflation-2.38-5.454.5-1.23.16 FDI (B) 6.3811.85.48.6NA Terms of Trade 96.9696.0393.29NANA

61 Case Study: Singapore (Dollar)


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