Exchange Rate Dynamics(I) Dr. J. D. Han King’s College U.W. O.

(Key Question) 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)?

1.Definition of Foreign Exchange Rates(FOREX or FX rates): Price of a unit of Foreign Currency in terms of Domestic Currency * This is the European quotation ; the American quotation of FX rate tells how many units of foreign currency does a unit of domestic currency fetches. *This definition is consistent with the definition of ‘prices in general’: Price of a hamburger (in terms of domestic currency)

Exchage Rates = Relative Value of Foreign Currency to Domestic Currency For instance, the representative FOREX rate for Canada is 1.3 for the U.S. dollar. FOREX rate “1.3” = Value of US $1/ Value of Canadian $1 = US $1 is 1.3 times as valuable as Cdn $1

2. What is the correct FOREX rate?: International Trade ->Purchasing Power Parity International Investment -> Interest Parity Theorem 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 Real Factor Analysis

Purchasing Power Parity: Links FOREX Rates to the economic and market fundamentals in International Trade 3. International Trade’s perspective

1) Purchasing Power Parity says Exchange 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 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, in a currency, everywhere in the world. -> “ Law of One Price for One Good”

2) When and where does Purchasing Power Parity hold? 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 eliminate the difference in the long-run.

In contrast, there is no reason why a price of non- tradable good should have the same price in two different countries unless the production factors are completely mobile between the two countries. Eg) A hair cut costs U.S. $25 in New York. An equally good hair cost costs 5 Yuan in Beijing. -The PPP might dictate the FOREX rate of 1Yuan for U.S. $ ___. -In fact, the actual FOREX rate is the opposite.

3) A widely cited evidence for/against PPP: “Big Mac Index” 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. Idea: C $2.60 buys a big mac in Canada; in U.S., a big mac costs U.S. $2. The correct FOREX rate for the U.S. dollar in Canadian dollar is _____.

Updated Big Mac Index; Mixed Evidence for/against PPP The actual FOREX rates differ signficantly from the Big Mac Index -Why? Recall : PPP presupposes Free Trade. PPP works for Tradable Goods only, and in the long-run only

4) Two versions of Purchasing Power Parity (1) Absolute PPP Theory: S P f = P S = P/P f S P f /P = 1 Empirical Evidence: not supported

(2) Relative PPP Theory: From S P f = P, we derive  % S =  % P -  % P f Evidence: still mixed

* What determines the value of a currency in a country? FOREX rate = Relative Value of Two Currencies = Relative Worth of Two Monies = Relative Inverse of Price Levels = Relative Inverse of Money Supplies

Formally by using Quantity Equation of Exchange, we can show that Price Level is determined by Three Factors: Money supply, Economic Growth Rate, and Velocity of Circulation

M V = P y P = M V/y 1/P = y/ (M V) Monetarists’ Theory: Quantity Equation of Exchange M f V f = P f y f P f = M f V f /y f 1/P f = y f / (M f V f ) S = P/P f = 1/P f / 1/P = {y f /M f V f } / { y/M V}

 %S =  %P -  %P f  %P =  % M -  % y +  % V  %P f =  % M f -  % y f +  % V f Combining the above two equations, we get  %S = (  % M-  % M f ) - (  % y -  % y f ) Note: Exchange rates are determined by the difference in money creation (between the domestic and the foreign countries) and the difference in economic growth.

4. International Investment’s Perspectives -In the Short-run, capital flows to a country with a higher interest rate and the FX falls for the country with capital inflows: Disequilibrium -Uncovered Interest Parity Theorem concerns the Long-Run equilibrium: no apparent international capital flows anymore

2) Uncovered Interest Parity Theorem -This theory presupposes free capital flows - UCIPT says that At Equilibrium (No Capital Movement), or in the Long Run, i = i f + (S e - S)/ S = i f +  %S e Therefore,  %S e = i - i f

3) What determines interest rates? Fisher equation says that Nominal Interest Rates vary with Expected Inflation Rates. i = r +  %P e i f = r f +  %P e f

Combining the Two  %S e = i - i f = r +  %P e - (r f +  %P e f ) = r - r f + (  % M-  % M f )- (  %y -  %y f )

Comments: The results are very similar to those of Exchange Rate Dynamics (I). -Monetary Policies affect Exchange Rates: Country with an Easy Monetary Policy faces a High Exchange Rate: Easy Monetary Policies – A Large Quantity of Money – Low Value of Money – High Price of A Foreign Currency in that Domestic Money – High FOREX Rate

5. Real Factors 1)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 -Price competitiveness

2) Empirical Evidence revisited: Does P.P.P. fully explain exchange rate fluctuations? In all cases, PPP works for Tradable Goods: S P T f /P T =1 S P f /P =1even in the long-run. How to reconcile the above two conflicting evidence?

3) Real ROREX rate: S P f /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 Competitiveness”

3) When does ‘q’ meander in the long –run? ‘q’ may deviate from 1 in the short-run even if PPP holds – Trivial issue ‘q’ may meander in the long-run if there is some structural change at force in the economy: PPP does not hold for general price level P (still PPP must hold for Tradable goods)

4) Case Study: Japanese Foreign Exchange Rates 1) Changes in Nominal Exchange Rates or S  %S can be only partially explained by (  % P-  % P f ) or (  % M-  % M f )- (  %y -  %y f ) 2) Changes in Real Exchange Rates or q The residual can be explained by changes in real exchange rates. S P T f / P T = 1 in L. R. without any failure Technical Innovation lowers P T. To come back to L.R. equilibrium, S should fall.

*Explaining Meandering S P f /P for Yen - No change in overall P f /P. as In Japan, P = 0.5 P T P NT - Due to Technical Innovations, Japanese Tradable becomes cheaper. - International Arbitrage of Goods pushes Demand for Japanese-produced Tradable goods. This leads to an increased demand for Yen. - The value of Yen goes up while the value of FOREX goes down. - S falls in Japan

Illustration of a change in S and q If S P T f / P T >1 for Tradable Goods,  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)  S   q  if overall price ratio P f /P is stable.

7. Case study of Canada Between s -S 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 Between S continues to fall -Manily disequilibrium capital flows from U.S. --may reflect improving real factors