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Exchange Rates

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Issues

• What are nominal exchange rates?

• What drives FX rates?

• Exchange rate regimes

• Speculative attacks on currencies

3Yen has moved from 350 to about 100, why?

Exchange Rates

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

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South East Currency Crisis

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Exchange Rates (Feb-12, 2003)

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Exchange Rates in the Long Run

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Purchasing Power Parity (PPP)Law of One Price

• Let ¥10,000 be the price of a TV in Japan, suppose the price of the same TV in the U.S is $90

• In the absence of transaction costs the Yen cost of this TV should be the same in Japan and the US

• This implies that the exchange rate should equal ¥10,000/$90 = 111.11 ¥ / $

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Purchasing Power Parity

• Let P* be the price in Yen of a basket of goods in Japan, that is, P* is the CPI in Japan. Denote the CPI in the US by P

• Purchasing Power Parity (PPP) refers to the condition

E = P*/P• PPP says that the Yen price of a basket of goods should be the

same in the U.S. and Japan

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Implication of PPP

• Changes in exchange rates reflect relative inflation differentials across countries. Approximately,

Change in Exchange rate = Foreign inflation rate – U.S inflation rate

• If goods prices rise faster in the U.S relative to that in Japan. Then the the Yen should appreciate in value and the dollar should fall in value– That is, the FX rate quoted as Yen/Dollar should decline

tt

tt

t

t

PPPP

EE

1

**

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Nominal Exchange Rates and Inflation Differentials

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Exchange Rates, Interest Rates and Inflation

Data: average for 1960-2000, annual percentages, exchange rates are foreign currency per dollar.• Japan: The yen has appreciated 2.90% per annum

• Japan has 0.25% less inflation than the US • Japan’s nominal interest rate is 1.9% less than the U.S.

• Chile: The Chilean currency has depreciated 37.79% per annum•Chile’s inflation is 60.97% higher than the U.S. •Chile’s nominal interest rate is about 31.54% higher than the U.S.

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Why has the U.S. Dollar risen in value during the recent recession?

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Short Run Inflation effect on FX when inflation is high

•Quarterly inflation and depreciation in Brazil, 1990–1997

•High inflation in Brazil leads to its currency falling in value (i.e., Brazilian currency/dollar rises)---as inflation ends, the currency stabilizes as well

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The Trend in Nominal Exchange Rates: Where is the Currency Value Going?

• The long-run trend in nominal exchange rates is determined by PPP

• Currency under- or over-valuation relative to PPP

• Big-Mac index

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Big Mac Index

Purchasing Power Parity (PPP): is a measure of the relative purchasing power of different currencies. It is measured by the price of

the same goods in different countries, translated by the FX rate (or exchange rate) of that country's currency against a "base currency".

How to read this table:

In this case, the goods is the Big Mac. For example, if a BigMac costs €3.06 in the countries that use Euro and costs $3.41 in US, then the

PPP exchange rate would be 3.06/3.41 = 0.8973.

If the actual exchange rate is lower, then the BigMac theory says that you should expect the value of the Euro to go up until it reaches the PPP exchange rate. If the actual exchange rate is higher, then the

BigMac theory says that you should expect the value of the Euro to go down until it reaches the PPP exchange rate.

The Over/Under valuation against the dollar is calculated as:

(PPP - Exchange Rate) ---------------------------------- x 100

Exchange Rate

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Interest Rates and Exchange RatesUncovered Exchange Rate Positions

Strategy 1

• Invest 1$ in the US risk-less asset.

• Payoff at year end: [1+Rt]$

Strategy 2

• Convert 1 dollar to Yen to receive Et ¥ today.

• Invest in a Japanese risk-less asset. Payoff at year end Et[1+Rt*] ¥.

• At the end of the year convert the Yen to dollars. The dollar payoff at year end: Et [1+Rt*]/Et+1 $.

• The dollar payoff on strategy 2 is uncertain, as it depends on the spot price, E(t+1), that will prevail at year end. This investment has currency risk.

• Uncovered Exchange Rate Parity

1+Rt = Et [1+Rt*]/Expected(Et+1)

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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. If a country’s interest is high, then its exchange rate is expected to depreciate.

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Exchange Rates and Interest Rates

Countries with high nominal interest rates have, typically, see a fall in the value of their currency

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Real Exchange Rates

• The real exchange rate is the quantity of foreign goods can I get in exchange for one unit of the U.S. good.

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Real Exchange Rate

• A hamburger costs 2 dollars in the U.S. and costs 1100 Yen in Japan

• Current nominal exchange rate is 110 yen per dollar, what is the hamburger rate of exchange?– For our example, real ex-rate is [110 * 2/1100 ] = 0.20 – If you sacrifice one U.S. hamburger you receive in exchange only 0.20 of

the Japanese hamburger– Suppose the dollar appreciates to 140 Yen/USD. The hamburger rate of

exchange is [140*2/1100]=0.25

• The relative price of Japanese goods have fallen---Japanese goods have become cheaper

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Real Exchange Rate

• The real exchange rate is defined as

e = E P/P* = (Yen price of US goods)/(Yen Price of Japanese goods)

• The real exchange rate is usually defined by using the consumer price indices (i.e., CPI)

• When the real exchange rate increases – US residents receive more foreign goods per unit of the US good – US residents have an incentive to buy more foreign goods relative to US

goods

• PPP implies the Real Exchange Rate e = 1

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United States

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Non-Traded Goodsand the Law of One Price

• Goods are traded goods or non-traded goods

• The law of one price holds only for traded goods

E = P*_traded/P_traded

• Non-traded goods are cheap in poor countries.

• Inflation can be high due to high inflation in non-traded goods

• But will sustained high interest rates lead to falling currency values?

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What drives the Ex Rate in the short run?

• In the short run exchange rates are determined by capital movements:

– If U.S. expected inflation increases then investors do not want to hold dollars the dollar looses value

– U.S. expected real interest rates go up relative to other countries---international capital moves towards U.S bonds and stocks. Foreign investors buy dollars to purchase U.S assets and value of the dollar increases

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Macro News and Exchange Rates(Short Run Movements in Home Currency Values)

Higher than expected inflation

PPP effect will drive currency value down

Better investment opportunities will attract foreign capital.

Higher than expected real GDP growth

Higher than expected Federal Funds rate

•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.

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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

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Key Message

• 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

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Fixed Exchange Rates

• Country on a fixed exchange rate regime fixes its currency value relative to the dollar

• It is used to limit exchange rate volatility

• What do fixed exchange rates mean?

– Et is a constant• Example, till last year Argentina, now countries in the Euro

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Implication of Fixed Exchange Rates

• The implication: Argentinean nominal interest rate should equal the US nominal interest rate. Why?

• Dollar return from investing 1 USD in Argentinean bond is

– Et[1+Rt*]/Et+1 $

– Et is the Pesos per dollar exchange rate

• Sure return from investing 1USD in the US T-bill is (1+Rt )

• However, if Et /Et+1=1, then Rt*=Rt

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Fixed Exchange Rates

• Main economic implication:

– Monetary policies of Argentina have to coincide with those of the US

– Argentina cannot pursue an independent monetary policy

• Argentina’s inflation rate has to approximately equal the US inflation rate

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Fixed and Flexible Exchange Rates: Developed Economies

In developed Economies:•FX volatility after 1973 (i.e.,post Bretton Woods) = 13 times of volatility during Bretton woods •Inflation is almost twice as high after 1973

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The Euro

• The Euro is the same as a “credible” fixed exchange rate regime amongst the 11 participating countries

• Benefits:

– Lower exchange rate volatility– Greater mobility of capital

• Costs:

– None of the 11 countries have independent monetary policy

• UK, Denmark and Sweden have not joined the Euro, partly to maintain an independent monetary policy

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Key Message

• Economies that are prone to high rates of inflation likely to rely on fixed exchange rate regimes to limit inflation

• Cost: No independent monetary policy

– Example: UK Pound 09/1992

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Financial Crisis in the 90’s

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Time series of recent collapsemonths

Jan90Dec90Dec91Dec92Dec93Dec94Dec95Dec96Dec97Dec98Dec99Dec00Dec01Dec02

Mexico

Thailand

Russia

Argentina

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Fixed Exchange Rates and Speculative Attacks

• Most fixed exchange rates are not credible and are susceptible to speculative attacks.

• Some recent episodes:

– 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

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Financial Crisis in South East Asia

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•Return to capital is falling well before the crisis in 1997•Note return to capital is reciprocal of Incremental capital-output ratio

South-East Asian Crisis

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Non-Performing Loans in South-East Asia (1997)

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5

10

15

20

25

30

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Thailand

Indonesia

SouthK

orea

Malaysia

Philipines

Singapore

Percentage of all loans Percentage of GDP

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Non-Performing Loans in South-East Asia (1997)

020406080

100120140160180

Th

ailand

Ind

onesia

Sou

th K

orea

Malaysia

Ph

ilipin

es

Sin

gapore

Percentage of government revenues

Non-performing loans if covered by the government are a huge liability.

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Speculative Attacks

• Speculative attacks are an outcome of inconsistency between the fiscal policy and the fixed rate of exchange

• Common features:

– Rise in Govt. Liabilities (e.g., promise to bail out commercial banks)

– Substantial credit creation during fixed exchange rate regime

– Large international dollar denominated borrowings during fixed exchange rate regime

• Implications:

– Risk of monetization high

– Expected inflation rises

– The currency is overvalued at the official fixed exchange rate!

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Speculative Attacks

• A sharp rise in expected inflation has to lower the value of the currency today

• Households and Firms swap local currency for dollars or other hard assets---as in an hyper-inflation

• Nobody wants to hold the local currency!

• Currency values have to drop

• Another ExampleMexico

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Mexico

•Mexican WPI (whole sale price index) expressed in dollars is Mexican WPI multiplied by the dollar/peso exchange rate

•Prior to the 1994 crisis the Mexican WPI indicates that the peso is overvalued—too much inflation in Mexico relative to the US

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Mexican Currency Crises(Mexico 1 Month Peso Interest Rate)

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10

20

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40

50

60

70

80

90

Jan-

94

Feb

-94

Mar

-94

Apr

-94

May

-94

Jun-

94

Jul-

94

Aug

-94

Sep-

94

Oct

-94

Nov

-94

Dec

-94

Jan-

95

Feb

-95

Mar

-95

Apr

-95

May

-95

Jun-

95

Jul-

95

Aug

-95

Sep-

95

Oct

-95

A rise in the local interest rate mirrors the rise in expected inflation. Further the central bank in an attempt to defend the currency raised nominal interest rates (hoping to raise real interest rates).

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Mexican Currency Crises

Central bank looses about $10B in defending the currency. The rise in the nominal and real interest rates squelched GDP growth. CA moves to surplus as fall in nominal exchange rate made Mexican goods cheaper and foreign goods more expensive.

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• 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.”

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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