Ch08 Understanding Exchange Rates.docx

CHAPTER 8: Understanding Exchange Rates FOCUS OF THE CHAPTER This chapter begins with an introduction to the foreign exchange rate and then proceeds to discuss its determination under various exchange rate regimes. An introduction to the current and capital accounts of the balance of payments is presented. The monetary and absorption approaches to the balance of payments and the concept of twin deficits are introduced. The role of the exchange rate in the determination of interest rates is analyzed. The importance of the exchange rate as a link between foreign and domestic interest rates on the one hand and foreign and domestic prices on the other is also discussed. Learning Objectives: Define an exchange rate and determine how many ways there are to measure exchange rates Identify the link between the exchange rate and prices in different countries Describe the types of exchange rate regimes that exist in the world today Identify the role of capital flows and the balance of payments in the movement of capital across countries Explain how the equilibrium exchange rate is determined Determine how interest rates and exchange rates interact Identify what the purchasing power parity hypothesis predicts Explain why the real exchange rate concept is important Explain why interest rate differentials between countries matter List some of the puzzling aspects of exchange rate behaviour Explain what the hysteresis hypothesis is SECTION SUMMARIES Exchange Rates Canada is a relatively small open economy in the world. Therefore, the exchange rate is an important factor in determining its international transactions. Definitions: An exchange rate expresses the price of one currency in terms of another. Therefore, the exchange rate is the relative price of two currencies, and can be expressed in two ways. For example, the exchange rate between the Canadian dollar and the US dollar can be expressed either as C$1 = US$0.6376 (the US dollar price of a Canadian dollar) or as US$1 = C$1.5683 (the Canadian dollar price of the US dollar). Note that in the text the exchange rate is defined as the Canadian dollar price of a foreign currency and is denoted by e. Cross-Rates: The exchange rate between two currencies, calculated via a third currency, is called the cross-rate. For example, given that US$1 = C$1.5683 and US$1 = £0.6813, the exchange rate between the British pound and the Canadian dollar can be calculated as (1.5683/0.6813) = 2.3688, meaning £1 = C$2.3019. Changes in Rates: Terms used in the literature for changes (increases or decreases) in the exchange rate differ, depending on whether the changes are brought about by market forces or by government regulation. An increase (decrease) in the value of a currency brought about by market forces, free of government intervention, is termed an appreciation (depreciation) of the currency. An increase (decrease) brought about by government regulation in a fixed (regulated) exchange system is termed a revaluation (devaluation). Effective or Trade-Weighted Exchange Rates: A country like Canada trades with many other countries in the world. As a result, many exchange rates exist between the currency of one country and the currencies of its trading partners. Therefore, for a given currency, a trade-weighted exchange rate (or effective exchange rate) can be calculated as a weighted average of these exchange rates, using the trade (export/import) ratios (i.e., the proportion of the country’s trade with the partner) as weights. Trade-weighted exchange rate = w1 e1 + w2 e2 + ... + w n en where w1 , w2, and w n are the country’s trade ratios with countries 1, 2, and n respectively, and e1, e2 , and en are the exchange rates with the currencies of countries 1, 2, and n respectively. The sum of the weights must be equal to unity. The Law of One Price: Under certain assumptions, the law of one price states that the domestic and foreign prices of a tradable good should be equal. Given the domestic price (P), the foreign price (Pf ) and the exchange rate (e), the law of one price implies that the domestic price will be equal to the product of the foreign price and the exchange rate, i.e., P = Pf e. The foreign and domestic prices of a good can differ due to transportation costs, tariffs, and other transaction costs, such as the cost of currency conversion. The law may be better applicable to financial instruments, since capital flows have relatively low cost. Today, capital can flow from one country to another instantly. Some argue that capital flows must be restricted because: 1) they are driven mainly by speculation on profits, and 2) countries do better under restrictions on capital mobility. However, the long-term capital flows known as foreign direct investment (FDI) contribute more to economic growth than short-term capital flows, known as "hot money." Exchange Rate Regimes Exchange rate systems (regimes) can be classified into three broad categories: 1) fixed exchange rate regime: Currency is pegged to another currency. The exchange rate is determined by the government. 2) flexible (floating) exchange rate regime: Market forces (the demand for and supply of foreign exchange) free of government intervention determine the exchange rate. 3) managed float (dirty float): The exchange rate is allowed to change within a certain range. A central authority (e.g., a central bank) intervenes in the foreign exchange market to maintain the exchange rate within the range. The International Monetary Fund (IMF) classifies Canada’s system as a flexible system; yet, at times the Bank of Canada intervenes in the foreign exchange market. Exchange Rate Determination: Flexible Exchange Rate Regime: Under a purely flexible exchange rate regime, the exchange rate is determined by the demand for and supply of foreign exchange (foreign currency). A country’s demand for foreign goods (imports) and assets generates a demand for foreign exchange. Foreigners’ demand for a country’s exports and assets generates a supply of foreign exchange. For example, consider the US dollar as the foreign exchange. Canada’s demand for US goods and assets denominated in US dollars generates a demand for the US dollar, while US demand for Canadian goods and assets denominated in Canadian dollars generates a supply of US dollars. Other things being equal, the quantity demanded of foreign exchange (foreign currency) is inversely related to the exchange rate. (Note that the exchange rate is defined as the domestic price of the foreign currency, say, the Canadian dollar price of the US dollar). Therefore, the demand curve for foreign exchange is downward-sloping. Other things being equal, the quantity supplied of foreign exchange is positively related to the exchange rate. Therefore, the supply curve for foreign exchange is upward-sloping. The equilibrium exchange rate is the exchange rate at which the supply and demand curves intersect. Fixed Exchange Rate Regime: Since the exchange rate is fixed by the government, the monetary authority (central bank) has to ensure that the quantity of foreign exchange supplied is equal to the quantity demanded at the fixed rate. Therefore, the supply curve is horizontal at the fixed rate. The Basics of the Balance of Payments: A country’s balance of payments records its transactions with the rest of the world (international transactions) during a given period of time. The balance of payments consists of two accounts: current account and capital account. The export and import values of goods (merchandise) and services, investment income, and transfer payments are recorded in the current account. The Canadian merchandise trade balance typically has been positive, but the balances in services and investment income generally have been negative. The capital account records the inflow and outflow of both direct investment and portfolio investment, government grants, and loans. A deficit in the current account needs to be financed by a surplus in the capital account. Explaining the Balance of Payments A surplus (deficit) in the current account does not offset exactly a deficit (surplus) in the capital account. The difference is the statistical discrepancy that arises for two reasons: a) the difficulty of recording international transactions, and b) the errors and omissions made in recording them, partly due to differences in the efficiency of statistical agencies. Foreign Exchange Intervention: The Bank of Canada occasionally intervenes in the foreign exchange markets as a) the manager of foreign exchange reserves, and b) to moderate fluctuations (volatility) in the exchange rate. However, Canada is one of the least interventionist countries. In a flexible exchange rate system, at any exchange rate above (below) the equilibrium rate the domestic currency is undervalued (overvalued). The Canadian dollar has been undervalued in recent years. Many believe this explains the worsening of current account balance in recent years. According to the monetary approach to the balance payments, the balance of payments deficits would be cancelled through changes in money supply, under fixed exchange rate regimes. The Bank of Canada can offset these changes in money by sterilization. Under a flexible exchange rate system, the monetary approach suggests that changes in the exchange rate itself produce necessary adjustments in the balance of trade. The absorption approach views surpluses or deficits of the balance of payments as resulting from the difference between output and consumption levels. The Twin Deficits/Surpluses: Fiscal (budget) deficits (surpluses) and external (balance of payments) deficits (surpluses) that occur simultaneously are referred to as twin deficits/surpluses. Until recently, Canada has run twin deficits (fiscal and current account deficits). The connection between the two deficits (or surpluses) can be described as follows: The level of output or income (y) is equal to the sum of consumption (c), investment (i), government expenditure (g), and the net exports or the difference between exports (x) and imports (im): y = c + i + g + (x-im) The level of output or income (y) is also equal to the sum of consumption (c), saving (s), and taxes (t): y = c + s + t This implies that: c + s + t = c + i + g + (x-im), and s + t = i + g + (x-im) By rearranging the equation we can show the following: s + (t -g) = i + (x-im) Note (t-g) is the fiscal surplus and (x-im) is the current account surplus. From this equation, we can see that if s and i are equal, then (t-g) and (x-im) are equal [i.e., fiscal surplus (deficit) and current account surplus (deficit) are equal]. The equation also shows that if i and s do not change, then the changes in (t-g) and (x-im) are equal [i.e., if ?i = ?s = 0, then ?(t-g) = ?(x-im)]. The Exchange Rate and Interest Rate Determination The loanable funds approach (discussed in Chapter 6) can be used to examine how the equilibrium rate of interest is determined in an open economy with international capital flows (international borrowing and lending). The supply of loanable funds tends to be more elastic when an economy is open for international borrowing and lending, compared to one that is closed. This is because, at interest rates higher than a certain rate, the quantity of loanable funds supplied becomes larger, as foreign lending increases in addition to domestic lending. At interest rates lower than a particular rate, the quantity of loanable funds supplied decreases, as lenders, both domestic and foreign, reduce their lending. The result is a relatively more elastic supply curve (a supply curve with a relatively smaller slope, when both supply curves are drawn on the same diagram). International lending and borrowing make the supply of loanable funds more sensitive to changes in interest rates. However, fluctuations (or changes) in the equilibrium rate of interest brought about by changes (increases or decreases) in the demand for loanable funds are smaller, since the supply is more elastic. Purchasing Power Parity The purchasing power of a currency is the amount of goods or services that one unit of the currency can buy. The hypothesis known as the purchasing power parity (PPP), states that the exchange rate is at equilibrium when the domestic purchasing power of the two currencies is equal. The PPP is simply a statement of the low of one price, using domestic price level (P) and the foreign price level (Pf). The PPP has two forms, known as absolute purchasing power parity and relative purchasing power parity. Absolute purchasing power parity is given by the following equation in terms of levels of the variables: e = (P/ Pf) where e is the nominal rate of exchange. Relative purchasing power parity is stated in terms of the rates of change in e, P, and Pf, as follows: ?e = ? - ?f where ?e is the rate of change in the exchange rate, ? is the domestic rate of inflation (rate of change in P), and ?f is the foreign rate of inflation (rate of change in Pf). Relative purchasing power parity can be viewed as a long-run equilibrium condition. According to relative purchasing power parity, domestic and foreign inflation rates will be equal when the exchange rate is fixed. What’s the Evidence on PPP? Careful examination of Canadian and US data suggest that the absolute and relative forms of PPP are valid expressions, at least for the long-run behaviour of exchange rates and price levels. According to the two forms of PPP, exchange rate should increase (i.e., the Canadian dollar should fall) whenever Canada’s rate of inflation is higher than the US rate. Evidence shows that this was the case until the early 1990s. Nevertheless, the PPP seems to hold only over long periods. Real Exchange Rate: The real exchange rate (?) is the exchange rate adjusted for changes in relative price levels in different countries, as follows: ? = e (Pf/ P) A greater increase in P relative to Pf leads to an increase in e (i.e., a depreciation of the domestic currency). The real exchange rate is used as an indicator of the international competitiveness of the country. An increase (decrease) in ? means a depreciation (appreciation) of the real exchange rate, which implies an increase in the home country’s competitiveness. Understanding Real Exchange Movements: The real exchange rate can also be interpreted as a measure of departure from PPP. Sources of persistent deviation of the exchange rate from its equilibrium value include the following: 1) slow changes in price of goods relative to exchange rates; 2) concentration of trade within borders or regions; 3) structural differences between countries; and 4) productivity differentials between countries. International Linkages in Interest Rates Financial instruments denominated in foreign currencies are subject to foreign exchange risk, due to possible changes in exchange rates. Therefore, an investor's decision to hold foreign bonds depends not only on domestic and foreign rates of return (R and Rf , respectively), but also on the spot and forward exchange rates (es and ef , respectively). The investor must calculate the implicit forward exchange rate—the future exchange rate at which the investor would be indifferent between domestic and foreign bonds. The solution for ef in the following equations is the implicit forward exchange rate: (1+R)/(1+Rf) = ef/es or ef = [(1+R)/(1+Rf)]es An investor can use a forward foreign exchange contract to hedge against the foreign exchange risk. To do so is called covered interest arbitrage (the purchase and sale of foreign currency assets in order to profit from changes in exchange rates). A situation known as interest rate parity exists when profits cannot be made by engaging in arbitrage. Interest rate parity (IRP) states that the domestic interest rate is equal to the sum of the foreign interest rate and the expected rate of change in the exchange rate (the expected rate of depreciation or appreciation). The IRP is given by the following equation: R = Rf + (eexp- es)/es where eexp is the expected rate of exchange. Empirical research shows that IRP is a reasonable approximation for Canadian and US data, and also for many other instances. This implies that foreign interest rates have no lasting influence as long as: 1) exchange rates float free; and 2) capital mobility is high. It is clear from the IRP equation that: 1) the foreign rate of interest and the exchange rate are negatively related; and 2) the domestic and foreign rates of interest are equal when the exchange rate is expected not to change. Hysteresis: The idea of hysteresis has been used to explain the phenomenon that many economic variables display persistent deviations from their equilibrium values, even though the fundamentals causing the deviations indicate that an equilibrium exists. Hysteresis is a hypothesis advanced to explain persistent deviations of exchange rates from purchasing power parity (i.e., persistent over/undervaluations of the exchange rate). Institutional factors may be contributing factors to hysteresis in exchange rates. MULTIPLE-CHOICE QUESTIONS 1. Which of the following is not a correct interpretation of an exchange rate? a) Exchange rate is the purchasing power of a unit of exports. b) Exchange rate is the relative price of two currencies. c) Exchange rate is the domestic price of a foreign currency. d) Exchange rate is the foreign price of the domestic currency. 2. Devaluation is the term used for a) a decrease in the value of a currency brought about by market forces under a flexible exchange rate regime. b) a decrease in the value of a currency brought about by market forces under a fixed exchange rate regime. c) a decrease in the value of a currency brought about by the government under a flexible exchange rate regime. d) a decrease in the value of a currency brought about by the government under a fixed exchange rate regime. 3. Foreign and domestic prices of a good are given by Pf and P. If the exchange rate (e) is defined as the domestic currency price of the foreign currency, which of the following is not a correct statement of the Law of One Price: a) P = ePf b) Pf = P/e c) Pf = eP d) P/Pf = e 4. According to the IMF classification, the Canadian exchange rate regime is a) a floating exchange rate regime. b) a dirty float regime. c) a fixed exchange rate regime. d) a crawling peg regime. 5. Under a floating exchange rate regime, an increase in the supply of foreign exchange results in a) a depreciation of the domestic currency. b) an appreciation of the domestic currency. c) either an appreciation or a depreciation of the domestic currency. d) no change in the exchange rate. 6. The record of the values of a country’s international transactions is called a) the National Balance Sheet. b) the National Income Statistics. c) the Balance of Payments. d) the Government Budget. 7. Which of the following is not recorded in the current account of the balance of payments? a) Merchandise exports b) Services imports c) Investment income d) Foreign direct investment inflows 8. If an excess supply of foreign exchange exists in a foreign exchange market free of government intervention, the domestic currency is a) undervalued. b) overvalued. c) at its equilibrium value. d) overvalued in the money markets, but undervalued in the capital markets. 9. Which of the following are two alternative approaches to the balance of payments? a) The loanable funds approach and the liquidity preference approach b) The absorption approach and the monetary approach c) The income approach and the expenditure approach d) The Keynesian approach and the Marshallian approach 10. The concept of twin deficits refers to the simultaneous occurrence of a) deficits in the current account and the capital account of the balance of payments. b) federal and provincial budget deficits. c) fiscal deficits and balance of payments deficits. d) budget deficits in both Canada and the US. 11. The existence of foreign borrowing and lending makes the supply of loanable funds a) relatively more inelastic with respect to the interest rate. b) relatively more elastic with respect to the interest rate. c) perfectly inelastic in recessions and perfectly elastic in economic expansion. d) negatively related to the interest rate. 12. The domestic and foreign inflation rates are 5% and 3% respectively. If relative purchasing power parity holds, a) the domestic currency depreciates by 2%. b) the domestic currency appreciates by 2%. c) the foreign currency appreciates by 8%. d) the foreign currency depreciates by 5%. 13. The exchange rate (Canadian dollars per US dollar) is 1.20. The Canadian and US price levels are 150 and 125 respectively. The real exchange rate a) is 0.89 (Canadian dollars per US dollar). b) is 1.12 (Canadian dollars per US dollar). c) is 0.78 (Canadian dollars per US dollar). d) is 1.00 (Canadian dollars per US dollar). 14. The exchange rate (Canadian dollars per US dollar) is 1.20. The Canadian and US price levels are 100 and 125 respectively. The real exchange rate a) is 0.67 (Canadian dollars per US dollar). b) is 1.12 (Canadian dollars per US dollar). c) is 0.78 (Canadian dollars per US dollar). d) is 1.00 (Canadian dollars per US dollar). 15. The exchange rate that would make an investor indifferent between domestic and foreign bonds is called a) the forward exchange rate. b) the real exchange rate. c) the spot exchange rate. d) the implicit forward exchange rate. 16. According to interest rate parity a) the domestic rate of interest is the sum of the foreign interest rate and the rate of inflation. b) the foreign rate of interest is the sum of the domestic interest rate and the rate of inflation. c) the domestic rate of interest is the sum of the foreign interest rate and the rate of depreciation of the domestic currency. d) the domestic rate of interest is the sum of the foreign inflation rate and the rate of appreciation of the domestic currency. 17. According to interest rate parity, a country’s currency will appreciate if a) the domestic rate of interest falls b) the foreign rate of interest rises c) the expected exchange rate rises. d) the expected exchange rate falls. PROBLEMS 1. Consider the following exchange rates (defined as US dollars per unit of foreign currency): Canada (Canadian dollar) 0.8797 U.K. (British pound) 1.7830 France (Franc) 0.1826 Germany (Deutschmark) 0.6242 Japan (Yen) 0.0070 Calculate cross-rates for a) Canadian dollars per British pound. b) Yen per Deutschmark. c) British pounds per franc. d) Francs per Canadian dollar. 2. Consider the following inflation rates for the year 2002, and exchange rates (domestic price of the US dollar) for the year 2001: Country Domestic Foreign (US) Exchange Inflation Rate Inflation Rate Rate (2001) Canada 5% 8% 1.500 Denmark 10% 6% 6.000 France 4% 6% 5.000 Under the assumption that relative purchasing power parity holds, calculate the exchange rates for the year 2002. Indicate whether the domestic currency has appreciated or depreciated in each case. 3. Explain the effect of an increase in demand for foreign bonds on the exchange rate under the following exchange rate regimes: a) floating exchange rate regime b) fixed exchange rate regime 4. Explain the impact on the exchange rate of increases in the demand for both exports and imports under a flexible exchange rate system. 5. Consider the following data, reported in millions of dollars for a country: savings = 100, investment = 150, government taxes = 200, and government expenditure = 200. What is the size of the current account surplus or deficit? 6. Explain what is meant by the twin deficits. Explain how this situation arises. Suppose that initially both the government’s budget is balanced and the current account is balanced. Explain what happens to the interest rate, the exchange rate, the trade balance, the capital account and the current account as the government maintains a deficit balance for an extended period of time. ANSWER SECTION Answers to multiple-choice questions: a (see page 136) d (see page 137) c (see page 138) a (see pages 139-140) b (see page 143) c (see page 144) d (see pages 144-145) a (see page 149) b (see pages 148-149) 10. c (see pages 149-150) b (see page 151) a (see page 152-153) d (see page 155) a (see page 155) d (see page 153) c (see page 156) d (see page 163) Answers to problems: 1. a) Canadian dollars per British pound = (1.7830/0.8797) = 2.0268 b) Yen per Deutschmark = (0.6242/.0070) = 89.1714 c) British pounds per franc = (0.1826/1.7830) = 0.1024 d) Francs per Canadian dollar = (0.8797/0.1826) = 4.8176 2. Country Rate of Change in Exchange Rate in 2002 Exchange Rate Canada 5% - 8% = -3% 1.500 + [1.500(-3%)] = 1.455 (appreciation) Denmark 10% - 6% = 4% 6.000 + [6.000(4%)] = 6.240 (depreciation) France 4% - 6% = -2 % 5.000 + [5.000(-2%)] = 4.900 (appreciation) 3. An increase in the demand for foreign securities increases the demand for foreign exchange, resulting in an upward/rightward shift in the demand curve for foreign exchange. This creates an excess demand (shortage) for foreign exchange at the existing equilibrium rate of interest. a) In a flexible exchange rate system, a shortage forces the exchange rate to increase, and a new equilibrium rate of interest will be established at a higher exchange rate, at which the supply curve and the new demand curve intersect. b) In a fixed exchange rate system, the central authority (central bank) wouldeliminate the shortage by selling foreign exchange at the prevailing rate, so that the quantity demanded and the quantity supplied would be equal at the fixed exchange rate. An increase in demand for imports increases the demand for foreign exchange, while an increase in demand for exports increases the supply of foreign exchange. A normal demand (supply) curve for foreign exchange is downward- (upward-) sloping. An increase in the demand for foreign exchange shifts the demand curve rightward/upward, while an increase in the supply of foreign exchange shifts the supply curve rightward/downward. The net impact on the equilibrium exchange rate depends on the relative size of the changes in the demand for and supply of foreign exchange. If the increase in demand (supply) is larger than the increase in supply (demand), then the equilibrium exchange rate increases (decreases). An increase in the exchange rate implies a depreciation of the domestic currency. 5. The size of the current account deficit or surplus can be calculated using the following equation: savings + (taxes - government expenditure) = investment + (exports - imports) 100 + (200 - 200) = 150 + (exports - imports) 100 + (200 - 200) - 150 = (exports - imports) -50 = (export - imports) The current account has a deficit of 50 million dollars. 6. An increase in government deficits will raise domestic interest rates leading to an inflow of capital and an appreciation of the domestic currency. This will cause the trade balance to deteriorate and a deficit to arise on the current account. Over time successive capital inflows will result in a deficit on the investment account and also contribute to the deficit in the current account.