1、Chapter 05 What Determines Exchange Rates? nThinking in terms of supply and demand is a necessary first step toward understanding exchange rates. The next step is the one that has to be taken in any market analysis: finding out what underlying forces cause supply and demand to change.nSince the gene
2、ral shift to floating exchange rates in the early 1970s, exchange rates between the U.S. dollar and other major currencies have been variable or volatile. Figure 5.1 reminds us just how variable exchange rates have been. (Panel A)Panel BnThe charts suggest three types of variability.First, there are
3、 long-term trends in which some currencies tend to appreciate against the dollar, and others tend to depreciate. Second, there are medium-term trends which are sometimes counter to the longer trends. Third, there is a substantial variability during the short run (from month to month, and indeed, fro
4、m day to day, hour to hour, and even minute to minute). nWhy do we see large changes in the values of floating exchange rates? nHow does short-run variability turn into long-run trends? nWhy are medium-run trends sometimes opposite to these longer trends?n5.1 Exchange Rates in the Short Run n5.2 The
5、 Long Run: Purchasing Power Parity (PPP)n5.3 The Long Run: The Monetary Approachn5.4 Exchange Rate Overshootingn5.5 How Well Can We Predict Exchange Rates5.1 Exchange Rates in the Short Run nTo analyze, we use the concept of uncovered interest parity from chapter 4. Recall that investors determine t
6、he expected overall return on an uncovered investment in a bond denominated in a foreign currency by using The basic return on the bond itself (the interest rate or yield), and The expected gain or loss on currency exchanges (the expected appreciation or depreciation of the foreign currency). nUncov
7、ered interest parity links together four variables: the domestic interest rate, the foreign interest rate, the current spot exchange rate and the expected future spot exchange rate. nChange in any one of these four variables implies that adjustments will occur in one or more of the other three.The R
8、ole of Interest RatesnSuppose the domestic interest rate (i) increases, while the foreign interest rate (if) and the spot exchange rate expected at some appropriate time in the future (eex) remain constant, if the international investors want to shift toward domestic currency assets, they first need
9、 to buy domestic currency before they can buy the domestic-currency bonds. nThis increase in demand for domestic currency increases the current spot exchange rate value of domestic currency, so the foreign currency depreciates (the home currency appreciates). nGiven the speed with which financial in
10、vestors can initiate shifts in their portfolios, the effect on the spot exchange rate can happen very quickly (instantaneously or within a few minutes).nFor example, page 73.nIf the foreign interest rate increases, then the foreign currency appreciates. nThen what happens if both interest rates chan
11、ge at the same time? The answer is that what really matters is the change in the interest differential if-i.The Role of the Expected Future Spot Exchange RatenSuppose that the interest rate differential is unchanged, the financial investors now expect the future spot exchange rate to be higher than
12、they previously expected, if the investors want to shift toward foreign-currency assets, they first need to buy foreign currency. nThis increase in demand for foreign currency increases the current spot exchange rate e. (The foreign currency appreciates; the domestic currency depreciates.) nFor exam
13、ple, page 74.nAs with a change in interest rates, the effect of a change in the expected future spot rate on the current spot exchange rate can happen very quickly (instantaneously or within a few minutes).nGiven the powerful effects what exchange-rate expectations can have on actual exchange rates,
14、 wed like to know what determines these expectations. Many different things can influence the value of the expected future exchange rate. nFirst, if expectations simply extrapolate recent trends, then a bandwagon is possible. Speculation then may be based on destabilizing expectations expectations f
15、ormed without regard to the economic fundamentalsand (speculative) bubbles can occur.nSecond, if expectations are based on a belief that exchange rates eventually follow PPP, then they lead to stabilizing speculationspeculation that tend to move the exchange rate toward a value consistent with the e
16、conomic fundamentals of national price levels.nThird, expectations are affected by various kinds of news about economic and political circumstances.nOverall, Figure 5.2 provides a road map by summarizing the effects. Figure 5.25.2 The Long Run: Purchasing Power Parity (PPP)nIn the short run, floatin
17、g exchange rates are often highly variable, and there are times when it is not easy to understand why the rates are changing as they are. nIn the long run, economic fundamentals become dominant, providing an “anchor” for the long-term trends. nOur understanding of exchange rates in the long run is b
18、ased on the purchasing power parity (PPP) hypothesis. nThree versions of PPP are presented: the law of one price for a single product, absolute PPP, and relative PPP.The Law of One PricenThe law of one price posits that a product that is easily and freely traded in a perfectly competitive global mar
19、ket should have the same price everywhere, once the prices at different places are expressed in the same currency. nIt proposes that the price (P) of the product measured in domestic currency will be equated to the price (Pf) of the product measured in the foreign currency through the current spot e
20、xchange rate (e, domestic currency/ foreign currency):nP = ePfnBig Mac index nFor example, using figures in July 2008:nthe price of a Big Mac was $3.57 in the United States (Varies by store) nthe price of a Big Mac was 2.29 in the United Kingdom (Britain) (Varies by region) nthe implied purchasing p
21、ower parity was $1.56 to 1, that is $3.57/2.29 = 1.56 nthis compares with an actual exchange rate of $2.00 to 1 at the time n(2.00-1.56)/1.56*100= +28% nthe pound was thus overvalued against the dollar by 28%nThe law of one price works well for heavily traded commodities, including gold, other metal
22、s, crude oil and various agricultural commodities.nHowever, it does not hold closely for most products that are traded internationally, including nearly all manufactured products. nInternational transport costs are imperfectly competitive, governments do not practice free trade, many markets are imp
23、erfectly competitive, firms with market power sometimes use price discrimination to increase profits by charging different prices in different national markets. nFor many products, the law of one price does not hold closely. Absolute Purchasing Power ParitynAbsolute PPP posits that a basket of produ
24、cts will have the same price in all countries when the prices are converted into a single currency using the market exchange rates.nP = ePfnWhere P and Pf refer to the average product price in domestic and foreign country, and e is the exchange rate measured as units of domestic currency per unit of
25、 foreign currency. nThe equation can be rearranged to provide an estimate of the spot exchange rate that is consistent with absolute PPP: ne = P/ PfnAbsolute PPP is clearly closely related to the law of one price. nHowever, based on the evidence, absolute PPP does not fare much better than the law o
26、f one price in the real world. Relative Purchasing Power ParitynBoth the law of one price and absolute PPP are posited to hold at a point in time. Another version of PPP looks at how things are changing over time. nRelative PPP posits that the exchange rate will change to offset differences between
27、changes in product-price levels in different countries. The formula is:n(et/e0) = (Pt/P0)/(Pf,t/Pf,0)nWhere the subscript 0 indicates values in the initial year and the subscript t indicates values in a subsequent year. nRelative PPP is often defined using an approximation. The ratio of the two exch
28、ange rates can be approximated by the percentage rate of appreciation (depreciation if negative) of the foreign currency over time. nThe ratio of the countrys product price levels can be approximated by the percentage increase in the price level over time, which is the inflation rate. nRelative PPP
29、can then be stated approximately as:nRate of appreciation of the foreign currency = fnWhere and f are the inflation rates for the domestic and foreign country. nRelative PPP provides some strong predictions about exchange rate trends, especially in the long term. nIt implies that low-inflation count
30、ries tend to have appreciating currencies and high inflation countries tend to have depreciating currencies. nIn fact, a strict application of PPP implies that each percentage point more of a countrys inflation per year tends to be related to a 1 percent faster rate of depreciation of the countrys c
31、urrency per year.Relative PPP: Recent ExperiencenIts suggested that PPP holds reasonably well in the long run, but poorly in the short run.Figure 5.3 provides evidence on the long run during the current period of floating exchange rates. nWe can also examine performance of PPP for both short and lon
32、g periods using data on the exchange rates of individual countries over time. Figure 5.4 shows the actual exchange rates against the U.S. dollar and the exchange rates that would be consistent with PPP for German Mark (DM) and Japanese yen. nThe examination shows that there is a tendency to follow r
33、elative PPP in the long run, but there are also substantial deviations from relative PPP in the short run.5.3 The Long Run: The Monetary ApproachnPurchasing power parity indicates that, at least in the long run, exchange rates are closely related to the price levels in different countries. nBut this
34、 suggests the next question: what determines the average national price levels? nEconomists believe that in the long run, the money supply (or its growth rate) determines the price level (or inflation rate), through the equilibrium between money supply and money demand.Money, Price Levels, and Infla
35、tionnThe link between domestic product and the demand for a nations money is central to the quantity theory of demand for money. nThe quantity theory equation says that in any country the money supply is equated with the demand for money, which is directly proportional to the money value of gross do
36、mestic product. nFor home country and the rest of the world, the equation may be:nMs = kPYnMsf = kfPfYfnWhere Ms and Msf are the home and foreign money supplies; P and Pf are the home and foreign price levels; Y and Yf are the real domestic products (that is real GDP).nThe explanation of k and kf ar
37、e as follow.nFor each country, the nominal or money value of GDP equals the price level times the real GDP (PY and PfYf). k and kf indicate the proportional relationships between money holdings and the nominal value of GDP. They represent peoples behavior. nIf the value of GDP and thus the value of
38、transactions increase, k indicates the amount of extra money that people want to hold to facilitate this higher level of economic activity.nSometimes quantity theories assume that the ks are constant, sometimes not. The facts are that any k varies. nFor present analysis, suppose each money supply (M
39、s and Msf) is controlled by each countrys monetary policy, and that each countrys real production (Y and Yf) is governed by such supply-side forces as factor supplies, technology, and productivity.nRearranging the terms, we can use the quantity theory equations of money supply to determine the ratio
40、 of prices between countries:nP/Pf = (Ms/Msf)(kf/k)(Yf/Y)Money and PPP CombinednCombining PPP and the quantity theory equations for two countries, we obtain a prediction of exchange rates based on money supplies and national products: ne = P/Pf = (Ms/Msf)(kf/k)(Yf/Y).nThe equation predicts that a fo
41、reign nation will have an appreciating currency (e up) if it has some combination of slower money supply growth (Ms/Msf up), faster growth in real GDP (Yf/Y up), or a rise in the ratio kf/k. nConversely, a nation with fast money growth and a stagnant real economy is likely to have a depreciating cur
42、rency.nGoing one step further, the equation implies that some key elasticities are equal to 1. That is, if the ratio (kf/k) stays the same, then e rises by 1 percent forEach 1 percent rise in the domestic money supply (Ms), orEach 1 percent drop in the foreign money supply (Msf), orEach 1 percent dr
43、op in domestic real GDP (Y), orEach 1 percent rise in foreign GDP (Yf).nThe exchange rate elasticities imply something else too: nAn exchange rate will be unaffected by balanced growth.nIf money supplies grow at the same rate in all countries, leaving Ms/Msf unchanged, and if domestic products grow
44、at the same rate, leaving Yf/Y unchanged, there should be no change in the exchange rate.5.4 Exchange Rate OvershootingnOur view of exchange rates as being determined in the long run by purchasing power parity, with its emphasis on average rates of inflation over many years, seems quite removed from
45、 the view that exchange rates in the short run are struck by rapid shifts in investors portfolio decisions. nYet the two must be related. The short run eventually flows into the long run.nIt is useful to consider this relationship in more depth, to explore the phenomenon of overshooting. nInternatio
46、nal investors can react rationally to news by driving the exchange rate past what they know to be its ultimate long-run equilibrium value. The actual exchange rate then moves slowly back to that long-run rate later on. nThat is, in the short run, the exchange rate overshoots its long-run value and t
47、hen reverts back toward it. nSuppose that the domestic money supply unexpectedly jumps 10 percent at time t0 and then resumes the rate of growth investors had already been expecting. nInvestors understand that this permanent increase of 10 percent should eventually raise the price of foreign exchang
48、e by 10 percent, if they believe that PPP and the monetary approach hold eventually. nIn the long run, both the domestic price level (P) and the price of foreign exchange (e) should be 10 percent higher.nTwo realistic side effects of the increase in the domestic money supply intervene and make the e
49、xchange rate take a strange path to its ultimate 10 percent increase:(1) Product prices are sticky in the short run, so considerable time must pass for domestic inflation to raise domestic prices P by 10 percent (relative to foreign prices).(2) Because prices are sticky at first, the increase in the
50、 money supply drives down the domestic interest rate, both real and nominal. nWith the domestic interest rate (i) lower, the return differential shifts to favor foreign-currency assets. In addition, the expected future spot exchange rate should increase. nTherefore, the overall return differential a
