Competiveness in a global
economy
Role of exchange rates
Session 7a
Macroeconomic Concepts and Issues
MSc Economic Policy Studies
Alan Matthews
Motivations
• Ireland has a high share of trade outside
the eurozone in which exchange rates play
a crucial role in determining
competitiveness
• Exchange rates are highly volatile
• The level of exchange rates can cause
problems for business
• What determines the level and volatility of
exchange rates?
US dollar/euro exchange rate
Euro
depreciates
Euro
appreciates
Source: ECB Statistical data warehouse
Sterling/euro exchange rate
Euro
depreciates
Euro
appreciates
Source: ECB Statistical data warehouse
The forex market
• Note its size!
– According to BIS, average daily turnover April 2010
was €3.98 trillion (see Wikipedia entry)
• Made up of a series of interrelated markets
–
–
–
–
Spot market
Forward market
Futures market
Derivative markets
• Swaps and options
• Determines the relative values of different
currencies
The exchange rate
• The price of foreign currency (dollar, sterling,
yen) in terms of domestic currency (euro)
– (viz. The price of apples – how much do you have to
pay in domestic currency)
• Suppose it costs US citizen $1.99 to buy 1 GBP
in 1991 and twelve years later it costs only $1.58
– dollar has appreciated
• From UK perspective, I USD cost 50p in 1991
and 63p in 2003 – sterling has depreciated
Impact of exchange rate on firms
• Advantages of a strong currency
– Makes imported raw materials cheaper
– Helps to control inflation
– Leads to lower interest rates
– Makes foreign assets cheaper
• Disadvantages of a strong currency
– Exporters lose price competitiveness
– Adverse impact on competitiveness may be
moderated if leads to lower wage demands
Effective exchange rates
• Bilateral exchange rates do not move together, so we
need some method to summarise the overall strength or
weakness of a country’s currency
• The nominal effective exchange rate (EER) is defined as
the exchange rate of the domestic currency vis-à-vis
other currencies weighted by their share in world trade
– Which currencies
– What weights?
– Significance of the base year
– Now called the Harmonised Competitiveness
Indicator (HCI)
Source: NCC, Annual Competitiveness Report 2008
Source: NCC, Annual Competitiveness Report 2010
Real Effective Exchange Rate
• Real effective exchange rate (REER) also takes account
of price level changes between countries
– adjusts the nominal EER by the ratio of foreign to domestic
inflation
– Used to assess change in competitive position of a country
relative to its competitors
• Example
– Suppose currency of country A has depreciated over one year
by 10% against currency of country B
– Suppose inflation rate in A is 7% and inflation rate in B is 2%
– Then real depreciation (change in REER) is 10% - (7% - 2%) =
5%
– Improvement in competitive position is 5%, not the 10%
suggested by the EER
• Now called the real HCI
Source: NCC, Annual Competitiveness Report 2010
Exchange rate determination
• The exchange rate between two
currencies is the price of one currency in
terms of the other
• Express the exchange rate as the number
of US dollars (price) per euro
• To determine the exchange rate we
examine both the demand for and the
supply of euros
The demand for euro
• A derived demand
• Americans want euro
– in order to pay for
European goods and
services (exports)
– In order to pay for
European assets
including government
bonds, equities and
property
$/€
2
Depreciation
1
0.5
Euro
The supply for euro
• A derived supply
• Europeans want
dollars
– in order to pay for
American goods and
services (imports)
– In order to buy
American assets
including government
bonds, equities and
property
$/€
2
Depreciation
1
0.5
Euro
Exchange rate equilibrium
$/€
S
D
Factors which shift the demand or
supply curves
• Interest rate differentials
– Shifts in demands for assets
• Inflation differentials
– If EU goods become more expensive
• Growth differentials
– Stronger growth usually associated with stronger currency
• Speculation
– Expectations about future exchange rates
– Affected by above factors as well as stance of economic policy
(budget deficits, balance of payments deficits, political outlook as
well as market psychological factors)
Reaching a new equilibrium
• Suppose euro interest
rates rise
• Will increase demand
for euro from US
investors
• Will decrease supply
of euro as EU
investors also shift
from US to EU assets
• Euro appreciates
$/€
D2
S2
S1
D1
Exchange rate equilibrium
• How can we tell if a currency is overvalued or under-valued?
• Is a currency likely to appreciate or
depreciate in the near future?
• Answers provided by
– Purchasing Power Parity theory
– Balance of payments approach
– Asset market or portfolio theories
Purchasing power parity
• PPP model holds that, in the long run, exchange rates
adjust to equalise the relative purchasing power of
currencies
• Draws inspiration from Law of One Price
– Arbitrage will ensure price levels converge
• Absolute PPP
– The exchange rate will be such as to make the general level of
prices the same in every country
– Exchange rates between currencies are in equilibrium when their
purchasing power is the same in each of two countries
– Unrealistic assumptions
– Difficulties with non-traded goods
Purchasing power parity
• Relative PPP
– Changes in the exchange rate are determined by the
difference between relative inflation rates in different
countries
• Over the long run we would expect exchange rates to
adjust to maintain purchasing power parity
• In other words, exchange rates should adjust to offset
differences in the rates of inflation, maintaining a
constant real exchange rate
• Do exchange rates adjust to maintain purchasing power
parity?
– Yes, in the long run, but very slowly for reasons that
are still unclear (see Rogoff JEL 1996)
Purchasing power parity
• How is PPP calculated?
– The Economist ‘Big Mac’ index
– People consume very different goods and services
across countries
– Standard estimates produced every six months by
OECD/Eurostat (OECD PPP database)
– OECD estimates in next chart compare the PPP of a
currency with its actual exchange rate compared to
US dollar. Green bars (top of chart) indicate currency
is overvalued and thus expected to depreciate against
he US dollar in the long run, and vice versa.
OECD PPP estimates
(relative to Euro)
Source: University of British Columbia Pacific FX Service
PPP uses
• Clearly there are significant discrepancies
between PPP and actual exchange rates
• But can PPP be used to predict exchange rate
changes?
– Poor empirical performance
– Real exchange rates not only determined by relative
inflation differentials
– Real exchange rates can and do change significantly over
time, because of such things as major shifts in productivity
growth, advances in technology, shifts in factor supplies,
changes in market structure, and commodity shocks
– Note objection: Rapid productivity growth -> higher
inflation -> currency appreciation (Balassa-Samuelson
effect)
– But important long-run benchmark
Balance of payments approach
• BoP approach focuses on relationship between
trade/current account balance, modified to taken
into account long-term capital flows, and the
exchange rate
• BoP approach also allows ER to be influenced
by real factors (economic fundamentals)
• Country with a persistent deficit is likely to
devalue, country with persistent surplus likely to
revalue
• Different to, but consistent with, PPP theory
– PPP -> If country A has higher inflation rate than B,
will run into a deficit and be forced to devalue
Examples of economic
fundamentals
• These are factors which can shift the
supply and demand curves for a currency
(see above)
– Changes in the growth rate
– Balance of payments (influencing
expectations)
– Equity and bond market performance
– Size of budget deficits and public debt
– Governance and political stability
Asset market (portfolio)
explanations
• PPP and BoP approaches focus on role of ER in
balancing flows of foreign exchange
• Modern approach emphasises role of ER in
balancing the supply and demand of domestic
and foreign assets
• Exchange rates adjust to reflect differences in
the rate of return on assets (bills and bonds) in
different currencies
• It is differences in the expected total return
which is relevant. This comprises the interest
rate on foreign assets plus the capital gain (loss)
from a appreciation (depreciation) of the foreign
currency
Asset market explanations
• Expected exchange rate changes (and
hence the expected capital gains or losses
from investing abroad) influence decisions
• Because expectations are influenced by
‘news’, and news is unpredictable, so are
short run fluctuations
Interest rate parity
• What determines international capital portfolio movements?
– Difference between interest rates at home and abroad
– Expectations about future exchange rates
• Interest rate parity describes the relationship between forward
exchange rates, spot exchange rates and interest rates between two
countries
• Rates of return on comparable assets should be equal around the
world, implying that exchange rates adjust so that difference
between interest rates is zero.
• It relies on the market’s tendency to correct itself through arbitrage
• Two versions
– Uncovered parity
– Covered parity
Uncovered interest rate (UIP) parity
• If US risk-free interest rate is 4% and euro rate is 2%,
why do fund managers not switch into dollar assets?
• Domestic interest rate less foreign interest rate =
expected change in exchange rate (Uncovered
interest rate parity)
• Assumes
– Perfect capital mobility
– Equal risk on home and foreign bonds
• If interest rate differential is greater than the expected
change in spot rates, potential for arbitrage
Covered interest rate (CIP) parity
• Borrow money in one currency (low interest rate), use to buy bonds
in second currency (higher rate), and protect (cover) against
exchange rate movements by buying the first currency forward
• Interest rate differences should equal the forward premium (covered
interest rate parity)
• Forward exchange rate is a proxy for exchange rate expectations.
UIP builds on CIP by assuming that market forces ensure the
forward exchange rate is equal to the expected future spot
exchange rate
– However, forward exchange rate is not a good (although
unbiased) predictor of the spot rate
– Underlines that exchange rates are affected by shocks which are
inherently unpredictable
Empirical performance of interest
rate parity
• Does (uncovered) interest rate parity hold?
– Hard to measure, since requires information
on expectations and on relative risk of bonds
• Cause or effect?
– if it holds, does it mean that interest rate
differentials determine exchange rate
changes, or vice versa?
Summary
• Exchange rate movements are an important determinant
of competitiveness
• Although we can understand the factors which move
exchange rates, their movement is very hard to predict
• Modern theory emphasises how the importance of the
balance of trade in goods and services (the real
economy) in influencing exchange rates is overwhelmed
by international capital movements, whose movement is
very hard to predict
• Firms can adapt strategies to insulate partially against
exchange rate movements, but they are partial and
costly
• International coordination of exchange rates?
Reading
• McAleese Chapter 21.1 – 21.3
• OECD, Purchasing power parities
measurement and uses, Statistics Brief,
2002.