Exchange Rates
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Issues
•
•
•
•
What are nominal exchange rates?
What drives FX rates?
Exchange rate regimes
Speculative attacks on currencies
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Exchange Rates
Yen has moved from 350 to about 100, why?
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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
E P P

E P P
*
t 1
t
t 1
t 1
*
t
t
• 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
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Nominal Exchange Rates and Inflation Differentials
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Exchange Rates, Interest Rates and Inflation
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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 $3.41 in US, then the
PPP exchange rate would be 3.06/3.41 = 0.8973.
If the actual exchange rate is lower, then the BigMac theory says that
you should expect the value of the Euro to go up until it reaches the
PPP exchange rate. If the actual exchange rate is higher, then the
BigMac theory says that you should expect the value of the Euro to go
down until it reaches the PPP exchange rate.
The Over/Under valuation against the dollar is calculated as:
(PPP - Exchange Rate)
---------------------------------- x 100
Exchange Rate
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Interest Rates and Exchange Rates
Uncovered Exchange Rate Positions
•
•
Strategy 1
Invest 1$ 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 Goods
and 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
Higher than expected real GDP
growth
Better investment
opportunities will attract
foreign capital.
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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exchange rates
national currency per dollar
Financial Crisis in the 90’s
Mexico
Thailand
Russia
Argentina
Jan90 Dec90 Dec91 Dec92 Dec93 Dec94 Dec95 Dec96 Dec97 Dec98 Dec99 Dec00 Dec01
Dec02
months
Time series of recent collapse
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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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South-East Asian Crisis
•Return to capital is falling well before the crisis in 1997
•Note return to capital is reciprocal of Incremental capital-output ratio
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Non-Performing Loans in South-East Asia (1997)
Percentage of all loans
Percentage of GDP
35
30
25
20
15
10
5
Singapore
Philipines
Malaysia
South
Korea
Indonesia
Thailand
0
40
Non-Performing Loans in South-East Asia (1997)
Percentage of government revenues
Singapore
Philipines
Malaysia
South Korea
Indonesia
Thailand
180
160
140
120
100
80
60
40
20
0
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 ExampleMexico
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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)
90
80
70
60
50
40
Oct-95
Sep-95
Aug-95
Jul-95
Jun-95
May-95
Apr-95
Mar-95
Feb-95
Jan-95
Dec-94
Nov-94
Oct-94
Sep-94
Aug-94
Jul-94
Jun-94
May-94
Apr-94
Mar-94
Feb-94
10
0
Jan-94
30
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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
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