International Finance and Exchange Rates

EC 302 Intermediate Macroeconomics Antonio Doblas-Madrid, Ph.D.

EXCHANGE RATES
Please Read: ABC 13.1 and 13.2
ABC Ch13: pp 501-504, 507-513
CIP-UIP-Carry__Notes.pdf

Contents:
Nominal vs. Real Exchange Rates
Purchasing Power Parity (PPP)
Interest Parity Covered and Uncovered
Fixed vs. Flexible Exchange Rates
The Nominal Exchange Rate e
nom
is the price of 1 US
Dollar in terms of foreign currency.
Example: e
nom
= 12 MXN/USD
(Mexican Pesos per US Dollar)

The Real Exchange Rate e is the price of 1 unit of
US goods in terms of foreign goods. Let P and P
For

denote domestic and foreign price levels, we have

e = e
nom
P

/P
For


Example: US shirt P = 50 USD, Mexican shirt P
For
200 MXN.
e = 12*50/200 = 3 Mexican shirts per US shirt.
Nominal vs. Real Exchange Rate
CHANGES IN e MUCH MORE
RELEVANT THAN CHANGES IN e
nom


If Mexican prices P
For
and the nominal exchange rate e
nom
both
double, the real exchange rate e remains unchanged

Example: US shirt P = 50 USD, P
For
= 400 MXN. e
nom
= 24 MXN/USD
e = 24*50/400 = 3 Mexican shirts per US shirt.

Nominal exchange rates are typically far more volatile than
prices. Therefore, when e
nom
changes, normally e changes in the
same direction.

But in some cases e changes even if e
nom
does not.
Example: In 1993/94, Mexico had a fixed nominal exchange rate against
the USD but also higher inflation than the US. Thus, e fell. This loss of
competitiveness contributed to the 94/95 Tequila crisis.
Appreciation and Depreciation
When e
nom
rises (falls) the Dollar appreciates (depreciates) in
nominal terms, and the Peso depreciates (appreciates) in nominal
terms.

When e rises (falls) the Dollar appreciates (depreciates) in real
terms, and that the Peso depreciates (appreciates) in real terms.

The terms Revaluation/Devaluation have the same meaning, but
are typically used for fixed exchange rate, when Central Banks
realign the level at which they fix the value of their currency.

WARNING: Exchange rates are a though nut to crack. When
predicting appreciation/depreciation, economists get it right more
than they get it wrong, but they do get it wrong often. A rule of
thumb is right 55-60% of the time and wrong 40-45% of the time.
FOR TRADE, TARIFFS MATTER EVEN
MORE THAN THE REAL EXCHANGE RATE

Given P
For,
imports can become more expensive either
because the US levies a tariff, or because the dollar
depreciates (e
nom
falls)
Example: In 2005, Treasury Secretary Snow urged China to let the Yuan
appreciate against the Dollar by about 20 percent, insinuating that if China
did not comply, Congress might impose a 20 percent tariff on Chinese goods.

Dollar depreciation and rising tariffs have the same effect on
prices. But there is much evidence that rising tariffs curb
imports much more than dollar depreciation.

Reason: Real exchange rates volatile, so changes in e
nom
could
be temporary. Changes in tariffs much more permanent.
THE LAW OF ONE PRICE AND ABSOLUTE PPP
A well-known example is The Economists Big Mac Index. See explanation
and video here: http://www.economist.com/markets/bigmac/

If LOOP held for all goods, and the baskets in the CPI were the same
everywhere, absolute purchasing power parity (PPP) would hold,
and the real exchange rate would be one. Under Absolute PPP:

j j
nom
For
P e P =
The Law of One Price (LOOP) holds when, expressed in Dollars, the
prices of the same good (or service) j are the same in two countries: (P
j
is
the price of good j)

1
nom
For
P
e e
P
= =
In practice, absolute PPP does not hold, since baskets differ between
countries and LOOP fails for some goods, and for most services, which
are often not tradable.

RELATIVE PPP
A less restrictive proposition is relative PPP, which says that
the rate of currency depreciation (or appreciation) shall
equal the difference between foreign and US inflation rates:




is the change in the nominal exchange rate where
nd foreign inflation rates, respectively and are the domestic a
,
For
For
nom
nom
nom
e
e
e
t t
t t
A
A
=


Relative PPP: real exchange rate e remains constant, as
movements in P

and P
For
are offset by movements in e
nom

In reality, relative PPP does have some traction,
especially in medium/long run. High (low) inflation
currencies tend to depreciate (appreciate).



To make the exposition less abstract, I will explain interest
parity concepts using a USD/JPY (Dollar/Yen) example. Of
course, the concepts apply to any currency pair.

There are two dates, t = 0 and t = 1.
i
$
is the nominal interest rate on US Dollars.
i
Yen
is the nominal interest rate on Japanese Yen.
is the spot Yen per Dollar nominal exchange rate at date t.
f is the forward Yen per Dollar nominal exchange rate in a
futures contract signed at t = 0 with delivery at t = 1.
INTEREST PARITY --- Preliminaries
t
nom
e
The spot exchange rate is the price, at time t, of 1 US Dollar
in terms of Japanese Yen.
Example: If equals 100, at time 0, 1$ is worth 100 Yen.

The forward exchange rate f is the exchange rate agreed upon
in a futures contract signed at t = 0 for delivery at t = 1.
Example: A futures contract signed at time 0 specifies that two parties
will, at time 1, exchange (a given number of) Dollars per Yen at the
agreed-upon exchange rate f.

Futures can be used to hedge against risk (e.g., at t = 0 you
know you will have to exchange Yen for Dollars at t = 1 and you
want to lock the rate) or to speculate (e.g., at t = 0 you think
will be higher than f . You sign the futures contract hoping to
make a profit at t = 1, buying Dollars at f, selling them at .)
Spot and Forward Exchange Rates
t
nom
e
0
nom
e
1
nom
e
1
nom
e
COVERED INTEREST PARITY (CIP)

Investing at the interest rate i
$
must yield the same as
exchanging Dollars for Yen, earning the interest rate
i
Yen
and converting back to Dollars at the locked rate f

CIP (exact)


CIP (approximate)


CIP actually holds in reality, it is a no-arbitrage condition.
Whenever CIP fails, investors make profits by borrowing at
a low rate and investing at a high rate. These trades exert
pressure on prices until CIP is restored.
$
0
1 1
Yen
nom
e
i i
f
| |
|
|
\ .
+ = +
$
0
0
.
Yen
nom
nom
f e
i i
e

=
UNCOVERED INTEREST PARITY
Investing in Yen at the interest rate i
Yen
without locking the time-1
rate is risky: If $ appreciates, there can be losses.

Uncovered Interest Parity (UIP) says that, on average, investing
in Dollars should yield the same as buying Yen, earning i
Yen
and
converting back to Dollars at whatever ends up being.

UIP (approximate)


where is the expected value of given information
available at time 0.

Despite intuitive appeal, in reality UIP does NOT hold. Contrary to
UIP, high-interest rate currencies tend to appreciate!
1
$
0
0
[ ]
.
nom
Yen
nom
nom
E e e
i i
e

=
1
nom
e
1
[ ]
nom
E e
1
nom
e
FAILURE OF UIP

Since CIP holds, high-interest rate currencies are worth less in the
forward than in the spot market (i.e., .) On the other hand,
since UIP fails, high-interest rate currencies tend to appreciate (i.e.,
, typically). In sum, f is a very poor forecast of .
International economists call this the forward premium puzzle.

For pairs of developed-country currencies, exchange rates rarely
go the way UIP predicts. In fact, high-interest rate currencies tend
to appreciate.

UIP saves face a bit when we consider, for example, the US and
a country with chronically higher inflation, like Costa Rica or
Venezuela. Higher-inflation countries have higher interest rates
than the US, and their currencies do tend to depreciate against the
Dollar. But UIP still fails, since the depreciation is typically not big
enough to compensate for the interest rate differential.
1
nom
e
0
nom
f e >
1 0
nom nom
e e <
UIP failure exploited by the carry trade. Many foreign
exchange (FX) traders are carry traders, who borrow
low-interest rate currencies and invest in high-interest
rate currencies, hoping that the latter appreciate.

Carry trade typically delivers small gains, but sometimes
it unwinds, generating huge losses. Hence the
nicknames Up by the stairs, down by the elevator or
Picking up nickels in front of steamrollers.

After years of neglect by economists, the carry trade has
recently become a hot research topic in academia, e.g.,
Brunnermeier, Rebelo, Eichenbaum, have recent papers
on this.

CARRY TRADES

EXCHANGE RATE REGIMES
From rigid to flexible

Hard Pegs:
Monetary Union
Using someone elses currency

Soft Pegs:
Currency board (hardest of soft pegs, sometimes listed as hard)
(Unbacked) fixed exchange rate
Exchange rate bands
Crawling peg
Crawling bands

Flexible exchange rate:
Managed or dirty float
Pure float









A currency union, e.g. the Euro, is a very rigid peg, since for a
member of the Euro to leave would be a very big deal politically.
Members of the Euro have common monetary policy, they all vote, and
share seignorage revenues.

Dollarization is similar: Ecuador, El Salvador, and Panam do not
have their own currency. Instead, they use US Dollars. They have no
say in US monetary policy and get no seignorage. Dollarization would
also be difficult to reverse.

Currency board: fixed exchange rate with added condition that all of
the monetary base must be backed by foreign exchange reserves in
central bank.
Example: Hong Kong 7.80HKD=1USD, Argentina 1993-2001: 1Peso=$1.

(Unbacked) fixed exchange rate: Commitment to exchanging ones
currency for another at a given rate.
Example: Saudi Central Bank committed to 3.75 Saudi Riyal = 1 USD.

Countries that fix their exchange rates always allow small fluctuations
around the fixed parity. If this fluctuation is bigger than 1%, the country
is said to have exchange rate bands.
Example: Danish Krona/Euro: 1 = DKK 7,46038 2.25%.

Crawling peg: A commitment to a fixed depreciation rate per year.
Example: Until 2006, Costa Rica was depreciating the Colon 8% per year
against the Dollar. Tunisia, Bolivia, Honduras currently have crawling pegs.

Crawling bands: A commitment to let the currencys value change, say,
between x% and y% per year.
Example: Mexico prior to the 1994 crisis. Chinas current system is best
described as crawling bands. Every day, the Chinese Yuan Renminbi can
change by a certain percentage vis--vis a (secret) basket of currencies.
Managed float: Central Bank intervenes in FX market, but without
explicit commitment about exchange rate levels.
Example: Korean authorities say that the Won floats freely. But in
practice, the Korean Central Bank often buys/sells FX reserves and
changes interest rates in order to stabilize the Won, which fluctuates
less than currencies of truly committed floaters. This phenomenon is
called Fear of floating. Japan also floats, but intervenes.


Pure float, also called purely flexible: Freely determined by supply
and demand. Governments do not intervene. Most developed countries
do this: US, Australia, UK, Euro area.

FIXED EXCHANGE RATES: OVER (&UNDER) VALUATION


Fixed exchange rates do not adjust to equate supply and demand.If
market supply of a currency exceeds market demand, we say that, at
the fixed exchange rate, the currency is overvalued. People want to
sell more Dollars than they want to buy.


The difference is bought by Central Banks, i.e., either the Fed sells
foreign exchange reserves to absorb the Dollars, or another Central
Bank, e.g, the Chinese Central Bank, must buys Dollars.


The loss of reserves by the Fed and/or gain of dollars at the Chinese
central bank represents a BOP deficit for the US.


If the Dollar is overvalued vis--vis the Yuan, the Yuan is undervalued
vis--vis the Dollar. Market demand for Yuan exceeds market supply,
and thus, the Chinese Central Bank has to sell the missing Yuan,
acquiring Dollars. China has a BOP surplus. (In Chinas KFA, the
official reserve assets line has a big negative entry---recall that signs in
the KFA are counterintuitive.)

WHY FIX?

1. Eliminate/reduce exchange rate risk. Volatility of floating rates
discourages firms from trading and investing internationally. Hedging
instruments, e.g., futures contracts, can be used to eliminate risk, but
these instruments come with transaction costs, fees, and require some
financial knowledge.

2. Fixing is a way to commit to a disciplined monetary policy. When
countries want to stop having inflation, they often fix the exchange rate
in an effort to force themselves not to print so much money.

WHY FLOAT?

1. A fixed currency may become overvalued, leading to a speculative
attack and currency crisis. Or it may become undervalued, making
imports too expensive and causing great reserve accumulation.

2. Loss of autonomy in monetary policy: When Euro interest rate
rises, Denmark always increases its rate by the same amount. If it does
not, investors would flee from Kronas to Euros.