Introduction

• Today’s topic, exchange rates:
  • Chapter 19: Real exchange rate — cost of living.
  • Chapter 20: Nominal exchange rate and forex markets.
  • Chapter 21: Currency crises and exchange rate regimes.
• Guaranteed and required question on final exam.
• Feedback time:
  • Constructive feedback always welcome.
  • Please fill out form, leave it on desk at front as you leave.

Guest Lecture Etc

• Fascinating talk by Clare MaCallan on how the Bank of England operates.
  • Opportunity to hear from those involved in policymaking:
    • What happens? What influences it? How do they do it?
• Should it act to bring inflation to target immediately, or at two-year horizon?
  • Where are we on the business cycle?
• Easy extra/wider reading around central part of the course.
• Slides: http://goo.gl/ghtA3a
• Great experience for those who attended:
  • Attendance: 20, or 12%.
• Reminder from earlier in term:
  • You are expected to do 12.1 hours per week of guided independent study.
• I will answer no more emails regarding this afternoon’s essay deadline.
  • Electronic only via Blackboard, no paper submissions accepted.

Chapter 19: Real Exchange Rates

• Bilateral exchange rate: Rate one currency swapped for another.
  • E.g. If £1 swapped for $1, exchange rate is 1:1.
  • Appreciation: £ worth more, e.g. £1=$1.5.
  • Depreciation: £ worth less, e.g. £1=$0.90.

• Effective exchange rate: Trade weighted average of bilateral exchange rates.

Euro Effective Exchange Rate

Real vs Nominal Exchange Rates

• Nominal: Actual rate one currency swaps for another.
• Real: How expensive goods and services are in different countries.
  • E.g. cup of coffee, Big Mac, nappies, petrol.
  • E.g. Starbucks venti latte £3 in UK, $3 in US, implied exchange rate 1:1.
  • If exchange rate £1=$1.50, can buy coffee and half in US for same price.
• Real exchange rate reflects all goods: \[ \text{Real exchange rate (RER)} = \text{Nominal exchange rate} \times \frac{\text{Domestic price level}}{\text{Overseas price level}}. \]
• If RER=1, then nominal exchange rate reflects cost of living in each country.
  • If RER\(<1\), numerator currency undervalued, RER\(>1\) overvalued.

Law of One Price

• Law of one price (LOOP): Identical commodities sell at same price wherever sold.

  • E.g. Coffee from Eat at different places on Reading Uni campus.

• Law based on arbitrage: If cheaper in one place, buy there, transport and sell on.

  • Demand for more expensive item falls, rises for cheaper, prices adjust.

• Real-life factors that prevent LOOP from holding:

  • Transportation costs.
  • Border effect.
  • Pricing to market.

Transportation Costs

Transportation Costs Broadly

The Border Effect

Pricing to Market

Purchasing Power Parity

• Broader variant of LOOP is Purchasing Power Parity (PPP):

  • PPP is exchange rate s.t. basket of goods costs same in each country:

\[ \text{PPP nominal exchange rate} = \frac{£}{\$} = \frac{\text{UK price of basket of goods}}{\text{US price of same basket of goods}}. \]

• Also: Change in nominal exchange rate = UK inflation - German inflation.
  • This is relative purchasing power parity.

Purchasing Power Parity?

Purchasing Power Parity?

Purchasing Power Parity

Big Mac Index

• Law of one price mixed up with PPP:
  • Idea: Big Mac should cost the same everywhere, shouldn’t it? \[ \text{nominal exchange rate} = \frac{£}{\$} ??? \frac{\text{UK price of Big Mac}}{\text{US price of Big Mac}}. \]

Billy Index

• Aside from mix-up between LOOP and PPP, why Big Mac/Billy indices show differences from exchange rates?
  • Big Macs are not tradeable, and are different across countries.
  • Local tax rates and subsidies may differ.
  • Local differences in input costs.

Balassa-Samuelson Effect

• Why else do prices differ?
• Balassa-Samuelson effect:
  • Countries with high productivity growth also experience high wage growth, which leads to higher real exchange rates.
• Increasing wages in tradable sector in growing economy (from productivity gains) leads to higher wages in non-tradable sector.
• Results in higher inflation (more money for no more produced).
• Implication: Inflation higher in faster growing economies.

The Balance of Payments

• Exchange rates too volatile for PPP theory; what else?
• Balance of payments: Statistical record of financial flows in and out of a country.
  • Split into current account and capital account.

\[ \text{Balance of payments} = \text{current account surplus} + \text{Capital account surplus} = 0. \]

• Further: \[ \begin{align} \text{Current account} =& \ \text{Balance of trade (exports of goods} - \text{imports of goods)}\\ &\quad +\text{Balance on services (exports of services} - \text{imports of services}\\ &\quad +\text{Investment income and dividends}\\ &\quad +\text{Net transfers}. \end{align} \]

The Balance of Payments

• Capital and financial account referred to as capital account: \[ \begin{align} \text{Capital and financial account} &= \ \text{Capital account} + \text{Financial account} \\&\quad+ \text{Errors and omissions}.\\ \text{Financial account} &= \text{Net direct investment} + \text{Net portfolio flows} \\ &\quad +\text{Net other investment} + \text{Change in reserve assets}. \end{align} \]
• Capital account: Acquisition/disposal of non-produced, non-financial assets.
• Direct investment: Agent in one country acquires interest in enterprise in another country.
• Portfolio investment: Mainly trade in shares and bonds.
• Reserve assets: Government’s buying and selling of assets.

Balance of Payments: US in Financial Account Surplus?

But US a Net Debtor? Return on Assets…

International Investment Position

Balance of Payments and Real Exchange Rate

• Summarising: \[ \text{Capital account deficit} = \text{Savings} - \text{Investment}. \]
• Back in Chapter 2, \(GNI=GDP+NIFA\) (net income on foreign assets), hence: \[ GDP + NIFA = C+T+PS, \quad \text{hence} \quad PS = GDP+NIFA-C-T. \]
• Since \(GDP=C+I+G+(X-M)\) then: \[ PS = I+G+(X-M) - T, \quad \text{rearranging:} \quad PS+(T-G)-I= X-M + NIFA. \]

Balance of Payments and Real Exchange Rate

• \(PS\) is personal savings, \(T-G\) is govt savings, hence \(S=PS+T-G\) so: \[ S-I = X-M + NIFA. \]
• \(S-I\) is capital account deficit, \(X-M+NIFA\) is current account surplus.
  • More importantly: Net savings (\(S-I\)) must equal net exports (\(X-M\)).
  • If not, \(NIFA\) must change to ensure balance of payments.

Twin Deficits/Surpluses

Real Exchange Rates and Net Exports Negatively Correlated

But a Real Depreciation Need not Have Instantaneous Impact

Exchange Rate Determination: Assume Net Savings Independent of Exchange Rate

US Investment and the Dollar

Changes in Export Demand Influence Real Exchange Rate

Real Exchange Rate Remains Very Volatile — Too Volatile?

Chapter 20: Nominal Exchange Rates

• Asset Markets Matter in Foreign Exchange.

Trading Centres have Heavily Traded Currencies

Covered Interest Rate Parity

Uncovered Interest Parity (UIP)

• Spot exchange rate: Exchange rate for `on-the-spot’ trade.
• Forward exchagne rate: Exchagne rate for some period in future.

• Covered: \((1+r^{US})(1+fp) = (1+r^{UK})\). Forward exchange rate contract:

  • Agree in advance return exchange rate in future.

• Uncovered: Convert back at future spot exchange rate.

  • More risky…

• Trade based on expected future exchange rate, not actual forward contract.

  • Expected appreciation of pound equal to (e.g.) \(r^{US}-r^{UK}\).

More Risky…

UIP for Current Exchange Rate

• Take expectations of future exchange rate as fixed: What is current exchange rate?

• UIP says it is function of interest rates.

• UIP formula: \[ \frac{s^e(1)-s(0)}{s(0)} = r^{US} - r^{UK} \quad \Longrightarrow \quad s(0) = \frac{s^e(1)}{r^{US}-r^{UK}+1}. \]

UIP for Current Exchange Rate

If domestic interest rate increases…

If foreign interest rates increase…

Immediate Effect of Rate Change Given Future Expectations

Expectation of Appreciation Leads to Immediate Appreciation

Future interest rates? Apply UIP Forward into ``Long Run’’

The Carry Trade

UIP Assumes Risk Neutrality

The Reality of Forex Markets: Swift Updating

The Reality of Forex Markets: Macro News Matters

The Reality of Forex Markets: Macro Irrelevant for Short Run

Chapter 21: Currency Crises and Exchange Rate Systems

GDP Growth and Currency Crises

Currency Crises

• Definition: Currency crisis has two features:

  • Exchange rate depreciation large relative to recent experience.
  • Nominal exchange rate depreciation must also affect real exchange rate.

• I.e. usually a real effect — GDP falls often sharply.

• Generations of models to explain crises…

First Generation Models

But for the ERM Crisis?

Second Generation Models: Speculation and Tipping Points

The Asian Crisis: Sudden Stops and Financial Liberalisation

Forex Intervention: Policy to Stave Off Crises?

Forex Reserves: Response to Asian Crisis

Composition of Reserves Over Time

IMF Crisis?

IMF Crisis?

IMF Crisis?

Capital Account Liberalisation and Crises?

No Obvious Impact on Growth?

Exchange Rate Regimes

Use of Different Regimes in Practice

Choice of Anchor

Concluding

• Today:
  • Chapter 19: Real exchange rate — cost of living.
  • Chapter 20: Nominal exchange rate and forex markets.
  • Chapter 21: Currency crises and exchange rate regimes.