Chapter 8: Learning Objectives Exchange rate definitions Theories of Exchange Rate Behaviour: From the Law of One Price to PPP The real exchange rate concept International linkages in interest rates Hysteresis in exchange rate behaviour

A Selection of Exchange Rates CAD $ 1.2062 US$ .8290 £ .4313 .5203 € .6086 0.7341 ¥ 85.48 103.11 SFr 0.9405 1.1344

What’s an exchange rate? The price of one currency in terms of another: $CDN per $1.00US = e $US per $1.00CDN Cross-rate: when bilateral quotes n.a. Appreciation vs. depreciation Devaluation vs. revaluation trade-weighted exchange rate the “law” of one price [Pfe=P]

Managed or “dirty” float Exchange Rate Systems Fixed or Pegged Flexible or Floating Managed or “dirty” float Target zone

Varieties of Exchange Rate Regimes

Financial Focus 8.1: German Reunification Two very different systems merged in 1990 Political motives were strong But an exchange rate had to found Can the LOOP help?

Exchange Rate Determination Demand for foreign exchange (foreign currency) foreign trade and capital flows Supply of Foreign exchange foreign trade, capital flows and exchange rate systems Equilibrium: Figure 8.1

Floating Exchange Rate Determination E=($CAN per US$) Dep’n S0=supply of US$ $1.25 E0 D0=demand for US$ App’n

Fixed Exchange Rate Determination E=($CAN per US$) Dep’n S0=supply of US$ $1.25 E0 D0=demand for US$ App’n

Balance of Payments Like a balance sheet for a firm the BOP records international financial transactions Divide into the CURRENT and CAPITAL accounts In theory the BOP=0 since current account and capital account balances should offset each other except for a “statistical discrepancy” The Current account reflect trade in goods and services; the capital account reflects cross-border financial flows Figure 8.3 provides some data

Canada’s Balance of Payments

The Canadian Balance of Payments

Foreign Exchange Intervention Central banks intervene in the foreign exchange market to influence the value of the currency. They believe the currency is over or under-valued (Figure 8.3) Does it work? In the very short-run, yes. Over sustained periods, no Some intervention is prompted by monetary policy such as the buying/selling of government bonds In the absence of “sterilization” domestic monetary/fiscal policies can lead to unwanted or undesirable effects

Figure 8.3 Exchange Rate Equilibrium • Quantity of US dollars Exchange rate (C$ per US$) S D $1.40 Q* Equilibrium Exchange rate Overvalued C$ Undervalued C$ Q0 $1.35 Q1

Economics Focus 8.2: Big Mac Parity CAN US Year P Pf P/Pf e Value 1986 1.89 1.60 1.18< 1.39 Under 1990 2.19 2.20 1.00< 1.16 1995 2.77 2.32 1.19< 1999 2.99 2.43 1.23< 1.51 2001 3.33 2.54 1.31< 1.56 2004 3.19 2.90 1.10< 1.37

The Twin Deficit (Surplus) Deficits in the government’s budget can have consequences for the balance of payments The “twin deficits” arises from the National Income accounting relation: y=c+i+g+(x-im) if i=s, (t-g)=(x-im) An excess of government spending leads to a current account deficit, but the empirical evidence is mixed Works symmetrically in the case of a surplus

Loanable Funds in an Open Economy Loanable funds and the “open” economy: Figure 8.4 Opening up the economy makes the supply of loanable funds more “elastic

Figure 8.4A. Loanable Funds with International Borrowing and Lending: A. Total Supply of Loanable Funds LFs Quantity of bonds 6 R% B0 B1 LFs + LFsf 8 B2 4

Figure 8.4B. Loanable Funds with International Borrowing and Lending: Equilibrium with International Lending and Borrowing R LFs Quantity of bonds R0 B* LFd0 LFd1 R2 B** LFs + LFsf R1

Purchasing Power Parity Absolute version Relative Version floating case fixed case Real exchange rate: a fall (app’n) means loss of competitiveness a rise (dep’n) means a rise in competitiveness

Absolute & Relative PPP in Canada

The Bank of Canada Equation

International Linkages in Interest Rates Capital mobility means that domestic and foreign rates will be linked via the exchange rate For a given maturity we would expect Return $C = Return in $C x Implicit invested abroad forward exchange rate OR R = Rf + (eexp – es)/es

A Numerical Case Study of IRP: Eurodeposits 3month eurodeposit Spot e 3 month forward R differential Exp % change in e US$ 6.08 1.4755 1.4718 -1.15 -1.00 $C 4.93 € 3.37 1.5134 1.5198 +1.56 +1.69 ¥ 0.18 69.38 68.55 +4.75 +4.86 £ 5.87 2.3933 2.3945 -0.94 -0.80

Digrammatic Exposition of Interest Rate Parity Rf0 Rf>R eexp < es R Rf<R eexp >es Rf0 e

Digrammatic Exposition of Interest Rate Parity Rf0 R Rf0 e

Digrammatic Exposition of Interest Rate Parity Rf0 R0 A Rf0 e

Digrammatic Exposition of Interest Rate Parity Rf0 B R1 R0 A R e

Digrammatic Exposition of Interest Rate Parity Rf0 B R1 R0 A Rho R e

Digrammatic Exposition of Interest Rate Parity Rf1 R Rf0 C R0 A Rf1 Rf0 e

Digrammatic Exposition of Interest Rate Parity Rf1 R Rf0 C R0 INF A Rf1 Rf0 e

Hysteresis “fundamentals” of exchange rate determination don’t explain exchange rate movements well implication: exchange rate forecasting difficult Hysteresis concept means that once the cause of an app’n or dep’n disappear, it can take some time for e to find its equilibrium

Summary The exchange rate reflects the relative value of currencies There exist a wide variety of exchange rate systems depending on the how unfettered the market for foreign exchange is Purchasing Power Parity can explain inflation differentials between countries The real exchange rate is a useful indicator of a country’s competitiveness