Exchange Rate Dynamics(II) Dr. J. D. Han King’s College U.W. O.

1. Recall that S and D of FOREX affect FX Rates through International Trade Supply Demand International Trade Export Imports FX rate + FX rate -

2. Real Factor Analysis What are the real factors that affect FOREX rates? -Supply of and demand for domestic versus foreign goods (tradable goods) -Mainly, Productivity or Technical Innovation of Export Industry

Real Factor Analysis focuses on the real factors affecting the Supply and Demand of Exports versus Imports Exports(Technical Innovation; Cost Conditions) Imports(International Demand) Any real factors raising EX-IM will move E down. eg1) Technical Innovation in a Canadian export industry will lower the cost and the price of exports. As more exports bring in more FOREX, E will fall. eg2) Unfavorable tax system and labor movement will raise the production cost of the Canadian export industry. Then……… eg3) An increase in the international demand for oil sand from Canada will …….. _______.

2. Case Study I: PPP in Japan of the 1970-80s : Did it work? Background: -Japanese Yen became strong: for the Japanese, FX rate or e fell - E fell more than P/ Pf fell.

1) Facts: Data of Japanese FOREX Rate Trends of P/P* and E in Japan P/P* E ‘76 ‘87

2)Analysis: - The appreciation of the Japanese Yen, or the falling E can be only partially explained by P/Pf as PPP suggests; Japanese price level was relatively stable compared to the U.S. price level Japanese monetary policy was relatively conservative compared to the U.S. monetary policy

E Pf / P is not equal to one, as suggested by PPP. There is a large part of the falling E, which cannot be explained by PPP. E Pf / P is not equal to one, as suggested by PPP.

Modification of PPP: Now, introducing ‘q’ A Meandering Real ROREX rate: E Pf /P = q (real factors), where q is called “Real Exchange Rate”

*Now use ‘q’ to explain the whole story: (i) Nominal Factors affecting the Price Level: Relative Overall Price Ratio between Japan and U.S. (Pf/ P) remains stable due to monetary policies

(ii) Real Factors affecting the Price Level: Overall Average Prices do not change very much. Suppose that In Japan, there are two sectors of industry: Tradables and Non-Tradables The overall price level in Japan is the weighted average of the prices of the two sectors: P = 0.5 PT + 0.5 PNT (in simpliest form) Technical Innovation happens only to Tradables industry - Due to Technical Innovations, Japanese Tradable becomes cheaper. Due to Technical Backwardness, Japanese Non-tradable becomes more expensive: Overall P stays stable (Pf/P stays the same).

(iii) Real Factors affecting the Prices of Tadables, and Trade: FOREX rate or E falls Japanese Tradable goods have price competitiveness edge over Foreign-produced Tradable goods: falls. Trade depends on PTf / PT , not Pf/P. International Substitution from foreign Tradable goods to domestic tradable goods Trade surplus for domestic country Excess Demand for domestic currency (Excess Supply of foreign currency) Nominal FOREX rate or E falls

(iv) Real FOREX rate or q falls: E falls while P f / P looks constant. q = E P f / P falls.

(v) PPP worked for Tradable Goods Prices only, not for the Overall Price Level: E PT f / PT = 1 for Tradable Goods E P f / P << 1 for overall price level Here, q(<<1) is a reflection of an increasing competitiveness of Japanese export goods.

3. Case study of Canada Facts Between 1975-1990s -E continued to rise (against Canadian dollars) -Nominal factors: Money supply increased faster in Canada than in U.S. -Real factors: Canadian productivity lagged behind the U.S. productivity Between 2001-2003 e continues to fall capital flows from U.S. : A higher interest rate in Canada than in the U.S. may reflect improving real factors

*Data: US-Canadian FOREX Rates of the 1970s to 2001. In fact, PPP was not exactly correct If PPP had been correct E q

*2) Analysis: Explaining with ‘q’ It is true that the Canadian monetary policy was more liberal than the U.S. monetary policy up to the 1990s: This explains the general rise of P and E. Theoretically, E and Pcanada /P us should have gone up proportionally. Yet, E went up faster than P/Pf Canada- inflation differentials between U.S. and Canada could not fully explain the changes in the nominal FX. This suggests that a substantial part of FOREX fluctuations between Canada and US is caused by ‘real factors’. What have caused the real FX rate to change, or deviate from unit(one)?

3) One More Application: “Canada should use U.S. Dollars?” Pros 1.No conversion/transactions cost 2. Eliminated FOREX Risks 3. Monetary Discipline for Canada Cons Most FX transactions were in a large amount and do not carry a large percentage of conversion costs Recently developed hedging has already reduced FOREX risks substantially Not much gains for Canada for now

*“How would the elimination of FX rates between the two countries affect the Canadian Economy?” The same currency means no floating FOREX rates. The same currency means the same monetary policies and the same rate of inflation for the two country (as PPP says).

-If the changes in the Canada-US exchange rate had reflected inflation differentials, then the adoption of the common currency would have nominal impacts only. In fact, the floating FOREX rates did have other function(s), the adoption of the common currency and thus the virtual fixed exchange rates would hinder the very function of the floating FOREX rates - Canada needs the floating FX rate system, which presupposes its own currency.

Suppose Real Adverse Shocks for Canada, not U. S *Suppose Real Adverse Shocks for Canada, not U.S. : eg) Canada is hit with a lower productivity; The demand for the Canadian goods fall. Under Flexible FX system The FOREX rates will take the first beating (Option II); The resulting depreciation of the domestic currency substantially restores the demand for the Canadian goods; The changes in Income will be mild. Under Fixed FX system Either Labor demand falls; and thus Wages fall Prices fall Demand for the Canadian goods may rise back Or If wages do not fall, Actual exports fall; Unemployment rises. *M. Friedman: “Changing the setting of the clock” is easier; Option II is better and easier for adjustment than Option I.