Lecture 3 International Finance ECON 243 – Summer I, 2005 Prof. Steve Cunningham

Exchange rate components Yen’s trade- weighted exchange value Fundamentally driven long-run equilibrium path Fundamentally driven medium-run cyclical path Technically driven short-run overshooting path Fundamental equilibrium path

What Determines Exchange Rates? Short run (hours, days, months) – related to financial transfers because of the speed of these transactions. Therefore: Short run (hours, days, months) – related to financial transfers because of the speed of these transactions. Therefore: Asset Market Approach: differences in real interest rates, hence our interest in: Asset Market Approach: differences in real interest rates, hence our interest in: Covered Interest Differentials Covered Interest Differentials Uncovered Interest Differentials Uncovered Interest Differentials Shifting expectations of future exchange rates Shifting expectations of future exchange rates Medium run (years) Medium run (years) Economic cycles (Income differentials) Economic cycles (Income differentials)

Interest Rate Differentials Short term real interest rate differentials influence international capital movements Short term real interest rate differentials influence international capital movements Real interest rate is nominal minus inflation Real interest rate is nominal minus inflation Low short term rates lead to less demand for the currency and depreciation Low short term rates lead to less demand for the currency and depreciation High rates lead to greater demand for the currency and appreciation High rates lead to greater demand for the currency and appreciation

Millions of Euros Impact of interest rate differentials Dollars per Euro S0S0 A D0D B D1D1 S1S1

Market expectations As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates As with stock markets, foreign exchange markets react quickly to news or even rumors that point to future changes affecting rates Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while Future expectations can be self-fulfilling; speculative bubbles can start without any real information but can become self sustaining for a while

Determining Exchange Rates (Continued) Long run (many years) - movements of goods, services, investment, influenced by: Long run (many years) - movements of goods, services, investment, influenced by: Inflation rates (relative prices: Purchasing Power Parity (PPP) Inflation rates (relative prices: Purchasing Power Parity (PPP) Long-term investment profitability Long-term investment profitability Consumer tastes Consumer tastes Long-term real GDP growth rates Long-term real GDP growth rates Productivity Productivity Trade policy Trade policy

Purchasing Power Parity (PPP) —some history The theory of PPP has been around as long as paper money. It is one of the oldest theories of exchange rate determination. Hence we present it first. The theory of PPP has been around as long as paper money. It is one of the oldest theories of exchange rate determination. Hence we present it first. It was discussed in 16 th Century Spain, for example. It was discussed in 16 th Century Spain, for example. It was last resurrected by Gustav Cassel in the period between WWI and WWII. He used it in discussions of how much European countries would have to either change their exchange rates or their domestic price levels, given that WWI had changed the relative prices in the countries (causing different inflation rates in the countries). It was last resurrected by Gustav Cassel in the period between WWI and WWII. He used it in discussions of how much European countries would have to either change their exchange rates or their domestic price levels, given that WWI had changed the relative prices in the countries (causing different inflation rates in the countries). It is based on the Law Of One Price (LOOP). It is based on the Law Of One Price (LOOP).

Law of One Price (LOOP) The law of one price is: The law of one price is: “In a competitive market, if two goods are identical, then they should sell for the same price.”  If the two goods were in the same place and both available to customers, then customers would always choose the cheaper of the two goods, forcing the sellers of the more expensive one to lower their price.

Arbitrage If the two goods were not in the same market (place), then arbitrage would operate to equalize the prices. If the two goods were not in the same market (place), then arbitrage would operate to equalize the prices. Arbitrage is the process of buying or selling something in order to exploit a price differential so as to make a riskless profit. Arbitrage is the process of buying or selling something in order to exploit a price differential so as to make a riskless profit. Arbitrageurs seek to find and exploit price differentials between markets (across space). Arbitrageurs seek to carry goods across markets. Arbitrageurs seek to find and exploit price differentials between markets (across space). Arbitrageurs seek to carry goods across markets.

Speculation If the two goods were not being demanded at the same time, and the good was storable, then speculation would tend to equalize prices. If the two goods were not being demanded at the same time, and the good was storable, then speculation would tend to equalize prices. Speculation is the holding of a good or security in the hope of profiting from a future rise in price. Speculation is the holding of a good or security in the hope of profiting from a future rise in price. Speculators “arbitrage” across time. Speculators “carry” the goods across time. Speculators “arbitrage” across time. Speculators “carry” the goods across time. Because no one really knows the future, speculation is inherently risky. (Spatial) arbitrage is not. Because no one really knows the future, speculation is inherently risky. (Spatial) arbitrage is not.

Deviations from LOOP Carrying (storage) costs reduce the profits from speculation, and Carrying (storage) costs reduce the profits from speculation, and Transportation costs reduce the profits from arbitrage. Transportation costs reduce the profits from arbitrage. Transactions costs are other costs associated with a transaction, over and above the cost of the good which actually changes hands. These also reduce the profits associated with arbitrage and speculation. Transactions costs are other costs associated with a transaction, over and above the cost of the good which actually changes hands. These also reduce the profits associated with arbitrage and speculation. All three of these can result in deviations from the LOOP. All three of these can result in deviations from the LOOP.

International LOOP Transportation costs can be significant. Transportation costs can be significant. Legal barriers and tariffs may exist. Legal barriers and tariffs may exist. Some goods are not traded internationally. These are goods for which inter-regional price differentials cannot be eliminated by arbitrage. Examples of nontradeable “goods” are: Some goods are not traded internationally. These are goods for which inter-regional price differentials cannot be eliminated by arbitrage. Examples of nontradeable “goods” are: Houses Houses Medical services Medical services Goods that are not available in all countries Goods that are not available in all countries Goods that do not survive transportation Goods that do not survive transportation

International LOOP (Continued) When we add the complication of (flexible) exchange rates, we have to restate the law of one price for international trade: When we add the complication of (flexible) exchange rates, we have to restate the law of one price for international trade: “In a competitive market, similar goods in different countries should sell for the same price when the prices are stated in the same currency.” In effect, this means that we have to apply the exchange rate to translate the prices of the goods to a common currency. After doing so, the prices should be equal.

International LOOP (Continued) Thus if p d is the domestic price and p f is the foreign price of the same good, and e is the spot price of the foreign currency in the domestic currency, then p d = e p f and ep f / p d = 1 and e = p d / p f Thus if p d is the domestic price and p f is the foreign price of the same good, and e is the spot price of the foreign currency in the domestic currency, then p d = e p f and ep f / p d = 1 and e = p d / p f But is this true? But is this true? Big Mac Index (Next Slide) Big Mac Index (Next Slide)

Purchasing Power Parity (PPP) Extending the LOOP, if P d is the domestic price level and P f is the foreign price level, Q = eP f / P d is called the real exchange rate whereas r s is called the nominal exchange rate. Extending the LOOP, if P d is the domestic price level and P f is the foreign price level, Q = eP f / P d is called the real exchange rate whereas r s is called the nominal exchange rate. If PPP holds, then Q = 1 and e = P d / P f. If PPP holds, then Q = 1 and e = P d / P f. This is referred to as absolute purchasing power parity. This is referred to as absolute purchasing power parity. Restated: The general level of prices, when converted to a common currency, will be the same in every country. Restated: The general level of prices, when converted to a common currency, will be the same in every country.

Q: Empirical Evidence CountryQ United Kingdom 0.96 Canada1.30 Japan0.78 Germany1.00 Sweden0.89 Norway0.89 Korea1.96 Mexico1.72 China4.76 India5.26

PPP (Continued) This is a simple monetary model of the exchange rate. This is a simple monetary model of the exchange rate. Strictly speaking, it does not depend upon the LOOP. Strictly speaking, it does not depend upon the LOOP. We have ignored transactions costs, transportation costs, carrying costs, tariffs, nontraded goods, etc. We have ignored transactions costs, transportation costs, carrying costs, tariffs, nontraded goods, etc. We have ignored the problem that not all markets are competitive. We have ignored the problem that not all markets are competitive. We have ignored the problem of different weights in computing the price levels of the countries involved. We have ignored the problem of different weights in computing the price levels of the countries involved.

PPP (Continued) This is an extension of the LOOP. At least on average (maybe?) goods should cost the same in all countries (aside from tariffs, transportation costs, etc.). This is an extension of the LOOP. At least on average (maybe?) goods should cost the same in all countries (aside from tariffs, transportation costs, etc.). If this is true, then exchange rates must adjust to make prices equal across countries, at least over the long run. If this is true, then exchange rates must adjust to make prices equal across countries, at least over the long run. This is LONG RUN because it does not consider that price rigidities exist that make price adjustments sometimes slow. This is LONG RUN because it does not consider that price rigidities exist that make price adjustments sometimes slow. If two countries have different inflation rates, exchange rates will tend to move in opposite directions to keep prices the same. If two countries have different inflation rates, exchange rates will tend to move in opposite directions to keep prices the same.

PPP (Continued) This leads to proposition known as Relative PPP: This leads to proposition known as Relative PPP: “The percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels.” This amounts to: rate of appreciation of the foreign currency = π d – π f, which implies that an increase in the domestic inflation rate will raise the spot exchange rate proportionately.

PPP and Interest Parity Notice that interest parity is essentially an extension of relative PPP. Notice that interest parity is essentially an extension of relative PPP. Interest is the price of borrowing, and interest parity arguments (covered interest parity and uncovered interest parity) argue that changes in these special prices will cause adjustments in the exchange rate. Interest is the price of borrowing, and interest parity arguments (covered interest parity and uncovered interest parity) argue that changes in these special prices will cause adjustments in the exchange rate. A major difference between interest parity and PPP is that interest parity is related to financial assets whose prices adjust very quickly, and that have substantially lower transactions costs, transportation costs, etc. A major difference between interest parity and PPP is that interest parity is related to financial assets whose prices adjust very quickly, and that have substantially lower transactions costs, transportation costs, etc.

Empirical Evidence PPP predicts fairly well, both in absolute and relative form, at the level of one heavily traded commodity for which the governments involved do not interfere with trade. (wheat, gold, etc.) PPP predicts fairly well, both in absolute and relative form, at the level of one heavily traded commodity for which the governments involved do not interfere with trade. (wheat, gold, etc.) Thus for something like wheat LOOP is a pretty good approximation. Thus for something like wheat LOOP is a pretty good approximation. PPP predicts only moderately well at the level of all traded goods. We run into a variety of problems, including barriers to trade, noncompetitive markets, and index construction. PPP predicts only moderately well at the level of all traded goods. We run into a variety of problems, including barriers to trade, noncompetitive markets, and index construction.

Empirical Evidence (Continued) PPP predicts poorly at the level of all products in an economy. (Using CPI, GDP deflators, etc.) PPP predicts poorly at the level of all products in an economy. (Using CPI, GDP deflators, etc.) PPP predicts better over the long run than the short run. PPP predicts better over the long run than the short run. According to Froot and Rogoff (1995), for major industrialized countries it takes about four years on average for a deviation from PPP to be reduced by half. According to Froot and Rogoff (1995), for major industrialized countries it takes about four years on average for a deviation from PPP to be reduced by half. PPP has its worst problems with nontraded goods. PPP has its worst problems with nontraded goods.

Relative PPP: Evidence (1)

Relative PPP: Evidence (2)

PPP: As Long-Run Tendency (1)

PPP: As Long-Run Tendency (2)

Monetary Approach: Quantity Theory According to the Quantity Theory, the money supply of a country is proportional to its nominal income. According to the Quantity Theory, the money supply of a country is proportional to its nominal income. Let Y be real GDP, P be the price level, and M s be the money supply. Then M = kPY where k (=1/V) is the average holding period for money. Let Y be real GDP, P be the price level, and M s be the money supply. Then M = kPY where k (=1/V) is the average holding period for money. Then for a foreign country, M f = k f P f Y f. Then for a foreign country, M f = k f P f Y f.

Monetary Approach: Quantity Theory Using the Quantity Theory, we can examine the relationship between prices in two countries: (P/P f ) = (M/M f )(k f /k)(Y f /Y) Using the Quantity Theory, we can examine the relationship between prices in two countries: (P/P f ) = (M/M f )(k f /k)(Y f /Y) We can then combine this with PPP to write: e = P/P f = (M/M f )(k f /k)(Y f /Y) We can then combine this with PPP to write: e = P/P f = (M/M f )(k f /k)(Y f /Y) Also note that a 1% change in (M/M f ), (k f /k), or (Y f /Y) leads to a 1% change in r s. We say that the elasticity of each of these terms is one. Also note that a 1% change in (M/M f ), (k f /k), or (Y f /Y) leads to a 1% change in r s. We say that the elasticity of each of these terms is one. This leads us to extend PPP to a more general monetary approach to exchange rate determination. This leads us to extend PPP to a more general monetary approach to exchange rate determination.

Monetary approach These approaches focus on exchange rates as the result of supply and demand for money at home and abroad. It is an equilibrium, supply and demand approach. These approaches focus on exchange rates as the result of supply and demand for money at home and abroad. It is an equilibrium, supply and demand approach. Money supply and demand operate through the linkage of prices and inflation rates. Money supply and demand operate through the linkage of prices and inflation rates. All else equal, the spot exchange rate is raised by: All else equal, the spot exchange rate is raised by: A rise in the domestic money supply relative to the foreign money supply, A rise in the domestic money supply relative to the foreign money supply, A rise in the domestic price level relative to the foreign one, or A rise in the domestic price level relative to the foreign one, or A rise in foreign real GDP relative to domestic real GDP. A rise in foreign real GDP relative to domestic real GDP. A rise in domestic velocity, or equivalently a decline in the domestic k, relative to domestic velocity or k, e.g., as the result of a change in the domestic payments system A rise in domestic velocity, or equivalently a decline in the domestic k, relative to domestic velocity or k, e.g., as the result of a change in the domestic payments system

Monetary Approach: Policy Prescriptions If a foreign country wanted to raise its exchange rate (relative to the dollar), it could do so by: If a foreign country wanted to raise its exchange rate (relative to the dollar), it could do so by: Decreasing its money supply Decreasing its money supply Causing disinflation Causing disinflation Reducing its money supply would raise domestic interest rates and slow the domestic economy. Eventually output would recover, but prices would decline (P f  )as a result of fewer dollars (M f  ). Reducing its money supply would raise domestic interest rates and slow the domestic economy. Eventually output would recover, but prices would decline (P f  )as a result of fewer dollars (M f  ).

Monetary Approach: Real income differentials A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal) A country with faster economic growth than the rest of the world will have a depreciating currency (other things being equal) Imports rise faster than exports Imports rise faster than exports Real income changes can also reflect other processes, which might lead to rising exports Real income changes can also reflect other processes, which might lead to rising exports

Impact of real income differentials Dollars per Pound S0S0 A D0D D1D1

Next: Shorter-Run— Asset-markets approach Currencies are a kind of financial asset that are part of asset portfolios held by investors Currencies are a kind of financial asset that are part of asset portfolios held by investors Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold Short run exchange rate changes are caused by shifts in the kind and location of financial assets investors want to hold Investors shift between assets based on market expectations for expected returns Investors shift between assets based on market expectations for expected returns