Competiveness in a global economy Role of exchange rates Session 7a Macroeconomic Concepts and Issues MSc Economic Policy Studies Alan Matthews

Motivations Ireland has a high share of trade outside the eurozone in which exchange rates play a crucial role in determining competitiveness Exchange rates are highly volatile The level of exchange rates can cause problems for business What determines the level and volatility of exchange rates?

US dollar/euro exchange rate Source: ECB Statistical data warehouseECB Statistical data warehouse Euro depreciates Euro appreciates

Sterling/euro exchange rate Source: ECB Statistical data warehouseECB Statistical data warehouse Euro depreciates Euro appreciates

The forex market Note its size! –According to BIS, average daily turnover April 2010 was €3.98 trillion (see Wikipedia entry)Wikipedia entry Made up of a series of interrelated markets –Spot market –Forward market –Futures market –Derivative markets Swaps and options Determines the relative values of different currencies

The exchange rate The price of foreign currency (dollar, sterling, yen) in terms of domestic currency (euro) –(viz. The price of apples – how much do you have to pay in domestic currency) Suppose it costs US citizen $1.99 to buy 1 GBP in 1991 and twelve years later it costs only $1.58 – dollar has appreciated From UK perspective, I USD cost 50p in 1991 and 63p in 2003 – sterling has depreciated

Impact of exchange rate on firms Advantages of a strong currency –Makes imported raw materials cheaper –Helps to control inflation –Leads to lower interest rates –Makes foreign assets cheaper Disadvantages of a strong currency –Exporters lose price competitiveness –Adverse impact on competitiveness may be moderated if leads to lower wage demands

Effective exchange rates Bilateral exchange rates do not move together, so we need some method to summarise the overall strength or weakness of a country’s currency The nominal effective exchange rate (EER) is defined as the exchange rate of the domestic currency vis-à-vis other currencies weighted by their share in world trade –Which currencies –What weights? –Significance of the base year –Now called the Harmonised Competitiveness Indicator (HCI)

Source: NCC, Annual Competitiveness Report 2008Annual Competitiveness Report 2008

Source: NCC, Annual Competitiveness Report 2010Annual Competitiveness Report 2010

Real Effective Exchange Rate Real effective exchange rate (REER) also takes account of price level changes between countries –adjusts the nominal EER by the ratio of foreign to domestic inflation –Used to assess change in competitive position of a country relative to its competitors Example –Suppose currency of country A has depreciated over one year by 10% against currency of country B –Suppose inflation rate in A is 7% and inflation rate in B is 2% –Then real depreciation (change in REER) is 10% - (7% - 2%) = 5% –Improvement in competitive position is 5%, not the 10% suggested by the EER Now called the real HCI

Source: NCC, Annual Competitiveness Report 2010Annual Competitiveness Report 2010

Exchange rate determination The exchange rate between two currencies is the price of one currency in terms of the other Express the exchange rate as the number of US dollars (price) per euro To determine the exchange rate we examine both the demand for and the supply of euros

The demand for euro A derived demand Americans want euro –in order to pay for European goods and services (exports) –In order to pay for European assets including government bonds, equities and property $/€ Euro Depreciation

The supply for euro A derived supply Europeans want dollars –in order to pay for American goods and services (imports) –In order to buy American assets including government bonds, equities and property $/€ Euro Depreciation

Exchange rate equilibrium $/€ S D

Factors which shift the demand or supply curves Interest rate differentials –Shifts in demands for assets Inflation differentials –If EU goods become more expensive Growth differentials –Stronger growth usually associated with stronger currency Speculation –Expectations about future exchange rates –Affected by above factors as well as stance of economic policy (budget deficits, balance of payments deficits, political outlook as well as market psychological factors)

Reaching a new equilibrium Suppose euro interest rates rise Will increase demand for euro from US investors Will decrease supply of euro as EU investors also shift from US to EU assets Euro appreciates D1D1 D2D2 S1S1 S2S2 $/€

Exchange rate equilibrium How can we tell if a currency is over- valued or under-valued? Is a currency likely to appreciate or depreciate in the near future? Answers provided by –Purchasing Power Parity theory –Balance of payments approach –Asset market or portfolio theories

Purchasing power parity PPP model holds that, in the long run, exchange rates adjust to equalise the relative purchasing power of currencies Draws inspiration from Law of One Price –Arbitrage will ensure price levels converge Absolute PPP –The exchange rate will be such as to make the general level of prices the same in every country –Exchange rates between currencies are in equilibrium when their purchasing power is the same in each of two countries –Unrealistic assumptions –Difficulties with non-traded goods

Purchasing power parity Relative PPP –Changes in the exchange rate are determined by the difference between relative inflation rates in different countries Over the long run we would expect exchange rates to adjust to maintain purchasing power parity In other words, exchange rates should adjust to offset differences in the rates of inflation, maintaining a constant real exchange rate Do exchange rates adjust to maintain purchasing power parity? –Yes, in the long run, but very slowly for reasons that are still unclear (see Rogoff JEL 1996 )Rogoff JEL 1996

Purchasing power parity How is PPP calculated? –The Economist ‘Big Mac’ index –People consume very different goods and services across countries –Standard estimates produced every six months by OECD/Eurostat (OECD PPP database)OECD PPP database –OECD estimates in next chart compare the PPP of a currency with its actual exchange rate compared to US dollar. Green bars (top of chart) indicate currency is overvalued and thus expected to depreciate against he US dollar in the long run, and vice versa.

OECD PPP estimates (relative to Euro) Source: University of British Columbia Pacific FX ServiceUniversity of British Columbia Pacific FX Service

PPP uses Clearly there are significant discrepancies between PPP and actual exchange rates But can PPP be used to predict exchange rate changes? –Poor empirical performance –Real exchange rates not only determined by relative inflation differentials –Real exchange rates can and do change significantly over time, because of such things as major shifts in productivity growth, advances in technology, shifts in factor supplies, changes in market structure, and commodity shocks –Note objection: Rapid productivity growth -> higher inflation -> currency appreciation (Balassa-Samuelson effect) –But important long-run benchmark

Balance of payments approach BoP approach focuses on relationship between trade/current account balance, modified to taken into account long-term capital flows, and the exchange rate BoP approach also allows ER to be influenced by real factors (economic fundamentals) Country with a persistent deficit is likely to devalue, country with persistent surplus likely to revalue Different to, but consistent with, PPP theory –PPP -> If country A has higher inflation rate than B, will run into a deficit and be forced to devalue

Examples of economic fundamentals These are factors which can shift the supply and demand curves for a currency (see above) –Changes in the growth rate –Balance of payments (influencing expectations) –Equity and bond market performance –Size of budget deficits and public debt –Governance and political stability

Asset market (portfolio) explanations PPP and BoP approaches focus on role of ER in balancing flows of foreign exchange Modern approach emphasises role of ER in balancing the supply and demand of domestic and foreign assets Exchange rates adjust to reflect differences in the rate of return on assets (bills and bonds) in different currencies It is differences in the expected total return which is relevant. This comprises the interest rate on foreign assets plus the capital gain (loss) from a appreciation (depreciation) of the foreign currency

Asset market explanations Expected exchange rate changes (and hence the expected capital gains or losses from investing abroad) influence decisions Because expectations are influenced by ‘news’, and news is unpredictable, so are short run fluctuations

Interest rate parity What determines international capital portfolio movements? –Difference between interest rates at home and abroad –Expectations about future exchange rates Interest rate parity describes the relationship between forward exchange rates, spot exchange rates and interest rates between two countries Rates of return on comparable assets should be equal around the world, implying that exchange rates adjust so that difference between interest rates is zero. It relies on the market’s tendency to correct itself through arbitrage Two versions –Uncovered parity –Covered parity

Uncovered interest rate (UIP) parity If US risk-free interest rate is 4% and euro rate is 2%, why do fund managers not switch into dollar assets? Domestic interest rate less foreign interest rate = expected change in exchange rate (Uncovered interest rate parity) Assumes –Perfect capital mobility –Equal risk on home and foreign bonds If interest rate differential is greater than the expected change in spot rates, potential for arbitrage

Covered interest rate (CIP) parity Borrow money in one currency (low interest rate), use to buy bonds in second currency (higher rate), and protect (cover) against exchange rate movements by buying the first currency forward Interest rate differences should equal the forward premium (covered interest rate parity) Forward exchange rate is a proxy for exchange rate expectations. UIP builds on CIP by assuming that market forces ensure the forward exchange rate is equal to the expected future spot exchange rate –However, forward exchange rate is not a good (although unbiased) predictor of the spot rate –Underlines that exchange rates are affected by shocks which are inherently unpredictable

Empirical performance of interest rate parity Does (uncovered) interest rate parity hold? –Hard to measure, since requires information on expectations and on relative risk of bonds Cause or effect? –if it holds, does it mean that interest rate differentials determine exchange rate changes, or vice versa?

Summary Exchange rate movements are an important determinant of competitiveness Although we can understand the factors which move exchange rates, their movement is very hard to predict Modern theory emphasises how the importance of the balance of trade in goods and services (the real economy) in influencing exchange rates is overwhelmed by international capital movements, whose movement is very hard to predict Firms can adapt strategies to insulate partially against exchange rate movements, but they are partial and costly International coordination of exchange rates?

Reading McAleese Chapter 21.1 – 21.3 OECD, Purchasing power parities measurement and uses, Statistics Brief, 2002.Purchasing power parities measurement and uses