Emerging Financial Markets 4: Macroeconomic Inconsistencies Prof. J.P. Mei

2 Exchange Rate Determination I u u Purchasing Power Parity: The Law of One price for the same good all over the world (Absolute PPP) – –Assumption: Free and frictionless trade (no transaction cost, taxes, and uncertainty) – –PPP is often violated in reality but tend to correct itself when large deviations occur. u u The Construction of the Big Mac Index (which currency is over-valued?)

Exchange Rate Determination I u u Purchasing Power Parity with Inflation (Relative PPP) s = I D - I F [s = (S 1 - S 0 )/ S 0, S=$/F] (1) 1. Relative PPP is based on Absolute PPP. 2. High inflation economy should have depreciating currency. u u This explains Why the Hong Kong dollar is vulnerable (Plot US and HK inflation) u u 50% of the deviation from Relative PPP gets corrected within 5 years.

3 Inflation Differential among US, Thailand, and Hong Kong

Exchange Rate Determination II u u Domestic Fisher Relation: r D =r +E(I D ) u u Law of One Price =>International Fisher Relation: r D - r F =E(I D ) -E(I F ), or E(s)= r D - r F (2) 1. Interest rate differential is determined by difference in inflation expectation. High inflation economy should have higher rates. 2. Expected exchange rate change is determined by Interest rate differential. High interest country should expect to see a weaker currency in the future. 4

Exchange Rate Determination III u u Interest Rate Parity (Arbitrage condition) F = S 0 * (1+r D )/(1+ r F ) or f = r D - r F (3) 1. Forward rate is determined by the spot rate and interest differentials. 2. Serious violation of IRP would lead to arbitrage profit 3. If F >>SF (synthetic forward), sell forward, buy SF (borrow $, sell $ spot, lend FX) 4. If F <<SF, buy forward, sell SF 5. Thai government’s money losing machine: Forward market operation to keep the forward rate high. 5

Interest Rate Differentials

Notes on Exchange Rate Determination u u RER tend toward PPP in the very long run. u u Short run deviation from PPP are large and volatile (Indonesia and Thailand). u u Deviation from PPP suggests segmentation in international goods markets. There is a large buffer within which nominal exchange rate can move without producing immediate response in relative domestic prices. (i.e., Big Mac price can remain low in Indonesia for quite a while.) 7

What went wrong in Thailand u Poor Export to Short-term Debt Coverage Ratio u Loss of Competitive Strength and Foolish Property Market Speculation Relatively Small Reserves u Large foreign currency debt led corporation to dramatically increase their demand of foreign currencies. Operational Errors: u Lack of Political Will to Defend the Currency u Inconsistency in Implementing the Defense u Reckless Forward Market Operation