Exchange Rates and Business Cycles Building Blocks

Exchange Rates and Long Run In long-run, relative PPP holds for countries at similar levels of development. Long run exchange rate, e LR, given by long-run real exchange rate, ε, and money fundamentals. Long run real exchange rate is given by level of economic development and competition in non-traded goods sector.

Exchange Rates in the Short-run Real exchange rates are volatile in the short run and closely correlated with nominal exchange rates. Under flexible exchange rates, nominal exchange rates tend to be more volatile than relative prices.

Smoother Relative Prices than Exchange Rates in Japan (source IFS)

Nominal & Real Yen/dollar rates

Building Block 1: Sticky Prices

Keynesian Explanation Under the neo-classical dichotomy, goods markets works like an auction. Firms produce a fixed number of goods and demand will determine the price. Under Keynesian theories, goods markets work like McDonalds. Firms post a certain price and produce as many goods as are demanded at that price.

Keynesian Good Market Equilibrium P Y P AD

Sticky Prices and Exchange Rates Because prices are sticky in the short-run, changes in nominal exchange rates will necessarily change the relative prices of domestic and foreign goods. Changes in money supply or velocity can translate into changes in both the nominal and real exchange rate.

Building Block 2: Real Exchange Rates and the Current Account

Trade Balance At any point in time, there may be a gap in the value of goods exported and the value of goods imported. Measure the trade balance in domestic currency. Assume imported goods are invoiced in US dollars  Value of exports, P∙ EX  Value of imports, e∙ P∙ IM  Value of trade balance or net exports, P∙ EX- e∙ P∙ IM

Effects of Real Exchange Rate on Real Trade Balance Direct Effects: Given real imports and exports, a rise in real exchange rate makes imports more costly, reducing the value of the trade balance.  Ex. A country exports 100 apples and imports 100 oranges. If relative price of apples and oranges is 100, then trade balance is 0. If relative price of imports (i.e. oranges) rises, trade balance will go into deficit.

Expenditure Switching Effect All else equal, purchasers of goods will switch their purchases to cheaper goods.  Real sales of exports will increase when re rises making domestic goods relatively cheaper,  Real sales of imports will increase when re rises making domestic goods relatively more expensive,. Both effects imply that an increase in re will lead to an increase in trade balance.

Net Effect of Real Exchange Rate on Trade Balance Two counter-veiling effects of real exchange rate on real trade balance  Net effects depend on which effect is stronger (i.e. does a weaker exchange rate sell more goods or does it just increase the cost of goods). Empirical results:  In short-run, direct effects are stronger.  In long-run, expenditure switching effects are stronger.

J Curve Dynamics: Effects of a once and for all real depreciation time re NX

Building Block 2: International Interest Parity

Spot vs. Forward Markets Two basic markets for foreign exchange. 1. Spot Markets – In spot markets, traders agree on terms/rates for currency trades with immediate delivery (within 48 hours). 2. Forward Markets – In forward markets, traders agree on terms/rates for currency trades at some specified future date (usually 30, 90 or 180 days) Define f t as the exchange rate for delivery at a date on period in the future.

Forward Markets bigger than spot (source: BIS)

An investor has $1 for saving. Consider two investment strategies Invest $1 in a domestic bond with interest rate 1+i. Return: 1+i Use $1 to buy 1/e t foreign dollars in spot markets. Invest 1/e t in US$ bonds at interest rate 1+i $. Agree on a forward contract to sell (1+i $ )/e t foreign currency for f t+1 domestic dollars. Return: Arbitrage in Forex Market Sets Returns from 2 strategies to Be Equal.

Spot & Forward Rates

Covered Interest Parity Sure returns on investing in different currencies should have the same price. Q: Does covered interest parity hold true?  A: Yes. Most forex traders use CIP equation to price forwards.

US$ and HK$ Government Bills

Uncovered Interest Parity Forward prices should equal the market’s expectation of future spot rate.  If traders think the future spot price of foreign currency, e t+1 > f t t+1, then why agree to deliver it at that price. If traders think the spot price of foreign currency e t+1 < f t t+1, why agree to pay that price. This should imply a term for exchange rate parity

Implications We observe that different countries have different interest rates. UIRP suggests that countries with high interest rates are expected to have their currency depreciate.  The only reason not to buy bonds in a high interest economy is that you expect the value of the currency to drop.

Exchange Rate Determination UIRP Creates a financial market theory of exchange rate determination Graph expected returns from investing in domestic and foreign currency. Exchange Rate equalizes the two returns. Invest in Domestic Bonds Invest in Foreign Bonds 1+i t Assume expected future exchange rate is equal to long run, e t+1 E = e LR

Equilibrium Exchange Rate 1+i Return etet e*e*

Exchange Rate Determination 1. Given future exchange rates, a rise in domestic interest rates or a fall in interest rates will lead to an appreciation. A temporary increase in domestic interest rates will lead to appreciation. 2. A rise in the future value of the currency will increase the current value. Current exchange rate depends on whole path of future interest rates. EventExchange Rate Temporary i↑ et ↓et ↓ Temporary i $ ↑ e t ↑ e LR ↑e t ↑

Rise in Domestic Interest Rates 1+i Return StSt e*e* 1+i’ e **

Contradiction and Dynamics If domestic bond yields are higher than foreign yields, we should expect a depreciation of domestic currency over the life of bond. A temporary increase in domestic yields leads to a domestic currency appreciation. Is this a contradiction? No, the domestic currency will immediately appreciate and subsequently depreciate back to the original position.

Time Path: Temporary Rise in Domestic Interest Rates e i time

Rise in Foreign Interest Rates or Future Depreciation 1+i Return etet e*e* e ***

Time Path: Temporary Rise in Foreign Interest Rates e iFiF time

Is UIRP true? UIRP does not hold especially for developed world countries.  High interest rate countries do not systematically see their countries currencies deteriorate. Buying bonds in high interest rate countries generates high average returns. Why don’t investors take advantage of these opportunities?  Investors perceive these countries as having some risk of an exchange rate depreciation and investors are risk averse.

Risk Adjusted UIRP We might assume that there is a risk premium (either positive or negative) for investing in domestic bonds relative to investing in foreign bonds. A temporary increase in the risk premium on foreign asset will lead to an appreciation of the domestic currency.

During Early 1990’s, there were persistently higher returns earned in Thai money markets than US.

But in July, 1997, owners of Thai bonds lost 50% of their investment in US dollar terms.

Costs of Exchange Rate Volatility Volatile exchange rates generate income risk for firms that export goods. This may eliminate some benefits of international trade. Volatile exchange rates generate liability risk for firms that borrow foreign currency to finance investment projects. This is especially significant for firms in emerging markets.

UIRP & Exchange Rate Volatility Using UIRP we can write the exchange rate as a function of the future series of exchange rate differentials. Since forecasts of future variables may be volatile and subject to optimism and pessimism, this may explain a large degree of exchange rate volatility.