1. Copyright SDA Bocconi 2004 1 MBA34 Managerial Excellence Exchange rate economics The firm and its environment - Francesco Giavazzi Copyright SDA Bocconi 2006

2. Copyright SDA Bocconi 2004 2 The exchange rate, a confusing concept The euro - one of many currencies –Each currency linked by a rate of exchange to the other n-1 currencies in the world. Exchange rates are in the first instance bilateral We may also compute the “average” rate of a currency with currencies of trading partners –This is the effective exchange rate A currency is also an asset, a way to store wealth. The value of a currency tomorrow is not the same as the value of that currency tomorrow set of today. –The spot rate between two currencies is not the same as their forward rate And the rate at which two currencies are exchanged is not the same as the exchange rate that measures the purchasing power of a given currency in terms of goods in the domestic country and in a foreign country –Nominal rates are not the same as real rates

3. Copyright SDA Bocconi 2004 3 Euro Effective Exchange Rate is Trade weighted, use amount of trade to weight bilateral Xrates

4. Copyright SDA Bocconi 2004 4 Euro effective exchange rate Yearly averages, from daily data Since 1999, the Euro has appreciated by some 25% or so on average with respect to the other currencies Source: Oecd Economic Outlook, June 2008

5. Copyright SDA Bocconi 2004 5 US$ effective exchange rate

6. Copyright SDA Bocconi 2004 6 Two ways of appreciating the euro appreciation with respect to US$ 1. How many euros to buy a dollar? Or: Yearly averages, from daily data Since 2001, the Euro has appreciated by some 40% or so with respect to the US dollar Source: Oecd Economic Outlook, June 2008

7. Copyright SDA Bocconi 2004 7 …. 2. How many dollars to buy a euro? ( Daily data) $/Euro

8. Copyright SDA Bocconi 2004 8 Appreciation/depreciation of nominal Xrates Appreciation of €: rise in value of €, so €1 buys more foreign currency –1.10 US$/€ in 1999 to 1.35 US$/€ in 2008 Depreciation of €: decline in value of €, so €1 buys less foreign currency –1.10 US$/€ in 1999 to 1.00 US$/€ in 2000

9. Copyright SDA Bocconi 2004 9 Real Exchange Rate is a measure of competitiveness (the nominal exchange rate is not) Real Rate = Nominal Rate x Domestic Price Level Foreign Price Level $ / € € $ Note that the real rate is unit-less To measure the real Xrate, we may also employ the ratio between labor costs

10. Copyright SDA Bocconi 2004 10 If Law of One Price holds, real rate =1 Law of One Price: The price of identical commodities, once converted in the same currency, is the same no matter where the commodities are sold LOP (Nominal rate) x (domestic price of bananas) = Foreign price of bananas LOP Based on idea of arbitrage If LOP holds real rate =1

11. Copyright SDA Bocconi 2004 11 Yet the Law of One Price doesn’t hold Transportation costs –US/Japan prices imply distance of 43 million miles. Border effects (tariffs, non-tradables, etc.)

12. Copyright SDA Bocconi 2004 12 Estimated transport cost for global trade: between 2 and 8%

13. Copyright SDA Bocconi 2004 13 If LOP doesn’t hold, ….. changes in nominal exchange rates go hand in hand with changes in real rates, hence in competitiveness

14. Copyright SDA Bocconi 2004 14 Currency Depreciation (% pa) Yet LOP is almost right over longer horizons Inflation and currency depreciation - Five Year Window Inflation Differential

15. Copyright SDA Bocconi 2004 15 Inflation and Currency Depreciation Twenty Year Window Currency Depreciation (% pa)

16. Copyright SDA Bocconi 2004 16 To understand what makes real rates change year by year we need to understand some Trade Accounting Current account –Records net transactions in goods and services –Exports - Imports Capital account –Records net transactions in assets –Net Saving

17. Copyright SDA Bocconi 2004 17 Current Account The sum of Exports – Imports (=trade balance) –Goods –Services Investment income and dividends from abroad (bond income and stock dividends) Net transfers from abroad (foreign aid)

18. Copyright SDA Bocconi 2004 18 Capital Account The balance of foreign trade in assets Capital transfers (debt forgiveness) Financial account –Direct investment –Portfolio investment –Other investment Reserve Assets –A country has a “balance of payments problem” if Financial account and reserves do not provide enough foreign currency to cover Current account deficits) (Plus: Errors and omissions –Fudge factor)

19. Copyright SDA Bocconi 2004 19 Trade Accounts X – M = T – G + PS – I – NIFA PS (private saving) = GDP + NIFA (net income from abroad) – C – T GDP = C + I + G + (X – M) X – M = S (national saving)– I – NIFA AND

20. Copyright SDA Bocconi 2004 20 Trade Accounts X – M + NIFA = S – I Net Exports = Current Account Surplus Net Saving = Capital Account Deficit

21. Copyright SDA Bocconi 2004 21 The U.S. and euro area balance of payments in 2005

22. Copyright SDA Bocconi 2004 22 Net foreign positions of the United States, euro zone and Japan

23. Copyright SDA Bocconi 2004 23 Trade accounts and the real exchange rate What mechanism ensures that net savings always equals the trade balance in equilibrium? In short, it is the adjustment in the real exchange rate -The real rate does NOT affect the net saving curve (it is thus vertical with respect to the real rate) -Instead a real depreciation of the dollar (in terms of the euro) improves the trade balance and the current account (US goods become cheaper) –As the real rate goes down (depreciation of the $) net exports up, trade balance and current account improves –Net exports curve negatively sloped with respect to the real rate

24. Copyright SDA Bocconi 2004 24 Net Export Market Real Exchange Rate X – M + NIFA S - I Net Exports €/$ Increase in net savings reduces real X rate E0E0 E1E1

25. Copyright SDA Bocconi 2004 25 Net Export Market Real Exchange Rate X – M + NIFA S - I Net Exports ₤/$ Decrease in net savings increases real exchange rate E0E0 E1E1

26. Copyright SDA Bocconi 2004 26 Real Exchange Rate Movements Decrease in Net Savings –Causes Decrease in private savings Increase in investment spending Fiscal Deficit –Effect Real exchange rate appreciates (dollars buy more of other currencies) Increases current account deficit Examples: US under Reagan, Germany after reunification

27. Copyright SDA Bocconi 2004 27

28. Copyright SDA Bocconi 2004 28 Summing up so far Definitions of exchange rates: real vs nominal Law of one price –Goods should sell at the same price everywhere PPP –Real exchange rate = 1 Trade accounts and the real exchange rate

29. Copyright SDA Bocconi 2004 29 Exchange rate regimes

30. Copyright SDA Bocconi 2004 30 Exchange rates and asset markets Key concepts Covered Interest Parity Uncovered Interest Parity Spot and Forward Exchange Rates Global Capital Markets

31. Copyright SDA Bocconi 2004 31 Nominal Exchange Rates Spot market: price for immediate delivery of one currency for another Forward market: exchange rate fixed today for future delivery of currency

32. Copyright SDA Bocconi 2004 32 Covered Interest Parity (CIP) $100$100(1+i us ) Stay in US

33. Copyright SDA Bocconi 2004 33 Covered Interest Parity $100 10900¥ Convert to Yen at Spot Rate 109¥/$ 10900(1+i Japan )¥ Convert to $ at Forward Rate 108¥/$ $101(1+i Japan )

34. Copyright SDA Bocconi 2004 34 Covered Interest Parity $100$100(1+i us ) 10900¥ Stay in US Con vert to Yen at Spot Rate 109 ¥/$ 10900(1+i Japan )¥ Convert to $ at Forward Rate 108¥/$ $101(1+i Japan ) Must be same rate of return

35. Copyright SDA Bocconi 2004 35 Covered Interest Parity $100 $100(1+i us ) 10900¥ Con vert to Yen at Spot Rate 109 ¥/$ 10900(1+i Japan )¥ $101(1+i Japan ) =

36. Copyright SDA Bocconi 2004 36 CIP i US + forward premium = i J

37. Copyright SDA Bocconi 2004 37 CIP Japanese interest rate > US interest rate –Forward rate > Spot rate –Dollar expected to appreciate with respect to the yen Japanese interest rate < US interest rate –Forward rate < Spot rate –Dollar expected to depreciate Sum: dollar depreciates if US interest rate exceeds Japanese interest rate

38. Copyright SDA Bocconi 2004 38 Uncovered Interest Parity (UIP) Investors don’t protect themselves against exchange rate movements. They wait before converting dollars in yen at future spot rate Use expected future spot rate. May earn more or less than expected Taking expectations as given, we can use UIP to determine the current level of the exchange rate

39. Copyright SDA Bocconi 2004 39 UIP and the Exchange Rate (for S e (1) given) S*(0) Current exchange rate (¥/$) Rate of Return iJiJ i US + [S e (1)-S(0)]/S(0) Return on dollar account: given S e (1), the higher the current Spot rate, the lower the return Return on yen account

40. Copyright SDA Bocconi 2004 40 UIP and the Exchange Rate Current exchange rate (¥/$) Rate of Return iJiJ i US + [S e (1)-S(0)]/S(0) As interest rate in Japan goes up, $ depreciates

41. Copyright SDA Bocconi 2004 41 UIP and the Exchange Rate Current exchange rate (¥/$) Rate of Return iJiJ i US + [S e (1)-S(0)]/S(0) As interest rate in Japan goes down, $ appreciates

42. Copyright SDA Bocconi 2004 42 UIP and the Exchange Rate If expectations of future rates are fixed Spot market depreciation of dollar –Rise in Japanese interest rates –Fall in US interest rates –Expectation of future dollar depreciation Spot market appreciation of the dollar –Fall in Japanese interest rates –Increase in US interest rates –Expectation of future Yen depreciation

43. Copyright SDA Bocconi 2004 43 Risk Averse Investors So far, we’ve neglected risk Risk averse investors require risk premium to hold risky assets US interest Rate + Expected Dollar Appreciation = Japanese Interest Rate + Risk Premium If positive, US is perceived as riskier than Japan. If negative, US is perceived as safer than Japan.

44. Copyright SDA Bocconi 2004 44 Decrease in risk premium Current exchange rate (¥/$) Rate of Return iJiJ i US + $ appreciation – Risk Premium $ appreciates

45. Copyright SDA Bocconi 2004 45 Difficulties with UIP Does perform well in forecasting forward exchange rate –High interest rate currencies tend to appreciate Incorporation of risk is not enough to explain volatility –Risk premium is not correlated with interest rate differentials –Not large enough to account for volatility Exchange rates appear to be not highly correlated with macroeconomic variables

46. Copyright SDA Bocconi 2004 46 Home country bias Diversification says balance portfolio in home and foreign assets Domestic savers tend to buy domestic assets Why? –Capital controls –Measurement problems –Asymmetric information

47. Copyright SDA Bocconi 2004 47 International financial integration, 1870-200 average abs value of current accounts in % of GDP

48. Copyright SDA Bocconi 2004 48 Summing up CIP UIP –Relation to interest rate movements –Relation to exchange rate movements –Role of risk aversion Global capital market puzzles