1. Exchange Rate Determination(4) Real Factor Approach
Dr. J. D. Han
King’s College
U.W. O.

2. 1. Recall that S and D of FOREX affect FX Rates through International Trade
FOREX Supply FOREXDemand
International Trade Export Imports
Impacts FX rate down FX rate up

3. 2. Real Factor Analysis: Beyond Nominal Factor Theory of Purchasing Power Parity
FOREX rate is negatively related to Current Account (surplus) of the Balance of Payment
Current Account of BP is positively correlated with the Relative Demand for Domestic Product to (Demand for) Foreign Product.
It is affected by the Relative Price Level, which is in turn set by relative monetary condition <- “Nominal Factors”
Besides, what are the Real factors that affect the relative international demand?

4. 1) Real Factor Analysis focuses on the real factors affecting the Supply and Demand of Products
(1) Supply Side
‘Technical Innovation’
-> Cost down, and (non-monetary, but real) Price down
–> Exports = Demand for Domestic Products up
-> Current Account up
-> Supply of FX up
-> Price of FX down
(2) Demand Side
‘International Demand Switch’ to, or ‘International Substitution’ of Domestic Products
-> Price of FX or FOREX rate down

5. 2) Principle
“Any real factors that favorably affect the Current Account of Balance Payment (EX-IM ) will lead to appreciation of Domestic Currency and depreciation of FOREX” (FOREX rate falls).

6. 3) Examples
eg1) Technical Innovation in a Canadian export industry will lower the cost and the price of exports. As more exports bring in more FOREX, E will fall.
eg2) Unfavorable tax system and labor movement will raise the production cost of the Canadian export industry. Then………
eg3) An increase in the international demand for oil sand from Canada will lead to a fall of FOREX rate in Canada.

7. 3. Nominal FOREX versus Real FOREX rates
Nominal (Foreign) Exchange rate or FOREX = E or S (spot)
Real FOREX rate ‘q’
= E / (P/Pf) = S / (P/Pf)
= E Pf/P = S Pf /P

8. A falling ‘q’ real exchange rate is a reflection of an Increasing International Competitiveness.
A falling ‘q’ means that the FOREX depreciates, and the domestic currency appreciates.

9. *Caution: The Direction of Causality
A falling ‘q’ means that the foreign currency becomes cheaper and the domestic currency becomes more expensive.
The falling ‘q’ is the reflection of the Country’s goods becoming more competitive.
The falling ‘q’ now may cause the country’s goods less competitive a little, but not enough to offset the initial rise in competitiveness.

10. In the case where real factors work in addition to nominal factor(money, and price level), the changes in FOREX rate cannot be fully explained by nominal factors, such as money supply and relative price level.
Thus, not only nominal FOREX (S or E) changes but also ‘q’ changes as well.

11. 4. Case Study I: Japan FOREX Changes in Japan of the 1970-80s :
Nominal versus Real Factors
Background:
-Japanese Yen became strong: for the Japanese, FX rate fell
- S fell more than P/ Pf fell; ‘q’ fell as well.

12. 1) Facts: Data of Japanese FOREX Rate
Trends of P/Pf and E in Japan
P/Pf
E = S
‘76
‘87

13. 2) Analysis: (1) Nominal Factor
- The appreciation of the Japanese Yen, or the falling E or S can be only partially explained by
P/Pf as PPP suggests.
- Japanese price level was relatively stable compared to the U.S. price level
because Japanese monetary policy was relatively conservative compared to the U.S. monetary policy.

14. (2) There is a large part of the falling E, which cannot be explained by PPP: These are the real factors that change ‘q’.

15. We can infer that q = (actual E) / (P / Pf ) fell
as E fell more than P/ Pf fell

16. *Now use ‘q’ to explain the whole story:
(i) Nominal Factors affecting the Price Level:
Relative Overall Price Ratio between Japan and U.S. (P / Pf) fell due to relatively conservative monetary policy in Japan.
-> International Demand for Japanese Goods up
-> S or E in Japan down
However, P/Pf is not enough to explain the changes in E or S.

17. (ii) Real Factors affecting the Price Level: Overall Average Prices do not change very much.
Suppose that In Japan, there are two sectors of industry: Tradables and Non-Tradables
The overall price level in Japan is the weighted average of the prices of the two sectors:
P = 0.5 PT PNT (in simpliest form)
Technical Innovation happens only to Tradables industry
- Due to Technical Innovations, Japanese Tradable becomes cheaper. Due to Technical Backwardness, Japanese Non-tradable becomes more expensive:
-> The Overall Japanese Price Level (P) stays relatively stable while the Japanese Tradable Good Price Level (PT ) falls.

18. (iii) Real Factors affecting the Prices of Tadables, and Trade: FOREX rate or E falls
Japanese Tradable goods have price competitiveness edge over Foreign-produced Tradable goods.
<- Trade depends on PT/ PT of Foreign Country, not P/Pf. International Substitution from foreign Tradable goods to domestic tradable goods
-> Trade surplus for Japan
-> Excess Demand for Japanese currency
(Excess Supply of foreign currency)
-> Nominal FOREX rate falls additionally in Japan beyond what PPP dictates.

19. (iv) Real FOREX rate or q falls:
E falls more than P / Pf .
q = E / (P/ P f ) falls as well.
-> a falling real exchange rate reflects a rising international competitiveness
<- a falling real exchange rate raises Japanese imports but does not fully offset the initial rise in competitiveness.

20. (v) PPP worked for Tradable Goods Prices only, not for the Overall Price Level:
E PT f / PT = 1 for Tradable Goods
E P f / P << 1 for overall price level
Here, q(<<1) is a reflection of an increasing competitiveness of Japanese export goods.

21. 5. Case study of Canada Facts Between 1975-1990s
-E continued to rise (against Canadian dollars)
-Nominal factors: Money supply increased faster in Canada than in U.S.
-Real factors: Canadian productivity lagged behind the U.S. productivity
Between
e continues to fall
capital flows from U.S. : A higher interest rate in Canada than in the U.S.
may reflect improving real factors

22. *Data: US-Canadian FOREX Rates of the 1970s to 2001.
In fact, PPP was not exactly correct
If PPP had been correct E q

23. *2) Analysis: Explaining with ‘q’
It is true that the Canadian monetary policy was more liberal than the U.S. monetary policy up to the 1990s: This explains the general rise of P and E.
Theoretically, E and Pcanada /P us should have gone up proportionally. Yet, E went up faster than P/Pf
Canada- inflation differentials between U.S. and Canada could not fully explain the changes in the nominal FX.
This suggests that a substantial part of FOREX fluctuations between Canada and US is caused by ‘real factors’.
What have caused the real FX rate to change, or deviate from unit(one)?

24. What is the real factor against Canada?
Relatively lower productivity, and
Speed of innovation
-> Demand for Canadian goods falls
-> Exchange rates rises more than PPP suggests.
-> ‘q’ rises as part of ‘the equilibriating/corrective forces’, which tries to increase the exports and thus to restore the equilibrium.

25. 3) One More Application: “Canada should use U.S. Dollars?”
Pros
1.No conversion/transactions cost
2. Eliminated FOREX Risks
3. Monetary Discipline for Canada
Cons
Most FX transactions were in a large amount and do not carry a large percentage of conversion costs
Recently developed hedging has already reduced FOREX risks substantially
Not much gains for Canada for now

26. *“How would the elimination of FX rates between the two countries affect the Canadian Economy?”
The same currency means no floating FOREX rates.
The same currency means the same monetary policies and the same rate of inflation for the two country (as PPP says).

27. -If the changes in the Canada-US exchange rate had reflected inflation differentials, then the adoption of the common currency would have nominal impacts only.
In fact, the floating FOREX rates did have other function(s), the adoption of the common currency and thus the virtual fixed exchange rates would hinder the very function of the floating FOREX rates
- Canada needs the floating FX rate system, which presupposes its own currency.

28. Suppose Real Adverse Shocks for Canada, not U. S
*Suppose Real Adverse Shocks for Canada, not U.S. : eg) Canada is hit with a lower productivity; The demand for the Canadian goods fall.
Under Fixed FX system
Either
Labor demand falls; and
thus Wages fall
Prices fall
Demand for the Canadian goods may rise back Or
If wages do not fall,
Actual exports fall;
Unemployment rises.
Under Flexible FX system
The FOREX rates will take the first beating (Option II);
The resulting depreciation of the domestic currency substantially restores the demand for the Canadian goods;
The changes in Income will be mild.
*M. Friedman: “Changing the setting of the clock” is easier; Option II is better and easier for adjustment than Option I.