1. EXCHANGE RATES

2. What level should it be? Link

4. Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation of domestic currency and a decrease in E is an appreciation. Exchange Rates

5. Exchange Rates as price of US$ Unlike textbook, we will describe a model of domestic country’s forex market in which US$ is vehicle currency BIS Triennial Survey of Foreign Exchange Turnover

6. Two Models UIRP Balance of Payments: Supply & Demand

7. Interest Parity

8. Saving It is January 1 st, and you have D$1000 to save for 1 year. You can put it into: 1. a domestic currency bank account at an interest rate i. 2. a foreign currency bank account at interest rate i F.

9. Payoff to strategy #2 Strategy two has three parts. 1. Buy foreign exchange at spot rate S t to get {D$1000/E t } F$.. 2. Put {D$1000/E t } F dollars into FC bank account. After 1 year get F$(1+i F )×{D$1000/E t } 3. Convert these funds into F$ at exchange rate prevailing at end of year.

10. Uncovered Interest Parity If, deposit funds then deposit in F$ account. If, deposit funds then deposit in D$ account. Then in equilibrium

11. Interest Rate Parity The only reason people would be willing to hold a US$ account when US interest rates were lower than domestic interest rates would be if they can achieve an expected gain from an increase in the value of US$ during the time that they were holding the account. Approximately

12. Three Reasons UIRP might not hold 1. Future exchange rates are risky, uncovered interest parity does not account for risk. A. Interest Parity Works for Forward Prices Forward Price for currency delivered at t+1 2. Domestic and foreign currency not perfect substitutes. People like to hold currency for liquidity reasons. 3. Currency controls

13. Balance of Payments Model

14. International Capital Flows Capital Outflows: domestic acquisition of foreign assets. Capital Inflows: foreign acquisition of domestic assets Net Capital Outflows = Capital Outflows – Capital Inflows Money is an asset. Most international financial transaction are swaps of one asset for another and have zero net effect on capital flows. Only net trade of foreign assets for goods or services creates opportunity for net capital flows. Current Account = Net Capital Outflows

15. Savings & Current Account Gross National Savings: GNS GNS = GNI – Consumption (PCE + GCE) GNI = GDP + NFI GDP = Consumption + Gross Capital Formation + Net Exports (Exports – Imports) GNS – GCF = NX + NFI = Current Account

16. Why do exchange rates change? Relative values of two currency determined by supply and demand by traders of the two currencies. Unlike textbook, we will describe a model of domestic country’s forex market in which US$ is vehicle currency Link Price of US$: E is the price of US$ in terms of DCU.

17. From Interest Parity People trade currencies to engage in foreign trade and international investment. Expected (Investment) Profit: Of Domestic Investors in Foreign Economy Of Foreign Investors in Domestic Economy

18. Consider the spot foreign exchange market. Supply of US$: People who want to acquire DCU to buy domestic goods or assets. Substitution Effects When US$ becomes expensive, domestic goods or assets get cheap and foreign investors are attracted to domestic currency. Expensive Expected Profit Effect - e.g. Expensive US$ magnifies returns on domestic accounts Expensive Exports Effect – Expensive US$ increases the attractiveness of domestic exports.

19. Demand for US$: Domestic people who want to acquire US$ for foreign purchases or overseas investment. Substitution Effects: When US$ get cheap, US$ goods or assets get cheap and demand for US$ rises Cheap Expected Profit Effect - e.g. Cheap US$ magnifies returns on foreign accounts Cheap Imports Effect – Cheap US$ increases the competitiveness of imports.

20. Balance of Payments Foreign Currency Received (Credit) Foreign Currency Paid (Debit) Exports (+) Income Receipts (+) {Non official} Capital Inflows (+) Imports (-) Income Payments (-) {Non reserve} Capital Outflows (-) BoP = Current Account + Capital & Financial Account Balance of Payments = Credits – Debits Link Supply of US$Demand for US$

21. Supply and Demand in Forex Mkt E Demand Supply Forex Turnover BoP > 0 BoP < 0

22. Equilibrium in the Forex Market Gap between supply and demand of US$ is the Balance of Payments. Two types of Forex Markets Floating: Forces of supply and demand equilibrate markets. Fixed: Gov’t/Central Bank buys excess foreign currency in market.

23. De Facto Classification of Exchange Rate Regimes and Monetary Policy Frameworks Currency board - explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed rate. Conventional Peg - formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies. Stabilized Arrangement - spot exchange rate remains w/in a margin of 2% for six months or more. Crawling - rate remains w/in a narrow margin of 2% relative to a trend Float - largely market determined, w/o ascertainable/predictable path Free Float – intervention occurs only exceptionally

24. Equilibrium with Floating Rates E Demand Supply E* Forex Turnover E E ⓪

25. Equilibrium with Floating Rates E Demand Supply E* E E ⓪ Forex Turnover

26. Equilibrium with Floating Rates E Demand Supply E* ⓪ Forex Turnover

27. Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods E Supply Demand E* Supply ' E** Domestic Currency Appreciates ⓪ ① Forex Turnover

28. Increase in Desired Capital Outflows by Domestic Investors/ Desired Purchases of Foreign Goods E Supply Demand E* Demand ' E** Domestic Currency Depreciates ⓪ ① Forex Turnover

29. Fixed Exchange Rate: Weak Currency Target E Demand Supply Forex Turnover BoP > 0 E TGT Gov’t Buys Excess Supply US$ Foreign Reserves Increase

30. Fixed Exchange Rate: Strong Currency Target E Demand Supply Forex Turnover BoP < 0 E TGT Gov’t Buys Excess DCU Foreign Reserves Decrease

31. Balance of Payments Crisis Basic asymmetry between weak and strong currency target. Weak target: Govt has infinite amount of domestic currency and can always maintain. Strong target: Govt has finite amount of foreign currency and may face a balance of payments crisis. BoP crisis: Gov’t must borrow funds from abroad or allow a weakening of the currency.

32. China Forex Market: Excess Supply of US Trade Surplus: Chinese exporters bringing cash home can sell foreign currency at policy rate to SAFE. Capital & Currency Controls: Non-trivial to move money into China and even harder to move it out. Govt policies to encourage FDI inflows and discourage portfolio outflows. Exchange Rate Policy: Crawling Peg

33. China Forex : Supply and Demand less sensitive to exchange rate or interest differentials. E Supply Demand E TGT

34. Source: IMF Balance of Payments Data

35. Link

36. Foreign Currency Intervention Sterilized vs. Unsterilized Two ways of financing interventions Foreign currency purchase: Central bank purchases foreign currency Unsterilized: Create additional domestic currency liquidity Sterilized: Borrow domestic currency from banks, govt, selling bonds. Foreign currency sale Central bank sells foreign currency Unsterilized: Withdraw domestic currency liquidity Sterilized: Repay domestic currency loans.

37. Exchange Rates are Volatile!

38. Future Exchange Rate Level If people’s expectation of the future exchange rate indicates a future depreciation, this will reduce the expected returns on investing in the domestic economy at any given interest rate. This will increase demand for US$ and reduce supply. An expected depreciation leads to a current depreciation!

39. Expectation of E t+1 Increases E Supply Demand E* Supply ' Demand ' E** Domestic Currency Depreciates 1 2

40. REAL EXCHANGE RATES & TRADE BALANCE

41. Real Exchange Rate: Measure of Competitiveness We can measure the competitive pricing of home goods. Numerator: # of domestic currency units needed to by the # of foreign currency units needed to buy 1 foreign good. Denominator: # of domestic currency units needed to buy 1 domestic good

42. Benchmark: PPP The first theory of exchange rates was Purchasing Power Parity – Arbitrage should insure the price of goods was equalized across countries Is PPP true? Not in short run. Trade arbitrage does not work that fast. How about long run?

43. Exchange Rates OECD Source: IFS 1975-1995

44. Exchange Rate Misalignment Over-valuation/Undervaluation of Currency Exchange rate misalignment: when price of currency differs from relative prices of goods making domestic goods relatively cheap/competitive or relatively expensive/uncompetitive Overvalued/ Uncompetitive E < Undervalued/ Competitive E >

45. Is the Currency Undervalued or Overvalued? When RER is weak (i.e. when currency is undervalued), domestic exports are competitive on global markets while foreign imports may be less attractive. For any pair of currencies, it is easy to observe the exchange rate, but what is the relative price we should consider when thinking about the competitiveness of currency?

46. Effective Exchange Rate Indices IMF constructs effective exchange rate indices both nominal and real. Indices are constructed so the growth rate of the index is equal to a weighted average of bilateral appreciation rates How about the long run?

47. Competitiveness & Current Account IMF Data Mapper

48. Learning Outcomes Students should be able to: Use interest differentials to calculate expected depreciation rate under UIRP. Use the Supply-Demand model of the forex model to explain the effect of international trade conditions on the exchange rate. Compare values measured in different currencies using the PPP and exchange rate method