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

2. 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. 3 2. Real Factor Analysis: Beyond Nominal Factor(P or M) 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. 4 1) What are ‘Real Factors’ which affect supply and demand for trade? (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 -> Current Account up -> Supply of FX up -> 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 Foreign Currency” (FX rate or ‘S’ falls). 5

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. 6

7. 3. Nominal versus Real FX rates Nominal FX rate: E or S Real FX rate: ‘q’ q = S / (P/Pf) = S Pf/P 7

8. Under PPP where S is set by all nominal factors such as P or M, q =1 at all times. When real factors are at work on S, ‘q’ may not be equal to one. 8

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. 9

10. A nominal factor affects S and P at the same time to the same degree. - thus,‘q’ does NOT change. A real factor may affect S and P differently. - thus, ‘q’ change. 10

11. In the case where real factors work in addition to nominal factor(money, and price level), the changes in FX rate cannot be fully explained by nominal factors, such as money supply and relative price level. Thus, nominal FX (S or E) changes and ‘q’ changes as well. 11

12. For example, Domestic ‘technical innovation’ leads to an increase in supply of manufactured/tradable goods and their falling prices. However, the overall price level of the domestic country may not fall much as technical innovation may not happen in some industries such as services and the price level is an average of manufactured goods and services. The international demand for tradable goods increases. As supply of FX rises, FX rate falls. Thus q = S Pf/P falls. 12

13. 13 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.

14. 14 1) Facts: Data of Japanese FOREX Rate Trends of P/Pf and E in Japan P/Pf E = S ‘76‘87

15. 15 2) Analysis : (1) Nominal Factor  The appreciation of the Japanese Yen, or the falling E or S can be only partially explained by P/P f 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.

16. 16 (2) There is a large part of the falling  E, which cannot be explained by PPP: These are the real factors that change ‘q’.

17. 17 q = S / (P / P f ) falls as S falls more than P/ P f falls We can infer that

18. 18 *Now use ‘q’ to explain the whole story: (i) Nominal Factors affecting the Price Level: relatively conservative monetary policy in Japan -> P/Pf fell. -> S in Japan fell according to the Purchasing Power Parity Theorem. * However, if this is all that has happened, S and P/Pf move by the same amount, and thus ‘q’ would not have changed. However, P/Pf is not enough to explain the changes in S.

19. 19 (ii) Real Factors: The Overall Average Prices do not change very much while the price of a specific sector directly related to the real factors change a lot. Suppose that In Japan, there are two sectors of industry: Tradable and Non-Tradable industries. The overall price level in Japan is the weighted average of the prices of the two sectors: P = 0.5 P T + 0.5 P NT (in simpliest form) Technical Innovation happens only to Tradable industry - Due to Technical Innovations, Japanese Tradable goods become cheaper. Due to Technical Backwardness, Japanese Non-tradable goods become more expensive: -> The Overall Price Level (P) stays relatively stable while Tradable Good Price(P T ) falls significantly.

20. 20 (iii) Real Factors affecting the Prices of Tradable goods: FX rate falls Japanese Tradable goods become more internationally competitive Trade depends on the relative prices of tradable goods between domestic and foreign country P T / P T of Foreign Country, not the overall relative prices 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 FX rate falls additionally in Japan beyond what PPP dictates.

21. 21 (iv) Real FX rate or q falls: S falls more than P / Pf. q = S / (P/ P f ) falls as well. -> a falling real exchange rate reflects a rising international competitiveness; This is called ‘Real Appreciation of Domestic Currency” <- a falling real exchange rate has a unfavorable reaction, decreasing Japanese exports and increasing Japanese imports. However, this secondary reaction may not fully offset the initial rise in competitiveness.

22. 22 (v) PPP worked for Tradable Goods Prices only, not for the Overall Price Level: S P T f / P T = 1 for Tradable Goods S P f / P << 1 for overall price level Here, q(<<1) is a reflection of an increasing competitiveness of Japanese export goods.

23. 23 5. Case study of Canada 1)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 2001-2003Between 2001-2003 -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

24. 24 *Data: US-Canadian FOREX Rates of the 1970s to 2001. In fact, PPP was not exactly correct If PPP had been correct E q

25. 25 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 P canada /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)? *2) Analysis: Explaining with ‘q’

26. 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. 26

27. 27 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 1.Most FX transactions were in a large amount and do not carry a large percentage of conversion costs 2.Recently developed hedging has already reduced FOREX risks substantially 3.Not much gains for Canada for now

28. 28 *“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).

29. 29 -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.

30. 30 *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.

31. 6. Case Study of China: A good topic for your assignment P/PfS q 31

32. *Confusing Use of S and q by some other authors Just like the case of direct versus indirect quotation of S, there are two different definition of q. Our way is right The other use of q (= 1/S P/Pf) is only for convenience. 32