Transcript Document

MBA34
Managerial Excellence
Exchange rate economics
The firm and its environment - Francesco Giavazzi
Copyright SDACopyright
Bocconi 2004
SDA Bocconi 2006
1
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
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Euro Effective Exchange Rate
is Trade weighted,
use amount of trade to weight bilateral Xrates
4% Singapore Dollar
4% Danish Krone
2% Norw egian
Krone
2% Canadian Dollar
1% Australian Dollar
25% US Dollar
4% Hong Kong
Dollar
5% Korean Won
6% Sw edish Krona
9% Sw iss Franc
15%
Japanese Yen
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24%
Pound Sterling
3
Euro effective exchange rate
Yearly averages, from daily data
135.0
130.0
125.0
120.0
115.0
110.0
105.0
100.0
1999
2000
2001
2002
2003
2004
2005
2006
2008
2007
95.0
Estimates and
assumptions1
Since 1999, the Euro has appreciated by some 25% or so on average
with respect to the other currencies
4
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Source: Oecd Economic Outlook, June 2008
US$ effective exchange rate
2% Brazilian Real
2% Thai Baht 2% Australian Dollar
3% Malaysian 2% Sw iss Franc
Ringgitt
3% Hong Kong
Dollar
1% Indonesian
Rupiah
1% Philippine Peso
19% Canadian
Dollar
3% Singapore dollar
4% Korean Won
4% Taiw anese
Dollar
5% Pound Sterling
9% Mexican Peso
7% Chinese Yuan
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18% Euro
16% Japanese Yen
5
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
1.200
1.100
1.000
0.900
0.800
0.700
0.600
2007
1999
1999
2001
2002
2003
2004
2005
2006
2008
Estimates and
assumptions1
Since 2001, the Euro has appreciated by some 40% or so with
respect to the US dollar
Copyright SDA Bocconi 2004
Source: Oecd Economic Outlook, June 2008
6
…. 2. How many dollars to buy a euro?
(Daily data)
1.3
$/Euro
1.15
1
0.85
0.7
06/12/19 23/06/20 09/01/20 28/07/20 13/02/20 01/09/20 20/03/20 06/10/20 23/04/20 09/11/20
99
00
01
01
02
02
03
03
04
04
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Appreciation/depreciation of
nominal Xrates
• Appreciation of €: rise in value of €, so €1
buys more foreign currency
– 1.10 US$/€ 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
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Real Exchange Rate
is a measure of competitiveness
(the nominal exchange rate is not)
€
Domestic Price Level
Real Rate = Nominal Rate x
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
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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
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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.)
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Estimated transport cost
for global trade: between 2 and 8%
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If LOP doesn’t hold, …
Euro vs dollar: Real and nominal exchange rates
130.0
125.0
120.0
115.0
110.0
105.0
100.0
1999
2000
2001
2002
2003
Real rate
2004
2005
2006
2007
Nominal rate
.. changes in nominal exchange rates go hand in hand with
changes in real rates, hence in competitiveness
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Yet LOP is almost right over longer horizons
Inflation and currency depreciation
- Five Year Window
Currency Depreciation (% pa)
30
23
17
10
3
-3
-10
-20
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-10
0
Inflation Differential
10
20
30
14
Inflation and Currency Depreciation
Twenty Year Window
12
Currency Depreciation (% pa)
9
6
3
0
-3
-6
-10
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-5
Inflation Differential
0
5
10
15
15
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
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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)
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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)
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Trade Accounts
PS (private saving)
= GDP + NIFA (net income
from abroad) – C – T
AND
GDP = C + I + G + (X – M)
X – M = T – G + PS – I – NIFA
X–M=
S (national saving)– I – NIFA
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Trade Accounts
X – M + NIFA = S – I
Net Exports =
Current Account
Surplus
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Net Saving =
Capital Account
Deficit
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The U.S. and euro area balance of payments in 2005
Current account and transfers
Goods and services
Income revenue
Transfers
Capital account*
Other investments, including
portfolio investment
Direct investment
Foreign exchange reserves
Statistical discrepancies
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UNITED STATES
% GDP
$Bn
-6.4%
-792
-717
11
-86
6,3%
785
EURO ZONE
% GDP
€Bn
-0.4%
-29
90
-53
-66
0.6%
40
870
101
-185
7
176
-155
19
-11
0.1%
-0.2%
21
Net foreign positions of the United States, euro zone and Japan
40%
30%
20%
% of GDP
Japan
10%
0%
Eurozone
-10%
USA
-20%
-30%
1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004
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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 $) net
exports up, trade balance and current account improves
– Net exports curve negatively sloped with respect to the
real rate
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Net Export Market
Real Exchange Rate
S-I
€/$
E0
E1
X – M + NIFA
Net Exports
Increase in net savings reduces real X rate
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Net Export Market
Real Exchange Rate
S-I
₤/$
E0
E1
X – M + NIFA
Net Exports
Decrease in net savings increases real exchange
rate
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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
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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
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Exchange rate regimes
Currency
board
ŌDollarizationÕ,
ŌeuroizationÕ
Low
flexibility
Monetary
union
Hard pegs
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Fixed exchange
rate
Crawling
peg
Soft peg with fluctuation
band
High
flexibility
Managed
float
Free float
Intermediate regimes
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Exchange rates and asset markets
Key concepts
• Covered Interest Parity
• Uncovered Interest Parity
• Spot and Forward Exchange Rates
• Global Capital Markets
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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
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Covered Interest Parity
(CIP)
$100
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Stay in US
$100(1+ius)
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Covered Interest Parity
$100
10900¥
Convert
to
Yen at
Spot Rate
109¥/$
Convert to $
at Forward
Rate 108¥/$
10900(1+iJapan)¥
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$101(1+iJapan)
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Covered Interest Parity
$100
Stay in US
Con
vert
to
Yen
10900¥
at
Spot
Rate
Convert to $
109
at Forward
¥/$
Rate 108¥/$
10900(1+iJapan)¥
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$100(1+ius)
Must be same rate of
return
$101(1+iJapan)
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Covered Interest Parity
Con $100
vert
to
Yen
at
Spot 10900¥
Rate
109
¥/$
$101(1+iJapan) = $100(1+ius)
(1  i Japan ) Forward Rate(Yen / $)

US
(1  i )
Spot Rate(Yen / $)
10900(1+iJapan)¥
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CIP
(1  i
) Forward Rate(Yen / $)

US
(1  i )
Spot Rate(Yen / $)
Japan
US
i
+ forward premium =
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J
i
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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
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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
(1  i ) Expected Future Spot (Yen / $)

US
(1  i )
Spot Rate(Yen / $)
Japan
• Taking expectations as given, we can use UIP to determine
the current level of the exchange rate
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Current exchange rate (¥/$)
UIP and the Exchange Rate
(for Se(1) given)
iJ
S*(0)
Return on yen account
Return on dollar account: given
Se(1), the higher the current Spot
rate, the lower the return
iUS + [Se(1)-S(0)]/S(0)
Rate of Return
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Current exchange rate (¥/$)
UIP and the Exchange Rate
iJ
iUS + [Se(1)-S(0)]/S(0)
Rate of Return
As interest rate in Japan goes up, $ depreciates
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Current exchange rate (¥/$)
UIP and the Exchange Rate
iJ
iUS + [Se(1)-S(0)]/S(0)
Rate of Return
As interest rate in Japan goes down, $ appreciates
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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
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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.
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Decrease in risk premium
Current exchange rate (¥/$)
iJ
$ appreciates
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iUS
+ $ appreciation
– Risk Premium
Rate of Return
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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
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45
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
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International financial integration, 1870-200
average abs value of current accounts in % of GDP
Avg abs. value of current account in % of GDP
6
5
4
3
2
1
04
20
00
-
94
19
90
-
84
19
80
-
74
19
70
-
64
19
60
-
54
19
50
-
44
19
40
-
34
19
30
-
24
19
20
-
14
19
10
-
04
19
00
-
94
18
90
-
84
18
80
-
18
70
-
74
0
Sources: Taylor (1996), FERI.
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Summing up
• CIP
• UIP
– Relation to interest rate movements
– Relation to exchange rate movements
– Role of risk aversion
• Global capital market puzzles
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