Transcript Exchange Rate Topics

Exchange Rate Topics
Chapter 35
Real Exchange Rate
Real Exchange Rate
• A country’s real exchange rate is the relative cost
of that country’s good when compared to foreign
goods when measured in domestic currency
PtUS
St
REX t  St  HOME 
Pt
PPPt
• 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
Purchasing Power Parity
• An currency achieves a PPP exchange
rate when the cost of purchasing foreign
goods equals domestic goods S = PPP,
REX = 1.
• Absolute PPP – REX = 1
• Relative PPP gREX = gS +[πUS – π] = 0
Does PPP Hold?
• Does Absolute or Relative PPP hold?
• In short run, NO. Exchange rates are much more
volatile than inflation rates.
• In long run for countries with similar levels of
development, PPP holds.
– Example. Twenty year averages for OECD countries.
Long Run: Developed Economies
Source: IFS 1975-1995
PORTUGAL
ITALY
SPAIN
SWEDEN
UNITED KINGDOM
AUSTRALIA
FRANCE
CANADA
BELGIUM
GERMANY
NETHERLANDS
JAPAN
-4.00%
-2.00%
0.00%
Inflation Differential
2.00%
4.00%
Exchange Rate Depreciation
6.00%
8.00%
Over-valued/Under-valued
• When the cost of purchasing foreign
goods is
– relatively high, S > PPP and a currency is said
to be undervalued.
– relatively low, S < PPP and a currency is said
to be overvalued.
•Is HK$ overvalued in 2008?
Calculate Real Exchange Rate
• Calculate Pt
– Get PPPReference from World Bank, U Penn etc.
– Convert CPI to World Bank Reference Year
Dollars for Domestic and Foreign Economy
CPI
CPIt
Pt  PPPReference 
CPI Reference
PtUSA
CPI tUSA

USA
CPI Reference
Example
• HK: PPP in 2005 was
5.69 meaning goods
that cost $1 in the US
cost HK$5.69 in HK.
• But prices (and
exchange rates) have
changed since then.
CPI
USA
HK
2005 196.400
100.3
2008 219.086
109.1
PPP
2005
1
5.69
S
2008
7.8
REX
• What is REX in HK?
• Is HK$ over or
undervalued.
2008 US
HK
P
1.115509 1.087737
S
7.8
PPP
5.548338
Relative PPP
• In the long-run, we expect prices to
converge through arbitrage trade (i.e.
exporters should ship goods from a cheap
market to an expensive one, until prices
equalize across markets).
• The average growth rate of the exchange
rate should be equal to the inflation
differentials.
S
HOME
US $
gt   t
 t
Long Run: Developed Economies
Source: IFS 1975-1995
PORTUGAL
ITALY
SPAIN
SWEDEN
UNITED KINGDOM
AUSTRALIA
FRANCE
CANADA
BELGIUM
GERMANY
NETHERLANDS
JAPAN
-4.00%
-2.00%
0.00%
Inflation Differential
2.00%
4.00%
Exchange Rate Depreciation
6.00%
8.00%
Hong Kong’s Exchange Rate
Regime
Clearing Accounts Reserves
• May 2005 Under the strong-side Convertibility
Undertaking, the HKMA undertakes to buy US
dollars from licensed banks at 7.75. Under the
weak-side Convertibility Undertaking, the HKMA
undertakes to sell US dollars at 7.85.
US Monetary Policy Causes
US Interest Rates Go Down Relative
Demand for US$ Goes Down
S
Supply
Supply'
1
S=7.8
Excess Supply
of US Dollars
S**
Demand
Demand '
Passive Forex Intervention
Money Supply
i
Money
Agents want
more Hong
Kong dollars
and excess
supply of US
dollars at
exchange rate.
Supply’
i*
i**
Rather than sell
US dollars at
falling prices,
sell to HKMA at
Strong Side
price
1
Money
Demand
2
M
HKMA
purchase of
forex increases
M and reduces
i.
Convertibility Undertaking Stabilizes Forex
Demand and Supply Curves Automatically
S
Supply
Supply'
1
S=7.8
Excess Supply
of US Dollars
S**
Demand
Demand '
Iron Triangle of International
Finance
Open to
International
Capital Flows
Monetary
Policy that
Controls The
Interest Rate
Pick 2 items from this menu
Fixed
Exchange
Rates
Advanced Topic
Uncovered Interest Parity
Exchange Rate Depreciation
• Exchange Rate: S - # of domestic
currency units purchased for 1 US$.
• An increase in S is a depreciation and a
decrease in S is an appreciation.
• Depreciation Rate
St 1  St St 1
t 1 

St
St
Saving
It is January 1st, and you have HK$1000 to
save for 1 year. You can put it into:
1. Put it into a domestic currency bank
account at an interest rate i.
2. a foreign currency bank account at
interest rate iF.
Payoff to strategy #2
• Strategy two has three parts.
1. Buy foreign exchange at spot rate S01/01 to get
{HK$1000/ S01/01} US dollars.
2. Put {S01/01 × HK$1000} into bank account.
After 1 year get US$(1+iF)×{HK$1000/S01/01 }
3. Convert these funds into US at exchange rate
prevailing in 1 year.
(1  i F )  S12 / 31
 HK $1000
S01/ 01
Uncovered Interest Parity
• If
(1  i F )  S12 / 31
> 1+i, deposit funds
S01/ 01
then deposit in US$ account.
F
(1

i
)  S12 / 31
• If
< 1+i, deposit funds
S01/ 01
then deposit in HK$ account.
• Then in equilibrium
(1  i
F
S01/ 01

)
1  i
S12 / 31
Interest Rate Parity
• The only reason people would be willing to
hold a US$ account when US interest rates
were lower than domestic interest rate
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.
F
• Approximately i  i  12 / 31
Fixed Exchange Rate
• If the central bank undertakes to keep the
exchange rate fixed and that is a credible
undertaking, then   0.
t 1
• If the relative values of currency are fixed,
then funds will flow out of the domestic
currency if domestic interest rates are too
low and flow into domestic currency if
interest rates are too high.
i = iF
Learning Outcome
• Calculate the real exchange rate and
judge whether the domestic currency is
over or undervalued.