Transcript Real Exchange Rate

Review of
Exchange Rate Basics
Key Points
1. An economy’s price level captures the average rate at which
money is traded for goods - and inflation measures how this
rate changes through time.
2. An economy’s nominal interest rate captures the price at
which individuals are willing to trade money through time.
3. An economy’s real interest rate captures the price at which
individuals are willing to trade goods through time.
4. The Fisher Effect captures a relationship between each of
these prices - which is enforced through risky arbitrage
activity.
Key Points
5. Prices and interest rates are determined by individuals’
demand for money (relative to that of goods or future money)
and its supply.
6. Central banks set the money supply via intervention in the
money market and the foreign exchange market, as well as
through regulation.
7. By adjusting the money supply, central banks can strongly
influence inflation and interest rates.
8. Exchange rate is a price, determined like any other price, by
buyers and sellers of currencies; relative supply and demand
for currencies.
Key Points
9. Since the exchange rate is determined by relative supply
and demand, other factors affecting supply and demand will
impact the exchange rate: inflation, interest rate changes,
government intervention.
10. Law of One Price, Purchasing Power Parity, and Relative
Purchasing Power Parity describe the relation between prices
and exchange rates.
11. These relationships hold well where goods arbitrage is
possible - in ‘tradable goods’.
12. The important exchange rate to focus on to determine the
real impact of exchange rate fluctuations is the Real
Exchange Rate - the exchange rate adjusted for inflation.
Key Points (cont’d)
13. Exchange rate risk involves, therefore,
unpredictable change in the real exchange rate.
14. Some real exchange rate changes are
predictable (i.e. in growing economies) but many
perhaps most are not.
Prices and Interest Rates
Prices and interest rates are simply numbers which
reflect the values of cash today relative to goods and
services today and to notes promising cash in the
future.
Prices and Interest Rates
Prices and interest rates are simply numbers
which reflect the values of cash today relative
to goods and services today and to notes
promising cash in the future.
Today
Tomorrow
Goods/Services
Price Level
Cash
Nominal Interest Rate
Cash
Prices and Interest Rates
We use Pt and R t, t+1 to denote the price level
and one-period nominal interest rate at time t:
Today
Tomorrow
Goods/Services
Pt
Cash
R t, t+1
Cash
Prices and Interest Rates
The percent change in the price level is the
inflation rate...
Today
Tomorrow
Goods/Services
Goods/Services
Pt
Cash
Inflation Rate
R t, t+1
Pt+1
Cash
Prices and Interest Rates
…which we denote as Pi.
Today
Tomorrow
Goods/Services
Goods/Services
Pt
Cash
t
R t, t+1
Pt+1
Cash
Prices and Interest Rates
The real interest rate - although not observed - can
be thought of as the price at which individuals are
willing to exchange goods today for goods
tomorrow…
Today
Tomorrow
Real Interest Rate
Goods/Services
Pt
Cash
Goods/Services
t
R t, t+1
Pt+1
Cash
Prices and Interest Rates
As before, we denote the real interest rate as
r t, t+1.
Today
Goods/Services
Pt
Cash
Tomorrow
r t, t+1
t
R t, t+1
Goods/Services
Pt+1
Cash
The Fisher Effect
The Fisher Effect captures the relationship between
inflation, nominal interest rates, and real interest
rates.
Today
Goods/Services
Pt
Cash
Tomorrow
r t, t+1
t
R t, t+1
Goods/Services
Pt+1
Cash
The Fisher Effect
This relationship says quite simply that nominal
interest rates are a product of real interest and
expected inflation.
1+R t, t+1 = (1+ E( t) + r t, t+1)
Today
Goods/Services
Pt
Cash
Tomorrow
r t, t+1
t
R t, t+1
Goods/Services
Pt+1
Cash
An Exchange Rate is Just a Price
An exchange rate is simply the price of one currency
in terms of another.
Why is there confusion?
• 1.68DM/$ is price of a Dollar in terms of Marks.
• $0.59/DM is price of a Mark in terms of Dollars.
No different from any other price.
• $0.5/Apple
• 2 Apples/$.
Exchange Rate Quotations
2 Ways:
1) Direct Terms or American Terms (S)
Units of home currency ($) for one unit
of foreign currency: S = $0.59/DM
2) European Terms
Price of home currency ($) in terms of
foreign currency: 1.68DM/$
Exchange Rate Quotations
2 Ways:
1) Direct Terms or American Terms (S)
Units of home currency ($) for one unit
of foreign currency: S = $0.59/DM
2) European Terms
Price of home currency ($) in terms of
foreign currency: 1.68DM/$
Unless noted otherwise,
we will use this notation.
Definitions:
Spot Exchange Rates:
Quotes for immediate exchanges of one currency
for another.
Forward Exchange Rates:
Quotes for transactions agreed upon now that will
take place 30, 90, and 180 days into the future.
Cross Exchange Rates
Exchange rates between two currencies when
neither is the domestic currency
Definitions:
No Triangular Arbitrage Condition:
The amount of currency B received by exchanging A
must equal that obtained exchange A to C then C to B.
i.e. Yen/$ = (DM/$) x (Yen/DM) = (Yen x DM)/(DM x
$) = Yen/$
Bid Price:
Price at which a dealer is willing to buy.
Ask Price:
Price at which a dealer is willing to sell.
Definitions:
Gross Return:
Current value of $1 invested originally = Today’s Price / Original
Price.
Net Return:
Gross Return - 1.
Compound Annual Return:
(Gross Return)1/N - 1
Investments Denominated in Foreign Currency:
Gross Return in $ = (Gross Return in FC) x (S today / S original)
Law of One Price
In the absence of shipping costs, tariffs, and other
frictions, identical goods should trade for the same
real price in different economies:
Pi = S P*i
The Law of One Price holds perfectly for
homogeneous goods with low transaction costs.
Why?
Examples: precious metals, wheat, oil
Purchasing Power Parity
Purchasing Power Parity is simply the extension of the Law
of One Price to all products in two economies. It says that
the overall real price levels should be identical:
P = S P*
Example:
Costs $1400 (P) to purchase a certain basket of U.S.
consumption goods. If Swiss Franc trades at 0.7 ($ per
Franc, S), how many Swiss Francs will the same basket cost
in Geneva (P*)?
2000 Swiss Francs
Relative Purchasing Power Parity
Because overall economy price levels consist of different
goods in different countries, a more appropriate form of PPP
is the relative form.
Relative Purchasing Power Parity asserts that relative changes
in price levels will be offset by changes in exchange rates:
% P - % P* = % s
Or denoting inflation (% P) as 
 - * = % s
RPPP asserts that differences in inflation rates will be offset
by changes in the exchange rate.
Relative Purchasing Power Parity
Example:
A year ago, the Brazilian Real traded at $0.417/Real.
For the last year, Brazil’s inflation was 4.2% and the
U.S. inflation was 1.7%.
What should be the value of the Real today?
$0.402/Real
Relative Purchasing Power Parity
 - * = % s
In general, how well does Relative PPP hold?
O.K. in the long run (over 5 years) and under
extreme conditions - not so well in the short run.
Why?
Arbitrage is not making all real prices the same
across countries.
What frictions exist?
Traded vs. Non-traded goods.
Exchange Rate Changes
This suggests that exchange rate changes which are a
result of inflation differentials will have very
different consequences for an economy than those
that are not:
- a country’s ability to export will be enhanced if its
exchange rate declines by more than its prices have
inflated.
- a tourist’s ability to travel abroad will be greater if her
wage increases have not been offset by a depreciation
in her country’s currency.
Real Exchange Rate
A currency’s real, inflation-adjusted value
can often be conveniently captured in a
measure known as it’s real exchange rate
(RER):
Real Exchange Rate
A currency’s real, inflation-adjusted value
can often be conveniently captured in a
measure known as it’s real exchange rate
(RER):
et =
Pt*
st
Pt
Real Exchange Rate
A currency’s real, inflation-adjusted value
can often be conveniently captured in a
measure known as it’s real exchange rate
(RER):
et =
Pt*
st
Pt
PPP (P = s P*) says: et = 1.
Real Exchange Rate
This suggests that firms should primarily be
concerned with changes in the real value of
their dollar in foreign country. That is, the
inflation-adjusted, or real, exchange rate:
et = st Pt*
Pt
PPP (P = s P*) says: et = 1
RPPP (% PI - % PI* = % s) says: et is
constant.
Calculating Real Exchange Rates
et = st
PIt*
PIt
Calculating Real Exchange Rates
et = st
PIt*
PIt
Year
st
2001
0.13
PIt*
PIt
et
100
100
???
Calculating Real Exchange Rates
et = st
PIt*
PIt
Year
st
PIt*
PIt
et
2001
0.13
100
100
0.13
Calculating Real Exchange Rates
et = st
PIt*
PIt
Year
st
PIt*
PIt
et
2001
0.13
100
100
0.13
2002
0.125
128
102
???
Calculating Real Exchange Rates
et = st
PIt*
PIt
Year
st
PIt*
PIt
et
2001
0.13
100
100
0.13
2002
0.125
128
102
0.157
Calculating Real Exchange Rates
et = st
PIt*
PIt
Year
st
PIt*
PIt
et
2001
0.13
100
100
0.13
2002
0.125
128
102
0.157
2003
0.12
154
104
0.178
etc...
Exchange Rate Risk
Changes in the real exchange rate can be expressed as
changes in the nominal exchange rate that are not
accounted for by inflation differentials:
%  e = %  s - ( -  *)
When is there exchange rate risk?
Only when %  e is unpredictable.
Exchange Rate Risk
Real exchange rate changes:
%  e = %  s - ( -  *)
Remember that %  s only holds well for tradedgoods:
%  s =  -  *
Combining, we get:
%  e = ( -  ) - ( * -  *)
Real exchange rate changes are differences in
relative inflation rates of traded and non-traded
goods in two economies.
Are RER Changes Predictable?
When are changes in relative prices of tradables to
non-tradables predictable?
Predictable: Growing economies (i.e. China)
commonly experience higher inflation in service (nontradables) sector.
Unpredictable: Government intervention - can never
be sure when intervention will take place.