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EXCHANGE RATES

EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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Page 1: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

EXCHANGE RATES

Page 2: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

What level should it be?

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Foreign Exchange Rate: Bank of Russia: US Dollar

Page 3: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Spot 1 Year Forward50

52

54

56

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Ruble/$ Rate December 30 2014 Forward Premium 1.1656071+i 1.17251+iF 1.006288(1+i)/(1+iF) 1.165173

Page 4: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

• 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

Page 5: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

Page 6: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Two Models• UIRP• Balance of Payments: Supply & Demand

Page 7: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Interest Parity

1(1 ) (1 )F tt t

t

Ei iE

Page 8: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Saving

It is January 1st, 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 iF.

Page 9: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Payoff to strategy #2

• Strategy two has three parts.1. Buy foreign exchange at spot rate St to get {D$1000/Et}

F$.. 2. Put {D$1000/Et} F dollars into FC bank account. After 1

year get F$(1+iF)×{D$1000/Et }

3. Convert these funds into F$ at exchange rate prevailing at end of year.

1(1 )$1000

Ft

t

i ED

E

Page 10: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Uncovered Interest Parity

• If , deposit funds then deposit in

F$ account.• If , deposit funds then deposit in

D$ account. • Then in equilibrium

1(1 )1

Ft

t

i Ei

E

1(1 )1

Ft

t

i Ei

E

1 (1 ) 1Ft

t

Ei i

E

Page 11: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

11

t tF F Et t t t

t

E Ei i i g

E

Page 12: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Three Reasons UIRP might not hold1. 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

{ }1

11

t tFt tt

iF Ei

{ }

1 :ttF

Page 13: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Balance of Payments Model

Page 14: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

International Capital Flows

• Capital Outflows: domestic acquisition of foreign assets.• Capital Inflows: foreign acquisition of domestic assetsNet 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

Page 15: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

Page 16: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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.

Page 17: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

1 (1 )Ftt

t

E iE

11t

tt

E iE

Page 18: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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.

• Expected Profit Effect - e.g. Expensive US$ magnifies returns on domestic accounts

• Exports Effect – Expensive US$ increases the attractiveness of domestic exports.

11t

tt

E iE

Page 19: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

• 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

• Expected Profit Effect - e.g. Cheap US$ magnifies returns on foreign accounts

• Imports Effect – Cheap US$ increases the competitiveness of imports.

1 (1 )Ftt

t

E iE

Page 20: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Balance of PaymentsForeign 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$

Page 21: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Supply and Demand in Forex Mkt

E

Demand

Supply

Forex Turnover

BoP > 0

BoP < 0

Page 22: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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.

Page 23: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

OtherU.S. dollar (66) Composite (15) Other (7) _ (44)

Currency board Hong Kong SAR Brunei Conventional Peg DenmarkStabilized Arrangement Cambodia Vietnam

Crawling & Crawl-like ChinaOther Managed Singapore Bangladesh, Malaysia MyanmarFloat Mongolia, Pakistan, Sri Lanka, Korea

Indonesia, Thailand, Philippines, IndiaFree Float Australia, New Zealand, J apan

Exchange rate arrangement

Monetary Policy FrameworkExchange rate anchor

Page 24: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Equilibrium with Floating Rates

E

Demand

Supply

E*

Forex Turnover

E

E

Page 25: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Equilibrium with Floating Rates

E

Demand

Supply

E*

E

E

Forex Turnover

Page 26: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Equilibrium with Floating Rates

E

Demand

Supply

E*

𝐸

Forex Turnover

Page 27: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Increase in Desired Capital Inflows by Foreign Investors/ Desired Purchases of Domestic Goods

E Supply

Demand

E*

Supply'

E**Domestic Currency Appreciates

Forex Turnover

Page 28: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Increase in Desired Capital Outflows by Domestic Investors/

Desired Purchases of Foreign GoodsE

Supply Demand

E*

Demand '

E** Domestic Currency Depreciates

Forex Turnover

Page 29: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Fixed Exchange Rate: Weak Currency Target

E

Demand

Supply

Forex Turnover

BoP > 0ETGT

Gov’t Buys Excess Supply US$

Foreign Reserves Increase

Page 30: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Fixed Exchange Rate: Strong Currency Target

E

Demand

Supply

Forex Turnover

BoP < 0ETGT

Gov’t Buys Excess DCU

Foreign Reserves Decrease

Page 31: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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.

Page 32: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

Page 33: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

E Supply

Demand

ETGT

Page 34: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

2005 2006 2007 2008 2009 2010 2011 2012 2013$0.0

$500.0

$1,000.0

$1,500.0

$2,000.0

$2,500.0

$3,000.0

$3,500.0

PRC Balance of Payments (Billions of US $)

Supply (Exports + Financial Inflows) Demand (Imports+Financial Outflows)

2005 2006 2007 2008 2009 2010 2011 2012 2013

Supply (Exports + Financial Inflows) $1,020.4 $1,281.3 $1,662.4 $1,839.6 $1,670.0 $2,333.2 $2,728.0 $2,728.2 $3,230.6Demand (Imports+Financial Outflows) $800.9 $1,008.2 $1,221.2 $1,385.1 $1,236.2 $1,817.8 $2,337.3 $2,553.1 $2,727.7Balance of Payments $250.6 $284.8 $460.7 $479.5 $400.3 $471.7 $387.8 $96.6 $431.4

Source: IMF Balance of Payments Data

Page 36: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Foreign Currency InterventionSterilized vs. UnsterilizedTwo 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.

Page 37: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Exchange Rates are Volatile!

Page 38: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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!

Page 39: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Expectation of Et+1 Increases

E

Supply Demand

E*

Supply'

Demand '

E**

Domestic Currency Depreciates1

2

Page 40: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

REAL EXCHANGE RATES & TRADE BALANCE

Page 41: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

Ft

t t HOMEt

PRER E

P

Page 42: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Benchmark: PPP• The first theory of exchange rates was Purchasing

Power Parity – Arbitrage should insure the price of goods was equalized across countries

1HOME USt t t tPPP P E P RER

•Is PPP true? Not in short run. Trade arbitrage does not work that fast. How about long run?

Page 43: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Exchange Rates OECDSource: IFS 1975-1995

Page 44: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Exchange Rate MisalignmentOver-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 >

HOME

FP

P

HOME

FP

P

Page 45: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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?

Page 46: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 201190.000

95.000

100.000

105.000

110.000

115.000

120.000

125.000

130.000

China, Real Effective Exchange Rate, CPI Based, 2005 = 100

How about the long run?

Page 47: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

Competitiveness & Current Account

IMF Data Mapper

Page 48: EXCHANGE RATES. What level should it be? Link Exchange Rate: E- # of domestic currency units purchased for 1 US$. An increase in E is a depreciation

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