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    What Determines Exchange Rates

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    Chapter Nineteen What Determines Exchange Rates? Thinking in terms of supply and demand is a necessary first step toward understand- ing exchange rates. The next step is the one that has to be taken in any market analy- sis: finding out what underlying forces cause supply and demand to change. We need to know what forces have caused the changes in exchange rates observed since the start of widespread “floating” back in the early 1970s. Figure 19.1 reminds us just how variable exchange rates have been. Between 1971 and the end of 1973, most currencies of other industrialized countries rose in value relative to the dollar, the aver- age rise being about 20 percent. After 1973, when the modern era of floating exchange rates clearly took hold, we can see three types of variability for these exchange rates, 4 First, there are long-term trends. As shown in Figure 19.1A, over the entire period the Japanese yen, Swiss franc, and German mark (DM) have tended to i appreciate, with the yen and the Swiss franc more than tripling in value, and the DM (fixed to the euro in 1999 and then retired in 2002) more than doubling. As shown in Figure 19.1B, over the entire period the Italian lira, British pound, Australian dollar, and Canadian dollar have tended to depreciate. The lira (also fixed to and then replaced by the euro) has lost almost two-thirds of its exchange ‘i rate value against the dollar, the Australian dollar has lost about a third, the pound i has lost about a quarter, and the Canadian dollar has lost about an eighth. Still other | currencies, such as the Israeli shekel or Argentine peso, dropped so far in value that they would almost hit zero if we added them to Figure 19.1B. ; Second, there are medium-term trends (over periods of several years), and these medium-term trends are sometimes counter to the longer trends. For instance, the Swiss franc, DM, and to a lesser extent the yen depreciated during the period 1980-1985. Another trend is the appreciation of the pound and the lira from 1985 to 1988. The decline in the dollar value of the euro from its introduction at the beginning of 1999 to late 2000, and then the euro’s rise back up in value from late 2000 to early 2005, can be seen in either of two currencies shown (DM, lira) that it has replaced. | Third, there is substantial short-term variability in these exchange rates from-month | to month (and indeed, from day to day, hour to hour, and even minute to minute). ‘We can look at the movements in the exchange rate value of the dollar as the reverse of those for each foreign currency, of we can calculate the average movement against a set a7 FIGURE 19.1 Selected Exchange Rates, 1970-2005 (Monthly) {A Swiss Franc, German Mark (DM), and Japanese Yen Exchange Rate Wanuary 1970 = 100) 450 400 350 300 Swiss franc 250 im “ ‘00 . B. Australian Dollar, Canadian Dollar, tish Pound Sterling, and Italian Lira sion sere oo a « « * . 2 2 8 es 2 “Beginning January 1999, these two currencies are fixed to the euro, so each ofthese rates is tracking the US S/euro exchange rate ‘movement ftom that dat, For each curreney, the dollar price ofthat currency (¢¢., $/) is shown, with units adjusted so that its January 1970 value is 100. For eny currency, an increase in the value shown from one time to another indicates thatthe currency has increased in exchange rate value (appreciated) relative tothe US. dollar during that ime period; a decrease inthe value shown indicate tat the curency has depreciated relative tothe US. dollar. For the currencies shown, the Japanese yen, Swiss franc, and German mark have appreciated ‘over the entire 35-year period, while the Italian lia, Australian dollar, British pound sterling, and Canadian dollar have depreciated. ‘At the beginning of 1999, the German mark and Italian lira were fixed tothe euro, and in 2002 the euro replaced these currencies, Source trons! Monetary Fund International Financia States, Chapter Nineteen What Determines Exchange Rates? 419 of other currencies. After the dollar's average value against the currencies of other indus- ttialized countries fluctuated modestly from 1973 to 1980, nearly all observers were stunned as the dollar rallied. By the time the dollar peaked in early 1985, it had gained over 50 percent in value since 1980 and was about 20 percent above its value in 1970, From early 1985 to early 1988, the dollar then fell (even more quickly) by a little more than it had risen in the previous five years. From early 1988 to 1995, the dollar fluctuated somewhat in average value against the currencies of the other industrialized countries, but it did not show any pronounced overall trend. From 1995 to early 2002, the dollar's aver- age value rose by about 40 percent, and it then fell back to its 1995 level by late 2004. ‘Why do we see lange changes in the values of floating exchange rates? How does short- run variability turn into long-run trends? Why are medium-run trends sometimes oppo- site to these longer trends? This chapter presents what economists believe, what they think they know, and what they admit they do not know about this challenging puzzle. A ROAD MAP This chapter focuses on what we know about the determinants of exchange rates.! The first part of the chapter focuses on short-run movements in exchange rates, To under- stand exchange rates in the short run, we must focus on the perceptions and actions of international financial investors. We believe that rather little of the nearly $2 trillion of foreign exchange trading that occurs each day is related to international trade in goods and services. Instead, most of itis related to the positioning or repositioning of the currency composition of the portfolios of international financial investors. The asset market approach to exchange rates emphasizes the role of portfolio repositioning by international financial investors. As demand for and supply of financial assets denominated in different currencies shift around, these shifts place pressures on the exchange rates among the currencies. Fortunately, we have a head start on this analysis because we can use the concept of uncovered interest parity from Chapter 18. Major conclusions of our analysis are that the exchange rate value of a foreign cur- renoy (¢) is raised in the short run by the following changes: + A rise in the foreign interest rate relative to our interest rate (i, — i). * A rise in the expected future spot exchange rate (e®). ‘The second part of the chapter turns to long-term trends. Why do some currencies tend to appreciate over the long run, while others tend to depreciate? A key economic “fundamental” that appears to explain these long trends is the difference in national rates of inflation of the prices of goods and services. The concept of purchasing power parity (PPP) contains our core understanding of the relationship between product prices, and exchange rates in the long run. The third part of the chapter examines the role of money as a determinant of national product price levels and inflation rates. Through the link of money to price "The forces examined here are central not only to understanding what causes floating rates to change but also to understanding the pressures on a system of fixed rates. Whatever would make a floating currengy sink oF rise would also make a fixed exchange rate harder to defend. The material has more uses than simply the search for determinants of floating exchange rates. It also applies to the analysis of the balance of payrnents under a fixed-rate system or a managed floating rat. 420. Part Three Understanding Foreign Exchange levels and inflation rates, the monetary approach to exchange rates emphasizes the importance of money supplies and demands as key to understanding the determinants of exchange rates. A major conclusion of the monetary approach is that the spot = exchange rate e, the price of foreign currency in units of our currency, is raised in the © Tong run by the following changes: + A tise in our money supply relative to the foreign money supply (M’/M;) + A ise in foreign real domestic product relative to our real domestic product (¥,/¥). ‘The fourth part of the chapter shows one way in which the short term flows into the medium term and then into the long term, We examine the tendency for exchange rates to “overshoot,” to change more than seems necessary in reaction to changes in gov- emment policies or to other important economic ot political news. After the over- shooting in the short run, the exchange rate moves in the medium run toward its long-run fundamental value. ‘The final part of the chapter looks at how useful these concepts and relationships really are. How well can we forecast future exchange rates? EXCHANGE RATES IN THE SHORT RUN Economists believe that pressures on exchange rates in the short run can best be under- stood in terms of the demands and supplies of assets denominated in different currencies. In principle the asset market approach to exchange rates incorporates all financial assets, Fortunately, we can grasp its key elements by focusing on investments in debt securities, such as government bonds, denominated in different currencies. In the analysis here we build on the discussion of uncovered international financial invest- ment and uncovered interest parity from Chapter 18, Recall that investors determine the expected overall return on an uncovered investment in a bond denominated in a foreign currency by using + the basic return on the bond itself (the interest rate or yield), and + the expected gain or loss on currency exchanges (the expected appreciation or depreciation of the foreign currency). While we may not believe that uncovered interest parity holds exactly, we still expect that there will be a noticeable relationship between the return on home-currency bonds and the expected overall return on foreign-currency bonds. These two returns will tend to be equal (or at least not too different). Emerging differences in these two returns will cause international financial investors to reposition their portfolios, and this repo- sitioning creates the pressures that move the two returns toward equality.* 2 This broad asset market approach built on the uncovered interest party is @ kind of portfolio balance approach because it emphasizes the role of portfolio repositioning in the determination of exchange rates, However, the portfolio balance approach can go further than this. One further conclusion of the portfolio balance approach is that @ change in the supplies of assets denominated in different currencies, affects the deviation from uncovered interest parity (in the form of a risk premium) that is necessary to induce investors to hold (demand) all of these assets. This conclusion results because assets denominated in different currencies actually are not perfect substitutes for each other in investors’ portfolios. Chapter Nineteen What Determines Exchange Rates? 421 FIGURE 19.2 _Determi f the Exchange Rate in the Short Run Implications for the Current Direction of international Spot Exchange Rate Change in Variable __ Financial Repositi (e = Domestic currency/Foreign currency) Domestic interest Rate (7) Increases ‘Toward domnestic-currenty assets __€ decreases (domestic currency appreciates) Decreases ‘Toward foreign-currency assets _e increases (domestic currency depreciates) Foreign Interest Rate (i) Increases Toward foreign-currency assets __ e increases (domestic currency depreciates) Decreases ‘Toward domestic-currency assets ¢ decreases (domestic currency appreciates) Expected Future Spot Exchange Rate (e") Increases Toward foreign-currency assets. increases (domestic currency depreciates) Decreases ‘Toward domestic-currency assets _¢ decreases (domestic currency appreciates) “The analysis for each change in one of the variables assumes thatthe other two variables are unchanged. ‘Uncovered interest parity (whether exact or approximate) links together, four vari- ables: the domestic interest rate, the foreign interest rate, the current spot exchange rate, and the expected future spot exchange rate. (The two exchange rates together imply the expected appreciation or depreciation.) Change in any one of these four vari- ables implies that adjustments will occur in one or more of the other three. We will here focus on implications for the current spot exchange rate of changes in each of the other three variables. Figure 19.2 provides a road map by summarizing the effects. The Role of Interest Rates Foreign exchange markets do seem sensitive to movements in interest rates. Jumps of exchange rates often follow changes in interest rates. The response often looks prompt, 0 much so that press coverage of day-to-day rises or drops in an exchange rate typi- cally point first to interest rates as a cause. If our interest rate (i) increases, while the foreign interest rate (j) and the spot exchange rate expected at some appropriate time in the future (e) remain constant, the return comparison shifts in favor of investments in bonds denominated in our currency. If international financial investors want to shift toward domestic-currency assets, they first need to buy domestic currency before they can buy the domestic- ‘currency bonds. This increase in demand for domestic currency increases the current spot exchange rate value of domestic currency (so ¢ deoteases). Given the speed with which financial investors can initiate shifts in their portfolios, the effect on the spot exchange rate can happen very quickly (instantaneously or within a few minutes). Let's consider an example involving the United States, Switzerland, and 90-day bonds. Initially, the U.S. interest rate is 9 percent per year, and the Swiss interest rate is 5 percent per yeat. The current spot rate is $.50 per Swiss franc (SFr), and the spot rate expected in 90 days is about $.505 per SEr. The franc is expected to appreciate about 1 percent during the next 90 days, so the annual rate of expected appreciation is about 422 Part Three Understanding Foreign Exchange US. interest rate increases to 11 percent? Given the other initial rates, the return differential shifts in favor of US.-dollar-denominated bonds. International financial § investors have an incentive to shift toward dollar-denominated bonds, and this increases the demand for dollars in the foreign exchange market. The dollar tends to appreciate immediately. Furthermore, we can determine that the dollar should appreciate to about _ $.4975 per SFr, assuming that the interest rates and the expected future exchange rate do not change. Once this new current spot exchange rate is posted in the market, the SFr then is expected to appreciate during the next 90 days at a faster rate, equal to about 6 percent at an annual rate, This reestablishes uncovered interest parity (5 percent interest plus about 6 percent expected appreciation matches the 11 percent USS. inter- est) and eliminates any further desire by international investors to reposition their portfolios. If our interest rate instead decreases, with foreign interest rates and the expected future spot rate unchanged, the spot exchange rate value of our currency is predicted to decrease (e increases). Ifthe foreign interest rate (j,) increases, the story is similar. Assuming that the domes- tic interest rate and the expected future spot exchange rate are constant, the return comparison shifts in favor of investments in bonds denominated in foreign currency. A shift by international financial investors toward foreign-curreney bonds would require them first to buy foreign currency in the foreign exchange market, This increase in demand for the foreign currency increases the current spot exchange rate, e (the domes- tic currency depreciates). Consider a variation on our previous example, still using 90 days and annualized rates. If the US. interest rate is 9 percent, the spot exchange rate is $.50 per SFr, and the expected future spot rate is about $.505 per SFr, what is the effect of an increase in the Swiss interest rate from 5 to 7 percent? The return differential shifts in favor of Swiss bonds. The increased demand for francs in the foreign exchange market results in a quick appreciation of the franc (and depreciation of the dollar). The current spot exchange rate must jump immediately to about $.5025 per SFr to reestablish uncov- ered interest parity, If instead the foreign interest rate decreases, the spot rate e, decreases. (The domestic currency appreciates.) ‘What happens if both interest rates change at the same time? The answer is straight- forward. What matters is the interest rate differential i i,. Ifthe interest rate differ- ential increases, the return differential shifts in favor of domestic-currency bonds, and tends to decrease. (The domestic currency appreciates.) If it decreases, e tends to - increase. The Role of the Expected Future Spot Exchange Rate Expectations of future exchange rates can also have a powerful impact on international financial positioning, and through this on the value of the current exchange rate. Consider what. happens when financial investors decide that they now expect the future spot exchange rate to be higher than they previously expected. Relative to the Chapter Nineteen Whar Determines Exchange Rates? 423 current spot rate, this means that they expect the foreign currency to appreciate more, or to depreciate less, or to appreciate rather than depreciate. Assuming that the inter- est rate differential is unchanged, the increase in the expected future spot rate alters the return differential in favor of foreign-currency-denominated bonds. The story from here is familiar. If international financial investors want to shift toward foreign- currency assets, they first need to buy foreign currency in the foreign exchange mar- ket before they can buy the foreign-currency bonds. This increase in demand for foreign currency increases the current spot exchange rate e, (The foreign currency appreciates; the domestic currency depreciates.) If instead the expected future spot exchange rate decreases, with the interest rate differential unchanged, the return dif ferential changes in favor of domestic-currency investments, and the current spot exchange rate value of our currency increases (e decreases). Consider another variation on our previous example. With the U.S. annualized inter- est rate at 9 percent, the Swiss annualized interest rate at 5 percent, and the current spot exchange rate at $.50 per SFr, what happens if the spot exchange rate expected in 90 days increases from about $.505 to about $.515 per SFr (pethaps because interna- tional investors believe that the political situation in Switzerland will improve rapidly)? Relative to the initial current spot rate, investors now expect the franc to appreciate more in the next 90 days, at about a 12 percent annual rate (rather than the previously expected 4 percent). This shifts the return differential in favor of Swiss- currency bonds. Because investors desire to reposition their portfolios toward Swiss assets, demand for the franc increases in the foreign exchange market. The current spot exchange rate increases (the franc appreciates and the dollar depreciates). In fact, the spot exchange rate moves to about $.51 per SFr. At this new spot rate, the franc then is expected to appreciate further by only about 4 percent (annual rate). Uncovered interest parity is reestablished, and there is no further incentive for international investors to reposition their portfolios. As with a change in interest rates, the effect ofa change in the expected future spot rate on the current spot exchange rate can happen very quickly (instantaneously or within a few minutes). This can be like a rapid-fite self-confirming expectation. In the Swiss franc example, the expectation that the franc would appreciate more than was previously expected resulted in a rapid and large appreciation of the franc. For another example, consider what happens if international financial investors shift from expect- ing no change in spot exchange rates (e* equals the initial e) to expecting a deprecia- tion of the foreign currency (e* decreases so that it is then below the initial current spot rate e). The willingness of international investors to reposition their international Portfolios away from foreign-currency bonds tesults in a depreciation of the foreign currency (e decreases)—exactly what they were expecting. Given the powerful effects that exchange-rate expectations can have on actual exchange rates, we would like to know what determines these expectations. Many dif- ferent things can influence the value of the expected future exchange rate. Some investors, especially for expectations regarding the near-term future (the next minutes, hours, days, or weeks), may expect that the recent trend in the exchange rate will continue. They extrapolate the recent trend into the future. This is a bandwagon. For instance, currencies that have been appreciating are expected to continue to do so. The recent actual increase in the exchange rate value of a country's 424 Part Three Understanding Foreign Exchange currency leads some investors to expect further increases in the near future. If th act on this belief, the currency will tend to appreciate further. This bandwagon effect is the basis for fears that speculation can sometimes be destabilizing in that the actions of international investors can move the exchange rate away from a long-run; equilibrium value consistent with fundamental economic influences. Expectations can be destabilizing if they are formed without regard to these economic funda. = mentals, which is quite possible if recent exchange rate trends are simply extrapo. lated into the future Expectations can also be based on the belief that exchange rates eventually ret to values consistent with basic economic conditions (for instance, purchasing power parity, which we will discuss in the next section). Expectations of this sort are consid ered stabilizing in the sense that they lead to stabilizing speculation, which tends to move the exchange rate toward a value consistent with some economic fundamentals such as relative national product price levels. 4 Changes in expectations can be based on various kinds of new information. The important part of the “news” is any unexpected information about government poli- cies, about national and international economic data or performance, and about polit- ical leaders and situations (both domestic politics and international political issues and = tensions). An example is that foreign exchange markets often react to news of official | figures about a country’s trade or current account balances, measures that largely. reflect the balance or imbalance between a country’s exports and imports of goods and services. There is logic to the market’s reactions to such news. For instance, an unex. pected increase in a country’s trade deficit or (especially) its current account deficit “| indicates that the country requires an increasing amount of foreign financing of the | deficit. If the increased foreign financing is not assured to be forthcoming, then the country’s currency will tend to fall in the foreign exchange market, The increasing demand for foreign currency as part of the process of paying for the excess of imports. over exports tends to appreciate the foreign currency and depreciate the domestic cur- rency. If this logic is built into the changed expectations of international investors, then the exchange rate change can occur quickly, rather than gradually as the trade imbal- ance would slowly add to market pressures. THE LONG RUN: PURCHASING POWER PARITY (PPP) In the short run, floating exchange rates are often highly variable, and there are times | when it ig not easy to understand why the rates are changing as they are. In the long | run, economic fundamentals become dominant, providing an “anchor” for the long- term trends. Our understanding of exchange rates in the long run is based on the | proposition that there is a predictable relationship between product price levels and exchange rates. The relationship relies on the fact that people choose to buy goods and services from one country or another according to the prices they must pay. We can present three versions of this relationship, depending on whether we are examinis one product or a set of products, and whether we are looking at a snapshot of the prod: uct price-exchange rate relationship or how product prices and exchange rates are: changing over time. Chapter Nineteen Wha: Determines Exchange Rates? 425 The Law of One Price The law of one price posits that a product that is easily and freely traded in a perfectly competitive global market should have the same price’everywhere, once the prices at different places are expressed in the same currency. In Part I we called this the equi- librium international, or world, price, although we did not specifically bring exchange rates into the picture. Now we can. The law of one price proposes that the price (P) of the product measured in domestic currency will be equated to the price (P,) of the product measured in the foreign currency through the current spot exchange rate (e, Domestic currency/Foreign currency): P=e+P, The law of one price works well for heavily traded commodities, either at a point in time or for changes over time, as long as governments permit free trade in the com- modity. Such heavily traded commodities include gold, other metals, etude oil, and various agricultural commodities. Consider, for example, No. 2 soft red Chicago wheat, and suppose that it costs $4.80 a bushel in Chicago. Its dollar price in London should not be much greater, given the cheapness of transporting wheat from Chicago to London. To simplify the example, let us say that it costs nothing to transport the wheat. It seems reasonable, then, that the pound price of wheat will be £3.00 if the exchange rate is $1.60 per pound. The dollar price of the wheat in London then is $4.80 per bushel (= 3.00 1.60). If it is not, it would pay someone to trade wheat between Chicago and London to profit from the price gap. For example, if an unexpected increase in British demand for wheat temporarily forces the price of wheat in London up to £3.75 per bushel, and the exchange rate is still $1.60 per pound, the dollar price in London is $6.00. As long as free trade is possible, we expect that the two prices would soon be bid back into equality, presumably somewhere between $4,80 and $6.00 per bushel for both countries. In the case of wheat (a standardized commodity with a well-established world market), we expect that arbitrage will bring the two prices into line within a week However, the law of one price does not hold closely for most products that are traded internationally, including nearly all manufactured products, It is not hard to find the culprits that explain the discrepancy. International transport costs are not negligi- ble. Governments do not practice free trade. And many markets are imperfectly com- petitive. Firms with market power sometimes use price discrimination to increase profits by charging different prices in different national markets (as we discussed in Chapter 11). One study concluded that the effect of the national border between the United States and Canada on product price differences is like adding thousands of miles of distance between Canadian and U.S. cities. For many products the law of one rice does not hold closely, Absolute Purchasing Power Parity Absolute purchasing power parity posits that a basket or bundle of tradable products will have the same cost in different countries if the cost is stated in the same currency, 426 Part Three Understanding Foreign Exchange ‘There is tremendous social importance to interna- tional comparisons of average income or produc- tion levels, To juclge which nations are most in need of United Nations aid, World Bank loans, and other help, officials compare their incomes per capita. To judge whether Japan has overtaken the United States in supply capability, we compare Japanese and US. gross domestic product per capita, All such ‘comparisons are dangerous 2s well as unavoidable. ‘The comparisons are likely to contain a host of large errors. One of the worst pitfalls comes in converting from one national currency to another, It turns out that the market exchange rate is a poor way to convert, because the purchasing power parity (PPP) hypothesis is not reliable when applied to all the goods and services that make up national expenditure or domestic production. Many of the products in such a broad bundle are not traded internationally. There is no direct reason (like arbi- ‘trage) to think that the prices of nontraded prod- ucts should equalize internationally when stated in @ ‘common currency using market exchange rates, and they usually do not. ifthe market exchange rate is unreliable, what should we use for comparing values of income per capita between countries? The principle is clear: We want to take the national income per capita measured using whatever prices exist in each country and convert these into values of national incomes per capita using a set of common inter- national prices like those that would exist if PPP applied. That way, we are comparing how many Units of a consistently priced bundle of goods and services the average resident of each nation could buy. But its difficult to get data on the prices of ‘a wide-ranging bundle of goods and services for every country, ‘That is where the United Nations international Comparisons Project (ICP) came in. A team of econ- omists at the University of Pennsylvania, led by ‘Alan Heston, Irving Kravis, and Robert Summers, did the hard work of measuring the prices of items in separate countries. The ICP group has assembled useful annual data on the price structures and income levels of over 130 countries since the 1950s. What they have found, in effect, are the true levels, Case Study Price Gaps and International Income Comparisons of P and P; for deflating the current-price national income figures. They confirm what was widely feared: On average for all goods and services, the market exchange rate @ is often far from the ratio Pip, that absolute PPP says it should equal. ‘The accompanying table shows the typical pat- ter in departures from absolute PPP and the impor- tance of replacing exchange rate conversions of income per capita with the better comparisons based ‘on common price levels. If purchasing power parity really held, then ‘every number in the right-hand column would be 400. The departures from that PPP norm are great enough to reshuffle some of the international rankings, making the better (PPP-based) measure ments of the center column differ from the ‘exchange-rate-based measures on the left. Two patterns are apparent in the figures. One is that ‘the price-

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