The purchasing power parity exchange rate (PPP) between a foreign currency and the
U.S. dollar can be defined as:
This gives us the exchange rate in terms of the units of foreign currency per dollar. The
dollars per unit of foreign currency is just the reciprocal.
The exchange rate between countries, therefore, should be such that the currencies have
equivalent purchasing power. For e.g. if a hamburger costs 3 US dollars in the United
States and 100 yen in Japan, then the exchange rate must be 100 yen per dollar. The
foreign exchange market would adjust, over the long term, to permit the functioning of
the "one price law", because the purchasing power of one currency increases (or
decreases) relative to another currency.
II.3. Relative Interest Rates
Interest rates on treasury bonds will influence the decision of foreigners to purchase
domestic currency in order to buy these treasury bonds. Higher interest rates will attract
capital from abroad, thereby increasing demand for the currency, and therefore the
currency will appreciate. Note, what is important is difference between domestic and
foreign interest rates, thus a reduction in foreign interest rates would have a similar effect.
Accordingly, an increase of domestic interest rates by the central bank could be
considered a way to defend the currency.
But, it may be the case that foreigners rather buy shares instead of treasury bonds. If this were the strongest component of currency demand, then an increase of interest rate may even lead to the opposite results, since an increase of interest rate quite often depresses the stock market, leading to share sales by foreigners. A restrictive monetary policy (increasing interest rates) usually also depresses the growth perspective of the economy.
If foreign direct investment are mainly attracted by future growth prospects and they
constitute a large component of capital flows, then this FDI inflow might stop and the
currency could weaken. Therefore, interest rates do have an important impact on
exchange rate but one has to be careful to check additional conditions.
II.4. Relative Price Changes
The inflation rate is also considered to be a determinant of the exchange rate. A high
inflation rate should be accompanied by depreciation of the exchange rate. The more so if
other countries enjoy lower inflation rates, since it should be the difference between
domestic and foreign inflation rates to determine the direction and the scale of exchange
rate movements.
Therefore, if a hamburger costs 5% more in Japan than a year ago, while in USA it costs 8% more, then the dollar should have been depreciated this year by about 8%-5%=3%. Here we have used the hamburger as a general example. The relationship between real, nominal exchange rates and inflation can be expressed as the following approximation:
In reference to the overall price level of the economy, if exchange rates would move
exactly counterbalancing inflation dynamics, then real exchange rates should be constant.
II.5. Speculators, Traders and Financial Instruments
George Soros is most famous for his single-day gain of US$1 billion on Sept 6, 1992, which he
made by short selling the British pound. At the time, England was part of the European Exchange
Rate Mechanism, a fixed exchange-rate system which included other European countries. The
other countries were pressuring England to devalue its currency in relation to the other countries in
the system or to leave the system. England resisted the devaluation, but with continued pressure
from the fixed system and speculators in the currency market, England floated its currency and the
value of the pound suffered. By leveraging the value of his fund, Soros was able to take a $10
billion short position on the pound which made him US$1 billion. This trade is considered one of
the greatest trades of all time.
Past and expected values of the exchange rate itself may impact on current values of it.
The activities of foreign exchange traders, speculators and investors may turn out to be
extremely relevant to the determination of the market exchange rate. Financial
instruments like futures and forwards may also play an important role on the
determination of exchange rates.
A foreign exchange speculator who expects the spot rate of a foreign currency to be
higher in three months can purchase the currency in the spot market today at today's spot
rate, hold it for three months, and then resell it for the domestic currency in the spot
market after three months. If he is right, he will make a profit; otherwise, he will break
even or incur a loss. On the other hand, a foreign exchange speculator who expects the
spot rate of a foreign currency to be lower in three months can borrow the foreign
currency and exchange it for the national currency at today's spot rate. After three
months, if the spot rate on the foreign currency is sufficiently lower, he can earn a profit
by being able to repurchase the foreign currency (to repay the foreign exchange loan) at
the lower spot rate. (NOTE: To make a profit, the new spot rate must be sufficiently
lower to overcome the excess interest paid on the foreign currency borrowed for three
months, over the interest received on an equal amount of the national currency deposited
in a bank for three months.)
It is important to note that foreign exchange speculation usually takes place in the
forward market because it is simpler and, at the same time, involves no borrowing of the
foreign currency or tying up of the speculator's funds. Actions in foreign exchange
options markets can also influence exchange rates, especially in the short-term. To
understand the dynamics between spot rates, interest rates and forward rates it is
interesting to understand the mechanics behind covered interest arbitrage.
II.5.1. Covered Interest Arbitrage
Covered interest arbitrage is the transfer of liquid funds from one currency to another to
take advantage of higher rates of return or interest, while covering the transaction with a
forward currency hedge. Since the foreign currency is likely to be at a forward discount,
the investor loses on the foreign transfer currency transaction per se. But if the positive
interest differential in favor of the foreign money center exceeds the forward discount on
the foreign currency (when both are expressed in percentage per year), it pays to make
the foreign investment.
For e.g., when interest rates in the United States are greater than in Brazil (or elsewhere), a Brazilian investor can exchange reals for dollars today and use these dollars to buy a 3- month T-bill in New York at 12%. She earns 4% more per year (or 1% more per 3 months) than if he had used his reals to buy a 3-month T-bill in Brazil at 8%. If the spot rate today is 3.0 real/$ and the spot rate in three months is 2.97 real/$, she will lose .03 reals or 1% on the foreign exchange conversion. The annualized 4% gain from the U.S. T-bill is just offset by the annualized 4% currency loss. She breaks even.
If, on the other hand, the 3-month forward rate is between 3.0 and 2.97, the investor can
cover her foreign exchange rate risk by buying a forward contract to sell dollars in 3
months in exchange for reals. E.g. if the forward rate us 2.985:
If the 3-month interest differential is 1% and the foreign exchange differential is only
0.5%, the investor nets 0.5% and should undertake the investment. This return (0.5%)
annualized is 2% per year. As long as the interest rate differential is greater than the
forward exchange rate differential, the Brazilian investor profits from buying U.S. T-bills
and selling forward dollars. In the process, she raises his return from 8% on the Brazilian
T-bill to 10.30% on the U.S. T-bill plus the foreign currency translation.
As funds are transferred from Brazil to the U.S., the supply of funds is reduced in Brazil
and increased in the US. This tends to put upward pressure on interest rates in Brazil and
downward pressure on interest rates in the US, so that the positive interest differential of
4% per year will tend to fall toward 2% per year.
At the same time, the increased demand for dollars in the spot market tends to raise the
spot rate for dollars and the increased forward supply of dollars tends to push down the
forward rate. For both reasons, the forward discount on the dollar will tend to increase,
pushing it up to the interest rate differential.
Under normal conditions, the relationship between spot and forward rates is determined
largely by covered interest arbitrage (this relationship is known as the interest rate parity).
If interest rates are higher abroad, covered interest arbitrage tends to keep the foreign
currency at a forward discount (and the domestic currency at a forward premium) equal
to the positive interest differential in favor of the foreign monetary center. If domestic
interest rates are higher, covered interest arbitrage tends to keep the foreign currency at a
forward premium relative to the spot rate (and the domestic currency at a forward
discount) equal to the domestic positive interest differential. However, this may not hold
even approximately when covered interest arbitrage is forbidden or with large
destabilizing speculation taking place.
II.5.2. Interest Rate Parity
Interest rate parity is a relationship that must hold between the spot interest rates of two
currencies if there are to be no arbitrage opportunities. The relationship depends upon
spot and forward exchange rates between the currencies. It is:
• s is the spot exchange rate, expressed as the price in currency a of a unit of currency b
• f is the corresponding forward exchange rate
• ra and rb are the interest rates for the respective currencies
• m is the common maturity in years for the forward rate and the two interest rates.
The interest rate parity (covered interest arbitrage) plays a fundamental role in foreign
exchange markets, enforcing an essential link between short-term interest rates, spot
exchange rates and forward exchange rates.
II.5.3. Influence of the FX Options Market on Short-Term Exchange Expectations
Implied volatility is one of the key variables used to calculate the price of an FX option.
It is often interpreted as the market’s measure about possible future movements in spot
(related to the standard deviation of returns over a sample period). In the FX options
market, the preference of calls (right to buy a currency) over puts (right to sell a
currency) is measured by an asset class called risk reversal skew (RR) which is
mathematically defined as:
The FX market closely watches these risk reversals. A positive RR, for example,indicates preference for calls over puts, a signal often perceived as bullish by the market, leading to overbought positions in the underlying currency, that further exacerbate the RR. This is a par excellence example of a self-fulfilling prophecy. A defining example of this phenomenon was the trend up in EUR from the lows in 2002that saw the risk reversal continually favouring EUR calls- see figure below.
FX Option positions also give rise to a phenomenon referred to as strike gravity. As the FX option trader deals in the spot market to hedge a significant FX option position against a counterparty that is not an active market participant, the spot gravitates towards the strike of the option as the trade approaches maturity. This effect is more pronounced when the said position is an exotic option with a digital payout and both the participants have access to liquidity in the cash market to actively manage the exotic option. These FX flows arising from aggressive hedging by the FX Option market players often dictate short-term currency moves.
II.6. Political and Psychological Factors
Political or psychological factors are also believed to have an influence on exchange
rates. Many currencies have a tradition of behaving in a particular way such as Swiss
francs which are known as a refuge or safe haven currency while the dollar moves (either
up or down) whenever there is a political crisis anywhere in the world. Exchange rates
can also fluctuate if there is a change in government. A few years back, India’s foreign
exchange rating was downgraded because of political instability and consequently, the
external value of the rupee fell. Wars and other external factors also affect the exchange
rate. For example, when Bill Clinton was impeached, the US dollar weakened. During the
Indo-Pak war the rupee weakened. After the 1999 coup in Pakistan (October/November
1999), the Pakistani rupee weakened.
III. The macroeconomic impact of the exchange rate
The exchange rate has a major influence on open economies (like most European countries), and since most of the effect of an independent change in the exchange rate occurs with a lag, monitoring the exchange rate-particularly the trade-weighted exchange rate-can give important information about future growth, inflation and the balance of payments.
III.1 Inflation and the exchange rate
The link between the exchange rate and inflation centres on the price of imported goods. If the exchange rate falls, the price of imported goods is likely to go up. This is because following a fall in the exchange rate-a fall in sterling, for example-foreign firms must either up the sterling price of the goods they sell into the UK market or see their local currency revenue fall. In practice, they will tend to keep their local currency prices relatively constant and allow the sterling price to rise.
The consequent increase in the sterling price of imports puts upward pressure on inflation in two ways: directly, by putting up the price of imported consumer goods (which may allow UK producers to do the same); and indirectly, by putting up the price of imported raw materials (oil, for example) causing UK producers also to put up their prices. In fact, if PPP is to hold in the long run, any fall in the exchange rate must eventually lead to an exactly offsetting rise in prices. In other words, the real exchange rate (the exchange rate adjusted for relative inflation) must, in the long run, be unaffected by changes in the nominal exchange rate. So, for example, in the UK exchange rate falls by 10% then, over a period of years, prices in the UK will rise 10% more than in other countries, causing inflation in the same time.
III.2 Economic growth and the exchange rate
Economic growth and the exchange rate are linked by the effect of competitiveness on international trade. When the exchange rate appreciates or inflation rises above that of countries with which we trade (ie if the real exchange rate appreciates), exporters find it more difficult to sell goods overseas since the foreign currency price of their goods increases. (Alternatively they may reduce their local currency prices and therefore their profits). At the same time, imports from overseas become cheaper and overseas producers therefore increase their market share. Both these effects serve to reduce the demand for domestically produced goods and consequently reduce GDP.
III.3 Balance of payments and the exchange rate
The balance of payments is affected by both the price and growth effects of movements in the exchange rate. The immediate effect of a fall in the exchange rate is to worsen the balance of payments, even though it increases competitiveness, because it increases the price of imports and decreases the local currency price of exports. In the longer run the general improvement in competitiveness means that the volume of imports decreases while exports increase, thereby overcoming the short-run price effect. This short-run deterioration followed by longer-term improvement of the balance of payments is called the J-curve effect.
IV. THE EFFECTS OF MONETARY AND FISCAL POLICIES ON INTERNATIONAL GOALS (Examples in the United States)
To say that achieving international goals is not the determining factor in the choice of macroeconomic policies isn’t to say that economists don’t consider the effects of monetary and fiscal policies on international goals. They watch these carefully.
Monetary policy affects exchange rates in three ways: (1) through its effect on the interest rate, (2) through its effect on income, and (3) through its effect on price levels and inflation.
IV.1 The effects on Exchange rates via Interest rates
Expansionary monetary policy pushes down the U.S. interest rate, which decreases the financial capital inflow into the United States, decreasing the demand for dollars, pushing down the value of the dollar, and decreasing the U.S. exchange rate via interest rate path. Contractionary monetary policy does the opposite. It raises the U.S. interest rate, which tends to bring in financial capital flows from abroad, increasing the demand for dollars, increasing the value of the dollar, and increasing the U.S. exchange rates.
An example of how important relative international interest rates are involves Germany and the European Union (EU). In 1992, the EU was heading toward a monetary union in which all member countries would use a common currency. As a stepping stone, the EU countries had exchange rates set within a narrow band. Because of fiscal problems caused by German reunification, the German central bank, the Bundesbank, felt it has to raise its interest rates. That rise put upward pressure on the mark, and destroyed the fixed exchange rate system and the upcoming monetary union. Many economists are willing to say that relative interest rates, because of their importance in the short run, are the primary short-run determinant of exchange rates.
IV.2 The effect on Exchange Rates via Income
Monetary policy also affects income in a country. As money supply rises, income expands; when money supply falls, income contracts. This effect on income provides another way the money supply affects the exchange rate. To buy foreign products, US citizens need foreign currency which they must buy with dollars. So when the US imports rise, the supply of dollars to the foreign exchange market increases as US citizens sell dollars to buy foreign currencies to pay for those imports. This decreases the dollar exchange rate. This effect through income and imports provides a second path through which monetary policy affects the exchange rate: Expansionary monetary policy causes US income to rise, imports to rise, and the US exchange rate to fall via the income path. Contractionary monetary policy causes US income to fall, imp-orts to fall, and the US exchange rate to rise the via income path.
IV.3 The effect on Exchange Rates via Price Levels
A third way in which monetary policy can affect exchange rates is through its effect on prices in a country. Expansionary monetary policy pushes the US price level up. As the US price level rises relative to foreign prices, US exports become more expensive, and good the US imports become cheaper, decreasing US competitiveness. This increases demand for foreign currencies and decreases demand for dollars. Thus, via the price path, expansionary monetary policy pushes down the dollar’s value for the same reason that an expansion in income pushes it down.
Contractionary monetary policy puts downward pressure on the US price level and slows down any existing inflation. This tends to decrease the US price level relative to foreign prices, making US exports more competitive and the goods the US imports more expensive. Thus, contractionary policy pushes the value of the dollar up via the price path.
Fiscal policy, like monetary policy, affects exchange rates via three paths: via income, via price and via interest rates.
IV.4 The effect on Exchange Rates via Income
Expansionary fiscal policy expands income and therefore increases imports, increasing the trade deficit and lowering the exchange rate. Contractionary fiscal policy contracts income, thereby decreasing the imports and increasing the exchange rate. These effects of expansionary and contractionary fiscal policy via the income path are similar to the effects of monetary policy.
IV.5 The effects on Exchange Rates via Price Levels
Expansionary fiscal policy increases aggregate demand and increases prices of a country’s exports; hence it decreases the competitiveness of a country’s exports, which pushes down the exchange rate. Contractionary fiscal policy works in the opposite direction. These are the same effects that monetary policy had.
IV.6 The effects on Exchange Rates via Interest Rates
Fiscal policy’s effect on the exchange rates via the interest rate path is different from monetary policy’s effect. Whereas expansionary monetary policy lowers the interest rate, expansionary fiscal policy raises interest rates because the government sells bonds to finance that deficit. The higher US interest rate causes foreign capital to flow into the US, which pushes up the US exchange rate. Therefore expansionary fiscal policy’s effect on exchange rate via the interest rate effect is to push up a country’s exchange rate. Contractionary fiscal policy decreases the interest rates since it reduces the bond financing of that deficit. Lower US interest rates causes capital to flow out of the US, which pushes down the US exchange rate.
V. Macroeconomic influences on the exchange rate
Of course, changes in inflation, trade and growth prospects can also influence the exchange rate. Clearly, if PPP applies, a change in inflation will produce an equal and opposite change in the exchange rate. However, growth and trade patterns can also influence the exchange. The most dramatic example of this is the ‘Dutch disease’, where the discovery of a natural resource (natural gas in the Netherlands) improves a country’s future growth prospects and causes the real exchange rate to appreciate. Unfortunately, although this makes people feel richer (by reducing the price of imports) and allows consumption to increase, it makes other domestic producers’ goods more expensive abroad and reduces export volumes (other than those of the natural resource itself). As a result, a country can become solely dependent on the new-found natural resource for export income, and therefore painfully vulnerable to changes in its world price (like many Third World countries); or even to the possibility of its exhaustion.
V.1 North Sea and the Dutch Disease
In the late 1970s the UK’s North Sea oil production began to pick up strongly. It became clear that oil would make a major contribution to the UK’s balance of trade for many years. As a result, the real exchange rate appreciated sharply, since oil production meant that the UK could keep in trade balance even with a highly uncompetitive exchange rate. Figure 6.4 shows how the UK real exchange rate rose sharply when North Sea oil production came on stream. This reduced the competitiveness of other UK exports.
The main benefit of the strong real exchange rate was that imports were now much cheaper, so that people’s standard of living rose and inflation fell. The main cost of the strong real exchange rate was that it became increasingly difficult for non-exporting firms to compete on the world market (or even against imports in the home market). Partly as a result, UK manufacturing industry declined in the early 1980s. The effect is known as the “Dutch disease”, and implies that the consequences of discovering natural resources are not all beneficial, particularly if the natural resource will eventually be exhausted.
Economic policy and the exchange rate
The economic policy in many countries is directed towards control of the exchange rate. Even in countries which do not operate a fixed exchange rate regime, the rate is closely monitored and extreme movements countered by direct policy action.
Monetary and fiscal policy and the exchange rate
Governments can influence the exchange rate most directly through monetary policy. As we saw earlier, relative interest rates exert strong leverage on the exchange rate-causing it to jump to a new level consistent with UIP. However, the jump does not occur if the change in interest rates has been anticipated by the foreign exchange market and incorporated into market expectations.
The link between expectations about monetary policy and the exchange rate implies that indirectly fiscal policy can also play a part through its effect on interest rates. A good example of how the fiscal/monetary policy mix combined to influence the exchange rate was observed in the US during the Reagan administration.
V.2 Reaganomics
When President Reagan came to office at the beginning of the 1980s he introduced a radical tax-cutting plan. He felt that US taxes were in the area of the Laffer curve where tax cuts would actually increase revenue. He therefore cut taxes in the hope that this would improve the budget deficit. Paul Volker, Chairman of the US Central Bank, the Federal Reserve, was not convinced. He felt that the tax cuts would overheat the economy and cause inflation. As a result, he increased interest rates dramatically just as President Reagan was loosening fiscal policy.
The result of the mixture of loose fiscal and tight monetary policy of the early 1980s was send the real exchange rate soaring upward as shown in Figure 6.5 and cause the trade deficit to worsen. As it turned out, Volker was proved to be correct: the government budget deficit increased dramatically and a number of draconian deficit-controlling measures had to be implemented as the Gramm-Rudman Act, an Act of Congress designed to enforce deficit reduction. Volker’s action had stenned the inflationary impact of Reagan’s measures, but the real exchange rate only came down when deficit control was initiated and concerted action (including intervention by many Central Banks) to bring the dollar down was undertaken in the Louvre Accord of 1984.
Foreign currency intervention
A further source of leverage on the exchange rate is available to governments through foreign currency intervention. Intervention involves buying or selling foreign currency for local currency solely to put pressure on the exchange rate. For example, if a government wishes to support the value of its currency (ie put upward pressure on the exchange rate), it sells foreign currency and purchases its own currency. This artificial increase in the demand for local currency may cause the exchange rate to rise. Governments hold reserves of foreign currency for this purpose, but even if those reserves run to billions of dollars, the turnover in the foreign exchange market shown in Table 6.1 is so huge that foreign exchange intervention can, at best, have only a temporary and marginal effect on the exchange rate.
Fixed vs floating exchange rate regimes
Credibility is crucial to economic policy. If the government can actually convince people that it is going to pursue a rigid counter-inflation policy, then achieving that policy is facilitated. One way of achieving policy credibility was also to follow a policy rule which makes it difficult to cheat. (‘Cheating’, in this case, is defined as loosening policy to generate a short-term pick-up in growth that does not feed through into inflation until much later). Given that the exchange rate is clearly linked to both inflation and growth, a fixed exchange rate regime, by which the government commits itself to stabilize the exchange rate at a fixed, non-inflationary level, has obvious advantages as a policy rule. Credibility benefits apart, such a policy may also help to encourage trade by reducing the risk of loss for exporting firms in currency transactions. However, such a policy is difficult to implement, for a number of reasons.
Similar policy objectives
Under a fixed exchange rate regime, all the countries in the system are obliged to run similar monetary policies. Theoretically, in a system where absolutely no exchange rate fluctuation is allowed, their interest rate should be identical. Furthermore, the loss of absolute control over monetary policy makes it important for the countries in the fixed exchange rate system to have the same policy objectives.
VI. Fixed exchange rates
The advantages of a fixed exchange rate system are:
1. Fixed exchange rates provide international monetary stability
2. Fixed exchange rates force governments to make adjustments to meet their international problems.
The disadvantages of a fixed exchange rate system are:
1. Fixed exchange rates can become unfixed. When they’re expected to become unfixed, they create enormous monetary instability.
2. Fixed exchange rates force governments to make adjustments to meet their international problems. (Yes, this is a disadvantage as well as an advantage).
Fixed exchange rates and Monetary Stability- To maintain fixed exchange rates, the government must choose and exchange rate and have sufficient reserves to support that rate. If the rates it chooses is too high, its exports lag and the country continually loses reserves. If the rate it chooses is too low, it is paying more for its imports than it needs to and is building up reserves, which means that some other country is losing reserves. A country that is continually gaining or losing reserves must eventually change its fixed exchange rate.
The difficulty is that as soon as the country gets close to its reserves limit, foreign exchange traders begin to expect a drop in the value of the currency, and they try to get out of that currency because anyone holding that currency when it falls will lose money. False rumours of an expected depreciation or decrease in a country’s fixed exchange rate can become true by causing a “run on a currency”, as well as traders sell that currency. Thus, at times fixed exchange rates can become highly unstable because expectations of a change in the exchange rate can force the change to occur. As opposed to small movements in currency values, under a fixed rate regime these movements occur in large, sudden jumps.
VII. Flexible Exchange Rates
The advantages and disadvantages of flexible exchange rates are the reverse of those of fixed exchange rates. The advantages are:
1. Flexible exchange rates provide for orderly incremental adjustments of exchange rates, rather than large, sudden jumps.
2. Flexible exchange rates allow government to be flexible in conducting domestic monetary and fiscal policies.
The disadvantages are:
1. Flexible exchange rates allow speculation to cause large jumps in exchange rates that do not reflect market fundamentals.
2. Flexible exchange rates allow government to be flexible in conducting domestic monetary and fiscal policies. (This too is a disadvantage as well as an advantage).
VIII. Bibliography:
- media.wiley.com
- Macroeconomics-second edition David C.Colander, Ed Richard, D.Irwin, INC, 1994 and 1995
