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2 The Global Macroeconomy (Subject) / Lecture 6 - Exchange Rates (Lesson)

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  • CA.1 CA Surplus, Capital Account Deficit CA = (S - I ) + (T - G) > 0 Increase CA by Increasing Trade Balance (X-M)  Increase NFI  Positive Trade Balance Residents produce more than they consume CA increases if the residents save more (Net Outflows); The country invests abroad: Net exports increase (Trade Balance improves); Net Foreign Income increases Net savings (running CA surplus) for many years will see their net external wealth increase Accumulation of foreign assets Example: Germany, Norway
  • CA.1 KA Surplus, Current Account Deficit Flow Account: KA = (I-S) - (G –T)
  • CA.1. IIP Net international investment position Net international investment position (IIP) = Stock of Creditor and Debtor countries (vs. Flow Current  Account) - Accumulation over time, every year Financial account shows flow of assets in a particular period Over time these accumulate to form a country’s stock of external wealth Current account surplus countries (Germany, Norway, China) Current account deficit countries (US) Case in Point: China - When Central Bank accumulates Foreign Currency over a long period of time it will increase its CA Very large CA surplus ($170 B in 2017) due to.. High propensity to save (save rather than buy imports from abroad vs. US who has a low savings rate) Undervalued currency (set as per policy to keep exports cheaper and imports expensive) Competitive Advantage in manufactured goods China  accumulate reserves to hedge for precautionary reasons (due to Financial Crisis in Asia and to keep parity of the Yuan to USD When crisis hit, they could not finance $ -> they want to be prepare for next crisis 
  • RER.1 Real Exchange Rate RERUK = e * ppound/ peuro e = Nominal Exchange Rate FC / HC (i.e. 1.2 $ for 1 EUR)  Appreciation of currency in nominal terms:  Increases in e -> holding relative prices constant, the RER appreciates too Not possible in Europe (e is constant at 1) Appreciation of currency in real terms: Increases in e Positive Inflation Differential (stronger increase in prices in UK relative to Eurozone) The higher RER, the lower the Competitiveness of Export Sector Competitiveness in Eurozone entirely dictated by differences in inflation  -> RER appreciation endangers competitiveness of export sector Real appreciation decreases demand for Brazilian apples in the US and hurts Brazilian exports
  • 3 Reasons for Holding Foreign Currency Largest Sector: Speculation and /or arbitrage  Investment (financial flows) - Hold Exchange Rate as Financial Investor or Government Trade (goods & services)
  • RER.3 Exchange Rate Determination Long Run - Flexible Prices Arbitrage condition in the goods market PPP holding implies that the RER is always equal to 1 Changes in nominal exchange rate = inflation differential Country with relatively lower inflation will see its nominal exchange rate appreciate Japan: strong appreciation in nominal exchange rate due to relatively lower inflation Why doesn’t PPP hold in short/medium run? - Sticky Prices (due to frictions) Medium run - Sticky Prices Demand and supply of foreign currency determined by business cycle conditions: Country’s economic growth - increase in imports and therefore increase in demand for foreign currency Growth abroad - increase of exports from HC and therefore an increase in the supply of foreign currency Short run (financial flows) Effects on the exchange rate stem from financial capital flows determined by  Interest rates Expectations of future exchange rates (Exchange Rate Risk) - Exchange Rate Risk
  • RER.2 Medium Run RER Medium run forces affecting exchange rate Country’s economic growth - increase in imports and therefore increase in demand for foreign currency Growth abroad - increase of exports from HC and therefore an increase in the supply offoreign currency
  • RER.3 Short Run (less than 1 year) RER Financial Capital Flows - determined by  Interest Rates - Uncovered Interest Rate Parity (UIRP) Exchange rate risk - Expectation of future exchange rates  1. Uncovered Interest Rate Parity (UIRP) The UIRP theory predicts that the equality above holds One might expect that no arbitrage opportunity implies 2. Exchange Rate Risk: Expected future payments in FC will likely yield a different amount in HC since the contract was signed
  • RER.5 The Impossible Triangle Impossible to Maintain All 3, Can Only Choose 2 Free Capital Flows Fixed Exchange Rate Independent Monetary Authority US - Free Capital Flows & Independent Monetary Policy HK - Free Capital Flows & Fixed Exchange Rate China - Fixed Exchange Rates & Independent Monetary Policy
  • RER. Exchange Rate Regimen - The Bretton Woods system of monetary management INCLUDED: United States, Canada, Western Europe, Australia, Japan (1944) Response to crises of Great Depression when floating exchange rates had been unsuccessful Semi-fixed system known as adjustable pegged exchange rates (Obligation for each country to adopt a monetary policy that maintained its external exchange rates within 1 percent by tying its currency to gold ( & ability of IMF to bridge temporary imbalances of payments)) Currencies values tied to each other Nations should use fiscal and monetary policies first to address balance of payments disequilibria last resort was to re-peg currencies; greater than 10% change required IMF permission
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  • RER.3 Exchange Rate Risk Exchange Rate Risk: Expected future payments in FC will likely yield a different amount in HC since the contract was signed WHY? Currencies are constantly changing in value WHO? International Firms with Product Market IntegrationHOW TO SOLVE? Add additional risk premium per unit of exchange rate covariance risk (1) Hedging Insure against exchange rate risk through buying a forward contract to sell foreign currency at the same time that bonds (inancial asset) matures Balance sheet hedging FC INFLOWS at a future date can be hedged by SELLING FC forward FC OUTFLOWS at a future date can be hedged by BUYING FC forward (2) Forward Exchange Rate: Price of currency that will be delivered in the future Allows an exporter or importer to sign a currency contract that guarantees a set price for the foreign currency in either 30, 90, or 180 days into the future
  • RER.1 Long Run RER Long Run - Flexible Prices - Arbitrage condition in the goods market Assumption: Purchasing Power Parity (PPP): the same basked of goods should sell for the same P wherever it is sold; because: There is Arbitrage whenever there is a profit without investment or risk Such a Free lunch cannot prevail in a financial market equilibrium If it existed, market participants would want to exploit Opportunity Prices would adjust until there is no more gain from Arbitrage PPP holding implies that the RER is always equal to 1 Changes in nominal exchange rate = inflation differential Country with relatively lower inflation will see its nominal exchange rate appreciate  Example Japan: strong appreciation in nominal exchange rate due to relatively lower inflation
  • RER.3 UIRP There is no forward contract A risk neutral investor is indifferent between German and UK investment  With CIP, we used to forward rate f, but now we use the expected exchange rate a year from now. TRADE-OFF FOR INVESTOR: Return on HC Bond - (1+i) Return on FC Bond  - (1+i) • e/ et STRATEGY (et = Expected future Exchange Rate) Invest in HC Bond if (1+i) > (1+iFC) • e/ et Invest in DC Bond if (1+i) < (1+iFC) • e/ et e/et = (1+i) / (1+iFC) ASSUMPTION No-Arbitrage Relationship IMPLICATION Currency with higher i should have a higher i should depreciate on average (lower e) here are 0 Excess Returns on average for "carry trade" (=borrowing in country with low interest rate and investing abroad ) EMPIRICAL TEST On average large excess returns for a long period of time from long dollar / short yen carry (particulary during crisis) AUGMENTED UIRP Takes into account currency risk premium (Covarianc of carry returns with stock market) Average Excess Return= Currency Risk Prempim 
  • RER.4 Fixed Exchange Rate (Peg) Fixed Exchange Rate (Peg) ~ 50% (88/183 in 2012) Official parity exchange rates between currencies: enforced by government, ties value to another country’s currency, or price of gold Reason: maintain a country’s currency value within a narrow band  Pro: Inflation control, Simplicity and Clarity of Exchange Rate Target, Automatic Rule for Monetary Policy Greater certainty for exporters and importers Low inflation, which keeps interest rates down Hope to limit speculation and provide stable system (developing economies), which stimulates trade and investment Con: No independent Monetary Policy, Vulnerability to Speculative Attacks Central Bank limited to adjust interest rate needed for econ growth No market adjustment when a currency becomes over- or undervalues Large pool of reserves required by Central Bank to support currency when under pressure Typically used by developing economies, smaller countries Conventional Peg: Barbados, Bahamas, UAE, Saudi Arabia (USD as Anchor), Hong Kong (USD as Anchor) 
  • RER.4 Floating Exchange Rate Pros and Cons - Currency price set by the FOREX market based on supply and demand compared to other countries - Most major economies allow free floats since collapse of Bretton Woods system in 1971- PRO: Simplified Institutional Arrangements, Independent Monetary and Fiscal Policy Central bank buy or sell currency to adjust exchange rate to stabilize volatile markets or achieve major change in the rate Central bank can also intervene indirectly in currency markets by raising interest rates to impact the flow of investors’ funds to the country G7 nations often work together to coordinate interventions for increased impact - CON Conductive to Inflation Disorderly markets can disrupt trade and investment patterns Reckless Financial Policies by Government   EU, Australian Dollar, Japan, Canada, UK, Chile, US, Norway
  • RER.1 What happens if PPP does not hold? If PPP does not hold, there is arbitrage opportunity in the goods market: One can buy good in relatively cheaper country and export it to the Eurozone.  This will increase the price of the good in the cheaper country due to lower supply of the good Decrease the price in the relatively more expensive country due to larger supply of the good And/ Or currency of relatively cheaper country will appreciate since there will be higher demand for cheaper currency in order to purchase the good 
  • RER.1 Why doesn't PPP hold in its strongest form? Transportation Cost CPI baskets differ across countries Non-Tradeable Goods – PPP will not hold for non-tradable goods since the price equilibrating mechanism is due to the ability to trade the good, i.e. services (RER usually calculated using CPI index which contains both tradable and non-tradable goods)

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