Macro Economics 5

8/9/2019 Macro Economics 5

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David ParsleyBusiness in the World Economy

Busin

ess

inthe

Worl d

Econom y

Management 321: Module 2b

Key points from Module 2aThe distinction between the SR & LR - is the flexibility of prices

In the long run all prices are flexible Hence, real resources (output, capital, labor) can adjust

The short run is that transition period before prices have fullyadjusted

Module 2b: Floating exchange ratesFour frameworks:

q Interest rate parityq Purchasing power parityq Fundamental equilibrium exchange rateq Random walk

Exchange rate regimes as a choiceü What are the tradeoffs?



2David ParsleyBusiness in the World Economy

Exchange Rate Fluctuations

n Are big: over the last year there have beenswings > 40%

q Managing this risk is important

q Not many other factors can affect the bottomline by 40% in a year

n You are affected by exchange rate changes if you (or your suppliers): (a) import or export;

(b) compete with companies that do; (c)compete with companies that are abroadq Points (b) and (c) are often overlooked




If you were Warren Buffett …n Warren Buffett announced that his Berkshire

Hathaway fund has been secretly buying a foreigncurrency.

n He said he is buying only one currency. Which one?“We will tell you about it next year.”

n If you were Warren Buffett, which currency would you

buy (in order to maximize the returns (computed inthe US dollar) a year from now?




which currency/country would you invest in?

n To do intelligent currency investment, youwould need a framework to forecastexchange rate movement.

n

n Even for hedging purposes, it is useful tohave such a framework. Why?

q For some developing countries, no liquidmarket for forwards or options;

q For developed countries, no long-datedinstruments




Exchange rate determination

Four frameworks:n

n Interest rate parity

n Purchasing power parityn

n Fundamental equilibrium exchange raten

n Random walk




Exchange Rate Determination (1)

n (Open) Interest Rate Parity Theory:n

q On average, the currency with a lower interest

rate is likely to appreciate in value

q The size of the expected appreciation is equalto the difference between the two interest

rates







Yen per US$ Exchange Rate

50.00

150.00

250.00

350.00

450.00

550.00

650.00

The Japanese yen was pegged to the dollar until 1971.Since that time the yen has generally appreciated – just as interest rate parity predicts!





n (Open) Interest Rate Parity Theory:q On average, the currency with a lower interest

rate is likely to appreciate in valueq

The size of the expected appreciation is equalto the difference between the two interestrates

q

q Exception: carry trade




Two equal investment possibilities:covered interest rate parity (IRP)

Time: Tnow T3months

US … @5%

1 million US$

(0.75e/$)

Europe… @9%

(1) Invest in the US market @5%; 1.0*(1+.05/4)=$1.0125

(2) a) Convert into euros at .75/$; 1=.75 million euros b) Invest in Europe @9%; .75*(1+.09/4)=0.766875 euros c) Buy forward contracts to convert euros 0.766875 into $

Returns must equal or firms/people will arbitrage the differences away! Why?




Interest Rate Parity Defined

n The scale of the project is unimportant

(1 + i$)

F $/ £

S $/ £ × (1+ i£)=

$1,000×(1 + i$)

$1,000

S $/ £

(1+ i£) × F

$/£ =

This is how the forward rate (F) is determined in practice





n Purchasing Power Parity (PPP) Theory:q In the long run, the prices of the same basket of goods

should be the same across countries.q Why is this a theory of exchange rate determination?

q On average, the currency in the country with a lower inflation rate tends to appreciate.

q The size of the expected appreciation is equal to thedifference between the two inflation rates

q Example:q Burma:

q 50%/year inflation -> 50% depreciation of itscurrency kyat on the black market.

q 10%/year inflation in another year is followed by10% depreciation







Big Mac overvaluation/undervaluation

Source: http://www.economist.com/markets/bigmac/ (July 5, 2007)

How long does it take for marketexchange rates to converge to

parity implied by Big Macs?q Rate of convergence:

Parsley and Wei (2007 &2008)

A t l ti b t h t d

http://www.economist.com/markets/bigmac/

http://www.economist.com/markets/bigmac/




A natural connection between exchange rate and

relative money supplies “Inflation is always and everywhere a monetaryphenomenon” Milton Friedman





n Purchasing Power Parity (PPP) Theory:q When does it work very well?

q In countries with high inflation ratesq Across countries over a long period of timeq

q When doesn’t it work very well?q PPP may not hold as well for consumer price

index as for producer price index (due to

immobile labor and services)q In countries with moderate inflation, even when itholds for more tradable part of the price index,the convergence is relatively slow.

q The half life is about 3-5 years




Take-away messages:Exchange rate determination

Four frameworksn

n Interest rate parity

n Purchasing power parityn

n Fundamental equilibrium exchange raten

n Random walk





n “Fundamental Equilibrium” Theoryq A country’s net foreign asset position cannot go to

either positive infinity or negative infinity on anexplosive path.

q Implication for exchange rate determination:q If at the current level of (real) exchange rate, the set

of fundamentals indicates that the country is goingto run large current account deficit forever, thenthe current level of real exchange rate is unlikelyto be sustainable, and will reverse itself at some

point.q Conversely, …




Current account has some tendencyto “lead” the real exchange rate




International ‘real’ links

Q: Review: Are CA deficits sustainable?q

q what might limit our ability to run CA deficits?ü (Hint: think about how CA deficits are financed)

qq What might the ultimate adjustment be?

ü (Hint: what would happen if there was no finance for the CAdeficits?)

ü Would interest rates be affected?

ü Would exchange rates be affected?

q




Thailand’s 1996 imbalances

n The Thai baht was actually undervaluedby the PPP standard in 1996, and it’sinflation was not much > than U.S.

inflationn Was the bhat collapse predictable?

q Perhaps. Use the “equilibrium” standard.q The Current Account deficit rose from 5% to

8% of GDP in the 3 years up to the crisisq Reserves fell from enough to cover 4 years of

the deficit to just 2.6 years





n “Fundamental Equilibrium” Theoryq What are the fundamentals?

n

q Current account, FX reserves (under pegged),

…q Hedge funds are running regressions as we

speak, trying to uncover these fundamentalsq

q Issues to be resolved?q The relationship does not appear to be very

stable




Random Walk model

n Meese-Rogoff in a famous research paper concluded:

q No model beats R.W. in short to mediumhorizons in out-of-sample competition for major currencies.

q

n Qualifiers:q Countries with very high and sustained inflation

rates, or very high foreign debt/reserve ratiosq In long enough horizons, PPP and some

fundamentals could win





What determines exchange rates?

Major models: Random Walk

q XR(t+1) = XR(t) + random drawq XR(t+2) = XR(t+1) + random drawq XR(t+3) = XR(t+2) + random drawq …

n This ‘model’ says “we don’t really know whatdetermines the exchange rate”, i.e., it is a randomwalk

q Given that the ‘model’ is so naïve, the random walk modelshould be very easy to beatq However, everyone who has studied it (Meese & Rogoff

were the 1st ) concludes that the random walk model isVERY difficult to beat!

n

What determines exchange rates?




What determines exchange rates?The graph below shows one random walk process. To make aforecast, we should repeat this 1000+ times and report theaverage.

1 .3 3 M a y - 0 81 . 4 7 2

1 . 3 3 J u n - 0 8 1 . 4 4 2 0 . 1 8 5 7 5 7= s ta n d a r d d e v i a ti o n

1 . 3 3 J u l- 0 8 1 . 3 7 2 - 0 . 0 8 0 0= + /1 s . d . r a n d o m d r a w s

1 . 3 3 A u g - 0 8 1 .3 8 2 0 . 0 0 0 0

1 .3 3 S e p - 0 8 1 .3 2 2 - 0 . 0 3 0 0

1 . 3 3 O c t- 0 8 1 . 3 5 2 - 0 . 0 7 0 0

1 . 3 3 N o v- 0 8 1 . 3 4 2 0 . 0 1 0 0

1 . 3 3 D e c - 0 8 1 .2 5 2 - 0 . 0 6 0 01 . 3 3 J a n - 0 9 1 . 1 6 2 0 . 0 3 0 0

1 .3 3 F e b - 0 9 1 .1 4 2 - 0 . 0 1 0 0

1 .3 3 M a r - 0 9 1 .0 7 2 - 0 . 0 9 0 0

1 . 3 3 A p r - 0 9 1 . 0 4 2 - 0 . 0 9 0 0

1 .3 3 M a y - 0 91 . 1 3 2 - 0 . 0 2 0 0

1 .3 3 J u n - 0 9 1 . 1 3 2 - 0 . 0 7 0 01 . 3 3 J u l- 0 9 1 . 1 4 2 - 0 . 0 3 0 0

1 . 3 3 A u g - 0 9 1 .1 7 2 0 . 0 9 0 0

1 . 3 3 S e p - 0 9 1 .1 5 2 0 . 0 0 0 0

1 . 3 3 O c t - 0 9 1 . 1 4 2 0 . 0 1 0 0

0 . 0 3 0 0

- 0 . 0 2 0 0

- 0 . 0 1 0 0

U .S . d o l la rs p

1 6 m o1

1 . 1

1 . 2

1 . 3

1 . 4

1 . 5

1 . 6

1 . 7

1 . 8

1 . 9

2




Take away messages (1)

n Exchange rate fluctuations are one of the major risks in internationalbusiness

n

n Exchange rate determinationq Interest parity

q Purchasing power parityq “Fundamentals” to ensure sustainable

CAq Random walk




Appendix: more detailed derivation of Purchasing Power Parity (PPP)

n PPP implies: ( ,prices are equal when expressed

in a)common currency

n

q Pd = domestic price

q Pf = foreign priceq E = nominal exchange rate (fc/dc)q (note: the exchange rate can be expressed either fc/dc or dc/fc)

q

n PPP is derived from the Law of One Price (LOP)n

q

q the “Law of One Price” says that a single good should sell for thesame price at home or abroad

n PPP is thus, an aggregate ‘no-arbitrage’ conditionq i.e., if markets are integrated, then no further arbitrage is possible

(ignoring: taxes, tariffs, transportation costs). It is just an

extension of the LOP to all goodsn

E P P f d /=

EPPf

id i /=




An example of the LOP(Law of one Price)

n Big Mac’s:

Suppose:

Pus = 3.41 dollars

Pchina = 11.0 yuan

n But according to the WSJ on that day, E = 7.60 !!This implies (a) the Yuan should appreciate (move

toward 3.23), or (b) the Big Mac price in the US

should fall, or (c) the Big Mac price in China should rise.

n i.e., the Yuan is undervalued according to PPP

n Thus, the LOP, or PPP is sometimes used for

forecasting exchange rate movements! See: http://www.economist.com/markets/Bigmac/Index.cfm

d

f f d

P

PEEPP =⇒= / Note: ( E = yuan/$)

11.0/3.41 =3.23

Price inthe US

Price inChina (in $)

http://www.economist.com/markets/Bigmac/Index.cfm

http://www.economist.com/markets/Bigmac/Index.cfm




Another use of PPP:Real versus nominal exchange rates

n You might want to know, for example, how much ¥1000 is worthin US dollars. The nominal exchange rate provides theanswer.

q ¥1000 * (nominal dollar/yen exchange rate) = $Xq e.g., ¥1000 * (1/106) = $9.43

n However, you might want to know how much ¥1000 will actually

buy in Japan (compared to what it would buy in the US), or,what is the ‘purchasing power’ of a given amount of moneyin two places?

q

n For that, just convert the PPP equation into the “real” exchangerate:

Definition: The real exchange rate (RXR) is the nominal exchangerate ‘adjusted’ for relative prices (purchasing power) at homeand abroad

f P

d EP

RXR E

f

P

d

P =⇒= /




Another use of PPP:Real versus nominal exchange rates

n If you have $10, how much could you buy in Japan?n

q Assume the ¥/$ exchange rate is 106,q Then, 10*106 = ¥1060

q

q But, how much would that buy in Japan?q If Japanese prices are higher (by say, 5%), then those in

the U.S., thenq the real exchange rate = 106*(1/1.05) = 100.95

n

n It would be as if you exchanged $10 in currencyand got only ¥1009.5 (i.e., 10*100.95 = ¥1009.5)instead of ¥1060 to spend in Japan.

n Purchasing power is lower in Japan becauseprices are higher in Japan






The Purchasing Power of Income

n The Table conveys a measure of Purchasing power of incomen

n By converting nominal GDP at nominal exchange rates youconvert foreign currency GDP into dollars. However, thismeasure does not compare for the difference in purchasingpower across the countries – i.e., which country has lower

prices? Using current PPP implied exchange ratesAustralia’s per capita GDP falls by over $7000. This isbecause Australian prices are above those in the U.S. If youwanted to compensate a US employee going to work inAustralia, you’d have to give them a ~22% (=42.5/34.9) raise.

n

n

For Argentina, the opposite is the case. The $6,310 nominalincome translates into > $10k buying power. So, if youwanted to compensate a US employee relocating toArgentina, you could give them a big raise, just by keepingthe salary the same.




Using PPP (2):forecasting nominal exchange rates

n If we write PPP in % change form we can compute the nominalexchange rate implied by PPP:

n

n If PPP held, the RXR would be constant. Thus, in principle, wecan solve for the implied, or “PPP” level of the exchange rate

n

n That is, if the inflation differential was 5%, then one could saythat PPP implied that the domestic currency should havedepreciated by 5%. The difference between the amount theexchange rate actually depreciated and what PPP impliesthen, becomes a prediction of future exchange rate changes

f d P P E RXR ∆−∆+∆=∆ %%%%

d f PPE ∆−∆=∆ %%%




More evidence on the relation between inflationand exchange rate depreciation

Source: Mankiw. points represent averages over 1972-2000




Summary:Purchasing Power Parity (PPP)

n PPP (purchasing power parity) is a generalization of theLOP (law of one price). It says that the price of abasket of goods in two countries should be the same –when expressed in a common currency.

n

n The expression for PPP can be rearranged to produce a“real exchange rate”: a nominal exchange rate adjustedfor relative (home and abroad) prices.

n

n Real exchange rates can be used to compute ‘PPPincomes’ – i.e., incomes adjusted for their purchasingpower .

q Computing buying power: how far will your money go?q Computing salary ‘adjustments’ for the firm’s employees

living outside their home countryq Forecasting the nominal exchange rate: what nominal

exchange rate would equalize domestic and foreignprices?



David Parsley

Take away messages (2)

n Exchange rate fluctuations are one of themajor risks in international business

n Exchange rate determinationq Interest parityq Purchasing power parityq “Fundamentals” to ensure sustainable CAq Random walk

n PPP is useful for q exchange rate forecastsq Computing purchasing power q Salary adjustments

Macro Economics 5

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