Powerpoint class 4 International Macroeconomics

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Exchange rates
Thomas Lagoarde-Segot, PhD, HDR
EXCHANGE RATES
1. The foreign exchange market
1.1 	Definition
1.2 Exchange rate basics
1.3 Foreign exchange operations
2. Understanding exchange rates
2.1 Purchasing power parity (PPP)
2.2 Uncovered interest rate parity (UIP)
2.3 A global theory
2
The forex market
Most countries have their own national currency
The US dollar, the Brazilian real or the Indian rupee
International trade implies exchanging currencies or exchanging banking deposits labeled in national currencies
When a European firm purchases goods internationally, euros (or banking deposits in euros) are converted in a foreign currency (or banking deposits in a foreign currency) to pay for these goods
Such exchange of currencies and banking deposits take place in the foreign exchange market 
Trading in this market determine the rate at which currencies can be exchanged for one another: the exchange rate
Exchange rates are important for international trade and international investment as the coexistence of currencies adds uncertainty
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https://www.imf.org/external/np/fin/data/param_rms_mth.aspx
https://fred.stlouisfed.org/categories/94
Why foreign exchange markets matter
Exchange rates matter in macroeconomic analysis: they determine the price of national goods in comparison to foreign goods
The euro price of a US made computer depends on two factors: the dollar price of this good, and the euro/dollar exchange rate 
Example: A French firm purchases a computer sold for 2000 dollars in the US
Assume the euro/dollar exchange rate is 1.1789: this computer will cost 2000/1.1789=1696 euros
Assume the dollar appreciates against the euro: the euro/dollar exchange rate reaches 0.8252. This computer will cost 2000/0.8252=2424 euros
Whenever the national currency appreciates, exported goods become more expensive while imported goods become cheaper; and reciprocally 
Why foreign exchange markets matter
https://fredblog.stlouisfed.org/2017/09/dollar-strength-and-the-trade-balance/
http://www.euractiv.com/section/economy-jobs/news/strong-euro-worries-europes-exporters-but-little-risk-to-growth/
Case #1 The home currency appreciates: 
The firm sells in the home currency
The firms’ export market share decreases as its relative price increases. 
The firm can either lower its margins by decreasing its home currency prices - in which case it maintain its markets shares (‘margin adjustment’) - or keep the same unit margins at the expense of lower volume (loss of market share). 
The firm sells in a foreign currency
The home currency appreciation leaves market shares unaffected. 
But home currency cash flows decrease (given that the foreign currency has depreciated against the home currency). 
In order to keep its unit margin constant, the firm would need to increase its export prices at the cost of lower volumes (loss of market share)
Why foreign exchange markets matter
Case #2 The home currency depreciates:
The firm sells in the home currency 
	
The firm gains market shares : its relative price decrease as the home currency is cheaper for foreign customers. 
The firm may want to keep production volume constant. In this case it could increase its export prices proportionally to the depreciation of the home currency. This strategy would increase its unit margins while keeping production volume (i.e. market shares) constant
The firm sells in a foreign currency 
The firm’s unit margin increase: the home currency value of sales in the foreign currency increases given that the foreign currency has appreciated against the home currency. 
The firm may choose to increase its production volume instead ( and keep its unit margin constant) by lowering its export price proportionally to the depreciation of the home currency
 
Why foreign exchange markets matter
The foreign exchange market
When you travel abroad and exchange euros for foreign money at the bureau de change, you are dealing with the retail foreign exchange market
 
This market only accounts for a very small part of the world foreign exchange transactions
Nearly all the of 6$ trillion worth of currency exchanges are traded through a worldwide network of dealers referred to as the over the counter foreign exchange market
The term “over the counter” implies that dealers maintain stocks of currencies that they are willing to buy and sell to whoever “steps up to the counter”
Dealers are located in the office of large banks and make a network of international businesses, pension funds, insurance companies, hedge funds and other larger investors
The foreign exchange market
Most foreign exchange transactions - about 90%- involve the US dollar as one of the currencies exchanged
Commodities (such as oil, coffee, copper…) are usually priced in dollars regardless of who is supplying or buying the commodity
Most international loans by large commercial banks to firms and governments of developing countries are denominated in US dollars – and many international firms/governments issue bonds in dollars
Finally the US dollar serves as a vehicle currency for many trades of less common currency
For instance, if you want to exchange Uruguayan pesos for Malaysian ringgit, you will have to first trade pesos for dollars and then dollars for ringgit. Using the dollar provides more liquidity to market participants
The foreign exchange market
Exchange rates are not determined in a given place: the foreign exchange market is not centralized 
Modern communication have created an integrated world market for foreign exchange that functions 24 hours per day
When it is late afternoon in San Francisco and market sclose, markets in Auckland, Sydney and Tokyo open; and before those markets close those of Singapore and the Middle East open, followed by those of London, Paris, and Frankfurt. When those markets are in late afternoon trading, dealers in New York open, followed by dealer sin Chicago and San Francisco, at which point the whole cycle starts over gain.
Individual transactions in the foreign exchange market exceed 1 million dollars
The forex market is the largest and the least regulated financial market in the world: daily turnover reaches 5.1 trillion dollars– for hedging and speculation purposes 
The foreign exchange market
There are three main types of foreign exchange transactions:
Spot transactions which consist of exchanges of currencies at current exchange rates
Forward transactions which consist of contractual arrangements closed today for an exchange of currencies to be carried out at a pre specified future date.
In actual practice, spot and forward transactions are settled 2 days after the actual exchange in order to give banks ample time to confirm the agreement and arrange for the debiting/crediting of accounts in different business locations
3. Foreign exchange swaps which permit investors to temporarily acquire foreign assets without incurring the risk of future exchange rate changes
These are contractual arrangements where a party buys (sells) foreign exchange for delivery on one date and agrees to sell (buy) it back at some later date. They provide a form of insurance against exchange rate swings, but are also a vehicle for speculative investment
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https://www.bis.org/publ/rpfx16.htm
The foreign exchange market
The exchange rate can be expressed either directly (price of the national currency expressed in foreign currency) or indirectly (price of the foreign currency expressed in the national currency) 
EXCHANGE RATES
1. The foreign exchange market
1.1 	Definition
1.2 Exchange rate basics
1.3 Foreign exchange operations
2. Understanding exchange rates
2.1 Purchasing power parity (PPP)
2.2 Uncovered interest rate parity (PNCTI)
2.3 A globaltheory
15
Exchange rates in the long run
Just like any other prices, exchange rates are determined by the forces of supply and demand 
The analysis of exchange rates hence begins with the « law of one price »
This law states that in the absence of trade barriers and significant transport costs, the price of a given good produced in two different countries should be the same when expressed in the same currency 
 
The reason is that if a good had different prices in two countries, arbitragists could purchase it in the ‘cheap country’ and sell it in the ‘expensive country’, hence making an arbitrage profit 
 
In the long run, arbitrage operations tend to eliminate international price differences by exerting pressures on the exchange rate
Assume that the following Euro-Dollar exchange rate holds ( where λe,p is the peso price of one euro)
Assume the price of wheat is 110 euros in France and 100 dollars in the USA
Arbitrage is possible:
I buy wheat for 100 US dollars in the US
I sell it in France for 110 euros 
I convert 110 euros back into dollars = 110*1.25 = 137.5 pesos
My profit = 37.5 dollars or 37.5%
Example
This arbitrage operation increases the demand for dollars in the foreign exchange market
The dollar appreciates against the euro until arbitrage profits are nil
Example
The euro depreciates against the dollar until no further arbitrage is possible, i.e. until:
 At this exchange rate, the dollar-denominated cash flow is:
 110 * 0.909 = 100 USD. My profit is zero (100–100 = 0)
 The variation of the exchange rate is (0.909-1,25)/0.909= -37.5% 
 The appreciation of the dollar has eliminated the arbitragists’ initial profit (+37.5%)
Example
 
 Let i be the home country, j be the foreign country, P be the macroeconomic price index, λi,j be the direct exchange rate
 1 domestic monetary units purchases 1/Pi domestic goods or (1*λi,j)/Pj foreign goods
 The law of one price implies the following two expressions: 
Purchasing power parity theory (PPP)
Absolute PPP
Relative PPP
http://www.economist.com/content/big-mac-index
The limits of PPP
Purchasing power parity rests on a set of rather unrealistic hypotheses:
Economies produce homogenous goods
Absence of non-tradable goods (services, real estate…)
Absence of transport costs
Absence of trade barriers
Absence of distribution costs
Absence of international oligopolies/monopolies
Long run exchange rates must depend on additional factors
The long run determinants of exchange rates
Economists agree that long run exchange rates depend on four main factors: 
Relative prices (PPP)
Trade barriers (e.g. taxes and quotas)
Consumer tastes and preferences (domestic versus foreign goods) 
The productivity of domestic firms
Anything that increases the demand for domestic goods to the detriment of foreign goods leads to an appreciation of the domestic currency
Anything that increases the demand for foreign goods to the detriment of domestic goods leads to an depreciation of the domestic currency
The long run determinants of exchange rates
Determinant
Evolution
Impact on exchange rate
Domestic inflation
(+)
(-)
Tradebarriers
(+)
(+)
Demandfor imported goods
(+)
(-)
Demandfor exported goods
(+)
(+)
Productivity
(+)
(+)
Under purchasing power parity (PPP):
 captures the joint effect of prices and exchange rates. It is called the ‘real exchange rate’:
The real exchange rate measures the value of the home country’s goods in terms of the foreign country’s goods. It is an indicator of competitiveness in foreign market 
The real exchange rate (RER)
Let us analyze the variations of the real exchange rate:
A country’s currency can depreciate in nominal terms while appreciating in real terms 
 (if the domestic to foreign inflation differential is positive and larger in absolute value than the corresponding depreciation of the nominal exchange rate)
 A country’s currency can appreciate in nominal terms while depreciating in real terms 
 (if the domestic to foreign inflation differential is negative and larger in absolute value than the corresponding appreciation of the nominal exchange rate)
The real exchange rate (RER)
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https://www.stlouisfed.org/on-the-economy/2015/may/internal-devaluation-in-eurozone-peripheral-countries
The short run determinants of exchange rates
The determinant of long run exchange rates are quite stable; however daily variations of exchange rates of often quite significant (several % points)
A short run theory of exchange rate determination is therefore necessary 
This short run theory explains exchange rates based on the exchange of financial assets (banking deposits, bonds and stocks) rather than on trade flows (which do not fluctuate much in the short run) 
The exchange rate is hence expressed as the price of domestic financial assets relative to foreign financial assets
This price is determined by the supply and demand of domestic versus foreign financial assets
Let the euro zone be the home economy, the US be the foreign economy 
The demand for domestic vs. foreign financial assets depends on relative expected returns for these two asset categories 
If investors anticipate an increase in returns for euro-denominated assets, demand for these assets increase, and the demand for dollar-denominated assets decrease 
Now assume that domestic assets pay an interest iD (labeled in euros) while foreign assets pay an interest iF (labeled in dollars)
In order to compare these two assets, investors must first express return in their own home currency
The short run determinants of exchange rates
In order to measure the returns of foreign assets, investors must take into account the expected evolution of exchange rates 
If a US investor anticipates a 3% appreciation of the euro next year, he expects the return of a 1 year maturity European asset, expressed in US dollars, to also increase by 3% given that the value of the euro expressed in dollars should increase during the investment horizon
Le Et be the spot exchange rate and Eet+1 be the expected value next period; the expected appreciation of the euro is:
For the US investor, the expected return of European assets in dollars is the sum of the interest rate and the expected appreciation of the euro :
The short run determinants of exchange rates
For the US investor, the expected return of European assets relative to US assets is the difference between the expected return of European assets (expressed in dollars) and the interest rate of US assets:
 
The short run determinants of exchange rates
Reciprocally, the return of a foreign assets expressed in the domestic currency is equal to the interest rate on foreign assets, minus the expected appreciation of the domestic currency 
If a European investor anticipates a 3% appreciation of the euro next year, he expects the return of a 1 year maturity US asset, expressed in euros, to decrease by 3% given that the value of the dollar expressed in euros should decrease during the investment horizon
For the European investor, the expected return of foreign assets expressed in euros corresponds to the difference between the foreign interest rate and the expected appreciation of the euro:
The short run determinants of exchange rates
For the European investor, the expected return of US assets relative to Euro denominated assets, (expressed in euros) is the difference between the domestic interest rate and the return on US assets expressed in euros:
(note that we got the exact same result when we took the standpoint of the US investor and measured the expected return of European assets (expressed in dollars)relative to US assets)
Therefore, relative returns are identical whether expressed in dollars or euros: domestic and foreign investors react identically following variations in expected returns 
 
The short run determinants of exchange rates
The interest parity condition
If the relative return of dollar denominated assets is higher than euro denominated assets, US and European investors will sell all their euro denominated assets to purchase dollar denominated assets, and reciprocally
Therefore, investors will hold both dollar and euro denominated assets only if relative returns are zero. 
This is the condition for all available assets to be held
The exchange market is in equilibrium when all existing assets are held, i.e. when:
The interest parity condition (IPC) describes the short term equilibrium in the foreign exchange market. It is written as follows:
It states that the domestic interest rate is equal to the foreign interest rate, minus the expected appreciation of the national currency
Example: if the European interest rate is 5% and the US interest rate is 3%, then financial markets anticipate a 2% depreciation of the euro against the dollar (or a 2% appreciation of the dollar against the euro)
 
The interest parity condition (IPC)
Analyzing the foreign exchange market
The demand for domestic financial assets depends on relative expected return
The above equation shows that the demand for domestic assets is a negative function of the exchange rate Et
Example: assuming that domestic interest rates(iD) and foreign interest rates (iF) are equal; that the expected exchange rate (Eet+1) = 1; that the observed exchange rate (Et) = 1.05, then, the expected relative return of domestic assets is: (1-1.05)/1.05 = - 4.8%. The demand for domestic assets (labeled in euros) should decrease.
 
Exchange rates
Supply of euro-denominated assets
E*=1
Demand of euro-denominated assets
Quantity of euro-denominated assets
Analyzing the foreign exchange market
E*=1
1.05
Exchange rates
Supply of euro-denominated assets
Demand of euro-denominated assets
Quantity of euro-denominated assets
Analyzing the foreign exchange market
E*=1
0.95
Exchange rates
Supply of euro-denominated assets
Demand of euro-denominated assets
Quantity of euro-denominated assets
Analyzing the foreign exchange market
The demand for domestic financial assets depends on relative expected returns:
In order to understand why exchange rates vary over time, we need to analyze the impact of variations of iD, iF et Eet+1 on asset demand curve, for any given value of the exchange rate Et
 
Analyzing the foreign exchange market
Consequence of an increase in domestic interest rates iD
Exchange rate
D1
Supply of euro-denominated assets
E1*
E2*
D2
Quantity of euro-denominated assets
D1
E1*
E2*
D2
Consequence of an increase in foreign interest rates iE
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
D1
E1*
E2*
D2
Consequence an increase of expected exchange rate Eet+1
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
The long run determinants of exchange rates
These factors have an impact on the expected exchange rate Et+1 They hence also have a short run effect
Determinant
Evolution
Impact on exchange rate
Domestic inflation
(+)
(-)
Tradebarriers
(+)
(+)
Demandfor imported goods
(+)
(-)
Demandfor exported goods
(+)
(+)
Productivity
(+)
(+)
D1
E1*
E2*
D2
Higher expected inflation decreases Eet+1 and the exchange rate
 
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
D1
E1*
E2*
D2
Anticipations of new trade barriers increase Eet+1 and the exchange rate 
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
Increased expected imports have a negative effect on Eet+1 and on the exchange rate
D1
E1*
E2*
D2
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
D1
E1*
E2*
D2
Increased expected exports have a positive effect on Eet+1 and on the exchange rate
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
D1
E1*
E2*
D2
Increased expected productivity has a positive effect on Eet+1 and on the exchange rate
Supply of euro-denominated assets
Exchange rate
Quantity of euro-denominated assets
Example
Assume the European Central bank announces an increase of its monetary base
What should be the short term impact on the exchange rate of the euro?
Increase in money supply + decrease in interest rate = the euro depreciates
D1
E1*
E2*
D2
Exchange rate
Supply of euro-denominated assets
Quantity of euro-denominated assets
Assignment