CHAPTER 8: Understanding Exchange Rates
FOCUS OF THE CHAPTER
This chapter begins with an introduction to the foreign exchange rate and then proceeds to discuss its determination under various exchange rate regimes. An introduction to the current and capital accounts of the balance of payments is presented. The monetary and absorption approaches to the balance of payments and the concept of twin deficits are introduced. The role of the exchange rate in the determination of interest rates is analyzed. The importance of the exchange rate as a link between foreign and domestic interest rates on the one hand and foreign and domestic prices on the other is also discussed.
Learning Objectives:
Define an exchange rate and determine how many ways there are to measure exchange rates
Identify the link between the exchange rate and prices in different countries
Describe the types of exchange rate regimes that exist in the world today
Identify the role of capital flows and the balance of payments in the movement of capital across countries
Explain how the equilibrium exchange rate is determined
Determine how interest rates and exchange rates interact
Identify what the purchasing power parity hypothesis predicts
Explain why the real exchange rate concept is important
Explain why interest rate differentials between countries matter
List some of the puzzling aspects of exchange rate behaviour
Explain what the hysteresis hypothesis is
SECTION SUMMARIES
Exchange Rates
Canada is a relatively small open economy in the world. Therefore, the exchange rate is an important factor in determining its international transactions.
Definitions: An exchange rate expresses the price of one currency in terms of another. Therefore, the exchange rate is the relative price of two currencies, and can be expressed in two ways. For example, the exchange rate between the Canadian dollar and the US dollar can be expressed either as C$1 = US$0.6376 (the US dollar price of a Canadian dollar) or as US$1 = C$1.5683 (the Canadian dollar price of the US dollar). Note that in the text the exchange rate is defined as the Canadian dollar price of a foreign currency and is denoted by e.
Cross-Rates: The exchange rate between two currencies, calculated via a third currency, is called the cross-rate. For example, given that US$1 = C$1.5683 and US$1 = £0.6813, the exchange rate between the British pound and the Canadian dollar can be calculated as (1.5683/0.6813) = 2.3688, meaning £1 = C$2.3019.
Changes in Rates: Terms used in the literature for changes (increases or decreases) in the exchange rate differ, depending on whether the changes are brought about by market forces or by government regulation. An increase (decrease) in the value of a currency brought about by market forces, free of government intervention, is termed an appreciation (depreciation) of the currency. An increase (decrease) brought about by government regulation in a fixed (regulated) exchange system is termed a revaluation (devaluation).
Effective or Trade-Weighted Exchange Rates: A country like Canada trades with many other countries in the world. As a result, many exchange rates exist between the currency of one country and the currencies of its trading partners. Therefore, for a given currency, a trade-weighted exchange rate (or effective exchange rate) can be calculated as a weighted average of these exchange rates, using the trade (export/import) ratios (i.e., the proportion of the country’s trade with the partner) as weights.
Trade-weighted exchange rate = w1 e1 + w2 e2+ ... + w n en
where w1 ,w2, and w n are the country’s trade ratios with countries 1, 2, and n respectively, and e1, e2 ,and en are the exchange rates with the currencies of countries 1, 2, and n respectively. The sum of the weights must be equal to unity.
The Law of One Price: Under certain assumptions, the law of one price states that the domestic and foreign prices of a tradable good should be equal. Given the domestic price (P), the foreign price (Pf ) and the exchange rate (e), the law of one price implies that the domestic price will be equal to the product of the foreign price and the exchange rate, i.e., P = Pfe.
The foreign and domestic prices of a good can differ due to transportation costs, tariffs, and other transaction costs, such as the cost of currency conversion. The law may be better applicable to financial instruments, since capital flows have relatively low cost.
Today, capital can flow from one country to another instantly. Some argue that capital flows must be restricted because: 1) they are driven mainly by speculation on profits, and 2) countries do better under restrictions on capital mobility. However, the long-term capital flows known as foreign direct investment (FDI) contribute more to economic growth than short-term capital flows, known as "hot money."
Exchange Rate Regimes
Exchange rate systems (regimes) can be classified into three broad categories:
1) fixed exchange rate regime: Currency is pegged to another currency. The exchange rate is determined by the government.
2) flexible (floating) exchange rate regime: Market forces (the demand for and supply of foreign exchange) free of government intervention determine the exchange rate.
3) managed float (dirty float): The exchange rate is allowed to change within a certain range. A central authority (e.g., a central bank) intervenes in the foreign exchange market to maintain the exchange rate within the range.
The International Monetary Fund (IMF) classifies Canada’s system as a flexible system; yet, at times the Bank of Canada intervenes in the foreign exchange market.
Exchange Rate Determination:
Flexible Exchange Rate Regime: Under a purely flexible exchange rate regime, the exchange rate is determined by the demand for and supply of foreign exchange (foreign currency). A country’s demand for foreign goods (imports) and assets generates a demand for foreign exchange. Foreigners’ demand for a country’s exports and assets generates a supply of foreign exchange. For example, consider the US dollar as the foreign exchange. Canada’s demand for US goods and assets denominated in US dollars generates a demand for the US dollar, while US demand for Canadian goods and assets denominated in Canadian dollars generates a supply of US dollars.
Other things being equal, the quantity demanded of foreign exchange (foreign currency) is inversely related to the exchange rate. (Note that the exchange rate is defined as the domestic price of the foreign currency, say, the Canadian dollar price of the US dollar). Therefore, the demand curve for foreign exchange is downward-sloping. Other things being equal, the quantity supplied of foreign exchange is positively related to the exchange rate. Therefore, the supply curve for foreign exchange is upward-sloping. The equilibrium exchange rate is the exchange rate at which the supply and demand curves intersect.
Fixed Exchange Rate Regime: Since the exchange rate is fixed by the government, the monetary authority (central bank) has to ensure that the quantity of foreign exchange supplied is equal to the quantity demanded at the fixed rate. Therefore, the supply curve is horizontal at the fixed rate.
The Basics of the Balance of Payments: A country’s balance of payments records its transactions with the rest of the world (international transactions) during a given period of time. The balance of payments consists of two accounts: current account and capital account. The export and import values of goods (merchandise) and services, investment income, and transfer payments are recorded in the current account. The Canadian merchandise trade balance typically has been positive, but the balances in services and investment income generally have been negative. The capital account records the inflow and outflow of both direct investment and portfolio investment, government grants,
and loans. A deficit in the current account needs to be financed by a surplus in the
capital account.
Explaining the Balance of Payments
A surplus (deficit) in the current account does not offset exactly a deficit (surplus) in the capital account. The difference is the statistical discrepancy that arises for two reasons: a) the difficulty of recording international transactions, and b) the errors and omissions made in recording them, partly due to differences in the efficiency of statistical agencies.
Foreign Exchange Intervention: The Bank of Canada occasionally intervenes in the foreign exchange markets as a) the manager of foreign exchange reserves, and b) to moderate fluctuations (volatility) in the exchange rate. However, Canada is one of the least interventionist countries.
In a flexible exchange rate system, at any exchange rate above (below) the equilibrium rate the domestic currency is undervalued (overvalued). The Canadian dollar has been undervalued in recent years. Many believe this explains the worsening of current account balance in recent years.
According to the monetary approach to the balance payments, the balance of payments deficits would be cancelled through changes in money supply, under fixed exchange rate regimes. The Bank of Canada can offset these changes in money by sterilization. Under a flexible exchange rate system, the monetary approach suggests that changes in the exchange rate itself produce necessary adjustments in the balance of trade. The absorption approach views surpluses or deficits of the balance of payments as resulting from the difference between output and consumption levels.
The Twin Deficits/Surpluses: Fiscal (budget) deficits (surpluses) and external (balance of payments) deficits (surpluses) that occur simultaneously are referred to as twin deficits/surpluses. Until recently, Canada has run twin deficits (fiscal and current account deficits). The connection between the two deficits (or surpluses) can be described as follows: The level of output or income (y) is equal to the sum of consumption (c), investment (i), government expenditure (g), and the net exports or the difference between exports (x) and imports (im):
y = c + i + g + (x-im)
The level of output or income (y) is also equal to the sum of consumption (c), saving (s), and taxes (t):
y = c + s + t
This implies that:
c + s + t = c + i + g + (x-im), and s + t = i + g + (x-im)
By rearranging the equation we can show the following:
s + (t -g) = i + (x-im)
Note (t-g) is the fiscal surplus and (x-im) is the current account surplus. From this equation, we can see that if s and i are equal, then (t-g) and (x-im) are equal [i.e., fiscal surplus (deficit) and current account surplus (deficit) are equal]. The equation also shows that if i and s do not change, then the changes in (t-g) and (x-im) are equal [i.e., if
Δi = Δs = 0, then Δ(t-g) = Δ(x-im)].
The Exchange Rate and Interest Rate Determination
The loanable funds approach (discussed in Chapter 6) can be used to examine how the equilibrium rate of interest is determined in an open economy with international capital flows (international borrowing and lending). The supply of loanable funds tends to be more elastic when an economy is open for international borrowing and lending, compared to one that is closed. This is because, at interest rates higher than a certain rate, the quantity of loanable funds supplied becomes larger, as foreign lending increases in addition to domestic lending. At interest rates lower than a particular rate, the quantity of loanable funds supplied decreases, as lenders, both domestic and foreign, reduce their lending. The result is a relatively more elastic supply curve (a supply curve with a relatively smaller slope, when both supply curves are drawn on the same diagram). International lending and borrowing make the supply of loanable funds more sensitive to changes in interest rates. However, fluctuations (or changes) in the equilibrium rate of interest brought about by changes (increases or decreases) in the demand for loanable funds are smaller, since the supply is more elastic.
Purchasing Power Parity
The purchasing power of a currency is the amount of goods or services that one unit of the currency can buy. The hypothesis known as the purchasing power parity (PPP), states that the exchange rate is at equilibrium when the domestic purchasing power of the two currencies is equal. The PPP is simply a statement of the low of one price, using domestic price level (P) and the foreign price level (Pf). The PPP has two forms, known as absolute purchasing power parity and relative purchasing power parity.
Absolute purchasing power parity is given by the following equation in terms of levels of the variables:
e = (P/ Pf)
where e is the nominal rate of exchange.
Relative purchasing power parity is stated in terms of the rates of change in e, P, and Pf, as follows:
Δe = π - πf
where Δe is the rate of change in the exchange rate, π is the domestic rate of inflation (rate of change in P), and πf is the foreign rate of inflation (rate of change in Pf). Relative purchasing power parity can be viewed as a long-run equilibrium condition. According to relative purchasing power parity, domestic and foreign inflation rates will be equal when the exchange rate is fixed.
What’s the Evidence on PPP? Careful examination of Canadian and US data suggest that the absolute and relative forms of PPP are valid expressions, at least for the long-run behaviour of exchange rates and price levels. According to the two forms of PPP, exchange rate should increase (i.e., the Canadian dollar should fall) whenever Canada’s rate of inflation is higher than the US rate. Evidence shows that this was the case until the early 1990s. Nevertheless, the PPP seems to hold only over long periods.
Real Exchange Rate: The real exchange rate (ε) is the exchange rate adjusted for changes in relative price levels in different countries, as follows:
ε = e (Pf/ P)
A greater increase in P relative to Pf leads to an increase in e (i.e., a depreciation of the domestic currency). The real exchange rate is used as an indicator of the international competitiveness of the country. An increase (decrease) in ε means a depreciation (appreciation) of the real exchange rate, which implies an increase in the home country’s competitiveness.
Understanding Real Exchange Movements: The real exchange rate can also be interpreted as a measure of departure from PPP. Sources of persistent deviation of the exchange rate from its equilibrium value include the following: 1) slow changes in price of goods relative to exchange rates; 2) concentration of trade within borders or regions; 3) structural differences between countries; and 4) productivity differentials between countries.
International Linkages in Interest Rates
Financial instruments denominated in foreign currencies are subject to foreign exchange risk, due to possible changes in exchange rates. Therefore, an investor's decision to hold foreign bonds depends not only on domestic and foreign rates of return (R and Rf , respectively), but also on the spot and forward exchange rates (es and ef , respectively).
The investor must calculate the implicit forward exchange rate—the future exchange rate at which the investor would be indifferent between domestic and foreign bonds.
The solution for ef in the following equations is the implicit forward exchange rate:
(1+R)/(1+Rf) = ef/es or ef = [(1+R)/(1+Rf)]es
An investor can use a forward foreign exchange contract to hedge against the foreign exchange risk. To do so is called covered interest arbitrage (the purchase and sale of foreign currency assets in order to profit from changes in exchange rates).
A situation known as interest rate parity exists when profits cannot be made by engaging in arbitrage. Interest rate parity (IRP) states that the domestic interest rate is equal to the sum of the foreign interest rate and the expected rate of change in the exchange rate (the expected rate of depreciation or appreciation). The IRP is given by the following equation:
R = Rf + (eexp- es)/es
where eexp is the expected rate of exchange.
Empirical research shows that IRP is a reasonable approximation for Canadian and US data, and also for many other instances. This implies that foreign interest rates have no lasting influence as long as: 1) exchange rates float free; and 2) capital mobility is high. It is clear from the IRP equation that: 1) the foreign rate of interest and the exchange rate are negatively related; and 2) the domestic and foreign rates of interest are equal when the exchange rate is expected not to change.
Hysteresis: The idea of hysteresis has been used to explain the phenomenon that many economic variables display persistent deviations from their equilibrium values, even though the fundamentals causing the deviations indicate that an equilibrium exists. Hysteresis is a hypothesis advanced to explain persistent deviations of exchange rates from purchasing power parity (i.e., persistent over/undervaluations of the exchange rate). Institutional factors may be contributing factors to hysteresis in exchange rates.
MULTIPLE-CHOICE QUESTIONS
1. Which of the following is not a correct interpretation of an exchange rate?
a) Exchange rate is the purchasing power of a unit of exports.
b) Exchange rate is the relative price of two currencies.
c) Exchange rate is the domestic price of a foreign currency.
d) Exchange rate is the foreign price of the domestic currency.
2. Devaluation is the term used for
a) a decrease in the value of a currency brought about by market forces under a flexible exchange rate regime.
b) a decrease in the value of a currency brought about by market forces under a fixed exchange rate regime.
c) a decrease in the value of a currency brought about by the government under a flexible exchange rate regime.
d) a decrease in the value of a currency brought about by the government under a fixed exchange rate regime.
3. Foreign and domestic prices of a good are given by Pf and P. If the exchange rate (e) is defined as the domestic currency price of the foreign currency, which of the following is not a correct statement of the Law of One Price:
a) P = ePf
b) Pf = P/e
c) Pf = eP
d) P/Pf = e
4. According to the IMF classification, the Canadian exchange rate regime is
a) a floating exchange rate regime.
b) a dirty float regime.
c) a fixed exchange rate regime.
d) a crawling peg regime.
5. Under a floating exchange rate regime, an increase in the supply of foreign exchange results in
a) a depreciation of the domestic currency.
b) an appreciation of the domestic currency.
c) either an appreciation or a depreciation of the domestic currency.