The nominal exchange rate is the price of one country s currency in terms of another country s currency.

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1 1 Exchange Rates The nominal exchange rate is the price of one country s currency in terms of another country s currency. For example, the nominal dollar-euro exchange rate might be one dollar and eight cents for a euro, or $1.08 =e1. When people refer to "the exchange rate" without specifying real or nominal, they almost always mean the nominal exchange rate. When we quote prices in the domestic currency, we always give them as number of dollar per good, because money is the unit of account. But an exchange rate is the price of two moneys, so it can be given either way. For instance, we can say that a dollar is worth four Mexican pesos, or a peso is worth 0.25 dollars. When an exchange rate is given in terms of two specific currencies, that is a bilateral exchange rate. There are also exchange rate indexes, which are the average exchange rate against a basket of other currencies. When the value of one currency increases, so that it is worth more, we say that it has become stronger, or that it has appreciated. Similarly, when the value of a currency decreases and it is worth less, we say that it has become weaker or depreciated. You shouldn t say that a currency has "gone up" or "gown down" because that is ambiguous. For example, suppose the Mexican peso appreciates from $0.25 to $0.33. We could also say it has gone from four pesos to the dollar,to three pesos to the dollar. This is an equivalent way of describing the exact same appreciation, but now the number has gone up rather than down. In these notes, we use the following notation: NE A/B means the nominal exchange rate in units of currency A per one unit of currency B. For example, we can write the exchange rate above as NE $/peso = 0.25 or NE peso/$ = 4. When a nominal exchange rate expressed NE A/B goes up, that is a depreciation of currency A and an appreciation of currency B. It now takes more units of A to buy one unit of B. The real exchange rate is the price of a basket of goods in one country in terms of an equivalent basket in another country. If we are interested in the terms on which one country?s money exchanges for another?s, we use the nominal exchange rate. This is the rate that we see directly, in the newspaper or when we go to change our money for a different country s money. But if we want to know the terms on which goods and services in one country exchange for

2 2 goods in another, we need to use the real exchange rate. (Note: In the remainder of these notes I will write "goods" when I mean "goods and services.") Another way to think of the real exchange rate is that it is the nominal exchange rate adjusted for inflation. A country experiences a real appreciation if there is a nominal appreciation of its currency, or if its inflation rate is higher than the inflation rate in the countries it trades with. So there are three ways a country s currency can appreciate unreal terms: (1) if its currency appreciates in nominal terms; (2) if it has high inflation; (3) if its trade partners have no inflation or deflation. Another way of thinking of the real exchange rate is that it is the number of baskets of a representative good you can get in currency B, in exchange for one basket of goods in currency A. For example, suppose you are a real estate speculator who is planning unselling 100 houses in the US and using the money to buy a bunch of similar houses in the UK. The number of British houses you are able to buy will increase if the number of dollars you get for each US house increases (that is, prices rise,or inflation, in the US); if you get more pounds for each dollar (that is, a nominal appreciation of the dollar against the pound); or if you get more British houses for the same amount of pounds (lower prices in the UK, that is, lower inflation or deflation). The real exchange rate is an index number.this means that we can describe changes in the real exchange rate, but not the level of the real exchange rate. It is possible to say what the nominal exchange rate between two countries currently is, and how much it changed over some period of time, or is expected to change in the future. But it is only possible to say how much the real exchange has changed or will change. If rewrite the real exchange rate between two currencies as RE A/B, and the percentage change in the real exchange rate as % RE A/B, then the change in the real exchange rate is given by an accounting identity: % RE A/B = % NE A/B inflation A + inflation B The percentage change in the real exchange rate of currency A, measured in units of currency A, is equal to the change in the nominal exchange rate of A in units of B, minus the inflation rate in the country using currency A, plus the inflation rate in the country using currency B. This is an accounting identity, meaning it is always exactly true, because it is simply how we define the real exchange rate. Note that an increase in the exchange rate given this way is a depreciation of currency A, and an appreciation of currency B. For example, if the euro appreciates against the dollar by 5% in

3 3 nominal terms, inflation is 2% in the US, and inflation is 0% in Europe, then the euro appreciates by 3% in real terms. We will get this same answer whichever currencies we call A and B. If the dollar is currency A, then we have % NE $/e = 5, and if the dollar is currency B, then we have % NE e/$ = 5. The nominal exchange rate is determined by supply and demand in foreign exchange markets. At any given moment, there are a large number of banks, wealthy speculators, and other foreign exchange traders making deals to exchange one currency for another. The currency exchange rate is the last terms on which such a deal took place. For example, suppose the current exchange rate is one dollar per euro. I have one million dollars, which I want to exchange for one million euros. I post this offer on an electronic exchange and hope someone else on the same exchange will be looking to sell a similar quantity of euros for dollars. Suppose, though, that I can t find anyone who wants to take the other side of the trade. If I really want the euros, I will have to offer amore favorable price. For instance, I might post a new offer of $1.01 million for one million euros. If someone accepts my new offer, this is the new exchange rate. So the nominal dollar euro exchange rate has just gone from NE $/e = 1 to NE $/e = 1.01, a nominal appreciation of the euro and a nominal depreciation of the dollar. This means that a currency will tend to appreciate when there are many people who want to hold that currency, and it will tend to depreciate when more people would rather hold some other currency. In the real world, the contracts are more complicated, but the logic is the same. If a country s central bank intervenes in the foreign exchange market to keep the exchange rate at a certain level, we say the exchange rate is fixed; if the central bank does not intervene, we say the exchange is floating. Governments may wish to keep their county s currency at a particular exchange rate for a variety of reasons. Normally, it is the central bank that is responsible for intervening in the foreign exchange market to achieve some target level for the exchange rate. When a central bank announces a particular level for the exchange rate relative to some other currency and is prepared to intervene as necessary to keep the market exchange rate near that level, we say that the exchange rate is fixed. If the central bank does not intervene in the foreign exchange market and lets the exchange rate be freely determined by private demand, we say the exchange rate is floating.there are also many in-between cases, where the central bank

4 4 intervenes in various ways but does not not announce one fixed exchange rate. For example, the central bank might announce that it would not allow the exchange rate to change at more than a certain percentage rate (for example, no more than a 1% appreciation or depreciation over any one month.) This is a crawling peg. Or, a central bank might announce a floor and a ceiling to the exchange rate but allow the foreign exchange market to set the rate in between. This is called a band.or, the central bank might not announce any official policy, but intervene on a case by case basis when it decides the currency is getting too strong or too weak. This is called a dirty float or managed float.there are many other possibilities as well, but we will focus on the two cases of fixed and floating exchange rates. Maintaining a fixed exchange rate requires a central bank to hold foreign exchange reserves. When governments do not seek to control the exchange rates of their currencies,we say the exchange rates arefloating. When a central bank announces that it intends to keep the exchange rate at a certain level,we say that is a fixed or pegged exchange rate. But normally, the fixed rate is not set by law or regulation. The central bank maintains its target exchange rate by buying and selling currency in the foreign exchange market just like private businesses and individuals do. It buys the domestic currency when it depreciates, and sells it when it appreciates. Since a central bank can always produce more of its own currency, it can always prevent its currency from appreciating, by selling more of its own currency and buying more of the foreign currency it is pegged to. But a central bank cannot print other countries currencies, so it cannot sell them unless it already has acquired them. A central bank s holdings of foreign currencies are called its foreign exchange reserves. When demand for the domestic currency drops for any reason, a central bank maintaining a fixed exchange rate must buy its own currency by selling off some of its own reserves. If it runs out of reserves, it will no longer be able to maintain the fixed rate. So countries that wish to successfully defend a fixed exchange rate, must hold large foreign exchange reserves. There are three sources of demand for foreign exchange: to buy goods from a country using that currency (trade); to buy assets or service debts denominated in that currency (investment); or to hold the currency itself, in the hopes that it will appreciate (speculation). In general,we think that trade demand is likely be the most important factor in long-term exchange rate movements appreciations or

5 5 depreciations over periods of many years or decades. Trade in goods is not a factor in short term changes in exchange rates. We think that speculation is the decisive factor in short-run changes in exchange rates appreciations or depreciations over a period of weeks, days or shorter periods. Investment demand is likely to be most important in appreciations or depreciations over a few years, though in some cases they may be important in longer run movements. In other words, if you want to know why the Japanese yen is much stronger than it was 40 years ago, persistent Japanese trade surpluses and low inflation are probably important parts of the answer. If you want to know why the dollar is stronger than it was two years ago, the answer is probably that American assets have become more desired by investors. And if you want to know why the Indonesian rupiah lost 80 percent of its value over a few weeks in the summer of 1997, the answer is that speculators became much more pessimistic about the future value of the rupiah. Insofar as trade dominates demand for foreign exchange, we expect to see appreciation in countries with trade surpluses, and depreciation in countries with trade deficits. The Purchasing Power Parity (PPP) hypothesis says that this effect will prevent large changes in real exchange rates. One reason you might want another currency is to buy goods or services from a country that uses that currency. Most of us need to use foreign currency ourselves only when we travel to a foreign country, but whenever we buy a good imported from a foreign country we are creating demand for that country s currency, since someone (the wholesaler,importer, etc.) had to acquire that country s currency in order to buy the good. Similarly, whenever a business in our country exports a good, that creates demand for our currency. Since a trade surplus means that our country is exporting more goods to the rest of the world than the rest of the world is buying from us, we expect that countries with trade surpluses will tend to see their currencies appreciate. Similarly,countries with trade deficits should tend to see their currencies depreciate. One important factor in demand for a country s goods is their price in general, people buy less of something when its price rises. High inflation is equivalent to a rise in price of all goods in our country. So insofar as trade flows depend on prices, and insofar as exchange rates predetermined by trade flows, higher inflation should be associated with a nominal depreciation of the currency. For example, if the inflation rate in the US is 2 points higher than in Europe, American goods will become more expensive relative to European goods. This may cause people to shift their purchases toeuropean

6 6 goods,and the resulting demand for euros rather than dollars will cause the dollar to depreciate. This will continue until the dollar has depreciated by 2 percent, offsetting the inflation difference and eliminating the price difference between American and European goods. If this effect is strong enough,the real exchange rate will stay constant over time. This hypothesis that real exchange rates should be constant is called Relative Purchasing Power Parity, or PPP. Many economists think that something like relative PPP is true in the very long run. If a country s inflation rate is persistently higher than its trade partners inflation rate, its currency should depreciate in nominal terms, and if its inflation rate is consistently higher, its currency should appreciate in nominal terms. This effect may be too weak to see in the short run; over periods of several years, real exchange rates seem to move freely. But if we look at periods of 10 or 20 years, real exchange rates appear more stable. Relative PPP clearly does not hold exactly, even over long periods.real exchange rates do change. But there are two things we can say with some confidence: 1. Prices for similar goods vary between countries, but they do not vary without limit. If a country has inflation much higher than elsewhere, its nominal exchange rate will eventually depreciate. And the higher the inflation, the more of it we should expect to see offset by changes in the exchange rate. The same effect can operate in reverse. If a country?s exchange rate is fixed,that may prevent its inflation rate from varying much from its trade partners?. Otherwise people would just buy things on the side of the border where they are cheaper. 2. A country with a trade deficit that continues over many years is likely to see its currency depreciate. A country with a trade surplus that continues over many years is likely to see its currency appreciate. For instance, Germany, Japan, and more recently China have all seen their currencies appreciate significantly. Insofar as investment dominates demand for foreign exchange, we expect to see appreciation in countries where interest rates are high or whose assets are attractive to investors for other reasons. Only a small fraction of transactions involving different currencies are for the purposes of buying or selling goods. A much larger fraction involve purchases of assets (bonds, stocks, businesses and other income-yielding property) in one country by investors in a different country,and loans by lenders in one country to borrowers in another. If wealthy individuals and financial institutions for whatever reason decide that assets in one country are a good investment, that will

7 create demand for that country s currency. And if they decide that its assets are not a good investment, that will reduce demand for its currency. There are a number of reasons investors might prefer assets in one country rather than another; which reasons are most important, will depend on the type of investment. Foreign direct investment the purchase of a business that the investor will control or manage themselves usually depends on factors specific to the business. For instance, a retailer may want to own outlets in a country where it hopes to sell its products, while a manufacturer might want to take control of a foreign supplier to assure a more reliable supply of inputs. Portfolio investment is the purchase of a foreign financial instrument like a stock or a bond, rather than a business that the investor will operate themselves. Portfolio investment may be influenced by perceptions of safety how likely is the borrower to default, how likely is the government likely to impose new taxes, etc.? It will also be influenced by liquidity whether the asset can be sold quickly, for a predictable price, in order to meet unexpected payment needs. This will tend to favor assets denominated in global reserve currencies, especially the US dollar, and also assets in countries with large, well-regulated financial markets. Just as inward foreign investment (purchases of our domestic by investors in other countries) creates demand for our currency, outward foreign investment creates demand for foreign currency and reduces demand for our currency. When a large number of wealth holders in a country wish to keep their wealth elsewhere, this is called capital flight. (This is a big problem in many poor countries,especially in Africa, where wealthy elites strongly prefer to hold assets in the US or Europe rather than in their own country.) A country experiencing capital flight will have less demand for its currency. Similarly, repayment of existing foreign loans creates demand for foreign currency and reduces demand for the country s own currency. Foreign investment is also influenced by the yield, or return, on assets in different countries. For bonds and foreign loans, the yield is the interest rate. So all else equal, a country with high interest rates will attract more foreign investment than one with lower interest rates. What matters here is not the absolute level of interest rates, but whether they are higher or lower than in other countries where investors might otherwise choose to lend. Interest rates are just one factor among others influencing foreign investment, but we give it special attention because interest rates are more easily observed than most of the other factors influencing foreign investment, and because interest rates are central to macroeconomic policy. 7

8 8 While it is much easier to buy and sell financial assets in other countries today than it was a generation ago, it is still usually easier to invest in your own country. For one thing, enforcing contracts and resolving disputes is easier when both the lender and the borrower are subject to the same government. The ease with which wealth holders can buy and sell assets across national borders is called capital mobility. When capital mobility is high, that means it is easy to buy an asset or to lend money to someone in a different country; when capital mobility is low, it is difficult or impossible. The more mobile is capital, the more strongly will flows of foreign investment respond to differences in yield. If capital is very mobile, it is hard for interest rates indifferent countries to vary much: If loans in one country offer higher interest rates than similar loans elsewhere, there will be a flood of foreign lending into the country with the higher interest rate, which will tend to push rates back down. We can draw three general conclusions about the effect of investment demand for foreign exchange. 1. A country whose assets are attractive to investors for whatever reason, and is experiencing an inflow of foreign investment, will tend to see its currency appreciate. A country whose assets reconsidered a poor investment, or which is experiencing capital flight, will tend to see its currency depreciate. 2. When interest rates rise in a country, its currency will tend to appreciate. When interest rates fall, the currency will tend to depreciate. 3. If capital is very mobile, interest rates in similar countries should all move together. Insofar as speculation dominates demand for foreign exchange, we expect exchange rates to follow an unpredictable random walk. The third reason someone might buy foreign exchange is neither to buy goods or services,nor to buy assets or make loans, but to hold the currency itself in the hopes it will increase in value. For example, suppose that the dollar-euro exchange rate is currently e1 = $1.06, but you believe that by next week the exchange rate is likely to be e1 = $1.10. If you are right, you can trade $1,060 for e1,000 today and then trade the e1,000 for $ 1,100 at the new exchange rate next week, making a quick profit. So you will sell dollars and buy euros, in the hopes of reversing the trade once the euro appreciates. But what happens if many other speculators in the foreign exchange markets agree with you? They will all be trying to buy euros and sell dollars too. This speculative demand will cause the euro

9 9 to appreciate against the dollar. Specifically, if the average or consensus expectations that the exchange rate will be e1 = $1.10 at some point in the near future, and the euro is worth less than that today, then speculators will continue buying euros until the current value of the euro reaches $1.10. As a result, when speculation is the dominant factor in foreign exchange markets we expect to see: current exchange rate = expected expected rate Otherwise, there would be an opportunity for speculators to make money by buying the currency expected to appreciate and selling the currency expected to depreciate. We can turn the equation above around: in a market dominated by speculation, the expected exchange rate should be equal to the current exchange rate. In other words, if someone asks you what you think the exchange rate between any two currencies will be tomorrow, next week, or next month, the best guess you can make is whatever it is today. We know that exchange rates will change, but it is impossible to predict in which direction. Because if it were possible to predict exchange rate changes, speculators would already have used that information to bid the currencies to their future values. So when speculation dominates, it is impossible to forecast exchange rate movements. Speculation is absolutely dominant in the very short run. Foreign exchange speculators have a great deal of liquidity they are able to take large positions and are very interested in what currencies will be doing in the next days or even hours. Trade and investment flows, on the other hand, are determined by factors that change more slowly; trade and many forms of foreign investment also involve decisions that cannot be made at short notice for a retailer to being sourcing clothes from a factory in Vietnam rather than China, for instance, would require finding new contractors, ensuring that they can meet the necessary standards for production, arranging for shipment from different ports, signing contracts, and so on a process that would take months if not years. Similar considerations apply to foreign direct investment and much foreign lending. Over longer periods, speculation is less important. Standard contracts in the foreign exchange market typically involve delivery in no more than three months. There are not many speculators making bets about exchange rates much farther into the future than this, and it is harder and riskier to do so. So while the expectations of speculators are the crucial factor in exchange rate changes over periods of days or weeks, they do not usually play a major role in changes over longer periods.

10 Because speculators are trying to guess what the exchange rate will be in the near future, and because the short-run behavior of exchange rates mainly depends on the expectations of speculators, there is a circular quality to exchange rate determination. Usually, the only reason why a currency strengthens or weakens, is because that is what speculators expected it to do. This dynamic can lead to herd behavior and self-fulfilling prophecies in foreign exchange markets. If speculators believe that a currency is likely to depreciate, they will sell it, meaning that it will depreciate even if there is nothing wrong with the country s economy or government policies. And if you are holding that currency, you want to be the first one to sell it, before it loses its value. As a result, the value of a currency can sometimes collapse very quickly, for no apparent reason. (The opposite case of a sudden appreciation much less common.) So the logic of speculation in foreign exchange markets can lead to what appears to be wild movements, panics, and exaggerated reactions to good or bad news even though all the individuals in the markets are behaving rationally. This kind of instability is especially destructive in smaller and poorer countries, because the flood of foreign-exchange speculation can overwhelm the relatively modest amounts of money involved in trade and longer-term foreign investment in those countries, as well as the resources of their central banks. This sort of speculative instability exists in other asset markets, but for various reasons it is strongest in foreign exchange markets. There is one situation in which speculation can be stabilizing. If a central bank is credible, that means that market participants believe that it will carry out its promises, and that it has the resources to do so successfully. Suppose, for instance, that the central bank of China decides that the renminbi has become too weak and announces a new, stronger, target. Normally, to bring this about, the central bank would have to intervene in the market by buying renminbi and selling dollars, using up some of its foreign exchange reserves. But given the bank s enormous reserves, most foreign exchange speculators would probably guess that the bank would be able to achieve the new, stronger exchange rate. So they will try to buy renminbi first, to profit when it appreciates. The result of this speculative buying will be to cause the renminbi to appreciate against the dollar. If the central bank is very credible, the announcement alone might be enough to get the currency to its new target value, without the central bank intervening at all. This kind stabilizing speculation was an important factor in the success of the Gold Standard in the 19th and early 20th centuries. Since no one doubted the commitment of central banks in Britain, France, the US and other rich countries to maintain their currencies 10

11 11 parity with gold, any temporary depreciation was treated as a buying opportunity by speculators. Speculative demand for foreign exchange is almost always the main factor in changes in exchange rates over periods of time much shorter than a year. This has three implications: 1. In the short run, exchange rates follow a random walk. If we want to predict what the exchange rate between two currencies will be a day, a week or a month from now, the best guess is whatever the exchange rate is today. 2. Because foreign-exchange speculators are mainly trying to guess what other speculators will do, foreign exchange markets are subject to herd behavior, with large shifts in demand between currencies for no apparent reason. 3. If central bank interventions are credible to foreign-exchange markets, speculation will reinforce central bank interventions, making it easier for central banks to keep the exchange rate at their target level.

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