Exchange Rates and Open-Economy Macroeconomics

Transcription

1 Exchange Rates and Open-Economy Macroeconomics Szabolcs Sebestyén Master Programmes INTERNATIONAL FINANCE Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 1 / 126

2 Outline PART 1: PART 2: PART 3: Money, Bond and Foreign Exchange Markets Money, Interest and Exchange Rates Price Levels and the Exchange Rate in the Long Run Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 2 / 126

3 Outline Part I: Money, Bond and Foreign Exchange Markets Outline of Part I 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 3 / 126

4 Outline Part II: Money, Interest and Exchange Rates Outline of Part II 5 The Money Supply and the Exchange Rate in the Short Run 6 Money, the Price Level and the Exchange Rate in the Long Run Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 4 / 126

5 Outline Part III: Price Levels and the Exchange Rate in the Long Run Outline of Part III 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 5 / 126

6 Part I Money, Bond and Foreign Exchange Markets Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 6 / 126

7 Determinants of Asset Demand Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 7 / 126

8 Determinants of Asset Demand Determining the Quantity Demanded of an Asset Wealth: the total resources owned by the individual, including all assets Ceteris paribus, the quantity demanded of an asset is positively related to wealth Expected return: the return expected over the next period on one asset relative to alternative assets The quantity demanded of an asset is positively related to its expected return relative to alternative assets Risk: the degree of uncertainty associated with the return on one asset relative to alternative assets The quantity demanded of an asset is negatively related to the risk of its returns relative to alternative assets Liquidity: the ease and speed with which an asset can be turned into cash relative to alternative assets The quantity demanded of an asset is positively related to its liquidity relative to alternative assets Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 8 / 126

9 Determinants of Asset Demand Response of the Quantity of an Asset Demanded to Changes in Wealth, Expected Returns, Risk, and Liquidity Source: Mishkin (2010), Table 5.1 Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 9 / 126

10 The Money Market Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 10 / 126

11 The Money Market Money Demand Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 11 / 126

12 The Money Market Money Demand Determinants of Money Demand by Individuals What influences demand of money for individuals and institutions? 1 Interest rates/expected rates of return on monetary assets relative to the expected rates of returns on non-monetary assets A rise in the interest rate/expected return causes the demand for money to fall 2 Risk: the risk of holding monetary assets principally comes from unexpected inflation, which reduces the purchasing power of money But many other assets have this risk too, so this risk is not very important in defining the demand of monetary assets versus non-monetary assets 3 Liquidity: a need for greater liquidity occurs when the price of transactions increases or the quantity of goods bought in transactions increases A rise in the average value of transactions of a household or firm causes its demand for money to rise Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 12 / 126

13 The Money Market Money Demand Determinants of Aggregate Money Demand What influences aggregate demand of money? 1 Interest rates/expected rates of return: monetary assets pay little or no interest, so the interest rate on non-monetary assets like bonds, loans, and deposits is the opportunity cost of holding monetary assets A higher interest rate/expected return means a higher opportunity cost of holding monetary assets = lower demand of money 2 Price level: the prices of goods and services bought in transactions will influence the willingness to hold money to conduct those transactions A higher level of average prices means a greater need for liquidity to buy the same amount of goods and services = higher demand of money 3 Real national income: greater income implies more goods and services can be bought, so that more money is needed to conduct transactions A higher real national income (GNP) means more goods and services are being produced and bought in transactions, increasing the need for liquidity = higher demand of money Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 13 / 126

14 The Money Market Money Demand A Model of Aggregate Money Demand The aggregate demand of money can be expressed as M d = P L (R, Y) where P is the price level Y is real national income R is a measure of interest rates on non-monetary assets L (R, Y) is the aggregate demand of real monetary assets Alternatively, M d P = L (R, Y) Aggregate demand of real monetary assets is a function of national income and interest rates Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 14 / 126

15 The Money Market Money Demand Aggregate Real Money Demand and the Interest Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 15 / 126

16 The Money Market Money Demand Effect on the Aggregate Real Money Demand Schedule of a Rise in Real Income Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 16 / 126

17 The Money Market A Model of the Money Market Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 17 / 126

18 The Money Market A Model of the Money Market Equilibrium in the Money Market The money market is where monetary or liquid assets, which are loosely called money, are lent and borrowed When no shortages (excess demand) or surpluses (excess supply) of monetary assets exist, the model achieves an equilibrium: M s = M d Alternatively, when the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, the model achieves an equilibrium: M s P = L (R, Y) Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 18 / 126

19 The Money Market A Model of the Money Market Determination of the Equilibrium Interest Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 19 / 126

20 The Money Market A Model of the Money Market Excess Supply and Demand of Monetary Assets When there is an excess supply of monetary assets, there is an excess demand for interest-bearing assets like bonds, loans, and deposits People with an excess supply of monetary assets are willing to offer or accept interest-bearing assets (by giving up their money) at lower interest rates Others are more willing to hold additional monetary assets as interest rates fall When there is an excess demand of monetary assets, there is an excess supply of interest- bearing assets like bonds, loans, and deposits People who desire monetary assets but do not have access to them are willing to sell non-monetary assets in return for the monetary assets that they desire Those with monetary assets are more willing to give them up in return for interest-bearing assets as interest rates rise Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 20 / 126

21 The Money Market A Model of the Money Market Effect of an Increase in the Money Supply on the Interest Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 21 / 126

22 The Money Market A Model of the Money Market Effect on the Interest Rate of a Rise in Real Income Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 22 / 126

23 The Bond Market Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 23 / 126

24 The Bond Market Supply and Demand in the Bond Market Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 24 / 126

25 The Bond Market Supply and Demand in the Bond Market Supply and Demand for Bonds An alternative way to determine the equilibrium interest rate At lower prices (higher interest rates), ceteris paribus, the quantity demanded of bonds is higher: an inverse relationship At lower prices (higher interest rates), ceteris paribus, the quantity supplied of bonds is lower: a positive relationship Market equilibrium occurs when the amount that people are willing to buy (demand) equals the amount that people are willing to sell (supply) at a given price B d = B s defines the equilibrium (or market clearing) price and interest rate When B d > B s, there is excess demand, price will rise and interest rate will fall When B d < B s, there is excess supply, price will fall and interest rate will rise Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 25 / 126

26 The Bond Market Supply and Demand in the Bond Market Supply and Demand for Bonds Source: Mishkin (2010), Figure 5.1. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 26 / 126

27 The Bond Market Changes in Equilibrium Interest Rates Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 27 / 126

28 The Bond Market Changes in Equilibrium Interest Rates Shifts in the Demand for Bonds Wealth: in an expansion with growing wealth, the demand curve for bonds shifts to the right Expected returns: higher expected interest rates in the future lower the expected return for long-term bonds, shifting the demand curve to the left Expected inflation: an increase in the expected rate of inflation lowers the expected return for bonds, causing the demand curve to shift to the left Risk: an increase in the riskiness of bonds causes the demand curve to shift to the left Liquidity: increased liquidity of bonds results in the demand curve shifting right Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 28 / 126

29 The Bond Market Changes in Equilibrium Interest Rates Factors That Shift the Demand Curve for Bonds Source: Mishkin (2010), Table 5.2. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 29 / 126

30 The Bond Market Changes in Equilibrium Interest Rates Shifts in the Supply for Bonds Expected profitability of investment opportunities: in an expansion, the supply curve shifts to the right Expected inflation: an increase in expected inflation shifts the supply curve for bonds to the right Government budget: increased budget deficits shift the supply curve to the right Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 30 / 126

31 The Bond Market Changes in Equilibrium Interest Rates Factors That Shift the Supply of Bonds Source: Mishkin (2010), Table 5.3. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 31 / 126

32 The Bond Market Changes in Equilibrium Interest Rates Application: Response to a Change in Expected Inflation (Fisher effect) Source: Mishkin (2010), Figure 5.4. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 32 / 126

33 The Bond Market Changes in Equilibrium Interest Rates Expected Inflation and Interest Rates (3-Month Treasury Bills), Source: Mishkin (2010), Figure 5.5. Expected inflation calculated using procedures outlined in Mishkin, The Real Interest Rate: An Empirical Investigation, Carnegie-Rochester Conference Series on Public Policy 15 (1981): These procedures involve estimating expected inflation as a function of past interest rates, inflation, and time trends. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 33 / 126

34 The Bond Market Changes in Equilibrium Interest Rates Application: Response to a Business Cycle Expansion Source: Mishkin (2010), Figure 5.6. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 34 / 126

35 The Bond Market Changes in Equilibrium Interest Rates Business Cycle and Interest Rates (3-Month Treasury Bills), Source: Mishkin (2010), Figure 5.7. Data source is Federal Reserve. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 35 / 126

36 The Bond Market Changes in Equilibrium Interest Rates Everything Else Remaining Equal? The money market framework leads to the conclusion that an increase in the money supply will lower interest rates: the liquidity effect Income effect finds interest rates rising because increasing the money supply is an expansionary influence on the economy (the demand curve shifts to the right) Price-level effect predicts an increase in the money supply leads to a rise in interest rates in response to the rise in the price level (the demand curve shifts to the right) Expected-inflation effect shows an increase in interest rates because an increase in the money supply may lead people to expect a higher price level in the future (the demand curve shifts to the right) Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 36 / 126

37 The Bond Market Changes in Equilibrium Interest Rates Price-Level Effect vs Expected-Inflation Effect A one-time increase in the money supply will cause prices to rise to a permanently higher level by the end of the year = the interest rate will rise via the increased prices Price-level effect remains even after prices have stopped rising A rising price level will raise interest rates because people will expect inflation to be higher over the course of the year When the price level stops rising, expectations of inflation will return to zero Expected-inflation effect persists only as long as the price level continues to rise Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 37 / 126

38 The Bond Market Changes in Equilibrium Interest Rates Response to an Increase in Money Supply Growth Source: Mishkin (2010), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 38 / 126

39 The Bond Market Changes in Equilibrium Interest Rates Money Growth (M2, Annual Rate) and Interest Rates (3-Month Treasury Bills), Source: Mishkin (2010), Figure Data source is Federal Reserve. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 39 / 126

40 The Foreign Exchange Market Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 40 / 126

41 The Foreign Exchange Market The Demand for Foreign Currency Assets Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 41 / 126

42 The Foreign Exchange Market The Demand for Foreign Currency Assets Basic Question What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency? The main issue is what the deposit will be worth in the future The future value depends on two factors: the interest rate it offers the expected change in the currency s exchange rate against other currencies Factors that influence the return on assets determine the demand of those assets Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 42 / 126

43 The Foreign Exchange Market The Demand for Foreign Currency Assets Risk and Liquidity Ceteris paribus, individuals prefer to hold those assets offering the highest expected real rate of return Savers typically care about two main characteristics of an asset other than its return: Risk: the variability it contributes to savers wealth Liquidity: the ease with which the asset can be sold or exchanged for goods An asset with a high expected return may be undesirable if its realised return fluctuates widely = risky asset Savers also prefer to hold some liquid assets as a precaution against unexpected expenses that might force them to sell less liquid assets at a loss Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 43 / 126

44 The Foreign Exchange Market The Demand for Foreign Currency Assets Interest Rates To compare returns on deposits in different currencies, two pieces of information are needed: How the money values of the deposits will change How exchange rates will change The first is the currency s interest rate: the amount of that currency one can earn by lending one unit of the currency for a year It is also the amount that must be paid to borrow one unit of the currency for a year Interest rates play an important role in the FX market because the large deposits traded there pay interest, each at a rate reflecting its currency of denomination Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 44 / 126

45 The Foreign Exchange Market The Demand for Foreign Currency Assets Interest Rates on $ and Deposits, Source: Krugman, Obstfeld and Melitz (2012), Figure 14.2.; the data source is Datastream. Three-month interest rates are shown. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 45 / 126

46 The Foreign Exchange Market The Demand for Foreign Currency Assets Changes in Exchange Rates A euro or a dollar deposit offers a higher expected rate of return? Example Suppose that today s exchange rate is $1.10/e, but you expect it to be $1.165/e in a year. The $ interest rate is 10% per annum while the e interest rate is 5%. Which of these deposits offers a higher return? Step 1 The dollar price of a e 1 deposit is $1.10 Step 2 At the end of the year, the e 1 deposit will be worth e 1.05 Step 3 Calculating with the expected exchange rate, the dollar value of the euro deposit after a year is $1.165/e e1.05 = $1.223 Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 46 / 126

47 The Foreign Exchange Market The Demand for Foreign Currency Assets Changes in Exchange Rates Example (cont.) Step 4 The expected dollar rate of return on a euro deposit is RR $/e = $1.223 $1.10 $1.10 = 0.11 or 11% per annum Step 5 Since the expected dollar rate of return on a euro deposit (11%) is greater than the dollar rate of return on a dollar deposit (10%) = hold you wealth in euro deposits Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 47 / 126

48 The Foreign Exchange Market The Demand for Foreign Currency Assets A Simple Rule Rate of depreciation: the percentage increase in the exchange rate In the last example the dollar s expected depreciation rate is $1.165 $1.10 = % $1.10 Rule: the dollar RR on euro deposits is approximately the euro interest rate plus the rate of depreciation of the dollar: RR e $/e = R e + Ee $/e E $/e E $/e The expected RR difference between dollar and euro deposits is R $ R e Ee $/e E $/e E $/e If it is positive, dollar deposits are more attractive, while if it is negative, euro deposits become more attractive Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 48 / 126

49 The Foreign Exchange Market The Demand for Foreign Currency Assets Comparing Dollar Rates of Return on Dollar and Euro Deposits Source: Krugman, Obstfeld and Melitz (2012), Table Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 49 / 126

50 The Foreign Exchange Market Equilibrium in the FX Market Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 50 / 126

51 The Foreign Exchange Market Equilibrium in the FX Market Interest Parity Interest Parity: the FX market is in equilibrium when deposits of all currencies offer the same expected rate of return In this case deposits in all currencies are equally desirable assets and no type of deposit is in excess demand or excess supply Interest parity also implies that R $ = R e + Ee $/e E $/e E $/e If it does not hold, arbitrage opportunities adjust the exchange rate until the equality is achieved Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 51 / 126

52 The Foreign Exchange Market Equilibrium in the FX Market Changes in Current Exchange Rates Ceteris paribus, depreciation (appreciation) of a country s currency today lowers (raises) the expected domestic currency return on foreign currency deposits For example, suppose that today s exchange rate is $1.00/e and the expected exchange rate a year from now is $1.05/e With 5% euro interest rate this gives a 5% bonus in terms of dollars If today s exchange rate suddenly jumps up to $1.03/e, then the expected rate of dollar depreciation is $1.05 $1.03 $1.03 = Hence the dollar return on euro deposits has fallen by 3.1 percentage points (5% 1.9%) Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 52 / 126

53 The Foreign Exchange Market Equilibrium in the FX Market Today s $/e Exchange Rate and the Expected Dollar Return on Euro Deposits When E e $/e = $1.05/e Source: Krugman, Obstfeld and Melitz (2012), Table Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 53 / 126

54 The Foreign Exchange Market Equilibrium in the FX Market Current $/e Exchange Rate vs the Expected Dollar Return on Euro Deposits Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 54 / 126

55 The Foreign Exchange Market Equilibrium in the FX Market The Equilibium Exchange Rate Exchange rates always adjust to maintain interest parity Assume that the dollar interest rate (R $ ), the euro interest rate (R e ), and the expected future dollar/euro exchange rate (E e $/e ) are all given The equilibrium exchange rate is given by R $ = R e + Ee $/e E $/e E $/e Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 55 / 126

56 The Foreign Exchange Market Equilibrium in the FX Market Equilibrium $/e Exchange Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 56 / 126

57 The Foreign Exchange Market Interest Rates, Expectations and Equilibrium Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 57 / 126

58 The Foreign Exchange Market Interest Rates, Expectations and Equilibrium Effect of a Rise in the Dollar Interest Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 58 / 126

59 The Foreign Exchange Market Interest Rates, Expectations and Equilibrium Effect of a Rise in the Euro Interest Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 59 / 126

60 The Foreign Exchange Market Interest Rates, Expectations and Equilibrium The Effect of Changing Interest Rates Ceteris paribus, an increase in the interest paid on deposits of a currency causes that currency to appreciate against foreign currencies The assumption of a constant expected future exchange rate is unrealistic Hence in reality we cannot predict how a given interest rate change will alter exchange rates unless we know why the interest rate is changing Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 60 / 126

61 The Foreign Exchange Market Interest Rates, Expectations and Equilibrium The Effect of Changing Expectations Ceteris paribus, a rise in the expected future exchange rate causes a rise in the current exchange rate Similarly, a fall in the expected future exchange rate causes a fall in the current exchange rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 61 / 126

62 The Foreign Exchange Market Case Study: Carry Trade Outline 1 Determinants of Asset Demand 2 The Money Market Money Demand A Model of the Money Market 3 The Bond Market Supply and Demand in the Bond Market Changes in Equilibrium Interest Rates 4 The Foreign Exchange Market The Demand for Foreign Currency Assets Equilibrium in the FX Market Interest Rates, Expectations and Equilibrium Case Study: Carry Trade Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 62 / 126

63 The Foreign Exchange Market Case Study: Carry Trade What is the Carry Trade Over much of the 2000s, Japanese yen interest rates were close to zero, while Australian interest rates were clearly positive What not borrow yen and invest the proceeds in AUD? According to interest parity, such a strategy should not be systematically profitable: the yen should appreciate Carry trade: investors borrow low-interest currencies (funding currencies) and buy high-interest currencies (investment currencies) Interest parity never holds exactly in practice (risk and liquidity factors, among others), but there is still a debate about explanations on carry trade Research suggests that investment currencies are subject to abrupt crashes and funding currencies to abrupt appreciations Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 63 / 126

64 The Foreign Exchange Market Case Study: Carry Trade Cumulative Total Investment Return in AUD Compared to, Source: Krugman, Obstfeld and Melitz (2012), Figure Exchange rates and three-month treasury yields from Global Financial Data. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 64 / 126

65 Part II Money, Interest and Exchange Rates Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 65 / 126

66 The Money Supply and the Exchange Rate in the Short Run Outline 5 The Money Supply and the Exchange Rate in the Short Run 6 Money, the Price Level and the Exchange Rate in the Long Run Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 66 / 126

67 The Money Supply and the Exchange Rate in the Short Run Introduction We take the price level (and output) as given = short-run analysis We know that in the short run, an increase (fall) in the money supply (M s ) lowers (raises) the interest rate We will show that an increase (reduction) in a country s money supply causes its currency to depreciate (appreciate) in the FX market Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 67 / 126

68 The Money Supply and the Exchange Rate in the Short Run Linking Money, Interest Rate and Exchange Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 68 / 126

69 The Money Supply and the Exchange Rate in the Short Run Money Market/Exchange Rate Linkages Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 69 / 126

70 The Money Supply and the Exchange Rate in the Short Run US Money Supply and the $/e Exchange Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 70 / 126

71 The Money Supply and the Exchange Rate in the Short Run Euro Money Supply and the $/e Exchange Rate Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 71 / 126

72 The Money Supply and the Exchange Rate in the Short Run US Money Supply and the $/e Exchange Rate How does the $/e exchange rate change when the Federal Reserve changes the US money supply? An increase in a country s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate A decrease in a country s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate How would a change in the supply of euros affect the US money market and foreign exchange markets? An increase in the supply of euros causes a depreciation of the euro (an appreciation of the dollar) A decrease in the supply of euros causes an appreciation of the euro (a depreciation of the dollar) Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 72 / 126

73 Money, the Price Level and the Exchange Rate in the Long Run Outline 5 The Money Supply and the Exchange Rate in the Short Run 6 Money, the Price Level and the Exchange Rate in the Long Run Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 73 / 126

74 Money, the Price Level and the Exchange Rate in the Long Run Short vs Long Run So far we have assumed that price levels and exchange rate expectations were given = short run view An economy s long-run equilibrium is the position it would eventually reach if no new economic shocks occurred during the adjustment to full employment It is the equilibrium that would be maintained after all wages and prices had had enough time to adjust to their market-clearing level In the long run, ceteris paribus, an increase in a country s money supply causes a proportional increase in its price level Long-run neutrality of money: a change in the money supply has no effect on the long-run values of the interest rate or real output Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 74 / 126

75 Money, the Price Level and the Exchange Rate in the Long Run Average Money Growth and Inflation in Western Hemisphere Developing Countries, Source: Krugman, Obstfeld and Melitz (2012), Figure The data is from IMF, World Economic Outlook, and various issues. Regional aggregates are weighted by shares of dollar GDP in total regional dollar GDP. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 75 / 126

76 Money, the Price Level and the Exchange Rate in the Long Run Short-Run and Long-Run Effects of an Increase in the US Money Supply Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 76 / 126

77 Money, the Price Level and the Exchange Rate in the Long Run Time Paths of US Economic Variables After a Permanent Increase in the US Money Supply Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 77 / 126

78 Money, the Price Level and the Exchange Rate in the Long Run Permanent Money Supply Changes and the Exchange Rate A permanent increase in a country s money supply causes a proportional long-run depreciation of its currency However, the dynamics of the model predict a large depreciation first and a smaller subsequent appreciation A permanent decrease in a country s money supply causes a proportional long-run appreciation of its currency However, the dynamics of the model predict a large appreciation first and a smaller subsequent depreciation Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 78 / 126

79 Money, the Price Level and the Exchange Rate in the Long Run Exchange Rate Overshooting The exchange rate is said to overshoot when its immediate response to a change is greater than its long-run response Overshooting helps explain why exchange rates are so volatile Overshooting is predicted to occur when monetary policy has an immediate effect on interest rates, but not on prices and (expected) inflation Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 79 / 126

80 Part III Price Levels and the Exchange Rate in the Long Run Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 80 / 126

81 The Law of One Price Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 81 / 126

82 The Law of One Price Definition of the Law of One Price Law of One Price (LOP): in competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency For example, if the $/e exchange rate is $1.20/e, a bottle of Portuguese wine that sells for e 1,000 in Lisbon must sell for $1,200 in New York If the exchange rate were $1.30/e, the dollar price of the wine in New York would be $1,300, a hundred dollar more than in Lisbon = wine would be shipped from Lisbon to New York until the price adjusts Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 82 / 126

83 The Law of One Price Formal Definition For any good i, Dollar price of good i = Euro price of good i Dollar per euro Formally, P i US = Pi EU E $/e or E $/e = Pi US P i EU Application: the Big Mac Index Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 83 / 126

84 Purchasing Power Parity Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 84 / 126

85 Purchasing Power Parity Definition of PPP Purchasing power parity (PPP): one dollar will buy the same basket of goods and services anywhere in the world, i.e., Dollar price of basket in the US = Dollar price of basket in the EU Rearranging yields Dollar price of basket in the US Dollar price of basket in the EU = 1 We can rewrite this as Dollar price of basket in the US Euro price of basket in the EU Dollar per euro = 1 Therefore, Dollar price of basket in the US Euro price of basket in the EU = Dollar per euro Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 85 / 126

86 Purchasing Power Parity Formal Definition and Implications Formally, E $/e = P US P EU where P US and P EU refer to the same basket of goods in the US and Europe The PPP theory predicts that a fall (increase) in a currency s domestic purchasing power (i.e., higher (lower) domestic price level) will be associated with a proportional currency depreciation (appreciation) While the LOP applies to individual commodities, PPP applies to the general price level If LOP holds for every commodity = PPP must hold However, the validity of PPP does not require the LOP to hold exactly Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 86 / 126

87 Purchasing Power Parity Absolute and Relative PPP (1) Relative PPP: the percentage change in the exchange rate between two currencies over any period equals the difference between the percentage changes in national price levels Relative PPP translates absolute PPP from a statement about levels into one about changes If the US price level rises by 10% over a year while Europe s rises by 5%, relative PPP predicts a 5% depreciation of the dollar against the euro Formally, E $/e,t E $/e,t 1 = π US,t π EU,t E $/e,t 1 where is the inflation rate π t = P t P t 1 P t 1 Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 87 / 126

88 Purchasing Power Parity Absolute and Relative PPP (2) Relative PPP can only be defined with respect to the time interval over which price levels and the exchange rate changes Relative PPP is also computationally easier due to the difficulties of computing price level indices Relative PPP may be valid even when absolute PPP is not Provided the factors causing deviations from absolute PPP are more or less stable over time, percentage changes in relative price levels can still approximate percentage changes in exchange rates Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 88 / 126

89 The Fisher Effect Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 89 / 126

90 The Fisher Effect Monetary Approach to the Exchange Rate Monetary approach to the exchange rate: factors that do not influence money supply or demand play no explicit role It is a long-run approach as it does not allow for price rigidities = prices adjust immediately to maintain full employment and PPP PPP states that E $/e = P US /P EU Prices are determined in the money markets as P US = M s US L (R $, Y US ) and P EU = M s EU L (R e, Y EU ) Hence, the exchange rate is fully determined in the long run by the relative supplies of monies and the relative real demands for them Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 90 / 126

91 The Fisher Effect Predictions of the Monetary Approach 1 Money supplies An increase in the US money supply causes a proportional long-run depreciation of the dollar against the euro 2 Interest rates A rise in the US interest rate lowers the real US money demand, so the long-run US price level rises, and the dollar must depreciate in proportion to the price level increase 3 Output levels A rise in US output raises real US money demand, so the long-run US price level falls, leading to an appreciation of the dollar Prediction 2 has the opposite conclusion we have seen earlier Recall that what matters is exactly why interest rates have changed Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 91 / 126

92 The Fisher Effect Ongoing Inflation and Interest Rates Central banks typically choose a growth rate for the money supply, and then allow money to grow smoothly Ceteris paribus, money supply growth at a constant rate eventually results in ongoing inflation at the same rate, with no effect on the (full-employment) output level or on the long-run relative prices While the long-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate If P e is expected price level in a country for a year from today, the expected inflation rate π e is π e = (P e P) /P If relative PPP holds, investors will also expect relative PPP to hold, yielding E e $/e E $/e = πus e πe EU E $/e Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 92 / 126

93 The Fisher Effect The Fisher Effect Combine this with the interest parity condition We obtain that R $ = R e + Ee $/e E $/e E $/e R $ R e = π e US πe EU Fisher effect: ceteris paribus, a rise (fall) in a country s expected inflation rate will eventually cause an equal rise (fall) in the interest rate that deposits of its currency offer It also implies that the real rate of return on the country s assets remains unchanged Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 93 / 126

94 The Fisher Effect Solving the Paradox In the long-run equilibrium (monetary approach), a rise in the difference between home and foreign interest rates occurs only when expected home inflation rises relative to expected foreign inflation Short-run approach: the interest rate can rise when the domestic money supply falls due to sticky prices In the monetary approach the price level would fall right away, leaving the real money supply unchanged and thus making the interest rate change unnecessary Suppose that the Fed unexpectedly increases the growth rate of the money supply at time t 0 from π to π + π Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 94 / 126

95 The Fisher Effect Long-Run Time Paths of US Economic Variables After a Permanent Increase in the Growth Rate of the US Money Supply Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 95 / 126

96 The Fisher Effect Long-Run Time Paths of US Economic Variables After a Permanent Increase in the Growth Rate of the US Money Supply Source: Krugman, Obstfeld and Melitz (2012), Figure Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 96 / 126

97 The Fisher Effect The Functioning of the Monetary Approach Source: Krugman, Obstfeld and Melitz (2012), Figure 16A.1. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 97 / 126

98 The Fisher Effect Monetary Approach to Exchange Rates Under PPP, acceleration in money supply growth generates expectations of more rapid dollar depreciation in the future Interest parity requires the dollar interest to rise The increase in nominal interest rates decreases the real money demand In order for the money market to maintain equilibrium in the long run, prices must jump so that P US = M s US L (R $, Y US ) In order to maintain PPP, the exchange rate must jump (the dollar must depreciate) so that E $/e = P US /P EU Thereafter, the money supply and prices are predicted to grow at rate π + π and the domestic currency is predicted to depreciate at the same rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 98 / 126

99 The Fisher Effect Long-Run vs Short-Run Approaches The contrasting predictions about how exchange and interest rate interact are explained by the different assumptions about the speed of price level adjustment Sticky prices After a fall in the money supply an interest rate rise is needed to preserve money market equilibrium, given that the price level cannot drop immediately An interest rate rise is associated with lower expected inflation and a long-run appreciation = the currency appreciates immediately Monetary approach A rise in the money supply growth induces an interest rate increase, which is associated with higher expected inflation and a future depreciation = the currency depreciates immediately Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 99 / 126

100 Empirical Evidence on PPP Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 100 / 126

101 Empirical Evidence on PPP Little Empirical Support All versions of the PPP theory do badly in explaining the facts Changes in national price levels often tell us relatively little about exchange rate movements However, PPP is a key building block of more realistic exchange rate models than the monetary approach The empirical failures of PPP give us important clues how more realistic models should be set up Absolute PPP is clearly rejected by the data Relative PPP is sometimes a reasonable approximation to the data, but it, too, usually performs poorly Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 101 / 126

102 Empirical Evidence on PPP PPP, US/UK, (March 1973 = 100) Source: Mishkin (2010), Figure The data source is Bureau of Labor Statistics. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 102 / 126

103 Empirical Evidence on PPP PPP, US/EU, (January 1999 = 100) Source: FRED. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 103 / 126

104 Empirical Evidence on PPP Exchange Rate Movements and Inflation Differentials, Source: Cecchetti and Schoenholtz (2015), Money, Banking, and Financial Markets, McGraw Hill, Figure The data source is the IMF. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 104 / 126

105 Explaining the Failure of PPP Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 105 / 126

106 Explaining the Failure of PPP Main Reasons The law of one price may not hold because of 1 Trade barriers and non-tradable products 2 Imperfect competition 3 Differences in measures of average prices for baskets of goods and services Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 106 / 126

107 Explaining the Failure of PPP Trade Barriers and Non-tradable Products Transport costs and governmental trade restrictions make trade expensive and in some cases create non-tradable goods or services Services are often not tradable: services are generally offered within a limited geographic region (for example, haircuts) The price of a non-tradable is determined entirely by its domestic supply and demand = a rise in the price of a non-tradable will rise the country s price level relative to foreign price levels The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 107 / 126

108 Explaining the Failure of PPP Imperfect Competition Pricing to market: a firm sells the same product for different prices in different markets to maximise profits, based on expectations about what consumers are willing to pay For example, in 2012 a Ford C-Max cost almost e 12,000 more in Portugal than in Spain despite the common currencies and the lack of trade barriers Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 108 / 126

109 Explaining the Failure of PPP Differences in Consumption Patterns and Price Measurement People living in different countries spend their incomes in different ways = government measures of the price level differ from country to country Since relative PPP makes predictions about price changes rather than price levels, it is a sensible concept regardless of the baskets used Change in the relative prices of basket components can cause relative PPP to fail tests that are based on official price indices Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 109 / 126

110 Explaining the Failure of PPP PPP in the Short and the Long Run The explaining factors can cause national price levels to diverge even in the long run, after all prices have had time to adjust to their market-clearing level However, due to sticky prices, departures from PPP may be even greater in the short run than in the long run Short-run price stickiness and exchange rate volatility seem to help explain the fact the violations of relative PPP have been much more flagrant over periods when exchange rates have floated Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 110 / 126

111 Case Study: Why Are Poor Countries Cheaper? Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 111 / 126

112 Case Study: Why Are Poor Countries Cheaper? Price Levels and Real Incomes, 2007 Source: Krugman, Obstfeld and Melitz (2012), Figure The data source is Penn World Table, version 6.3. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 112 / 126

113 Case Study: Why Are Poor Countries Cheaper? The Balassa-Samuelson Effect The labour forces of poor countries are less productive than those of rich countries in the tradables sector, but international productivity differences in non-tradables are negligible If the prices of traded goods are roughly equal in all countries, lower labour productivity in the tradables sectors of poor countries implies lower wages than abroad = lower production costs in non-tradables = lower price of non-tradables Rich counties with higher labour productivity in the tradables sector will tend to have higher non-tradable prices and higher price levels Productivity statistics give some empirical support to the Balassa-Samuelson effect Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 113 / 126

114 The Real Exchange Rate Outline 7 The Law of One Price 8 Purchasing Power Parity 9 The Fisher Effect 10 Empirical Evidence on PPP 11 Explaining the Failure of PPP 12 Case Study: Why Are Poor Countries Cheaper? 13 The Real Exchange Rate Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 114 / 126

115 The Real Exchange Rate Definition Because of the shortcomings of PPP, economists have tried to generalise the monetary approach to PPP to make a better theory Real exchange rate: the rate at which one can exchange the goods and services from one country for the goods and services from another country It is the cost of basket of goods in one country relative to the cost of the same basket of goods in another country Assume that the Starbucks in New York charges $1.95 for an espresso, in Florence it costs e 1.00, and the nominal $/e exchange rate is $1.30 per euro Then, the real coffee exchange rate is Dollar price of espresso in Italy ( e 1.00 $1.30/e ) Dollar price of espresso in the US ( $1.95 ) = 2/3 Hence, one cup of Italian espresso buys 2/3 cups of Starbucks espresso Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 115 / 126

116 The Real Exchange Rate General Formula We can compute the real exchange rates to compare baskets of goods between countries Then the real exchange rate is q $/e = Dollar price of foreign goods Dollar price of domestic goods = E $/e P EU P US If q $/e > 1, then foreign products will seem more expensive The real exchange rate is much more important than the nominal because it tells us where things are cheap and where they are expensive Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 116 / 126

117 The Real Exchange Rate Real Depreciation/Appreciation Real depreciation: the dollar prices of European goods (E $/e P EU ) rise relative to those of US goods (P US ) = America s goods and services become cheaper relative to Europe s A real appreciation of the dollar against the euro is a fall in q $/e It indicates a decrease in the relative price of products purchased in Europe, or a rise in the dollar s European purchasing power compared with that in the US Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 117 / 126

118 The Real Exchange Rate Real Dollar-Euro Exchange Rate, Source: FRED. Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 118 / 126

119 The Real Exchange Rate What Influences the Real Exchange Rate? A change in relative demand for US products An increase in relative demand for US products causes the price of US goods relative to the price of foreign goods to rise Real appreciation of the value of US goods: P US rises relative to E $/e P EU = lower q $/e The real appreciation of the value of US goods makes US exports more expensive and imports less expensive A decrease in relative demand of US products causes a real depreciation of the value of US goods A change in relative supply of US products An increase in relative supply of US products causes the price of US goods relative to the price of foreign goods to fall Real depreciation of the value of US goods: P US falls relative to E $/e P EU = higher q $/e The real depreciation of the value of US goods makes US exports less expensive and imports more expensive A decrease in relative supply of US products causes a real appreciation of the value of US goods Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 119 / 126

120 The Real Exchange Rate Nominal and Real Exchange Rates in the Long-Run Changes in national money supplies and demands give rise to the proportional long-run movements in nominal exchange rates and price level ratios predicted by relative PPP Demand and supply shifts in national output markets cause nominal exchange rate movements that do not conform to PPP Rearranging the definition of the real exchange rate yields E $/e = q $/e P US P EU Comparing this with E $/e = P US /P EU, the former accounts for possible deviations from PPP by adding the real exchange rate as an additional determinant of the nominal exchange rate The theory now includes the valid elements of the monetary approach, but in addition it corrects the monetary approach by allowing for non-monetary factors that can cause sustained deviations from PPP Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 120 / 126

121 The Real Exchange Rate Determinants of Long-Run Nominal Exchange Rates (1) A shift in relative money supply levels A permanent, one-time increase in a country s money supply rises the country s price level and nominal exchange rate in the long run, while leaving the real exchange rate unchanged = consistent with relative PPP A shift in relative money supply growth rates A permanent increase in the growth rate of a country s money supply leads to persistent inflation and a proportional depreciation of the country s currency, leaving q $/e unaffected = consistent with relative PPP A change in relative output demand Since long-run national price levels do not change, the long-run nominal exchange rate will change only insofar as q $/e changes Higher relative demand for domestic products implies a real appreciation = nominal appreciation Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 121 / 126

122 The Real Exchange Rate Determinants of Long-Run Nominal Exchange Rates (2) A change in relative output supply An increase in relative domestic output supply leads to the real depreciation of the country s currency It also raises real money demand, thereby pushing the long-run price level down The net effect on the nominal exchange rate is ambiguous Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 122 / 126

123 The Real Exchange Rate Conclusions When all disturbances are monetary in nature, exchange rates obey relative PPP in the long run in the long run, a monetary disturbance affects only the general purchasing power of a currency and no change in the real exchange rate occurs When disturbances occur in output markets, the exchange rate is unlikely to obey relative PPP, even in the long run the real exchange rate changes Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 123 / 126

124 The Real Exchange Rate Effects of Money Market and Output Market Changes on the Long-Run Nominal $/e Exchange Rate Source: Krugman, Obstfeld and Melitz (2012), Table Sebestyén (ISCTE-IUL) Exchange Rates and Open-Economy Macro International Finance 124 / 126