# Exchange Rates. Costas Arkolakis teaching fellow: Federico Esposito. January Economics 407, Yale

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1 Exchange Rates Costas Arkolakis teaching fellow: Federico Esposito Economics 407, Yale January 2014

2 Outline De nitions: Nominal and Real Exchange Rate A Theory of Determination of the Real Exchange Rate Foreign Exchange Market Price Arbitrage: Purchasing Power Parity Interest Rate Arbitrage: Uncovered and Covered Interest Rate Parity Determination of the Nominal Exchange Rate

3 De nitions: Nominal Exchange Rate (NER) Nominal Exchange Rate is the price of a foreign currency in terms of the home currency E \$/e = =US exchange rate (in US terms, Dollars per Euro) E e/\$ = =Euro exchange rate (in European terms, Euros per Dollar) Thus, E \$/e = 1/E e/\$ An increase in E \$/e means a dollar depreciation. If a currency can buy more (less) of another currency, we say it has been appreciated (depreciated) " E \$/e or E e/\$ # : dollar depreciation, euro appreciation

4 Nominal vs Real Exchange Rates (RER) Real exchange rate is the Nominal Exchange rate times the inverse of the relative price levels Dollar pound real exchange rate e \$/ = E \$/ P UK P US where E \$/ :dollar price of 1 pound, P UK : is the price level in UK, P US price level in US e \$/ : the relative price of a consumption basket in the UK in terms of consumption in US

5 US dollar depreciation vs other Currencies Makes US residents relatively poorer Makes US products cheaper to foreigners Figure: Source: Feenstra and Taylor 2010

6 US dollar depreciation vs other Currencies Makes US residents relatively poorer Makes US products cheaper to foreigners

7 US dollar Depreciation and Appreciation

8 Currency Crisis: Argentinian Peso depreciation Between Jan and Jul 02, Argentine Peso depreciated 70% What does it mean for Argentinians?

9 Headline News: E ects on Argentinians Consequences of the Argentinian devaluation episode Jan 2002, Argentine gov. announced default on \$155 billion in debt. Unrest, political upheaval As of 2006, unemployment rate was still 10%. In ation increased dramatically for 2 years, still remains high. Real GDP in dollars fell dramatically. Figure: Argentine and World Real GDP per capita in \$ (World Bank)

10 Real Exchange Rate Determination

11 Real Exchange Rates Real exchange rates are persistent Figure: Consumer Price Indices (CPI) for UK and US in US dollar terms (log scale). Taylor and Taylor, Journal of Economic Perspectives, 2004.

12 A Theory of Determination of the Real Exchange Rate Objective: A Theory of What Determines RER A Theory of RER is far easier to develop: In general, economic theories work better with real than nominal magnitudes Step 1: Derive a relationship between RER and relative prices Step 2: Derive a relationship between relative prices and economic fundamentals

13 Step 1: RER and Relative Prices De nitions:. P T : price of tradeables, P N : price of non-tradeables, P : overall price level * indicates foreign variable. Assumptions: Law of one price holds for traded goods P T = EP T For nontraded goods, in general, P N 6= EP N

14 Step 1: RER and Relative Prices Assume the price level, P, is a function φ (.,.) of the price of tradables and nontradables, P = φ (P T, P N ), where φ is homogeneous of degree 1 Homogeneous of degree 1: φ (x, y) = λφ (x/λ, y/λ), or λφ (x, y) = φ (λx, λy)

15 The Impact of Non-Tradables in the RER Assume P = φ (P T, P N ) where φ is homogeneous of degree 1 e EP P = E φ (P T, P N ) φ (P T, P N ) = EP T φ P T φ 1, P N P T 1, P N P T Now use Law of one price for tradeables, P T = EPT, e = φ 1, P N PT φ 1, P N P T

16 The Impact of Non-Tradeables in the RER. Law of one price implies e = φ 1, P N PT φ 1, P N P T Therefore, e > 1 if P N PT > P N P., i.e. RER depends on relative prices of T tradeables to non-tradeables Is this true in the data? We will study the academic research on this hypothesis in detail later on The last piece of the theory is to develop a theory of how P N P T determined is

17 The Impact of Non-Tradeables in the RER. Law of one price implies e = φ 1, P N PT φ 1, P N P T Therefore, e > 1 if P N PT > P N P., i.e. RER depends on relative prices of T tradeables to non-tradeables Is this true in the data? We will study the academic research on this hypothesis in detail later on The last piece of the theory is to develop a theory of how P N P T determined The Balassa-Samuelson e ect is

18 Step 2: Relative Prices & Economic Fundamentals (Balassa-Samuelson) A theory with Nontradeables and Tradeables 2 goods, traded: Q T, non-traded: Q N Production functions: Q T = a T L T, Q N = a N L N a i :productivity, L i : labor used, where i = T, N Pro ts in each sector P i Q i wl i, where i = N, T Zero pro t condition: P i Q i = wl i, for i = N, T Using production functions P i a i L i = wl i =) w = P i a i Therefore, P N P T = a T a N

19 The Balassa-Samuelson E ect in the Data

20 Foreign Exchange Market

21 The Market for Foreign Exchange Exchange rates are set minute by minute in the Foreign Exchange (Forex) market Individuals, corporations, public institutions trade currencies An over-the-counter market since it is not an organized exchange market The global currency trade is 3.2 trillion per day, 290% more than in 1992 Major exchange centers: UK, US, Japan

23 Spot Contracts Spot exchange: a contract for immediate exchange of currencies In the rest of the course, we will mostly talk about spot contracts How it works Trader 1 calls Trader 2 and asks for a price of a currency, say GBP The bid price is the exchange rate (ER) at which 2 is willing to buy GBP The ask (or o er) price is the ER at which 2 is willing to sell GBP The di erence (bid-ask spread) generates pro ts for Trader 2

24 Derivatives Derivatives: contracts for which their pricing is derived from the spot rate Forwards, swaps, futures and options. These contrants exist to allow investors to trade currency for delivery at di erent times or with di erent contigencies Forwards: It is a contract where the settlement date for the delivery of the currencies is forward in the future for a set price E.g. the time of the delivery -the maturity- could be 90 days from now, a year from now etc Because the contract has a xed price it carries no risk.

25 Price Arbitrage: Purchasing Power Parity

26 Absolute & Relative Purchasing Power Parity (PPP) Absolute PPP: Real exchange rate is expected to be 1 Absolute Purchasing Power Parity would imply: log (E \$/ P UK ) log (P US ) PPP refers to the price index while law of one price to one good at a time Relative PPP implies that there no expected movements in the Real exchange rate Relative Purchasing Power Parity would imply: d log (E \$/ P UK ) d log (P US )

27 Absolute Purchasing Power Parity Absolute PPP: Real exchange rate is expected to be 1 Absolute Purchasing Power Parity would imply: log (E \$/ P UK ) log (P US ) PPP is based on the law of one price: in the absense of transaction costs, prices should be the same across markets because of arbitrage In the short run, obviously this is not true.

28 Absolute PPP in the Data If all the goods were instantly tradeable, PPP theory should be true! Not true in the short run. Approximately true in the long-run. Figure: Consumer Price Indices (CPI) for UK and US in US dollar terms (log scale). Taylor and Taylor, Journal of Economic Perspectives, 2004.

29 Testing for Relative PPP Postulate that log E t \$/ Pt UK log (P t US ) for some time t. We know that for small periods, it may not hold. Can it hold over large periods of time? Consider the following derivation log E\$/ t n Pt UK n log PUS t log PUS t n =) \$/ n + log PUK t /Pt UK n log P t US /PUS t n =) log (E\$/ t /E \$/ t n {z } ) log (PUS t /Pt US n {z } ) log (PUK t /Pt UK n {z } ) log E\$/ t Pt UK log E\$/ t /E t change in exchange rate Ratio of prices in the US (in ation) Ratio of prices in the UK (in ation) We can now proceed and look at the empirical counterparts

30 Relative PPP in the long-run Taylor and Taylor 04 paper. Testing PPP in the long-run

31 Failure to generate PPP Obviously not all goods are tradeable. Example of non-tradeable goods: haircuts, restaurant meals For many countries, non-tradeable goods are more than 1/2 of GDP.

32 Interest Rate Arbitrage: Covered & Uncovered Interest Parity

33 Interest Rate Parity Interest Rate Parity: Given foreign exchange market equilibrium, the interest rate parity condition implies that the expected return on domestic assets will equal the exchange rate-adjusted expected return on foreign currency assets. Two types of interest rate parity Covered Interest Rate Parity and Uncovered Interest Rate parity

34 Covered Interest Parity Covered interest rate parity: no arbitrage condition that states that the interest rate di erential is covered with the use of a forward contract: 1 + i t = (1 + r ) {z } F t : Forward exchange rate at time t F t E t foreign bonds return This interest rate di erential is called covered because the use of the forward exchange rate covers the investor against exchange rate risk. It is expected to hold approximately when capital markets are perfect.

35 Covered Interest Parity in the Data Figure: Domestic Interbank minus Eurocurrency 3-month interest rates

36 More Evidence on Covered Interest Parity Figure: Deviations from Covered Interest Parity over time (Source: Courtesy of Lorenzo Caliendo)

37 Uncovered Interest Parity Uncovered interest rate parity: a no-arbitrage condition that states that the interest rate di erential equals to the expected change of the interest rate (e.g. due to expected in ation in one country) 1 + i t = (1 + r Et+1 e ) {z } E t foreign bonds return Et+1 e : expected nominal exchange rate at time t + 1. In the absense of uncertainty we have Et+1 e = E t+1: 1 + i t {z } gross return of domestic bond = (1 + r ) E t+1 E t {z } return of foreign bonds in domestic currency Limited evidence to support the validity of this assumption: hard to measure E e t+1

38 Uncovered Interest Parity Uncovered interest rate parity: a no-arbitrage condition that states that the interest rate di erential equals to the expected change of the interest rate (e.g. due to expected in ation in one country) 1 + i t = (1 + r Et+1 e ) {z } E t foreign bonds return Et+1 e : expected nominal exchange rate at time t + 1. In the absense of uncertainty we have Et+1 e = E t+1: 1 + i t {z } gross return of domestic bond = (1 + r ) E t+1 E t {z } return of foreign bonds in domestic currency Limited evidence to support the validity of this assumption: hard to measure E e t+1 Still a great theoretical device for rational expectation models!

39 Uncovered Interest Parity Uncovered interest rate parity: a no-arbitrage condition that states that the interest rate di erential equals to the expected change of the interest rate (e.g. due to expected in ation in one country) 1 + i t = (1 + r Et+1 e ) {z } E t foreign bonds return Et+1 e : expected nominal exchange rate at time t + 1. In the absense of uncertainty we have Et+1 e = E t+1: 1 + i t {z } gross return of domestic bond = (1 + r ) E t+1 E t {z } return of foreign bonds in domestic currency Limited evidence to support the validity of this assumption: hard to measure E e t+1 Still a great theoretical device for rational expectation models! Of course if capital markets are perfect and expectations are correct F t = E e t+1

40 Nominal Exchange Rate Determination

41 The Money Demand Assume a money demand of the form M t P t = L ( C, i t ) M t denotes money P t denotes price level C denotes consumption i t denotes nominal interest rate L (.,.) is liquidity preference increasing in C, decreasing in i

42 Money Demand No barriers to international trade PPP implies that P t = E t P t. Normalize one price (Warlas law) P t = 1. Combining PPP with money demand, we have M t P t = M t E t = L ( C, i t )

43 Government Budget Constraint Govenrment has three sources of income tax revenues, P t T t, money creation, M t M t 1, interest from foreign bonds E t r B g t 1 Spending on new bonds E t Bt g B g t 1, government expenditure, P t G t E t Bt g B g t 1 + P t G t = P t T t + (M t M t 1 ) + E t r B g t 1 {z } change in bond holdings

44 Government Budget Constraint Govenrment has three sources of income tax revenues, P t T t, money creation, M t M t 1, interest from foreign bonds E t r B g t 1 Spending on new bonds E t Bt g B g t 1, government expenditure, P t G t E t Bt g B g t 1 + P t G t = P t T t + (M t M t 1 ) + E t r B g t 1 {z } change in bond holdings Dividing by P t = E t, B g t B g t 1 = M t M t 1 P t {z } seignorage revenue Gt T t r B g t 1 {z } real secondary de cit

45 Government Budget Constraint Govenrment has three sources of income tax revenues, P t T t, money creation, M t M t 1, interest from foreign bonds E t r B g t 1 Spending on new bonds E t Bt g B g t 1, government expenditure, P t G t E t Bt g B g t 1 + P t G t = P t T t + (M t M t 1 ) + E t r B g t 1 {z } change in bond holdings Dividing by P t = E t, B g t B g t 1 = M t M t 1 P t {z } seignorage revenue Gt T t r B g t 1 {z } real secondary de cit Fiscal de cit must be accompanied by money creation or decline in assets.

46 Fixed Exchange Rate Regime Fixed exchange regime: the government intervenes in the foreign exchange market in order to keep the exchange rate at a xed level Government intervenes so that E t = E Given E, PPP implies that P t = E. Also, PPP and uncovered interest rate parity imply i t = r. Money demand is thus xed, EL ( C, r ) = M t /P t = M t /E Equilibrium in the money market, implies M t = EL ( C, r ) = M t money demand is xed E ectively, seignorage revenue is lost Bt g B g t 1 = G t T t r B g t 1 {z } real secondary de cit 1, i.e.

47 Floating Exchange Rate Regime Floating Exchange Rate: the government lets the nominal exchange rate be determined in the foreign exchange market. In this case, the model implies (under conditions) that E t+1 E t = P t+1 P t As we have seen there is a strong connection between the exchange rate and the growth of prices

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