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Dubai

International Finance And Financial Institutions-03

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Published in: Economics | Finance
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Relationship between the Exchange Rate and Other Macroeconomic Variables

Namal I / Dubai

10 years of teaching experience

Qualification: BA(Economics)Special (Hons)(2nd Class). MA(Economics), MA(Financial Economics),M.Econ, MBA, PGD in Information Technology, MIT-Master of Information Technology, NVQ Level 4: Diploma in Computer Networking.

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  1. International Finance and Financial Institutions Relationship between the Exchange Rate and Other Macroeconomic Variables - Ill
  2. Readings Shapiro Chapter 4: International Finance and Currency: Parity Conditions Eun and Resnick Chapter 5: International Parity Relationships and Forecasting Foreign Exchange Rates Online Version
  3. Theory of Purchasing Power Parity Law of One Price is the starting point for understanding how exchange rates are determined — Long term determination — Short term determination Theory of purchasing power parity (PPP) is one of the most prominent theories of how exchange rates are determined — The idea behind PPP evolved from the law of one price (idea that arbitrage will ensure that the same good sold both at home and abroad will have the same price when that price is expressed in a common currency) 3
  4. Theory of Purchasing Power Parity Significance of PPP — wieldy used by central banks as a guide to establish new par values for their currencies when the old ones are in disequilibrium — used to forecast exchange rates and in business decisions — explains long term determination of exchanges rates Ref: Ben Craig, 'The Growing Significance of Purchasing Power Parity' https://vvm.'w.clevelandfed.org/en/newsroom-and-events/publications/economic-commentarv/economic- commentary-archives/2005-economic-commentaries/ec-20050401-the-growing-significance-of-purchasing- power-parity.aspx
  5. • Theory of Purchasing Power Parity Purchasing Power Parity (PPP): — Exchange rates between any two currencies will adjust to reflect changes in the price levels of the two countries Definition: Purchasing Power Parity (PPP) states that the currency of two countries are in equilibrium when the purchasing power in both the countries are- same. To put in another way, the expenditure 'incurred in purchasing an item in two different countries must be the same Online Version
  6. Theory of Purchasing Power Parity • Purchasing Power Parity (PPP): — An application of the law of one price to national price levels rather than to individual prices • If the yen price of Japanese steel rises 10% (to 11,000 yen) relative to the dollar price of US steel (unchanged at $100), for the law of one price to hold, the exchange rate must rise to 110 yen to the dollar, a 10% appreciation of the dollar Online Version
  7. Theory of Purchasing Power Parity PPP — Absolute Version — indicates that price levels should be equal worldwide when expressed in a common currency — a unit of domestic currency should have the same purchasing power around the world — ignores the effects on free trade of transportation costs, tariffs, quotas, other restrictions and product differentiation Online Version
  8. Theory of Purchasing Power Parity PPP — Absolute Version: Big Mac Index — published by 'The Economist' as an informal way of measuring PPP between two currencies — uses the Law of One Price (prices of the same goods measured in a common currency should be equal in different countries) — based on the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services Online Version
  9. Theory of Purchasing Power Parity PPP — Absolute Version: Big Mac Index — The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency) or xamp e, a lg c on anua ough by its U.S. price cf $4.20 implies a PPP exchange rate of RS2.45/$ : R$10.25 = R$2.45/$ The actual exchange rate on that date was R$l .81. By this measure, the real was 35% overvalued on January Il, 2012: RS245 81 = 35% RS1.81 Online Version 9
  10. Theory of Purchasing Power Parity PPP — Absolute Version: Big Mac Index The hamburger Sta douar. % .50 -5 against douM. % states Chi 3.06 2.39 ppm 3.93 r, 07 m 07 1.05 t' ø_ts 1.31 guLga,ia Rep Leba non Serbla n XiAE 2124 139 11.7 a 85 2405 s. 66 2.18 Online Version 10
  11. Theory of Purchasing Power Parity PPP — Absolute Version: Big Mac Index — Can be used to calculate over/undervaluation of the exchange rates — PPP value can be compared with the actual exchange rate • if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second • if it is higher, then the first currency is over-valued Online Version The Big Mac index Lxal currency under-liver-valuation against S, Jarwary 2020 %urces 'atastrea•" Eunastat 20 0 US "Jar •base currerxy .20 Eum Chikn https://www.economist.com/news/2020/01/15/the-big-mac-index 11
  12. Reading Indicators Big Mac Index and Exchange Rate in Sri Lanka The Sri Lankan rupee is 44% undervalued against the US dollar January 2020 Undervalued Ovexalued US dollar A Big Mac costs 580 rupees in Sri Lanka and USS5.67 in the United States. The implied exchange rate is 102.29. The difference between this and the actual exchange rate, 181.45, suggests the Sri Lankan rupee is 436% undervalued Online Version The Sri Lankan rupee is undervalued against the US dollar January 2021 US dollar Croatian kuna A Big Mac costs rupees in Sri Lanka and usS566 in the United states. The implied exchange rate is 123.67. The difference between this and the actual exchange rate, 189.00, suggests the Sri Lankan rupee is 34.6% undervalued 12
  13. Theory of Purchasing Power Parity PPP — Relative Version — Exchange rate between the domestic currency and any foreign currency will adjust to reflect changes in the price levels between two countries — Example: • If inflation in USA is 3% and 2% in UK, then the dollar value of the UK sterling must rise by 1% to equalize the dollar price of goods in the two countries Online Version 13
  14. Theory of Purchasing Power Parity PPP — Relative Version (1 + ih)t (1 + if)t ih and if are period price increases for home country and foreign country; eo is the domestic currency value of one unit of foreign currency at the beginning of the period; et is the spot exchange rate in period t PPP rate equals to et Online Version (1 + ih)t (1 -F if)t 14
  15. PPP — Relative Version — General approximation el — eo — Exchange rate change during a period should equal the inflation differential for that same period — Currencies with high rates of inflation should depreciate relative to currencies with lower rates of inflation Online Version Theory of Purchasing Power Parity — —if -2 Percentage change in home currency value ot foreign 5 4 3 2 —5 Parity line Inflation differential, home country relative to foreign country (%) 15
  16. Theory of Purchasing Power Parity PPP — Relative Version — PPP predicts a relationship between changes in prices and changes in exchange rates, rather than a relationship between their levels — PPP is the best predictor for future spot rate — PPP suggests nominal exchange rate is less meaningful in decision making Online Version 16
  17. Purchasing Power Parity and Real Exchange Rate PPP is the real exchange rate • Real exchange rate: price of domestic goods relative to the price of foreign goods denominated in the domestic currency Pfis foreign price level and Phis domestic price level both are indexed to 100 Alternatively, Online Version (1 + ih)t 17
  18. Theory of Purchasing Power Parity Implications — Real exchange rate indicates whether a currency is relatively cheap or not — PPP predicts that real exchange rate is always equal to 1.0 (purchasing power of the dollar is the same as that of other currencies) — If change in nominal exchange rate is fully offset by changes in the relative price levels between two countries, then the real exchange rate remains unchanged — Deviations from PPP leads to real exchange gains and losses Online Version 18
  19. Expected Inflation and Exchange Rate Changes • An increase in a currency's expected rate of inflation, (all other things being equal), makes that currency more expensive to hold over time — value is being eroded at a faster rate — less in demand at the same price • Consequently, the value of higher-inflation currencies will tend to be depressed relative to the value of lower-inflation currencies (other things being equal) Online Version 19
  20. Monetary Approach of PPP PPP has been reformulated into the monetary approach to exchange rate determination based on the quantity theory of money Growth rates to give the determinants of domestic inflation Online Version Combining equations along with PPP leads to predicted exchange rate change: — if = (l_Lh — — (gyh — gyf) + (gvh — gvf) 20
  21. Theory of Purchasing Power Parity PPP suggests that if one country's price level rises relative to another's, its currency should depreciate (and the other country's currency should appreciate) 2M (cpWcpvus) FIGURE 2 Purchasü'PowerParRyUnitedStatø/lJnitedKingdom, 1973-2014(IndexMarch 1973 = In.) in British relative I.-_S "ice lwel is with a riq in the af —ted PPP PPP Mt shone: Online Version Evidence for PPP in the Long Run Relationship betvæen the rate of dep•eciation against the US. dollar and the inflation differential against the US over the long run. for a sample Of 82 countries. The correlation between the two variables is strong and bears a close resemblance to the prediction of PPP. 21
  22. Theory of Purchasing Power Parity . Concerns: • Law of one price does not hold for all goods PPP theory does not consider many goods and services (whose prices are included in a measure of a country's price level) traded across borders PURCHASING POWER PARITY EMPIRICAL DATA, 1993-2006 PPP holds up well in the long run, but not as well over shorter time periods Online Version 22
  23. Empirical Evidence of Purchasing Power Parity Mixed Evidence — Hoque (AAE, 1995); Holmes (JM, 2001) - evidence against purchasing power parity for most less developed countries — Salehizadeh and Taylor (JIFIM, 1999) - relatively strong evidence for emerging countries in favor of the long-term applicability of PPP — Huang and Yang (IREF, 2015) - mean-reverting in real exchange rates in euro area is much weaker in the post- 1998 euro period — Kargbo (AEL, 2009) - support for PPP, thereby making it a useful guide for exchange rate policy reforms Online Version 23
  24. Next... The Fisher Effect Online Version Thank You 24

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