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EXCHANGE
RATE
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by Valentino Piana (2001) |
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The exchange rate expresses the national currency's quotation in respect to foreign ones. For example, if one US dollar is worth 10 000 Japanese Yen, then the exchange rate of dollar is 10 000 Yen. If something costs 30 000 Yen, it automatically costs 3 US dollars as a matter of accountancy. Going on with fictious numbers, a Japan GDP of 8 million Yen would then be worth 800 Dollars. Thus, the exchange rate is a conversion factor, a multiplier or a ratio, depending on the direction of conversion. In a slightly different perspective, the exchange rate is a price. If the exchange rate can freely move, the exchange rate may turn out to be the fastest moving price in the economy, bringing together all the foreign goods with it. It is customary to distinguish nominal exchange rates from real exchange rates. Nominal exchange rates are established on currency financial markets called "forex markets", which are similar to stock exchange markets. Rates are usually established in continous quotation, with newspaper reporting daily quotation (as average or finishing quotation in the trade day on a specific market). Central bank may also fix the nominal exchange rate. Real exchange rates are nominal rate corrected somehow by inflation measures. For instance, if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the nominal exchange rate took place, then country A has now a currency whose real value is 10%-5%=5% higher than before [1]. In fact, higher prices mean an appreciation of the real exchange rate, other things equal. Another classification of exchange rates is based on the number of currencies taken into account. Bilateral exchange rates clearly relate to two countries' currencies. They are usually the results of matching of demand and supply on financial markets or in banking transaction (usually with central bank as a one side of the relationship). Other bilateral exchange rates may be simply computed from triangular relationships: if the exchange rate dollar/yen is 10 000 and the dollar/Angolan kwanza is 100 000 then, as a matter of computation, one yen is worth 10 kwanza. No direct yen/kwanza transaction needs to take place. If, instead, there exist a financial market for yen to be exchanged with kwanza, the expectation is that actions by speculators (arbitrage among markets) will bring the parity of 10 kwanza per yen as an effect. Multilateral exchange rates are computed in order to judge the general dynamics of a country's currency toward the rest of the world. One takes a basket of different currencies, select a (more or less) meaningful set of relative weights, then computes the "effective" exchange rate of that country's currency. For instance, having a basket made up of 40% US dollars and 60% German marks, a currency that suffered from a value loss of 10% in respect to dollar and 40% to mark will be said having faced an "effective" loss of 10%x0.6 + 40%x0.4 = 22%. Some countries impose the existence of more than one exchange rate, depending on the type and the subjects of the transaction. Multiple exchange rates then exist, usually referring to commercial vs. public transactions or consumption and investment imports. This situation requires always some degree of capital controls. In many countries, beside the official exchange rate, the black market offers foreign currency at another, usually much higher, rate. When the exchange rate can freely move, assuming any value that private demand and supply jointly establish, "freely floating exchange rate" will be the name of currency institutional regime. Equivalently, it is called "flexible" exchange rate as well. If the central bank timely and significantly intervenes on the currency market, a "managed floating exchange rate regime" takes place. The central bank intervention can have an explicit target, for example in term of a band of currency acceptable values. In "freely" and "managed" floating regimes, a loss in currency value is conventionally called a "depreciation", whereas an increase of currency's international value will be called "appreciation". If the dollar rise from 10 000 yen to 12 000 yen, then it has shown an appreciation of 20%. Symmetrically, the yen has undergone a 8.3% depreciation. But central banks can also declare a fixed exchange rate, offering to supply or buy any quantity of domestic or foreign currencies at that rate. In this case, one talks of a "fixed exchage rate". Under this regime, a loss of value, usually forced by market or a purposeful policy action, is called a "devaluation", whereas an increase of international value is a "revaluation". The most stabile fixed exchange regimes are backed by an international agreement on respective currency values, often with a formal obligation of loans among central banks in case of necessity. A "currency crisis" is a rupture of fixed exchange rates with an unwilling devaluation or even the end of that regime in favour of a floating exchange rate. An extreme national engagement to fixed exchange rates is the transformation of the central bank in a mere "currency board" with no autonomous influence on monetary stock. The bank will automatically print or lend money depending on corresponding foreign currency reserves. Thus, exports, imports and capital inflows (e.g. FDI) will largely determine the monetary policy. Determinants
of the nominal exchange Fixed exchange rates are chosen by central banks and they may turn out to be more or less accepted by financial markets. Changes in floating rates or pressures on fixed rates will derive, as for other financial assets, from three broad categories of determinants: i) variables on
the "real" side of the economy; Let's see them separately for the case of the exchange rate. Real variables 1. Exports, imports and their difference (the trade balance) influence the demand of currency aimed at real transactions. A rising trade surplus will increase the demand for country's currency by foreigners, so that there should be a pressure for appreciation. A trade deficit should weaken the currency. Were exports and imports largely determined by price competitiveness and were the exchange rate very reacting to trade unbalances, then any deficit would imply a depreciation, followed by booming exports and falling imports. Thus, the initial deficit would be quickly reversed. Trade balance saldo would almost always be zero. This is hardly the case in contemporary world economy. Trade unbalances are quite persistent, as you can verify with these real world data. Additionally, not so seldom, exchange rates go in the opposite direction than one would infer from trade balance only. 2. An even more radical form of real determination of exchange rate is offered by the "one price law", according to which any good has the same price worldwide, after taken into account nominal exchange rates. If a hamburger costs 3 US dollars in the United States and 30 000 yen in Japan, then the exchange rate must be 10 000 yen per dollar. The forex market would passively adjust to permit the functioning of the "one price law". But in order to equalize the price of several goods, more than one exchange rate may turn out to be "necessary". Moreover the "one price law" seems to suffer from too many exceptions to be accepted as the fundamental determinant of exchange rates. Large, persistent and systematic violations of Purchasing Power Parity are connected to price-to-market decisions of firms in this paper of September 2007. Monetary and financial variables in cross-linked markets 1. Interest rates on Treasury bonds should influence the decision of foreigners to purchase currency in order to buy them. In this case, higher interest rates attracts capital from abroad and the currency should appreciate. Decisive would be the difference between domestic and foreign interest rates, thus a reduction in interest rates abroad would have the same effects. Similarly other fixed-interest financial instruments could be object of the same dynamics. Accordingly, an increase of domestic interest rates by the central bank is usually consider a way to "defend" the currency. Nonetheless, it may happen that foregners rather buy shares instead of Treasury bonds. If this were the strongest component of currency demand, then an increase of interest rate may even provoke the opposite results, since an increase of interest rate quite often depresses the stock market, favouring a tide of share sales by foreigners. In the same "inversal" direction might foreign direct investments work. A restrictive monetary policy usually depresses the growth perspective of the economy. If FDI are mainly attracted by sales perspectives and they constitute a large component of capital flows, then FDI inflow might stop and the currency weaken. Needless to say, those conditions are quite restrictive and not so usually met. As a temporary conclusion, interest rates should have an important impact on exchange rate but one has to be careful to check additional conditions. 2. Inflation rate is often considered as a determinant of the exchange rate as well. A high inflation should be accompanied by depreciation. The more so if other countries enjoy lower inflation rates, since it should be the difference between domestic and foreing inflation rates to determine the direction and the scale of exchange rate movements. All this would be implied by a weak version of "one price law" stating that price dinamics of a good are the same worldwide, after taking into account nominal exchange rates. Thus, here the absolute level is not requested to be equalized but just the percentage differences in price. If an hamburger costs in Japan 5% more than a year ago, while in USA it costs 8% more, then the dollar should have been depreciated this year by about 8-5=3%. But in order to equalize the price dynamics of different goods, more than one exchange rate change may turn out to be "necessary". In reference to the overall price level of the economy, if exchange rates would move exactly counterbalancing inflation dynamics, then real exchange rates should be constant. On the contrary, this is not true as a strict universal rule. Still, even if this weak version of the "law" does not always hold, high inflation usually give rise to depreciation, whose exact dimension need not match the inflation itself or its difference with foreign inflation rates. 3. The balance of payments can highlight pressures for devaluation or revaluation, reflected in large and systematic trend of foreing currency reserves at the central bank. Autonomous dynamics on the forex market Past and expected values of the exchange rate itself may impact on current values of it. The activities of forex specialists and investors may turn out to be extremely relevant to the detemination of market exchange rate also thanks to their complex interaction with central banks. Sophisticated financial instruments like futures on exchange rates may play an important role. Imitation and positive feedbacks give rise to herd behaviour and financial fashions. For a full-text free book on artificial forex market based on empirical field research see here. Levels and fluctuations in the exchange rate exert a powerful impact on exports, imports and the trade balance. A high and rising exchange rate tends to depress exports, to boost import and to deteriorate the trade balance, as far as these variables respond to price stimuli. Consumers find foreign goods cheaper so the consumption composition will change. Similarly, firms will reduce their costs by purchasing intermediate goods abroad. A devaluation or depreciation should work in the opposite direction, improving the trade balance thanks to soaring exports and falling imports. If, however, imports have an elasticity to price less than 1, their values in local currency will grow instead of falling. Hosting different industries, regions usually exhibit a differenciated degree of international openness: exchange rate fluctuations will have a uneven impact on them. Similarly, the number of job places and the working conditions may be influenced by the degree of international competition and exchange rates levels. Exchange rate influences also the external purchasing power of residents abroad, for example in term of real estate purchasing. Exchange rate devaluation or depreciation give rise to inflationary pressures: imported good become more expensive both to the direct consumer and to domestic producer using them for further processing. Symmetrically, the central bank may use a fixed exchange rate as a nominal anchor for the economy, compelling domestic producer to face tougher competition as soon as they decide to increase prices. Some geographical monetary areas have enjoyed long periods of stable exchange rate, with moments of consensual realignment after divergence in inflation rates. Many countries strive to keep their currency at a fixed level toward the dollar, the Euro (earlier the German mark) or a basket with multiple currencies. Still, most currency progressively devaluate, especially those issued by periphery countries. US dollar have extremely wide fluctuations with years of "weak" and "strong" dollar. Too many elements are at work for the exchange rate possessing a clearly-defined business cycle behaviour. To the extent that the exchange rate is determined by the trade balance, the exchange rate is counter-cyclical as the latter. At peaks, the trade deficit would depress the exchange rate, forcing it to depreciate. If it is rather the interest rate that turns out to the main driver of the exchange rate, a possible pro-cyclicity of the interest rate would imply a pro-cyclical exchange rate. In this scenario, recovery and boom are accompanied by rising interest rates and exchange rates. At peaks, we would see very strong currency. Together with domestic demand pressures, this would be the source of a high trade deficit. If autonomous dynamics in the forex market are the main determinants of the exchange rate, then intense micro-fluctuations and long term tides would ride the exchange rate, possibly with central bank significant interventions. Exchange rates for 200 currencies, spanning across more than 20 years Inflation rates for 170 countries (1970-1996) Total exports, imports, trade balances for 181 countries - a time-series - Absolute values, shares in world market, rankings Bilateral
imports and exports among 186 countries (a time series of 52 years) Monthly data for interest rates (1980-2006) in 6 major countries Long-term interest rates in OECD countries (1982-1998) Lending
and deposit interest rates in 13 EU countries (1980-2001) 93 Food products prices in 198 countries (1985-2001) Data for all the variables in IS-LM model
Formal
models How do managers react to exchange rate volatility? An empirical survey in Latin America corporations Recent and historical daily currency exchange rates
[1] To be precise, the required operation is not a subtraction but a ratio:
This means that the exact appreciation was 4.76%. |
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- Huge dataset