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Topic 5: The Real Exchange Rate

Topic 5: The Real Exchange Rate. Burda + Wyplosz, 7.1, 7.2, 19.1, 19.2. The Nominal Exchange Rate. Nominal exchange rate E the domestic price of foreign currency e.g. E = IR£0.40 per DM this quotation is in European terms alternative is in British terms: IR£1= DM2.51

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Topic 5: The Real Exchange Rate

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  1. Topic 5: The Real Exchange Rate Burda + Wyplosz, 7.1, 7.2, 19.1, 19.2

  2. The Nominal Exchange Rate • Nominal exchange rate E • the domestic price of foreign currency • e.g. E = IR£0.40 per DM • this quotation is in European terms • alternative is in British terms: • IR£1= DM2.51 • this was more convenient pre-decimalisation, but we always use the European version

  3. Depreciations and Appreciations • If E rises, foreign currency more expensive: • a depreciation of the domestic currency • If E falls, foreign currency less expensive: • an appreciation of the domestic currency • In a quasi-fixed exchange rate regime, changes in the parities are... • devaluations and revaluations

  4. Effective exchange rates • Nominal exchange rate usually bilateral: country to country • But, many trading partners, many E’s • The effective exchange rates weights each nominal exchange rate by its importance in trade • Say n trading partners with nominal exchange rates E1....En • Share of trade for each is w1....wn

  5. Effective exchange rate • Effective Exchange Rate • E = (E1)w1 (E2)w2 (E2)w2.... (En)wn • where wi = 1 , i = 1,...n • E an index number • a rise (fall) in E is a depreciation (an appreciation) against a representative basket of currencies

  6. The Real Exchange Rate • Let E be the (bilateral) nominal exchange rate • Let P* be the foreign price of a foreign good • Then EP* is the domestic price of the foreign good e.g. E = IR£0.40 per DM P* = DM2 for some good in Germany Then IR£0.80 is price of that good in IR£ • Let P be the price of the equivalent good in Ireland

  7. The Real Exchange Rate • Then (EP*)/P is the relative price of the foreign good in terms of the equivalent good domestically • e.g. say P = IR£0.20 • Then (EP*)/P = 4 • i.e. 1 unit of the foreign good costs 4 units of the domestic good • Real exchange rate is 4 =  = (EP*)/P

  8. The Real Exchange Rate • In practice we consider P*, and P for many goods • i.e. they are price indexes e.g. CPI, GDP deflator • It is , rather than E which will be economically relevant

  9. Real effective exchange rates •  = ((E1P1)/P)w1 ((E2P2)/P)w2.... ((EnPn)/P)wn

  10. Linking interest rates and exchange rates • Arbitrage vs. speculation • Arbitrage: exploitation of price differences for riskless profits • Speculation: risk taking in pursuit of profits

  11. Foreign Exchange Markets • Daily turnover: • $1,300,000,000,000 • The spot market • The forward market • Futures and options

  12. Linking interest rates and exchange rates • Interest rate parity relationships • Consider two equally risky/liquid assets, in two countries • e.g Irish, German 1 year government bonds • from point of view of Irish resident: • yield on Irish bond i (% p.a.) • yield on German bond i* (% p.a.)

  13. Linking interest rates and exchange rates • Exchange rate at start of year Et • i.e. IR£ Et per DM • so Irish resident can buy 1/ Et German bonds with IR£1, i.e., 1/ Et DMs • At year end, gets (1+ i*)/ Et DMs • Convert to IR£ (using Et +1): • (1+ i*) Et +1 / Et

  14. Linking interest rates and exchange rates • Impose arbitrage condition: • (1 + i ) = (1+ i*) Et +1 / Et • Approximately: • i = i* + (Et +1 - Et)/ Et • domestic interest rate = foreign interest rate + expected exchange rate depreciation • Uncovered interest rate parity condition

  15. Exchange Rate Determination in the Short Run • Burda & Wyplosz Section 19.4 • IS/LM framework to determine E • Money market equilibrium: • Uncovered Interest Rate Parity (UIP) • Goods market equilibrium: • Purchasing Power Parity (PPP) • use to look at impact of policy on E

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