The Foreign Exchange Market and Exchange Rates

1. The Foreign Exchange Market and Exchange Rates • Balance of Payments: • Record of a country’s economic transactions with the rest of the world. • Rule: receipt = positive (+) , payment = negative (-). • If receipts > payments = surplus. • If receipts < payments = deficit. • 2 main accounts: currentand capital. • Different implications for the economy. The current account directly affects AD • It is possible to have a current a/c deficit as long as there is a capital a/c surplus. Example, USA.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

2. Balance of Payments Current account Trade a/c Services Freight Tourism Royalties Investment income Direct investment income National debt interest Transfers Balance on current account Capital account Private capital Official capital Government securities sold abroad Banking transactionsBalance on capital account  Leddin and Walsh Macroeconomy of the Eurozone, 2003

5. Foreign Exchange Market • Balance of payments and international transactions underlie the foreign exchange market. • Different ways of quoting exchange rates: • Indirect quote = ($/€). • Direct quote = (€/$). • Define e as the price of a euro in $ • i.e how many $ per €  Leddin and Walsh Macroeconomy of the Eurozone, 2003

6. Foreign Exchange Market The supply and demand for euro on the FEM determines e. “Floating exchange rate.” S e1 D € billions  Leddin and Walsh Macroeconomy of the Eurozone, 2003

7. Fixed vs Floating • In a certain trivial sense the BOP always balances • Supply equals demand • For floating exchange rate this is achieved by the free market • For fixed exchange rates the government makes up the difference • Current account surplus is counteracted by cap deficit and/or changes in reserves • US vs China

8. Fixed Erates • Governments may try to fix the exchange rate (why? See later) • Requires supplying foreign currency to market when there is excess demand • Requires buy foreign currency when there is excess supply • Can influence the exchange rate via interest rates (EMS or dirty float) • Mechanism by which an currency crisis can occur

9. Fixed e By co-incidence it is at market eqm. Not likely S e* D € billions  Leddin and Walsh Macroeconomy of the Eurozone, 2003

10. Fixed e Below market rate. CB print extra € and buy $ S e* D € billions  Leddin and Walsh Macroeconomy of the Eurozone, 2003

11. Fixed e E above market value. CB must buy € with $ S e* D € billions  Leddin and Walsh Macroeconomy of the Eurozone, 2003

12. Irish Exchange rate Policy • 1920-79: Sterling Link • Currency Board • Sensible: strong currency, major trading partner • Have British inflation and interest rates. • 1979: break with sterling • Seek lower inflation with Germany • didn’t work: inflation diverged • Interest rates converged only after 10 years • Competitiveness declined  Leddin and Walsh Macroeconomy of the Eurozone, 2003

13. Effect of e on AD • e affects the location of the AD curve. • e  X and M (see over) •  AD  real GNP, employment, unemployment and inflation just as with any FP or MP • Note that this effect works through the current account • Thuse is another instrument of economic policy. • See diagram • Policy-maker can contrive to improve competitiveness by under-valuing e. • Over-valued e can have a detrimental effect on key macroeconomic variables. • A depreciation cause inflation in the log run  Leddin and Walsh Macroeconomy of the Eurozone, 2003

14. X rises following a depreciation (e falls) • Price in $ of goods produced in Ireland falls • Example: furry leprechaun €5 • e=1.4 • 1€ gets $1.4 • leprechaun costs $5*1.4=$7 • Depreciation e=1.2 implies €1 get $1.2 • Cost is $5*1.2=6 • Sales rise

15. LRAS p SRAS(pe) AD1 AD0 Y* Y

16. Determinants of Exchange Rates • At most fundamental level: • BOP determines Supply and demand for euro (€) • foreign exchange market determines e. • Receipts (e.g. Exports): Demand for Euro. • Payments (e.g. Imports): Supply of Euro. • Factors that influence the supply and demand include: • Interest Rates (UIP) • Prices (Competitiveness) • Growth:.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

17. Prices • Relative inflation rates. •    X and M • Demand curve to the left, • Supply curve to the right. • Result is e depreciation. • Countries with high inflation rates tend to have weak exchange rates. • PPP theory (see later)  Leddin and Walsh Macroeconomy of the Eurozone, 2003

18. Interest Rates • Interest rates can be used to influence capital flows and therefore defend a currency. • ieuro > ius Capital inflow e • ieuro < ius Capital outflow  e • Usually used to prevent depreciation of the exchange rate.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

19. Output • Two effects: • Economic growth leads to an increase in imports (via MPM), a current a/c deficit and depreciation. • Economic growth is reflected in high company profits, a rising stock market and high returns. • This leads to a capital inflow and a capital a/c surplus. • As long a (B) > (A) the exchange rate will appreciate. • United States in the 1990’s and 2000’s.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

20. Prices (Competitiveness) • Look in detail at the link between prices and exchange rates and their joint effect on output • PPP: equal value for money for goods and services. • Prices of similar goods expressed in a common currency should be the same. • Based on arbitrage. Buy cheap, sell expensive to make profit. • Actions should lead to a convergence of prices • How expensive is Ireland?  Leddin and Walsh Macroeconomy of the Eurozone, 2003

21. Absolute PPP • Pirl e = Pw • Prices, adjusted for the exchange rate, should be the same in different countries. • Example: Levi Jeans, • Pirl = €10 in Dublin, • Pus = $20 in New York. • If e = $/€ = 2 then PPP holds. • If e  2, PPP does not hold.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

22. Real Exchange Rate • Compare price levels of different countries • In a common currency (usually US$) • Related to the concept of purchasing power parity (PPP) • Law of one price • Simple example is the Hamburger index • What is the US$ price of a Big Mac in various countries • $PIRL=€ PIRL*e • Is $PIRL >$PUS

23. What does this tell you? • “competitiveness” • Are one country’s goods cheaper than another’s? • Do for all goods in a basket and calculate the ratio • i.e. CPI or GDP or wages • Look at R for Ireland over time • Level doesn’t tell much • Trend does

24. What is the effect of an increase in real e rate? • competitiveness • Our goods more expensive • Their goods relatively cheaper • Expect exports to fall and imports to rise • Better off? • What causes R to change • e changes • Prices change i.e. inflation can erode competitiveness • productivity

27. Relative PPP • Total differentiation of the absolute PPP equation gives: •  Pirl +  e =  Pw • Or irl + e = w • Inflation rates, adjusted for changes in the exchange rate, should be similar across countries. • Weak form of PPP. • Prices can be initially different, but change at the same rate over time.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

28. PPP as a Economic Theory: Under Flexible Exchange Rates • PPP becomes a theory of exchange rates. •  e = w - irl • Inflation is the most important determinant of e. Country’s with high inflation rates will experience weak exchange rates and visa versa. • Why? • Very relevant in the case of large countries: USA, Japan and EMU.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

29. PPP as an Economic Theory: Under Fixed Exchange Rates • PPP becomes a theory of inflation. • irl = w -  e • If e is fixed, irl is determined by w. • Ireland is a price taker on international markets. • One of the main reasons for fixed e • EMS & EMU. • Used by small countries world-wide.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

30. Ireland’s Competitiveness • Big mac index • Economist magazine • Balassa-Samuelson theory • Expect richer countries to be more expensive • Deviation from PPP because of “non-tradable” • Susan O'Carroll thesis • Real Effective E-rate • Current situation • Euro appreciated • High but falling(?) costs

31. 2000

32. 2004

33. Capital Account • So far have paid most attention to current account • Competitiveness affects current account and AD • Historically this was the most important part of BOP • Nowadays capital flows account for most BOP flows • Recent phenomenon • Capital controls were the norm until 1980

34. Interest Rate Parity • Capital account is driven by differences in interest rates • A comparison of domestic and foreign interest rates must allow for the expected change in the exchange rate. • Compare a domestic (Eurozone) and a foreign (US) investment. • Domestic investment: (1 + iez) • €1,000(1 + 0.1) = €1,100  Leddin and Walsh Macroeconomy of the Eurozone, 2003

35. Foreign Investment • 1st January: Convert € into $ using the spot exchange rate et. • Invest $ in the USA. Total return (1 + ius). • 31st December: Convert the total $ return back into €. (1/ee t+1). Note it is the expected e as the exchange rate 12 months from now is unknown. • US return measured in Euro is: • (1 + ius)et/ee t+1.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

36. Two Parts to the Foreign Investment • 1. Interest rate. • 2. Gain or loss on the foreign exchange market. • Arbitrage should now ensure: • (1 + iez) = (1 + ius)et/ee t+1 • Rearrange: • (ee t+1 -et)/et = (ius - iez)/(1 + iez)  Leddin and Walsh Macroeconomy of the Eurozone, 2003

37. Implications • Difference between the future and current exchange rates equals the interest rate differential. • If ius < iezExpect € depreciation • If ius > iezExpect € appreciation • The interest rate differential gives an indication of how the market expects the exchange rate to move. • This is key to understanding currency crises  Leddin and Walsh Macroeconomy of the Eurozone, 2003

38. Implication: Fixed e • UIP gives another rationale for fixed exchange rates • Interest rate will track that of the larger country • With a single currency in the Eurozone, it is not possible for interest rates to diverge between countries. • So as EMU comes closer interest rates will converge • Eastern Europe now  Leddin and Walsh Macroeconomy of the Eurozone, 2003

39. Dutch, German, and Irish Interest Rates converged as EMU approached and it was anticipated that E would be “irrevocably fixed” Irl NL D

41.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

42. Currency Crises • UIP & Competitiveness help explain how currency crises arise. • Basic story • Country in a recession with fixed e rate • Markets expect that gov will devalue to boost AD • Expectation of devaluation leads to higher interest rates • Makes recession worse • Speculators try to sell their holdings of the domestic currency • Self fulfilling prophecy • Devaluation usually but not always occurs.

43. EMS Crisis 1992 • Background to EMS • Objective is to stabilise exchange rates. • Reduce e uncertainty and thereby encourage international trade. • Key point is that for the system to work, there must be similar inflation, interest rates and growth rates. • In turn, this requires policy co-ordination: (fiscal, monetary policies) • Why?

44. EMS until 1992 • Seen as step on way to EMU • Not fixed • Limit movement to band of +/- 2.25% around central rate • Possible to adjust central rate • 1979-87: numerous realignments mostly involving an appreciation of the DM. Ir£ devalued twice. March 1983 and August 1986. • Usual reason: no co-ordination of fiscal and monetary policies. • 1987-92: no realignments. System was a success. Look forward to EMU. • All ended with the currency crisis of September 1992.  Leddin and Walsh Macroeconomy of the Eurozone, 2003

45. Currency Crisis of 1992-93 • German unification in 1990 lead to huge budget deficit. • Could not be financed by increasing taxes • AD shifts right. • Bundesbank raises interest rates to combat inflation • i (by 3%). • AD shift to left • Because of fixed exchange rates, the increase in interest rates was transmitted to rest of Europe • The FP was not • Everyone else’s AD shifts left. • Europe has recession (worse for UK)

46. Germany 1992 LRAS p SRAS(pe) AD1 AD0 Y* Y

47. UK 1992 LRAS SRAS(pe) p AD0 AD1 Y* Y

48. However, the UK was in recession, needed lower not higher i. • Speculators took view that DM/Stg£ e was not sustainable. • Expect that gov will boost AD by devaluation and/or reduction in interest rates • Attacked the currency. • Try to sell stg and buy DM • Situation becomes self re-enforcing • As speculators fear a devaluation, sell stg (supply increases) • CB has to use up more reserves • Anticipation of devaluation pushes up int rates making recession worse, making devaluation more likely • Conspiracy: George Soros moves the market • Black Wednesday. • Bank of England spends £10b of reserves and then gives up • Stg£ withdrawn from ERM. • Immediately depreciated to low level. • Speculators made a killing. • Economy rebounds as AD pushed up • Political death of gov

49. Stg/DM E above market value. CB must buy £ with DM S e* D £ billions  Leddin and Walsh Macroeconomy of the Eurozone, 2003

50. The Irish Pound and the Crisis of 1992-93 • Example of SOE • Sterling’s dropped EMS in September and the currency depreciated by 15% • Market attacked Irish Pound • Likely that Irish pound was likely to be devalued to avoid competitive loss (AD curve shifts left) • strangle Celtic tiger at birth • U still high (12%) so not credible to keep e overvalued • Hence, funds flowed out of Ireland in anticipation of a devaluation of the Irish pound. • Despite this severe misalignment, the government decided on this occasion to resist devaluation.  Leddin and Walsh Macroeconomy of the Eurozone, 2003