CHAPTER 5 What Determines Exchange Rates?
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The Variability of Exchange Rate
Three types of variability after early 1970s. • Long-term trends • Medium-term trends (which can be counter to the long-term trends) • Short-term trends
A country with a relatively low inflation rate will have an appreciating currency (an increasing nominal-exchange-rate value of its currency).
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Figure 5.1, Panel A
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Figure 5.1, Panel B
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In the Long run: Purchasing Power Parity
· Changes over time (relative PPP):
From time 0 to time t:
Pt P0 Pf,t . et Pf,0 e0
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In the Long Run: Purchasing Power Parity
The absolute PPP: e = P/Pf
Where, P: a basket of products measured in domestic currency Pf : a basket of products measured in foreign currency e: domestic currency/foreign currency
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In the Short Run : the Asset Market Approach
The uncovered interest parity: recalling from Chapter 4, the value of a foreign currency will go up when there is • A rise in the foreign interest rate (if) relative to domestic interest rate; • A rise in the expected future spot exchange rate (eex );
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Example 2
• Exchange rate is in equilibrium initially; • π = 0.04， πf = 0.07 • How will the value of foreign currency adjust according to PPP in the long run?
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Relative PPP: Evidence
For figure 5.4 • The actual value of DM in term of U.S. dollar can differ greatly from its PPP rate • The divergences can persist for several years • There is a tendency for the actual rate to follow the PPP rate in the long run.
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Relative PPP: Evidence
For figure 5.3 • The U.S. inflation rate is higher than Japan’s, so Yen tends to appreciate; • The U.S. inflation rate is much lower than Brazil’s, so Brazil’s currency tends to depreciate;
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Figure 5.2
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In the Long Run: Purchasing Power Parity


The law of one price : P = Pf e At a point of time in a perfectly efficient global market, a easily traded product should have the same price everywhere. The law of one price works well for heavily traded commodities.
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Absolute PPP: Evidence
• BMI : Big Mac Index
Currency/BigMac U.S. Brazil PPP implicated
as of the end of 2000
Actual spot rate April 25, 2000 Deviation (%)
In the Short Run: the Asset Market Approach
• Most of the daily exchange trading is related to the tradings of international financial investors. • The tradings of international financial investors in assets market will place pressures on demand and supply.
So,
P Ms e= s P M f f k f Yf k Y
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The Effect of
s on M
e
• Supply of £↓ , harder to borrow and spend, aggregate demand in Britain ↓ , output & jobs↓, products price Pf↓ ; • Over time, output & jobs↑, but with lower products price, e ↑ • What will happen when there is a rise in the $ supply?
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In the Long Run: Purchasing Power Parity
• • • • All the goods are tradable? Free trade among nations? International transport costs are negligible? Commodity markets are perfectly efficient?
The absolute PPP does not hold very closely in the real world at a point in time. Evidence shows large divergences do tend to shrink over time for traded goods.
Foreign currency will depreciate by 3% . π – πf=4%-7%= -3% Or, Foreign currency will depreciate by 2.8%. (1+π)/(1+πf)-1= -2.8%
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Key Implications of Relative PPP
A country with a relatively high inflation rate will have a depreciating currency (a declining nominalexchange-rate value of its currency).
Foreign currency will appreciate by 2% . π – πf=5%-3%=2% Or, Foreign currency will appreciate by 1.94% . (1+π)/(1+πf)-1=1.94%
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Purchasing Power Parity