Lecture 6 Exchange Rate Theory Based on Sloman

Lecture 6: Exchange Rate Theory Based on Sloman Chapter 24

Definitions of the Exchange Rate Price of £ 1 is 1. 49 Euros (Euros per pound) Price of good in UK= price on continent by exchange rate

Definitions of the Exchange Rate Price in £ (pennies) of 1 Euro –. 67 per Euro e= Domestic price of foreign currency Price of good in UK = price of foreign currency multiplied by the price of good abroad

But what determines ER Trade equalises prices of tradable good Once local prices are determined e is determined. Conversely, if world prices and exchange rate is determined then local prices are determined

What determines Prices • Some people argue that prices are determined by money supply • P. Y= MV • GNP=must be paid for • GNP= Money by the time it changes hands

What determines Prices • If so exchange rate is determined by ratio of prices

What determines Prices • So if increase Md, prices up, E goes down (a depreciation, worth less) • If Velocity rises) money goes around faster, prices up, depreciation • If Income rises (prices fall!!!), E up

• Big Mac Index • Burgernomics is based on theory of purchasingpower parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a Mc. Donald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued. • http: //www. economist. com/markets/bigmac/index. cfm

Purchasing Power Parity • Tradeable goods prices are equal – Need to exclude transport costs, – Looking only at the purely tradable component -have to discount fact that property prices in London are the same as in Skye ( NON-TRADABLE GOODS) – Labour costs – e. g. Hair cuts in Budapest v Birmingham

Alternative Theory – Interest rate parity • If I invest money in UK expect same return as invest in France • So Interest rates have to be the same • But not. • SO if invest in UK interest rate +movement on ER = return in France. • So if irf =3% and iruk=5% then 3% =5%-depreciation of 2%

Alternative Theory – Interest rate parity • So if irf =3% and iruk=5% then 3% =5%-depreciation of 2% So can put £ 1 in UK bank at £ 1. 05 OR buy Euro at. 67 per Euro=1. 492537 Get 3% =1. 5372313 Sell at 0. 683009= 1. 5372313*0. 683009 =1. 05

So ir reflect EXPECTED depreciation At start - 0. 67 At end 0. 683009 So price of Euro rises (worth less) at end of period

• These explanations imply government can control the ER • Do I believe? • ER as a random variable? • OK lets focus in ER as something deterministic driven either by trade or finance flows. • Can government manipulate the ER and why?

Exchange rate E = Price in Euros of 1£ The exchange rate as a price for the demand supply of domestic currency S 1 Supply – sell £ to buy Forex for imports or foreign investment – Higher E means buy more abroad er 1 Demand – Foreigners buy £ to buy exports or inward investment D 1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand supply Exchange rate S 1 er 1 S 2 UK ER fates fall, EU up switch to Euros – S of £ shifts out Depreciation er 2 D 2 O Quantity of £s D 1

Adjustment of the exchange rate to a shift in demand supply Exchange rate S 1 S 2 Fall in demand for UK exports er 1 Depreciation er 2 D 2 O Quantity of £s D 1

Adjustment of the exchange rate to a shift in demand supply Exchange rate S 1 er 1 D 1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand supply S 3 S 1 Exchange rate er 3 er 1 D 3 D 1 O Quantity of £s

Adjustment of the exchange rate to a shift in demand supply S 3 S 1 Exchange rate er 3 Appreciation er 1 D 3 D 1 O Quantity of £s

• With a floating Exchange Rate the price of £ changes in response to S & D. • What will happen to Balance of Payments? • Fluctuations in E ensure the value of imports always equals value of exports so Balance of payments always in balance

Fixed Exchange Rate and Balance of Payments deficit Exchange rate This creates external imbalance: i. e. currency flow deficit r 1 S 1 by UK S 2 by UK Fixed exchange rate D by overseas residents O Quantity of £s

Fixed Exchange Rate and Balance of payments surplus Exchange rate S by UK Fixed rate D 2 D from abroad O Quantity of £s

UK balance of payments as % of GDP: 1980– 2000 Source: Datastream

UK balance of payments as % of GDP: 1980– 2000 Current account Source: Datastream

UK balance of payments as % of GDP: 1980– 2000 Current account Trade in goods Source: Datastream

$ / £ exchange rate: 1976 -99 $/£ Index 1990=100

$ / £ exchange rate and £ exchange rate index: 1976 -99 $/£ Index 1990=100

Exchange rate indices averages for each period (1995 = 100) Source: Sloman based on data in European Economy Statistical Annex (Commission of the European Union)

The crawling peg within exchange rate bands Exchange rate $1. 60 $1. 40 O No intervention Source: Sloman Central bank buys domestic currency No intervention Central bank sells domestic currency No intervention Time

If Government changes ER –depreciation- imports become more expensive (shift in) S 2 (Epf) Price in £ S of imports So imports fall helping deficit - but cost more hurting deficit r 1 Demand for Imports O Quantity

If Government changes ER –depreciation- and Exports become competitive (shift out) S of Exports Price in £ Exports rise helping deficit r 1 D 2 (pd/E) Demand for Exports O

r 1 S 2 (Epf) S of imports Price in £ If Government changes –depreciates imports become more expensive (shift in) and Exports become competitive (shift out) r 1 Demand for Imports O S of Exports D 2 (pd/E) Demand for Exports O Argument is that sales of exports and lower imports outweigh additional expense of remaining imports – SO BOP Better But dedpreciation – import tax (tarrif) and export subsidy

EXCHANGE RATE SYSTEMS IN PRACTICE • UK experience of dirty floating – first oil crisis and its aftermath – second oil crisis and the rise in monetarism – effects of growing US budget and trade deficits in the 1980 s – the 1985 exchange crisis – joining and leaving the ERM – experience since leaving ERM ² fluctuations in the pound ² exchange rate consequences of targeting the inflation rate • The volatility of exchange rates