IV. Stabilization policy
B. Foreign exchange markets
2. Exchange rate arrangements

    Good graphical ER source: FX plot interface
    Tips:
    (1) to get smoother trends for long periods, select "monthly" frequency
    (2) to express another country's ER as we do in class (value of its currency), make the country you choose the "base currency," the US$ the "target currency" and select "volume" notation

    Examples for ER values
    (1) floating ERs: US (Dollar vs euro 1/1/99-): floating--appr, then depr
    (2) United Kingdom (US and Euro)--App v. US$, depr v. Euro
    (3) fixed: China (1998-2004)
          crawling peg, rising: China (2005+)
    (4) Thailand (1993+)
    (5) Argentina (1996+)
    (6) Turkey (1995+): continuous inflation through 2001

3. Exchange rate determination

    Particularly now that we're in a world of floating ERs, questions arise concerning:
    What makes ERs move around?
    Why should we care?

    ER changes might be neutral. Like neutral money, they may have no effect on economic activity.
    If they aren't neutral, they will have an effect on the level of economic activity.
    We want to know whether foreign exchange rate changes affect the level of macro activity or not

    Recall the 2 types of I/T:
    (1) CA (commercial transactions in the popular press)
    (2) KA (financial transactions in the popular press)

    Individuals carrying out these 2 types of transactions in FX markets influence the level of ERs

    The question is, which group of dealers dominates.
    2 alternative theories match the 2 categories of I/T:
    (1) Purchasing power (PP) approach focuses on CA transactions
    (2) Asset market approach focuses on KA transactions

a. The purchasing power approach to ER changes

    Purchasing power approach focuses on CA transactions as the decisive factor in ER determination.

(1) Theory: the purchasing power parity (PPP) condition

    Context: We want to buy goods and services from each other, and FX simply facilitates that process.
    PPP => ERs change to preserve stable real prices of goods and services

PPP is based on:
The law of one price: in terms of any currency, any specific good must sell for the same price everywhere.

    %DR = %DE + %DPdom - %DPfor

    Result: PPP predicts: %DE = %DPfor - %DPdom

    In words, PPP => the change in the nominal value of a country's currency over time matches the difference between foreign and domestic inflation rates.

    High-inflation countries should have depreciating currencies
    Low-inflation countries should have appreciating currencies
        Example: US v. Turkey

Example: %DPfor = 12% %DPdom = 4% Per PPP:  Expected %DE = +8% Suppose: Actual %DE=+6% => %DR = +6% - (12%-4%)         = -2%     Nominal $ appreciation, but real $ depreciation.     Rise in E not enough to offset higher foreign inflation.

(2) Evidence concerning PPP

    Key implication of PPP:
    PPP => ER neutrality
    E may change but R is constant => international competitiveness remains constant
    Since inflation arises mainly from changes in the money supply, this theory is also known as the monetary approach to ER determination (Friedman, 1953, "The Case for Flexible Exchange Rates").
    If PPP is true: flexible exchange rates give countries monetary policy autonomy: Different inflation rates are accommodated by offsetting exchange rate adjustments
    Inflation is completely neutral.

    So PPP leads to specific predictions about R and E over time.

? With changes in E offsetting inflation differentials, how should R behave over time?

    Example 1: Turkey

    PPP often works well to offset large inflation differentials

    Example 2: US exchange rates handout.
    (data source: classes\ec311\realwrld\wrldecon.xls)

    Note 1: PPP works well over the long run
    Note 2:  PPP does not work so well over shorter time periods

    Empirically, changes in nominal ERs have in general meant parallel changes in real ERs.
    Good news for Wall Street Journal: tracking E is a good proxy for tracking R
    Bad news for advocates of PPP: ER changes have real effects.

    Bottom line: PPP applies mainly for
    (1) periods of hyperinflation and 
    (2) the long run (what did Keynes say about the long run?)

    So, what's wrong? Problems with PPP:
    --Imperfect arbitrage for tradables (example: trade barriers)
    --Many tradables are imperfect substitutes
    --imperfect price indexes (they include nontradables)
    Most important: --PPP overlooks financial transactions.
    PPP basically assumes that current account drives exchange rates.
    Asset transactions have a big effect, especially in these days of high capital mobility.
    Friedman was more likely right back in 1953 when there was less K-mobility, less well-developed financial markets, and policies in place to discourage asset flows.

b. The asset market approach to ER changes

    Poor performance of PPP => need another explanation of ER changes.
    The asset market approach is that other explanation. Now widely accepted

    Recall, PP approach to ERs => that ER changes would be neutral.
    E could change, but only to offset inflation differentials, so R would be constant.
    No changing R to disrupt the economy.

    That's not what we have. When E moves, R typically moves right along with it.

    Recall: PP approach focused on FX for financing current account (goods and services) activities
    The asset market approach focuses on financial asset transactions.

    Financial asset transactions are motivated by the rate of return that assets earn in different countries.

    ? How can such i-rate differences exist at the same time? 

    Financial assets give us information about which currencies savers think are overvalued or undervalued relative to their long-run levels.