Long Run Exchange Rate

10 Key excerpts on "Long Run Exchange Rate"

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  eBook - ePub

  Economics for Investment Decision Makers

  Micro, Macro, and International Economics

  • Christopher D. Piros, Jerald E. Pinto(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  In recent decades, exchange rate policies have often been at the center of debates among G-20 policy makers. In the 1980s and 1990s, the value of the Japanese yen was a major point of contention in United States/Japan trade negotiations. In the 2000s, the value of the Chinese yuan dominated United States/China trade talks. In response to the needs of its member countries, and in connection with its mandate to ensure the stability of the international monetary system, the International Monetary Fund (IMF) has been deeply involved in assessing the long-run value of exchange rates.

  One of the IMF’s core mandates is exchange rate surveillance. The IMF Consultative Group on Exchange Rate Issues (CGER) has used a three-pronged approach to derive long-run equilibrium exchange rate assessments for both developed and emerging market currencies:

  1. The macroeconomic balance approach estimates how much exchange rates need to adjust in order to close the gap between the medium-term expectation for a country’s current account imbalance and that country’s normal (or sustainable) current account imbalance.

  2. The external sustainability approach differs from the macroeconomic balance approach by focusing on stocks of outstanding assets or debt rather than on current account flows. The external sustainability approach calculates how much exchange rates would need to adjust to ensure that a country’s net foreign-asset/GDP ratio or net foreign-liability/GDP ratio stabilizes at some benchmark level.

  3. A reduced-form econometric model seeks to estimate the equilibrium path that a currency should take on the basis of the trends in several key macroeconomic variables, such as a country’s net foreign asset position, its terms of trade, and its relative productivity.

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  Alternative Theories of Competition

  Challenges to the Orthodoxy

  • Jamee K. Moudud, Cyrus Bina, Patrick L. Mason, Jamee K. Moudud, Cyrus Bina, Patrick L. Mason(Authors)
  • 2012(Publication Date)
  • Taylor & Francis

    (Publisher)

  which is the real exchange rate between them – will be regulated by the real labor costs of the regulating capitals of those commodity bundles, adjusted for the tradable/nontradable content (the openness) of the consumption bundle (see Appendices A and B for further details). From this, it is only a short step to explain movements of the real exchange rate in terms of other price indexes such as CPIs or GDP price deflators.

  Implications of the alternate approach to Long Run Exchange Rates

  Several practical implications can be derived from equation 9.4 .

  •  First, it allows us to derive a practical policy rule-of-thumb for the movements of the (real and nominal) exchange rate: the sustainable real exchange rate is that which corresponds to the relative competitive position of a nation, as measured by its relative real unit labor costs.

  •  Second, it tells us that since the real exchange rate is pinned (through competition) by real unit costs and other factors, it is not free to adjust in such a way as to eliminate trade imbalances. Indeed, such imbalances will be persistent, and will have to be covered by corresponding direct payments and/or capital inflows. It follows that currency devaluation will not, in itself, eliminate trade deficits. Rather, it would be successful only to the extent that it affects the real unit costs (via the real wage) and/or the tradables/nontradables price ratio of consumer goods (Shaikh 1995, p. 72). And that depends on the ability of workers and consumers to resist such effects.

  •  Third, it tells us that the real exchange rate of a country is likely to depreciate when a country’s relative competitive position improves

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  The Economics You Need

  • Enrico Colombatto(Author)
  • 2016(Publication Date)
  • Taylor & Francis

    (Publisher)

  Of course, exchange rates are not only a convenient way of registering transactions and enhancing accounting practices. Exchange rates are also important because operators must buy and sell foreign currencies in order to pay for foreign goods or to obtain the domestic monetary units with which to buy domestic inputs. The exchange rate, therefore, is also the rate at which individuals buy/sell currencies with a view to expanding the range of their economic transactions.

  The study of the variables that affect the dynamics of currency markets is the core of exchange-rate economics, which usually follows different lines of reasoning depending on the regime adopted by a country or group of countries. By and large, the nature and degree of government intervention give origin to five different exchange-rate regimes: the gold standard (sections 9.2–9.5), flexible-exchange rates (sections 9.6–9.10), fixed-exchange rates (section 9.11), currency boards (section 9.12) and monetary unions (section 9.13). For each regime, this chapter illustrates the underlying working assumptions, some of the consequences the various regimes generate with regard to the domestic economy, the extent to which government commitments are credible, and the variables that affect adjustment.

  9.2 Simple exchange rate economics: the gold standard

  When the monetary system is based on a real standard (e.g., the gold standard), the determination of the exchange rate is straightforward. As we noted in Chapter 7 (section 7.2), each monetary unit (the dollar, the pound or the franc) designates a given quantity of gold. This is known as the gold parity. Since gold is gold regardless of the jurisdiction from which it comes, and independent of how one calls the (gold) coins minted in that jurisdiction, under a gold standard the exchange rate between two currencies is necessarily the ratio between the two gold parities. If 1.5 grams of gold are called one dollar in the USA, and 0.20 pounds in Britain, the dollar/pound exchange rate is inevitably 5 dollars per pound (1/0.20). Put differently, you need the amount of gold ‘contained’ in five US dollars in order to match the amount of gold ‘contained’ in one British pound.

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  Flexible Exchange Rates

  • Jan Herin(Author)
  • 2019(Publication Date)
  • Routledge

    (Publisher)

  The various implications of this approach that go beyond the particular model examined above are also discussed. (i) In the long run there is symmetry between the regime of fixed and flexible exchange rates. Under fixed exchange rates, the exchange rate is exoge-neous and the supply of money endogeneous. Under flexible exchange rates, the supply of money is exogeneous and the exchange rate endogeneous. A devaluation under fixed exchange rates increases the supply of money propor-tionately in the long run; under flexible exchange rates, an increase in the money stock increases the exchange rate proportionately in the long run. An important long-run difference between the two regimes is that under flexible rates the rate of inflation can be varied independently of the rest of the world. Changes in the rate of inflation can be interpreted as changes in the tax on domestic money and they will have systematic effects on the long-run stock of wealth and its composition. Other instruments of fiscal policy can be used in both regimes to alter the stationary state. Because fiscal policy and other real variables have an effect on the long-run demand for money, it is not correct to say that the exchange rate can be explained by monetary factors alone, even in the long run. (ii) The adjustment process is quite different under the two regimes. In both systems, the stock of wealth adjusts to its long run desired level through defi-cits and surpluses in the current account. Under fixed exchange rates portfolio equilibrium between domestic money and foreign assets at a given level of wealth is obtained through instantaneous capital inflows and outflows because the Central Bank supplies foreign assets at a fixed price. Under flexible ex-change rates instantaneous portfolio equilibrium is obtained through changes in the valuation of assets-that is, through changes in the exchange rate. Exchange rate in the short run and in the long run 169 Whereas a desire to hold.

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  Applied International Economics

  • W. Charles Sawyer, Richard L. Sprinkle(Authors)
  • 2020(Publication Date)
  • Routledge

    (Publisher)

  CHAPTER 14

  Exchange rates and their determination

  A basic model

  The exchange rate is determined from day to day by supply and demand of home currency in terms of foreign currency. Each transaction is two-sided, and sales are equal to purchases. Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day, or from moment to moment.

  Joan Robinson

  INTRODUCTION

  T he international value of a country’s currency has become an inescapable part of the daily flow of economic information. Most of us are aware that a country’s exchange rate is important, but many of us do not have a clear idea of why the exchange rate matters or what causes it to change. As the chapter’s opening quote indicates, the familiar tools of supply and demand analysis can be used to determine a country’s exchange rate. In this chapter, you will learn why the supply and demand model works in analyzing exchange rates—in the same manner, in fact, that it works in analyzing the price of gasoline or pizza, for one dollar or one yen or one gallon of gasoline is indistinguishable from another. By the end of this chapter you should have a good grasp of why exchange rates are important and what factors cause them to change over the long run. Finally, it is obvious to even a casual observer that exchange rates change frequently. These changes, or volatility, are a source of aggravation for individuals, businesses, and governments. The chapter explains what economists know about the effects of exchange rate volatility on international trade and how changes in exchange rates affect the prices of the goods and services we purchase. The final part of the chapter deals with the underlying value of a currency. While the exchange rate we observe in the market often differs from that value, it is very useful to know what that value is.

  EXCHANGE RATES

  Suppose that a U.S. importer is purchasing British Jaguars. To purchase the Jaguars, the importer needs to obtain British pounds by exchanging dollars for pounds. The demand for foreign currency is derived from individuals demanding foreign goods and services. This relationship can be applied in reverse. As individuals in the U.K. demand U.S. products, there is an increased demand for dollars. However, this raises the question of how many dollars must be exchanged to obtain the requisite number of pounds, or vice versa? In this example, the relevant exchange rate is the U.S. dollar–U.K. pound exchange rate. In general, the exchange rate is the price of one country’s currency in terms of another. The demand for British pounds relative to the supply of pounds will determine the exchange rate, just as the demand for gasoline relative to the supply of gasoline determines the price of gasoline. Exchange rates fluctuate considerably over time. However, unlike the price of gasoline, changes in the exchange rate are expressed as changes in the value of the domestic country’s currency. An increase in the value of a currency is referred to as appreciation. Analogously, a decline in the value of the currency is referred to as depreciation

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  Exchange Rate Regimes

  Fixed, Flexible or Something in Between?

  • I. Moosa(Author)
  • 2006(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  2 The Role of the Exchange Rate in the Economy Macroeconomic linkages through exchange rates The exchange rate provides a key macroeconomic linkage between the domestic economy and the rest of the world that takes place through the goods and asset markets. In the goods market, the exchange rate establishes linkages between domestic and foreign prices through the relationship P ¼  þ EP  ð2:1Þ where P is domestic prices, P* is foreign prices and the exchange rate is expressed as the domestic currency price of one unit of the foreign currency. The parameters that reflect transaction costs and other market imperfections are  and  . This is a linear relationship between domes- tic prices and foreign prices expressed in domestic currency terms. It shows that the higher the exchange rate, other things being equal, the higher the price of foreign goods in the home country (@P/@E > 0). The same relationship can be seen in Figure 2.1, which depicts P as a func- tion of P*. As the exchange rate rises (the domestic currency depreciates) the line P ¼  þ EP* rotates upwards, leading to higher P for the same level of P*. This happens either directly (because the domestic price of imported goods rises) or indirectly (because domestic firms can afford to raise their prices when competitors’ prices rise). Some of the effect is transmitted through the labour market, as workers may demand wage increases when higher import prices raise the cost of living. Govern- ments that are aware of this connection would prefer to stop depreci- ation but if they do so in the face of domestic inflation they risk a loss in competitiveness. Naturally, the effect of domestic currency appreciation 29 on domestic prices can be augmented by a rise in foreign currency prices as shown in Figure 2.2. On the other hand, it can be seen in Figure 2.3 that domestic currency appreciation (falling exchange rate) can offset the effect of rising foreign prices.

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  Exchange Rate Determination Puzzle: Long Run Behavior and Short Run Dynamics

  • Falkmar Butgereit(Author)
  • 2010(Publication Date)
  • Diplomica Verlag

    (Publisher)

  Census Bureau and U.S. Bureau of Economic Analysis. P a g e | 4 exchange rate movements may be much more subject to trades based on heterogeneous expectations incurred by investors, speculators and market makers. Particularly in the short-run, exchange rates exhibit considerably greater volatility than macroeconomic time series leaving an impression of noisy and chaotic behavior. Throughout this work it will become evident that heterogeneous beliefs and actions of market participants are the key to understand short-run exchange rate dynamics from daily to monthly horizons. Over longer horizons of one month and longer standard fundamentals like money, inflation, productivity, interest rates and output will shimmer through and push the exchange rate towards a fair equilibrium value. This thesis is structured as to firstly looking at exchange rate driving forces over longer periods. Afterwards in chapter 3 it will start by examining the low predictive power of standard macroeconomic exchange rate models and present more recent successes in forecasting and explaining exchange rates. It continues with analyses of chart-technique, impact of news, and order flow which all constitute important building blocks of exchange rate determination and prediction over shorter horizons. Part 4 presents some more evidence on the non-linear behavior of exchange rates and the relationships between today’s exchange rate and its historical movements as well as fundamentals (particularly interest rates) at different frequencies. Chapter 5 concludes. 2 Long-Run Exchange Rate Behavior 2.1 Purchasing Power Parity The Purchasing Power Parity ( PPP ) approach relates the foreign exchange rate to the ratio of national price levels. Exchange rate movements are thought to reflect changes in relative prices based on the notion of arbitrage across tradable goods and services leading to the law of one price.

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  Economics for Investment Decision Makers

  Micro, Macro, and International Economics

  • Christopher D. Piros, Jerald E. Pinto(Authors)
  • 2013(Publication Date)
  • Wiley

    (Publisher)

  According to Equation 10-14, a high-yield currency’s real value will tend to rise in the long run when the long-run equilibrium value of the high-yield currency ( q L=H ) is trending higher. Typically, however, oscillations around this long-run equilibrium trend can persist for relatively long periods of time (refer back to Exhibit 10-2 for an illustrative diagram of this process). These cyclical movements around the long-run equilibrium trend are often associ- ated with movements in the differentials in Equation 10-14. That is, the real exchange rate q L/H will tend to rise, relative to its long-run equilibrium value q L=H , when (1) the nominal yield spread between the high- and low-yield market rises, (2) inflation expectations in the high-yield market decline relative to the low-yield market, and/or (3) the risk premium demanded by investors to hold the assets of the high-yield market declines relative to the low- yield market. It is important to recognize that movements in all of these various differentials can be gradual but persistent and thereby lead to persistent movements in the exchange rate. Consider the case of a high-yield, inflation-prone emerging market country that wants to promote price stability and long-term sustainable growth. To achieve price stability, policy makers in the high-yield economy will initiate a tightening in monetary policy by gradually raising the level of domestic interest rates relative to yield levels in the rest of the world. Assuming that the tightening in domestic monetary policy is sustained, inflation expectations in the high-yield economy should gradually decline relative to the trend in inflation expec- tations in the rest of the world. The combination of sustained wide nominal yield spreads and a steady narrowing in relative inflation expectations should exert upward pressure on the real yield spread and thus on the high yield currency’s value.

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  Exchange Rate Alignments

  • J. Mills(Author)
  • 2012(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The only practical way of making any economy competitive is to position the exchange rate correctly. This is why the parity of the currency is critic- ally important. There is no other feasible way for a country to change 2 The Exchange Rate The Exchange Rate 21 the price it charges for the whole of its output sufficiently to make the necessary difference. The higher the proportion of a country’s GDP involved in world trade, the more obvious it is that its exchange rate needs to be correctly aligned vis-à-vis its competitors. Perhaps one of the illusions under which the USA has suffered is that, because its foreign trade exposure is compara- tively small, the impact on the economy of unmanageable competition from abroad may have appeared relatively slight. Whether the parity of the dollar on the foreign exchanges was appropriate for the inter- ests of the domestic economy may therefore have been given less atten- tion than it should have been. In fact, the exchange rate of the dollar against all other world currencies has been as critically important in determining the US growth rate as it has been to all economies exposed to any significant degree of international competition, as US economic history clearly shows. In sum, for any economy, pricing its output at a competitive level by adopting appropriate macroeconomic policies is the key to expan- sion. The policy instrument available to any sovereign government to provide growth conditions is to position the exchange rate at a level which will enable its country’s goods and services to compete success- fully both at home and in world markets. The theme which runs through this book is that history has been shaped to a much greater degree than most people realise by the exchange-rate policies which the governments of all the world’s economies have pursued.

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  Exchange Rate Theory and Practice

  • John F. Bilson, Richard C. Marston, John F. Bilson, Richard C. Marston(Authors)
  • 2007(Publication Date)
  • University of Chicago Press

    (Publisher)

  The long-run expected rate of inflation having already been determined, the determination of the long-term real interest rate requires only the speci- fication of an equation for the long-term nominal interest rate. This is done by inverting a demand-for-money equation in which the long-term rate of interest represents the opportunity cost of holding money. In the resulting equation (7), it is expected that a lower real money stock leads, by itself, to a higher nominal interest rate, while the sign of the coefficient of the ex- pected long-run inflation term is indeterminate.6 The last term in equation (7) represents an expected liquidity squeeze or glut, which should have a positive coefficient. As explained in Artus (1981), when a shift to monetary restraint leads to a downward shift in the long-run expected growth rate of money, the slow speed of price adjustment will lead private market partici- pants to expect that the real money stock is going to decline. The excess of the short-run over the long-run expected inflation rate will indicate how se- vere the liquidity squeeze is likely to become in forthcoming quarters. If this excess is large, private market participants will bid up the interest rate in anticipation of the forthcoming squeeze. The exchange rate block is based on the asset market theory of exchange rate determination. In the equation that explains the change in the DM/$ exchange rate, the three explanatory variables are the expected inflation rate differential, the change in the uncovered short-term interest rate differential, and the relative current balance position of Germany and the United States.’ A derivation of this equation was presented in Artus (1981, appendix 1). One of the results of the derivation was that the introduction of the relative current balance position could be justified on two grounds. First, the substi- tutability of domestic and foreign securities may be limited.

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