Global economics

BCO221 GLOBAL ECONOMICS

Prof. Nelson H. S. Ferreira [email protected] orcid.org/0000-0003-2637-3211

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Unit 9: Exchange Rates

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Exchange rates: real and nominal

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Exchange Rates

u What is the exchange rate? it is the price of a currency in terms of another currency.

Please, note that the exchange rate can be defined in two opposite ways:

- direct: domestic currency per unit of foreign currency for example: 0.70 € / $ (we need 0.7 € to buy 1 $)

- indirect: foreign currency per unit of domestic currency for example: 1.33 $ / € (we need 1.33 $ to buy 1 €)

Exchange Rates 5

u Examples

How much does it cost in US Dollars ($) to buy a sweater that costs 50 UK Pounds (UKP) if the exchange rate is 1.50 $/UKP ?

1.50 $

𝑈𝐾𝑃 × 50 𝑈𝐾𝑃 = $75

… And to do the inverse we divide by the exchange rate:

How much does it cost in UK Pounds (UKP) to buy a pair of jeans that costs 85 US Dollars($) if the exchange rate is 1.50 $/UKP ?

85 $ ÷ 1.50 $

𝑈𝐾𝑃 = 56,67 𝑈𝐾𝑃

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Exchange Rates

The demand and supply of currencies are determined by: u Relative interest rates u The demand for imports (D$) u The demand for exports (S$) u Investment opportunities u Speculative sentiments u Global trading patterns u Changes in relative inflation rates

Appreciation of the exchange rate:

A rise in the value of £ in relation to other currencies: each £ buys more of the other currency e.g. £1 = $1.85 £1 = $1.91

u UK exports appear to be more expensive ( X) u Imports to the UK appear to be cheaper ( M)

Exchange Rates

Depreciation of the Exchange Rate A fall in the value of the £ in relation to other currencies - each £ buys less of the foreign currency e.g. £1 = € 1.50 £1 = € 1.45

u UK exports appear to be cheaper ( X)

u Imports to the UK appear more expensive ( M)

Exchange Rates

Exchange Rates 9

When the price of one currency in terms of another currency increases, then we say that the former currency is appreciating

•… it means the latter currency is now cheaper

When the price of one currency in terms of another currency falls, then we say that the former currency is depreciating

•… it means that the latter currency is now more expensive

The change in the exchange rate affects a lot the cost of goods that we import.

•Example: oil price

Exchange Rates $ per £

Quantity on ForEx Markets

D£

S£

1.85

Q1

Assume an initial exchange rate of £1 = $1.85. There are rumours that the UK is going to increase interest rates

Investing in the UK would now be more attractive and demand for £ would rise

D£1

Q2

Shortage

1.90

Q3 The rise in demand creates a shortage in the relationship between demand for £ and supply – the price (exchange rate) would rise

Exchange Rates 11

Bitcoin appreciating in the graph

Exchange Rates

Suppose that now the exchange rate is 1.25 $/UKP instead of 1.5$/UKP. Hence, the UK Pound has: a) Depreciated b) Appreciated c) Remain the same

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Exchange Rates 13

Hence, when one compares the price of two goods that are denominated in different currencies, looking at the relative price itself is not sufficient: we need to know the nominal exchange rate too so that we compare them in the same currency.

All else equal, the appreciation of a country’s currency raises the relative price of its exports and lowers the relative price of its imports.

Do you know of any currency that has substantially appreciated during 2017 or recently?

Exchange Rates 14

Do you know of any currency that has substantially appreciated during 2018?

Exchange Rates 15

Conversely, a depreciation lowers the relative price of a country’s exports and raises the relative price of its imports.

Is there any currency that has substantially depreciated during 2017 or recently?

Exchange Rates Do you know of any currency that has substantially depreciated during 2018?

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17Causes of the short-term fluctuations in exchange rates

“Among the crucial short-term factors are interest rates, economic growth, trade flows, inflation, commodity-based currency impact, political or geopolitical conflicts and natural calamities in a country.”

Source: https://economictimes.indiatimes.com/markets/forex/short-long-term-factors-that-impact-currencies-across-the- world/articleshow/20829254.cms

Causes of the short-

term fluctuations in exchange

rates

u “Interest rate: It plays a crucial role in providing direction to a currency, and a weak policy could lead to depreciation. A central banker usually adopts a loose policy when economic growth needs a boost.

u Trade balance: This has a major impact on the currency movement. A nation that has more exports than imports will witness a trade surplus, which will support gains for the currency. On the other hand, trade deficit will lead to depreciation in the currency.

u Inflation: If inflationary expectations in a country are high, the central banker will look to curb it by increasing interest rates, or vice versa. A rise in rates will support the currency, while a fall will cause the demand for the currency to deteriorate.

u Commodity imports: The countries that are dependent on commodity imports for domestic consumption usually face headwinds in terms of the currency movement. For India, the increase in gold imports caused the trade deficit to widen sharply, leading to depreciation in the currency.

u Political turmoil, geopolitical tensions or natural disasters can also have a negative impact. Currency movement is largely dependent on the day-to-day economic data released across the globe, movement in the global equity markets and a change in commodity prices.”

18Source: https://economictimes.indiatimes.com/markets/forex/short-long-term-factors-that-impact-currencies-across-the- world/articleshow/20829254.cms

Causes of the Long-

term factors fluctuations

in exchange

rates

u “Economic growth and inflation: Expectations of economic growth and inflation over a long period affect currency price movement. Consider the US economy, which underwent a long period of slow growth, during which the Dollar Index suffered losses. However, the current expectations of longterm growth are bullish, strengthening the Dollar Index as markets expect a reversal in the state of the economy.

u As for inflation, the central the central bank targets a lower range as a higher inflation rate leads to depreciation in the currency as each unit can buy fewer goods and services. A high rate will restrict central bankers' steps to change the rate scenario. Hence, inflation expectations drive currency movement.”

19Source: https://economictimes.indiatimes.com//markets/forex/short-long-term-factors-that-impact-currencies-across-the-world/articleshow/20829254.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

20Causes of the Long-term factors fluctuations in exchange rates

Stimulus measures: Such steps by central bankers to boost economic growth also impact currency. The quantitative easing program by the Federal Reserve led to a sharp bounceback in market sentiment during the financial crisis and led to the weakening of the Dollar Index. While stimulus measures led to a rise in risk sentiment and weakened the Dollar Index, the ongoing developments on the withdrawal of these steps is strengthening the Dollar Index, indicating the economic recovery .”

Source: https://economictimes.indiatimes.com//markets/forex/short-long-term-factors-that-impact-currencies-across-the- world/articleshow/20829254.cms?utm_source=contentofinterest&utm_medium=text&utm_campaign=cppst

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currency, interest

rate and exchange

rate

u Please note: u “All other factors being equal, higher

interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. However, such simple straight-line calculations rarely exist in foreign exchange.

u Although interest rates can be a major factor influencing currency value and exchange rates, the final determination of a currency's exchange rate with other currencies is the result of a number of interrelated elements that reflect the overall financial condition of a country with respect to other nations.”

Source: https://www.investopedia.com/ask/answers/040315/how-do-changes- national-interest-rates-affect-currencys-value-and-exchange-rate.asp

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currency, interest

rate and exchange

rate

Factors in Currency Values: u “Generally, higher interest rates increase

the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.1

u Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency's relative value.

u This simple occurrence is complicated by a host of other factors that impact currency value and exchange rates. One of the primary complicating factors is the relationship that exists between higher interest rates and inflation. If a country can achieve a successful balance of increased interest rates without an accompanying increase in inflation, its currency's value and exchange rate are more likely to rise.”

Source: https://www.investopedia.com/ask/answers/040315/how-do-changes- national-interest-rates-affect-currencys-value-and-exchange-rate.asp

Purchasing Power Parity (PPP) 23

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Purchasing Power Parity (PPP)

u “Purchasing power parity (PPP) is a popular metric used by macroeconomic analysts that compares different countries' currencies through a "basket of goods" approach.

u Purchasing power parity (PPP) allows for economists to compare economic productivity and standards of living between countries.

u Some countries adjust their gross domestic product (GDP) figures to reflect PPP.”

“According to this concept, two currencies are in equilibrium—known as the currencies being at par—when a basket of goods is priced the same in both countries, taking into account the exchange rates.”

Purchasing Power Parity (PPP)

u Calculating Purchasing Power Parity

S= P1/ P2

S= Exchange rate of currency 1 to currency 2 P1= Cost of good X in currency 1 P2= Cost of good X in currency 2

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26Drawbacks of Purchasing Power Parity

“Since 1986, The Economist has playfully tracked the price of McDonald's Corp.’s (MCD) Big Mac hamburger across many countries. Their study results in the famed "Big Mac Index". In "Burgernomics"—a prominent 2003 paper that explores the Big Mac Index and PPP—authors Michael R. Pakko and Patricia S. Pollard cited the following factors to explain why the purchasing power parity theory is not a good reflection of reality.”

Source: https://www.investopedia.com/updates/purchasing-power-parity-ppp/

Drawbacks of

Purchasing Power Parity

“Transport Costs

u Goods that are unavailable locally must be imported, resulting in transport costs. These costs include not only fuel but import duties as well. Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.6

Tax Differences

u Government sales taxes such as the value-added tax (VAT) can spike prices in one country, relative to another.6

Government Intervention

u Tariffs can dramatically augment the price of imported goods, where the same products in other countries will be comparatively cheaper.6

Non-Traded Services

u The Big Mac's price factors input costs that are not traded. These factors include such items as insurance, utility costs, and labor costs. Therefore, those expenses are unlikely to be at parity internationally.6

Market Competition

u Goods might be deliberately priced higher in a country. In some cases, higher prices are because a company may have a competitive advantage over other sellers. The company may have a monopoly or be part of a cartel of companies that manipulate prices, keeping them artificially high.”

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Final remarks 28

u "While it's not a perfect measurement metric, purchase power parity does allow for the possibility of comparing pricing between countries that have differing currencies.”

Source: https://www.investopedia.com/updates/purchasing-power-parity-ppp/

u What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency? And hence, what causes short-term fluctuations in exchange rates?

u Factors that influence the return on assets determine the demand of those assets. The main factors are: u interest rates that the assets will earn u expectations about appreciation or depreciation

The Demand of Currency Deposits

u Many countries try to fix or “peg” their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets.

u Many with a flexible or “floating” exchange rate in fact practice a managed floating exchange rate. u The central bank “manages” the exchange rate

from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility.

Central Bank Intervention

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Source: https://www.tutor2u.net/economics/reference/exchange- rates-currency-systems

Have a look on ‘Fixed and Floating Exchange Rates’:

https://www.youtube.com/watch?v=5GvwMqMBScI&feature=youtu.be

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u Countries with a flexible or “floating” exchange rate in fact practice a managed floating exchange rate. u The central bank “manages” the exchange

rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility.

Central Bank Intervention

u Changes in the central banks balance sheet lead to changes in currency in circulation or changes in deposits of banks, which lead to changes in the money supply. u If their deposits at the central bank increase, banks are

typically able to use these additional funds to lend to customers, so that the amount of money in circulation increases.

Central Bankʼs Balance Sheet

The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined prices.

Central Bank Intervention

Source: https://www.investopedia.com/terms/forex/f/foreign-exchange-markets.asp

FINANCIAL MARKETS – FX Markets

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Chinese yuan:

How does China Manipulate its currency? (3min 27’’)

https://www.youtube.com/watch?v=Qy1V7tWpTGY

Central Bank Intervention

u “Chinese yuan: China’s central bank has allegedly devalued yuan by buying large amounts of US dollars with yuan, thus increasing the supply of the yuan in the foreign exchange market, while increasing the demand for US dollars, thus increasing the price of USD. As of the end of 2016, China’s foreign exchange reserve holds roughly $3.2 trillion, making it the highest foreign exchange reserve in the world. Roughly 60% of this reserve is composed of US government bonds and debentures.

u A debenture is one of the most typical forms of long term loans that a company can take. It is normally a loan that should be repaid on a specific date, but some debentures are irredeemable securities (sometimes referred to as perpetual debentures). The majority of debentures come with a fixed interest rate.”

Central Bank Intervention

Source: https://en.wikipedia.org/wiki/Currency_intervention

Russian ruble:

“Declining oil prices and economic sanctions imposed by the West in response to the Russian annexation of Crimea led to worsening Russian recession. On December 15, 2014,the ruble dropped as much as 19 percent, the worst single-day drop for the ruble in 16 years.”

The Russian central bank response was twofold:

“First, continue using Russia's large foreign currency reserve to buy rubles on the forex market in order to maintain its value through artificial demand on a larger scale. The same week of the December 15 drop, the Russian central bank sold an additional $700 million in foreign currency reserves, in addition to the nearly $30 billion spent over previous months to stave off decline. Russia's reserves then sat at $420 billion, down from $510 billion in January 2014.”

Central Bank Intervention

Source: https://en.wikipedia.org/wiki/Russian_financial_crisis_(2014%E2%80%932017)

Russian ruble: “Second, increase interest rates dramatically. The central bank increased the key interest rate 650 basis points from 10.5 percent to 17 percent, the world's largest increase since 1998, when Russian rates soared past 100 percent and the government defaulted on its debt. The central bank hoped the higher rates would provide incentives to the forex market to maintain rubles. Current Russian foreign reserves sit at $360 billion. In response to the ruble's surge, the Russian central bank lowered its key interest rate further to 14 percent in March 2015. The ruble's recent gains have been largely accredited to oil price stabilization and the calming of conflict in Ukraine.”

Central Bank Intervention

Source: https://en.wikipedia.org/wiki/Currency_intervention