Overview
Since the general shift to floating exchange rates in the early1970s, exchange rates between the U.S. dollar and other major currencies havebeen variable or volatile. The charts at the beginning of the chapter suggestthree types of variability. First, there are long-term trends in which somecurrencies tend to appreciate against the dollar, and others tend to depreciate.Second, there are medium-term trends which are sometimes counter to the longertrends. Third, there is substantial variability during the short run. Thechapter presents what we know about exchange movements during these timeperiods of different lengths.
The chapter first examines short-run movements in exchange rates. Itpresents the version of the asset market approach to exchange rates thatfocuses on debt securities and the uncovered interest parity relationshipdeveloped in Chapter 18, presuming that this relationship holds approximatelyif not exactly. The basic discussion examines the pressure on the current spotexchange rate if one of the other three rates (the domestic interest rate, theforeign interest rate, and the expected future spot exchange rate) changes,with the other two held constant. If the domestic interest rate increases, thenthe foreign currency depreciates (the home currency appreciates). If theforeign interest rate increases, then the foreign currency appreciates. (Thetext notes that what really matters is the change in the interestdifferential.)
If the expected future spot exchange rate value of the foreigncurrency increases, then the current spot exchange rate value of the foreigncurrency increases. Many different things can influence the expected futurespot exchange rate. First, if expectations simply extrapolate recent trends,then a bandwagon is possible. Speculation then may be based on destabilizingexpectations—expectations formed without regard to the economic fundamentals—and(speculative) bubbles can occur. Second, if expectations are based on a beliefthat exchange rates eventually follow PPP, then they lead to stabilizingspeculation—speculation that tend to move the exchange rate toward a valueconsistent with the economic fundamentals of national price levels. Third,expectations are affected by various kinds of news about economic and politicalcircumstances.
The chapter then examines long trends in exchange rates. Ourunderstanding of exchange rates in the long run is based on the purchasingpower parity (PPP) hypothesis. Three versions of PPP are presented: the law of one price for a single product,absolute PPP, and relative PPP.
Absolute PPP posits that a basket of products will have the sameprice in all countries when the prices are converted into a single currencyusing the market exchange rates. In symbols absolute PPP is P = e×Pf (or e = P/Pf), where the P's are prices(measured in local currencies) in the home and foreign countries, and e is theexchange rate measured as units of domestic currency per unit of foreigncurrency. When we examine actual prices and exchange rates, divergences fromabsolute PPP (and the simpler law of one price) can be large.
Relative PPP posits that the exchange rate will change to offsetdifferences in the rates of product price inflation in different countries. Insymbols, (et /e0) = (Pt /P0)/(Pf,t/Pf,0), where the subscript 0 indicates the initial yearvalues and the subscript t indicates values in a subsequent year. The textpresents evidence on the relative version of PPP by examining inflation rates(rates of change of product prices) in different countries and the rates of thechange of the exchange rate between the countries' currencies. A relationshipconsistent with relative PPP is clear—low-inflation countries tend to haveappreciating currencies and high inflation countries tend to have depreciatingcurrencies. In addition, examination of the dollar-mark and dollar-yen exchangerates shows that there is a tendency to follow relative PPP in the long run,but that there are also substantial deviations from relative PPP in the shortrun.
If exchange rates follow national price levels in the long run, whatdetermines national price levels in the long run? In the long run the nationalmoney supply (or its growth rate) determines the national price level (or thenational inflation rate), through the equilibrium between money supply andmoney demand. In the text we use the demand for money that follows the quantitytheory of money, in order to draw out the relationships in the most directmanner possible. Money is held to facilitate transactions, so that money demandis based on the annual turnover of transactions that require money, and thisturnover is proxied by the level of (nominal) domestic product (P×Y, where Y is real GDP). The quantity theory then says that, foreach country, Ms = k×P×Y, where Ms is the national money supply, which iscontrolled by national monetary policy, and k is a behavioral parameter.
Combining PPP and the quantity theory equations for two countries,we obtain a basis for the monetary approach to explaining or predictingexchange rates in the long run: e = P/Pf = (Ms/Msf)×(kf /k)×(Yf /Y).If the ratio of the k's is steady, then the exchange rate will change over thelong run as the money supplies change and as real GDPs grow, with elasticitiesof one. Other things equal, in the long run a lower level (or slower growthover time) of a country's money supply, or a higher level (or faster growth) ofits real GDP, tend to result in a higher value (an appreciation over time) ofthe country's currency, because each implies a lower level (or slower rate ofincrease) in the country's price level.
The box on “Tracking the Exchange Rate Value of a Currency”introduces some concepts and distinctions that are useful in examining exchangerates. Nominal bilateral exchange rates are simply the standard rates quoted inthe foreign exchange market. The nominal effective exchange rate is an indexthat tracks the weighted-average nominal value of a county's currency.Deviations from PPP can be measured using the real exchange rate, which can bemeasured as an index between two currencies (bilateral) or as a weightedaverage index relative to a number of other currencies (effective). If PPPholds in the long run, then the real exchange rate tends to return to its"normal" value (e.g., 100). As we will discuss in Chapter 22, changesin the real exchange rate also can be used as an indicator of changes in theinternational price competitiveness of a country’s products.
How do we get from the short run in which portfolio adjustments byinternational investors place the major pressures on exchange rates to the longrun of PPP? We can view this as a process in which the exchange rate overshoots(relative to the value consistent with PPP) in the short run, and then(gradually) reverts to PPP in the long run. This can be seen most clearly byconsidering an abrupt change in the domestic money supply. The additional (and presumablyrealistic) assumption is that product price levels adjust slowly toward thelevel consistent with the quantity theory equation. If the domestic moneysupply increases abruptly, then, at first, the domestic price level does notrise much, but eventually it will. With the increase in the money supply (andnot so much of an increase in money demand at first), domestic interest ratesdecrease. In addition, investors expect that eventually the foreign currencywill appreciate (the domestic currency will depreciate) relative to its initialvalue, because the domestic price level eventually will be higher (PPP in thelong run). For both of these reasons (lower interest rate and expectedappreciation of the foreign currency relative to its initial value), investorsshift their investments toward foreign-currency assets. This causes an abrupt,large appreciation of the foreign currency—more than is consistent with thesmall amount of change in the domestic price level in the short run, and alsomore than is consistent with the long run change in the price level. Once theexchange rate value of the foreign currency overshoots in the short run, itthen is expected to and does decline back toward the long run value that isconsistent with PPP. In fact, this subsequent expected depreciation of theforeign currency is necessary to reestablish uncovered interest parity. Theoverall return on foreign-currency assets is then lowered by the expecteddepreciation of the foreign currency, so that it is about equal to the lowerdomestic return resulting from the lower domestic interest rate.
The chapter concludes with a discussion of how difficult it is topredict exchange rate movements in the short run. Generally, we cannot beat thenaive model of a random walk, which predicts that the exchange rate in thefuture will simply be the same as the exchange rate today. A major reason forthis inability to forecast is that the current spot exchange rate reactsquickly and strongly to unexpected (and therefore unpredictable) news. A secondreason may be that traders and investors form their short-run expectations ofexchange rates based not only on economic fundamentals but also on recenttrends. The expectations are then self-confirming, resulting in bubbles in themovement of exchange rates over time.
