ACE2006: Exchange rates

Contents:

Introduction

Imports (IM) are a leakage or withdrawal from the circular flow of income, and exports (X) are an injection. Booms in the domestic economy tend to increase Imports,  and possibly also discourage Exports, since there is stronger demand at home for the exported goods and services - unless the boom itself is "export-led", that is, a consequence of a growth in foreign demand for domestic exports.

Imports involve buyers in the home economy spending money (income) in foreign countries (economies), so the income leaks out of the domestic economy and is not then available for further rounds in the circular flow. As a result, increased imports are typically regarded as deflationary.

The superficial macroeconomic view is that imports are "bad news" - they are a leakage from the circular flow of income, depressing the domestic economy. However, for most of us, imports are good- otherwise we would not buy them.  Preventing imports both denies domestic consumers the choice of alternative supplies (reducing competition at home) and also denies foreign countries the chance of earning incomes (with which they might well choose to buy our exports).

Exports involve sellers in the home economy receiving income from abroad, and thus adding to the circular flow of income (and are thus injections into the circular flow) and add to the multiplier process. Hence, increasing exports are reflationary (and may be inflationary if capacity limits are effective).  Exports are typically seen as good news - but they are only good news in earning incomes for domestic suppliers - otherwise they involve higher prics for consumers and users of these goods and services than would otherwise be the case - [remember our previous market analysis of trade]

BUT: What about the Exchange Rate? This is the price of one currency in terms of another (the $s one has to pay to get £s and vice versa)

The Forex Market:
The Foreign Exchange (Forex) market is simply the market in which domestic currencies (£ in our case) are traded for (exchanged with) foreign currencies (like the $ or DM, Yen, Franc etc.). Thus, to represent the Forex market, we need to consider:

Importers have £s (from the domestic purchasers of imports) which they need to convert into $s (in order to pay the suppliers of the imports), so they are selling £s and buying $. The more £s they try and sell, the lower we would expect the price of £s to be.  Notice, Imports include imports of services (like domestic residents taking foreign holidays and travelling abroad, and domestic businesses buying banking and insurance services from abroad)

IM => Supply of £s to FOREX market (equivalent to Demand for Foreign exchange)

Exporters, on the other hand, are being paid in $s and need to sell these and buy £s to pay their home bills etc. So increased exports will increase the demand for £s in the foreign exchange market (and simultaneously increase the supply of $s), which is expected to increase the price of £s (and decrease the price of $s).  Again, notice that exports include the export of services (foreign visitors to the UK and UK firms selling financial, insurance and banking services to foreigners).

X => Demand for £s from FOREX market (equivalent to Supply of Foreign exchange)

But, importers and exporters (including those "importing" and "exporting" holidays and other services) are not the only people and businesses needing to convert currencies.  Capital (investment) flows into and out of the economy also lead to the need to exchange currencies:


The exchange rate is determined by the interaction (intersection) of the Supply of and Demand for foreign exchange - equivalent to the Demand for and Supply of domestic currency in the Foreign Exchange (ForEx) market.


NOTE:  In contrast to many of the text-books on the subject, I prefer to picture the Forex market in terms of the SUPPLY AND DEMAND FOR £s, rather than the supply and demand for Forex or $ (exchange rates as £/$ and quantity traded as $) - so beware!

At least my way round, the horizontal (quantity) axis shows BoP values in £s (as they are normally reported in the UK BoP statistics), and the vertical axis as $/£, which is the way we normally think of an exchange rate, so that movements up the vertical axis represent appreciations of sterling and vice versa - movements down the vertical axis represent depreciation  of sterling. So, what do demand and supply look like in the forex market?

Demand for sterling in Forex Market: (equivalent to the supply of ForEx.) derived from: Exports; Capital inflows; Remission of UK Co. profits from abroad etc.
The demand is downward sloping (ceteris paribus - all other things being equal or unchanged) - Quantity of £s demanded Increase as ER falls: because:

Supply of sterling to Forex Market: (Equivalent to the demand for ForEx) derived from: Imports; Capital outflows; Submission of foreign Co. profits from UK etc.
The supply is upward sloping (ceteris paribus) - Quantity of £s supplied Increases as ER rises - because:

The Forex Market Diagram (illustrated with 1996 data):


In 1996, there was a £2bn. deficit in the Balance of Payments (Imports + Capital Outflows > Exports + Capital Inflows). 

Other things being equal, this deficit (supply greater than demand) should have led to a depreciation of the exchange rate to Ee - the exchange rate was "too high" in 1996.  This depreciation was prevented by the Bank of England selling some of its own Forex reserves and thus adding to the demand for £s by £2 bn.  This "official financing" of the Forex market by the BoE supported the exchange rate at $1.6/£ (at Ea) rather than allowing it to depreciate to Ee.

Since the UK was operating under a floating exchange rate system in 1996 (and still is) the implication of the 1996 BoP account (with a negative balance offset by a running down of the Forex reserves) was that (over the course of the year) the exchange rate was tending to depreciate, with the Bank of England slowing this depreciation by buying in £s and selling forex reserves. In fact, by the last quarter of 1996, the exchange rate began to appreciate (allowing the bank to begin to re-build forex reserves by selling £s and buying forex).  It appreciated and remained strong, at least against the Euro, throughout the 1990's and against the $ more recently, as the $ has depreciated (largely because of both relatively large Trade and Budget deficits in the US)

Purchasing Power Parity (PPP) Theory, and (trade) equilibrium exchange rates.

(The Economist, May 25th, 2006) " WHEN our economics editor invented the Big Mac index in 1986 as a light-hearted introduction to exchange-rate theory, little did she think that 20 years later she would still be munching her way, a little less sylph-like, around the world. As burgernomics enters its third decade, the Big Mac index is widely used and abused around the globe. It is time to take stock of what burgers do and do not tell you about exchange rates. The Economist's Big Mac index is based on one of the oldest concepts in international economics: the theory of purchasing-power parity (PPP), which argues that in the long run, exchange rates should move towards levels that would equalise the prices of an identical basket of goods and services in any two countries. Our “basket” is a McDonald's Big Mac, produced in around 120 countries. The Big Mac PPP is the exchange rate that would leave burgers costing the same in America as elsewhere."

Suppose that Forex markets ONLY reflect demands and supplies of currencies resulting from the Current Account (ignore the Capital Account and financial capital movements for the present).

Now, in addition, suppose that there is NO government or official intervention in the Forex markets - no 'official financing' - no building up of running down of Forex reserves - so the Forex rate is genuinely 'floating'; entirely determined by the supplies and demands for currencies.

Now, suppose that there is ONLY one commodity which can possibly be traded in this highly simplified world - MacDonald Big Mac Hamburgers - and that the costs of shipping these products between countries is zero - to make things as simple as possible.

This assumption also means that there are NO barriers or prevention of possible trade between countries in Big Macs. (These stupidly simple assumptions will be relaxed later on - they just help clarify the logic of the argument for the present).

Now, if the price of Big Macs is low in one country - say the US - and high in another - like the UK, what will happen? Some smart soul will start to buy Big Macs in the US and sell them in the UK - that way s/he can make money in this simple world.
But, buying Big Macs in the US and selling them in the UK involves buying dollars and selling sterling in the Forex market - so (remembering that Big Macs are the only tradable good in this simplified world) there will be an over supply of sterling (and an excess demand for dollars) in the forex market -> leading to?

A decrease in the value of sterling (and an increase in the value of the dollar) in the forex market - the pound will depreciate and (in this simple example with just two countries) the dollar will appreciate until the demand for sterling is balanced with the supply of sterling and the corresponding demand for and supply of dollars is also balanced.

Of course - in this stupidly simple world, with no other goods which can be traded, there will be NO demand for pounds or supplies of dollars (no one is able to buy anything in the UK and sell in the US - that is, unless the price of Big Macs becomes lower in the UK than the US.)

So, the exchange rate (dollars per pound) will fall until?? Think, before you read on.

Until the price of the Big Mac is the SAME in both the US and the UK and no one is trying to trade them anymore.

What would happen if the exchange rate fell even further? again, think before you read on.

Then, the price of the Big Mac in the UK would be lower than the price in the US, and it would be profitable to trade in the other direction - buying them cheap in the UK and selling them dear in the US - and then what would happen in the Forex market? Think before you read on.

There would be an excess demand for sterling (and an excess supply of dollars) in the forex market and our $/£ exchange rate would rise, until the price of Big Macs was the same in each country.

This is the essence of the Purchasing Power Parity Theory of exchange rates - freely floating exchange rates will adjust in response to trade-driven demands and supplies of currencies so that (or until) the prices of the same goods are the same in all countries.

Repeating this argument for many goods and services rather than just one - the Big Mac - does NOT affect the logic - so long as exchange rates are driven by trading possibilities, the  prices of an identical 'basket' of goods and services should be the same in all countries - freely floating exchange rates will adjust to ensure that this is the case - these freely floating exchange rates are known as the 'purchasing power parity' rates (ppp rates).

This theory relies simply on the pursuit of profitable trading opportunities - there are at least some people or firms who will take advantage of the opportunities to buy cheap and sell dear and make a profit. If they can, they will, and will go on doing so until the prices (and exchange rates) adjust to remove the profitable opportunities. This pursuit of trading profit is also known as arbitrage - from the same root as arbitrate - to arbitrate between prices on the basis of profit opportunities. It is this arbitrage which ensures, in this simple 'model' or view of the world, the adjustment of prices and exchange rates to make prices the same in all countries - it is only then that arbitrage opportunities are eliminated.

The existence of transport and marketing costs between countries also does NOT alter this logic - all it means is that the prices of traded goods will be cheaper in the exporting country than in the importing country by the costs of moving and marketing the good between the exporter and the importer. The price differential will simply be the amount necessary to cover the full costs of moving the product or marketing the service (as we have already seen in section 1.

In addition, even though not all goods and services are tradable, even these non-tradables have more or less close price relationships with the tradable goods -

both because they are compliments or substitutes for consumers, or at least compete for the scarce the incomes of consumers, who make choices between things on the basis of price or expense (among many other reasons);

and because in the whole economy the production of these non-tradables has to compete for scarce resources with the production of tradables.

Thus, the working of the price and market system, and arbitrage again between alternatives, will link all the prices together - a system known as general equilibrium.

Finally, these linkages can also be expected to work on the capital account as well - investment opportunities and choices between and within countries will also present arbitrage opportunities, leading to adjustments in domestic prices and in exchange rates until the opportunities no longer exist.

<>Thus, in a freely working market system in the long run,when all possible arbitrage opportunities have been exhausted and everyone is earning just normal profits - which are just sufficient to cover all costs, including opportunity costs - the prices of the same baskets of goods should be the same in all countries (where import and export price differences cancel out within the overall basket) -> the purchasing power parity [PPP] theory of exchange rates.

The BigMac Index:<>

The Big Mac PPP is a gross (but powerful) simplification of this theory and would work just as well as the full basket of goods and services if markets were prefectly free - if there were no government interventions to 'distort' significant parts of the price of the Big Mac between countries, or restrictions and interventions which distort and prevent trade in other goods and services, or restrictions and interventions on capital movements between countries.

The fact that Big Macs are not tradable doesn't matter - exchange rates should adjust on the basis of tradable goods, which will feed through to non-traded goods. Thus the Big Mac ppp can be taken as a reasonable or workable approximation to the long-run equilibrium exchange rates towards which the current conditions are tending to move.

Of course, present conditions will change - and when and as they do, so too will the long run equilibrium towards which the system is moving. Thus, if some countries are generally getting better at the things they do faster than other countries, we would expect them to become more competitive (and to get richer), and for their exchange rates to appreciate as a consequence and vice versa.

<>Quoting from The Economist (May 25th, 2006) "The index was never intended to be a precise predictor of currency movements, simply a take-away guide to whether currencies are at their “correct” long-run level. Curiously, however, burgernomics has an impressive record in predicting exchange rates: currencies that show up as overvalued often tend to weaken in later years. But you must always remember the Big Mac's limitations. Burgers cannot sensibly be traded across borders and prices are distorted by differences in taxes and the cost of non-tradable inputs, such as rents.

Despite our frequent health warnings, some American politicians are fond of citing the Big Mac index rather too freely when it suits their cause—most notably in their demands for a big appreciation of the Chinese currency in order to reduce America's huge trade deficit. But the cheapness of a Big Mac in China does not really prove that the yuan is being held far below its fair-market value. Purchasing-power parity is a long-run concept. It signals where exchange rates are eventually heading, but it says little about today's market-equilibrium exchange rate that would make the prices of tradable goods equal. A burger is a product of both traded and non-traded inputs.

It is quite natural for average prices to be lower in poorer countries than in developed ones. Although the prices of tradable things should be similar, non-tradable services will be cheaper because of lower wages (reflecting lower incomes). PPPs are therefore a more reliable way to convert GDP per head into dollars than market exchange rates, because cheaper prices mean that money goes further. This is also why every poor country has an implied PPP exchange rate that is higher than today's market rate, making them all appear undervalued. Both theory and practice show that as countries get richer and their productivity rises, their real exchange rates appreciate. But this does not mean that a currency needs to rise massively today. Jonathan Anderson, chief economist at UBS in Hong Kong, reckons that the yuan is now only 10-15% below its fair-market value.

Even over the long run, adjustment towards PPP need not come from a shift in exchange rates; relative prices can change instead. For example, since 1995, when the yen was overvalued by 100% according to the Big Mac index, the local price of Japanese burgers has dropped by one-third. In the same period, American burgers have become one-third dearer. Similarly, the yuan's future real appreciation could come through faster inflation in China than in the United States.

The Big Mac index is most useful for assessing the exchange rates of countries with similar incomes per head. Thus, among emerging markets, the yuan does indeed look undervalued, while the currencies of Brazil, Turkey, Hungary and the Czech Republic look overvalued. Economists would be unwise to exclude Big Macs from their diet, but Super Size servings would equally be a mistake."

Big Mac Rates (as of Feb.1st, 2007)


 Big Mac Prices
 Big Mac Prices Implied PPP
 Actual $
% Under (-).
Country in local currency
 in $
 rate/$
 exchange rate
 Over(+) valuation
US
 $3.22 $3.22


UK
 £1.99
 $3.90
 1.62
 1.96
 +21
Japan
 280Yen
 $2.31
 87
 121
 -28
China
 11Yuan
 $1.41
 3.42
 7.77
 -56
Euro Area
 €2.94
 $3.82
 1.10
 1.30
 +19

For 2009 PPP rates, using the Big Mac Index - see here.

Back to Competition