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Economic Theories of Exchange Rate Determination At the most basic level, exchange rates are determined
by the demand and supply of one currency relative to the demand and supply
of another. For example, if the demand for dollars outstrips the supply
of them and if the supply of German deutsche marks is greater than the
demand for them, the dollar/mark exchange rate will change. The dollar
will appreciate against the mark (or the mark will depreciate against
the dollar). However, while differences in relative demand and supply
explain the determination of exchange rates, they do so only in a superficial
sense. This simple explanation does not tell us what factors underlie
the demand for and supply of a currency. Nor does it tell us when the
demand for dollars will exceed the supply (and vice versa) or when the
supply of German marks will exceed demand for them (and vice versa). Neither
does it tell us under what conditions a currency is in demand or under
what conditions it is not demanded. In this section, we will review economic
theory's answers to these questions. This will give us a deeper understanding
of how exchange rates are determined. Prices and Exchange Rates To understand how prices are related to exchange rate movements, we first need to discuss an economic proposition known as the law of one price. Then we will discuss the theory of purchasing power parity (PPP), which links changes in the exchange rate between two countries' currencies to changes in the countries' price levels. The Law of One Price The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.6 For example, if the exchange rate between the dollar and the French franc is $1 = FFr 5, a jacket that retails for $50 in New York should retail for FFr 250 (50 * 5) in Paris. Consider what would happen if the jacket cost FFr 300 in Paris ($60 in US currency). At this price, it would pay a company to buy jackets in New York and sell them in Paris (an example of arbitrage). The company initially could make a profit of $10 on each jacket by purchasing them for $50 in New York and selling them for FFr 300 in Paris. (We are assuming away transportation costs and trade barriers.) However, the increased demand for jackets in New York would raise their price in New York, and the increased supply of jackets in Paris would lower their price there. This would continue until prices were equalized. Thus, prices might equalize when the jacket cost $55 in New York and FFr 275 in Paris (assuming no change in the exchange rate of $1 = FFr 5). Purchasing Power Parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the "real" or PPP exchange rate that would exist if markets were efficient. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers.) A less extreme version of the PPP theory states that given relatively efficient markets--that is, markets in which few impediments to international trade and investment exist--the price of a "basket of goods" should be roughly equivalent in each country. To express the PPP theory in symbols, let P$ be the US dollar price of a basket of particular goods and PDM be the price of the same basket of goods in German deutsche marks. The PPP theory predicts that the dollar/DM exchange rate should be equivalent to: $/DM exchange rate = P$/PDM Thus, if a basket of goods costs $200 in the United States and DM 600 in Germany, PPP theory predicts that the dollar/DM exchange rate should be $200/DM600 or $0.33 per DM (i.e., $1 = DM 3). The next step in the PPP theory is to argue that the exchange rate will change if relative prices change. For example, imagine there is no price inflation in the United States, while prices in Germany are increasing by 20 percent a year. At the beginning of the year, a basket of goods costs $200 in the United States and DM 600 in Germany, so the dollar/DM exchange rate, according to PPP theory, should be $0.33 = DM 1. At the end of the year, the basket of goods still costs $200 in the United States, but it costs DM 720 in Germany. PPP theory predicts that the exchange rate should change as a result. More precisely, by the end of the year, $0.27 = DM 1 (i.e., $1 = DM 3.6). Because of price inflation, the DM has depreciated against the dollar. One dollar should buy more marks at the end of the year than at the beginning. Money Supply and Price Inflation In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. Theoretically, a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower. Because the growth rate of a country's money supply and its inflation rates are closely correlated,7 we can predict a country's likely inflation rate. Then we can use this information to forecast exchange rate movements. Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises faster than the stock of goods and services; that is, when the money supply increases faster than output increases. Imagine what would happen if everyone in the country was suddenly given $10,000 by the government. Many people would rush out to spend their extra money on those things they had always wanted--new cars, new furniture, better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department stores, and other providers of goods and services would respond to this upsurge in demand by raising prices. The result would be price inflation. A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the government and for individuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be inflation. This relationship has been observed time after time in country after country. So now we have a connection between the growth in a country's money supply, price inflation, and exchange rate movements. Put simply, when the growth in a country's money supply is faster than the growth in its output, price inflation is fueled. The PPP theory tells us that a country with a high inflation rate will see a depreciation in its currency exchange rate. Consider the case of Bolivia. In the mid-1980s, Bolivia experienced hyperinflation--an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly. Table 9.4 presents data on Bolivia's money supply, inflation rate, and its peso's exchange rate with the US dollar during the period of hyperinflation. The exchange rate is actually the "black market" exchange rate, as the Bolivian government prohibited converting the peso to other currencies during the period. The data show that the growth in money supply, the rate of price inflation, and the depreciation of the peso against the dollar all moved in step with each other. This is just what PPP theory and monetary economics predict. Between April 1984 and July 1985, Bolivia's money supply increased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the Bolivian government instituted a dramatic stabilization plan--which included the introduction of a new currency and tight control of the money supply--and by 1987 the country's annual inflation rate was down to 16 percent.8 Another way of looking at the same phenomenon is that an increase in a country's money supply, which increases the amount of currency available, changes the relative demand and supply conditions in the foreign exchange market. If the US money supply is growing more rapidly than US output, dollars will be relatively more Table 9.4 Macroeconomic Data for Bolivia, April 1984 - October 1985
Source: Juan-Antino Morales, "Inflation Stabilization in Bolivia," in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988). plentiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will depreciate on the foreign exchange market against the currencies of countries with slower monetary growth. Government policy determines whether the rate of growth
in a country's money supply is greater than the rate of growth in output.
A government can increase the money supply simply by telling the country's
central bank to print more money. Governments tend to do this to finance
public expenditure (building roads, paying government workers, paying
for defense, etc.). A government could finance public expenditure by raising
taxes, but since nobody likes paying more taxes and since politicians
do not like to be unpopular, they have a natural preference for printing
money. Unfortunately, there is no magic money tree. The inevitable result
of excessive growth in money supply is price inflation. However, this
has not stopped governments around the world from printing money, with
predictable results. If an international business is attempting to predict
future movements in the value of a country's currency on the foreign exchange
market, it should examine that country's policy toward monetary growth.
If the government seems committed to controlling the rate of growth in
money supply, the country's future inflation rate may be low (even if
the current rate is high) and its currency should not depreciate too much
on the foreign exchange market. If the government seems to lack the political
will to control the rate of growth in money supply, the future inflation
rate may be high, which is likely to cause its currency to depreciate.
Historically, many Latin American governments have fallen into this latter
category, including Argentina, Bolivia, and Brazil. There are signs that
many of the newly democratic states of Eastern Europe might be making
the same mistake. PPP theory predicts that changes in relative prices will result in a change in exchange rates. A country in which price inflation is running wild should expect to see its currency depreciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the connection between a country's price inflation and exchange rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed results.9 While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less. In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets. The theory is less useful for predicting short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates. Several factors may explain the failure of PPP theory to predict exchange rates more accurately. PPP theory assumes away transportation costs and barriers to trade and investment. In practice, these factors are significant, and they tend to create price differentials between countries. As we saw in Chapters 5 and 7, governments routinely intervene in international trade and investment. Such intervention, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory. Another factor of some importance is that governments also intervene in the foreign exchange market in attempting to influence the value of their currencies. We will look at why and how they do this in Chapter 10. For now, the important thing to note is that governments regularly intervene in the foreign exchange market, and this further weakens the link between price changes and changes in exchange rates. Perhaps the most important factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates, however, is the impact of investor psychology and other factors on currency purchasing decisions and exchange rate movements. We will discuss this issue in more detail later in this chapter. Interest Rates and Exchange Rates Economic theory tells us that interest rates reflect expectations about likely future inflation rates. In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect. The Fisher effect states that a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). More formally, i = r + I For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. As predicted by the Fisher effect, a strong relationship seems to exist between inflation rates and interest rates.10 We can take this one step further and consider how it applies in a world of many countries and unrestricted capital flows. When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real interest rates did emerge between countries, arbitrage would soon equalize them. For example, if the real interest rate in Germany was 10 percent and only 6 percent in the United States, it would pay investors to borrow money in the United States and invest it in Germany. The resulting increase in the demand for money in the United States would raise the real interest rate there, while the increase in the supply of foreign money in Germany would lower the real interest rate there. This would continue until the two sets of real interest rates were equalized. (In practice, differences in real interest rates may persist due to government controls on capital flows; investors are not always free to transfer capital between countries.) It follows from the Fisher effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates. Thus, if the expected rate of inflation in the United States is greater than that in Germany, US nominal interest rates will be greater than German nominal interest rates. Since we know from PPP theory that there is a link (in theory at least) between inflation and exchange rates, and since interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates. This link is known as the International Fisher Effect (IFE). The International Fisher Effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. Stated more formally, (S1 - S2)/S2 * 100 = i$ - iDM where i$ and iDM are the respective nominal interest rates in the United States and Germany (for the sake of example), S1 is the spot exchange rate at the beginning of the period, and S2 is the spot exchange rate at the end of the period. If the US nominal interest rate is higher than Germany's, reflecting greater expected inflation rates, the value of the dollar against the deutsche mark should fall by that interest rate differential in the future. So if the interest rate in the United States is 10 percent, and in Germany it is 6 percent, reflecting 4 percent higher expected inflation in the United States, we would expect the value of the dollar to depreciate by 4 percent against the mark. Do interest rate differentials help predict future currency movements? The evidence is mixed; as in the case of PPP theory, in the long run, there seems to be a relationship between interest rate differentials and subsequent changes in spot exchange rates. However, considerable short-run deviations occur. Like PPP, the International Fisher Effect is not a good predictor of short-run changes in spot exchange rates.11 Investor Psychology and Bandwagon Effects Empirical evidence suggests that neither PPP theory nor the International Fisher Effect are particularly good at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Increasing evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates.12 In turn, expectations have a tendency to become self-filling prophecies. We discussed a good example of this mechanism in the Management focus about George Soros. When George Soros shorted the British pound in September 1992, many foreign exchange traders jumped on the bandwagon and did likewise, selling British pounds and purchasing German marks. As the bandwagon effect gained momentum, with more traders selling British pounds and purchasing deutsche marks in expectation of a decline in the pound, their expectations became a self-fulfilling prophecy with massive selling forcing down the value of the pound against the deutsche mark. In other words, the pound declined in value not because of any major shift in macroeconomic fundamentals, but because investors moved in a herd in response to a bet placed by a major speculator, George Soros. According to a number of recent studies, investor psychology and bandwagon effects play a major role in determining short-run exchange rate movements.13 However, these effects can be hard to predict. Investor psychology can be influenced by political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Moreover, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behavior of politicians. Something like this seems to have occurred in Southeast Asia during 1997 when one after another, the currencies of Thailand, Malaysia, South Korea, and Indonesia lost between 50 percent and 70 percent of their value against the US dollar in a few months. For a detailed look at what occurred in South Korea, see the accompanying Country Focus. The collapse in the value of the Korean currency did not occur because South Korea had a higher inflation rate than the United States. It occurred because of an excessive buildup of dollar-denominated debt among South Korean firms. By mid-1997 it was clear that these companies were having trouble servicing this debt. Foreign investors, fearing a wave of corporate bankruptcies, took their money out of the country, exchanging won for US dollars. As this began to depress the exchange rate, currency traders jumped on the bandwagon and speculated against the won (selling it short). Summary Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. They are poor predictors of short-run changes in exchange rates, however, perhaps because of the impact of psychological factors, investor expectations, and bandwagon effects on short-term currency movements. This information is useful for an international business. Insofar as the long-term profitability of foreign investments, export opportunities, and the price competitiveness of foreign imports are all influenced by long-term movements in exchange rates, international businesses would be advised to pay attention to countries' differing monetary growth, inflation, and interest rates. International businesses that engage in foreign exchange transactions on a day-to-day basis could benefit by knowing some predictors of short-term foreign exchange rate movements. Unfortunately, short-term exchange rate movements are difficult to predict. |
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