Amélia Heckel

International Economics

Session 6 – The Exchange Rate Market

Looking at exchange rate from POV of someone who wants to buy goods and services.

Nominal Exchange Rate – rate at which you exchange currencies (the price of foreign
currency) will make supply and demand of foreign currency equal
Why so important?
• Relevant to all who trade goods/financial assets/services with other
countries
How is it determined?
• Supply and demand of foreign currency
• Registers in the balance of payments
o Credits in the CA = supply of foreign currency
o Debits in the CA = demand for foreign currency
§ Ex. Export car, (credit CA), receive payment (Debit FA)

The exchange rate (S) – relative price of 2 currencies

Ex. Euros vs. dollars SUSD/EUR = 1.3, this means that one would pay US$1.3 to buy
1euro.
SEUR/USD = 0.77, one would pay 0.77euro to buy US$1

It is the inverse.

Domestic over foreign.

Credit in CA, selling something, money is coming in as debit, if you are exporting, you receive
foreign currency as debit as demand for foreign currency.

We usually quote the ER as the price of the foreign currency in terms of the domestic
currency. (In this case how many euros you need to buy foreign currency)
Same everywhere except USA.

When domestic currency loses value = ER depreciation

When foreign currency loses value = currency is getting more expensive
ER increases, value of our currency dcreases

Value of domestic currency increase = ER appreciation

Foreign currency is becoming cheaper
Amélia Heckel

Value of ER decreases, value of our currency increases

If interest is to consume goods/services in another country, we compare prices in the 2

countries by converting them into the same currency by using the ER.

Real exchange rate – measures relative price of goods between the two countries (measure
of purchasing power)

𝑆𝑃 ∗
𝑄=
𝑃
P*= price in foreign country
P = price in home country

If RER is high, prices in foreign country are higher than in home country = purchasing power
of domestic country in foreign country is lower
Depreciation of the RER (Q increases)

If RER is lower, purchasing power of domestic country in foreign country is higher

Appreciation of the RER (Q decreases)

S is nominal

Multilateral exchange rate – average of all bilateral exchange rates (take each bilateral
exchange rate between each partner and take the weighted average) with trading partners

Big sign (multiplication of all terms following the sign)

i = value of trading partner
I = category
Wi = weight given to certain partner

RER depreciation – foreign goods are more expensive, PPP decreases

If domestic consumers are more willing to buy their own goods, then imports will be lower.
Amélia Heckel

If foreign consumers have more incentives to buy domestic goods, then domestic country will
have more exports.

6.1 Law of One Price

If there are no transportation costs or trade barriers, price of a good should be the same for
both countries, when measured in the same currency. If not the same, people buy at country
with lower cost

Possibility of arbitrage drives prices to be the same in both countries

SP*b = Pb

Pb = price of good in domestic country

P*b = price of good in foreign country

Big Mac Index – informal way of measuring the purchasing power parity (PPP) between two
currencies
Product that should be the same price everywhere, based on the price in US in dollars,
but this is not the case. If price of foreign country is more than in US, then it is currency of
foreign country is appreciated.

If actual ER is bigger than implied ER then undervalued/overdepreciated.

Undervalued = less depreciated

Overvalued = more appreciated

Overappreciated
Overdepreciated

Purchasing-power parity (PPP) – theory of exchange rates where a unit of any given currency
should be able to buy the same quantity of goods in all countries (same purchasing power)
• based on LOP; law of one price
o a good must sell the same price in all locations

RER is always constant and equal to 1. If the law of one price is true for every single item,
then that ratio should be equal to 1.
Amélia Heckel

Each RER level is associated to a trade balance value.

Appreciated exchange rate, trade balance is lower
Depreciated exchange rate, trade balance is higher
Equilibrium RER is the RER level associated with the equilibrium CA balance.
• Equilibrium CA (current account) balance is balance compatible with the optimal
aggregate savings and investment in the economy

CA = S - I

K = equilibrium value of the RER

RER at equilibrium level at relative PPP (not equal to 1 but constant)

SP*/P = K

How are they evolving w.r.t? (Derivative of log)

Why is PPP not valid?

• Transportation costs
o Physical goods
• Non-tradable goods
o Locally, factors of production can be non-tradable even for some tradable
goods
o Transportation outweighs value of service
§ Ex. Haircut in NY when living in France, is it worth it?
o Goods that cannot be sent to another country
§ Ex. Land
• Differentiated goods
o Same goods in characteristics but can be a little different according to where
they are produced
§ Ex. Producing cars in France or in Japan, depends on consumer taste
(same good different price)
• Differences in preferences
o Same good can be preferred in some countries and not others, adding more
weight to the good
Amélia Heckel

PPP and RRR

- Link between ER and trade balance
- Depreciation, increase in trade balance
o Import less, export more
- Appreciation, decrease in trade balance
o Import more, export less

% change in ER = difference between domestic and foreign inflation

Session 7 – The Exchange Rate Market Cont.

Looking at exchange rate from POV of someone interest in buying/selling financial assets
Returns of financial assets.

Arbitrage until things are equal at parity (covered/uncovered)

When comparing two countries, you cannot use the exchange rate today to convert dollars
into euros as the amount earned is only in one period from now.
Use the forward market
• Make contract with bank telling them how many dollars you will have
in one period from now
• State exchange rate for conversion for no risk
• Exchange rate determined (most important)

tFt+1 = forward rate settled at t for redemption at t+1

the amount of euros that I will have one period from now:

! 𝐹!"#
(1 + 𝑖! ∗)
𝑆!

In sum:
1euro à convert à US$ 1/St à invest à (1+it*) à converts back à tFt+1/St (1+it*) euro

Now we can compare to German assets (DIFF):

! 𝐹!"#
(1 + 𝑖! ) − (1 + 𝑖! ∗)
𝑆!
Amélia Heckel

This return differential is one of the criteria that investors use to decide which asset to
purchase.
• Assets can differ in relation to their liquidity/risk associated with them
• The higher the relative return of the American asset, the higher its attractiveness will
be in relation to the German, so the demand will also be higher. (vice versa)

When I am deciding how much I am going to buy of assets of different countries, what matters
is not the value of the exchange rate TODAY, (unlike goods) what matters how the exchange
rate will CHANGE over time. How it will evolve.
• Investing is something that will happen through time
• Return is received in future; I need to convert earnings into my own currency

If exchange rate doesn’t change:

Asset giving me higher return = asset giving higher interest rates

Appreciation of euro = decreases return on foreign assets

Extreme assumptions
• Assume 2 assets from two different countries do not differ apart from return
o If free capital mobility (any financial investor can buy financial assets from any
country)
§ Difference in return will lead them to allocate all available wealth to
invest in asset with highest return (assuming no risk)
• Everyone will buy that asset, which will raise its price and lower
its return until both returns are equal

If free capital mobility, both returns will be the same.

Non arbitrage condition, returns are equal to each other:

! 𝐹!"#
(1 + 𝑖! ) = (1 + 𝑖! ∗)
𝑆!

Non arbitrage condition – covered interest parity condition

• Arbitrage – when you are able to make profit by gaining due to changes in exchange
rate
o No arbitrage because return on investment is the same
• Returns of both assets are the same
• No risk premium
• Fixed for forward market
o Covered from exchange risk
Amélia Heckel

• 2 assumptions
o Free capital mobility (PPP)
o Perfect substitutability of assets
§ Perfect substitutes to each other apart from currency denomination of
assets

(1 + 𝑖! ) ! 𝐹!"#
=
(1 + 𝑖! ∗) 𝑆!

right hand side – how the exchange rate changes from today to tomorrow
left hand side – ratio between interest rate on German asset and int. rate on American asset

For an investor – the ER doesn’t matter, it is the variation in time.

• ER change between time of buying and selling a foreign asset alters the value of the
foreign asset in domestic currency

Despite perfect mobility of capital, there can be differences in return between assets if they
are not perfect substitutes. This then affects their relative attractiveness
Ex. Differences in risk (investors only buy riskier asset if it has higher return)

Credit risk ratings are attributes to countries, companies and banks for information.
Is it worth what I am paying?

Countries with higher risk, supply higher yield on assets to compensate investors for risk
incurred.

Risk premium – increase in return associated with ability to pay off issuer of asset

(1 + 𝑖! )
! 𝐹!"#
(1 + 𝑖! ∗)
𝑆!

Denominator should be higher if country is riskier.

Domestic over the return of the foreign
>1, domestic is riskier
<1, foreign is risker
=1 one as risky as the other, can invest in one or the other doesn’t matter

If investors don’t care about the exchange rate risk:

Amélia Heckel

Uncovered interest parity condition – investors may opt to arbiter between the return of two
assets without resorting to the future exchange market. ‘go with the flow, no defined ER’, you
don’t know the market in 3 years
Transaction is not covered for the exchange rate risk.

(1 + 𝑖! ) 𝐸(𝑆!"# )
=
(1 + 𝑖! ∗) 𝑆!

Instead of using F, we use the expectation € of the exchange rate tomorrow. (uncertain) (no
exchange rate risk premium)

𝐸(𝑆!"# ) ! 𝐹!"#
=
𝑆! 𝑆!

Either there is no risk, or there is a risk, but they are indifferent to that risk, so there is no
exchange rate risk premium.

If UIP is valid, then assets between two countries are perfect substitutes so their equilibriums
will be the same when measured in the same currency. Depreciation in one asset to
compensate for interest rate diff or other difference between both assets.

7.1 Carry Trade

Gains from carry trade – contract debt in a country where the interest rate is low and invest
in assets when the return is higher.
Make profit when borrowing from country where interest rate is lower and investing
in assets where the interest rate is higher.

Why can’t we do this until gains are exhausted?

If there is abrupt depreciation (change in exchange rate) in country where resources
are invested, you lose a lot

It’s just arbitrage – lose in terms of expectations

Session 8 – Monetary Policy and Exchange Rate

Focus on the money market and the analysis of the impact of monetary stocks.
Studied in the LR – period where there is enough time for complete adjustment of
price of goods/services to economic stocks (flexible) prices adjust to shocks in
economy
Amélia Heckel

Consequence of price flexibility – CA is always at its optimum level, with RER at its equilibrium
level (RER balances out the trade balance see above)
GDP of country is constant/exogenous (prices adjust for output to be at equilibrium
level).

8.1 Money, Assets, and good markets

We consider a small open economy: all foreign variables are exogenous.

When we say country is a small open economy – how much this economy is buying/selling in
international markets is not affecting international prices. (Too small for impact on prices)

Open economy: interaction of six markets

• Domestic + foreign money markets (money market in equilibrium)
o Supply = demand of money
§ Supply – government decision (central bank) stock of currency/liquid
instruments
• Cash, coins, balances in checking accounts, savings accounts
§ Demand – decision made by private agents
• Nominal IR increases, people want to save
• Increasing function of income
o higher income in country, the more things you need to
buy/sell = higher demand for money
• Decreasing function of interest rate
o Interest rate – opportunity cost of retaining money
(putting money in savings gives higher interest rates)

M(t) – p(t) = fy(t) - hi(t)

Left hand side: real money supply (total amount of money in economy divided by prices) log
of money supply – log of prices
Right hand side: real money demand log of (changes in) income (exogenous) (higher fi means
higher impact on RMD) – log of 1+interest rate in economy (higher interest rate = lower
demand)

• Domestic + foreign assets markets

o Assets from different countries are perfect substitutes, investors are risk
neutral, perfect capital mobility
Amélia Heckel

§ Uncovered interest parity condition must be true (ensures

equilibrium)
§ Evolution of exchange rate over time = ratio between domestic int.
rates and international int. rates
§ Measure instantaneous rate of change of exchange rates

𝒅𝒔(𝒕)
𝑬/ 3 = 𝒊(𝒕) − 𝒊 ∗ (𝒕)
𝒅𝒕

Left hand side: expected exchange rate variation rate for period t
Right hand side: i(t) is log of 1+interest rate and i*(t) is log of 1+foreign interest rate

• Domestic + foreign goods markets

o Prices of goods are totally flexible, no transport costs, no barriers to
international trade
§ Purchasing power parity should be true (ensures equilibrium)

S(t) + p*(t) – p(t) = 0

Left hand side: log of nominal exchange rate + log of international prices – log of domestic
prices
Right hand side: 0 because log1 = 0

Combine all 3 equations:

𝒅𝒔(𝒕)
𝒎(𝒕) − (𝒔(𝒕) + 𝒑 ∗ (𝒕)) = ∅𝒚(𝒕) − 𝜼 :𝑬( ) + 𝒊 ∗ (𝒕);
𝒅𝒕

When this equation is true, all 3 other equations are true.

𝒅𝒔(𝒕)
𝒔(𝒕) = m(t) - 𝒑 ∗ (𝒕) - ∅𝒚(𝒕) + 𝜼𝒊 ∗ (𝒕) + 𝜼𝑬( )
𝒅𝒕

How are the different variables impacting the nominal exchange rate?
Function of exogenous variables (fundamentals of economy impacting ER).

EXAMPLES (vice versa)

• Permanent increase in money supply = ER increases, depreciates
o Depreciation of domestic currency
• Increase in international prices = lower domestic ER (higher foreign prices)
o Appreciation of domestic currency
• Positive income shock = lower domestic ER
Amélia Heckel

o Appreciation of domestic currency

• Higher international interest rates = higher ER
o Depreciation of domestic currency

Asset price = fundamentals of asset price + expected price change

ER depends on current level of economic fundamentals and on expected changes in the very
exchange rate.

8.2 Exchange Rate Path

Exogenous variables that explain exchange rate level correspond to economic fundamentals
defined as:

F(t) = M(t) – p*(t) – fy(t) + hi*(t)

Exchange rate path:

𝒅𝒔(𝒕)
𝒔(𝒕) = f(𝒕) + 𝜼𝑬( )
𝒅𝒕

How does the nominal exchange rate s(t) evolve over time?

Fixed exchange rate regime à commitment to use the monetary policy to maintain the
fundamentals fixed

Monetary contraction abroad à domestic monetary contraction to maintain exchange rate

fixed

8.3 Credibility

If there is uncertainty to keeping the fixed ER regime. Only works when country trusts the
government

To maintain fixed ER under a lack of credibility, the government has to put in place a more
restrictive monetary policy. Costs of maintaining this fixed ER regime are higher.

Higher expected ER depreciation = bigger contraction

Impossible trinity – impossible to simultaneously have:

• Free capital mobility
• Fixed ER rate regime
• Independent monetary policy
Amélia Heckel

o Has to go with level of ER that we want to maintain

Get rid of one to have both of the others, can’t have all three.

Problems with model

• Monetary model with flexible prices doesn’t help to understand relation between ER
and real side of econ
o Prices adjust immediately to any movement in nominal exchange rate, so RER
is always constant
o Changes in nominal exchange rate affect neither output level nor trade
balance
o Long term representation of prices where they had time to adjust to ER
changes

Session 9 – International Monetary Systems

Classification of exchange rate regimes

• Floating regimes
o Free floating
§ No government intervention in markets, no use of using monetary
policy to affect ER
§ ER is determined by supply and demand of money (equilibrium price of
foreign currency)
o Managed/Dirty floating
§ Government can make interventions to prevent excessive/undesired
fluctuations
• Flexible parity regimes
o Crawling Bands
§ ER floats with limits, government intervenes to prevent it from crossing
barriers
• Lower and upper bound can change over time
o Crawling Pegs
§ ER is periodically adjusted according to previous announced program
§ High inflation countries – programmed ER adjustments served as
nominal anchors in price stabilization programs
o Fixed ER
§ Government pledges to intervene in foreign exchange market/use int.
rate policy to maintain ER fixed at previously announced level
§ Soft peg: no mechanism to provide strong government commitment to
maintain parity
• Fixed parity regimes
o Currency board
Amélia Heckel

§ Legal obligation to maintain a given ER parity (by law)

§ CB has to back monetary base with foreign currency
• All money in circulation, same amount of money needs to be in
CB
• Has no control on money supply, cannot be lender of last resort
to banks
o Dollarization
§ Unilateral adoption of currency of another country
§ Country with original currency continues to have sovereignty
o Monetary union
§ Members of a monetary union share same currency and manage
currency together
§ IMF classifies ER regime of countries according to regime adopted for
the common currency
• Ex. EU

De Jure vs. De Facto

• IMF de Jure classification ER regimes
o Regime officially communicated to IMF by countries and registered in Annual
Report
§ Countries don’t always follow what they announce
• IMF de Facto classification ER regimes
o Investigation of what countries actually do and commitments to trajectory

Choosing to peg currency – intertemporal inconsistencies in monetary policy choices are

many times the root of chronic inflation
• To stimulate economy: governments inflate when expectations are low
o Result: chronic inflation that is unable to raise output
• Committing to lower inflation rate: peg currency to that of a country with low inflation

S(t) = p(t) – p*(t)

Advantage of ER as an anchor – visible and easily verifiable (sign of government commitment

to low inflation rate)

Disadvantage – government loses monetary policy autonomy (impossible trinity)

Finish session 9

SUMMARY SESSIONS
Amélia Heckel

SESSION 6