Exchange Rate DeterminationII Real Factor Approach

1
Exchange Rate Determination(II)Real Factor
Approach

• Dr. J. D. Han
• Kings College
• U.W. O.

2
1. Recall that S and D of FOREX affect FX Rates
through International Trade

• Supply Demand
• International Trade Export Imports
• FX rate FX rate -

3
2. Real Factor Analysis

• What are the real factors that affect FOREX
  rates?
• -Supply of and demand for domestic versus foreign
  goods (tradable goods)
• -Mainly, Productivity or Technical Innovation of
  Export Industry

4
Real Factor Analysis focuses on the real factors
affecting the Supply and Demand of Exports versus
Imports

• Exports(Technical Innovation Cost Conditions)
• Imports(International Demand)
• Any real factors raising EX-IM will move E down.
• eg1) Technical Innovation in a Canadian export
  industry will lower the cost and the price of
  exports. As more exports bring in more FOREX, E
  will fall.
• eg2) Unfavorable tax system and labor movement
  will raise the production cost of the Canadian
  export industry. Then
• eg3) An increase in the international demand for
  oil sand from Canada will .. _______.

5
2. Case Study I

• PPP in Japan of the 1970-80s Did it work?
• Background
• -Japanese Yen became strong for the Japanese, FX
  rate or e fell
• - E fell more than P/ Pf fell.

6
1) Facts Data of Japanese FOREX Rate

• Trends of P/P and E in Japan

P/P
E
76
87
7
2)Analysis

• - The appreciation of the Japanese Yen, or the
  falling E can be only partially explained by
• P/Pf as PPP suggests
• Japanese price level was relatively stable
  compared to the U.S. price level
• Japanese monetary policy was relatively
  conservative compared to the U.S. monetary policy

8
There is a large part of the falling E, which
cannot be explained by PPP.

• E Pf / P is not equal to one,
• as suggested by PPP.

9
Modification of PPP Now, introducing q

• A Meandering Real ROREX rate
• E Pf /P q (real factors),
• where q is called Real Exchange Rate

10
Now use q to explain the whole story

• (i) Nominal Factors affecting the Price Level
  Relative Overall Price Ratio between Japan and
  U.S. (Pf/ P) remains stable due to monetary
  policies

11

• (ii) Real Factors affecting the Price Level
  Overall Average Prices do not change very much.
• Suppose that In Japan, there are two sectors of
  industry Tradables and Non-Tradables
• The overall price level in Japan is the weighted
  average of the prices of the two sectors
• P 0.5 PT 0.5 PNT (in simpliest form)
• Technical Innovation happens only to Tradables
  industry
• - Due to Technical Innovations, Japanese
  Tradable becomes cheaper. Due to Technical
  Backwardness, Japanese Non-tradable becomes more
  expensive
• Overall P stays stable (Pf/P stays the same).

12

• (iii) Real Factors affecting the Prices of
  Tadables, and Trade FOREX rate or E falls
• Japanese Tradable goods have price
  competitiveness edge over Foreign-produced
  Tradable goods
• falls.
• Trade depends on PTf / PT , not Pf/P.
  International Substitution from foreign Tradable
  goods to domestic tradable goods
• Trade surplus for domestic country
• Excess Demand for domestic currency
• (Excess Supply of foreign currency)
• Nominal FOREX rate or E falls

13

• (iv) Real FOREX rate or q falls
• E falls while P f / P looks constant.
• q E P f / P falls.

14

• (v) PPP worked for Tradable Goods Prices only,
  not for the Overall Price Level
• E PT f / PT 1 for Tradable Goods
• E P f / P ltlt 1 for overall price level
• Here, q(ltlt1) is a reflection of an increasing
  competitiveness of Japanese export goods.

15
3. Case study of Canada

• Facts
• Between 1975-1990s
• -E continued to rise (against Canadian dollars)
• -Nominal factors Money supply increased faster
  in Canada than in U.S.
• -Real factors Canadian productivity lagged
  behind the U.S. productivity
• Between 2001-2003
• e continues to fall
• capital flows from U.S. A higher interest rate
  in Canada than in the U.S.
• may reflect improving real factors

16
Data US-Canadian FOREX Rates of the 1970s to
2001.
In fact, PPP was not exactly correct
If PPP had been correct
E
q
17
2) Analysis Explaining with q

• It is true that the Canadian monetary policy was
  more liberal than the U.S. monetary policy up to
  the 1990s This explains the general rise of P
  and E.
• Theoretically, E and Pcanada /P us should have
  gone up proportionally. Yet, E went up faster
  than P/Pf
• Canada- inflation differentials between U.S. and
  Canada could not fully explain the changes in the
  nominal FX.
• This suggests that a substantial part of FOREX
  fluctuations between Canada and US is caused by
  real factors.
• What have caused the real FX rate to change, or
  deviate from unit(one)?

18
3) One More Application Canada should use U.S.
Dollars?

• Pros
• 1.No conversion/transactions cost
• 2. Eliminated FOREX Risks
• 3. Monetary Discipline for Canada

• Cons
• Most FX transactions were in a large amount and
  do not carry a large percentage of conversion
  costs
• Recently developed hedging has already reduced
  FOREX risks substantially
• Not much gains for Canada for now

19
How would the elimination of FX rates between
the two countries affect the Canadian Economy?

• The same currency means no floating FOREX rates.
• The same currency means the same monetary
  policies and the same rate of inflation for the
  two country (as PPP says).

20

• -If the changes in the Canada-US exchange rate
  had reflected inflation differentials, then the
  adoption of the common currency would have
  nominal impacts only.
• In fact, the floating FOREX rates did have other
  function(s), the adoption of the common currency
  and thus the virtual fixed exchange rates would
  hinder the very function of the floating FOREX
  rates
• - Canada needs the floating FX rate system, which
  presupposes its own currency.

21
Suppose Real Adverse Shocks for Canada, not
U.S. eg) Canada is hit with a lower
productivity The demand for the Canadian goods
fall.

• Under Flexible FX system
• The FOREX rates will take the first beating
  (Option II)
• The resulting depreciation of the domestic
  currency substantially restores the demand for
  the Canadian goods
• The changes in Income will be mild.

• Under Fixed FX system
• Either
• Labor demand falls and
• thus Wages fall
• Prices fall
• Demand for the Canadian goods may rise back
• Or
• If wages do not fall,
• Actual exports fall
• Unemployment rises.

M. Friedman Changing the setting of the clock
is easier Option II is better and easier for
adjustment than Option I.