Exchange Rate

Determination 4
Week Four

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 International Parity Relationships

Learning objectives:
• Understand how to forecast foreign exchange
rates
– Examines Purchasing power parity (PPP)
– Study important approaches to forecast exchange rate
such as the fundamental approach, efficient markets
approach and the technical approach

2
 Topics
• Review UIRP relationship
• Forecasting future exchange rates:
– PPP considerations
– Current account considerations
– Fundamental approach
– efficient markets approach
– Technical approach
– Performance of the professional forecasters

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 Uncovered Interest Rate Parity (UIRP)
• The IRP defined below,
F$/£
(1 + i$) = × (1+ i£)
S$/£

is often referred to as covered interest rate parity.

• When F$/£ = E(S$/£,t+1),

E(S$/£,t+1)
(1 + i$) = × (1+ i£)
S$/£,t

which is called uncovered interest rate parity (UIRP).

 Exchange Rate Determination

• Using the UIRP relationship: a link between

current interest rates, current exchange rate, and
expected future exchange rate.
 UIRP and Exchange Rate Determination

• We can write the UIRP as:

E(S$/£,t+1)
=
(1 + i$) × (1+ i£)
S$/£,t

• Written in this way, the UIRP can be viewed as

a relationship that determines the current spot
exchange rate St.

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 UIRP and Exchange Rate Determination
• In particular, the relationship implies that, everything
else equal, a higher domestic (foreign) interest rate
would lead to a domestic currency appreciation
(depreciation).
• At the same time, expected future exchange rate,
E(S$/£,t+1) also affects the current exchange rate S$/£,t .
– In particular, when people expect the exchange rate to
rise in the future, it rises now—an example of self-
fulfilling expectations.

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 But What Determines E(St+1)?
• Forecasting Future Exchange Rates:
– Purchasing Power Parity considerations
– Balance of Payment considerations
– Fundamental Approach
– Technical Approach

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Purchasing Power Parity (PPP)
 Purchasing Power Parity (PPP)
• Purchasing power parity (PPP) states that exchange
rates between 2 currencies are in equilibrium when
their purchasing power is the same in each of the two
countries.
• Hence, the exchange rate between two countries
should equal the ratio of the two countries' price level
of a fixed basket of goods and services.
• If a country's domestic price level is increasing when
it faces inflation, then country's exchange rate must be
depreciated in return to PPP.
 Purchasing Power Parity (PPP)
• When PPP holds, the exchange rate between two
currencies should equal the ratio of the countries’ price
levels:
P$
S($/£) =
P£
 For example, if a standard commodity basket costs
$300 in the U.S. and £150 in the U.K., then the price of
one pound in terms of dollars should be:
P$ $300
S($/£) = = = $2/£
P£ £150
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 Purchasing Power Parity (PPP)

• The absolute version of PPP holds that the price

level in a country is equal to the price level in another
country times the exchange rate between the two
countries.
 S = P$/P£.
• The relative version of PPP holds that the rate of
exchange rate change between a pair of countries is
about equal to the difference in inflation rates of the
two countries.
 e = $ - £
13
 PPP and Exchange Rate Forecasting
• The theoretical basis for PPP is the law of one price for
international goods.
 The law of one price (LOP) refers to the international
arbitrage condition for the standard consumption basket.
 LOP requires that the consumption basket of standard
goods should be selling for the same price in a given
currency across countries.

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 PPP and Exchange Rate Forecasting
• The theoretical basis for PPP is the law of one price for
international goods.
• Clearly, it does not hold all the time; but it is often
viewed as a useful way of long-run exchange rate
forecasting
PPP is not useful for predicting exchange rates on
the short-term basis mainly because
international commodity arbitrage is a time-
consuming and costly process.

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 PPP and Exchange Rate Forecasting
• A famous application of PPP is the
―Economist’s Big Mac index ‖ published
by The Economist.
• It was first launched in 1986 as a guide to
judge whether currencies were at their
correct exchange rate.

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PPP and Exchange Rate Forecasting
• Economist’s Big Mac index (also called
Burgernomics) is based on the theory of
purchasing-power parity (PPP).
– Big Mac Index is the exchange rate that would
leave hamburgers costing the same in each
country.
– Comparing a currency’s actual exchange rate with
its PPP signals whether the currency is
undervalued or overvalued.
Big Mac PPP
 Why doesn’t PPP hold exactly?
• Transport costs
– Why do they matter? Think of what it takes for an
arbitrageur to ―buy low sell high‖
• Some goods/services are immovable or inseparable from
their providers—we call these nontradable goods/services
– E.g. haircuts, real estate
– Even tradable goods have nontradable components (e.g.
think of an orange sold in Tokyo vs. Bangkok.)
• Pricing to market
– Sellers set price based on the strength of demand for the
good in a particular market => same good sold for more in
markets with stronger demand
Questions

?
 The Current Account and
Exchange Rate Forecasting

• Motivation: In the financial press, you often

hear the claim that a country that runs a current
account deficit (such as the U.S. in recent
years) is expected to have a weaker exchange
rate.
• What is the reasoning behind this claim?

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 Current Account Defined
• First, what is the current account?
• Current Account Balance (BCA) =
Exports (X) – Imports (M)
• When BCA > 0, a country runs a current
account surplus; when BCA < 0, a country
runs a current account deficit.

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 The Current Account
and Exchange Rate Forecasting
• The basic premise is that countries cannot run
current account deficits indefinitely.
• For the current account to be balanced in the long
run, the relative price of US goods must drop to
induce higher US exports to the rest of the world
(and lower US imports from the rest of the world)
• Thus, a country that runs a current account deficit
is expected to have a weaker exchange rate in the
long run.

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 Fundamental Approach
• As its name suggests, this approach uses
economic fundamentals to help forecast future
exchange rates.
• The economic variables this approach considers
can include, but not limited to, the PPP
deviations and the current account balance we
just learn.

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 Fundamental Approach
• In the textbook gives an example of what other
variables can be included.
– For example, it includes the relative money
supply of two countries—a country that prints
more money will have a weaker currency.
(Why does this make sense? Think of supply
and demand)

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 Efficient Markets Approach
• Financial markets are efficient if prices reflect all
available and relevant information.
• If this is true, exchange rates will only change
when new information arrives, thus:
St = E[St+1]
and
Ft = E[St+1| It]
• Predicting exchange rates using the efficient
markets approach is affordable and is hard to beat.

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 Technical Approach
• Technical analysis looks for patterns in the
past behavior of exchange rates.
• Clearly it is based upon the premise that
history repeats itself.
• Unlike the Fundamental Approach, it is not
based on any economic theory of the exchange
rate.

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 Technical Approach: An Example

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 Technical Approach: An Example
• SMA: short-term moving average
• LMA: long-term moving average
• Since the SMA weighs recent exchange rate
changes more heavily than the LMA, the SMA
will lie below (above) the LMA when the
pound is falling (rising) against the dollar.
=> detect trends based on the crossover of
SMA and LMA

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 Technical Approach: An Example
• When the SMA crosses LMA from below (at
point A), an appreciating trend of the pound is
developing => should buy pounds at point A.
• When the SMA crosses LMA from above (at
point D), an depreciating trend of the pound is
developing => should sell pounds at point D.

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 Performance of the Forecasters

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Performance of the Professional Forecasters

• As a whole, forecasters cannot do a better job of

forecasting future exchange rates than the
forward rate.

• The founder of Forbes Magazine once said:

“You can make more money selling financial
advice than following it”

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 Learning Activities
• Please recall what you learn in the lecture
today by creating a list of terms or ideas
related to it
 Summary
– PPP considerations
– Current account considerations
– Fundamental approach
– Technical approach
– Performance of the professional forecasters

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 End of Week 4

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