PPP & Exchange rate determination & Forecasting

Introduction•Exchange rate influences trade and capital flows across national boundaries, relative profitability of various industries, real wages of workers & allocation of resources within and across countries.•Economists have been entrusted with analysing the effects of policy induced changes in the levels of exchange rates.•Effects of changes – devaluations & revaluations investigated w.r.t their impact on trade flow & BOP•It is possible to understand, individually, several separate dimensions of the problem of exchange rate determination – role of current account balances, relative monetary growth, inflation differentials, capital flows and asset composition, expectations – but not how they all tie together.•Exchange rate forecasts may be "purchased" from commercial banks – knowledge of exchange economics still helps to evaluate them.

Purchase Power Parity & Real Exchange Rate

One of the oldest dectrines of International Economics – PPP attributed to Swedish Economist – Gustav Cassel.If 1$ = Rs 65.65 or 87.09 Yen or 1.015 CHFPPP advocates exchange rate reflects the purchasing power of currencies i.e. The basket of goods and services that can be purchased with 1 dollor in the US will cost CHF 1.015 in Switzerland, Rs 65.65 in India and 87.09 Yen in Japan.Type – Relative and Absolute

Absolute PPP

•In 2009, S(USD/CHF)=P(sw) / P (us) = 1.1054 = 110.54/100•In 2010, S(USD/CHF)=P(sw) / P (us) = 1.0775 = 112.06/104•Where P(sw) and P(us) denote price indices in the two nations respectively, which measures costs of a specified basket of goods and services in those countries in their respective currencies. S is the spot rate expressed as Swiss franc price per $. •[1 + ΔS/S] = (1+Лsw) / (1+Лus) ---CorollaryΔS/S = proportional change in exchange rate; Лsw & Лus denote inflation rates in SW & US.•Absolute PPP spot rate = P(trh)/P(trf) where latter represent price index in home & foreign countries w.r.t a common starting point or base year.

Contd..

•Underlying absolute version of PPP is the "Law of one price", that commodity arbitrage will equate prices of a good in all countries when prices are expressed in a common currency.•This "Law" is invalid on account of various factors viz defining "good", style, quality & standard differences, transportation cost, tariffs & trade barriers, which will prevent equalization of prices for goods which are traded between nations.•For "Non tradeables" (services) even if the above limitations were not there arbitrage cannot equate prices. They could cause the deviations of the exchange rate from PPP.•Also consumption patterns & preference differs world-wide•Harrod-Balassa-Samuelson effect

Contd..

•P(h) = α x (Pnth) + (1-α) x (Ptrh)•P(f) = β x (Pntf) + (1-β) x (Ptrf)•Get P(h)/P(f)•Divide numerator by P(trh) and denominator by SxP(trf)•After a few rearrangement of the above notation Spot = P(h) x [β x (Pntf)/(Ptrf) + (1-β)]• P(f) x [α x (Pnth)/(Ptrh) + (1-α)]•Bigmac Index

Relative PPPIn 2009 a basket of goods costs 100$ in US and 155.26 CHF, where exchange rate = 1.2938, thus the cost in SW = 120 $ (converted)In 2010 a basket of goods costs 105$ in US and 154.51 CHF, where exchange rate = 1.2263, thus the cost in SW = 126 $ (converted)In both the cases it is up by 20% in SW. As absolute PPP is invalid, so is spot = P(sw)/P(us) invalidBut from above spot = k x [P(sw)/P(us)]Also we still have [1 + ΔS/S] = (1+Лsw) / (1+Лus)Rearranging we have ΔS/S = (Лsw-Лus) / (1+Лus)which is nearly = (Лsw-Лus) if Лus is small (and ignored)

Contd..In the last example, the US and Sw inflation rates are 5% and -0.48%, hence (Лsw-Лus) = -5.48%. The USD/CHF rate has decined with % appreciation of CHF = 5.22%This result is known as Realtive PPP. In words it says that the proportionate (or %) change in exchange rate between 2 currencies A and B between 2 points of time (aprox) equals the difference in the inflation rates in the 2 countries over the same time interval. Transport costs, tariffs, etc may prevent absolute PPP from holding but the discrepancy remains constant (proportionally) over time.

Contd..•Relative PPP holds only for traded goods•Real Excahnge Rate – measure of exchange rate between two currencies adjusted for relative purchasing power of currencies•Changes in real exchange rates have significant implications.•Eg USD/INR – 35.90 in 1997 and 44.01 in 2007 while CPI in India and US in 2007 was 171 and 128 wrt 1997 as base year.•Nominal deprecition of rupee is over 22.5% while real appreciation is over 8% inflation adjusted•Real rate at time t, Rt(B/A) = St(B/A) x PBt/PAt •Where St(B/A) = spot rate at time t•PBt & PAt are price indices (for eg. - CPI's) in countires A and B wrt a common base year.

Contd..•If Relative PPP and Real exchange rate holds between 2 periods, it can be concluded that commodity arbitrage is effective in keeping changes in exchange rates in line with changes in price levels.•Export & import implications – if an exporter can raise foreign currency price in line with foreign inflation and his cost increase wrt domestic inflation AND if the exchange rate depreciates by an amount equal to the excess of home inflation over foreign inflation, his export compititiveness is unchanged.•Real appreciation of home currency also hurts import subtitution and reallocate resource allocation towards the production of non-traded goods.•Effective exchange rates (EER) and REER

Factors Affecting Exchange RateRelative Inflation RatesRelative Interest RatesRelative Economic Growth RatesPolitical and Economic Risk

Factors Affecting Exchange RateRelative Inflation RatesRelative Interest RatesRelative Economic Growth RatesPolitical and Economic Risk

Calculating Exchange Rate ChangesIf USD/INR = 50(or e0) in t0 and 52(or e1) in t1Than $ change (appreciation) (52-50)/50 or (e1-e0)/e0Rupee change (depreciation) = (50-52)/52 (e0-e1)/e1If Thai Baht fell 17% against the Yen, by how much has the Yen appreciated against the Baht? If Govt of Yugoslavia devaluates its dinar from 6 to 10.92 by how much has the dinar depreciated and by how much has the dinar depreciated and $ appreciated?