ch8 parity conditions in international finance and currency forecasting

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CHAPTER 8 PARITY CONDITIONS IN INTERNATIONAL FINANCE AND CURRENCY FORECASTINGThis chapter emphasizes that currency prices are determined in the same way that other asset prices are, by the interaction of supply and demand curves. The key concept here is the relationship between inflation and exchange rate changes --the internal devaluation of a currency (inflation) eventually leads to its external devaluation.

K EY POINTS1. Inflation is the logical outcome of an expansion of the money supply in excess of real output growth. As the supply of one commodity increases relative to supplies of all other commodities, the price of the first commodity must decline relative to the prices of other commodities. In other words, its value in exchange or exchange rate must decline. Similarly, as the supply of money increases relative to the supply of goods and services, the price of money in terms of goods and services must decline, i.e., the exchange rate between money and goods declines. 2. The international parallel to inflation is domestic currency depreciation relative to foreign currencies. In order to maintain the same exchange rate between money and goods both domestically and abroad, the foreign exchange rate must decline by (approximately) the difference between the domestic and foreign rates of inflation. This is purchasing power parity, which is itself based on the law of one price. 3. Although the nominal or actual money exchange rate may fluctuate all over the place, we would normally expect the real or inflation-adjusted exchange rate to remain relatively constant over time. The same is true for nominal versus real rates of interest. However, although the prediction that real interest and exchange rates will remain constant over time is a reasonable one ex ante, ex post we find that these real rates wander all over the place. As we will see in Chapter 11, a changing real exchange rate is the most important source of exchange risk for companies. 4. Four additional equilibrium economic relationships tend to hold in international financial markets: purchasing power parity, the Fisher effect, international Fisher effect, interest rate parity, and the forward rate as an unbiased estimate of the future spot rate. 5. These equilibrium relationships are at the heart of a working knowledge of international financial management. I point out to the students that they will be seeing them in many different guises--from the analysis of a firm's foreign exchange exposure to currency forecasting to the decision as to which currency to borrow or lend in. The final section makes six key points about exchange rate forecasting: 1. The foreign exchange market is no different from any other financial market in its susceptibility to being profitably predicted. 2. It is difficult to outperform the market's own forecasts of future exchange rates as embedded in interest and forward differentials. However, while interest rates and forward rates provide unbiased forecasts of future exchange rates, these forecasts are highly inaccurate. 3. Those who have inside information about events that will affect the value of a currency or of a security should benefit handsomely.

CHAPTER 8: PARITY CONDITIONS IN INTERNATIONAL FINANCE/CURRENCY FORECASTING

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4. Those without such access will have to trust either to luck or to the existence of a market imperfection, such as government intervention, to earn above average risk- adjusted profits. 5. Given the widespread availability of information and the many knowledgeable participants in the foreign exchange market, only the latter situation--government manipulation of exchange rates--holds the promise of superior returns from currency forecasting. This is because when governments, for political purposes, spend money to control exchange rates, that money flows into the hands of those who bet against the government. The trick is to predict government actions. 6. The black-market rate is a good indicator of where the official rate is likely to go if the monetary authorities give in to market pressure. However, although the official rate can be expected to move toward the black-market rate, we should not expect to see it coincide with that rate because of the bias induced by government sanctions. The black-market rate seems to be most accurate in forecasting the official rate one month hence, and is progressively less accurate as a forecaster of the future official rate for longer time periods. I usually bring in several currency column clippings from the Wall Street Journal to point out the effect of changing inflationary expectations or interest rates on foreign exchange rates. The case "Oil Levies: The Economic Implications" is a useful exercise that illustrates the difference between operating in a segmented national economy and operating in a world economy, while simultaneously demonstrating the implications of the law of one price. It can be found immediately following this chapter. The case "President Carter Lectures the Foreign Exchange Markets" helps students understand some of the policy implications of the key parity conditions, particularly the relation between inflation, interest rates, and exchange rates. It also points out the trust factor that underlies the value of a currency. This case immediately follows the case "Oil Levies." The cases Indonesia's Currency Board Proposal and Brazil Defends the Real help students understand the political economy of currency changes by examining the intersection of politics and economics in currency values.

SUGGESTED ANSWERS TO CHAPTER 8 QUESTIONS1. What are some reasons for deviations from purchasing power parity?

ANSWER . PPP might not hold because: The price indices used to measure PPP may use different weights or different goods and services.

Arbitrage may be too costly, because of tariffs and other trade barriers and high transportation costs, or too risky, because prices could change during the time that an item is in transit between countries. Since some goods and services used in the indices are not traded, there could be price discrepancies between countries. Relative price changes could lead to exchange rate changes even in the absence of an inflation differential. Government intervention could lead to a disequilibrium exchange rate.

2. Under what circumstances can purchasing power parity be applied?

90 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

ANSWER . The relative version of purchasing power parity holds up best in two circumstances: (a) over long periodsof time among countries with a moderate inflation differential since the general trend in the price level ratio will tend to dominate the effects of relative price changes, and (b) in the short run during periods of hyperinflation since with high inflation changes in the general level of prices quickly swamp the effects of relative price changes. 3. One proposal to stabilize the international monetary system involves setting exchange rates at their purchasing power parity rates. Once exchange rates are correctly aligned (according to PPP), each nation would adjust its monetary policy so as to maintain them. What problems might arise from using the PPP rate as a guide to the equilibrium exchange rate?

ANSWER . The proposal to adjust monetary policy so as to maintain purchasing power parity assumes that the PPPrate is the equilibrium rate. This assumption ignores the many shortcomings of PPP as a theory of exchange rate determination. Deviations from PPP have prevailed throughout the history of floating rate regimes. Thus there is good reason to believe that PPP provides a poor proxy for the equilibrium exchange rate at any point in time. If the PPP benchmark is used as a proxy for the equilibrium exchange rate when there are equilibrium departures from PPP, this guideline will interfere with long-run equilibration in the foreign exchange ma rket. Here is the basic problem: Domestic and foreign goods are not perfect substitutes, and hence issues of spatial arbitrage and the law of one price are irrelevant. Imagine that at the PPP exchange rate U.S. firms can't find buyers for their goods, while Japanese firms work overtime to meet the demand for their goods. Something will have to give, probably the real exchange rate. When a country opens new markets, introduces new products, or experiences a favorable or unfavorable price shock for its traditional exports, the real exchange rate will change. Monetary policy that stabilizes a disequilibrium exchange rate is clearly inappropriate. 4. Suppose the dollar/rupiah rate is fixed but Indonesian prices are rising faster than U.S. prices. Is the Indonesian rupiah appreciating or depreciating in real terms?

ANSWER . The rupiah's real value is rising since it is not depreciating to compensate for higher Indonesian inflation.5. If the dollar is appreciating against the Polish zloty in nominal terms but depreciating against the zloty in real terms, what do we know about Polish and U.S. inflation rates?

ANSWER . The Polish inflation rate must be exceeding the U.S. inflation rate in order for the zloty to rise in real termseven as it is depreciating in nominal terms. This can be seen by studying Equation 8.6. 6. Suppose the nominal peso/dollar exchange rate is fixed. If the inflation rates in the Mexico and the United States are constant (but not necessarily equal in both countries), will the real value of the peso/dollar exchange rate also be constant over time?

ANSWER . No. In order for the real exchange rate to remain constant, the price levels in both countries must remainconstant. To see this, suppose that at time 0 the nominal exchange rate is 1, as is the real exchange rate. If U.S. inflation is 2% and Mexican inflation is 15%, then according to Equation 8.6, the peso's real exchange rate i