us dollar exchange rate
TRANSCRIPT
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Some of the prominent currencies, as far as exchange rates are concerned, are the
Great Britain Pound, the Euro and the United States. These are the traditional
superpowers in this context. In recent times, theAustralian dollar and the Japanese Yen
have gained prominence. This status of theirs is a testimony to the overall economic
prosperity that has been enjoyed by these countries. However, in recent times the
exchange rate of the US dollar has fallen in the aftermath of the sub-prime mortgagemarket crisis.
Theory of Exchange Rate Determination: PPPApproach
This paper focuses on the different theories used in the determination of exchange rates.
Purchasing Power Parity (PPP) Approach
The PPP Approach is based on the law of one price. According to this law, goods that
are identical in nature should be sold at the same price. The implication of this law is
that the exchange rates should change in response to the price differentials that exist
between countries.
Stated mathematically,
Pt = Pt*/et
Where Pt is the domestic price for time period t
Pt* is the foreign price for time period t
et is the exchange rate for time period t
The main problem with the Purchasing Parity Approach in the determination of
Exchange rates s that it does not hold true in the short or the medium term. But this is
very much applicable in the long run.
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Balance of Payments Approach
This approach determines the exchange rate at which both the internal and the external
economy are in equilibrium. Internal equilibrium in the economy reflects a state of full
employment whereas external equilibrium implies equilibrium in the balance of
payment.
The lacuna of this theory is that it is difficult to determine an exchange rate in the short run that
is consistent with the natural rate of unemployment or equilibrium in the balance of payments.
The magnitude o this problem gets reduced in the long run.
Monetary and Portfolio Approach in the Determination of Exchange Rates
This approach is based on the assumption that economic agents can chose from a
portfolio of domestic and foreign assets. The assets that can be in the form of money orbonds have an expected return. The arbitrage opportunity that is attached with thisreturn determines the exchange rate.
The monetary or the portfolio approach also faces problem in its applicability in the short
run.
EXCHANGE RATE
An exchange rate is the price of one currency in terms of another currency. A country’s exchange
rate influences, and is influenced by, its balance of payments and its performance in the context of
domestic macroeconomics. Exchange rate movements also exert a major influence upon activity in
the sphere of international economics.
Contents
[hide]
1 Definitions
2 Exchange rate regimes
o 2.1 Fixed exchange rates
o 2.2 Floating exchange rates
o 2.3 Hybrid regimes
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o 2.4 Common currencies
3 Theories of exchange rate determination
4 Volatility and speculation
5 References
Definitions
A country’s market exchange rate is the rate that is determined by transactions in the foreignexchange market. Transactions in the foreign exchange spot market take effect immediately,whereas transactions in the forward market take effect in three months’ or six months’ time. The ratioof the forward price of a currency to its spot price indicates the market’s expectation of anappreciation or depreciation of that currency.
A country’s effective or trade-weighted exchange rate is the average of its exchange rates withthe those of the countries with which it trades - after each has been multiplied by a weight basedupon its relative importance in that country’s trade [1](For example, the weight assigned to the USdollar in calculating its part in the index for the pound sterling depends upon the importance to UKdomestic market imports of imports from the USA and the degree of competition between the UKand the USA in the USA market and in third country markets.) Indexes of the effective exchangerates of the pound sterling, the US dollar and the Euro are published are published monthly by theBank of England. A rise in a country’s effective exchange rate index is generally taken to indicate acorresponding reduction in its international competitiveness. In calculating a country’sreal effectiveexchange rate index the weight assigned to each country is further adjusted to take account of itsgeneral price level relative to that of the original country [2].
A country’s purchasing power parity (PPP) exchange rate is defined as the number of currencyunits required to buy goods equivalent to what can be bought with one unit of the currency of thebase country, usually the US dollar". PPP rates are used in making international comparisonsof gross domestic product. A number of international organisations collaborate to provide PPPindexes for member countries [3] [4] using the method of calculation described in an OECD statisticsbrief [5], and the resulting indexes are published by the OECD [6].
Exchange rate regimes
Fixed exchange ratesAs part of the 1944 Bretton Woods Agreement, the signatory countries each agreed to control (or“peg”) the exchange rate of its currency with the United States dollar so as to maintain it within astipulated band about a fixed level. The United States government, for its part, agreed always to bewilling to exchange dollars for gold at the fixed rate of $35 per ounce. The Bretton Woods systemwas abandoned in 1971 when the United States government cancelled its undertaking to buy gold ata fixed rate. However, a substantial number of countries have continued to peg their currencies tothe US dollar.
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Floating exchange ratesAfter 1971, the governments of the majority of developing countries abandoned attempts to controlthe exchange rates of their countries and have since allowed them to be determined by transactionsin the foreign currency market (or, in other words, to “float”)
Hybrid regimesAmong intermediate regimes that have been proposed with a view to maintaining some of theadvantages of both fixed and floating regimes was the “crawling peg” proposal that would enableexchange rates to be adjusted at a regulated rate.
Common currenciesThe adoption of a common currency among trading neighbours has the advantage of avoiding theadverse consequences of exchange rate fluctuations. Countries that have abandoned their domesticcurrencies for that purpose include members the Organisation of East Caribbean States, two groupsof former French colonies in Africa, and the a group of members of theEuropean Union that haveadopted the Euro. The East African dollar and the Central and West African francs are pegged to the
Euro.
Foreign exchange marketFrom Wikipedia, the free encyclopedia
"Forex" redirects here. For the football club, see FC Forex Braşov .
Foreign exchange
Exchange rates
Currency band
Exchange rate
Exchange rate regime
Fixed exchange rate
Floating exchange rate
Linked exchange rate
Dollarization
Markets
Foreign exchange market
Futures exchange
Retail forex
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Assets
Currency
Currency future
Non-deliverable forward
Forex swap
Currency swap
Foreign exchange option
Historical agreements
Bretton Woods Conference
Smithsonian Agreement
Plaza Accord
Louvre Accord
See also
Bureau de change / currency exchange
(office)
Hard currency
The foreign exchange market (forex, FX, or currency market) is a global, worldwide decentralized financial
market for trading currencies. Financial centers around the world function as anchors of trading between a wide
range of different types of buyers and sellers around the clock, with the exception of weekends. The foreign
exchange market determines the relative values of different currencies.[1]
The primary purpose of the foreign exchange is to assist international trade and investment, by allowing
businesses to convert one currency to another currency. For example, it permits a US business to import
British goods and pay Pound Sterling, even though the business' income is in US dollars. It also supports direct
speculation in the value of currencies, and the carry trade, speculation on the change in interest rates in two
currencies.[2]
In a typical foreign exchange transaction, a party purchases a quantity of one currency by paying a quantity of
another currency. The modern foreign exchange market began forming during the 1970s after three decades of
government restrictions on foreign exchange transactions (the Bretton Woods system of monetary
management established the rules for commercial and financial relations among the world's major industrial
states after World War II), when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of
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its huge trading volume representing the largest asset class in the world leading to high liquidity;
its geographical dispersion;
its continuous operation: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until
22:00 GMT Friday;
the variety of factors that affect exchange rates;
the low margins of relative profit compared with other markets of fixed income; and
the use of leverage to enhance profit and loss margins and with respect to account size.
As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstandingcurrency intervention by central banks. According to the Bank for International Settlements,[3] as
of April 2010, average daily turnover in global foreign exchange markets is estimated at $3.98 trillion, a growth
of approximately 20% over the $3.21 trillion daily volume as of April 2007. Some firms specializing on foreign
exchange market had put the average daily turnover in excess of US$4 trillion.[4]
The $3.98 trillion break-down is as follows:
$1.490 trillion in spot transactions
$475 billion in outright forwards
$1.765 trillion in foreign exchange swaps
$43 billion Currency swaps
$207 billion in options and other products
Contents
[hide]
1 Market Size and liquidity
2 Market participants
o 2.1 Banks
o 2.2 Commercial companies
o 2.3 Central banks
o 2.4 Forex fixing
o 2.5 Hedge funds as speculators
o 2.6 Investment management firms
o 2.7 Retail foreign exchange traders
o 2.8 Non-bank foreign exchange companies
o 2.9 Money transfer/remittance companies and bureaux de change
3 Trading characteristics
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4 Determinants of FX rates
o 4.1 Economic factors
o 4.2 Political conditions
o
4.3 Market psychology
5 Financial instruments
o 5.1 Spot
o 5.2 Forward
o 5.3 Swap
o 5.4 Future
o 5.5 Option
6 Speculation
7 Risk aversion in forex
8 Further reading
9 See also
10 Notes
11 References
12 External links
Market Size and liquidity
Main foreign exchange market turnover, 1988 –2007, measured in billions of USD.
The foreign exchange market is the most liquid financial market in the world. Traders include large
banks, central banks, institutional investors, currency speculators, corporations, governments, other financial
institutions, and retail investors. The average daily turnover in the global foreign exchange and related markets
is continuously growing. According to the 2010 Triennial Central Bank Survey, coordinated by the Bank for
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International Settlements, average daily turnover wasUS$3.98 trillion in April 2010 (vs $1.7 trillion in 1998).[3] Of
this $3.98 trillion, $1.5 trillion was spot foreign exchange transactions and $2.5 trillion was traded in outright
forwards, FX swaps and other currency derivatives.
Trading in the UK accounted for 36.7% of the total, making UK by far the most important global center for
foreign exchange trading. In second and third places, respectively, trading in the USA accounted for 17.9%,
and Japan accounted for 6.2%.[5]
Turnover of exchange-traded foreign exchange futures and options have grown rapidly in recent years,
reaching $166 billion in April 2010 (double the turnover recorded in April 2007). Exchange-traded currency
derivatives represent 4% of OTC foreign exchange turnover. FX futures contracts were introduced in 1972 at
the Chicago Mercantile Exchange and are actively traded relative to most other futures contracts.
Most developed countries permit the trading of FX derivative products (like currency futures and options on
currency futures) on their exchanges. All these developed countries already have fully convertible capitalaccounts. A number of emerging countries do not permit FX derivative products on their exchanges in view of
controls on the capital accounts. The use of foreign exchange derivatives is growing in many emerging
economies.[6] Countries such as Korea, South Africa, and India have established currency futures exchanges,
despite having some controls on the capital account.
Foreign exchange trading increased by 20% between
April 2007 and April 2010 and has more than doubled
since 2004.[8] The increase in turnover is due to a number
of factors: the growing importance of foreign exchange asan asset class, the increased trading activity of high-
frequency traders, and the emergence of retail investors
as an important market segment. The growth of electronic
execution methods and the diverse selection of execution
venues have lowered transaction costs, increased market
liquidity, and attracted greater participation from many
customer types. In particular, electronic trading via online
portals has made it easier for retail traders to trade in the
foreign exchange market. By 2010, retail trading is
estimated to account for up to 10% of spot FX turnover, or $150 billion per day (see retail trading platforms).
Because foreign exchange is an over-the-counter (OTC) market where brokers/dealers negotiate directly with
one another, there is no central exchange or clearing house. The biggest geographic trading center is the UK,
primarily London, which according toTheCityUK estimates has increased its share of global turnover in
traditional transactions from 34.6% in April 2007 to 36.7% in April 2010. Due to London's dominance in the
Top 10 currency traders [7]
% of overall volume, May 2011
Rank Name Market share
1 Deutsche Bank 15.64%
2 Barclays Capital 10.75%
3 UBS AG 10.59%
4 Citi 8.88%
5 JPMorgan 6.43%
6 HSBC 6.26%
7 Royal Bank of Scotland 6.20%
8 Credit Suisse 4.80%
9 Goldman Sachs 4.13%
10 Morgan Stanley 3.64%
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market, a particular currency's quoted price is usually the London market price. For instance, when
the International Monetary Fund (IMF) calculates the value of its Special Drawing Rights (SDRs) every day,
they use the London market prices at noon that day.
Market participants
Financial markets
Public market
Exchange
Securities
Bond market
Fixed income
Corporate bond
Government bond
Municipal bond
Bond valuation
High-yield debt
Stock market
Stock
Preferred stock
Common stock
Registered share
Voting share
Stock exchange
Derivatives market
Securitization
Hybrid security
Credit derivative
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Futures exchange
OTC, non organized
Spot market
Forwards
Swaps
Options
Foreign exchange
Exchange rate
Currency
Other markets
Money market
Reinsurance market
Commodity market
Real estate market
Practical trading
Participants
Clearing house
Financial regulation
Finance series
Banks and banking
Corporate finance
Personal finance
Public finance
v · d · e
Unlike a stock market, the foreign exchange market is divided into levels of access. At the top is the inter-bank
market, which is made up of the largest commercial banks and securities dealers. Within the inter-bank market,
spreads, which are the difference between the bid and ask prices, are razor sharp and not known to players
outside the inner circle. The difference between the bid and ask prices widens (for example from 0-1 pipto 1-2
pips for a currencies such as the EUR) as you go down the levels of access. This is due to volume. If a trader
can guarantee large numbers of transactions for large amounts, they can demand a smaller difference between
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the bid and ask price, which is referred to as a better spread. The levels of access that make up the foreign
exchange market are determined by the size of the "line" (the amount of money with which they are trading).
The top-tier interbank market accounts for 53% of all transactions. From there, smaller banks, followed by large
multi-national corporations (which need to hedge risk and pay employees in different countries), large hedge
funds, and even some of the retail FX market makers. According to Galati and Melvin, “Pension funds,
insurance companies, mutual funds, and other institutional investors have played an increasingly important role
in financial markets in general, and in FX markets in particular, since the early 2000s.” (2004) In addition, he
notes, “Hedge funds have grown markedly over the 2001 –2004 period in terms of both number and overall
size”.[9] Central banks also participate in the foreign exchange market to align currencies to their economic
needs.
Banks
The interbank market caters for both the majority of commercial turnover and large amounts of speculative
trading every day. Many large banks may trade billions of dollars, daily. Some of this trading is undertaken on
behalf of customers, but much is conducted by proprietary desks, which are trading desks for the bank's own
account. Until recently, foreign exchange brokers did large amounts of business, facilitating interbank trading
and matching anonymous counterparts for large fees. Today, however, much of this business has moved on to
more efficient electronic systems. The broker squawk box lets traders listen in on ongoing interbank trading and
is heard in most trading rooms, but turnover is noticeably smaller than just a few years ago. [citation needed ]
Commercial companies
An important part of this market comes from the financial activities of companies seeking foreign exchange to
pay for goods or services. Commercial companies often trade fairly small amounts compared to those of banks
or speculators, and their trades often have little short term impact on market rates. Nevertheless, trade flows
are an important factor in the long-term direction of a currency's exchange rate. Some multinational companies
can have an unpredictable impact when very large positions are covered due to exposures that are not widely
known by other market participants.
Central banks
National central banks play an important role in the foreign exchange markets. They try to control the money
supply, inflation, and/or interest rates and often have official or unofficial target rates for their currencies. They
can use their often substantial foreign exchange reserves to stabilize the market. Nevertheless, the
effectiveness of central bank "stabilizing speculation" is doubtful because central banks do not go bankrupt if
they make large losses, like other traders would, and there is no convincing evidence that they do make a profit
trading.
Forex fixing
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Forex fixing is the daily monetary exchange rate fixed by the national bank of each country. The idea is that
central banks use the fixing time and exchange rate to evaluate behavior of their currency. Fixing exchange
rates reflects the real value of equilibrium in the forex market. Banks, dealers and online foreign exchange
traders use fixing rates as a trend indicator.
The mere expectation or rumor of central bank intervention might be enough to stabilize a currency, but
aggressive intervention might be used several times each year in countries with a dirty float currency regime.
Central banks do not always achieve their objectives. The combined resources of the market can easily
overwhelm any central bank.[10] Several scenarios of this nature were seen in the 1992 –93 European Exchange
Rate Mechanism collapse, and in more recent times in Southeast Asia.
Hedge funds as speculators
About 70% to 90%[citation needed ] of the foreign exchange transactions are speculative. In other words, the person
or institution that bought or sold the currency has no plan to actually take delivery of the currency in the end;
rather, they were solely speculating on the movement of that particular currency. Hedge funds have gained a
reputation for aggressive currency speculation since 1996. They control billions of dollars of equity and may
borrow billions more, and thus may overwhelm intervention by central banks to support almost any currency, if
the economic fundamentals are in the hedge funds' favor.
Investment management firms
Investment management firms (who typically manage large accounts on behalf of customers such as pension
funds and endowments) use the foreign exchange market to facilitate transactions in foreign securities. For
example, an investment manager bearing an international equity portfolio needs to purchase and sell severalpairs of foreign currencies to pay for foreign securities purchases.
Some investment management firms also have more speculative specialist currency overlay operations, which
manage clients' currency exposures with the aim of generating profits as well as limiting risk. Whilst the number
of this type of specialist firms is quite small, many have a large value of assets under management (AUM), and
hence can generate large trades.
Retail foreign exchange traders
Individual Retail speculative traders constitute a growing segment of this market with the advent of retail forex
platforms, both in size and importance. Currently, they participate indirectly through brokers or banks. Retail
brokers, while largely controlled and regulated in the USA by the Commodity Futures Trading
Commission and National Futures Association have in the past been subjected to periodic foreign exchange
scams.[11][12] To deal with the issue, the NFA and CFTC began (as of 2009) imposing stricter requirements,
particularly in relation to the amount of Net Capitalization required of its members. As a result many of the
smaller and perhaps questionable brokers are now gone or have moved to countries outside the US. A number
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of the forex brokers operate from the UK under Financial Services Authority regulations where forex trading
using margin is part of the wider over-the-counter derivatives trading industry that includes Contract for
differences andfinancial spread betting.
There are two main types of retail FX brokers offering the opportunity for speculative currency
trading: brokers and dealers or market makers .Brokers serve as an agent of the customer in the broader FX
market, by seeking the best price in the market for a retail order and dealing on behalf of the retail customer.
They charge a commission or mark-up in addition to the price obtained in the market. Dealers or market
makers , by contrast, typically act as principal in the transaction versus the retail customer, and quote a price
they are willing to deal at.
Non-bank foreign exchange companies
Non-bank foreign exchange companies offer currency exchange and international payments to private
individuals and companies. These are also known as foreign exchange brokers but are distinct in that they do
not offer speculative trading but rather currency exchange with payments (i.e., there is usually a physical
delivery of currency to a bank account).
It is estimated that in the UK, 14% of currency transfers/payments[13] are made via Foreign Exchange
Companies.[14] These companies' selling point is usually that they will offer better exchange rates or cheaper
payments than the customer's bank. These companies differ from Money Transfer/Remittance Companies in
that they generally offer higher-value services.
Money transfer/remittance companies and bureaux de change
Money transfer companies / remittance companies perform high-volume low-value transfers generally by
economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion
of remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and
the Philippines) receive $95 billion. The largest and best known provider is Western Union with 345,000 agents
globally followed by UAE Exchange[citation needed ]
Bureau de change or currency transfer companies provide low value foreign exchange services for travelers.
These are typically located at airports and stations or at tourist locations and allow physical notes to be
exchanged from one currency to another. They access the foreign exchange markets via banks or non bank
foreign exchange companies.
Trading characteristics
Most traded currencies by valueCurrency distribution of global foreign exchange market turnover
[3]
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Rank CurrencyISO 4217 code
(Symbol)
% daily share
(April 2010)
1 United States dollar USD ($) 84.9%
2 Euro EUR (€) 39.1%
3 Japanese yen JPY (¥) 19.0%
4 Pound sterling GBP (£) 12.9%
5 Australian dollar AUD ($) 7.6%
6 Swiss franc CHF (Fr) 6.4%
7 Canadian dollar CAD ($) 5.3%
8 Hong Kong dollar HKD ($) 2.4%
9 Swedish krona SEK (kr) 2.2%
10 New Zealand dollar NZD ($) 1.6%
11 South Korean won KRW (₩) 1.5%
12 Singapore dollar SGD ($) 1.4%
13 Norwegian krone NOK (kr) 1.3%
14 Mexican peso MXN ($) 1.3%
15 Indian rupee INR ( ) 0.9%
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Other 12.2%
Total[15] 200%
There is no unified or centrally cleared market for the majority of FX trades, and there is very little cross-border
regulation. Due to the over-the-counter (OTC) nature of currency markets, there are rather a number of
interconnected marketplaces, where different currencies instrumentsare traded. This implies that there is not
a single exchange rate but rather a number of different rates (prices), depending on what bank or market maker
is trading, and where it is. In practice the rates are often very close, otherwise they could be exploited
by arbitrageursinstantaneously. Due to London's dominance in the market, a particular currency's quoted price
is usually the London market price. A joint venture of the Chicago Mercantile Exchange and Reuters,
calledFxmarketspace opened in 2007 and aspired but failed to the role of a central
market clearing mechanism.[citation needed ]
The main trading center is London, but New York, Tokyo, Hong Kong andSingapore are all important centers
as well. Banks throughout the world participate. Currency trading happens continuously throughout the day; as
the Asian trading session ends, the European session begins, followed by the North American session and
then back to the Asian session, excluding weekends.
Fluctuations in exchange rates are usually caused by actual monetary flows as well as by expectations of
changes in monetary flows caused by changes in gross domestic product (GDP) growth, inflation (purchasing
power parity theory), interest rates (interest rate parity,Domestic Fisher effect, International Fisher effect),
budget and trade deficits or surpluses, large cross-border M&A deals and other macroeconomic conditions.
Major news is released publicly, often on scheduled dates, so many people have access to the same news at
the same time. However, the large banks have an important advantage; they can see their customers' order
flow.
Currencies are traded against one another. Each currency pair thus constitutes an individual trading product
and is traditionally noted XXXYYY or XXX/YYY, where XXX and YYY are the ISO 4217 international three-
letter code of the currencies involved. The f irst currency (XXX) is the base currency that is quoted relative to
the second currency (YYY), called the counter currency (or quote currency). For instance, the
quotation EURUSD (EUR/USD) 1.5465 is the price of the euro expressed in US dollars, meaning 1 euro =
1.5465 dollars. The market convention is to quote most exchange rates against the USD with the US dollar as
the base currency (e.g. USDJPY, USDCAD, USDCHF). The exceptions are the British pound (GBP), Australian
dollar (AUD), the New Zealand dollar (NZD) and the euro (EUR) where the USD is the counter currency (e.g.
GBPUSD, AUDUSD, NZDUSD, EURUSD).
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The factors affecting XXX will affect both XXXYYY and XXXZZZ. This causes positive
currency correlation between XXXYYY and XXXZZZ.
On the spot market, according to the 2010 Triennial Survey, the most heavily traded bilateral currency pairs
were:
EURUSD: 28%
USDJPY: 14%
GBPUSD (also called cable ): 9%
and the US currency was involved in 84.9% of transactions, followed by the euro (39.1%), the yen (19.0%), and
sterling (12.9%) (see table). Volume percentages for all individual currencies should add up to 200%, as each
transaction involves two currencies.
Trading in the euro has grown considerably since the currency's creation in January 1999, and how long the
foreign exchange market will remain dollar-centered is open to debate. Until recently, trading the euro versus a
non-European currency ZZZ would have usually involved two trades: EURUSD and USDZZZ. The exception to
this is EURJPY, which is an established traded currency pair in the interbank spot market. As the dollar's value
has eroded during 2008, interest in using the euro as reference currency for prices in commodities (such as
oil), as well as a larger component of foreign reserves by banks, has increased dramatically. Transactions in
the currencies of commodity-producing countries, such as AUD, NZD, CAD, have also increased.
Determinants of FX rates
See also: exchange rates
The following theories explain the fluctuations in FX rates in a floating exchange rate regime (In a fixed
exchange rate regime, FX rates are decided by its government):
(a) International parity conditions: Relative Purchasing Power Parity, interest rate parity, Domestic
Fisher effect, International Fisher effect. Though to some extent the above theories provide logical
explanation for the fluctuations in exchange rates, yet these theories falter as they are based on
challengeable assumptions [e.g., free flow of goods, services and capital] which seldom hold true in
the real world.
(b) Balance of payments model (see exchange rate): This model, however, focuses largely on tradable
goods and services, ignoring the increasing role of global capital flows. It failed to provide any
explanation for continuous appreciation of dollar during 1980s and most part of 1990s in face of
soaring US current account deficit.
(c) Asset market model (see exchange rate): views currencies as an important asset class for
constructing investment portfolios. Assets prices are influenced mostly by people's wil lingness to hold
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the existing quantities of assets, which in turn depends on their expectations on the future worth of
these assets. The asset market model of exchange rate determination states that “the exchange rate
between two currencies represents the price that just balances the relative supplies of, and demand
for, assets denominated in those currencies.”
None of the models developed so far succeed to explain FX rates levels and volatility in the
longer time frames. For shorter time frames (less than a few days) algorithms can be devised to
predict prices. It is understood from the above models that many macroeconomic factors affect
the exchange rates and in the end currency prices are a result of dual forces of demand and
supply. The world's currency markets can be viewed as a huge melting pot: in a large and ever-
changing mix of current events, supply and demand factors are constantly shifting, and the price
of one currency in relation to another shifts accordingly. No other market encompasses (and
distills) as much of what is going on in the world at any given time as foreign exchange.
Supply and demand for any given currency, and thus its value, are not influenced by any single
element, but rather by several. These elements generally fall into three categories: economic
factors, political conditions and market psychology.
Economic factors
These include: (a)economic policy, disseminated by government agencies and central banks,
(b)economic conditions, generally revealed through economic reports, and other economic
indicators.
Economic policy comprises government fiscal policy (budget/spending practices)
and monetary policy (the means by which a government's central bank influences the supply
and "cost" of money, which is reflected by the level of interest rates).
Government budget deficits or surpluses: The market usually reacts negatively to widening
government budget deficits, and positively to narrowing budget deficits. The impact is
reflected in the value of a country's currency.
Balance of trade levels and trends: The trade flow between countries illustrates the demand
for goods and services, which in turn indicates demand for a country's currency to conduct
trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of anation's economy. For example, trade deficits may have a negative impact on a nation's
currency.
Inflation levels and trends: Typically a currency will lose value if there is a high level of
inflation in the country or if inflation levels are perceived to be rising. This is because inflation
erodes purchasing power, thus demand, for that particular currency. However, a currency
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may sometimes strengthen when inflation rises because of expectations that the central
bank will raise short-term interest rates to combat rising inflation.
Economic growth and health: Reports such as GDP, employment levels, retail
sales, capacity utilization and others, detail the levels of a country's economic growth and
health. Generally, the more healthy and robust a country's economy, the better its currency
will perform, and the more demand for it there will be.
Productivity of an economy: Increasing productivity in an economy should positively
influence the value of its currency. Its effects are more prominent if the increase is in the
traded sector [1].
Political conditions
Internal, regional, and international political conditions and events can have a profound effect on
currency markets.
All exchange rates are susceptible to political instability and anticipations about the new ruling
party. Political upheaval and instability can have a negative impact on a nation's economy. For
example, destabilization of coalition governments in Pakistan and Thailand can negatively affect
the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a
political faction that is perceived to be fiscally responsible can have the opposite effect. Also,
events in one country in a region may spur positive/negative interest in a neighboring country
and, in the process, affect its currency.
Market psychology
Market psychology and trader perceptions influence the foreign exchange market in a variety of
ways:
Flights to quality: Unsettling international events can lead to a "flight to quality", a type
of capital flight whereby investors move their assets to a perceived "safe haven". There will
be a greater demand, thus a higher price, for currencies perceived as stronger over their
relatively weaker counterparts. The U.S. dollar, Swiss franc and gold have been traditional
safe havens during times of political or economic uncertainty.[16]
Long-term trends: Currency markets often move in visible long-term trends. Although
currencies do not have an annual growing season like physical commodities, business
cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may
rise from economic or political trends.[17]
"Buy the rumor, sell the fact": This market truism can apply to many currency situations. It is
the tendency for the price of a currency to reflect the impact of a particular action before it
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occurs and, when the anticipated event comes to pass, react in exactly the opposite
direction. This may also be referred to as a market being "oversold" or "overbought".[18] To
buy the rumor or sell the fact can also be an example of the cognitive bias known
as anchoring, when investors focus too much on the relevance of outside events to currency
prices.
Economic numbers: While economic numbers can certainly reflect economic policy, some
reports and numbers take on a talisman-like effect: the number itself becomes important to
market psychology and may have an immediate impact on short-term market moves. "What
to watch" can change over time. In recent years, for example, money supply, employment,
trade balance figures and inflation numbers have all taken turns in the spotlight.
Technical trading considerations: As in other markets, the accumulated price movements in
a currency pair such as EUR/USD can form apparent patterns that traders may attempt to
use. Many traders study price charts in order to identify such patterns.[19]
Financial instruments
Spot
A spot transaction is a two-day delivery transaction (except in the case of trades between the US
Dollar, Canadian Dollar, Turkish Lira, EURO and Russian Ruble, which settle the next business
day), as opposed to the futures contracts, which are usually three months. This trade represents
a “direct exchange” between two currencies, has the shortest time frame, involves cash rather
than a contract; and interest is not included in the agreed-upon transaction.
Forward
See also: forward contract
One way to deal with the foreign exchange risk is to engage in a forward transaction. In this
transaction, money does not actually change hands until some agreed upon future date. A buyer
and seller agree on an exchange rate for any date in the future, and the transaction occurs on
that date, regardless of what the market rates are then. The duration of the trade can be one day,
a few days, months or years. Usually the date is decided by both parties. Then the forward
contract is negotiated and agreed upon by both parties.
Swap
Main article: foreign exchange swap
The most common type of forward transaction is the FX swap. In an FX swap, two parties
exchange currencies for a certain length of time and agree to reverse the transaction at a later
date. These are not standardized contracts and are not traded through an exchange.
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Future
Main article: currency future
Futures are standardized and are usually traded on an exchange created for this purpose. The
average contract length is roughly 3 months. Futures contracts are usually inclusive of anyinterest amounts.
Option
Main article: foreign exchange option
A foreign exchange option (commonly shortened to just FX option) is a derivative where the
owner has the right but not the obligation to exchange money denominated in one currency into
another currency at a pre-agreed exchange rate on a specified date. The FX options market is
the deepest, largest and most liquid market for options of any kind in the world.
Speculation
Controversy about currency speculators and their effect on currency devaluations and national
economies recurs regularly. Nevertheless, economists including Milton Friedman have argued
that speculators ultimately are a stabilizing influence on the market and perform the important
function of providing a market for hedgers and transferring risk from those people who don't wish
to bear it, to those who do.[20]Other economists such as Joseph Stiglitz consider this argument to
be based more on politics and a free market philosophy than on economics.[21]
Large hedge funds and other well capitalized "position traders" are the main professionalspeculators. According to some economists, individual traders could act as "noise traders" and
have a more destabilizing role than larger and better informed actors.[22]
Currency speculation is considered a highly suspect activity in many countries.[where? ] While
investment in traditional financial instruments like bonds or stocks often is considered to
contribute positively to economic growth by providing capital, currency speculation does not;
according to this view, it is simply gambling that often interferes with economic policy. For
example, in 1992, currency speculation forced theCentral Bank of Sweden to raise interest rates
for a few days to 500% per annum, and later to devalue the krona.
[23]
Former Malaysian PrimeMinister Mahathir Mohamad is one well known proponent of this view. He blamed the devaluation
of the Malaysian ringgit in 1997 on George Soros and other speculators.
Gregory J. Millman reports on an opposing view, comparing speculators to "vigilantes" who
simply help "enforce" international agreements and anticipate the effects of basic economic
"laws" in order to profit.[24]
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In this view, countries may develop unsustainable financial bubbles or otherwise mishandle their
national economies, and foreign exchange speculators made the inevitable collapse happen
sooner. A relatively quick collapse might even be preferable to continued economic mishandling,
followed by an eventual, larger, collapse. Mahathir Mohamad and other critics of speculation are
viewed as trying to deflect the blame from themselves for having caused the unsustainable
economic conditions.
Risk aversion in forex
See also: Safe-haven currency
Fig.1 Chart showing MSCI World Index of Equities fell while the US Dollar Index rose.
Risk aversion in the forex is a kind of trading behavior exhibited by the foreign exchange market
when a potentially adverse event happens which may affect market conditions. This behavior is
caused when risk averse traders liquidate their positions in risky assets and shift the funds to less
risky assets due to uncertainty.[25]
In the context of the forex market, traders liquidate their positions in various currencies to take up
positions in safe-haven currencies, such as the US Dollar.[26] Sometimes, the choice of a safe
haven currency is more of a choice based on prevailing sentiments rather than one of economic
statistics. An example would be the Financial Crisis of 2008. The value of equities across world
fell while the US Dollar strengthened (see Fig.1). This happened despite the strong focus of the
crisis in the USA.
The Bretton Woods system of monetary management established the rules
for commercial and financial relations among the world's majorindustrial states in the mid 20th century.
The Bretton Woods system was the first example of a fully negotiated monetary order intended to govern
monetary relations among independent nation-states.
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Existing Theories of Exchange Rate Determination
We have seen that existing studies have produced a number of different
estimates of the exchange rate of the renminbi. The reason behind thedifference is that different theories, data and econometric methods are used.
It is clear that not all the theories that are actually used are suitable forforecasting the movement of exchange rate. Some may be better thanothers. Thus, it is very important for researchers who study exchange ratesto choose or create a better model with micro foundations for an empirical
study. In this Chapter, we investigate existing theories, their preconditions,implications and advantages and disadvantages, which will be helpful to the
modeling efforts to be made in the next part.
The exchange rate theories investigated in this part can be classified into
three kinds: partial equilibrium models, general equilibrium models and
disequilibrium or hybrid models. Partial equilibrium models include relativePPP and absolute PPP, which only consider the goods market; and coveredinterest rate parity (CIRP) and uncovered interest rate parity (UCIRP), which
only consider the assets market, and the external equilibrium model, whichstates that the exchange rate is determined by the balance of payments.General exchange rate equilibrium models include the Mundell- Flemingmodel, which deals with the equilibrium of the goods market, money market
and balance of payments, but lacks micro-foundations to some extent; theBalassa-Samuelson model, which is built on the maximization of firms profit;
the Redux model, which was developed by Obestfeld and Rogoff, and the
PTM (Pricing to Market) model, created on the maximization of consumer’sutility; A simple monetary model with price flexibility and the Dornbusch
model (or Mundell-Fleming-Dornbusch model), are actually obtained bycombining the monetary equilibrium with the adjustment of price and the
adjustment of output toward their long run equilibrium, and can be calledhybrids of monetary equilibrium with PPP or UCIRP. The balance of
payments is covered in this investigation since many studies regards it as afoundation of equilibrium exchange rate determination.
3.1 Purchasing Power Parity
The starting point of exchange rate theory is purchasing power parity (PPP),which is also called the inflation theory of exchange rates. PPP can be traced
back to sixteen-century Spain and early seventeencentury England, butSwedish economist Cassel (1918) was the first to name the theory PPP.
Cassel once argued that without it, there would be no meaningful way todiscuss over-or-under valuation of a currency.
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Under this model, let i P and * i P denote, respectively, the price level of
good i in the home currency and foreign currency. Letter “ S ” denotes thenominal exchange rate that expresses the price in foreign currency in terms
of the domestic currency. According to the “law of one price,” the price of one good should be equal at home and abroad, say, * i i SP P = . If the
prices of each good are equalized between the two countries and if thegoods baskets and their weights in the two countries are the same, then,
then absolute PPP holds: * SP P = (3.1)
Absolute PPP theory was first presented to deal with the price relationship of goods with the value of different currencies. The theory requires very strong
preconditions. Generally, Absolute PPP holds in an integrated, competitive
product market with the implicit assumption of a risk-neutral world, in whichthe goods can be traded freely without transportation costs, tariffs, export
quotas, and so on. However, it is unrealistic in a real society to assume thatno costs are needed to transport goods from one place to another. In the
real world, each economy produces and consumes tens of thousands of commodities and services, many of which have different prices from country
to country because of transport costs, tariffs, and other trade barriers.
Absolute PPP is generally viewed as a condition of goods market equilibrium.Under absolute PPP, both the home and foreign market are integrated into a
single market. Since it does not deal with money markets and the balance of
international payments, we consider it to be only a partial equilibriumtheory, not the general one. Perhaps because absolute PPP require many
strong impractical preconditions, it fails in explaining practical phenomenon,
and signs of large persistent deviations from Absolute PPP have beendocumented.11
Although absolute PPP may contradict practical data, this does not implymarket failure. It may simply reflect the inability, without expenses, to
instantaneously move goods from one place to another. Thus, a moregeneral version of PPP, called the relative purchasing power parity, was
introduced to describe the relationship of prices with the exchange rate in
different economies. Generally, relative PPP can be derived by assuming thattransaction costs are proportionately related to price level. For example,
assuming that a commodity’s home price at time t is t P , and the transportcost is t kP , where k is constant, the foreign price of the commodity is equal
to the price of foreign currency multiplied by the exchange rate t P k) 1 ( +in terms of home currency, that is
(3.2)
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By taking the logarithm and then carrying out a differential operation on
each side of equation (3.2) with regard to time t, we get relative PPPexpressed by
(3.3)
(3.3) states that the relative change of the exchange rate equals thedifference of the inflation rate between the two economies.
Assuming that
can be reexpressedas
(3.3) Can also be derived by taking the logarithm and differential operation
directly from (3.1). If the real exchange rate is denoted by the ratio of national price levels,
if absolute PPP holds, the, the real exchange rate equals one. If relative PPP
holds, the real exchange rate should be a constant, but is not necessarilyequal to one. If an economy adopts a fixed exchange rate regime, therelative PPP model forecasts that the home prices change at the same speedas foreign prices. Conversely, if the inflation rates in the two economies are
the same, according to relative PPP, the exchange rate should be constant.
Mundell has in fact taken the fact that the PRC and the US experience thesame inflation rate as a rationale for supporting a renminbi peg to the dollar.
It is clear that absolute PPP is built on the assumption of a perfect market
setting with high information efficiency in both foreign exchange and goodsmarkets. Allowing for transport costs, tariffs and trade barriers, absolute PPP
may not hold. Many empirical studies show that neither absolute nor relativePPP holds in the short run, since the adjustment is a time-consuming
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process. Though controversies over PPP remain, it seems that only relative
PPP can hold in the long run (Pippenger, 1993). This may explain why PPPwas thought by some to be a long-run equilibrium condition, instead of a
casual relationship (Pongsak Hoontrakul, 1999). Relative PPP implies thatthe real exchange rate is constant. However, this theory itself does not
explain why the real exchange rate should remain constant over a particularperiod of time.
Empirically, evidence against PPP may be caused by inaccuracy of the price
index measuring the inflation rate for the countries studied (Frenkle, 1978;Genberg, 1978; and Thurow, 1997), the statistical procedure, or the
problem of simultaneous determination of both price and exchange rate
(Levi, 1976).
Theoretically, deviations of the PPP from its practical value may also be
caused by differences in production technology and consumer’s preferencestoward risk and uncertainty. For example, the Balassa-Samuelson modelargues that a rise in the productivity rate in the home country relative to a
foreign country can lead to a real appreciation of the home currency againstthe foreign currency. Many other models (Liu, Zhao and Ma, 2002) state that
the real exchange rate is associated with the preferences of consumers. Inaddition, tax or tariff policy may also change the real exchange rate. For
example, to offset the effect of the East Asia crisis, the PRC increased export
tax refunding after 1998, and this had a similar impact as the realdepreciation of home currency. Also, currently, the PRC plans to increase the
tariff on textile exports to avoid sanctions by European countries, and this is
equivalent to a real appreciation of home currency12.
As for whether PPP holds in the PRC, Chou and Shih (1998) showed that the
renminbi was overvalued after the economic reform was launched in 1979,but that purchasing power parity holds in the long run. Using the ADF-test
and Engle-Granger unit root test and integration test, Hu Yuancheng (2003)concluded that the real exchange rate of the renminbi was not stationary,
and thus that at least in the short run, PPP does not hold.
3.2 Interest Rate Parity
As early as the period of the gold standard, monetary policymakers found
that exchange rates were influenced by changes in monetary policy. The riseof the home interest rate is usually followed by the appreciation of the home
currency, and a fall in the home interest rate is followed by a depreciation of
the home currency. This indicates that the price of assets plays a role inexchange rate variations. The interest rate parity condition was developed
by Keynes (1923), as what is called interest rate parity nowadays, to link the
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exchange rate, interest rate and inflation. The theory also has two forms:
covered interest rate parity (CIRP) and uncovered interest rate parity(UCIRP). CIRP describes the relationship of the spot market and forward
market exchange rates with interest rates on bonds in two economies.
UCIRP describes the relationship of the spot and expected exchange ratewith nominal interest rates on bonds in two economies.
3.2.1 Covered Interest Rate Parity
Under this model, assume that the home country denotes the PRC and theforeign country denotes the US. The nominal interest rate at time t in the
PRC is t i and that at time t in the US is * t i , the spot exchange rate is t Sand the forward exchange rate at time t+1 is 1 + t S . If an investor in the
PRC deposits one yuan in Chinese currency, he will get a return of t i at timet+1, and the sum of his principal and interest rate at time t+1 is t i + 1 . If
this investor exchanges his one yuan renminbi into USD at time t and thendeposits it in a US bank with interest rate * t i , the sum of his principal and
interest in dollar terms is t t S i / ) 1 ( * + . However, since the forward
change rate is 1 + t S , this sum of the principal and interest in yuan termsis t t t S S i / ) 1 ( 1 * + + . In a perfectly competitive market, it is generally
recognized that it is less likely for the gap between the renminbi’s yield andthat of the USD to persist for any length of time. In other words, the returnfrom depositing renminbi in the PRC must be the same as the return from
depositing USD in US. This relation can be expressed using the coveredinterest rate parity condition:
(3.5)
or
(3.6)
(3.6) is the precise form of the covered interest rate parity condition. CIRPcan also be derived directly from the Fisher condition and PPP. Under the
Fisher condition, the real interest rates at home and abroad are, respectively
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Since the real interests rates are equal, the following formula holds:
Assuming
or PPP holds, we again obtain the CIRP condition
To simplify the model, we introduce the sign:
(3.7)
where
is defined as the forward premium (discount), the proportion by which the
forward exchange rate exceeds (falls below) its spot rate.
Using (3.7), (3.6) can be rewritten as
(3.8)
Since
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is such a small number that it can be omitted, (3.8) can be written
approximately as
(3.9)
This is the normal form of the covered interest rate parity, which states thatthe domestic interest rate must be higher than the foreign interest rate by
an amount equal to the forward premium (discount) on domestic currency.
According to CIRP, if the exchange rate of, say, the renminbi against theUSD is fixed, the interests of the two countries should be equal. Thus, a
small country with a pegged exchange rate regime cannot carry outmonetary policy independently. Empirically, using weekly observations from
Jan. 1962 to Nov. 1967, Frenkle and Levich (1975) confirmed that CIRP
held. Later (1977) they extended their studies into three periods: 1962–67,known as the “tranquil peg”; 1968–69, the “turbulent peg”; and 1973–1975,the managed float, and strengthened the findings of their previous study
that CIRP still holds during these periods even when the effect of transactioncosts is taken into account. Levi (1990) indicated that deviations from CIRP
might occur due to four major reasons: (1) transaction costs, (2) politicalrisk, (3) potential tax advantages, and (4) liquidity preference.
3.2.2 Uncovered Interest Rate Parity
However, investors face uncertainty over future events. In a rational
expectation framework, the forward exchange rate may be stronglyinfluenced by the market expectations about the future exchange rate if newinformation is taken into consideration. In an uncertain environment, an un-
hedged interest rate parity condition may hold. Given that all othervariables’ symbols do not change but that the forward exchange rate 1 + t Sis substituted by the expected exchange rate ) ( 1 + t S E , the UCIRP
condition can be written as
(3.10)
This is the precise form of uncovered interest rate parity. Like PPP, theUCIRP does not allow for investor’s preferences. In other words, (3.10) isderived under the condition that investors are risk neutral. This means that
agents are indifferent between an investment yielding a completely securereturn, on the one hand, and one offering the prospect of an identical return
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on average, but with the possibility of a much higher or lower return, on the
other hand. In other words, they are concerned only with average returns.
Similarly, using the following approximate expression:
(3.11)
where,
is the expected rate of appreciation of foreign currency, and then
substituting (3.11) into (3.10) and ignoring the smaller number as we didpreviously, we get the formal uncovered interest rate parity condition:
(3.12)
Formula (3.12) states that the domestic interest rate must be higher than
the foreign interest rate by an amount equal to the appreciation rate of
foreign currency. As with PPP, uncovered and covered interest rate parityconditions are derived under the assumption of no transaction barriers, a
perfectly competitive capital market and no arbitrage opportunities atequilibrium. Obviously, this kind of equilibrium is still partial, because only
the assets market is considered.
Very few empirical studies support UCIRP. For example, Using a K-step-ahead forecasting equation and overlapping techniques on weekly data of
seven major currencies, Hansen and Hodrick (1980) reject the marketefficiency hypothesis for exchange.
We have indicated above that the Fisher Open condition can be a basis for
covered interest rate parity. This condition implies that the expected realinterest rates are equal in different countries, with the real interest ratedefined as the nominal interest rate divided by the sum of one plus the
expected inflation rate. The Fisher Open condition implies approximately thatthe difference of nominal interest rates equals the difference of expected
inflation rate between two countries. Empirically, little evidence supports theFisher Open hypothesis (Cumby and Obstfeld 1981, 1984). When the Fisher
Open hypothesis is denied, real interest rate parity cannot hold.
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3.3 The Mundell-Fleming Model
Money is important, because it serves as a medium of exchange, ruler of
value, and means of storage. As a modern invention, paper money orcurrency plays an important role in reducing transaction costs. However, this
role was not included in the previous section. Thus, the effect on the nominalexchange rate of monetary policy is not clear from previous models. The
Mundell-Fleming model is developed by extending the IS-LM model to thecase of an open economy, and thus provides understanding of how the
exchange rate is determined. The IS-LM model considers three markets:goods, money and assets, and is mainly used to analyze the impacts of
monetary policy and fiscal policy. When the goods market is not in full
employment equilibrium level, it shows how to use fiscal policy andmonetary policy to adjust an economy to a new full employment equilibrium.
Since only two of the three markets are independent, the IS-LM model onlyestablishes a linkage between the money market and goods market. In the
Mundell-Fleming model, the balance of international payments is consideredanother equilibrium condition in addition to the money market and goods
market.
Let us first define the goods market equilibrium as the IS curve
(3.13)
where Y denotes domestic national income; C = C(Y) denotes consumptionwhich is a function of income; I = I(i) denotes investment, which is adecreasing function of nominal interest rate i ; G denotes government
spending; X = X(Y*,q) denotes exports , which is an increasing function of foreign national income and real exchange rate. M = M(Y,q) denotesimports, an increasing function of domestic income and decreasing function
of the real exchange rate.
The real exchange rate is defined by
where S is the nominal exchange rate; P,P* denote, respectively, domesticand foreign prices.
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Second, we define the money market equilibrium through the LM curve.
LetM d /P = L(Y,i) represent money demand, which is an increasing function of domestic income and decreasing function of the interest rate,
and M srepresent money supply. The money market equilibrium condition canbe expressed as
M s /P = L(Y,i). (3.14)
Finally, the external equilibrium is denoted by the BP equation: BP = CA +KA = 0 (3.15)
where, current account CA = PX - SP*M and capital account
One of the most important issues addressed by the model is the so-called
trilemma, which states that perfect capital mobility, monetary policyindependence and a fixed exchange rate regime cannot be achieved
simultaneously. Specifically, It argues that a country cannot sustainmonetary policy independence in a fixed exchange rate regime with perfect
capital mobility. However, this argument is made in a small country setting,and it is not necessarily true in a bigger economy, say, the PRC. What we
have seen in the PRC is that it is not so small and is maintaining certaincapital control and its monetary policy has seemed to be independent so far.
The model also forecasts that the exchange rate level is perfectly correlated
with the level of monetary supply in the long run, and thus that monetarypolicy may only play a trivial role. Another important implication is that
devaluation may lead to further devaluation if fiscal discipline, inflation andbalance of payments are not well managed or if the assets market produces
a self-fulfilling bubble.
Finally, the impact of devaluation on the improvement of the current accountmay be weakened if an economy is heavily reliant on the reexport
processing industry.
3.4 Exchange Rate and Productivity: The Balassa-Samuelson Model
From the discussion above, we conclude that PPP and CIRP (and UCIRP) only
express forms of partial equilibriums and do not clearly relate producerbehavior and consumer behavior. However, price levels are determined by
the interaction between supply and demand. Since the supply of anddemand for products are associated with producer and consumer’s behavior,a starting point for studying the determinants of the real exchange rate is to
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investigate producer’s behavior and consumer’s behavior, which areassociated with the microeconomic foundations of exchange rate theory. Inthis section, from the angle of producer behavior, we investigate the
Balassa- Samuelson model (Balassa, 1964; Samuelson, 1964). It allows usto see the role that productivity plays in the real exchange rate.
The standard version of the B-S model is presented using a single-factor
aggregate production function in Obstfeld and Rogoff (1996). For simplicity,this model assumes that the production functions of tradable (T) and
nontradable goods take the following form:
where Y is production, A is a constant describing technology, and L is labor
force. Foreign economies employ the same kind of technology as thedomestic economy, but may differ from it in the value of the technological
parameter, A. the subscript T denotes the tradable sector, and the subscriptN the nontradable sector. This model also assumes that the law of one price
holds for tradable commodities and that the world price of tradable
commodities is equal to one without a loss of generality. In addition, perfectlabor mobility is assumed between sectors within an individual economy, but
zero mobility of labor is assumed between economies. The mobility of laborinsures that the wage rates w are equal in other sectors of the same
economy. We define the price index as the weighted geometric average of prices of tradable and nontradable goods:
where
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is the share of tradable goods in total outputs. If this share is the same at
home as abroad, the relative price vis-a-vis the outside world is
the nominal GDP per employee can be expressed as
So the relative price can be transformed into
(3.16)
This formula states that the relative price is determined by relative GDP andthe relative technological level or productivity in nontradable sector of the
two economies. Given a level of productivity at home and abroad, a highernominal GDP growth in home than abroad leads to an appreciation of the
real exchange rate. On the other side, given an economic growth rate,higher productivity of nontradables in the home country than the foreign
country will lead to depreciation of the real exchange rate.
This simplified model can be easily extended to a more general one that
includes two production factors: labor and capital. Let us consider a smalleconomy that produces two composite goods: tradables and nontradables.
We assume that the production functions are functions of capital and laborwith constant return to scale:
where K denotes capital. The other variables are the same as above.
Through some manipulation, the log-differentiation of the relative price of tradable goods and nontradable goods can be expressed as
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(3.17)
where
and
are respectively the labor share of the income generated in the tradable and
nontradable goods sectors.
Provided that nontradables are relatively labor intensive, meaning
the model forecasts that the domestic economy will experience realappreciation if its productivity-growth advantage in tradables exceeds itsproductivity growth advantage in nontradables.
The Balassa-Samuelson model is one of the cornerstones of the traditionaltheory of the real equilibrium exchange rate. The key empirical observation
underlying the model is that countries with higher productivity in tradablescompared with nontradables tend to have high price levels. The B-S model
hypothesis states that productivity gains in the tradable sector allow realwages to increase commensurately and, since wages are assumed to link the
tradable to the nontradable sector, wages and prices also increase in the
nontradable sector. This leads to an increase in the overall price level in theeconomy, which in turn results in an appreciation of the real exchange rate.
During the starting period of economic reform and opening up, productivity
in both tradable and nontradable goods production in PRC was very lowcompared with developed countries. With the opening up and economic
reform, the lag in the economic and technological level allowed the PRC toenjoy three advantages over developed countries, namely, cheap labor, high
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productivity growth and spillover effects of foreign direct investment. These
advantages have allowed the PRC to enjoy much faster growth inproductivity in the tradable sector than the nontradable sectors and at home
than in foreign markets. According to the B-S model, this should result in thePRC experiencing real depreciation, and thus incurring nominal appreciation
pressure in the long run.
However, the shortcomings of this model are clear. First, It assumes that thetradable price at home is the same as that abroad. This is clearly an
unrealistic special form of PPP, but for tradable goods only. Under thissetting, how the prices of tradables are determined remains unknown.
Second, since it says nothing about the demand side, it is criticized by the
Keynesian school, which regards price to be rigid or sticky. Third, withoutconsidering the behavior of consumers, or the demand side, it is difficult to
interpret how market prices are formed. Last and most importantly, thismodel does not deal with the role of money; it can at best explain partly how
the real exchange rate is determined.
Integrating the model with a model of accumulation of capital and with thedemand side of the economy, Tomâŝ Holub and Martin Ĉihâk (2003) claimedthat that the predictions of their model were generally consistent withempirical findings for Central and Eastern European countries. But the
extended model still does not have room for money and the nominal
exchange rate. This implies that money is assume out of this kind of modeland that prices are assumed to be flexible enough to adjust to supply and
demand.
3.5 A Simple Monetary Exchange Rate Model with Price Flexibility
Unlike the Mundell-Fleming model, which involves the balance of
international payment, a simple monetary model was originally created in africtionless world with only one good and one bond (Mussa, 1976, Frenkle,
1976), in which money market equilibrium, PPP and UCIRP are reached. Thismodel includes three blocks.
The first block is the money market equilibrium equation given by
(3.18)
Where p is the log price level, i is nominal interest rate, y is the log of realoutput and m is the log of money supply. The second block is purchasing
power parity. Let e be the log of the nominal exchange rate, defined as the
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price of foreign currency in terms of home currency; p*,p denote the log of
the world foreign currency price of the goods basket and the log of the homecurrency price level. The purchasing power parity in log terms is
(3.19)
The third block is uncovered interest parity, which can be approximately
expressed in the forms of logs:
(3.20)
Substituting (3.19) and the uncovered interest rate parity approximationequation (3.19) into money market equilibrium equation (3.18), we have
(3.21)
Given money supply, foreign interest rate and price, this simple monetarymodel demonstrates that the exchange rate depends on both current values
as well as expected future values of related variables; that an increase in thedomestic money supply and foreign interest rate raises both the domestic
price level and nominal exchange rate level; and that changes in realdomestic income and the foreign price level have a negative effect on the
domestic level and nominal interest rate.
In the extreme case of a fixed exchange rate regime, the domestic interest
rate and price level are equal to their foreign counterparts. The moneysupply is endogenously determined by domestic output, the foreign interest
rate and foreign price level:
3.6 The Dornbusch Overshooting Model
Many studies document the fact that deviations from the law of one price arehighly correlated with nominal exchange rate changes (for example, Isard,
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1977; Giovannini, 1988). Evidence also shows that real exchange rates
always seem much less volatile when nominal exchange rates are fixed thanwhen they are floating (Mussa, 1986).
During the Bretton Woods period up until December 1971, the nominal
exchange rate of the lira to the French franc was relatively fixed and realexchange rate volatility was fairly low. During the periods when the relative
value of the two currencies was not effectively fixed (the early 1970sthrough 1987), real exchange rate movements were much more volatile and
short-run real changes virtually mirrored short-run changes in the nominalexchange rate.
This indicates that the choice of exchange rate regime can have importanteffects on real variables. Such forms of evidence motivate a sticky priceextension of the flexible exchange rate monetary model above, namely theDornbusch Overshooting model, which was presented in the influential
masterpiece “Expectations and exchange rate dynamics” by RudigerDornbusch (1976) (Kenneth Rogoff, 2002). Under the Dornbusch model,
uncovered interest rate parity and the money equilibrium of the simplemonetary model are retained. However, the assumption of flexible prices is
replaced by sticky prices. Similarly, The first condition in Dornbusch’s modelis monetary equilibrium:
(3.22)
where m is the money supply, p is the domestic price level, and y isdomestic output, all in logarithms; η and φ are positive parameters. (3.22)implies that higher interest rates raise the opportunity cost of holding moneyand thereby lower the demand for money; on the other hand, a higherinterest rate also means high costs of speculation, which lowers the demand
of money as well. Conversely, an increase in output raises the transactiondemand for money. Finally, the demand for money is positively related to
the level of prices. The second condition is uncovered interest rate parity,which can be rewritten as
(3.23)
where e is the logarithm of the exchange rate (home currency price of foreign currency), and E t denotes market expectations based on information
at time t .
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and
are approximately correct. The foreign interest rate i* is taken as a given
exogenous variable. In accordance with uncovered interest rate parity, thehome interest rate must be equal to the foreign interest rate i* plus the
expected depreciation rate of the home currency
Unlike under the perfectly flexible price model, the prices of goods are stickyand cannot adjust immediately to clear the market in the Dornbusch model.
With sticky prices, an adjustment mechanism is needed for an economy toconverge to its equilibrium path in which full employment is realized. Given
the magnitude of the real exchange rate’s departure from its long-termequilibrium, the force to pull it back to equilibrium will increase. Dornbusch
assumes that if the real exchange rate rises over its long-term equilibriumlevel, or if the foreign currency is overvalued or the domestic currency is
undervalued, the demand for domestic goods will increase; contrarily, if thereal exchange rate falls below its long-term equilibrium level, or the foreigncurrency is undervalued or domestic currency is overvalued, then the
demand of domestic goods will fall. In this connection, the third condition isan adjustment mechanism of the demand for domestic goods, which can be
expressed as
(3.24)
Where p and p* are, respectively, logarithms of the domestic price level P in
domestic currency and foreign price levels P* in foreign currency, δ is a
constant greater than zero,
(3.25)
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is the real exchange rate at time t, and y and
respectively, denote the exogenous longterm equilibrium output and real
exchange rate, at which full employment is realized.
The last or fourth condition is the price adjustment equation. Keynes
assumed that the domestic price level p does not move instantaneously inresponse to unanticipated monetary disturbances, but adjusts only slowly
over time. However, under Dornbusch’s model the feature of sticky prices isdifferent from that in the Mundell-Flemming model where the domestic price
level is basically assumed to be fixed.
Using the price adjustment mechanism proposed by Mussa (1982), which is
better suited than Dornbusch’s original formulation to dealing with morecomplex exogenous shocks, the sticky-price adjustment process can be
described as
(3.26)
The Dornbusch model is well known for its overshooting phenomenon, which
states that one permanent change in the money supply must lead to aproportionate change in the price level and the exchange rate in the long
run. But in the short run, the price level is fixed and the nominal exchangerate must overshoot its long-run equilibrium. That is, any initial disturbance
of money supply will cause an even larger unanticipated rise in the instantexchange rate than in the long-term exchange rate.
Another significant conclusion of the Dornbusch model is that the impact onthe exchange rate of a monetary shock is greater when prices are sticky
than when they are flexible. The third conclusion is that the exchange rateconverges to its flexible-price equilibrium value following an initial
overshooting after a shock and that the nominal exchange rate is morevolatile than the real exchange rate when ψδ < 1.
Fourth, the Dornbusch model tells not only a story of overshooting, but ithas important policy implications for the exchange rate regime. A centralconclusion of the model is that with sticky prices and flexible exchange
rates, purely monetary shocks will have significance for the real economy,
leading to large changes in prices and output and prolonged adjustment. If the exchange rate is fixed, the real effects of money demand shocks can be
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eliminated by setting money supply to money demand (so-called
nonsterilized foreign exchange intervention).
The model also states that the exchange rate policy is to some extentinconsistent with the independence of monetary policy. When a real shock
occurs, say a long-run rise in the real exchange rate, buffeting the economy,the model forecasts that a new full employment equilibrium adjustment will
occur immediately under a floating exchange rate regime, and need notchange the price level. If the exchange rate were fixed, in order to recover
the real economy to equilibrium, the entire burden would have to be borneby the prices of goods. But because these prices are sticky, it is a time-
consuming process for the economy to reach equilibrium.
Dornbusch’s model is not without deficiencies. For example, it is unable todeal adequately with the current account and fiscal policy dynamics or, morefundamentally, with welfare issues, because it lacks a micro foundation. In
addition, it is premised on the assumption that capital is perfectly mobileand the market is clear. In cases where capital mobility is imperfect, or
where capital control is stringent, as happened in the PRC and otherdeveloping countries, there is a lot of room for the model to be improved.
Finally, a fixed exchange rate regime may not be a viable option in the longrun, given the limited ability of an economy to endure pervasive speculative
attacks on a fixed exchange rate.
It is worth mentioning that the above arguments are obtained in the contextof a small country model. For a big economy, further studies are needed to
determine whether these conclusions are applicable.
3.7 The Obstfeld and Rogoff Model
Probably from the awareness that previous models have an inadequatemicro foundation, and are unable to deal adequately with current accounts
and balances of international payments, economists have made considerableefforts to explore a new setup for exchange rate determination.
The modern models of Obstfeld and Rogoff were set up based on simple PPP,
which implicitly assumes that nominal prices are producer’s currency of production (PCP). As a result, the exchange rate changes “pass-through” one hundred per cent to consumer prices and a flexible exchange rate is a
perfect substitute for flexible goods price. In their pioneering work, based onPCP, Obstfeld and Rogoff (1995) developed a perfect-foresight two-countryequilibrium monetary model with preset prices.
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Their model assumes that the world is inhabited by a continuum of individual
monopolistic producers, indexed by z ∈ [0,1], each of which produces a
single differentiated good, also indexed by z. All producers reside in one of
two countries, home or abroad. The home consists of producers on theinterval [0,n], whereas foreign producers are on interval (n,1]. But this
model revolves around the endogeneity of output of good z, y, (z).
One of the important contributions of the model is that it introduces a utility
function consumer j, j ∈ [0,1], which depends on the consumption index,
real money balances, and effort made in production:
(3.27)
Here, the real consumption index for individual j is defined as
(3.28)
where c j
(z) is the j-th home individual’s consumption of good z, and θ > 1.
Let p(z) be the home-currency price of good z . Then the home money price
level is
3.29)
Let p*(z) be the home-currency price of good z . Then the foreign moneyprice level is
(3.30)
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The law of one price holds for individual goods, and the home and foreign
price levels are related by purchasing power parity. That is P = ε P*
An individual’s budget constraint
(3.31)
r t denotes the real interest rate on bonds between t-1 and t, y t , ( j ) is theoutput of good j, and pt ( j ) is its domestic currency price. Because there is
production differentiation, pt ( j ) need not be the same for all j. The M is agent j’s holdings of nominal money balances entering period t, and t τ denoteslump-sum taxes.
Compared with the Dornbusch model, the Obstfeld and Rogoff model has
four advantages. First, it was developed on a firm micro foundation thatmaximizes the welfare of consumers. Second, though money the demand
functions in the Dornbusch model and Obstfeld and Rogoff model havesimilar forms, the output variable in the former was substituted by
consumption in the later. Third, a goods differential is allowed in theObstfeld and Rogoff model, but Dornbusch’s model revolves around themarket structure and the endogeneity of output. Fourth, in the Obstfeld andRogoff model, a comparison of the impact of external shocks on consumer’swelfare is allowed, but it isn’t in Dornbusch model.
According to Obstfeld and Rogoff (1995, 1998, 2000a), the flexibility of theexchange rate is desirable in the PCP setting, because: (1) flexible exchange
rates are a perfect substitute for flexible nominal prices. Relative price
adjustment is achieved by exchange rate flexibility under PCP pricing; (2)the policy that achieves the flexible price allocation is a constrained Pareto
optimum; (3) this optimal policy is completely self-oriented. No policycoordination across countries is required or desirable. In this sense, perfectly
flexible exchange rates are optimal (Engle, 2002).
3.8 Price to Market and the Exchange Rate Regime
The modern models of Dornbusch and Obstfeld and Rogoff are based onsimple PPP, which implicitly assumes that nominal prices are PCP. As aresult, the “pass-through” of exchange rates to consumer prices is onehundred per cent and flexible exchange rates are a perfect substitute forflexible goods prices. However, a number of empirical studies and
experiences of Japan (Chapter 6) indicate that in the short run, nominalexchange rate changes only partly pass through to consumer prices. To
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reflect this phenomenon, Devereux and Engle (2003) put forward another
type of price-stickiness: prices are preset in the consumer’s currency(denoted by local currency pricing or LCP).
Under LCP, the short-run responses of consumer prices to exchange rate
changes are very small. When prices are not very responsive to exchangerate changes, the monetary policymaker cannot rely on the exchange rate to
provide the necessary adjustment to real shocks. Since consumers do notinterpret exchange rate changes as relative price changes in the short run, it
is not easy to control the relative demand for domestic goods and foreigngoods through exchange rate changes. In the absence of strong
expenditureswitching effects, the benefits of floating exchange rate are
diminished. This implies that an optimum monetary rule would not utilizeexchange rate movements at all and that welfare-maximizing monetary
policies may entail a fixed exchange rate (Engle and Devereux 2003).
This theoretical framework can be viewed as a major challenge to theFriedman case for exchange rate flexibility, according to which floating
exchange rates are helpful in cushioning national economies from realidiosyncratic shocks, and one that is applicable to industrial rather than
emerging economies.
Otstfeld (2004) improved on the model of Devereux and Engle in two ways.First, he modeled the monetary policy as a choice of the nominal interest
rate rather than a monetary aggregate. Second, he introduced non-tradedgoods in the LCP framework. However, his conclusion challenges that of
Devereux and Engle. He declared that even when the exchange rate playsno role, countries may wish to have flexible exchange rates in order to freethe domestic interest rate as a stabilization tool.
3.9 Balance of Payments Equilibrium and Exchange RateMisalignment
Ronald Macdonald (2000) made an overview of the concepts for calculating
equilibrium and discussed the advantages and disadvantages of variousapproaches to the estimating equilibrium exchange rate, such as BEERs
(Behavioral Equilibrium Exchange rates), PEERs (Permanent and TransitoryDecompositions of Real Exchange Rates), and FEERs (Fundamental
Equilibrium Exchange Rates). All the approaches regard the balance of payments as a starting point. According to Ronald Macdonald, the standard
balance of payments equilibrium condition holds under floating exchange
rates in the absence of intervention in the foreign exchange market:
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(3.32)
where cat and kat = 0 denote, respectively, the current account and capital
accounts of the balance of payments. Ignoring some minor components, thecurrent account is determined by:
(3.33)
where nx t denotes net exports and i t nfat represents net interest payments onnet foreign assets.
This model does not assume PPP to be true in all cases, but assumes thatthe real exchange rate or term of trade as a measure of competitivenesshave an impact on net exports and the current account. It also assumes that
a rise in domestic income worsens net exports through its effect on imports,
while a rise in foreign income improves the net export position through itsinfluence on domestic exports. Thus, net exports are determined by a
standard relationship:
(3.34)
where st is the log of the spot exchange rate, pt is the log of the domestic
price level, y t is the log of domestic income, pt * is the log of the foreign pricelevel and y>t * is the foreign income. a's are elasticities.
In practice, the international capital markets are not necessarily perfect, and
thus the uncovered interest parity may not hold everywhere. However, whenthe capital markets are not in equilibrium, a mechanism for adjusting the
flows of capital will take effect. In other words, if other things are equal, arise in the domestic interest rate raises capital inflow, while a rise in the
foreign interest rate lowers capital inflow, leading to a rise in the expectedexchange rate (domestic currency deprecation), which will encourage capital
outflow.
(3.35)
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where i t denotes an interest rate yield of domestic deposits, and i*t an
interest rate yield of foreign deposits, and ∆set+k is the expected change in
the exchange rate. Substituting (3.34) into (3.33) and the resulting
expression, along with (3.35) into (3.32) we obtain the balance of paymentsexchange rate equation:
(3.36)
This formula is usually thought to be a general expression of an equilibrium
exchange rate in that it satisfies the balance of payments equilibrium underfloating exchange rates.
It is clear that u → ∞ means that UCIRP is satisfied and a 1 → ∞ αmeansthat PPP is satisfied.
Combining (3.36) and the definition of the real exchange rate
(3.37)
The real exchange rate at time t can be rewritten as:
(3.38)
3.10 Summary of Model Implications
In this section, we provide a brief review of exchange rate determination
theories and their policy implications. This review demonstrates that eachtheory holds in a particular setting and explains some macroeconomic
phenomena. No single theory contains all the factors that may have animpact on foreign exchange rates.
Purchasing power parity (PPP) theory, which is classified into two types(absolute PPP and relative PPP) is covered in this review as a starting point
for understanding how exchange rates are determined in the goods market.It builds linkage between the exchange rate and prices of goods in twoeconomies. This is why it is called the “inflation theory of exchange rates.”
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Since it deals only with the goods market, and not the assets market, it is a
partial equilibrium theory. The minimum preconditions for absolute PPPinclude: (1) same production technology for individuals, (2) neutral-risk
preferences, (3) perfectly competitive goods markets in two differenteconomies, (4) no trader barriers such as transport costs, tariffs and trade
quotas, and so on. It is established on the “law of one price.” Actually, thepreconditions for absolute PPP do not hold since transport costs, tariffs, and
technological and preferential differences exist at all times and places.Absolute PPP is rejected by most empirical surveys. Relative PPP allowsexchange rates to deviate from absolute PPP. It is equivalent to the realexchange rate being constant. Empirically, both absolute PPP and relative
PPP in the short run are rejected, but some studies find that relative PPP
seems to hold in the long run.
Another popular partial equilibrium exchange rate theory, interest rateparity, examines how the exchange rates are determined in financial
markets. Since interest rates change frequently in the short run, interestrate parity is thought of as “short run exchange rate theory.” Interest rateparity also has two types, CIRP and UCIRP, both of which are based on theassumption that asset markets are frictionless and that there is no arbitrage.
A lot of evidence supports CIRP as a forward exchange rate pricing model.However, variations in monetary policy, degree of risk aversion, politicalrisks, barriers to capital mobility, and microstructure variations in themarket may cause persistent variations in the risk premium over time.
UCIRP and the Fisher open condition are also covered in this review, butboth lack support from empirical studies.
Three monetary models are presented to introduce the impact of monetaryfactor and real factor shocks on the exchange rate. The first model, known
as the simple monetary model in the setting of flexible prices, forecasts howthe exchange rate and price level change with current and expected future
values of related variables, such as money supply, foreign interest rate, andincome level.
The second model, the Mundell-Fleming model, is extended from a closedIS-LM model. Unlike the simple monetary model, in which prices are viewed
as flexible, it assumes that prices are preset in the short run. In addition tothe internal monetary market equilibrium, goods market equilibrium, and
external equilibrium condition, the balance of payments is also considered inthe Mundell- Fleming model. Thus, it can be viewed as a general equilibrium
model. One of the most important forecasts of the model is the socalledtrilemma, which states that perfect capital mobility, monetary policy
independence and a fixed exchange rate regime cannot be achievedsimultaneously. In the long run, the exchange rate level is perfectly
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correlated with the level of monetary supply, and monetary policy may only
play a trivial role in economic growth. Another important forecast is thatdevaluation may lead to further devaluation if fiscal discipline, inflation and
the balance of payments are not well managed, because a self-fulfillingbubble may be produced. Finally, the impact of devaluation on current
account improvement may be weakened if an economy is heavily dependenton the re-export processing industry.
The third monetary model, Dornbusch model, loosens the condition that
prices must be preset, but allows for slow price adjustments. A famousinsight into policy implication of this model is the overshooting of the
nominal exchange rate over its long-run equilibrium, when an economic
system is shocked with monetary supply. This character is regarded as anadvantage of a fixed exchange rate regime over a floating one. This model
shows that once a real economic shock happens, markets may move toequilibrium either through a flexible exchange rate or change of prices. The
difference between the two is mainly that in the latter, adjustment mayconsume more time and be less risky than in the former. If prices are
relatively flexible and inflation can be controlled in a moderate range, a fixedchange rate regime is desirable.
These models were criticized frequently for their lack of micro foundations,
and for their failure to elucidate the effect of the balance of payment on the
determination of the exchange rate. However, their clear implications forpolicymakers should not be underestimated. The Ballasa-Samulson model
partly addressed the issue of the lack of a micro foundation in modeling
work by incorporating productivity differentials or technological changes inproduction into a one-factor production technology model, which was thenextended to a two-factor model. The main contribution of this kind model is
that they built linkages between productivity, output and the real exchangerate (terms of trade) through the rational behavior of producers. However,
they fail to incorporate paper money or nominal exchange rate and thebehavior of the demand side that might have important impacts on theexchange rate.
The latest important development in exchange rate studies is the pioneering
work in 1995 of Obstfield and Rogoff (Redux), whose model incorporates thedemand side. However, this model still relied on PPP and price presetting.
Though it allows the welfare effects of different shocks to be compared, itmerely seems to be a Dornbusch model based on maximization behavior.
There are still many deficiencies in the model. First, it does not considerinvestment and producer’ behavior; second, it regards absolute PPP as aprecondition, but this has not been supported by empirical studies.
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To address the unsuitability of PPP, recent modeling efforts have been
formulated in the setting of consumer’s currency pricing or LCP. In the LCPsetting, some implications are found to be different from that in the PCP
setting, especially regarding the choice of the exchange rate regime. In PCP,perfectly flexible exchange rates are to some extent optimal. However, some
economists argue that the LCP setting is more practical than PCP, at least inthe short run. In the LCP setting, an optimum monetary rule does not utilize
exchange rate movements at all and welfare-maximizing monetary policiesmay entail a fixed exchange rate. However, Otstfeld argues that if substituting interest rate for aggregate money demand in LCP, even whenthe exchange rate plays a trivial role, countries may wish to have flexible
exchange rates in order to free the domestic interest rate as a stabilization
tool.
Existing exchange rate models have done little regarding the role of fiscalpolicy and income policy in dealing with trade surpluses and deficits. For a
perfect market economy, this may not be a problem, because fiscal policyand income policy are usually regarded as nonmarket measure and may
cause distortions of the market. But for a country that is undergoing reformand marketization, structural factors may play a key role in the balance of
trade and payments. PRC already had some experiences in this regard. Forexample, when it was suffering shocks from the Southeast Asian crises in1998, many researchers forecasted that the PRC would have to devaluatethe RMB, but in the end it decided to raise export tax rebates, which had a
similar effect as a devaluation. Presently, though the PRC has a tradesurplus and a large amount of foreign exchange reserves, it faces structural
issues, involving social security funds, pensions, health insurance, laborsecurity, implicit fiscal deficits, and an inefficient banking system, which arechallenging policymakers. Thus, all those factors mentioned here may have
an impact on government decisions. However, the following modeling workwill start mainly from the macro aspect.