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Chapter 19
What Determines Exchange Rates?
Overview
Since the general shift to floating exchange rates in the early 1970s, exchange rates between the
U.S. dollar and other major currencies have been variable or volatile. The charts at the beginning
of the chapter suggest three types of variability. First, there are long-term trends in which some
currencies tend to appreciate against the dollar, and others tend to depreciate. Second, there are
medium-term trends which are sometimes counter to the longer trends. Third, there is substantial
variability during the short run. The chapter presents what we know about exchange movements
during these time periods of different lengths.
The chapter first examines short-run movements in exchange rates. It presents the version of the
asset market approach to exchange rates that focuses on debt securities and the uncovered
interest parity relationship developed in Chapter 18, presuming that this relationship holds
approximately if not exactly. The basic discussion examines the pressure on the current spot
exchange rate if one of the other three rates (the domestic interest rate, the foreign interest rate,
and the expected future spot exchange rate) changes, with the other two held constant. If the
domestic interest rate increases, then the foreign currency depreciates (the home currency
appreciates). If the foreign interest rate increases, then the foreign currency appreciates. (The text
notes that what really matters is the change in the interest differential.)
If the expected future spot exchange rate value of the foreign currency increases, then the current
spot exchange rate value of the foreign currency increases. Many different things can influence
the expected future spot exchange rate. First, if expectations simply extrapolate recent trends,
then a bandwagon is possible. Speculation then may be based on destabilizing expectations—
expectations formed without regard to the economic fundamentals—and (speculative) bubbles
can occur. Second, if expectations are based on a belief that exchange rates eventually follow
PPP, then they lead to stabilizing speculation—speculation that tends to move the exchange rate
toward a value consistent with the economic fundamentals of national price levels. Third,
expectations are affected by various kinds of news about economic and political circumstances.
The chapter then examines long trends in exchange rates. Our understanding of exchange rates in
the long run is based on the purchasing power parity (PPP) hypothesis. Three versions of PPP are
presented: the law of one price for a single product, absolute PPP, and relative PPP.
Absolute PPP posits that a basket of products will have the same price in all countries when the
prices are converted into a single currency using the market exchange rates. In symbols absolute
PPP is P = ePf (or e = P/Pf), where the P's are prices (measured in local currencies) in the home
and foreign countries, and e is the exchange rate measured as units of domestic currency per unit
of foreign currency. When we examine actual prices and exchange rates, divergences from
absolute PPP (and the simpler law of one price) can be large.
Relative PPP posits that the exchange rate will change to offset differences in the rates of product
price inflation in different countries. In symbols, (et/e0) = (Pt/P0)/(Pf,t/Pf,0), where the subscript 0
indicates the initial year values and the subscript t indicates values in a subsequent year. The text
presents evidence on the relative version of PPP by examining inflation rates (rates of change of
product prices) in different countries and the rates of the change of the exchange rate between the
countries' currencies. A relationship consistent with relative PPP is clear—low-inflation countries
tend to have appreciating currencies and high inflation countries tend to have depreciating
currencies. In addition, examination of the dollar-mark and dollar-yen exchange rates shows that
there is a tendency to follow relative PPP in the long run, but that there are also substantial
deviations from relative PPP in the short run.
If exchange rates follow national price levels in the long run, what determines national price
levels in the long run? In the long run the national money supply (or its growth rate) determines
the national price level (or the national inflation rate), through the equilibrium between money
supply and money demand. In the text we use the demand for money that follows the quantity
theory of money, in order to draw out the relationships in the most direct manner possible.
Money is held to facilitate transactions, so that money demand is based on the annual turnover of
transactions that require money, and this turnover is proxied by the level of (nominal) domestic
product (PY, where Y is real GDP). The quantity theory then says that, for each country, Ms =
kPY, where Ms is the national money supply, which is controlled by national monetary policy,
and k is a behavioral parameter.
Combining PPP and the quantity theory equations for two countries, we obtain a basis for the
monetary approach to explaining or predicting exchange rates in the long run: e = P/Pf =
(Ms/Msf)(kf/k)(Yf/Y). If the ratio of the k's is steady, then the exchange rate will change over
the long run as the money supplies change and as real GDPs grow, with elasticities of one. Other
things equal, in the long run a lower level (or slower growth over time) of a country's money
supply, or a higher level (or faster growth) of its real GDP, tend to result in a higher value (an
appreciation over time) of the country's currency, because each implies a lower level (or slower
rate of increase) in the country's price level.
How do we get from the short run in which portfolio adjustments by international investors place
the major pressures on exchange rates to the long run of PPP? We can view this as a process in
which the exchange rate overshoots (relative to the value consistent with PPP) in the short run,
and then (gradually) reverts to PPP in the long run. This can be seen most clearly by considering
an abrupt change in the domestic money supply. The additional (and presumably realistic)
assumption is that product price levels adjust slowly toward the level consistent with the quantity
theory equation. If the domestic money supply increases abruptly, then, at first, the domestic
price level does not rise much, but eventually it will. With the increase in the money supply (and
not so much of an increase in money demand at first), domestic interest rates decrease. In
addition, investors expect that eventually the foreign currency will appreciate (the domestic
currency will depreciate) relative to its initial value, because the domestic price level eventually
will be higher (PPP in the long run). For both of these reasons (lower interest rate and expected
appreciation of the foreign currency relative to its initial value), investors shift their investments
toward foreign-currency assets. This causes an abrupt, large appreciation of the foreign currency
—more than is consistent with the small amount of change in the domestic price level in the
short run, and also more than is consistent with the long run change in the price level. Once the
exchange rate value of the foreign currency overshoots in the short run, it then is expected to and
does decline back toward the long run value that is consistent with PPP. In fact, this subsequent
expected depreciation of the foreign currency is necessary to reestablish uncovered interest
parity. The overall return on foreign-currency assets is then lowered by the expected depreciation
of the foreign currency, so that it is about equal to the lower domestic return resulting from the
lower domestic interest rate.
The chapter next discusses of how difficult it is to predict exchange rate movements in the short
run. Generally, economic models (like the asset market approach or the monetary approach)
cannot beat the naive model of a random walk, which predicts that the exchange rate in the future
will simply be the same as the exchange rate today. A major reason for this inability to forecast is
that the current spot exchange rate reacts quickly and strongly to unexpected (and therefore
unpredictable) news. A second reason may be that traders and investors form their short-run
expectations of exchange rates based less on economic fundamentals and more on recent trends.
The expectations are then self-confirming, resulting in bubbles in the movement of exchange
rates over time.
The chapter concludes by introducing some concepts and distinctions that are useful in
measuring and examining exchange rate values. (In the previous 15th edition of the book, this
section was a box; it has been shifted to the text for the 16th edition.) Nominal bilateral exchange
rates are simply the standard rates quoted in the foreign exchange market. The nominal effective
exchange rate is an index that tracks the weighted-average nominal value of a county's currency.
Deviations from PPP can be measured using the real exchange rate, which can be measured as an
index between two currencies (bilateral) or as a weighted average index relative to a number of
other currencies (effective). If PPP holds in the long run, then the real exchange rate tends to
return to its "normal" value (e.g., 100). As we will discuss in Chapter 22, changes in the real
exchange rate also can be used as an indicator of changes in the international price
competitiveness of a country’s products.
Tips
For understanding short-run movements in exchange rates, one point is clear—short-run
pressures on major currencies and many others result from portfolio adjustments or financial
repositioning by international investors and traders. Beyond this, we must be somewhat humble.
While we have some understanding of the basic reasons for these adjustments and repositioning,
there is also much that we cannot explain or predict by relatively simple theories.
The presentation of the short-run pressures on the current spot rate from changes in the other
rates emphasizes two compatible explanations. The first is the flow pressure on the current spot
rate that results from financial repositioning of international portfolios. This seems to be the best
way to get students to grasp intuitively the logic of the relationships. The second is the rate
adjustment necessary to reestablish (at least approximately) uncovered interest parity. This is
consistent with a stock equilibrium in the holding of financial assets.
During class discussion of the short-run pressures on exchange rates, inquisitive students may
ask if both the interest rate (say, the domestic interest rate) and the expected future spot exchange
rate change at the same time. Here is one possible way to respond. If the increase in the nominal
domestic interest rate is caused by a higher expected rate of inflation, then it may also be
accompanied by an expectation (based on PPP) that the domestic currency will depreciate in the
future. In this case, there is no simple prediction for the pressure on the current spot exchange
rate, because the higher domestic interest rate and the expected depreciation are pushing in
opposite directions. (Alternatively, the discussion of overshooting presents a different scenario in
which both the domestic interest rate and the expected future spot exchange rate change.)
The more complicated version of the asset market approach that emphasizes variations in risk
premiums is mentioned in footnote 2. We do not develop this version in the text—it seems
needlessly complicated, and empirical tests generally fail to show that it is important.
In the presentation of the monetary approach, we choose not to elaborate on the money demand
function at this time. In Chapters 22-25 we formally add the interest rate as a determinant of
money demand, but for the long-run analysis emphasized in the monetary approach it does not
seem necessary. An instructor could incorporate the interest rate as a determinant of money
demand by discussing what might determine the k value in the quantity equation.
Some students find grasping the technical aspects of overshooting to be challenging. Figure 19.5
may help some students by showing the sequences of effects. Still, an instructor can deemphasize
the analysis of overshooting without encountering serious problems in covering the material of
subsequent chapters.
Students benefit from the application of the concepts from Chapters 16-19 to the real world. You
may want to consider an assignment like the one that Pugel and others at New YorkUniversity
have used successfully. It asks students to apply the concepts to a country other than the United
States. The sample assignment on the accompanying pages shows one version, in which students
worked in groups, but the students could instead be asked to work individually. If you use a
comparable assignment, it can be distributed about the time that you finish covering the material
from Chapter 19, especially PPP and real exchange rates. (In addition, each group used the same
country that it had used for a previous assignment in the course, shown as the sample assignment
for Chapter 5 in this Instructors Manual.)
Appendix F shows that interest rate parities and purchasing power parity can be combined. This
combination provides additional insights, including the proposition of the equality of real interest
rates across countries.
