Question

What factors cause the real exchange rate to rise? What does real exchange rate appreciation (depreciation) imply for net exports? Why? What is PPP predicted real exchange rate? PPP predicted nominal exchange rate? 

Answer 1

(a) Aside from factors such as interest rates and inflation, the currency exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here, we look at some of the major forces behind exchange rate movements.

1.Differentials in Inflation:Typically, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the 20th century, the countries with low inflation included Japan, Germany, and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency about the currencies of their trading partners. This is also usually accompanied by higher interest rates.

2.Differentials in Interest Rates:Interest rates, inflation, and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates.

3.Current Account Deficits:The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest, and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests.

4.Public Debt: Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices.

(b) After the domestic real interest rate rises the exchange rate appreciation reduces net exports. If the foreign country's real interest rate rises the supply of domestic currency increases, the exchange rate depreciates, and the domestic country net exports rise.

(c) To determine whether a currency is over-valued or under-valued we need a benchmark that provides the true value of a currency should be. One popular benchmark model is provided by the purchasing power parity (PPP) concept, which links exchange rates to the prices of goods in different countries. This benchmark also provides a baseline forecast for future exchange rates that is usually considered whenever it is necessary to forecast future cash flows in different currencies, especially when inflation rates differ across these countries. Consequently, PPP plays a fundamental role in corporate decision making, and could be used as a discount rate for the repatriation of earnings or dividends from an investment. Similarly, deviations from PPP could affect the profitability of firms, particularly where they may need to set international prices, or where they are engaging in long-term international contracts, hedging cash flows of foreign operations, etc. It is also worth noting that PPP is also particularly useful in various developmental studies as it is used to assess the cost-of-living in different countries.

(d) As time has gone by, people have increasingly chosen to compare the economies of different nations based on purchasing power parity (PPP) rather than nominal exchange rates. PPP provides some interesting information about economies, but when it comes to the larger issues at play, I will put forth a case in the following that it is nominal exchange rates that are of real significance.It is also erroneous to expect that nominal exchange rates will move toward convergence in the long-term, i.e., toward equalizing the prices of superficially identical baskets of goods and services as reflected in the PPP measure.Let us define these two terms first. The nominal exchange rate is what the market offers you, but the PPP rate adjusts for differences in the price of a selected basket of goods and services.The Economist has its own measure, the Big Mac Index, as an informal PPP measurement. If a burger in the US is priced at US$5.28 at current exchange rates and in India at US$2.82, the US dollar (USD) is held to be 87% overpriced compared to the Indian Rupee (INR). Based on a basket of goods — intended to reflect real PPP — the USD is 287% more expensive than the INR (or so it is claimed).

While the huge difference between the Big Mac Index and real PPP might lead one to dismiss the Big Mac Index as useless, important information is hiding there: As countries like India go up the value chain, the seeming undervaluation of their currencies starts to disappear. In other words, their price structure is such that the more complex products are, the more expensive they are on a relative basis.