Exchange Rates and Real Interest Rates: An Analysis - Prof. Charles Engel, Study notes of Finance

Download Exchange Rates and Real Interest Rates: An Analysis - Prof. Charles Engel and more Study notes Finance in PDF only on Docsity! The main take-aways from our study of exchange rate models: 1. The average real exchange rate for the US and other advanced countries is related to the difference between foreign and US real interest rates. a. This relationship is weaker on a currency-by-currency basis. 2. It is nearly impossible to forecast exchange rate changes using this model, or any other model. 3. “Technical analysis” is of dubious value. 4. Currency crises might be predictable. 1 How are exchange rates related to real interest rates? I present here a somewhat simplified version of the discussion in Chapter 10. We start with the “approximate” versions of uncovered interest parity and relative purchasing power parity. Approximate uncovered interest parity: +Δ = − * 1(% ) US t t t tE S i i Approximate relative purchasing power parity: π π+ + +Δ = − * 1 1 1(% ) ( ) ( ) US t t t t t tE S E E Together, these imply: π π+ +− = − * * 1 1( ) ( ) US US t t t t tE E i ti , or π π+ +− = − * * 1 1( ) ( US US t t t t ti E i E )t . Real US interest rates equal real foreign interest rates. 2 What aspect of the model should we change? Let’s modify relative PPP. We will acknowledge that sometimes the real exchange rate, is different from its long run level, tRS RS . Here is our new model of expected changes: π π+ + + ⎛ ⎞− Δ = − − ⎜ ⎟ ⎝ ⎠ * 1 1 1(% ) ( ) ( ) US t t t t t t t RS RSE S E E a RS This model says that the exchange rate depreciation tends to reflect differences in expected inflation, π π+ +− * 1 1( ) ( ) US t t t tE E . But if exceeds tRS RS , there is some tendency for the exchange rate to fall. So the exchange rate also is expected to erase a fraction a of the percentage difference between and tRS RS . Because adjustment is slow, a is small. 5 Combine with uncovered interest parity to get: π π+ + ⎛ ⎞− − = − − ⎜ ⎟ ⎝ ⎠ * * 1 1( ) ( ) US US t t t t t t t RS RSi i E E a RS , or π π+ + ⎛ ⎞− − − = − −1 . ⎜ ⎟ ⎝ ⎠ * * 1 1( ) ( ( )) US US t t t t t t t RSi E i E a RS Solve this out to get: ( )π π+ += − − − −* *1 111 ( ) ( ( ))US USt t t t t t tRS i E i EaRS This says that when the US real interest rate rises above the foreign real interest rate, falls relative to tRS RS . There is a real dollar appreciation. 6 ayes DFuYyoXo [ray oro STO O10 SOO 000 O10- oz0- or 0- oro- T T T T T T T T O100 8000 9000 F000 cD c000- [enuaIaypIp ayer ysaraqur [Bad Panty 900'0- 2005 2000 1995 1990 1985 1980 1975 Time There is evidence that long-run relative PPP is useful for forecasting real exchange rates at long horizons (4 years). But this finding is true for an “average” US real exchange rate. Forecasting individual currency exchange rates is more uncertain. Bottom line: Economic models are not useful for forecasting US exchange rates of individual currencies. 10 The text discusses “technical analysis” as a means of forecasting exchange rates. These forecasts are based on statistical rules of thumb. There is little rigorous evidence that these models are useful for forecasting. The evidence that is favorable toward these models is subject to “reporting bias” or “publication bias”. • Indeed, models that report success in forecasting generally no longer exhibit success after publication. 11 Currency crises: A currency crisis occurs when a fixed exchange rate system breaks down. Then the country’s currency may depreciate by a large amount. Examples: Europe in 1992 Mexico 1994-1995 Southeast Asia 1997 Why might a currency collapse? Macroeconomic fundamentals Self-fulfilling expecations Contagion In some cases, currency crises may be predictable 12 Mexico had been following a crawling peg against the US dollar. But in 1994, inflation was high in Mexico and the Mexican central bank found it difficult to keep the peso from depreciating outside the band. Speculators were betting on a large depreciation. Mexico was following a policy of government borrowing in US dollars – tesobonos. The idea was that this would add credibility to their exchange rate policy. But indeed credit markets lost faith in Mexico’s ability to repay these loans. In the end, the tesobonos actually undermined the peso, because markets began to doubt the ability of the government to repay the loans if the peso did devalue. There ultimately was a large depreciation in December 1994. To some extent at least the timing of the crisis was determined by self-fulfilling expectations. 15 The currencies of Indonesia, Malaysia, the Phillipines, Korea, and Thailand experienced very large depreciations in 1997. These countries were running current account deficits, and building up dollar-denominated debt. • For a long time it seemed like this path was sustainable. • The borrowing of these countries did not arise from low private saving. (Recall that the current account equals (saving – investment). • Instead, investment levels were high. However, the markets began to question whether the growth in these countries really could sustain the level of borrowing. Was all of the investment productive? 16 This crisis exhibits features of all three causes of crises: fundamentals, self-fulfilling expectations, and contagion. The underlying fundamental problem was excessive borrowing for investment. As markets began to worry, the currencies depreciated. Depreciation made the problem worse because it increased the value of debt in local-currency terms. As one country’s currency depreciated, it put pressure on neighboring countries. Exports (to the U.S., for example) are cheaper when a currency depreciates. As Indonesia, for example, depreciates, its exports become cheaper relative to the other countries. This puts more pressure on the currencies of other countries to depreciate. 17