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| | Exchange rates
What determines exchange rates?
Effects of exchange-rate movements
Effective exchange rates
Real effective exchange rates
Purchasing power parity (PPP)
The gold standard
Adjustable exchange rate pegs
Floating exchange rates
What determines exchange rates?
Exchange rates are nothing more than the price of one currency
in terms of another. They are determined mainly by supply and demand,
which reflect trade and other international payments, and, much
more important, volatile capital flows which are constantly shifting
around the world in search of the best expected investment returns.
The prime indicator of market pressures on a currency is the figure
for total currency flows in the balance of payments account. Other
important influences are relative interest rates and yields and
inflation.
Effects of exchange-rate
movements
The most immediate effect of a weaker currency is higher domestic
inflation owing to dearer imports. At the same time, those exports
priced in foreign currencies and inflows of rents, interest, profits
and dividends generate more income in domestic-currency terms. But
those exports priced in the local currency generate the same revenue
as before. The net effect of this is for the trade and current-account
balances deteriorate.
Later, after perhaps as much as 12 - 18 months, relative price
movements cause a shift from imports to domestic production and
exports. This boosts GDP and the trade and current accounts improve.
(Their deterioration followed by improvement is known as the J-curve
effect.) However, higher inflation caused by a weaker currency can
wipe out any current account improvement within a number of years.
With regard to the capital account of the balance of payments,
a weaker currency makes inward investment look more attractive.
In foreign-currency terms outlays are lower and returns are higher,
but this may not be enough to attract investors if the currency
weakened because of unfavourable domestic economic conditions.
Effective exchange rates
An effective exchange rate measures the overall value of one currency
against a basket of other currencies. Changes indicate the average
change in one currency relative to all the others.
Effective exchange rates are weighted averages of many currency
movements with weights chosen to reflect the relative importance
of each currency in the home country's trade. For example, if the
dollar appreciates by 10% against the Japanese yen but is unchanged
against all other currencies, and if the yen accounts for 25% of
US trade, the dollar's effective exchange rate has risen by 2.5%.
For obvious reasons effective exchange rates are sometimes known
as trade-weighted exchange rates. There are many ways of selecting
the weights, based on imports of manufactured goods, total trade,
and so on.
Effective exchange rates do not take account of inflation so they
do not reveal anything about changes in a country's competitiveness
(see real effective exchange rates).
Real effective exchange
rates
A country's international competitiveness depends on relative
movements in costs or prices after adjusting for exchange-rate movements.
For example, if prices increase by 4% in Germany and 6% in the USA,
US competitiveness appears to have fallen by 2%. However, if over
the same period the dollar fell by 3%, overall US competitiveness
has actually improved by 1%.
Such measures of overall competitiveness are known as "relative
costs or prices expressed in a common currency" or, more simply,
real exchange rates. The indicators are expressed in index form.
The index rises if domestic costs or prices increase faster than
foreign costs or prices. Thus a larger index number (stronger real
exchange rate) indicates that the home country is less competitive.
The broad implication is that to restore competitiveness, the currency
must weaken or domestic prices/costs will have to increase less
than foreign prices/costs.
There is no ideal measure of competitiveness. Those in common
use are listed below. They are described in terms of the US, but
the calculations are the same for any country.
Relative export prices. US export prices divided by a weighted
average of competitors' export prices, all expressed in a common
currency. This might seem to be a logical basis for assessing price
competitiveness but there are several drawbacks. Such an exchange
rate covers only goods that are traded; it does not take account
of competition between imports and domestic production in home or
overseas markets; it measures orders but ignores unsuccessful quotations;
and it fails to take account of profitability (exporters in general
are price-takers; they may be forced to absorb exchange-rate movements
in profits).
Relative export profitability. US export prices divided
by US producer prices. This is not a measure of international competitiveness,
but it is a useful supplement to relative export prices. It indicates
the extent to which changes in export prices reflect changes in
the profit margins on exports against home sales. If export prices
rise less rapidly than domestic prices, export profitability has
declined.
Import price competitiveness. US producer prices divided
by US import prices. This provides a guide to import competitiveness,
but again it ignores relative profitability.
Relative producer prices. US producer prices divided by
a weighted average of competitors' producer prices. This compares
home prices with prices that they will be competing against overseas.
It tends to overemphasise domestic markets.
Relative consumer prices. US consumer prices divided by
a weighted average of competitors' consumer prices. This ignores
capital and intermediate goods, but it is good for comparing relative
consumer purchasing power.
Relative GDP value-added deflators. The US GDP deflator
divided by a weighted average of competitors' GDP deflators. This
is the most comprehensive basis for comparison, covering unit labour
costs and profits per unit of output. One drawback is that some
of the items in GDP are not traded, although it might be argued
that inflation pressures are ultimately transmitted uniformly through
all goods and services. Another problem is that the deflators are
available only after a sizeable lag.
Relative unit labour costs. An alternative to price competitiveness
is to look at cost competitiveness. This has the advantage of covering
all industries: exporters, potential exporters and those competing
with imports. However, because of a lack of data the only sensible
indicator is relative unit labour costs (say, US ULCs divided by
a weighted average of competitors' ULCs, all in a common currency).
This excludes profits and prices of materials.
Normalised relative unit labour costs. These are relative
unit labour costs adjusted to allow for short-term deviations in
productivity from long-term trends. This smoothes out differences
in the cyclical position of the countries being compared, but because
of the difficulties of adjusting productivity for the cycle it should
be treated with care.
Purchasing power parity (PPP)
In order to make comparisons between GDP and GDP per head between
different countries, output has to be expressed in a common currency.
The use of market exchange rates as conversion factors can give
very misleading results, mainly because they do not adequately reflect
relative price differentials (at best, the use of market exchange
rates would equalise prices in the tradables sector). Also, market
exchange rates fluctuate for reasons that have little to do with
the purchasing power of a currency.
Purchasing power parities (PPPs) are conversion factors which
eliminate the difference in price levels between countries. GDP
at PPP thus measures the volume of goods and services produced at
a common set of prices. The PPP is usually defined and expressed
as the number of units of a country's currency required to buy the
same amount of goods and services as one dollar would buy in the
US.
The calculation of average international prices, and PPPs, is
a complex and time-consuming exercise, mainly because it involves
the collection of price data for a large number of goods and services
across countries. International agencies have been conducting this
exercise for several decades at 3- and 5-year intervals. The OECD
now makes the calculation for its members on an annual basis. The
EIU bases its figures on the most appropriate and up-to-date source.
The gold standard
Before 1914 exchange rates were fixed in terms of gold, trade
was mainly in physical goods and capital flows were limited. A country
which developed a deficit on its current account would first consume
its reserves of foreign currencies. Then it would have to pay for
the imports by shipping gold. The transfer of gold would reduce
the money supply in the deficit country and boost it elsewhere,
since currencies were then convertible on demand into gold.
In the deficit country the contracting money supply would tend
to depress output and prices. Elsewhere the expanding money supply
would boost output and inflation. The deficit country could then
only afford to import a lower quantity of dearer foreign goods.
The surplus countries could import a higher quantity of the deficit
country's cheaper goods. Thus the current account would automatically
return to equilibrium.
That was the theory. It seemed to work in practice until the system
got out of balance in the 1920s. The gold standard was temporarily
suspended during the first world war. Countries experienced rapid
and varying rates of inflation and exports were grossly underpriced
or overpriced when the gold standard was reintroduced at pre-war
rates. Large current-account surpluses and deficits developed. The
gold standard fell from favour and was abandoned almost universally
by the early 1930s.
Adjustable exchange rate
pegs
An international conference was convened in the US at Bretton
Woods, New Hampshire, in June 1944. Participants agreed to form
the IMF and World Bank to promote international monetary cooperation
and the major currencies were fixed in relation to the dollar. Fluctuations
were limited to 1% in either direction, although larger revaluations
and devaluations were allowed with IMF permission. In addition,
the American government agreed to buy gold on demand at just over
$35 an ounce, which left only the dollar on a gold standard.
Floating exchange rates
The Bretton Woods system of adjustable pegs broke down by the
1970s. Persistent US deficits had led to an international excess
of dollars and US gold reserves came under pressure. In August 1971
the US suspended the convertibility of the dollar, imposed a 10%
surcharge on imports and took other measures aimed at eliminating
its balance of payments deficit. The major currencies were allowed
to float, some within constraints imposed by exchange controls (dirty
floats).
Fixed rates with some flexibility were reintroduced in December
1971 following a meeting of the IMF Group of Ten at the Smithsonian
Institute in Washington (the "Smithsonian agreement").
However, sterling was floated "temporarily" in June 1972
and by the following year all major currencies were floating or
subject to managed floats. Despite bouts of extreme turbulence,
most major currencies have remained floating ever since. The exceptions
are the euro-zone currencies which have entered European Monetary
Union.
Related topics:
Interest rates
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