Determinants of an exchange rate

Table of Content

1. Introduction
1.1 The History of the International Currency Exchange System
1.2 The History of the Euro as the Common Currency of Europe

2. General Determinants of Exchange Rates in the Short and Long Run
2.1 The Short Run – The Role of Interest Rate Differentials and Market Expectations
2.2 The Long Run – Purchasing Power Parity (PPP)
2.2.1 Purchasing Power Parity – Absolute and Relative
2.2.2 The Monetary Approach (Quantity Theory Equation)

3. The Relationship between the Euro and the US Dollar
3.1 The Short Run – Interest Rate Parity
3.2 The Long Run – Economic Fundamentals, Inflation Rates and Long Term Trends
3.3 The US ’Twin Deficit’ and the Chinese Role in the €-$ Relationship

4. Conclusion

References

Appendix

1. Introduction

This paper will discuss the general relationship between the two major currencies of the world: the US-Dollar and the Euro and the determinants for the exchange rate fluctuations since the introduction of the Euro as the common currency of Europe during the period between January 1999 and November 2005. Since the introduction of the Euro as the common currency of the European Monetary Union (EMU) in 1999 this relationship was first characterized by a sharp depreciation of the Euro followed by a three year lasting appreciation of the same that passed over in a slight depreciation again from the beginning of 2005 in the long run.^[1] This paper will first focus on the History of the international currency exchange system from the 19th century until the end of the Bretton Woods System in 1973 and on the history of the currency system in the European community. It will then discuss the general determinants of exchange rates in the short and long run. It will be pointed out that in the short run interest rate differentials and expectations of international portfolio investors matter and in the long run the economic fundamentals such as inflation rates and GDP growth rates of either economic region are the main factors for the behaviour of the exchange rate. In this context the theories of the Law of one price and the purchasing power parity are introduced. In the third part of the paper the exchange rate theories introduced in the previous part are applied to the €-$ exchange rate in the time period between 1999 and 2005. Thus, the short term and long term factors are used to explain the relationship between the two currencies in this period. Finally, the last part serves as a conclusion.

1.1 The History of the International Currency Exchange System

In history, there were several different approaches to optimally devise and design the international currency system for making the global economic development more stable and international transactions and trade easier and less costly. Before World War 1, the classical gold standard unified all important trading nations to one currency system. It allowed for a long period of increasing trade and economic stability. This ‘golden age’ in terms of international economic prosperity is sometimes referred to as the first globalization stage in world’s economic history. The international gold standard emerged by 1870 in Britain. Britain tied the pound sterling more closely to gold than to silver from the late 17th century on. This link was crucial especially since Britain rose to primacy in industrialization and world trade in the 19th century that enhanced the prestige of the metal tied to the currency of this leading country. But huge depreciation runs during the depression of 1929 stopped the development of this system even before World War 2 started. Between 1929 and 1945, in the so called interwar period, the international currency system was characterized by instability and a chaotically behaviour of the exchange rates of the major currencies and a drop of the payment balances of the major industrialized nations. In 1944 another fixed exchange rate system called Bretton Woods System was installed which replaced the gold by the US-dollar as the key currency on which the entire system was built. Every member state had to direct its currency policy towards the US-dollar by giving up an independent money policy. This fixed exchange rate system minimized exchange rate fluctuations and thus stabilized international transactions and enhanced international trade. But in 1973 the system had to be given up due to capital accounts deficits of the US that caused a lack of gold reserves in the course of the first oil crisis and the Vietnam War that led to high inflation rates and high public account deficits in the US. Therefore, a ‘nonsystem’ of flexible exchange rates were established that coordinates the major currencies until today.^[2]

1.2 The History of the Euro as the Common Currency of Europe

In 1979, the countries of the European Community established the European Currency System (ECS I) that fixed all involved currencies to the artificial currency unit ‘ECU’. The EMU ‘I’ was eventually displaced by the so called European Currency Union (ECS II) with the introduction of the Euro in 1999. Within the currency area of the Euro, which currently includes 12 member states of the European Union^[3], free mobility of products, services, and production factors such as labour and capital is established (ecb.int). Since 1999, the Euro is the common currency for 12 European countries, integrated into a global flexible exchange rate system mainly dominated by the major important currencies such as the US-Dollar, the Japanese Yen and the British Pound. In the past six years its performance towards these major currencies was quite different. As the graph above shows, the relationship between the Euro and the US-Dollar was discontinuous and different through the time. It rather reflected the underlying economic conditions of the economic blocs (the Euro zone and USA) during short term, medium term and even long term trends. In the short run, there are fluctuations and market volatility of the price when it comes to securities trading. Observing and analyzing the medium and long term trends seems to be more interesting. As it is shown in the appendix (Figure1), shortly after the introduction of the Euro, the currency experienced a strong depreciation towards its major competitor, the US-Dollar. This depreciation took place from the end of 1998 until the mid of 2001 with an exception of two temporary corrections in April and December of 2003. Then in December 2004, it appreciated even more from about 0.85$/€ in June 2001 to about 1.35$/€, again with several periods of short term depreciation in that time. After its peak in December 2004 the Euro had started again depreciating to about 1.17$/€ in November 2005. The reasons for these trends in the performance of the currency in the long/medium run and the determinants of shifts and continuities will be discussed in the further part of this paper. The first main part will focus on the general determinants of exchange rates both in the short run and the long run.

2. General Determinants of Exchange Rates in the Short and Long Run

When it comes to changes in the exchange rates, a difference between long/medium term trends and short term fluctuations can be observed. Accordingly, there are different determinants that cause different impacts on the exchange rate either short term or long term. In general, thinking in terms of supply and demand is a necessary first step towards understanding exchange rates.^[4] Exchange rates must be understood as the prices for specific commodities, the currencies, and thus move with the supply and demand in these currencies.

2.1 The Short Run – The Role of Interest Rate Differentials and Market Expectations

To understand exchange rates in the short run, there is a need to focus on the actions of international financial investors. Exchange rates are strongly related to the positioning and repositioning of portfolios of international financial investors. This is the so called asset market approach to exchange rates. According to this approach, the exchange rate value of a foreign currency (e) is influenced in the short run by two variables: the difference between the domestic and the foreign interest rate and the expected future spot exchange rate (eex). If international financial investors want to shift toward assets nominated in the domestic currency, they first need to buy domestic currency before they are able to purchase these assets such as bonds or stocks. This increase in demand for domestic currency increases also the current spot exchange rate value of it and so decreases e, the exchange rate value of a foreign currency. As these shifts can be done by global investors quite quickly, the effect on the spot exchange rate is accordingly very abrupt which results in that high volatile short term fluctuations. What matters is the interest rate differential (i-if ), where i stands for the domestic and if for the foreign interest rate. If the differential increases, international investors are more attracted by the new higher domestic interest rate so that the demand in the domestic currency goes up and thus e decreases. Vice versa for the case of a declining interest rate differential results in a increasing e. The relationship between the domestic and foreign interest rates and e can be summarized as followed: If i increases or if decreases, the value of the foreign exchange rate e will go down and the domestic currency will appreciate. If i decreases or if increases, the value of the foreign exchange rate e will go up and the domestic currency will tend to depreciate. This mechanism is also called the interest rate parity which captures the relationship between the spot and forward exchange rates and the interest rates in two countries. It can be written as:

FT = S0(1+r)T/(1+ ρ)T,

where S0 is the spot exchange rate, FT is the forward exchange rate, r is defined as the domestic interest rate level and ρ the foreign interest rate so that the relationship between the forward and the spot exchange rates is determined by the relationship between the risk-free interest rates in the two countries.^[5] Besides the interest rate differential, expectations and rumours in the marketplace have also a major impact on exchange rates. If foreign investors expect the domestic currency to increase, they will buy assets denominated in the domestic currency. As a result of this increasing demand for the currency, its value will go up. On the other hand, when they expect the currency to depreciate, they will likely sell the bonds and stocks they own, which thus affect the exchange rate in the opposite way. So the currency will depreciate. This phenomenon is also called bandwagon, the principle of self fulfilling prophecies. Currencies that have been appreciating in the frequent past are expected to do so in the future. Expectations of depreciations or appreciations of a specific currency causes the currency to react accordingly, which means that the past behaviour is used by speculators to predict of future behaviour of the currency.

2.2 The Long Run – Purchasing Power Parity (PPP)

Whereas exchange rates often behave kind of randomly in the short run, the long run is mainly characterized and determined by economic fundamental factors such as inflation, real economic output (the real GDP growth rates) and prices of goods and services. There are two theoretical approaches to explain long term trends of exchange rates. The first one is the so called purchasing power parity (PPP) which assumes an inverse relationship between product prices and the value of currencies. The second one is the monetary approach based on the quantity theory equation.

2.2.1 Purchasing Power Parity – Absolute and Relative

The first approach, the purchasing power parity, has three versions to explain and derive the relationship between product prices and currency values, depending on whether examining one product or a set of products and whether looking at a static relation or how product prices and exchange rates are changing over time.

- the law of one price
- absolute purchasing power parity
- relative purchasing power parity

First of all, the law of one price assumes that a product in a perfectly competitive global market has the same price in every country of the world when the price is expressed in the same currency. The law of one price suggests that the price of the product measured in domestic currency equals to the price of the product in the foreign currency times the current spot exchange rate e^[6]. However, the law of one price does not hold good for most products that are internationally traded. The reason for this is the existence of international transportation costs, the lack of free trade and imperfect competition in reality. At least for traded commodities such as gold, other metals, crude oil and agricultural commodities this model works pretty well if free trade is permitted.

The absolute PPP assumes that not one single product but a basket or bundle of tradable goods will have the same price in different countries if the price is expressed in the same currency. That means that the product price level, the average price of these products, in different currencies is the same if converted to one common currency. But however, in the real world absolute PPP has the same problems as the law of one price due to the same reasons.

The second version of PPP, the relative purchasing power parity, examines the changing of exchange rates over time. It assumes that the difference between product price level changes in two currency areas over time will result in the accordant change of the exchange rate over the same time^[7]. Relative PPP is useful to predict the exchange rates over time even if absolute PPP does not hold often at specific times. The right hand side of the equation represents the inflation rate of the domestic (numerator) and foreign (denominator) products, the percentage increase in the price level over time. Whereas the left hand side of the equation is the percentage rate of appreciation or depreciation of the foreign currency over time. So we can also write the relative PPP as:

[...]

^[1] See Appendix, Figure 1: The Euro-Dollar exchange rate between January 1999 and November 2005

^[2] Compare Pugel, 2004, International Economics; A. Madison, 1997, Monitoring the World Economy 1820-1992

^[3] Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain

^[4] Pugel, 2004, International Economics

^[5] Compare Don M. Chance, 2004, An Introduction to Derivatives & Risk Management, 6th Edition, p.327

2 it is: P = e∙Pf, where e equals the domestic currency/foreign currency; this formula

is applied for both the law of one price and the absolute PPP

^[7] The formula for relative PPP is: et/ eo = (Pt/Po) / ( Pf,t/Pf,0)