play-the-game

Lesson 10 The Value of the Dollar is the Steve Martin of EconoWorld
The Dollar Will Continue to Soar
Exchange rates, my bicycle pump, and a rubber crutch

pracactice

Value of a currency is the exchange rate of that currency for another currency or currencies. With 1 dollar you might receive 3 Brazilian Real. In that case, the exchange rate can be equally described as 3 or of 1/3 (=0.333). Below is a great site for exchange rates ⎯ you can get most rates quickly and easily.  Also the site has articles, forecasts, and other things…. http://www.oanda.com

Currency appreciation and depreciation…this terminology refers to the increases and decreases in a currency’s value. When I was teaching in Europe in 1995, I could buy around 5 French francs with a dollar. When I visited Europe again in 1999, I could get nearly 7. Over those years, the value of the dollar increased significantly.  I drank a lot more wine in 1999. How many French francs can a dollar buy today? (This is a trick question!)

Real value of a currency is the relative purchasing power of that currency ⎯  for a foreign goods basket relative to a domestic one. When the real value of a currency increases that implies that its power to buy foreign goods and services rises relative to its power to buy domestic goods and services. The real value of the dollar is determined by three things:

  • the value of the dollar,
  • the price level abroad,
  • the price level at home.  

The real value of the dollar rises, for example, when any one or more of those three items change and cause a dollar to be able to buy more foreign goods relative to domestic ones:

  • a rise in the value of the dollar
  • a fall in the foreign price level
  • a rise in the domestic price level.

Scroll down to the bottom of the page of this website to see changes in the real value of the dollar since  the early 1990s. This chart is reproduced below. At the bottom of this page you see the real effective value of the dollar. The real value of the dollar has followed generally the pattern of changes as seen in the graph of the market value of the dollar. It peaked in 2001 and has declined ever since.

http://research.stlouisfed.org/publications/iet/us/page5.pdf

Screen Shot 2016-04-24 at 4.11.11 PM
Major currency index relates the currency value of one country to the values of several major currencies. A U.S. major currency index is basically an average of the exchange rates of the dollar against each major currency.  For example, you might want to know how the dollar is doing against the 12 largest trading partners of the U.S. If so, you would look for a major currency index. There are several published, mostly by Federal Reserve Banks.

But first, you might ask – who are the top trading partners of the U.S.?  You can check them out here: http://www.census.gov/foreign-trade/statistics/highlights/top/top1104cm.html . Some things to note from this: In 2011 the top US export destinations were Canada, Mexico, China, Japan, UK, Germany, S.Korea. In 2011 the US received most imports from China, Canada, Mexico, Japan Germany, S. Korea, and the UK. Canada and Mexico received about 32% of all US exports. They accounted for about 27% of all US imports.

Look at the exchange rate graph on this web site (reproduced below) for a long-term perspective on the value of the dollar relative to the yen, the euro, and a major currency index published by the Federal Reserve Bank of St. Louis. The middle chart in this slide shows the dollar against the yen, the euro, and against a composite of its major trading partners. After peaking in 1985 the dollar has been generally depreciating except for a cycle of appreciation from 1995 to 2002.  The dollar was lower in 2011 than at any time since 1985.

http://research.stlouisfed.org/publications/net/page18.pdf

Screen Shot 2016-04-24 at 4.11.22 PM
Industrial application

Why would you want to use a major currency index?

Let’s suppose your U.S. company is having trouble selling in South America and you are analyzing the situation. You might want to construct an index of how the dollar is doing against the currencies of the countries of South America. If the value of the dollar against a major currency index of South American countries has increased, then that might be one reason for your difficulty in selling in that part of the world.  When U.S. policymakers want to know why the U.S. trade deficit is increasing, it helps to have a major currency index of the main U.S. trading partners.

Real effective exchange rate describes a major currency index, real version. The Federal Reserve Bank of St. Louis publishes these for major countries. For each country, the nominal bilateral exchange rates of its major trading partners are averaged using weights that reflect relative buying shares as well as relative country prices. The St. Louis version uses unit labor costs rather than consumer prices.

Purchasing power parity is a theory that suggests that nominal exchange rates tend to offset changes in relative country prices. If PPP is true, a country’s real exchange rate tends to stay constant. Consider an example.

Suppose U.S. inflation soars, relative to other countries. That alone would cause the real value of the dollar to rise, since the dollar’s value in buying foreign goods relative to domestic ones would increase.

PPP predicts that the market value of the dollar would have to fall, causing the real value of the dollar to return to its original level. Would it? Logic suggests that if U.S. goods are more expensive than foreign goods, and people switch to buying foreign goods, then the relative demand for dollars in world markets will fall. So it seems to make sense. But does the dollar actually fall enough to offset the full increase in inflation? Hardly ever. Thus, while PPP seems to make good sense it may not predict perfectly and is more often used as a rough guide to explain some changes in exchange rates and is not often used to forecast exchange rates.

Working with the Data

PPP is not a good predictor of the market exchange rate: PPP is based on the law of one price.

  • Homogenous traded goods (commodities) should have the same price around the world (net of transportation costs).
  • Arbitrage (buying where it is cheap and selling where it is expensive) would be profitable and should drive out the margins.

Nowadays, however, international capital movements are frequently very important in impacting exchange rates. International interest rate differentials, as one example, can cause sizeable changes in capital flows and cause exchange rates to deviate from PPP. Since PPP focuses on prices of goods and services and not on these other factors, it does not provide a good model of exchange rate change. In addition, many goods (real estate, most services) are not internationally traded (and therefore named nontradables) yet find their ways into price indices. Therefore, different price developments of nontradables among countries might attribute to deviations from PPP. Thus, PPP is an interesting theory but an unreliable and bad predictor for present and future exchanges. Below we introduce a more complete model that should do better.

You may read about GDP or other such concepts ⎯ measured at PPP. What that means is that someone wanted to compare GDP across two or more countries. Recognizing that GDP is typically reported in the country’s own currency, economists have to convert these foreign values into dollars.  Instead of using the current exchange rate for the valuation, they sometimes use the exchange rate that would exist if PPP actually held. This will affect the real GDP value if the current exchange rate is quite different from the PPP value.

Let’s suppose that the Brazilian real, according to PPP, is much lower in value than its actual value is today. Suppose the PPP value is 25 U.S. cents (4 real to the dollar) while today’s current value is 33 U.S. cents (3 real to the dollar).   That means that if we value Brazil’s GDP in dollars, the current dollar value is going to be much higher than the PPP value of Brazil’s GDP. Suppose Brazil’s real GDP today is 1000 real. That means the value at current exchange rates would be $333. At PPP it would equal $250.

The weekly magazine, The Economist, publishes a PPP-index for all major currencies based on the respective price for Big Macs in various countries, the BigMac-index. Two classic articles from the Economist Magazine, from 2000 and 1999 are linked below. These articles discuss the theory of purchasing power parity. Most discussions focus on whether a currency is over- or under-valued relative to PPP. This tongue-in-check article about PPP is mouth-watering reading. The Economist publishes updates of the BigMac-index periodically.

Screen Shot 2016-04-24 at 4.11.31 PM

http://www.economist.com/markets/Bigmac/index.cfm

Undervalued/overvalued are terms used to describe whether the value of a currency is high or low relative to what it “ought to be.” Often but not always, what it ought to be is based on what people think is the PPP value of the currency. If someone says a currency is overvalued, they mean to imply that its value should fall in the future. Such judgments are not always correct. The U.S. currency had been, according to many experts, overvalued for quite a while. Until the middle of 2002, the dollar remained quite strong. Another indicator for under- or overvaluation might be the current account. A current account deficit indicates imports being too cheap (exports too expensive). Sometimes people measure the degree of over- or –under value by comparing the current exchange rate to one that prevailed when the country last had a balance in its current account.  

Working with the Data

U.S. Exchange rates and trade balances

Below are some graphs for the U.S. ⎯ trade balances and real effective exchange rates (see the definition above). Using your eyeball, do you see any relationship between U.S. trade balances and effective real exchange rates?  The value of the dollar according to this major currency index is comprised of 7 currencies.  You cannot see the increase in the value of the dollar from 1978 to 1985 (not on this chart) but the decline afterward is evident in the chart. Exchange rates in 2002 were similar in value to those of 1980 and 1987. Notice that from 1987 to 1992, the trade deficit improved (top two charts) while the dollar was generally declining. Perhaps a falling dollar led to an improving trade deficit? Notice that between 1991 and 2004 the trade deficit was worsening. Did a rising dollar cause that? From 1991 to 1995 the dollar was falling. But from 1995 to 2001 the dollar was increasing, only to fall again in 2002 to 2004. This shows that there was no perfect relationship from exchange rates to trade balances – but it is suggestive of two things:

(1) Sustained and large changes in exchange rates can impact trade balances and

(2) Sometimes it takes time for exchange rate trend changes to cause changes in trade balances.

Another thing to keep in mind is that graphs never prove anything. It takes careful statistical analysis to “prove” a relationship between any two variables.

http://research.stlouisfed.org/publications/iet/us/page5.pdf

Screen Shot 2016-04-24 at 4.11.40 PMScreen Shot 2016-04-24 at 4.11.47 PM

Try the following link to choose similar graphs for other countries:

http://research.stlouisfed.org/publications/iet/

Exchange rate policy refers to a national policy aimed at producing a particular value in a county’s currency.  Typically, exchange rate policy is aimed at lowering the value of a country’s currency so as to lower the real exchange rate and promote the country’s exports. Sometimes a country will want to increase the value of its currency. This happens usually when the country wants to reduce inflation. A lower currency value means that a country’s residents are paying more currency for imported goods. The higher prices for the imported goods can sometimes affect the country’s inflation rate.

International Application

Exchange rate changes in various countries

The first data application is a table of exchange rate percentage changes for various countries:  http://research.stlouisfed.org/publications/aiet/page11.pdf

Screen Shot 2016-04-24 at 4.11.56 PM

These show annual percent changes of the dollar against each currency. A + sign indicates a rise in the dollar or a depreciation in the foreign currency. The exchange rate for the dollar is a major currency index. A + sign indicates an appreciation of the dollar.

  • The dollar depreciated in 2010 after appreciating in 2009.
  • 21 of the 26 countries had appreciations against the dollar in 2010.
  • The euro depreciated against the dollar by more than 20% after it emerged in 1999 – and then reversed course after that. It has been faltering, however, in 2009 and 2010.
  • It is no accident that China and Malaysia had zero change against the dollar for several years. These countries “peg” their currencies to the dollar. More will be said about pegging below.  

The following graphs are for the euro area ⎯ http://research.stlouisfed.org/publications/iet/euro/page5.pdf

The second chart in the link shows the real effective exchange rate of the euro currency. See above for the meaning of this term.

Screen Shot 2016-04-24 at 4.12.04 PM

What happened to the value of the euro? Recall that the euro was adopted by 12 countries in 1999. The data before 1999 uses the value of these 12 currencies in what was called an ecu. After 1999, you can see that in real terms, the euro depreciated against its major trading partner’s currencies only to appreciate about a year later. The chart shows that in 2005  it had returned to its value in early 1999 but was still lower than values that prevailed in the 1990s. That the real value of the euro is low relative to the past suggests that these were good conditions for strong exports from Europe. The chart below suggests this is partly correct. That chart shows exports greater than imports – implying a euroland trade surplus. But since late 2000 this lower real rate did not cause exports to rise relative to GDP. With imports on the rise, the trade balance was moving towards deficit in 2005. As it approaches 2011, imports and exports seem to be almost even, ending up slightly in deficit.

Screen Shot 2016-04-24 at 4.12.08 PM