the real exchange rate

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Section A

Question One

1. What is the real exchange rate? How does change in the real exchange rate affect the international competitiveness of a country?

The real exchange rate is an approach extensively showing how goods and services in a country can be exchanged for goods and services in another foreign country. Real exchange rates are important is they raise a country’s level of economic health. This improves the currency of a country which makes a county’s imports less expensive which on the other hand makes its exports more expensive in foreign markets. Therefore, real exchange rates compare the relative price of the two countries’ consumer baskets. However, to know the rate of exchange of a country, we have to consider the nominal Exchange Rate and the price of the two countries’ consumer baskets.

1. If the last month’s exchange rate was 1.6 GBP/USD, and today it is 1.8 GBP/USD, is this an appreciation or depreciation of GBP?

Currency depreciation is considered to be the loss of value of any country’s currency when compared to one or more foreign currency and on the other hand, an increase in the value of a country’s currency as compared to the currency of another country is known as appreciation.

In this case, the pound has increased in value from 1.6 GBP/USD to 1.8 GBP/USD and therefore it means that the pound has appreciated domestic currency has got more expensive whereby 1 USD will buy less of GBP. The USD will buy more today (1.8) pounds than it did last month (1.6)

1. What are the factors that can affect the equilibrium spot exchange rate? Explain

An equilibrium Exchange rate is a long term Exchange rate which when compared to the purchasing power parity is found to be equal in the condition where all goods are fully traded and the markets are fully efficient. A spot exchange rate refers to the current price that directly enables one to exchange one currency for another in the market towards the delivery of the earliest value date.

Several factors affect the equilibrium spot exchange rate. The balance of payments which shows the total demands and the total supplies of a foreign currency purely helps in determining the value of the currency. Secondly, Inflation which affects the cost of living of people is another factor. The inflation rate crucially depicts the rates at which different costs of different goods will operate. This influences the underlying currency negatively while deflation affects the rates of the currencies positively. Thirdly the money supply decreases interest rates and therefore affects the equilibrium spot exchange rate. The changes of politics influence the operations of an economy which influences the exchange rates thereof.

Further, the spot exchange is affected by national income. In this case, an increase in the total income of the residents in an economy influences the money supply positively and increases the production and their capacities. This initiates exports that in turn result in dilution of the domestic currency of the country.  Another factor affecting the spot exchange rate is the resource discoveries, which ignite exports and result in strong positions in the exchange market.

1. (i)  The current spot rate between the UK and USA is 0.80 GBP/USD and the current spot rate between France and the USA is 0.90 EUR/USD. What should be the EUR/GBP exchange rate that would be indicative of an absence of arbitrage?

What is the EUR/GBP rate??

i.e. if we 1 GBP how many EUR would it buy?

1 USD yields 0.80 GBP : 1 * (1/0.80)

0.90 EUR yields how many GBP?

= 0.67 GBP

  (ii)  If the actual rate observed in the market is 1.3 EUR/GBP, what would be your arbitrage profit if you had 10 GBP??                                           

Arbitrage profit is a risk-free profit that can be made by taking advantage in case of mispricing in the quotation of the currencies in the FX market.

Normal profit would be the normal rate: 0.67 * 10= 6.7

Arbitrage profit, we use the rate observed = 1.3 * 10= 13

Therefore the Arbitrage Profit = 13- 6.7 =6.3 EUR/GBP

Question 2

• What is the difference between the Law of One Price (LOP) and Purchasing Power Parity (PPP)?

The law of one price is an economic concept which points out that any good must sell for the same price in all locations which means a euro should sell an equivalent good as a dollar would.

The term Purchasing power Parity means that in the long run, the relative price levels will tend or the exchange rates will change so that the ability to purchase or the purchasing power will remain constant. So that a dollar will purchase whatever a Euro would.           

• Consider a world that only comprises 3 goods (Good 1, Good 2, Good 3) and 2 countries (France and Japan).  Assume that the consumption weights of these goods for both countries be (0.50, 0.25, 0.25).

The price of the goods at time t is listed below:

• For each good, what exchange rate is consistent with the law of one price?

(ii) Let the spot exchange rate at time t be equal to 0.50 EUR per Yen. Does absolute purchasing power parity (PPP) hold between France and Japan?

France       Yen

Good 1 0.50*40=20 0.50*20=10

Good 2 0.50*80=40 0.50*55=28

Good 3       0.50*60=30 0.50*150=75

Absolute Purchasing Power Parity means that the nominal exchange rate is equivalent to the ratio of the relevant National prices. This, therefore, means that Absolute Purchasing power parity does not hold between France and  Japan as their nominal rate is not equal to the national prices prices

You are now given the following time t+1 information:

Using the information in (b), what spot exchange rate at time t+1 does relative purchasing power parity (PPP) apply?      Relative PPP considers the fact that changes in the exchange rate are equal to changes in relative national prices

Therefor Good 1 75-60=15

Good 2: 135-150=-15

Good 3: 105-285= -80

QUESTION THREE

• Define covered interest rate parity (CIP). Derive the equations of CIP in both levels and logs.

Interest Rate Parity Refers to the interest rate differential between two countries which are equal to the differential between the spot exchange rate and the exchange rate. The interest rate parity plays an important and vital role in the foreign exchange market by connecting interest rates, spot exchange rates, and foreign exchange rates. Covered Interest rate refers to that theoretical condition in which the connection between interest rates and the spot forward currency values are in equilibrium

Assume PCM and consider UK investor with E1 investing for say 1 period

Two options available In UK     E1 ( 1+iuk)

In France    E 1 1/St ( 1 + ifr) Ft+1

At times t then the Value of the UK investment should at the same as French Investment if it is expressed in the same currency.

Therefore % forward premium = a % interest differential

• (i) Let the spot rate between the UK and Canada by 3.5 CAD/GBP, and the Canadian 6 month (annualized) interest rate is 6% and the 6 months (annualized) UK interest rate is 8%. What should the market quoted forward rate be to ensure there is no arbitrage opportunity?

F t+ 6 months=  3.5  (1+0.08/12/6)  /  1 +0.06/(12/6) = 3.47

• (ii) If the actual forward rate was 4.5 CAD/GBP, demonstrate how you make an arbitrage profit with 1 CAD. You are now given the following time t+1 information:

Using the information in (b), what spot exchange rate at time t+1 does relative purchasing power parity (PPP) apply?

The Actual forward late is 4.5 CAD/GBP

PA,t = 50 Pat+1= 40

PB,t= 90   PB, t+1=100

PC,t =70 PC, t+1= 10

At an actual forward rate 4.5 CAD/GDB and a Spot rate of 3.47  1 GDB = 4.5 CAD

Therefore 1 CAD would yield 3.47*4.5 = 16%

As the prices start rising relative to the Yen both France and Japanese Consumers will look out for substitutes of France for Japanese

Goods. This will lead to an increase in the supply of France and the demand for the Japanese yen and a total reduction of the dollar. Similarly, the dollar will depreciate

Section Two

What is meant by debt sustainability? Does a high public debt imply an impending debt crisis? Finally, discuss the role of exchange rate movements on debt sustainability.

Debt sustainability is a framework that assists the government in its constraints on budget and evaluating how it can be met without necessarily disrupting the monetary and fiscal policies (Sundararajan, Dattels and Blommestein, n.d.). The amount of public debt of a government should not exceed the present value of all future basic surpluses. As borrowing is an important tool in the financing of investment, it cannot be avoided. However, it should be controlled and monitored to avoid jeopardizing future investments.

Continuous borrowing can be a burden to different countries depending on the presence of control and plans that are available thereof. High debt does not necessarily imply an impending debt crisis. A Debt Crisis is a situation in which a government, a state, or a nation loses its ability to pay back its already used debt. When the expenditures of a government supersede its revenue on taxes for a long period, a government may risk entering into debt crisis (Nguyen, 2004). However, a country can adopt simple means of attaining long term debt sustainability through fostering adequate and appropriate debt financing, debt restructuring, debt relief, and managing debt profoundly. With a major goal of attaining a comprehensive national financing strategy towards reducing vulnerabilities, strengthening the monitoring and efficient management of assets is vital.

Any country should work on its efforts to maintain its ability to sustain debts as well as improve on its strength of analyzing its tools of assessment. If there is continuous mismanagement of debts and a continued plan of increasing debt, then a country might fall into a chance of debt crisis (Nguyen, 2004). The underlying future implication of the debt crisis increases the chances of financial breakdown which are hard to amend. As a result of the prevention of debt crisis, debtors and creditors must collaborate and work on the resolutions of reducing debt. An important movement should work on restructuring sovereign obligations and improve on the arrangements of collaboration between debt and its usage. This establishes grounds for improvement of the effective and efficient utilization of the debt which improves the public debt sustainability.

Debt Sustainability is a crucial issue in developing, developed, and in transit economies. Any bubble in the exchange rate can result in a sudden collapse in the sustainability of a country’s debt.  Further, the Monetary can be under the control of the exchange rate depending on the nature of that particular debt (Neck and Sturm, 2008). Therefore the stabilization of the exchange rate is important as it increases domestic non-price competitiveness which ensures that there is an improvement in trade and the balance of the economy. Maintaining favorable rates of exchanges in the short run positively affects debt sustainability in the long run. The main causes of the rate of growth of a country’s debt are the GDP growth rate and the change in the real exchange rate. In cases of a decrease in the depreciation of a county’s currency the debt burden in terms of domestic currency is likely to increase. Consequently, the increase in the debt burden encourages capital outflow on the financial account of the balances in payments which directly influences a downward pressure on the exchange rate.

In the cases of very weak currencies, the vicious circle arises because there is induced change in the exchange rate which automatically increases the debt burden and weakness of the currency (Neck and Sturm, 2008). If the chain of occurrences is not analyzed in the short run, then it will result in the unsustainability of a country’s foreign debt which can make a country bankrupt even after increasing the GDP growth rate.

In a nutshell, any developing country that faces difficulties in financing their public deficit by way of issuing domestic debt may be forced to use foreign debt to fund their public expenditures. In this case, it’s critical and equally important to keep the rate of exchange quite stable as it complements debt sustainability and further helps in avoiding currency crises that are brought forth by unsustainable foreign debt.

References

Bagchi, B., Dandapat, D., and Chatterjee, S., n.d. Dynamic Linkages And Volatility Spillover.

Bradbury, M., n.d. Rates Of Exchange.

Cashin, P., and McDermott, C., 2001. An Unbiased Appraisal Of Purchasing Power Parity. [Washington, D.C.]: International Monetary Fund.

Corden, W., Keim, D., and Ziemba, W., 2003. Inflation, Exchange Rates, And The World Economy. Chicago: University of Chicago Press.

Hasanov, F., and Cherif, R., 2012. Public Debt Dynamics. Washington: International Monetary Fund.

Manzur, M., 2008. Purchasing Power Parity. Cheltenham: Edward Elgar.

Neck, R., and Sturm, J., 2008. Sustainability Of Public Debt. Cambridge, Mass.: MIT Press.

Nguyen, T., 2004. External Debt, Public Investment, And Growth In Low-Income Countries. [Place of publication not identified]: International Monetary Fund (IMF).

Pérez Jurado, M. and Vega, J., 2000. Purchasing Power Parity. Madrid: Banco de España.

Sundararajan, V., Dattels, P., and Blommestein, H., n.d. Coordinating Public Debt And Monetary Management.

Taylor, M., 2013. Purchasing Power Parity And Real Exchange Rates. Hoboken: Taylor and Francis.