International_Economics_Tenth_Edition (1)

account surplus. In other words, a country with a current account deficit surrenders claims on future income--such as physical assets, stocks, and bonds-to foreigners. In 2003, a U.s. current account deficit of 5 percent of GOP translated into an average of $1.6 billion in net capital imports per business day. That is, foreign investors were accumulating U.S. assets at an unusually high rate.

Foreign investors might become wary of holding increasingly larger portions of their wealth in u.s. assets. In order to promote continued investment in the United States, U.S. assets would then have to become more attractive. One way of attracting foreign investment is to lower the price of the asset in foreign-currency terms. A decline in the foreign-exchange value of the dollar would do just that. Therefore, a large current account deficit might be expected to depress the value of the dollar over time. But will the current account deficit decrease in response to currency depreciation? Researchers at the Federal Reserve Bank of St. Louis studied 25 episodes of current account reversals of industrial countries during the period 1980-1997. They found that, when a current account deficit approaches 5 percent of GOP, a country's real exchange rate startsdepreciating. Typically, the current account starts to reverse

toward balance one year after the onset of the currency depreciation. Three years after the peak deficit, most of the countries show a nearly complete reversal of a balanced current account.

The figure shows the real effective U.S, dollar exchange rate and the u.s. current account balance as a percentage of GOP for the period 1998-2003. In spite of a current account deficit in the neighborhood of 4 percent of GOp' the real effective value of the u.s. dollar appreciated considerably from 2000 to early 2002; subsequently, the dollar started declining amidst further widening of the current account deficit to about 5 percent of GOP. The researchers concluded that if the United Statesfollows the typical pattern of current account reversals, then from 2003 to 2006 the real effective exchange rate should keep depreciating and the current account deficit will swing back to balance. It remains to be seen whether this forecast is correct.

Source: Frank Schmid. "Is the Current Account Deficit Weighing on the Dollar?" International Economic Trends. Federal Reserve Bank of Sl. Louis. August 2003. and Caroline Freund. "Current Account Adjustment in Industrialized Countries." International Finance Discussion Paper No. 692. Board of Governors of the Federal Reserve System. December 2000.

The volatility of exchange rates is further intensified by the phenomenon of overshooting. An exchange rate is said to overshoot when its short-run response (depreciation or appreciation) to a change in market fundamentals is greater than its long-run response. Changes in market fundamentals thus exert a disproportionately large short-run impact on exchange rates. Exchangerate overshooting is an important phenomenon because it helps explain why exchange rates depreciate or appreciate so sharply from day to day.

Exchange-rate overshooting can be explained by the tendency of elasticities to be smaller in the short run than in the long run. Referring to

Figure 12.5 on page 390, the short-run supply schedule and demand schedule of the British pound are denoted by So and Do, respectively, and the equilibrium exchange rate is $2 per pound. If the demand for pounds increases to Db the dollar depreciates to $2.20 per pound in the short run. Because of the dollar depreciation, however, there occurs a decrease in the British price of u.s. exports, an increase in the quantity of u.s. exports demanded, and thus an increase in the quantity of pounds supplied. The longer the time period, the greater the rise in the quantity of exports is likely to be, and the greater the rise in the quantity of pounds supplied will be.

The long-run supply schedule of pounds is thus more elastic than the short-run supply schedule, as shown by 51 in the figure. Following the increase in the demand for pounds to D 1, the long-run equilibrium exchange rate is $2.10 per pound, as compared to the short-run equilibrium exchange rate of $2.20 per pound. Because of differences in these elasticities, the dollar's depreciation in the short run overshoots its long-run depreciation.

Overshooting can also be explained by the fact that exchange rates tend to be more flexible than many other prices. Many prices are written into long-term contracts (for example, workers' wages) and do not respond immediately to changes in market fundamentals. Exchange rates, however, tend to be highly sensitive to current demand and sup-

ply conditions. Exchange rates often depreciate or appreciate more in the short run than in the long run so as to compensate for other prices that are slower to adjust to their long-run equilibrium levels. As the general price levelslowly gravitates to its new equilibrium level, the amount of exchangerate overshooting dissipates, and the exchange rate moves toward its long-run equilibrium level.

Previous sections of this chapter have examined various factors that determine exchange-rate movements. Bur even a clear understanding of how fac-

tors influence exchange rates does not guarantee that we can forecast how exchange rates will change. Not only do exchange-rate determinants often point in the opposite direction, but predicting how these determinants will change is also difficult. Forecasting exchange rates is tricky.

A major issue, as far as business is concerned, however, is whether forecasting exchange rates is feasible and, if so, how to do it. Because the future is unclear, participants in international financial markets are unsure what the spot rate will be in the months ahead. Exchange-rate forecasts are used by exporters, importers, investors, bankers, and foreign-exchange dealers.

Multinational enterprises need short-term currency-price forecasts for a variety of reasons. For example, corporations often have for brief periods large amounts of cash, used to make bank deposits in various currencies. Choosing a currency in which to make deposits requires some idea of what the currency's exchange rate will be in the future. Long-term corporate planning, especially concerning decisions about foreign investment, necessitates an awareness of where exchange rates will move over an extended time period-hence, the need for long-term forecasts. For multinational enterprises, short-term forecasting tends to be more widespread than long-term forecasting. Most corporations revise their currency forecasts at least every quarter.

The need of multinational enterprises and investors for forecasted currencyvalueshas resultedin the emergence of consulting {inns, including Predex, Goldman Sachs, and Wharton Econometric Forecasting Associates. In addition, large banks such as Chase Manhattan Bank, Chemical Bank, and Citibank have provided freecurrency forecasts to corporate clients. Customers of consulting firms often pay fees ranging up to $100,000 per year or more for expert opinions. Consulting firms provide forecast services rangingfrom videoscreens to "listening-post" interviews with forecast service employees who provide their predictions of exchange-rate movements and respond to specific questions from the client. It has become customary for corporate managers to use home or hotel telephones to connect portable terminals to advisory services that make available foreign-exchange forecasts.

Most exchange-rate forecasting methods use accepted economic relationships to formulate a model that is then refined through statistical analysis of past data. The forecasts generated by the models are usually tempered by the additional insights or intuition of the forecaster before being offered to the final user.

In the current system of market-determined exchange rates, currency values fluctuate almost instantaneously in response to new information regarding changes in interest rates, inflation rates, money supplies, trade balances, and the like. To successfully forecast exchange-rate movements, it is necessary to estimate the future values of these economic variables and determine the relationship between them and future exchange rates. Even the most sophisticated analysis, however, can be rendered worthless by unexpected changes in government policy, market psychology, and so forth. Indeed, people who deal in the currency markets on a daily basis have come to feel that market psychology is a dominant influence on future exchange rates. Despite these problems, exchange-rate forecasters are in current demand. Their forecasting approaches are classified as judgmental, technical, or fundamental (econometric). Table 12.7 on page 392 provides examples of exchange-rate forecasting organizations and their methodologies:

Judgmental Forecasts

Judgmental forecasts are sometimes known as subjective or commonsense models. They require the gathering of a wide array of political and economic data and the interpretation of these data in terms of the timing, direction, and magnitude of exchange-rate changes. Judgmental forecasters formulate projections based on a thorough examination of individual nations. They consider economic indicators, such as inflation rates and trade data; political factors, such as a future national election; technical factors, such as potential intervention by a central bank in the foreign-exchange market; and psychological factors that relate to one's "feel for the market."

'This section is drawn from Sam Cross, The Foreiqn-Exchanqe Market in the United States, Federal Reserve Bank of New York, 1998, pp.

113-f 15.

Technical Forecasts

Technical analysis involves the use of historical exchange-rate data to estimate future values. The approach is technical in that it extrapolates from past exchange-rate trends and ignores economic and political determinants of exchange-rate movements. Technical analysts look for specific exchange-rate patterns. Once the beginning of a particular pattern has been determined, it automatically implies what the short-run behavior of the exchange rate will be.

Technical analysis encompasses a variety of charting techniques involving a currency's price, cycles, or volatility. A common starting point for technical analysis is a chart that plots a trading period's opening, high, low, and closing prices. These charts most often plot one trading day's range of prices, but also are created on a weekly, monthly, and yearly basis. Traders watch for new highs and lows, broken trendlines, and patterns that are thought to predict price targets and movement.

To illustrate technical analysis, assume you have formed an opinion about the yen's exchange value against the dollar based on your analysis of economic fundamentals. Now you want to look at what the markets can tell you; you're looking for price trends, and you can use charts to do it.

As shown in Figure 12.6, you might want to look at the relative highs and lows of the yen for the past several months; the trendlines in the figure connect the higher highs and the lower lows for the yen. If the yen's exchange rate moves substantially above or below the trendlines, it might signal that a trend is changing. Changes in trends help you decide when to purchase or sell yen in the foreign-exchange market.

Because technical analysis follows the market closely, it is used to forecast exchange-rate movements in the short run. Determining an exchangerate pattern is useful only as long as the market continues to consistently follow that pattern. No pattern, however, can be relied on to continue more than a few days, perhaps weeks. A client must therefore respond quickly to a technical recommendation to buy or sell a currency. Clients require immediate communication of technical recommendations, so as to make timely financial decisions.

Although fundamental-based models have not been successful in forecasting exchange-rate movements over short-run periods, many technicalbased models have been useful in explaining exchange-rate movements over short-run periods. It is not surprising that most foreign-exchange dealers use some technical model input to help

them formulate their forecast for exchange rates, especially for intra day and one-week horizons.

Fundamental Analysis

Fundamental analysis is the opposite of technical analysis. It involves consideration of economic variables that are likely to affect a currency's value. Fundamental analysis uses computer-based econometric models, which are statistical estimations of economic theories. To generate forecasts, econometricians develop models for individual nations that attempt to incorporate the fundamental variables that underlie exchange-rate movements: trade and investment flows, industrial activity, inflation rates, and the like. If you take an econometric course at your university, you might consider preparing an exchange-rate forecast as your class project. "Exploring Further 12.1" at the end of this chapter gives you an idea of the types of variables you might include in your econometric model.

Econometric models used to forecast exchange rates, however, face limitations. They often rely on predictions of key economic variables, such as inflation rates or interest rates, and obtaining reliable information can be difficult. Moreover, there are always factors affecting exchange rates that cannot easily be quantified (such as intervention by a country's central bank in currency markets). Also, the precise timing of a factor's effect on a currency's exchange rate may be unclear. For example, inflation-rate changes may not have their full impact on a currency's value until three or six months in the future. Thus, econometric models are best suited for forecasting long-run exchangerate trends.

As we have learned, those who forecast foreignexchange rates often are divided into those who use technical analysis and those who rely on analysis of economic determinants. Nearly all traders acknowledge their use of technical analysis and charts. According to surveys, a majority say they

394 Exchange-Rate Determination

employ technical analysis to a greater extent than fundamental analysis and that they regard it as more useful than fundamental analysis-a contrast to 30 years ago, when most said they relied more heavily on fundamental analysis.

In spite of the appeal of technical analysis, most forecasters tend to use a combination of fundamental, technical, and judgmental analysis, with the emphasis on each shifting as conditions change. They form a general view about whether a particular currency is overvalued or undervalued in a longer-term sense. Within that framework, they assess all current economic forecasts, news events, political developments, statistical releases, rumors, and changes in sentiment, while also carefully studying the charts and technical analysis.

Forecast Performance of

Advisory Services

To be successful, a forecasting model should provide better information about future exchange rates than is available to the market in general. Successful

forecasters are those who can consistently profit from their forecasting activities by predicting more accurately than the rest of the market.

In evaluating the performance of forecasters, it is important to determine what a naive forecast would be in the absence of any specific model or information. Assuming efficient foreign-exchange markets in which prices reflect all available information, what exchange-rate prediction is implicit in market quotations? As discussed in Chapter 11, the [oruiard-exchange rate (the spot rate plus the interest-rate differential) is the rational approximation of the market's expectation of the spot rate that will exist at the end of the forward period. This means that the forward premium or discount on a currency serves as a rough benchmark of the expected rate of appreciation or depreciation of a currency. The forward rate is widely considered to be useful as a forecasting device for a period of one to three months. A successful forecaster should thus be able to predict spot rates better than what is implied by the forward rate.

1.In a free market, exchange rates are determined by market fundamentals and market expectations. The former includes real interest rates, consumer preferences for domestic or foreign products, productivity, investment profitability, product availability, monetary policy and fiscal policy, and government trade policy. Economists generally agree that the major determinants of exchange-rate fluctuations are different in the long run than in the short run.

2.The determinants of long-run exchange rates differ from the determinants of short-run exchange rates. In the long run, exchange rates are determined by four key factors: relative price levels, relative productivity levels, consumer preferences for domestic or foreign goods, and trade barriers. These factors underlie trade in domestic and foreign goods and thus changes in the demand for exports and imports.

3.In the long run, a nation's currency tends to appreciate when the nation has relatively low levels of inflation, relatively high levels of productivity, relatively strong demand for its export products, and relatively high barriers to trade.

4.According to the purchasing-power-parity theory, changes in relative national price levels determine changes in exchange rates over the long run. A currency maintains its purchasing power parity if it depreciates (appreciates) by an amount equal to the excess of domestic (foreign) inflation over foreign (domestic) inflation.

S.Over short periods of time, decisions to hold domestic or foreign financial assets play a much greater role in exchange-rate determination than the demand for imports and exports does. According to the asset-market approach to exchange-rate determination, investors consider two key factors when deciding

between domestic and foreign investments: relative interest rates and expected changes in exchange rates. Changes in these factors, in turn, account for fluctuations in exchange rates that we observe in the short run.

6.Short-term interest-rate differentials between any two nations are important determinants of international investment flows and shortterm exchange rates. A nation that has relatively high (low) interest rates tends to find its currency's exchange value appreciating (depreciating) in the short run.

7.In the short run, market expectations also influence exchange-rate movements. Future

expectations of rapid domestic economic growth, falling domestic interest rates, and high domestic inflation rates tend to cause the domestic currency to depreciate.

8.Exchange-rate volatility is intensified by the phenomenon of overshooting. An exchange rate is said to overshoot when its short-run response to a change in market fundamentals is greater than its long-run response.

9.Currency forecasters use several methods to predict future exchange-rate movements: (a) judgmental forecasts, (b) technical analysis, and (c) fundamental analysis.

• Asset-market approach

(page 382)

• Forecasting exchange rates

(page 391)

• Fundamental analysis

(page 393)

• Judgmental forecasts

(page 391)

•Law of one price (page 376)

•Market expectations

(page 372)

•Market fundamentals

(page 372)

• Nominal interest rate

(page 382)

•Overshooting (page 389)

•Purchasing-power-parity approach (page 376)

•Real interest rate (page 383)

•Relative purchasing power parity (page 379)

•Technical analysis

(page 392)

1.In a free market, what factors underlie currency exchange values? Which factors best apply to long-run exchange rates and to short-run exchange rates?

2.Why are international investors especially concerned about the real interest rate as opposed to the nominal rate?

3.What predictions does the purchasing-power- parity theory make concerning the impact of domestic inflation on the home country's exchange rate? What are some limitations of the purchasing-power-parity theory?

4.If a currency becomes overvalued in the foreignexchange market, what will be the likely impact on the home country's trade balance? What if the home currency becomes undervalued?

5.Identify the factors that account for changes in a currency's value over the long run.

6.What factors underlie changes in a currency's value in the short run?

7.Explain how the following factors affect the dollar's exchange rate under a system of marketdetermined exchange rates: (a) a rise in the U.s. price level, with the foreign price level

held constant; (b) tariffs and quotas placed on u.s. imports; (c) increased demand for u.s.

exports and decreased U.S. demand for imports; (d) rising productivity in the United States relative to other countries; (e) rising real interest rates overseas, relative to U.S. rates;

(f)an increase in U.S. money growth; (g) an increase in U.S. money demand.

396Exchange-Rate Determination

8.What is meant by exchange-rate overshooting? Why does it occur?

9.What methods do currency forecasters use to predict future changes in exchange rates?

10.Xtra! For a tutorial of this questi~n, go to

....."'@.. http://carbaughxtra.swlearnmg.com

Assuming market-determined exchange rates, use supply and demand schedules for pounds to analyze the effect on the exchange rate (dollars per pound) between the u.s. dollar and the British pound under each of the following circumstances:

a.Voter polls suggest that Britain's conservative government will be replaced by radicals who pledge to nationalize all foreignowned assets.

b.Both the British economy and u.s. economy slide into recession, but the British recession is less severe than the U.s. recession.

c.The Federal Reserve adopts a tight monetary policy that dramatically increases U.S. interest rates.

d.Britain's oil production in the North Sea decreases, and exports to the United States fall.

e.The United States unilaterally reduces tariffs on British products.

f.Britain encounters severe inflation, while price stability exists in the United States.

g.Fears of terrorism reduce U.S. tourism in Britain.

h.The British government invites U.S. firms

to invest in British oil fields.

I.The rate of productivity growth in Britain decreases sharply.

J.An economic boom occurs in Britain, which induces the British to purchase more U.S.-made autos, trucks, and computers.

k.Ten-percent inflation occurs in both Britain and the United States.

11.Explain why you agree or disagree with each of the following statements:

a."A nation's currency will depreciate if its inflation rate is less than that of its trading partners."

b."A nation whose interest rate falls more rapidly than that of other nations can expect the exchange value of its currency to depreciate."

c."A nation that experiences higher growth rates in productivity than its trading partners can expect the exchange value of its currency to appreciate."

12.The appreciation in the dollar's exchange value from 1980 to 1985 made U.S. products (less/more) expensive and foreign products (less/more) expensive, (decreased, increased) U.S. imports, and (decreased, increased) U.S. ex ports.

¥Suppose the dollar/franc exchange rate equals $0.50 per franc. According to the

purchasing-power-parity theory, what will happen to the dollar's exchange value under each of the following circumstances?

a.The U.S. price level increases by 10 percent and the price level in Switzerland stays constant.

b.The u.s. price level increases by 10 percent and the price level in Switzerland increases by 20 percent.

c.The U.S. price level decreases by 10 percent and the price level in Switzerland increases by 5 percent.

d.The U.S. price level decreases by 10 percent and the price level in Switzerland decreases by 15 percent.

14.Suppose that the nominal interest rate on 3- month Treasury bills is 8 percent in the United States and 6 percent in the United Kingdom, and the rate of inflation is 10 percent in the United States and 4 percent in the United Kingdom.

a.What is the real interest rate in each nation?

b.In which direction would international investment flow in response to these real interest rates?

c.What impact would these investment flows have on the dollar's exchange value?

12.1 Historical information on exchange rates can be found at the home page of the Federal Reserve Bank of St. Louis. After going to the link, click on Economic Research, FRED II, and then U.S. Trade & International Transactions and Trade Balances. Set your browser to this URL:

http://www.stls.frb.org

12.2 The Pacific Exchange Rate Service provides information on current and past daily exchange rates, as well as exchangerate forecasts for the Canadian dollar relative to five other major currencies. Set your browser to this URL:

http://pacific.commerce.ubc.ca/xr

...0

~Recall that fundamental forecasting involves

~estimating an exchange rate's responseto changes in economic factors. By determining

how these factors have influenced exchangerate fluctuations in the past, one can get insight about the future course of the exchange rate. Regression analysis is often used to make such an assessment. Forecasting organizations, such as Chase Econometrics, construct regression models based on 20 or more economic determinants of exchange rates.

Suppose we wish to forecast the percentage change in the Swiss franc's exchange value against the dollar in the next quarter. For simplicity, assumethat our forecast for the franc is dependent on only two factors that influence the franc's exchange value: (1) theinflation-rate differential between the United States and Switzerland; and (2) the income-growth differential, measured as a percentage change, between the United States and Switzerland. Assume also that these factors have a lagged effect on the franc's exchange rate. A regression model can be constructed as follows:

wherein the dependent variable, the quarterly percentage change in the franc's exchange value (Y), is related to quarterly percentage changes in the two independent variables, the U.S.lSwiss inflation differential (X1) and the U.S.lSwiss income growth differential (X2). In

the model, b2 is a constant, b, indicates the sensitivity of the franc's exchange valueto

changes in the inflation differential between the United States and Switzerland, b2 indicates the sensitivity of the franc'sexchange value to changes in the income growth differential between the United States and Switzerland, t stands for the time period, n indicates the number of quarters lagged, and U t is an error term with all assumed statistical properties.

Once the regression model is constructed, a set of historical data must be compiled for quarterly changes in the franc'sexchange rate, the U.S.lSwiss inflation differential, and the U.S.lSwiss income-growth differential. A large time-series database is desirable, generally consisting of 30 or more quarters of information. Using these data, suppose our model estimates the following regression coefficients:

The regression coefficient b, = 0.6 implies that for every 1-unit percentage change in the U.S.lSwiss inflation differential, the predicted percentage change in the franc'sexchange value is 0.6 percent, the income-growth differential remaining constant. Underlying this positive relationship is the tendency for relatively high inflation in the United States to cause a rise (appreciation) in the franc'svalue against the dollar, and vice versa. The regression coefficient b2 = 0.4 suggests that for each 1-unit percentage change in the U.S.lSwiss income-growth differential, the predicted percentage change in the franc'sexchange value