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The Foreign Exchange Rate Determination Issue and its Empirical Deviations

Enrique Muñoz-Salido

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The discussion about the theories that determine the foreign exchange rate is a recurrent issue in the economic literature. Theoretical and empirical approaches achieved to outline a shaky framework in the past decades.

The mainstream of modern economic literature holds that relative prices of countries determine the behavior of their foreign exchange rate. The most well-known theoretical approach to this explanation is the Purchasing Power Parity (PPP) theory, which asserts that the purchasing power of countries is the same when measure in the same currency.

The reason for the PPP model to hold is the presence of the international arbitrage, which makes prices equal between countries and corrects their purchasing power disparities. This is possible due to when the price of a good is cheaper in the domestic country than in the foreign country, foreign importers and domestic exporters will buy the good in the domestic country in order to sell it in the foreign country to obtain the profit derived from the both countries price imbalance. As a result of this situation, the price of the domestic good would increase while the price of the foreign good would decrease making one price equals to the other. This would lead to assert that when PPP holds, the purchasing power of those countries is the same (constant) over time.

Canada/U.S. Foreign Exchange Rate vs. PPP

exchangerate

*Percentage change relative to the base year 2010

Source (Muñoz-Salido, 2016)

As it can be seen in this graph of the Canada/U.S. foreign exchange rate and the PPP theory, there are consistent patterns regarding to the theoretical relationship of those variables. In general, it can be observed that whenever the value of Canadian dollar falls (so it implies an appreciation of the U.S. dollar against the Canadian dollar) against the value of the U.S. dollar, then always the Canada’s price level falls relative to that in the U.S., and , conversely, whenever there is a depreciation of the U.S. dollar against the Canadian dollar (so there is an increase in the value of the Canadian dollar relative to that in the U.S. dollar) then there is an increase in the Canadian price level relative to that in the U.S., which is strongly consistent with the PPP theory.

The only periods when this pattern is distorted is from 1974 to 1977 and from 2007 to 2013. This is not consistent with the PPP theory and it can be associated with not having the proper conditions for the PPP to hold, concretely. Following Coughlin’s & Koedijk’s (1990) statements, it can be explained by economic shocks, in this case the energy crisis at earlier 1970s which ended in the later 1970s and by the financial crisis which covered the aforementioned period.

Bearing in mind our results in this sample dataset, Stockman (1978) suggests that while a great part of changes in the exchange rate can be explained by inflation rates, there is many substantial changes in the exchange rate that remain unexplained. Stockman tries to justify part of this deviation by the role of the information about the future (id est. an increase in the expected rate of domestic inflation). He asserts that this information role makes a reduction on the demand for domestic money and connotes all nominal prices, including the price of foreign exchange, to rise. Nevertheless, he stresses that this alone cannot account for deviations from PPP unless exchange rates are associated with fluctuations in the ratio of domestic and foreign price levels. Stockman’s (1978) also addresses part of this deviation issue by associating its cause with other policies such a tariffs, quotas and controls on foreign exchange transactions which may affect the exchange rate indirectly by directly affecting the terms of trade.

In light of this ever-present deviation of empirical findings from the theory, Musa (1984) fiercely criticise the stickiness of prices. He addresses the short-run deviations to the slow price adjustment due to they are fixed in the short-run and they don’t adjust immediately to its equilibrium value. Stockman (1978) adds that this fact could be the main cause for the exchange rate to depreciate in the short-run, due to in the long-run good prices have already had time to adjust to a market equilibrium. Nevertheless, De Grauve et al. (1985) associate part of empirical deviations from PPP with the influence of the size of the stochastic disturbances in the money market by setting the assumption that the larger the size of the monetary and inflationary disturbances, the larger the variability of the real exchange rate. They also notice that this relation is not linear connoting an increase in the variability of the real exchange rate when monetary and inflationary disturbance occurs but levelling off after this immediate increase due to the force of goods arbitrage. They also set the international arbitrage as a grader factor when this disturbance arises.

In addition, Coughlin & Koedijk (1990) attribute part of this deviation to the fact that floating exchange rates are relatively new over time, so that the exchange rate determination is trying to be addressed by the convergence of two different type of exchange rate that have different behaviour. Under this assumption, they stress the fact that the relative price ratio of the real exchange rate fluctuates more in the floating-rate period than in the fixed exchange rate period. Also, they hold that another possibility that may explain this deviation is the effect of random shocks of various origins which disturb the real exchange rate theoretical behaviour, such as oil price shocks. As stated above, our results in the graph of Canada/U.S. foreign exchange rate and PPP theory coincide in dates with two economic shocks when the PPP theoretical pattern is distorted from 1974 to 1977 and from 2007 to 2013. Following Coughlin’s and Koedijk’s statements, this fact can be explained by the energy and the financial crisis influence in the aforementioned period.

Taylor & Taylor (2004) try to address this deviation issue by introducing trade costs and real shocks to the model with the aim to correct the deviations of the real from the foreign exchange rate. They hold that in order to improve the better understanding of the volatility of the real exchange rate, it can be combined the PPP theory with transactions costs and nonlinearity (due to, for example, the long-lasting effects made by price rigidities as stated above by Musa and Stockman) to obtain a more consistent empirical results that allow for the theory to properly hold.

Another requirement for the PPP model to hold is that the real version of the exchange rate achieved provided by PPP must show mean-reversion, so the behaviour of the real exchange rate is stable as it returns to a long-run level despite its fluctuations. When this assumption is violated, it entails that there are trends, random walks or cycles that may explain the causality of the foreign exchange rate instead the PPP model. In other words, this doesn’t allow for the foreign exchange rate to be explained or predicted by the PPP. De Gauve et al. (1985) propose an improvement to the stationarity of the series by applying an alternative statistical technique that makes it possible to decompose a time series into cycles of different frequencies, the spectral analysis. The results on this analysis would show how much of the total change is due to an observed cycle (a low-frequency cycle that repeats itself some times) and how much to seasonal movement (a high-frequency cycle that repeats itself predominantly). As a result, it is obtained a regression information on the extent to which the total variability of series is due to cycles of different frequencies.

In light that the theory assumes the trade to be constant, it can be asserted that in some periods of economic weakness the perfect arbitrage cannot play the same role for correcting purchasing power imbalances than when the economic system is not disturbed. Also, there could be potential factors for the international arbitrage to change over time such as the presence of the internet-based trade since 2000s or the development of new technologies, which can accelerate and change the international trade patterns.

In short, some of these hypothetical deviation statements can lie as a suitable explanation for slight deviations of empirical results from the theoretical framework of PPP theory of the literature in the past decades.

A conclusion to be drawn from this analysis is that PPP theory tends to hold with peculiarities. In the light of this evidence, Dornsbusch (1985) asserts that “There can be no objection to the strong or absolute version of PPP as a theoretical statement. Objections arise, however, when it is interpreted as an empirical proposition”. It can be asserted that the more the model simplifies the reality through theoretical assumptions the more the reality can be distorted. By logical thinking, it can be considered that the more this model is corrected for such an inaccuracy the more the deviation can be reverted.

In short, the vicissitudes with which the PPP holds in the literature over time can be considered as a challenging avenue for future research and as a suggestion for developing in depth the assumptions in which theoretical economic models are based.

Enrique is an MSc Candidate in Social Anthropology at Regent’s Park College, University of Oxford. His research interests lie at the intersection of human behaviour and social interactions and his top analytical skills comprise macro and micro data analysis and statistical methods. Prior to joining Oxford, Enrique completed his MSc in Economics (distinction) at the University of Brighton, UK, where he was a Santander Scholar, and his undergraduate degree at the Autonomous University of Barcelona, Spain.

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Economic Growth in Africa Rebounds, But Not Fast Enough

MD Staff

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Sub-Saharan Africa’s growth is projected to reach 3.1 percent in 2018, and to average 3.6 percent in 2019–20, says Africa’s Pulse, a bi-annual analysis of the state of African economies conducted by the World Bank, released today.

The growth forecasts are premised on expectations that oil and metals prices will remain stable, and that governments in the region will implement reforms to address macroeconomic imbalances and boost investment.

“Growth has rebounded in Sub-Saharan Africa, but not fast enough. We are still far from pre-crisis growth levels,” said Albert G. Zeufack, World Bank Chief Economist for the Africa Region. “African Governments must speed up and deepen macroeconomic and structural reforms to achieve high and sustained levels of growth.”

The moderate pace of economic expansion reflects the gradual pick-up in growth in the region’s three largest economies, Nigeria, Angola and South Africa. Elsewhere, economic activity will pick up in some metals exporters, as mining production and investment rise. Among non-resource intensive countries, solid growth, supported by infrastructure investment, will continue in the West African Economic and Monetary Union (WAEMU), led by Côte d’Ivoire and Senegal. Growth prospects have strengthened in most of East Africa, owing to improving agriculture sector growth following droughts and a rebound in private sector credit growth; in Ethiopia, growth will remain high, as government-led infrastructure investment continues.

For many African countries, the economic recovery is vulnerable to fluctuations in commodity prices and production,” said Punam Chuhan-Pole, World Bank Lead Economist and the author of the report.  “This underscores the need for countries to build resilience by pushing diversification strategies to the top of the policy agenda.”

Public debt relative to GDP is rising in the region, and the composition of debt has changed, as countries have shifted away from traditional concessional sources of financing toward more market-based ones. Higher debt burdens and the increasing exposure to market risks raise concerns about debt sustainability: 18 countries were classified at high-risk of debt distress in March 2018, compared with eight in 2013.

“By fully embracing technology and leveraging innovation, Africa can boost productivity across and within sectors, and accelerate growth,” said Zeufack.

This issue of Africa’s Pulse has a special focus on the role of innovation in accelerating electrification in Sub-Saharan Africa, and its implications of achieving inclusive economic growth and poverty reduction. The report finds that achieving universal electrification in Sub-Saharan Africa will require a combination of solutions involving the national grid, as well as “mini-grids” and “micro-grids” serving small concentrations of electricity users, and off-grid home-scale systems. Improving regulation of the electricity sector and better management of utilities remain key to success.

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Multilateral Development Banks Present Study on Technology’s Impact on Jobs

MD Staff

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Rapid technological progress provides a golden opportunity for emerging and developing economies to grow faster and attain higher levels of prosperity. However, some disruptive technologies could displace human labor, widen income inequality, and contribute to greater informality in the workforce. Tapping new technologies in a way that maximizes benefits, mitigates adverse effects, and shares benefits among all citizens will require public-private cooperation and smart public policy.

That is one of the main conclusions of a new study, The Future of Work: Regional Perspectives, released today by four regional multilateral development institutions: the African Development Bank (AfDB), the Asian Development Bank (ADB), the European Bank for Reconstruction and Development (EBRD), and the Inter-American Development Bank (IDB).

The study, which was presented at a seminar hosted 19 April at the IDB in Washington, D.C., explores the potential impact of technology in global labor markets and identifies concrete actions countries can take to prepare for the changing nature of jobs and leverage the benefits of emerging technologies.

The Future of Work: Regional Perspectives analyzes the challenges and opportunities presented by artificial intelligence, machine learning, and robotics in what is known as the Fourth Industrial Revolution. Potential challenges include increased inequality and the elimination of jobs, as well as the high degree of uncertainty brought about by technological change and automation. The greatest opportunities come from gains in economic growth that can result from increased productivity, efficiency, and lower operating costs.

The study includes chapters focusing on how new technological developments already are affecting labor markets in each region.

In the case of Asia and the Pacific, ADB research shows that even in the face of advances in areas such as robotics and artificial intelligence, there are compelling reasons to be optimistic about the region’s job prospects. New technologies often automate only some tasks of a job, not the whole. Moreover, job automation goes ahead only where it is both technically and economically feasible. Perhaps most importantly, rising demand—itself the result of the productivity benefits that new technologies bring—offsets job displacement driven by automation and contributes to the creation of new professions.

“ADB’s research shows that countries in Asia will fare well as new technology is introduced into the workplace, improving productivity, lowering production costs, and raising demand,” said Yasuyuki Sawada, ADB’s Chief Economist. “To ensure that everyone can benefit from new technologies, policymakers will need to pursue education reforms that promote lifelong learning, maintain labor market flexibility, strengthen social protection systems, and reduce income inequality.”

The publication was launched with a panel discussion featuring senior officials of the four regional development banks leading the study: Luis Alberto Moreno (IDB President), Charles O. Boamah (AfDB Senior Vice-President), Takehiko Nakao (ADB President), and Suma Chakrabarti (EBRD President). They were joined by Susan Lund (Lead of the McKinsey Global Institute) and Pagés, one of the co-authors.

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Circular economy: More recycling of household waste, less landfilling

MD Staff

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EU Parliament backs ambitious recycling targets, under legislation on waste and the circular economy, adopted on Wednesday.

Improving waste management will not only benefit the environment, climate, and human health. The four pieces of legislation are also part of a shift in EU policy towards a circular economy, i.e. a system where the value of products, materials and resources is maintained in the economy for as long as possible.

By 2025, at least 55% of municipal waste (from households and businesses) should be recycled, says the text, as agreed with Council of Ministers. The target will rise to 60% by 2030 and 65% by 2035. 65% of packaging materials will have to be recycled by 2025, and 70% by 2030. Separate targets are set for specific packaging materials, such as paper and cardboard, plastics, glass, metal and wood.

Landfilling to become an exception

The draft law also limits the share of municipal waste being landfilled to a maximum of 10% by 2035. In 2014, Austria, Belgium, Denmark, Germany, the Netherlands and Sweden sent virtually no municipal waste to landfill, whereas Cyprus, Croatia, Greece, Latvia and Malta still landfill more than three quarters of their municipal waste.

Textiles and hazardous waste from households will have to be collected separately by 2025. By 2024, biodegradable waste will also have to be either collected separately or recycled at home through composting.

Reduce food waste by 50 %

In line with the UN sustainable development goals, member states should aim to reduce food waste by 30% by 2025 and 50% by 2030. In order to prevent food waste, member states should provide incentives for the collection of unsold food products and their safe redistribution. Consumer awareness of the meaning of “use by” and “best before” label dates should also be improved, say MEPs.

“With this package, Europe is firmly committed to sustainable economic and social development, which will at last integrate industrial policies and environmental protection”, said lead MEP Simona Bonafè (S&D, IT). “The circular economy is not only a waste management policy, but is a way to recover raw materials and not to overstretch the already scarce resources of our planet, also by profoundly innovating our production system”.

“This package also contains important measures on waste management, but at the same time goes further, by defining rules taking into account the entire life cycle of a product and aims to change the behaviour of businesses and consumers. For the first time, Member States will be obliged to follow a single, shared legislative framework”, she added.

Background: what is a circular economy?

A circular economy implies reducing waste to a minimum as well as re-using, repairing, refurbishing and recycling existing materials and products. Moving towards a more circular economy will reduce pressure on the environment, enhance security of supply of raw materials, increase competitiveness, innovation and growth, and create jobs.

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