Theories of Exchange Rates - International Monetary and Credit Relations

Exchange Rate Theory

Underlying the understanding of the exchange rate as a category of international monetary relations are two main theoretical concepts - purchasing power parity and interest rate parity. The objective basis of such a "price" money, as a currency, is the purchasing power of one currency compared to another. Theoretical attempts to predict changes in the exchange rate have been made for a long time.

The most popular and fundamentally developed theory of determining the exchange rate is the theory Purchasing Power Parity put forward in 1556 by Martin de Azzilqueta Navarro, and later, in the XIX century, which became the subject of research by D. Ricardo, and D. Hume. But the most complete and comprehensive analysis of the theory of the purchasing power parity of currencies was made by the famous Swedish scientist Gustav Kassel at the beginning of the 20th century. Based on the hypothesis that the exchange rate is interconnected with the domestic price level in the country, he concluded that there is a single price law that argued that in the conditions of perfect competition, the same product in different countries has the same price, if it is expressed in one and the same same currency. Logically, the Single Price Law can be written as follows:

where P (t) - the price of the goods A within the country; E - spot rate; P (n ) - the price of goods A abroad.

The effect of this law is Absolute purchasing power parity (APTA), meaning that the exchange rate between the currencies of the two countries is equal to the ratio of price levels in countries. APA is expressed by the formula

where P (t) - the level of prices for goods and services in the domestic market; P (n) - the level of prices for goods and services in the external market.

In other words, according to the theory of absolute purchasing power parity ( Absolute Purchasing Power Parity - APPP) in one country should correspond to the price for the same goods in another country, recalculated at the current rate or, the same basket of goods should equally cost both in the US and in the UK. If in the US it can be bought for \$ 2.4, and in the UK for \$ 1.00. the exchange rate of the pound to the dollar will be:

In the search for an "equilibrium course" that would support a balance of payments equilibrium, modern economists follow D. Ricardo's statement. They believe that the exchange rate is determined by the relative value of the national money of the two countries, which depends on the price level, which, in turn, depends on the amount of money in circulation. Hence the important conclusion that it is necessary to reduce the rate of inflation in order to increase the purchasing power of the national currency.

Supporters of this theory believe that the alignment of the exchange rate based on the purchasing power of currencies is automatic, but with the simultaneous impact of a number of other factors affecting the demand and supply of money.

If we consider the essence of the exchange rate to proceed from the fact that this is a value category, then it must be taken into account that it reflects the value ratio of the two national economies. It shows the ratio of economic factors such as per capita GDP growth, the growth rate of production, the development of foreign trade, the dynamics of prices, the state of money circulation, the level of interest rates, the state and currency regulation.

In determining the purchasing power parities of currencies, at the beginning of the 20th century, as a rule, it was customary to compare only the commodity consumer basket, which always provided the opportunity to bring objections. For example, it is almost impossible to find even two countries with the same set of consumed goods, because consumption is influenced by, among other things, traditions, climatic conditions, fashion, habits of the population of a particular country, and therefore this estimate will have limited certainty.

The practical use of PPP theory for forecasting exchange rates is complicated by the variety of methods for calculating purchasing power parity, which give different results. In particular, it raises the need to use relative GDP deflators, consumer price indices, producer price indices, wages, average cost of a workplace and other indicators for calculations. When calculating price indices, different countries traditionally impart different weights to specific goods. So, for example, with the increase in the price of coffee all over the world, for countries where coffee enters the index with a high weight, the index will grow stronger than in those countries where its weight is small.

Supporters of the theory of PPP consider it necessary to include in the basket of goods and services only liquid and completely identical goods, for which there are no barriers and restrictions, and all additional transportation costs and other costs are not included in the price of the goods.

However, the practical application of the theory of absolute purchasing power parity is hampered by a number of factors, pointed out by JM Keynes. International comparisons cause difficulties related to a number of factors, including differences in the structure of national product baskets, which, according to the assumptions of the theory of PPP, should be homogeneous (homogeneous) in countries whose currencies are compared. Since national consumption baskets are traditionally different across countries, and there are also differences in transportation costs and other additional costs, the percentage deviation from purchasing power parity is quite fair, but how true these discrepancies in parities can be determined only by an analysis of additional factors.

Nevertheless, a comparison of the purchasing power parities of national currencies makes it possible to compare the level of development of the economies of different countries and the levels of their domestic prices for a number of goods and services. The APSP theory did not pass the test by the practice of the functioning of the international currency market because in practice it is practically impossible to measure the general level of prices in the domestic and foreign markets. After all, countries vary considerably in price level - hence the impossibility of conducting adequate international comparisons. There are several simplifications of the APSS theory that make it untenable:

• comparable consumer baskets from homogeneous goods;

• transport costs and government restrictions;

• goods and services not traded on the market, but affecting domestic prices;

• international capital flows;

• Full employment, as well as flexibility of domestic prices and wages.

With the globalization of the economy and the strengthening of national trade regulation, the difficulties of international comparisons of various characteristics of goods are significantly increasing, so a more appropriate version of the theory of PPPs is now considered to be the Relative Purchasing Power Parity - RPPP).

According to the theory of relative purchasing power parity, fluctuations in the exchange rate are proportional to a relative change in the price level in the two countries. According to this theory, the fluctuation of the exchange rate is proportional to the relative change in the price level in two countries:

where - the exchange rate in the current period; - the exchange rate in the base period; - the level of prices for goods and services on the domestic market in the current period; - the level of prices for goods and services on the domestic market in the base period; - the level of prices for goods and services on the international market in the current period; . - the level of prices for goods and services on the international market in the base period.

For practical purposes, a course is taken for the exchange rate in the base period at the time when it is stable or coincides with its moving average. As a price gauge, several indicators are most often used: the consumer price index, the wholesale producer price index and the GDP deflator. Forecasting the dynamics of the exchange rate on the international foreign exchange market on the basis of the theory of OPPS corresponds to the extrapolation of the current rate for the future period, based on a comparison of inflation in the two countries.

The equilibrium exchange rate is calculated as follows:

where - inflation in the domestic and international markets; E t and - Exchange rates at times t and t + 1.

The OPSS theory serves as a long-term basis for predictions of nominal exchange rate movements, which allow to reveal a stable correlation between the exchange rate and purchasing power parity. In addition, with high inflation, the theory of OPPS allows us to assess the macroeconomic imbalance in the international foreign exchange market. Finally, on a parity basis, the real international value of national goods and services is determined.

In conditions of fixed exchange rates, the forecasting of their dynamics based on the theory of relative PPP corresponds to the extrapolation of the current rate for the future period, based on a comparison of inflation in the two countries. In conditions of floating exchange rates, according to the research of the professor of the Massachusetts Institute of Technology R. Dornbusch, the theory of OPPS leads to inaccurate estimates of the exchange rate. More detailed studies of American economists-mathematicians P. Kugler and K. Lenz proved that this theory is valid for individual currencies. Moreover, since it is difficult to explain the phenomenon of a weak link between exchange rates and price levels, it was called the "purchasing power parity puzzle". In accordance with the generalizations of K. Rogoff and M. Obstfeld in 2000, all attempts to explain this riddle have no empirical evidence. As a result of the research, the following conclusions were drawn:

- the prices for exports and imports are faster to take into account fluctuations in the exchange rate than the consumer price index;

- commodity arbitrage is possible only in the wholesale market, as a result of which the theory of PPPs is more applicable to industrial producer prices than to the consumer price index.

Nevertheless, in modern practice, the calculation of purchasing power parities is used by central banks as a basis for establishing effective exchange rates of national currencies. In the process of development of world economic relations, with the development of forms of economic cooperation and the growth of the volume of operations in all sectors of the world financial market, the change in exchange rates should take place in such a way that the purchasing power of currencies of different countries is maintained. To the goods and services that are taken into account when comparing the purchasing power parities of currencies, it is necessary to take into account the flow of money flows in the world financial market servicing the movement of financial capital. In the context of financial globalization and the financialization of the world economy, the exchange rate may be affected by changes in the profitability of financial transactions in all segments of the world financial market, that is, the so-called "replacement effect."

The portfolio approach to determining the exchange rate continues the development of monetarist views. In the globalization of the financial market, prerequisites arise for the effect of the "replacement effect" national bonds by foreign ones. The need to take into account the likelihood of currency and credit risks, even with high potential profits, forces investors to withdraw money from those national financial markets, where the business environment worsened.

The crisis in the US financial market (primarily in its currency and credit sectors) in 2007-2008. caused turbulence in the world monetary and financial market and the flow of capital into the European currency. A consequence of the manifestation of the current debt crisis in a number of European countries was the desire of capitals to find the possibility of risk-free placement in the financial markets of Southeast Asia and Australia. Moreover, mobility in the movement of financial and foreign exchange flows can increase not only in countries where the stability of financial markets is directly violated, but also affect the markets of other countries. For example, in 1997 the crisis in South-East Asia caused an outflow of financial flows not only from the markets of the countries of this region, but also from other countries related to emerging markets, including from the United States market of government obligations.

For each investor from the point of view of the theory of portfolio balance, it is possible to place their temporarily free funds in bank notes, foreign government securities, which generate a constant interest income if this income is higher than the interest income on national bonds. The investor's intention to place his money is determined by the expected return on the domestic market of government obligations and foreign, with a possible change in the exchange rate. With an increase in the supply of money, it is possible to reduce their exchange rate and increase the demand for bonds, which generate more revenue taking into account the inflation factor. Increased demand for bonds leads to a depreciation of the national currency, and a fall in interest rates on national bonds may lead to demand for foreign bonds and a depreciation of the national currency, which forces the central bank to raise interest rates on government obligations.

The concept of parity of interest rates, as the basis for calculating the exchange rate, is especially important for the equilibrium functioning of the international currency market. Interest parities, on which the balance of the international foreign exchange market is based, were developed by the American scientist of the early 20th century. I. Fisher in the work "Theory of Interest". In total, four types of parity interrelationships of interest rates are distinguished:

• purchasing power parity (PPP), describing the relationship between inflation and the exchange rate exchange rate;

• The international Fisher effect, which considers the change in the spot rate and interest rates;

• parity of interest rates, analyzing the relationship between interest rates and premiums on futures contracts (see below);

• The Fisher effect, which characterizes the relationship between inflation and interest rates.

These types of parities form the basis of the simplest model of the international currency market. The analysis of the practical parity of percentage parity allows:

• test the validity of the hypothesis of uncovered interest rate parity;

• determine the risk premium for financial assets;

• to study the degree of financial openness of the country's economy for the international currency market;

• find out the elasticity of the exchange rate at interest rates.

The need for an analysis of interest parities arose in the 1970s. because of the transition to floating exchange rates in the international foreign exchange market. The hypothesis of uncovered interest rate parity states that if economic agents expect the same interest income to be maintained in two countries, the difference in nominal interest rates in both national financial markets will equal the expected rate of change in the nominal exchange rate of currencies for the relevant period of time.

Mathematically, covered interest parity can be represented as follows:

where is the forward exchange rate at the time t with the due date for the contract through k periods; S t - the spot exchange rate for a period of time t; I t is the interest rate on an internal financial asset with an investment horizon of k periods; I * t is the interest rate for a similar foreign asset.

For example, if the spot rate of the ruble against the US dollar on the interval t averaged 30 rubles/dollar, and the forward rate for the same time period was 32 rubles/USD, then the covered interest parity should be 1.06. If the interest rate on an internal financial asset with an investment horizon of k is 18%, then the interest rate for a similar foreign asset should be at least 19.08.

Changes in financial markets cause central banks to spend their national gold and currency reserves, first of all, implementing large foreign exchange interventions, as a measure aimed at stabilizing the currency exchange rate of the national currency .

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