Stefan C. Norrbin

Prices and Exchange Rates

The tendency for similar goods to sell for similar prices globally provides a link between prices and exchange rates. As prices change internationally, exchange rates must also change to keep the prices measured in a common currency equal across countries. In other words, exchange rates should adjust to offset differing inflation rates between countries. This relationship between the prices of goods and services and exchange rates is known as purchasing power parity (PPP). It is important to study the relationship between price levels and exchange rates in order to understand the role of goods markets (as distinct from financial asset markets) in international finance. This chapter explores this relationship through discussions of absolute purchasing power parity, relative purchasing power parity, the Big Mac index, and deviations from PPP. Also discussed is the relationship between time, inflation and PPP. Real exchange rates are examined, as compared to the nominal exchange rate. The chapter concludes with an appendix on the effect of relative price changes on PPP, using a real-world example.

The Monetary Approach

The monetary approach to open economy macroeconomics emphasizes the determinants of money demand and money supply. The monetary approach can be analyzed separately for fixed and floating exchange rates. If the exchange rate is fixed then the monetary approach pertains to the balance of payments, and in such a case the approach is called the Monetary Approach to Balance of Payments (MABP). In contrast, if exchange rates are floating then the approach explains exchange rate movements and is called the Monetary Approach to Exchange Rates (MAER). Both approaches are discussed thoroughly in this chapter, beginning with basic concepts and assumptions and also addressing the policy implications of these models. Sterilization, the offsetting of international reserve flows by central banks that wish to follow an independent monetary policy, is examined in detail, as is sterilized intervention in a floating exchange rate system.

International Monetary Arrangements

Abstract International monetary relations are subject to frequent change, with fixed exchange rates, floating exchange rates, and commodity-backed currency all having their advocates. This chapter considers the merits of various alternative international monetary systems, and also provides an interesting and useful historical background of the international monetary system, beginning with the late 19th century when the gold standard began and continuing to present-day systems. International reserve currencies are discussed in detail, with emphasis on the types of foreign exchange arrangements. Major topics covered include currency boards, “dollarization,” choices of exchange rate systems, optimum currency areas, the European Monetary System, and the emergence of the euro.

Chapter 8 – Foreign Exchange Risk and Forecasting

This chapter considers the issue of foreign exchange risk, which is the presence of risk that arises from uncertainty regarding the future exchange rate; this uncertainty makes forecasting necessary. If future exchange rates were known with certainty, there would be no foreign exchange risk. The various types of foreign exchange risk are explored by working through a real-world example. The effects of foreign exchange risk on the determination of forward exchange rates are then explored, clarifying the terms risk and risk aversion. Market efficiency is defined for the foreign exchange market, meaning that spot and forward exchange rates quickly adjust to any new information. Since future exchange rates are uncertain, forecasts must be made; the authors conclude the chapter with a worked-through forecasting example.

Extensions and Challenges to the Monetary Approach

This chapter considers some of the extensions and challenges to the monetary approach of exchange rate (MAER) determination. Five different extensions to the MAER approach are examined. The first is the “news” approach, which allows the MAER to be forward-looking. The portfolio-balance approach and the trade balance approach both add missing variables to the MAER relationships, whereas the overshooting approach and the currency substitution approach extend the MAER approach by adjusting the underlying equation. Finally, the chapter discusses some fundamentals of the “new thinking” of the New International Macroeconomics, including recent innovations and challenges to the MAER approach. Concepts such as pricing to market and the equilibrium approach are explored.

Chapter 13 – The IS-LM-BP Approach

This chapter considers economic goals from the point of view of an open economy, in which authorities must consider the impact of policy on balance of trade, capital flows, and exchange rates. It describes the major tools of macroeconomic policy used to achieve macroeconomic equilibrium: fiscal policy and monetary policy. The IS-LM-BP macroeconomic equilibrium diagram, in which IS represents goods market equilibrium, LM represents money market equilibrium, and BP represents balance of payments equilibrium, is examined in detail. Economic equilibrium requires that all three markets be in balance. Monetary and fiscal policy under fixed and floating exchange rates is discussed. The Asian financial crisis is used as an example to illustrate using the IS-LM-BP framework to explain macroeconomic events. The final section of the chapter summarizes the international debate concerning fiscal and monetary policy coordination.

Chapter 10 – International Investment

This chapter applies some basic ideas of modern finance to understand and analyze the incentives for international investment. It first looks at portfolio diversification, a motive that leads to the two-way flows of capital between countries, showing that investors are concerned with return on investment and also risk attached to the investment, with diversification as a means to reduce risk. Simple examples demonstrate the effects of diversification. Both systematic and nonsystematic risks are defined and explained. The chapter then delves into reasons for the fact that investors have a bias in favor of domestic assets despite expected gains from diversification; various alternatives are considered. International investment opportunities are discussed, with the example of the stock market collapse of 1987 used to demonstrate the types of problems that can arise in turbulent times. The chapter also looks at the globalization of equity markets, which has opened many markets to the world, and explores what happens when a country moves from a segmented market to a globalized market in which restrictions are lifted for foreign and domestic investors. Finally, the chapter covers Foreign Direct Investment as well as foreign capital inflows.

Prices, Exchange Rates, and Purchasing Power Parity

The tendency for similar goods to sell for similar prices globally provides a link between prices and exchange rates. As prices change internationally, exchange rates must also change to keep the prices measured in a common currency equal across countries. In other words exchange rates should adjust to offset differing inflation rates between countries. This relationship between the prices of goods and services and exchange rates is known as purchasing power parity (PPP). It is important to study the relationship between price levels and exchange rates in order to understand the role of goods markets (as distinct from financial asset markets) in international finance. This chapter explores this relationship through discussions of absolute PPP, relative PPP, the Big Mac index, and deviations from PPP. Also discussed is the relationship between time, inflation, and PPP. Real exchange rates are examined, as compared to the nominal exchange rate. This chapter concludes with an appendix on the effect of relative price changes on PPP, using a real-world example.

Chapter 14 – The Monetary Approach

The monetary approach to open-economy macroeconomics emphasizes the determinants of money demand and money supply. The monetary approach can be analyzed separately for fixed and floating exchange rates. If the exchange rate is fixed then the monetary approach pertains to the balance of payments, and in such a case the approach is called the Monetary Approach to Balance of Payments. In contrast, if exchange rates are floating then the approach explains exchange rate movements and is called the Monetary Approach to Exchange Rates. Both approaches are discussed thoroughly in this chapter, beginning with basic concepts and assumptions and also addressing the policy implications of these models. Sterilization, the offsetting of international reserve flows by central banks that wish to follow an independent monetary policy, is examined in detail, as is sterilized intervention in a floating exchange rate system.

Eurocurrency Markets and the LIBOR

The international deposit and loan market in a nondomestic currency is called the Eurocurrency market , and banks that accept these deposits and make loans are often called Eurobanks . This chapter describes the major points and issues of the Eurocurrency market, providing some pertinent history as well. The reasons for and benefits of offshore banking are discussed. LIBOR, the London Interbank Offered Rate , is covered in detail, because of its use in determining variable interest rates and cost of swaps around the world. Much attention is paid in the chapter to interest rate spreads and risk, with practical examples provided. Also discussed in detail are international banking facilities and offshore banking practices, including syndicates of Eurobanks.