Factors with an immediate

Overview
The foreign exchange market is a “fast-moving”
market. It can react immediately to any news which
could potentially impact exchange rates. Changes in
expectations are almost immediately noticeable on
the foreign exchange market in the form of rate realignments.
This chapter describes the factors that
have an immediate impact on foreign exchange market
movements. It starts by explaining the concept of
interest rate parity. This is followed by an analysis of
how exchange rates can overshoot their new longterm
values in the short term although purchasing
power parity still obtains in the long run. Finally, the
effects of monetary and fiscal policy on exchange
rates under fixed and flexible exchange rate regimes
will be discussed.
In the short run, the primary factor affecting the value
of exchange rates is demand for currencies from investment
decisions. These capital flows are oriented to
expected returns. The returns on investments abroad
depend on the relevant foreign interest rate and the
expected movement in the value of the currency. These
expected exchange rate movements can be derived
from the difference between the relevant interest
rates of the two currencies. For example, if the foreign
interest rate is higher than the domestic rate, and no
exchange rate movement is anticipated, capital will
flow abroad because interest rates are higher there.
When capital starts to flow out, a shortage would
occur in the domestic capital markets and interest rates
would start to rise. On the foreign exchange markets,
the demand for foreign currency and the supply of
domestic currency would rise, which is why any
expectation that there will be no change cannot be
correct. The concept of interest rate parity gives us
one answer to this apparent contradiction. This says
that the domestic interest rate equals the foreign
interest rate, plus the expected movement in the
exchange rate. The interest differential reflects the
anticipated future development of the exchange rate.
Interest rate parity: interest
differentials correspond
to expected exchange rate
movements
24
Example:
Interest rate parity
On 26 May 2000, the EUR/CHF exchange rate
was 1.5660. On the same date, the yield on a 1-year
money market investment was 3.69% in CHF and
4.81% in EUR. The anticipated exchange rate in one
year’s time (X) can be derived from these figures.
3.69% = 4.81% + (X–1.5660)
1.5660
X can be calculated as follows:
X = 1.5660 (3.69%–4.81%) + 1.5660 = 1.5485
In other words, the market expects the exchange rate
to be 1.5485 for 26 May 2001.
The expected future interest rate level thus plays a
key role in determining interest rate developments.
In the long term, purchasing power parity means
that the exchange rate reflects the relative development
of prices for goods and services. Because the
prices of goods and services even out only gradually,
purchasing power parity cannot apply in the short
term. In the long term, however, the interest differential
should be the same as the difference in
inflation between the two currencies. In other words,
the exchange rate movement ensures that real interest
rates are in line with each other internationally.
As long as the price adjustment process for goods
and services is a drawn-out one, exchange rates
must ensure that expected returns are evened out.
For example, if the domestic central bank suddenly
increases money supply growth, the market will
expect the rate of inflation to rise once prices have
adjusted. In the long term, this will result in the
devaluation of the domestic currency, in other words
the exchange rate will have to rise. However, the
greater money supply growth also means that there
Interest and purchasing
power parity:
real interest rate parity
Rigid price adjustments
result in exchange rates
overshooting
25
is a surplus of money. The initial effect of this is to cut
interest rates. The principle of interest rate parity,
however, states that the greater interest differential
should mean that the exchange rate will be expected
to fall, i.e. appreciation will set in.
The more expansionary policy of the central bank
causes an apparent dilemma for expectations: a
higher exchange rate – a devaluation – is expected in
the long term, but in the short term, expectations of
an appreciation are needed to fulfil interest rate parity.
On the basis of its predictive nature, the foreign
exchange market is able to reconcile these expectations
immediately, although they appear to be incompatible
in both the short and the long term. If the
announcement of an expansionary monetary policy
results in the exchange rate rising beyond its new
level expected in the long term, together with falling
interest rates, the medium-range development
towards the long-term level will correspond to the
expected appreciation resulting from the interest
differential. The reaction of the exchange rate is to
overshoot its new long-term level (exchange rate
overshooting).
Overshooting

In the medium term, higher inflation will push interest
rates up again and cause the exchange rate to
fall. The narrowing interest differential also cuts
expectations of exchange rate changes. Once all
prices have been adjusted, the exchange rate again
reflects purchasing power parity and the interest
differential merely reflects the different inflation rates
in the two countries.
The phenomenon of overshooting explains at least
part of the prolonged deviation of exchange rates
and purchasing power parity. The more inflexible the
price adjustment process, the greater these deviations
will necessarily be. If you remember that interest
rate parity means that all factors which can trigger a
change in future exchange and interest rates result in
a change in today’s exchange rates, then it also becomes
apparent why exchange rates are so volatile.
This is why it is so important to take account of a
variety of factors, their interactions and their impact
on market expectations when analyzing the foreign
exchange market.
A booming foreign economy may have two consequences.
Firstly, strong demand for labour and heavy
production capacity utilization are likely to cause
inflation rates to rise. Secondly, a central bank driven
by price stability considerations will try to restrain the
economy at an early stage before any sharp increase
in inflation by tightening the money supply, and thus
pushing up interest rates.
If the foreign central bank does not react, the foreign
interest rates will remain slightly higher than domestic
rates due to the cyclically induced greater demand
for money. The exchange rate initially over-shoots its
purchasing power parity, followed by a continuous
devaluation of the foreign currency. According to the
theory of overshooting, a preventive interest rate hike
by the central bank should cause the exchange rate
Creating expectations
through foreign booms
and monetary policy
27
to climb further, followed by a gradual depreciation
of the foreign currency. The key question affecting
the actual movement of the exchange rate over time
is the extent to which any change in monetary policy
is expected by the market. If the market has anticipated
that interest rates will rise, the exchange rate
may fall immediately even if the expectation is met.
In such cases, the market has already anticipated
the rise in interest rates and the exchange rate has
risen even before the change in monetary policy.
The primary factor affecting exchange rate developments
is therefore the expectations of the market
players.
Example:
Publication of US labour market statistics
On 7 March 1997, as on the first Friday of every
month, the currency market was waiting for the
release of the latest US labour market statistics.
Publication of US labour market statistics
1.7200
1.7180
1.7160
1.7140
9 10 11 12 13 14 15 16 17 18 Time of day
USD/DEM
28
Prior to publication of the data, the market assumed
that 225,000 new jobs had been created in February.
The exchange rate rose slightly before the data were
published. When the figures were published at
1.30 p.m., they showed that, at 339,000, the number
of new jobs created was again well above expectations.
The market therefore decided that the Fed
would adopt a tighter monetary stance in the future.
As a result, the USD rose more than DEM 0.0050 in
the following 15 minutes.
Changes in a country’s fiscal policy can also impact
exchange rates. If government spending rises,
growing public-sector demand is likely to have a
direct effect on economic growth in the first instance,
as it flows directly into the national accounting
system when gross domestic product is calculated.
Indirect effects can be derived from the secondary
orders in the economy resulting from government
contracts. The contribution of fiscal expansion to
economic growth thus exceeds the amount originally
spent, and this is termed the “multiplier effect” of
fiscal policy.
A rising gross domestic product also means that
there will be a lag in the rise of inflation. In any case,
demand for money rises, so interest rates will rise as
well. If government spending has been financed by
borrowing, interest rates will climb again substantially.
However, this rise in interest rates will normally
restrain private demand, a phenomenon which economists
term “crowding out.” If this occurs, the
public-sector demand for capital to finance its deficit
will displace the private demand for capital to finance
investments. In other words, the additional publicsector
demand is offset by reduced private demand
and there would no longer be any impact on growth.
In reality, however, complete displacement never
happens. The expansion in public-sector debt generally
results in borrowing abroad. Together with a
rise in inflation, the deterioration in the net domestic
An expansionary fiscal
policy can have a positive
impact on economic growth
Rising interest rates result
in restrained private
demand, a deterioration in
the current account and
currency devaluation
29
asset position results in devaluation of the currency
over the long term. In the short term, the theory
of overshooting would initially see devaluation,
followed by gradual appreciation.
Example:
Expansionary fiscal policy in the USA
When the USA started to cut taxes in 1981, the
budget deficit rose sharply, from 2.2% in 1980 to
4–5% between 1982 and 1986. At the same time,
real interest rates rose to over 8% and the USD
appreciated 25% by 1985. Sustained depreciation in
the dollar did not set in until foreign debt increased
dramatically.
The illustration of the various factors affecting
exchange rates shows clearly that, with flexible
exchange rates, economic stimuli can be transferred
across borders. The rise in the exchange rate means
that positive economic developments abroad have a
Fiscal expansion in the USA
80 81 82
% Real exchange rate index
83
Real interest
Deficit as per cent of GDP
Real exchange rates
84 85 86 87 88
125
120
115
110
105
100
95
90
10
8
6
4
2
0
– 2
–4
–6
Flexible exchange rates
stabilize the global
economy
30
dual impact on the domestic economy. On the one
hand, other countries will increase their demand for
domestically produced goods and services. On the
other, exports become cheaper. This shows that
exchange rates promote the cross-border transfer of
growth stimuli. At the same time, they restrain excessive
fluctuations in the national economy and it is
true to say that exchange rates have a stabilizing
effect on the global economy. As explained in the
previous chapter, however, the past and present
are full of examples of countries which jointly
anchor their currencies in a fixed exchange rate
mechanism.
It is worth examining the effects of economic policy
stimuli in a system of fixed exchange rates. If incomes
rise abroad in such an exchange rate system, demand
for export industry goods will rise in exactly the same
way as with flexible exchange rates. On the foreign
exchange markets, the rising demand for goods
means increased demand for the domestic currency.
However, because the exchange rate is fixed, the
domestic central bank is immediately forced to absorb
the upward pressure by buying foreign currencies.
In other words, the central bank sells its national
currency against foreign currency. The issue of
national currency by the central bank causes a rise
in money supply. As exports increase, the gross
domestic prod-uct grows, domestic demand for
imports rises, and the initial current account surplus
is reduced.
In a system of fixed exchange rates, fiscal policy
measures can also result in increased growth. Higher
government spending boosts domestic incomes.
On the domestic money market, there is excess demand
for liquid funds and interest rates have to rise.
In such a case, the domestic economy will attract
foreign capital and the result will be currency firming.
To prevent this, the central bank will provide the
money market with the amount of liquid funds it
An expansionary fiscal
policy makes an expansionary
monetary policy
necessary
Fixed exchange rates:
foreign economic stimulus
from export growth
31
wants. The rise in public-sector spending thus raises
incomes and forces the central bank to support the
economy through monetary expansion. This combination
of an expansionary fiscal and monetary policy
increases incomes still further.
Thus, the need to assure the fixed exchange rate
means that monetary policy has totally lost any form
of independence. Monetary expansion would merely
lead to a surplus on the domestic monetary market,
with a fall in interest rates. The domestic currency
would then come under pressure to devalue. However,
in a fixed exchange rate system, the exchange
rate cannot depreciate because the central bank is
obliged to guarantee it. If there is pressure to devalue,
the central bank is forced to make direct sales
of its currency reserves to remove domestic currency
from the market. In doing so, it immediately reduces
the money supply again. The original monetary expansion
needs to be reversed at once. In short: with
fixed exchange rates, active monetary policy is a
non-starter.
In both fixed and flexible exchange rate systems, any
excessively expansionary monetary policy will result
in a long-term rise in prices. Whereas exchange rate
movements in systems with flexible exchange rates
can still absorb this, differing rates of inflation in a
system of fixed exchange rates present a number of
problems. Exchange rates must be realigned regularly,
and in practice, fixed exchange rates are nothing but
an illusion.
Example:
India 1995
Between the start of 1993 and autumn 1995, the
Indian government tried to peg the rupee to the
USD. This was doomed to failure because the Indian
central bank could not cut inflation to the US level.
With an inflation differential of up to 12%, the result
was serious overvaluation of the Indian currency. In
An active monetary policy
is no longer possible
32
the long term, the USD/INR exchange rate had to be
adjusted to a level that reflected purchasing power
parity.
India 1995
Following the explanations of the underlying factors
affecting exchange rates, the next chapter gives a
brief outline of the history of the foreign exchange
market.
44
39
34
29
24
19
14
9
4
20%
10%
0%
– 10%
1990 1991 1992
Current USD/INR
USD/INR
Inflation differential
Purchasing power parity
1993 1994 1995 1996 1997