Effect of change in the price of currency
To address this question it is necessary to introduce the notion of the real exchange rate.
The real exchange rate is the ratio in which the exchange of goods and services of different countries. Ie And if American-made goods is twice cheaper than similar goods of English manufacture, the real exchange rate will be? English units of goods per unit of U.S. 1.
Thus, while the nominal exchange rate is the proportion in which the exchange of currency, the real exchange rate - is the proportion in which the exchange of domestic and foreign goods. Naturally, for the study of changes in exchange rates do not consider the prices of individual goods, and the overall price level. For this purpose, easy to use price indexes, for example, the consumer price index (CPI - Consumer Price Index).
The relationship between nominal and real exchange rate is described by the following formula:
The real exchange rate (S) = Nominal exchange rate (E) x
x [price in the domestic market (R) price in the international market, denominated in foreign currency (P *)]
The real exchange rate directly affects the value of net exports of any state. Lowering the real exchange rate means that domestic goods cheaper compared with foreign, which should lead to increased exports and lower imports, and vice versa.
You can now proceed to consider the first and simplest theory of exchange rates, known as the Theory of purchasing power parity (PPP). She argues that the unit of any currency should be given the opportunity to acquire the same amount of goods and services in any country. This theory is still has many adherents who believe that the theory of PPP describes fundamental mechanism of interaction of economic forces that determine the setting of exchange rates in the long run.
The theory of PPP is based on a principle called the law a single price, which asserts that at any point of the country the goods must be sold at the same price, because otherwise the trade is not benefiting from the opportunity of making a profit. Indeed, in the case did not meet the conditions described above, the principle could be to profit by buying goods in one place and selling in another, which inevitably would lead to a corresponding change in supply and demand and, consequently, price.
The same principle applies to international trade. If a certain amount of currency to buy permits in the domestic market more goods than the foreign, then this anomaly would lead to an increase in exports. This, in turn, alter the balance of supply and demand in the domestic and foreign markets, resulting in prices level off, ie purchasing power of currency in both markets will be the same.
Thus, the PPP theory argues that a currency must have a single real value in any country in the world.
For greater visibility and ease of understanding the theory of PPP is to take advantage of simple mathematical transformations. We use the above symbols. Then the purchasing power of $ 1 will be equal to 1 / R. Abroad, the dollar can be exchanged for the E units of foreign currency which, in turn, have purchasing power equal to E / R *. To ensure that the purchasing power of the dollar was the same in both countries, should perform the following equality:
After moving to the right of R we get:
The conclusion to be drawn from the theory of PPP - to provide the same purchasing power of the dollar in the U.S. and abroad, the real exchange rate should be equal to one! In case of deviation values of the real exchange rate of the unit as a result of changes in price levels, to restore equality must include a mechanism, which is a process of change in nominal exchange rates!
In support of this conclusion, a further transformation:
Ie in accordance with the theory of PPP the nominal exchange rate of the two countries should reflect the ratio of price levels in these countries - hence the change in the nominal exchange rate depends on the change in the price level.
Now it is possible to trace a further significant dependence on the effects of monetary policy by central banks to exchange rate fluctuation.
When the Central Bank increases the money supply, which in turn leads to an increase in domestic prices, it is, thus, reducing the nominal exchange rate against the currencies of other countries.
Limitations of the application of the theory of PPP
With all of its logical theory of PPP can not be perfect, because the change in nominal exchange rates can not always ensure the real value of the currency. The explanation may include the following two factors.
The first of these is that many goods and services are not of interest to a wide range of consumers. For example, it is unlikely that many people will travel abroad to take advantage of the services of a hairdresser or a dentist only for the fact that their services abroad are cheaper.
The second factor is that the same popular with the public goods produced in different countries, are not always interchangeable. That is, a mechanism to ensure the permanence of the real value of the currency interfere established preferences of consumers.
Despite the above factors, the theory of PPP provides the correct basis for understanding processes of exchange rates. In rejecting the real exchange rate of the units have a greater economic actors incentives to move goods across borders. How does this process leads to a change in the nominal exchange rate, we will see in subsequent publications.
Even if the forces that seek to establish a PPP will not be able to completely fix the value of the real exchange rate, they suggest that changing this value will be insignificant and occur only from time to time. Therefore, the general trends of changes in exchange rates in the long run usually reflect the true fluctuations of prices for goods and services domestically and abroad.
These theoretical foundations of the application of the theory of PPP in the fundamental analysis of the international currency market.
Application of the theory of PPP in the FA in practice.
To cite an example of how to apply the theory of PPP in the analysis of macroeconomic performance in terms of changes in the exchange rate.
Let us analyze the behavior of the currency pair GBP / USD from 1971 to 2004.
As price levels are values of the price index - the GDP deflator. Over 100 accepted value of 1971 goda.Istochnik Information USA - www.research.stlouisfed.org UK - search.treasury.gov.uk
The values of the GDP deflator and the exchange rate for each year are for uniformity, as average values from the middle of this year until the middle of the next.
Next, calculate the relevant price level in the U.S. to the level of prices in the UK. Then, to multiply the results at a basic level of the exchange rate in 1971, we obtain the dynamics of the exchange rate, if all developed in strict accordance with the theory of PPP.
Baseline data and results of calculations are summarized in the following table.
Performance of the GBP / USD (actual and in accordance with the theory of PPP) is represented on the graph.
For greater visibility on the actual schedule for GBP / USD trend line superimposed.
What conclusions can be drawn from the analysis?
Yes, the actual value of the exchange rate differ from the ideal (in accordance with the theory of PPP), but overall the trend is clearly marked, that certainly confirms the core of the theory of PPP, as set out in this publication.
Thus, guided by the theory of PPP, and having an idea of what monetary policy in the long run, holds the government of a country, it is possible with a reasonable degree of certainty possible to talk about trends in currency exchange rates.
To address this question it is necessary to introduce the notion of the real exchange rate.
The real exchange rate is the ratio in which the exchange of goods and services of different countries. Ie And if American-made goods is twice cheaper than similar goods of English manufacture, the real exchange rate will be? English units of goods per unit of U.S. 1.
Thus, while the nominal exchange rate is the proportion in which the exchange of currency, the real exchange rate - is the proportion in which the exchange of domestic and foreign goods. Naturally, for the study of changes in exchange rates do not consider the prices of individual goods, and the overall price level. For this purpose, easy to use price indexes, for example, the consumer price index (CPI - Consumer Price Index).
The relationship between nominal and real exchange rate is described by the following formula:
The real exchange rate (S) = Nominal exchange rate (E) x
x [price in the domestic market (R) price in the international market, denominated in foreign currency (P *)]
The real exchange rate directly affects the value of net exports of any state. Lowering the real exchange rate means that domestic goods cheaper compared with foreign, which should lead to increased exports and lower imports, and vice versa.You can now proceed to consider the first and simplest theory of exchange rates, known as the Theory of purchasing power parity (PPP). She argues that the unit of any currency should be given the opportunity to acquire the same amount of goods and services in any country. This theory is still has many adherents who believe that the theory of PPP describes fundamental mechanism of interaction of economic forces that determine the setting of exchange rates in the long run.
The theory of PPP is based on a principle called the law a single price, which asserts that at any point of the country the goods must be sold at the same price, because otherwise the trade is not benefiting from the opportunity of making a profit. Indeed, in the case did not meet the conditions described above, the principle could be to profit by buying goods in one place and selling in another, which inevitably would lead to a corresponding change in supply and demand and, consequently, price.
The same principle applies to international trade. If a certain amount of currency to buy permits in the domestic market more goods than the foreign, then this anomaly would lead to an increase in exports. This, in turn, alter the balance of supply and demand in the domestic and foreign markets, resulting in prices level off, ie purchasing power of currency in both markets will be the same.
Thus, the PPP theory argues that a currency must have a single real value in any country in the world.
For greater visibility and ease of understanding the theory of PPP is to take advantage of simple mathematical transformations. We use the above symbols. Then the purchasing power of $ 1 will be equal to 1 / R. Abroad, the dollar can be exchanged for the E units of foreign currency which, in turn, have purchasing power equal to E / R *. To ensure that the purchasing power of the dollar was the same in both countries, should perform the following equality:
After moving to the right of R we get:
The conclusion to be drawn from the theory of PPP - to provide the same purchasing power of the dollar in the U.S. and abroad, the real exchange rate should be equal to one! In case of deviation values of the real exchange rate of the unit as a result of changes in price levels, to restore equality must include a mechanism, which is a process of change in nominal exchange rates!In support of this conclusion, a further transformation:
Ie in accordance with the theory of PPP the nominal exchange rate of the two countries should reflect the ratio of price levels in these countries - hence the change in the nominal exchange rate depends on the change in the price level.Now it is possible to trace a further significant dependence on the effects of monetary policy by central banks to exchange rate fluctuation.
When the Central Bank increases the money supply, which in turn leads to an increase in domestic prices, it is, thus, reducing the nominal exchange rate against the currencies of other countries.
Limitations of the application of the theory of PPP
With all of its logical theory of PPP can not be perfect, because the change in nominal exchange rates can not always ensure the real value of the currency. The explanation may include the following two factors.
The first of these is that many goods and services are not of interest to a wide range of consumers. For example, it is unlikely that many people will travel abroad to take advantage of the services of a hairdresser or a dentist only for the fact that their services abroad are cheaper.
The second factor is that the same popular with the public goods produced in different countries, are not always interchangeable. That is, a mechanism to ensure the permanence of the real value of the currency interfere established preferences of consumers.
Despite the above factors, the theory of PPP provides the correct basis for understanding processes of exchange rates. In rejecting the real exchange rate of the units have a greater economic actors incentives to move goods across borders. How does this process leads to a change in the nominal exchange rate, we will see in subsequent publications.
Even if the forces that seek to establish a PPP will not be able to completely fix the value of the real exchange rate, they suggest that changing this value will be insignificant and occur only from time to time. Therefore, the general trends of changes in exchange rates in the long run usually reflect the true fluctuations of prices for goods and services domestically and abroad.
These theoretical foundations of the application of the theory of PPP in the fundamental analysis of the international currency market.
Application of the theory of PPP in the FA in practice.
To cite an example of how to apply the theory of PPP in the analysis of macroeconomic performance in terms of changes in the exchange rate.
Let us analyze the behavior of the currency pair GBP / USD from 1971 to 2004.
As price levels are values of the price index - the GDP deflator. Over 100 accepted value of 1971 goda.Istochnik Information USA - www.research.stlouisfed.org UK - search.treasury.gov.uk
The values of the GDP deflator and the exchange rate for each year are for uniformity, as average values from the middle of this year until the middle of the next.
Next, calculate the relevant price level in the U.S. to the level of prices in the UK. Then, to multiply the results at a basic level of the exchange rate in 1971, we obtain the dynamics of the exchange rate, if all developed in strict accordance with the theory of PPP.
Baseline data and results of calculations are summarized in the following table.
Performance of the GBP / USD (actual and in accordance with the theory of PPP) is represented on the graph.
For greater visibility on the actual schedule for GBP / USD trend line superimposed.
What conclusions can be drawn from the analysis?Yes, the actual value of the exchange rate differ from the ideal (in accordance with the theory of PPP), but overall the trend is clearly marked, that certainly confirms the core of the theory of PPP, as set out in this publication.
Thus, guided by the theory of PPP, and having an idea of what monetary policy in the long run, holds the government of a country, it is possible with a reasonable degree of certainty possible to talk about trends in currency exchange rates.
Andrew Khamidullin
abuser1977@mail.ru
abuser1977@mail.ru
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