All Terrain Thinking

A Compendium of things I think are Important

Economics: It's not just whats' in your wallet

A Theory of Exchange Rates

What's going on with the dollar?  What is going to happen with the Euro?  How low can the Russian ruble go?  Will the Japanese yen continue its rebound?  How can the yen continue to rise while the Japanese economy continues to fall?  What caused the Asian currencies to crash and burn in 1997 - 98?  Why did Malaysia impose currency controls in 1998 - and what does that mean?  Why did Brazil need 35 percent interest rates to defend the real in 1998 and then watch as the currency's value fell in January of 1999?  With the arrival of the Euro, the collapse of many East Asian countries, and the devaluation of the Brazilian real in 1999 everybody seems to be interested in exchange rates. What better indicator of the much publicized globalization process could there be?

The good news is that a considerable amount of insight into exchange rates can be gained with the use of a simple supply-demand model of prices since exchange rates are just the price of a country's currency.  First, however, let's talk about where you would get information on exchange rates?  You can get them in the WSJ in the Currency Trading table.  In the WSJ table you will actually get two exchange rates - the US $ equivalent and the Currency per US $.  For example, the Mexican peso is worth .1134 US dollars which means that there are approximately 8.82 pesos to the US $.  When you look at the supply-demand graphs in this section you will be looking at the second of these prices - the price of the dollar in terms of pesos. 

When we use this version of the price, a depreciation of the dollar would be a decrease in the price of the dollar while an appreciation would be an increase in the price.  For example, a depreciation of the dollar would be a change from a dollar price of 4 marks to 3 marks to the dollar.  After a depreciation of the US $, it would take fewer German marks to buy a US $ or it would take more US $s to buy a German mark.  [Note: if you want some on-line help with making the conversions, check out the Currency Converter site]

You will also hear people mention the trade-weighted exchange rate which is a weighted average of exchange rates where the weights are based on patterns of US foreign trade.  As you can see in the diagram below, the value of the dollar rose after 1995 before it began its fall in 1998, and in early 1999 it remains far below its peak in the mid 1980s.  

At the heart of the 'theory' that explains these movements in exchange rates is the supply and demand model of prices.  People seem to know the basics of supply and demand, even if they have never had an economics course. We have all been immersed in an economic system that has conditioned us to know instinctively that a decline in price can be caused by either an increase in supply or a decrease in demand. Once the dollar problem can be translated into this model, I am confident that even those who have no formal training in economics can understand what they are hearing.

First, however, we need the ground rules.

• the price of the dollar, what some would refer to as the value of dollar or the exchange rate, is the number of units of a foreign currency needed to buy a dollar (ex. 97 yen per dollar).
• people want to be paid in their domestic currency.  German workers want to be paid in German marks while the US government will want US dollars when it sells Treasury securities to English investors.
• the exchange rate is set in the international money market, something very much akin to the US stock market.  In that market there are buyers and sellers of currencies and the exchange rate is determined by the interaction of the buyers and sellers.  People will need to come to the international money market when they are involved in an international transaction.
• demand for dollars is generated every time someone anywhere in the world wants to buy US goods and services or US assets. The export of US rice to Japan in 1997 or the purchase of US government 'mortgages' by investors in Germany are examples of transactions that would generate a demand for dollars.  Both the US government and the farmers producing the rice would like to be paid in dollars so foreign buyers will go to the international money market with their domestic currency and demand (buy) US dollars to pay their bills for the rice and mortgages.
• supply of dollars is generated every time someone in the US tries to buy goods and services and assets from abroad.  When Americans buy French wine or travel to Tokyo for business they will pay for the wine in French francs and the hotel room in Japanese yen.  In both cases they will need to go to the international money market where they will supply US dollars to the money market to exchange them for the francs and yen needed to make their purchases. 

The supply - demand model presented graphically below should look very familiar to anyone who has seen a supply-demand model.  All that we will do now is make a few modifications in the traditional model and we will have a model of exchange rates.

Exchange Rate

We will begin with the questions: why do the curves have the familiar slopes?  Why is the demand curve downward sloping and the supply curve upward sloping?  A simple example will help.  Let's assume that there is a $1,000 computer produced in the US and a 50f bottle of French wine.  What will these goods cost if they are exported?  The prices of the goods in each country when the exchange rate is 5f per $ are presented in the table below.  At this exchange rate the computer costs 5,000f in France and the wine costs $10 in the US. 

Prices at exchange rate of 5f per $

What happens when the exchange rate falls - what is called either a depreciation or devaluation.  The table below has prices when the exchange rate has fallen to 2f per $.  It now costs fewer francs to buy a US dollar so we would say that the dollar has depreciated.  At this exchange rate the computer costs 2,000f and the wine costs $25 in the importing country.  If you assume that demand is downward sloping for the two goods, then you should expect the higher price for the wine in the US to lower demand for wine. If we have lower demand for wine then we will have fewer people supplying US Ss to exchange them for French francs.  The decrease in the value of the dollar generates a decrease in supply of dollars - a positive relationship that is reflected in the positively sloped supply curve.

Prices at exchange rate of 2f per $

As the exchange rate falls, we also find that the price of the computer in France has fallen which should result in increased demand for computers.  The increased demand for imported computers should increase demand for dollars as more foreigners convert their currency to US $s to buy the computers.  In this case we see the decrease in the exchange rate creating additional demand for US $s and thus we have a negative relationship between the price of a dollar and demand for dollars.  This is why we have a negatively sloped demand curve in the diagram.

Now we were ready for the our "Spring Break" theory of exchange rates. We know that in the spring many students head to Cancun, Mexico for their spring break.  Before leaving for break, however, these students have to 'buy' pesos which they use while in Cancun to pay for their hotels, restaurant, and bar bills.   Many will have 'bought' the pesos at their local bank with dollars that their bank will then take to the international money market.  At the market the local bank will sell the dollars in order to buy the pesos needed by the students. But as we saw above, any decrease in the demand or increase in the supply of dollars will drive down the price of the dollars.  In this case the increase in supply would be reflected in an outward shift in the supply curve and the price of the dollar would drop. 

It should come as no surprise, however, that this is not the only 'theory' of the dollar's decline to have paraded before the American people in recent years.  A few of the alternatives that have been proposed at various times over the years are listed below, but as we will see, they are variations on the same theme.

• Deterioration in the balance of trade deficit: to pay for the increase in imports that produces the trade deficit, Americans must sell dollars to buy the foreign currency necessary to pay for their imports. [supply curve shifts out]
• Rapid growth outside of the US: US investors, seeking the highest rate of return on their money, are increasing their supply of dollars to purchase foreign currency which they need to finance their purchase of stock on foreign stock exchanges. [supply curve shifts out]
• Low interest rates in the US: foreign investors, seeking the highest rate of return on their money, are selling US government securities and buying foreign securities that generates an increase in the supply of US dollars. [supply curve shifts out]
• Kobe earthquake: demand for dollars by Japanese investors to buy US assets will decline as some of the investors decide to use their funds to help rebuild Kobe rather than buy US government securities [demand curve shifts in].
• Loss in 'confidence' in the dollar: demand for dollars in the post W.W.II era remained high as foreign investors and central bankers preferred to hold their cash as dollars, but the rise of new economic super powers Japan and Germany has prompted both investors and central bankers to diversify their cash portfolio by selling their dollars to buy Japanese yen and German marks. [demand curve shifts in].

Before leaving our discussion of exchange rates, we need to look at what happened in the currency markets after mid 1997.  By the end of 1998 the currency markets in Southeast Asia had been routed as the world witnessed a more modern version of the domino theory.  It all began with the dramatic drop in the value of Thailand's currency that is apparent in the diagram below.  In a very short time period in 1997, the bhat price of the dollar more than doubled (from 26 bhat per $ to 54 bhat per $) creating hardship for Thailand's people who would see the price of all their imported goods doubled.  After the decline in Thailand's bhat a contagion spread across the currency markets sparing virtually no one.  By the second half of 1998 the focus of attention moved to Russia and Latin America.  The difficulty in Russia was that its government was simply unable to collect enough taxes to pay its bills and it therefor needed to borrow funds to keep going.  George Soros' fund gained some short-lived press in September when it announced a $2 billion loss, but this was soon forgotten when Merriweather's hedge fund was 'saved' after losses exceeding $3 billion.  One nation that seemed to have weathered the storm, at least the initial phase, was Hong Kong.  But this came about only as a result of substantial government intervention into the currency and stock markets.  The government, shedding its hands off image, moved aggressively into the markets as a buyer to increase demand and stabilize prices.

What happened in these currency markets?  The specifics may vary across countries, but the basics are the same.  Investors with DEEP pockets had been attracted to Asia in recent years because of the rapid growth in the region's economies and asset markets.  Their money poured in to buy their exports, real assets (factories, land) and financial assets(stocks, bonds).  This created a substantial demand for Asian currencies that drove up the value of the currencies.   When investor confidence was shaken, however, the inflow of currency turned around and the demand curve shifted in as investors moved their money out of Asia.  At this time we also saw currency flight as wealthy residents of the beleaguered countries began 'exporting' their domestic currency - converting it to safer currencies which increased the supply further driving down the price of the currency. 

Once investor confidence in Asia was shaken, they began to look elsewhere for potentially vulnerable investments.  It did not take long for Russia to work its way onto the radar and the ruble fell in September of 1998.  The contagion spread to Brazil that month which prompted their newly elected president to propose an austerity package to stem to outflow of reals.  A piece of the package was interest rates above 30 percent.  The hope was that the exceptionally high interest rate would compensate investors for the risk of investing in Brazil and that this would keep money flowing into the country (increase demand for the real) and stop the outflow (reduce the supply of reals).  In Malaysia, a currency board was established to peg the value of the ringhat - a return to fixed exchange rates. 

Where things go from here is still an open question, but what we can be certain of is that exchange rates will continue to find their way onto the front pages of the nation's newspapers. What you will need to do to make sense of the discussions is be able to translate the stories into the supply-demand framework.  As an example, you should look at the article "Whither the Dollar" where the author is trying to make sense of the decline in the value of the dollar relative to the yen.  The decline is explained as follows.

"More recently, the dollar's decline has likely been prompted by a growing awareness of the striking differences in the relative valuations of U.S. and Japanese equity and bond prices. The U.S. stock market is at record highs as are valuations. The price-earnings ratio on the S&P 500 is a stratospheric 33.5, more than double the average PE since World War II. U.S. bond yields are also extraordinarily low, with 30-year Treasury yields trading at just over 5%. In contrast, Japanese stock prices are at rock bottom and with the recent sell off in the Japanese bond market, real Japanese bond yields appear attractive. Besides, given the inadequate capital positions of many Japanese financial institutions, most are anxious not to take risks in increasingly risky U.S. financial markets."

The problem facing the dollar is that investors in the US are looking to Japan as a place where they should invest for a future high rate of return, while Japanese investors are looking to lower their investments in the US.  The increase demand for Japanese stocks will increase supply of dollars as US investors need to turn in their dollars to buy yen so they can buy Japanese stock.   Meanwhile, the decrease in Japanese demand for US stocks will mean that the demand for dollars the world money market will fall.  The combined effect can be demonstrated in the diagram below where the supply curve shifts out and the demand curve shifts in.  The result is a decrease in the value (price) of the dollar. 

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