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What is an exchange rate?

1 March 2013

What is an exchange rate?

All around the world people are complaining about exchange rates.  This is all well and good; I am well versed in complaining about things myself.  But before we consider whether complaints about the exchange rate are justified we need to first ask a very important question – what is an exchange rate?  Many people will act as if this question is far too obvious, but to be honest this is an issue we have to make sure we understand before we start banging on about exchange rates – and matters are far from as clear as many people like to pretend!

For a second, let me ask you to forget the complaints and feelings you have about what the exchange rate is and what it is doing.  Let’s start by consider the simple case of two countries – called A and B.

The exchange rate between these two countries is a simple way of measuring the value of country A’s currency relative to the value of country B’s currency.  If country A uses the A dollar, and country B uses the B pound, then country A’s exchange rate tells us how many pounds can be purchased with one dollar.

When A’s currency appreciates you can purchase more pounds for each dollar, and so this number rises, when A’s currency depreciates you can purchase fewer pounds for each dollar, so this number falls.

Nice, most of you already know this story.  However, things get significantly more exciting when we stop trading money with each other, and start trading goods and services which we use the money to buy!

Adding in goods and services

Here the value of A’s dollars vs B’s pounds is the foreign currency exchange rate.  However, there is also a rate of exchange for dollars against the goods A produces, pounds against the goods B produces, dollars against the goods B produces, and pounds against the goods A produces!  We know the first two as the price of goods and services within a country in local currency, while the latter two tell us the price of goods and services within a country in foreign currency.

In a nice neat world where people in country A and country B could instantly and costlessly transport goods between each other, we would expect the foreign currency exchange rate to end up at a level where it costs someone in country A the same amount of dollars to buy the same good in country A as it would in country B.  This extreme way of working out the currency is called purchasing power parity.   Under this view, the currency is set to equalise the prices of goods and services in the two countries.

The Economist’s “Big Mac” index gives an example of this sort of logic – by comparing the price of Big Mac’s around the world to the price in the US, when they are all set in US$.  

Of course purchasing power parity doesn’t always hold.  It is costly to send goods around the world, it takes time for people to recognise and take advantage of “pricing differences” between nations, and some goods are “non-tradable”.  Furthermore, beyond all of this there is a significant time dimension.

A dollar or a pound doesn’t go off, so as a result you can hold a dollar and if the price goes up you make a capital gain!  Furthermore, currency can be used to purchase assets within a country that have a long life, and offer a rate of return.  As a result, people will buy more of A’s dollars if the capital they can buy in A offers a higher rate of return than in B (interest rates), or if they expect A’s dollars to become more valuable in the future. 

In this way, a currency itself is just like an asset, and the price of this asset moves in ways that are very hard to predict (no matter how much some people like to pretend we can pick them) and nearly impossible to control in any sensible way.

Now I’m sure many of you find none of this particularly surprising.  However, this is where things get a bit more serious.  Any description we have for what is going on with an exchange rate, or what we “should do” has to be based on these fundamental elements of what an exchange rate is.  And this is where a lot of discussion around the exchange rate breaks down – because many people start seeing this relative price as a means to change real things in the economy, rather than as a signal of the underlying causes.

What is this a symptom of?

An exchange rate is a price.  It moves due to relative rates of return, relative price levels, relative inflation, and expectations of future growth/returns/changes in export and import prices.  We can’t predict the exchange rate, but as a price the exchange rate provides very useful information to us at a point in time.  For example, Chen, Rogoff, and Rossi showed in a paper that movements in “commodity currencies” such as the New Zealand dollar provide a lot of information about the outlook for commodity prices.  This makes a lot of sense if we think of currency like an asset, and a lift in export prices as indicative of an increase in the rate of return on that asset!

So given that the New Zealand dollar can be viewed as this sort of price we can say draw up a whole list of potential explanations for the high dollar (that are also consistent with the relatively higher interest rates, and persistent current account deficits in NZ) over recent years:

1.       The build-up of reserves/savings in Asian countries (especially China) has both made imported goods cheap, and competing firms less competitive – showing up in our exchange rate (this is explained here).

2.       The increasing value of dairy products, and to a lesser extent meat, is expected to continue in the future – as a result, people have purchased the dollar due to expected appreciation.

3.       Low savings relative to investment and/or poor investment by New Zealander’s led to capital inflows, new capital that hasn’t offered a high enough social rate of return.

4.       The inconsistent taxation of different investment vehicles has led to too little savings and/or too much investment with a low return (suggested by residential investment data).

5.       Working for families led to an increase in consumer demand without an underlying boost in national income, pushing up interest rates relative to where they would otherwise have been and thereby the exchange rate.

6.       Other countries may be expected to “overinflate” their way out of debt – in which case the relative value of their currency has been pushed down, and we will see very strong inflation overseas in the coming years.  This is the currency war view.

Figuring out which of these explanations is an important empirical question, and is the sort of thing that economists in New Zealand have been gradually working on. 

It is the answer to questions about the cause of the appreciation which should determine what we “do about exchange rates”, if anything.  Trying to get the RBNZ to print money or cut the official cash rate now to change this “symptom” will not solve the underlying ailment that is perceived to be causing pain to some in society.

This article is written by Matthew Nolan. For more information please contact matthewn@infometrics.co.nz.