Business

What moves the exchange rate?

The Sterling Report

By Marian Ross

Sunday, August 19, 2018

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Classic economic theory presents a few important concepts that help us understand the movements in exchange rates, with one of the most relevant being purchasing power parity (PPP).

According to purchasing power parity, the price of the same good should be the same in all countries. Put another way, the prices of comparable goods should NOT be different in two separate locations.

If a good is cheaper in one place than another, people will buy more of it and drive its price up until the difference disappears. In other words, inflation will rise sufficiently to make the “real” value (ie nominal price less inflation) of the good equal between countries.

This theory forms the basis of the classical theory of exchange rates.

The classical theory of exchange rates purports that the rate of depreciation of a currency is equal to the difference between the inflation rates of the two countries.

According to this theory, countries with higher inflation, should have higher depreciation and vice versa. In the 2017 fiscal year, Jamaica's inflation rate was 5.2 per cent (while the US inflation rate was roughly 2.0 per cent, but the currency appreciated by 2.6 per cent.

Therefore the current adjustment we are witnessing is consistent with widely established and accepted economic theory.

However, these theories are generally tested over the long and short run separately. Therefore, one year's worth of data cannot be analysed in isolation.

Despite the past few years of low inflation, Jamaica's average 16-year inflation rate (2001 to 2017) is still 9.3 per cent per annum. That compares to the US's average inflation rate of 2.1 per cent over the same time period.

In reality, there are many reasons PPP may not hold exactly, such as trade barriers, differences in the same good between countries (ie goods are not necessarily homogeneous), price discrimination, among other things.

In the data, PPP has been found to hold in the long run but not so well in the short run. The laws of PPP suggest that exchange rates will move until prices of goods within countries are comparable.

So what accounts for the short-term movements in exchange rates?

No one knows for sure but there are many theories. One thing is for certainselling down net international reserves does not solve the problem in the medium to long term.

What are the implications of an appreciation or depreciation in the currency?

An appreciation of the exchange rate means that our exports become more expensive overseas and demand for our goods and services declines. It also means imports become cheaper, leading to a rise in consumption of imports and a worsening of the current account of the balance of payments. Imports subtract from total GDP.

A depreciation of the exchange rate means that our exports become cheaper for the rest of the world and demand for them will rise. Imports become more expensive and consumption of foreign goods and services declines in response to the higher prices.

It is worth noting that central banks in the USA, Europe and Japan have spent a large part of the past 10 years aggressively trying to devalue their currencies in an attempt to increase demand for their exports. A cheap currency is widely viewed as a key ingredient for export-led growth.

According to Nobel Prize- winning economist Nouriel Roubini, “In the long run, exchange rates generally reflect prices and monetary policies. In the short run, though, the only certainty is that exchange rates are uncertain.”

Movements in the exchange rate, just like movements in oil or labour prices, is a universal challenge that is experienced by businesses all across the world.

Marian Ross is an assistant vice-president of Trading & Investment at Sterling Asset Management. Sterling provides financial advice and instruments in US dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm

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