International trade theories
An effective evaluation of real exchange rate should be preceded by a brief discussion on some of the international trade theories. This is imperative because to begin with, the exchange rate is broadly defined as the price of various currencies in international currency markets and again because the exchange rate is, to a large extent, determined by the relative balance of trade between countries. Some of these theories include the Hecksher-Ohlin theory, the Stopler- Samuelson theory and the factor price equalization theory.
The Hecksher- Ohlin theory developed by Hecksher and Ohlin, states that differences in factor endowments are the key determinants of international trade. The theory further states that countries should specialize in the production of commodities that require factors they are endowed with and in turn import goods whose production factors are within their reach.
This is what drives trade between countries. However, different countries may be producing the same goods due to similar factor endowments. In this case, international trade will be driven by the difference in quality between the two sets.
The factor price equalization theory explains international trade as initiated by differences in factor prices and returns (Frenkel, 1978, p. 176). Two countries may be equally endowed with a production factor but differ in price of that factor or returns from the use of that factor due to technological differences. This is eventual drive of international trade. This is almost similar to the Stopler- Samuelsson theory developed by Stopler and Samuelson in 1941 that attributes international trade to relative price changes.
If production factors can be used to make two goods and the price of one good is higher relative to the other, then the production factor should be utilized in the production of the good with the higher price. Differences in relative prices between countries, therefore, act as a driver to international trade. These theories represent only a small fraction of existing international trade theories.
A common proposition among them is the role played by differences in relative prices of goods and production factors in determining the direction of trade. In international markets, the exchange rate significantly determines relative price differentials.
The exchange rate
The exchange rate is the rate of exchanging one currency for another in international currency markets. It simultaneously determines the value of a currency and the value of a country’s exports. Just like other prices, supply and demand forces play a significant role in determining the exchange rate.
In this case, the supply and demand of the currency act as a proxy of the supply and demand of a country’s exports (Edwards, 1988, p. 33). The exchange rate therefore, reflects the level of a country’s competitiveness in the international export markets.
The real exchange rate
Over the years, there have been several definitions of the real exchange rate. Bilson (1978) argues that “the real exchange rate concept involves adjusting a specified nominal exchange rate for relative inflation between a domestic country and a foreign one in order to determine the incentives to produce, purchase and store goods and services”.
The difference between nominal and real exchange rates is that the nominal exchange rate, being a monetary concept, measures the strength of one currency relative to another while the real exchange rate, being a real phenomena, measure the price of one good relative to another good.
Bautista (1987) broadly defines the real exchange rate as the real worth of a country’s domestic currency in terms of foreign exchange. He further argues that the real worth of foreign exchange in one year differs from the value in subsequent years due to changes in relative prices.
The different definitions present in literature can broadly be classified under two categories. The first category defines the real exchange rate in terms of domestic relative prices of tradable goods (PT) to non-tradable goods (PN). The real exchange rate is therefore “a ratio of prices of tradable goods to prices of non-tradable goods” (Bilson, 1978, p. 52). This ratio summarizes incentives that guide resource allocation across the tradable goods and non-tradable goods sectors.
An increase in real exchange rate in economic terms is a real depreciation and makes the production of traceable goods relatively profitable and thus induces resource movement out of the non-traceable sector into the traceable sector. This is the dependent economy concept of the real exchange rate.
The second category defines the real exchange rate (EPPP) as equal to the nominal exchange rate (E) multiplied by the ratio of foreign price level (P*) to the domestic price (P):
Eppp = E. P*/ P
Depending on whether P and P* are consumer or producer price, Eppp will be the relative price of foreign to domestic consumption or production baskets. This is the purchasing power parity definition of the real exchange rate.
Measurement of the real exchange rate
Notable models of measuring the real exchange rate include the Purchasing Power Parity (PPP), the Balance of Payments approach, the Monetary Models and the Portfolio Balance Model. Other variants of exchange rate models stem from one or more of these models.
The Purchasing Power Parity Model
This model determines the real exchange rate by adjusting the nominal exchange rate with the ratio of a foreign price index to a domestic price index,
Rt = E. Pt/P*t
Where Rt which is the exchange rate is defined as the domestic currency price per foreign currency, Pt is the domestic price index and P*t is the foreign price index. This is the absolute purchasing power parity. In relative form, the theory is stated in difference form as,
∆Rt = ∆Pt/∆ P*t.
Bilson (1978) provides a more sophisticated version of the purchasing power parity model by stating that the exchange rate is equal to the ratio of consumer prices while deviations from the equilibrium rate are primarily due to short term factors particularly interest rate differentials. In this model, if the equilibrium exchange rate is characterized by a stable exchange rate, then the equilibrium rate will be equal to the ratio of prevailing consumer prices (Frenkel, 1978, p. 182).
The traceable and non-traceable goods approach
This approach uses the relative prices of traceable goods and non-traceable goods to determine the exchange rate. Traceable goods are those produced by a country for export while non-traceable goods are those that are produced for home country use. It assumes that differences in production cost between countries are almost similar to the price structures in those countries. The real exchange rate in this model is given as;
Where Rt is the real exchange rate, Pt and P*t are the domestic and international prices of tradable goods respectively, while Pn is the price of non-traceable goods.
The Balance of Payments approach
This approach addresses the exchange rate as an asset price whose determination depends on the interaction between aggregate demand for and supply of respective assets (foreign currencies) as derived from underlying supplies of imports and exports (Bilson, 1978, p. 62).
In this model, movements in the exchange rate are derived from the corresponding initial movements in either the determinants of demand for imports, supply of exports or both. The model further identifies determinants of the exchange rate as changes in foreign reserves, relative foreign real incomes, interest rates differentials and net foreign asset earnings.
The monetary approach
The monetary model is based on two assumptions emanating from the model’s approach to the balance of payments: (1) Demand for money is a stable function of a limited number of economic variables and (2) In the absence of transportation costs and trade restrictions, the law of one price holds in international trade markets (Edwards, 1988, p. 40). The monetary approach concentrates on the mechanisms through which the exchange rate eliminates capital inflows.
This includes adjustment in real money balances through exchange rate induced price level variations and adjustment in nominal interest rate through changes in exchange rate depreciation. There are three main variants of the monetary model: The flexible price monetary model, the stick price monetary model and the real interest differential model. The key feature of these models is that demand and supply of money are the key determinants of the exchange rate.
The sticky price model developed by Dornbusch (1976) states that in the short run, wages and prices are sticky and only the exchange rate changes in response to changes in economic policy. Wages and prices only adjust in the long run in response to economic policies and exogenous shocks.
Moreover, wages are more likely to be sticky upwards than downwards while prices are likely to be sticky downwards than upwards (Dornbusch, 1976, p. 11). Price stickiness is explained by a phenomenon called menu costs that states that firms incur costs when they have to change their prices, for example costs of advertising the new prices to the public.
The flexible price model, on the other hand, assumes that purchasing power parity holds continuously hence prices and wages can adjust in the short run. In the model, flexible relative prices are key determinants of the exchange rate.
The real interest rate differential model developed by Frankel (1978) combines the stick price and flexible price models. The model’s equilibrium exchange rate is equal to both long run and short run exchange rates with a slight difference in the short run rates due to sticky prices. The model takes the expected inflation differential rates as the key determinant of the exchange rate unlike the monetary model that emphasizes money growth rates as the key determinant.
The portfolio balance model
This model assumes that investors view domestic and foreign bonds as having different risk profiles with different rates of return. The relatively risky bonds are taken as having higher interest rates and vice versa. Exchange rate is therefore, determined by the relative rates of returns of the various bonds on offer and the investors’ level of risk aversion.
Difficulties in measuring the real exchange rate
Various difficulties arise when measuring the real exchange rate. The first relates to the choice of price index to be used since different price indices can be used in the purchasing power parity approach. The main indices used are the consumer price indices and the wholesale price indices with the GDP deflator and the producer price indices providing alternatives.
The drawback of using the wholesale price index is that it traces price changes of tradable commodities whose prices may not differ substantially when valued by a standard currency (Bilson, 1978, p. 65).
Therefore, exchange rates measured using the wholesale price index may not give accurate estimates of a country’s level of competitiveness in the international markets. The same drawback is valid for the producer price index which also includes the prices of traceable commodities. The consumer price index also includes non traceable commodities while data on the GDP deflator is not available monthly.
The implication of distinguishing between traceable goods and not traceable commodities is that no single index can accurately trace movements of traceable and non traceable commodities. However, the exchange rate reflects the prices of both traceable and non-traceable goods without distinguishing between the two classes of commodities. Bilson (1978) suggests the use of the foreign country’s consumer price index to represent prices of traceable commodities and use the home country’s wholesale price index for non-traceable prices.
The choice of base year used in constructing the indices presents the second problem in measuring the real exchange rate. Different countries use different base years when constructing indices which may lead to an inaccurate interpretation of the exchange rates when two indices constructed using different base years are used. (Bilson, 1978) states that the base year chosen for a particular country should be one that exhibits both internal and external equilibrium in the economy.
Empirical and theoretical literature on the real exchange rate
Most empirical studies on the real exchange rate have focused on the purchasing power parity concept of real exchange rate due to the difficulty in obtaining reliable time series data on the prices of traceable goods and non traceable goods.
Although both the purchasing power parity and dependent economy concepts of the real exchange rate both capture the level of a country’s relative competitiveness, Edwards (1988) observes that the drawback of the purchasing power parity approach is in its inability to capture variations in incentives that guide resource allocation between production of traceable and non traceable goods.
Edwards further states that the purchasing power parity approach fails to provide accurate information on how relative prices affect the import and export sides of the balance of payments account.
Favaro and Spiller (1989) analyzed the determinants of the real exchange rate behavior in Uruguay using data from 1950-1984. Their regression results showed that an increase in capital inflows in Uruguay during this period resulted in a real exchange rate appreciation. Their results also found that an increase in the level of trade taxes especially import tariffs in Uruguay resulted in a real exchange rate appreciation.
Edwards (1988) investigated the role of capital inflows in determining the real exchange rate in Chile during the period 1977-1982. The results showed that an increase in net capital flows was associated with a real appreciation. He also found that a deterioration of the terms of trade resulted in a real appreciation.
Meridor and Pessach (1995) used real variables (government purchases, changes in production factors nod terms of trade) to explain changes in the real exchange rate in Israel during the 1960s and 1970s. Results showed that external terms of trade had a positive coefficient when elasticity of the real exchange rate to the terms of trade was less than one and the coefficient of the government purchases was negative.
Edwards (1988) used data for 12 developing countries to test the important real and monetary determinants of the real exchange rate. Using panel data in his estimation, results showed that measures of macroeconomic policy were significantly positive implying real exchange rate appreciation while increase in terms of trade resulted in an equilibrium real appreciation with government expenditure having a positive coefficient in several estimation equations implying real depreciation.
Some implications of the real exchange rate
The real exchange rate is a macroeconomic variable that impacts on other variables in the economy. Two effects are analyzed in this paper: The effect on tax revenues and the effect on inflation.
The real exchange rate and tax revenues
The real exchange rate is one of the macroeconomic variables that affect tax revenue. This relationship can be analyzed from two perspectives: The direct relationship and the indirect relationship. The direct relationship between real exchange rate and taxes is a negative relationship between the real exchange rate appreciation and tax revenues especially on trade taxes.
Appreciation of exchange rate causes a fall in value of a country’s imports measured in domestic currency; hence a fall in import revenues especially when import duties are levied on an ad-valorem basis. In the same way, appreciation of real exchange rate results to a drop in value of exports which is the export tax base for countries that levy taxes on exports.
The real exchange rate similarly affects revenue through several indirect channels (Bautista, 1987, No. 59). For instance, an appreciation of the real exchange rate reduces the incentive to produce goods for export since exports under a strong domestic currency will have a lower domestic value compared to the value under a weak domestic currency.
Reduced exports in turn reduce a country’s revenue base and its foreign exchange earnings. That is perhaps the reason why China has been devaluing its currency to the chagrin of her trading partners.
The real exchange rate and inflation
The real exchange rate affects inflation through a phenomenon known as the pass-through effect. The proposition of this effect is that increase in import prices following currency devaluation is passed on to domestic prices. A real devaluation of domestic currency raises the prices of imports hence an increase in the domestic price of imports leading to supply induced inflation.
For instance, devaluation of the currency of an oil importing country with respect to the dollar (that is used in the international oil market) increases the price of that country’s oil imports. An increase in the oil import bill will lead to price increase in other sectors of the economy such as transportation and manufacturing leading to a general increase in the inflation rate (Dornbusch, 1976, p. 15).
The United States exchange rate regime
In the United States, policy directions regarding the exchange rate are given by the treasury department and the Federal Reserve System, the two statutory monetary authorities in the United States. These two bodies set the exchange policies that are in turn implemented through operations of the Federal Reserve Bank, New York in the foreign exchange markets.
These two bodies can intervene in the foreign exchange markets using various policy instruments to stabilize the dollar when the dollar comes under speculative attack and consequently gives a misrepresentation of the prevailing fundamentals of the overall United States’ economy. If for instance the dollar depreciates against major currencies due to speculation, the monetary authorities can elect to raise the Federal Reserve rate in order to reverse the depreciation.
They can also elect to release more foreign currencies in the market and simultaneously buy back dollars from the market. However, most of these interventions are rare and are only short term interventions. Foreign currencies that are used in the intervention process come from treasury’s exchange stabilization fund and the Federal Reserve holdings (Favaro, and Spiller, 1989).
Despite several approaches of defining the real exchange rate, the one that is ubiquitous in academic literature defines the real exchange rate as the nominal exchange rate adjusted by a ratio of price domestic and foreign price indices. The real exchange rate reflects the level of a country’s competitiveness in the international market.
Demand for a currency reflects demand for that country’s exports. For instance, if a country is a major exporter of tea then other countries will demand her currency in order to finance their tea purchases. However, most international trade transactions are dollar denominated hence the level of a country’s competitiveness and the value of her currency is determined by the strength of that currency against the dollar.
Various empirical studies have been undertaken to analyze the determinants of real exchange rates in different countries. Some of the key determinants arising from these studies include capital inflows, terms of trade and macroeconomic policy. The real exchange rate on its part affects other macroeconomic variable such as prices and tax revenues (Bilson, 1978, p. 68).
However, it is perhaps its effect on a country’s balance of payment account and its indication of a country’s level of competitiveness that makes it a key concern of monetary policy authorities. It is a macroeconomic policy instrument that can be used to achieve economic stability.
Bautista, R. (1987). Production incentives in Philippine agriculture: Effects of trade and exchange rate policies. IFPRI research report No. 59. International Food Policy Research Institute, Washington D.C.
Bilson, J. (1978). The Monetary Approach to Exchange Rate: Empirical evidences. IMF staff Papers 25, 48-75.
Dornbusch, R. (1976). Expectations and Exchange Rate Dynamics. Journal of political economy, 84, 1-18.
Edwards, S. (1988). Real and monetary determinants of the real exchange rate behaviour: Theory and evidence from developing countries. Journal of development economics 29, 34-41
Favaro, E. and Spiller, P. (1989). Determinants of real exchange rates in post war Uruguay. World Bank, Washington D.C.
Frenkel, J. (1978). The purchasing power parity: Doctrines and perspectives from the 1920s. Journal of Economics 9, 169-191.