Exchange Rate Misconceptions: 2001 to 2005
By: Ryan Pitylak
University of Texas, Austin
10/13/2005
Introduction
Typically, a decrease (increase) in interest rates should lead to depreciation (appreciation) of an exchange rate under the interest parity condition, if expected exchange rates and foreign interest rates stay constant. Between January 2001 and November 2001, the exchange rate of the dollar vis-à-vis the euro did not depreciate. The main reasons why the exchange rate did not depreciate are: 1) the large capital inflows into the United States because of a preference for U.S. asset; and 2) the lack of expected exchange rate decreases. Between June 2003 and January 2005, the exchange rate depreciated, contrary to the interest parity condition mentioned above. This deprecation was caused by two main factors: the shift to U.S. assets which initially led to an appreciation, and a shift in preference towards foreign goods relative to U.S. goods.
Part I : Dollar Appreciation vis-à-vis the Euro (2001)
Economists have conducted a large volume of research on the subject of the dollar appreciation during 2001. There has been a lot of dissent about the reasons for the appreciation. The dollar appreciated despite interest rate decreases according to Oliver
|
|
Table 1
Sources: European Central Bank (2005): Key ECB interest rates; Federal Reserve Bank of New York (2005): Federal Funds Data
|
|
Blanchard, Francesco Giavazzi, and Filipa Sa (2005). Between January 1999 and January 2001, the dollar appreciated 19.67% ((.9484-1.1807)/1.1807). By looking at Table 1, you can see that during 2001, the dollar appreciated 4.6% ((.9042-.9484)/.9484). Interest rates declined in the United States from 6.67% in January 2001 to 2.61% in November 2001, and continued declining until June 2004. Despite the drastic decline in interest rates during 2001, neither did forward exchange rates appreciate, nor did foreign interest rates decline enough to explain the combination of the dollar appreciation and the United States interest rate decreases during that period, under the interest parity condition. Forward exchange rates actually appreciated 5.32% ((.901-.9517)/.9517) during 2001.
Figure
1
Source: Mann (2004)
When the condition that the perfect substitutability of assets is relaxed for the interest parity condition, an exchange rate appreciation in conjunction with declining interest rates is possible, as was the case in 2001. This condition is replaced with the assumption of imperfect substitutability of foreign and domestic assets (Blancard, Giavazzi, and Sa 2005). The substitutability of assets relies on a bias of investors and central banks for specific domestic or foreign capital. Foreign purchases of U.S. assets can be seen in Figure 1. Looking at Figure 1, the preference for United States assets that started in 1995 becomes apparent.
Ron Alquist and Menzie Chinn claim that the difference in productivity between Europe and the United States was one of the causes for the bias for United States assets (Alquist, Chinn 2002). Bernd Schnatz (2003) explains that the dollar appreciation vis-à-vis the euro could not be explained only by productivity differentials. Schnatz reconstructs the standard productivity model to account for GDP per hour worked. This productivity differential accounts for 18% of the appreciation of the dollar vis-à-vis the euro. In contrast, the productivity model analysts in the exchange rate market would have used during 2001 would have suggested that the productivity differentials should have accounted for 41% of the appreciation of the dollar vis-à-vis the euro (Schnatz 2003). Schatz argues that this miscalculation may have caused the exchange rate to appreciate.
Another cause of large capital inflows to the United States was the Asian Financial Crisis in 1997. Investors needed a safe place to put their money after this problem. Meanwhile, good policy by the U.S. Central Bank, and faster U.S. economic growth after 1995, kept the position of the dollar strong. This led to a shift in preference for U.S. assets that began with private investors. The increased demand for U.S. currency led to an appreciation of the dollar because real money supply rates were not changing drastically. (Christian E. Weller and Laura Singleton 2002)
An alternative view for the preference for dollars was the strength of the dollar against most other currencies: “U.S. market capitalization rose from about 80% of GDP [Gross Domestic Product] in 1994 to 180% in 1999, an increase of 2¼ times” (Meredith 2001). The large initial value of the GDP compared to the euro-area markets was one reason why capitalization was 40% larger in the United States. Consumers had a higher marginal propensity to consume because wealth was gained through the equity market. This consumption was biased towards domestic products because the consumption basket of the domestic (United States) market is composed primarily of domestic products. This increased demand for domestic products led to a currency (dollar) appreciation (Meredith 2001).
Meredith (2001) asserts that the introduction of the euro brought a shift in capital market activity in Europe that caused a depreciation (appreciation) of the euro (dollar) vis-à-vis the dollar (euro). The shift occurred for several reasons: euro debt was issued outside the euro area; foreign-currency debt was replaced with euros by euro-area borrowers; and the diversification into non-euro assets by euro-area lenders. This shift increased the supply of euro assets relative to the demand of these assets. The increased supply of these assets led to a depreciation (appreciation) of the euro (dollar). (Meredith 2001)
Part II: Dollar Depreciation vis-à-vis the Euro (2003-2005)
The explanation for the dollar deprecation vis-à-vis the euro between 2003 and 2005 is
Figure 2
Source: Mann (2004)
more straight forward. The shift in bias for U.S. assets before 2002 contributed to the 24.27% (19.67+4.6) appreciation of the dollar. A natural correction followed from this appreciation because of the current account deficit created during this type of appreciation (Blanchard, Giavazzi, Sa 2005). The current account has been in a deficit since 1999. Table 2 shows that
|
the current account balance from 1999, 2000, and 2001 was $-1007B ($-260B+$-380B+$-367B). The high level of net debt, along with skepticism in the media about the financial stability of United States corporations, led to an outflow of capital from the United States. Consumers in foreign countries increased their consumption after their wealth increased because of the bias for goods produced in their own country (Blanchard, Giavazzi, Sa 2005). This was another reason for the deprecation of the dollar. A countering effect to this home |
|
Table 2
Source: Bureau of Economic Analysis (2005): National Income and Product Accounts Table |
||||||||||||||
|
bias is that a cheaper dollar leads to increased exports from foreign demand, and decreased imports because foreign goods are more expensive in the United States. In sum, these effects have attributed to the dollar depreciation, despite the interest rate increases. Figure 1 shows that there was an interest rate increase from 1.3% in January 2003 to 3.02% in June 2005. This has not led to the exchange rate appreciation expected under the interest parity condition. The interest parity condition has been relaxed for the same reason stated in Part I of this paper. |
||||||||||||||||
Conclusion
Interest parity condition advocates would be amazed at what has happened over the past few years. The assumption of the substitutability of assets in the pure interest parity condition is wrong. A bias for United States assets caused large capital inflows into the United States before 2002, which caused an appreciation of the dollar. Between June 2003 and January 2005, the exchange rate depreciated, despite interest rate increases. The current account deficit, and an increased preference for more foreign goods, has contributed to the dollars’ deprecation.
References
Ali Al-Eyd, Ray Barrell and Olga Pomerantz (2005), “Dollars and Deficits – The US Current Account and its Exchange Rate Consequences,” National Institute Economic Review, Issue 191 (31-36)
Bernd Schnatz, Focco Vijselaar, Chiara Osbat (2003), Productivity and the “Synthetic” Euro-Dollar Exchange Rate, Germany: European Central Bank
Bureau of Economic Analysis (2005), Washington D.C.
Christian E. Weller and Laura Singleton (2002), Reining in exchange rates: A better way to stabilize the global economy, Washington D.C.: Economic Policy Institute
Corsetti, Giancarlo (2004), Productivity and the Euro-dollar Exchange Rate, Florence, Italy: European University Institute
European Central Bank (2005), Germany
Federal Reserve Bank of New York (2005), New York, New York
Lewis, Vivien (2005), Productivity and the real euro-dollar exchange rate, Leuven, Belgium:
Mann, Catherine (2004) “Managing Exchange Rates: Achievement of Global Re-balancing or Evidence of Global Co-dependency?,” Business Economics, July (20-29)
Maurice Obstfeld and Kenneth Rogoff (2005), The Unsustainable US Current Account Position Revisited, Cambridge, MA: National Bureau of Economic Research
Meredith, Guy (2001), Why has the euro been so weak, Washington D.C.: International Monetary Fund
Olivier Blanchard, Francesco Giavazzi, Filipa Sa (2005), The U.S. Current Account and the Dollar, Cambridge, MA: MIT
Poole, William (2004), “A Perspective on U.S. International Capital Flows,” Federal Reserve Bank of St. Louis Review, Issue 86 (1-8)
Richard Portes (2001), Monetary Policy Issues 2001 Q1, London, United Kingdom: London Business School
Ron Alquist, Menzie D. Chinn (2002), Productivity and the Euro-Dollar Exchange Rate Puzzle, Cambridge, MA: National Bureau of Economic Research
Shams, Rasul (2005), Dollar-Euro Exchange Rate 1999-2004 - Dollar and Euro as International Currencies, Hamburg, Germany: Hamburg Institute of International Economics