Understanding Finance from scratch

Chapter 41 Does Rising Exchange Rates Affect Our Lives—Finance for International Trade (1)
Exchange rate: the focus in the chaotic game
On July 2005, 7, the People's Bank of China announced that my country began to implement a managed floating exchange rate system based on market supply and demand and adjusted with reference to a basket of currencies.According to the calculation of the reasonable and equilibrium level of the exchange rate, starting from July 21, the RMB will appreciate against the US dollar by 7%, that is, 21 US dollar to 2 yuan.

After the news of the appreciation of the RMB exchange rate came out, there were many discussions at home and abroad.So why is the exchange rate so touching?What is the difference between a floating exchange rate and a fixed exchange rate?

To put it bluntly, the exchange rate is the ratio of one country's currency to another country's currency, which is the price of one currency expressed in another currency.Since the names and values ​​of the currencies of various countries in the world are different, a currency of one country must have an exchange rate for the currencies of other countries, that is, the exchange rate.

The reason why the currencies of various countries can be compared and form a mutual price comparison relationship is that they all represent a certain amount of value, which is the basis for determining the exchange rate.Under the gold standard system, gold is the standard currency.The currency units of two countries that implement the gold standard system can determine the exchange rate between them according to their respective gold content.For example, when implementing the gold coin standard system, the British stipulated that the weight of 1 pound was 123.27447 grains, and the fineness was 22 carats, that is, the gold content was 113.0016 grains of pure gold; the United States stipulated that the weight of 1 dollar was 25.8 grains, and the fineness was 900‰, that Gold content 23.22 grains of pure gold.According to the comparison of the gold content of the two currencies, 1 pound = 4.8665 US dollars, and the exchange rate fluctuates up and down on this basis.Under the paper money system, countries issue paper money as a representative of metal currency, and refer to the past practice, to stipulate the gold content of paper money by decree, which is called the gold parity. The comparison of the gold parity is the basis for determining the exchange rate between the two countries.

But the situation of banknotes is different, it cannot be exchanged for gold, therefore, the legal gold content of banknotes is often useless.Therefore, in countries that implement an official exchange rate, the exchange rate is set by the national monetary authority (the Ministry of Finance, the Central Bank or the foreign exchange management authority), and all foreign exchange transactions must be carried out in accordance with this exchange rate.

So what are the factors that affect exchange rate fluctuations?

The difference between imports and exports is the main factor.Export is the process of selling domestic goods or services abroad, which is the process of earning foreign exchange (earning foreign exchange); import is the process of purchasing foreign goods or services with foreign exchange, and is the process of paying foreign exchange.If a country exports more goods and services than it imports, resulting in a trade surplus, the country earns more foreign exchange and spends less foreign exchange, that is, there is more supply of foreign exchange and less demand. At this time, the price of foreign exchange— - The exchange rate will naturally fall, and the country's currency will appreciate accordingly.Over the past few years, my country has been facing a huge and sustained trade surplus, and therefore the RMB is also facing pressure to appreciate.On the contrary, if a country’s exports of goods and services are less than its imports, and a trade deficit occurs, correspondingly earning less foreign exchange, spending more foreign exchange, less foreign exchange supply, and more demand, at this time, the foreign currency exchange rate will naturally rise, and the country’s currency may Not very valuable, facing the pressure of depreciation.

The difference between inflow and outflow of capital.When a country has more capital inflow than capital outflow, the country will have a capital account surplus, that is, the supply of foreign exchange is large and the demand is small, and the exchange rate of foreign currency will naturally fall.On the contrary, if a country's capital outflow exceeds capital inflow, the country will have a capital account deficit, and the foreign currency exchange rate will tend to rise.

Interest rate differentials are also an important factor.With the integration of the world economy, the flow of capital between countries has become more and more free.If a country's interest rate is higher than that of other countries, a large amount of capital will flow in and be converted into the country's currency to obtain higher interest rates, which will promote the appreciation of the country's currency.Conversely, if the country's interest rates are lower than those of other countries, there will be pressure to depreciate its currency.

The level of inflation will also affect the exchange rate.If a country's inflation rate is high, it means that the purchasing power of the country's currency will decline. Compared with countries with a low inflation rate, its currency will naturally have pressure to depreciate.Conversely, if a country has a lower inflation rate than other countries, its currency tends to appreciate.

People's psychological expectations are also an important factor affecting short-term exchange rate fluctuations.If people believe that a country's economic development is worrisome, or the political situation is unstable, and the currency is expected to depreciate soon, they will sell the country's currency.As a result, the country's currency suffered a severe depreciation and even a currency crisis broke out.

The government's intervention in the exchange rate also affects the exchange rate to a large extent.For example, in 1985, the United States was suffering from high fiscal and trade deficits, and the appreciation of the dollar exacerbated its trade deficit, so the United States and Western powers reached the famous "Plaza Agreement", and the governments of various countries jointly invested 200 billion U.S. dollars in foreign exchange The market buys yen, and as a result, the dollar depreciates sharply and the yen appreciates sharply.

Let me talk about the floating exchange rate system we are currently implementing.The official adoption and general implementation of the floating exchange rate system began after the dollar crisis intensified in the late 20s.

When an old system breaks down, it doesn't mean a perfect new system is in sight.In the early 20s, the main members of the IMF met meeting after meeting to try to create a new system to replace Bretton Woods, but failed to reach an agreement.In the absence of anyone able to devise a new system, the financial world has naturally moved into a floating exchange rate system.From the Smithsonian agreement in 70 to the establishment of the floating exchange rate regime in 1971, it was a period of trial and error.Almost everyone was groping for the right exchange rate level, and everyone was trying to maintain stability in this new and unfamiliar environment.Not long after the Smithsonian agreement, the world struggled for a time to support this new parity relationship, known as the "central exchange rate."But this time the system lacks the necessary cornerstone of a dollar backed by gold.Efforts to restore a system of fixed parity, central exchange rates, or whatever it is called will in fact fail as long as the differences between the important economic variables of the major economic powers are not eliminated.

In this context, the new forum of the C-20 made real efforts to re-establish a sustainable exchange rate regime, but conflicting national interests crushed any hope of an early agreement. In the autumn of 1973, the first oil shock changed global capital flows, and countries around the world gradually realized that there was no practical alternative to a floating exchange rate system, and that there was no hope of returning to a fixed exchange rate system in the foreseeable future.

A floating exchange rate would solve these problems through the law of supply and demand without political significance.No country has to give up its national prerogatives to choose a certain exchange rate.There is also no obligation on a country to back its own currency by intervening, so that liquidation problems are avoided, as market forces will force the economy to adjust itself.Therefore, it is only necessary to revise the agreement of the International Monetary Fund to legalize the floating exchange rate system.Gold must be freed from its official price, and a mechanism must be established within the IMF to enforce international oversight to prevent the floating system from being abused to gain an unfair competitive advantage.

The combination of rising inflation and the oil shock of late 1973 took a long time to establish an international monetary system characterized by a floating exchange rate currency.By the mid-20s, revisions to the terms of the IMF's agreement gave floating currencies another layer of sanctity.And by the end of the 70s, it had so deeply influenced academic thought, government policy, and bank practice that those who aspired to implement fixed exchange rates on a larger scale or on a more general basis were all denied.

However, people's satisfaction with the actual operation has not improved with the progress of the reform (that is, the change from a fixed exchange rate system to a floating exchange rate system).Quite the contrary, the recession of the mid-20s was the worst since the war, and inflation was staggeringly high.The road is bumpy, and all currency indices are showing ominous signals: huge exchange rate volatility, rapid increases in world reserves and national money supplies, and high interest rates.The so-often hope that when the world adjusts to floating exchange rates, both exchange rates and economic conditions will stabilize are beginning to fade.

The Theory of Exchange Rate Determination Along the Way
2008年4月10日有这样一条新闻：来自中国外汇交易中心的最新数据显示，4月10日，人民币对美元汇率中间价“破7”，以6.9920改写了汇改以来的新高纪录。在全球关注的目光中，人民币汇率毫无悬念地进入了“6时代”。

以2005年汇改前的人民币对美元比价8.2765：1计算，目前人民币对美元累计升值超过18％。而2008年以来短短的3个多月中，人民币汇率升幅也达到4.27％。

So why is the exchange rate so important?How did the exchange rate determination theory develop?

The theory of exchange rate determination is one of the core contents of international financial theory, which mainly analyzes what factors determine and influence the exchange rate.The theories of exchange rate determination are all the most adequate, effective and closest descriptions of the exchange rate mechanism at that time under specific economic, financial and political backgrounds in different historical periods.Exchange rate determination theories mainly include international lending theory, purchasing power parity theory, interest rate parity theory, balance of payments theory, and asset market theory.Asset market theory is divided into currency analysis method and asset portfolio analysis method.Currency analysis is divided into elastic price currency analysis and sticky price currency analysis.However, we will not discuss it here. The focus is on the evolution history of the exchange rate determination theory.

In the Middle Ages, the commodity economy of various countries developed greatly, the currency system was relatively sound, and currency exchange began to be regularized, so people began to pay attention to the issue of exchange rates.From then to now, the monetary system has experienced the precious metal standard system, the metal exchange standard system and the credit paper currency standard system, from which we can also trace the development track of the exchange rate theory.

In 1642, another scholar, Lu Guo, proposed that the exchange rate is determined by the intrinsic value of currency, that is, the gold content, while its change is affected by the external value, which mainly depends on the supply and demand of currency.Scholars in the Middle Ages explained the determination of the exchange rate and its changes mainly in two points: one is that the determination of the exchange rate is based on coin parity; the other is that the change of the exchange rate is affected by the scarcity or abundance of money.

Montesquieu, a representative of the French Enlightenment in the 18th century, made a detailed analysis of currency exchange ratios.He gave the concepts of absolute value and relative value of money.He believed that the monarch could stipulate the following relations: the ratio between the quantity of silver as metal and silver as currency; the ratio of various metals used as currency; the weight and fineness of each currency; The imaginary value mentioned above.He called the value of money in these four relationships absolute value.The value of the money of each country when compared with the money of other countries is called the relative value, and the relative value is based on the absolute value, established by exchange, and based on the most extensive valuation of the merchants.The exchange rate of a currency thus determines the current temporary value of the currency.He also analyzed the exchange parity and pointed out that if French silver coins of the same color and weight can be exchanged for the same amount of silver coins in the Netherlands, it is called exchange parity.If it is higher than parity, the exchange rate of the local currency is high, otherwise, the exchange rate is low.

So far, the exchange rate theory introduced so far was in an era when precious metal standards were widely practiced in all countries, among which the gold standard was the most typical.Under this system, the ratio of the gold content between the currencies of the two countries, that is, mint parity, is generally considered to be the basis of the currency exchange rate between the two countries.The exchange rate theory in this period was almost the theory of mint parity, and the differences among the various theoretical schools were only reflected in the explanation of exchange rate changes.

From the late 19th century to the 20s, the capitalist economy generally went through two stages. The former stage was sustained economic growth, and the latter stage was during the two world wars. This is exactly when capitalism changed from free competition to monopoly stage transition period.The research on the exchange rate in this period combined the reality from the gold standard system to the non-convertible paper currency system, and the research of five economists deserves attention.They are Gossen, Valla, Aftarion, Kassel and Cairns.For example, Walras used the general equilibrium method to analyze the problem of exchange rate determination.Through analysis, it is found that the exchange rate is inversely proportional to the remittance based on which the two are reciprocal.This is because the exchange rate is essentially the price of a unit of currency in any region or a certain amount of currency when it is paid in other regions.He also pointed out that the exchange rate has a fixed limit, which is the transportation cost of a unit of gold.He gave the general equilibrium condition of the exchange rate, when the foreign exchange rate of any one area to any other area is equal to the ratio between the foreign exchange rates of these two areas to any third area respectively, then the overall exchange rate can be achieved Balance, when the overall balance is disturbed, it will be restored through arbitrage activities.

The idea of ​​interest rate parity can be traced back to the Middle Ages, but the real symbol of the formation of interest rate parity theory is Keynes's "On the Reform of Currency" completed in 1923.At that time, frequent exchange rate fluctuations, currency depreciation, and changes in the gold standard caused great changes in international currencies.Keynes put aside the traditional theory of exchange rate determination under the gold standard, and studied exchange rate issues under the new situation.He regards the essence of the exchange rate as the relative price of the currencies (assets) of the two countries.A sum of money can be invested in the country or abroad, and the demand for foreign currency is due to foreign investment.Investment is the result of interest comparison. Investment generates international capital flows, and the exchange rate depends on the comparison of interest rates in different countries and periods.In this way, Keynes established the classical interest rate parity theory, that is, the forward exchange rate theory. The forward exchange rate is determined by the short-term deposit spread and fluctuates around the interest rate parity.

Later developed by other economists, the theory of interest rate parity gradually matured. Its basic idea is: in the absence of transaction costs, the forward foreign exchange level must be equal to the interest rate differential.This is because people can buy foreign bonds risk-free.Therefore, when investors choose between local currency bonds and foreign currency bonds, once the forward exchange rate premium is smaller than the interest rate difference, people will sell foreign currency bonds and buy local currency bonds, and the funds will flow into the country to lower the interest rate; vice versa.Therefore, people's arbitrage behavior makes capital flow freely, and finally eliminates the deviation of interest rates in various places, so that the real interest rates are equal.

According to the theory of interest rate parity: if the domestic and foreign interest rates are equal, the forward exchange rate is equal to the spot exchange rate, that is, the forward price difference (premium or discount) is equal to zero; if the domestic interest rate is higher than the foreign interest rate, the forward foreign exchange price difference must be a premium; If the foreign interest rate is higher than the domestic interest rate, the forward foreign exchange spread must be at a discount.

The research of several other economists during this period is also worthy of attention.The exchange parity theory of the Swedish economist Wixel is the gold parity theory based on the gold standard system.He believed that when foreign claims and debts were nearly equal, the price of foreign bills of exchange at maturity would be roughly equal to the ratio of the gold content of the domestic currency to the foreign currency.The exchange rate fluctuates around this parity and is affected by supply and demand.Marshall was the first to distinguish between domestic and foreign causes of currency depreciation.He pointed out that whether a country's currency exchange rate is set high or low should be measured by the purchasing power of the two currencies. Not all currency depreciations can stimulate exports. Only when the capital flight caused by political panic When the exchange rate falls, the value of the exchange rate will stimulate exports.Once capital flight stops, the exchange rate adjusts immediately to return to the basis of the relative purchasing power of the two countries.Ohlin believes that anything that affects the supply and demand of foreign exchange can affect the exchange rate, including changes in fundamental conditions, monetary policy, capital transfers, and so on.

Understanding the Mystery of Purchasing Power Parity

The "Big Mac Index" launched by "The Economist" is a classic case.If a McDonald's Big Mac costs $2 in the US and £1 in the UK, then according to purchasing power parity, the exchange rate is £1 to $2.If the current market exchange rate is 1 pound to 1.7 US dollars, then the pound is called an undervalued currency, while the US dollar is called an overvalued currency, and this theory believes that the future exchange rate will tend to change to a par exchange rate of 2 dollars to 1 pound.

This short story simply explains the meaning of purchasing power parity, so how did purchasing power parity appear?

In economics, it is an equivalence coefficient between currencies calculated according to different price levels of various countries, so as to make a reasonable comparison of the gross domestic product of various countries.As an important international economic comparison method, purchasing power parity refers to the price ratio of goods (goods and services) in different countries, that is, the quantity of goods that can be purchased by the unit currency of the base country, and the amount of currency that is needed in the country when purchasing in the comparison country .

(End of this chapter)