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Chapter 15 Exchange Rate: Leveraging the Pivot of Global Trade (1)
what is the exchange rate

There is such a story about exchange rate and economy.

The story takes place in a small town on the border between the United States and Mexico.A tourist bought a glass of beer for 0.1 pesos in a small town on the side of Mexico. He paid 1 peso and got back 0.9 pesos.He went to a small town on the American side and found that the exchange rate between the US dollar and the peso was 1 US dollar: 0.9 pesos.He exchanged the remaining 0.9 pesos for 1 dollar, bought a beer with 0.1 dollars, and got back 0.9 dollars.Back in his small town in Mexico, he found that the exchange rate between pesos and dollars was 1 peso: 0.9 dollars.So, he exchanged 0.9 dollars for 1 peso, and bought beer to drink, so that he would still have 1 dollar or 1 peso in the two small towns.In other words, he got free beer.

Why does this tourist always get free beer in both countries?
The mystery of the story is that the exchange rates of the two countries are different.In the United States, the dollar-peso exchange rate is 1:0.9, but in Mexico, the dollar-peso exchange rate is about 1:1.1.In Mexico, the peso-dollar exchange rate is 1:0.9, but in the United States, the peso-dollar exchange rate is about 1:1.1.The tourist relied on the difference in exchange rates between the two countries to carry out arbitrage (arbitrage) activities and drink free beer.Free beer means that the drinker pays nothing, but the hotel still gets paid.Who paid for it?If the U.S. exchange rate is correct and Mexico undervalues ​​the peso, the beer is paid for by Mexico.If Mexico's exchange rate is correct and the U.S. undervalues ​​the dollar, the beer is paid for by the U.S.If neither country has the correct exchange rate, the money is paid jointly by both parties.

Exchange rate is also known as "foreign exchange market or exchange rate".The exchange rate of one country's currency to another country's currency 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.

Exchange rate is the most important adjustment lever in international trade.Because the cost of goods produced in a country is calculated in its own currency, if it wants to compete in the international market, the cost of its goods must be related to the exchange rate.The level of the exchange rate will directly affect the cost and price of the commodity in the international market, directly affecting the international competitiveness of the commodity.

An important consideration for Japan and the United States to demand the appreciation of the renminbi is that the appreciation of the renminbi will greatly increase the cost of China’s export products in the international market, hurt the competitiveness of Chinese products, and in turn stimulate China to import their products in large quantities.

Of course, the impact of the exchange rate on the economy is far from being so intuitive and simple.The exchange rate is also closely related to the domestic price level.This point can also be expressed through a shallow story widely circulated on the Internet.

It is said that an alien came to the earth and found a delicious fruit. He said, "I want to eat this kind of fruit." If you buy it in China, you can buy it for [-] yuan, and if you go to Europe, you can buy it for [-] euro."

The alien said: "Then I'll buy one for [-] euro."

People on Earth said: "Slow! In fact, you don't need to spend money. You can borrow one fruit from China and exchange it for 10 euro in Europe. If you take 90 euro to China, you can exchange it for 900 fruits. You can return one fruit to China." People, you get [-] berries for nothing, you take another [-] berries and exchange them for [-] euros, then go to China to exchange [-] berries, then take these [-] berries and exchange them for [-] euros, and then go to China to exchange [-] berries Fruits...if this continues, you will take away all the fruits in China!" The alien said in surprise: There is such a good thing!Then why don't the Chinese ship the fruit to Europe to sell it for money?

"Because the Chinese government needs to export foreign exchange, it stipulates that 10 yuan = 10 euro, which means that [-] Chinese fruits are equal to one European fruit. Even if you sell Chinese fruits, you can't make money."
"It's no wonder that China's foreign exchange reserves are the largest in the world! Then what is China going to do with so much foreign exchange?"

"Temporarily speaking, so much foreign exchange has not come in handy yet! Because if China spends this money in foreign countries, it will play the role of only buying one fruit, which means that there are 10 fruits in hand, and once exchanged It becomes only [-] fruit, and if it is exchanged again, it will become [-] fruit, and if it is exchanged again, it will become [-] fruit... Then the more exchanges in this way, the poorer it becomes. Now China replaces it with RMB, So now we have more and more renminbi, which will cause inflation.”
The impact of exchange rates on the economy is profound.Therefore, China's exchange rate system is reforming towards a free floating exchange rate system.However, since exchange rate fluctuations will bring about large-scale fluctuations in import and export trade, the primary key to monetary exchange rate policy is to be stable, and reforms should be gradual.This is exactly what China's monetary policy hopes to achieve.

The law of one price: the relationship between commodity prices and exchange rates
When 1 US dollar = 8 yuan, a commodity that sells for 2 dollar in the United States should sell for 1 yuan in China, that is, the price in US dollars should also be 8 dollar.In this example, whether the commodity is overvalued or undervalued in China or the United States, it will cause the movement of the commodity in the two markets until the prices in the two markets are exactly the same.

The law of one price can be simply expressed as: when trade is open and transaction costs are zero, the same goods will have the same price no matter where they are sold.Because the price of a certain commodity is different in different countries, as long as the price difference exceeds the transportation cost, speculators will buy this commodity from the country with low price, and then ship it to the country with high price to sell it, so as to level the price .If transportation costs are not considered, the law of one price can be written as Ph=S×Pf (where Ph is the domestic price of a certain commodity, Pf is its foreign price, and S is the spot exchange rate of foreign currency expressed in domestic currency).

The law of one price is a theory about the price relationship of a certain commodity in different countries.This reveals a fundamental link between domestic commodity prices and exchange rates.

The law of one price holds that in a free competitive market without transportation costs and official trade barriers, the price of the same commodity sold in different countries should be equal if it is priced in the same currency.

According to the theory of the law of one price, the value of any commodity in different countries is the same. (The prices after exchange rate conversion are the same.) If there is a price difference among countries, international trade of goods will occur until the price difference is eliminated and trade stops. At this time, the equilibrium state of the commodity market is reached.

This law applies to commodity markets, and a similar law that applies to capital markets is the theory of interest parity.

The theory of interest parity means that in the process of capital circulation, capital should have the same value in different countries, and the price after exchange rate conversion should be the same in all countries. If there is a price difference between countries, international capital trade will occur. Until then The price difference is eliminated, trade stops, and the equilibrium state of the capital market is reached.

Although the equilibrium state it describes is difficult to achieve in the current economic environment, economic development follows this law.

"Big Mac" Index - Purchasing Power Parity Theory
In September 1986, the famous British magazine "The Economist" launched an interesting "Big Mac Index".The Big Mac index (Big Mac index?) is an informal economic index used to measure whether the exchange rate between two currencies is theoretically reasonable.Assuming that a McDonald's Big Mac costs $9 in the United States and £4 in the UK, economists believe that the purchasing power parity exchange rate between the dollar and the pound is £3-$3.And if the price of a McDonald's Big Mac is US$4 in the United States, 2.54 pounds in the UK, 1.99 euros in the Eurozone, and 2.54 yuan in China, then economists infer from this that the RMB is the most valuable currency in the world. Most undervalued currency.Because according to the law of one price, the same commodity should have the same price all over the world.If the Big Mac index is greater than 9.9, it means that the price of McDonald's in this country is lower than that of the United States, and vice versa.From the perspective of the exchange rate, it means that the exchange rate of the country's currency is undervalued, or the exchange rate of the US dollar is overvalued.

The price of the same product in currencies around the world varies greatly, and is completely inconsistent with the official exchange rate conversion. Therefore, in the eyes of some Western economists, McDonald's Big Mac has become an index for evaluating the true value of a currency.

"Big Mac Index" derived the term "Burgernomics" (hamburger economy) in English-speaking countries. Every year after 1986, "The Economist" publishes a new "Big Mac Index", which has become popular all over the world.

The main premise of purchasing power parity is that the exchange rate of two currencies will naturally adjust to a level, so that the price of a basket of goods in the two currencies is the same (the law of one price).In the Big Mac index, the "basket" of goods is a Big Mac hamburger sold in McDonald's fast food restaurants.The reason for choosing the Big Mac is that the Big Mac is available in many countries, and its production specifications are the same everywhere, and the local McDonald's distributors are responsible for negotiating prices for the materials.These factors allow the index to meaningfully compare national currencies.

The PPP exchange rate for Big Macs between the two countries is calculated by dividing the local currency price of a Big Mac in one country by the local currency price of a Big Mac in the other country.The quotient is used to compare with the actual exchange rate; if the quotient is lower than the exchange rate, it means that the exchange rate of the currency of the first country is undervalued (according to the theory of purchasing power parity); on the contrary, if the quotient is higher than the exchange rate, the first The exchange rate of the national currency is overvalued.

The Big Mac Index is an informal economic index used to measure the theoretical rationality of the exchange rate between two currencies.The basic premise of this measurement method is to assume that the purchasing power parity theory is established.

After the First World War, the world economy was in turmoil, and various countries did not cash their banknotes. Prices rose and inflation accelerated.In response to this situation, Kassel proposed to establish new official exchange rates of various countries on the basis of purchasing power parity, so as to eliminate trade difficulties caused by price changes and restore normal international trade relations. This is the exchange rate between domestic and foreign currencies. Equal to the ratio between the domestic and foreign price levels.

For example, if a representative group of goods is worth $2 in the United States and 10 francs in France, the exchange rate should be $1 to 5 francs.Therefore, the theory of purchasing power parity holds that a balanced exchange rate is the exchange rate that makes the two currencies being compared equal in their respective domestic purchasing power, and it is impossible for a long-term existence to deviate from the exchange rate that makes the domestic purchasing power equal.If a good in the United States is worth one-fifth the price in dollars of a franc in France, and the exchange rate is that one dollar equals one franc, then everyone who holds francs will exchange francs for the same amount. US dollars, and can buy 1 times the goods in the United States.But the demand for dollars in the market will cause the exchange rate to rise until the dollar is equal to 5 francs, that is, until the ratio of the purchasing power of its currency is equal to the price level expressed by the currencies of various countries.

Purchasing power parity theory holds that people demand foreign currency because they can buy foreign goods and services with it, and foreigners need their own currency because they can use it to buy domestic goods and services.Therefore, the exchange of domestic currency for foreign currency is equivalent to the exchange of domestic and foreign purchasing power.Therefore, the price of foreign currency expressed in domestic currency, that is, the exchange rate, is determined by the ratio of the purchasing power of the two currencies.Since purchasing power is actually the reciprocal of the general price level, the currency exchange rate between two countries can be expressed by the ratio of the two countries' price levels.This is the theory of purchasing power parity.From the point of view of expression, purchasing power parity theory has two advantages, the definition is absolute purchasing power parity and relative purchasing power parity.

Purchasing power parity determines the long-term trend of exchange rates.Regardless of the various short-term factors that affect exchange rate fluctuations in the short term, in the long run, the trend of the exchange rate is basically consistent with the trend of purchasing power parity.Therefore, purchasing power parity provides a better method for forecasting long-term exchange rate trends.

Equilibrium exchange rate: the "reassurance" of economic stability

Zhou Xiaochuan, governor of the People's Bank of China, stated in early 2009 that he would continue to manage the floating exchange rate mechanism with reference to a basket of currencies and strive to keep the RMB exchange rate stable.Zhou Xiaochuan also analyzed the savings rate of Eastern and Western countries. He pointed out that the savings rate of Southeast Asian countries including China is generally high. Since [-], China has adopted various policies to reduce the savings rate, but the adjustment cannot achieve results in a short time. , it is expected that the unbalanced savings rate in the world will still exist for some time to come.

Zhou Xiaochuan also said on the sidelines of attending the central bank meeting in Malaysia that the central bank will continue to allow market supply and demand factors to play a greater role in the RMB mechanism, will adhere to the consistent RMB policy, and will continue to manage the floating exchange rate mechanism with reference to a basket of currencies. Keep the RMB exchange rate at a balanced, reasonable and stable level.

Since 2005, China has started a floating exchange rate system with a basket of currencies. Since then, the issue of the RMB exchange rate has been a hot topic of public opinion at home and abroad. In 2006, the appreciation of the RMB accelerated. With the rapid economic development in 07 and 08, the RMB gradually stabilized after a "high rise" all the way.This gave the central bank a big sigh of relief.For the central bank, maintaining the internal and external balance of the RMB exchange rate has always been the focus of the central bank's policies.But what kind of exchange rate level is the equilibrium?This issue is worth exploring.

In 1934, the British economist Gregory first proposed the concept of equilibrium exchange rate.He said that there are actually three kinds of exchange rates: first, the de facto exchange rate, that is, the prevailing exchange rate in the market; second, the real equilibrium exchange rate, which is based on purchasing power parity and then estimates various factors in the balance of payments and other factors that have nothing to do with inflation; third, purchasing power parity, which is the exchange rate calculated based on the comparison of the general price levels of various countries.Gregory believes that the real equilibrium exchange rate is only very close to purchasing power parity, not equal to purchasing power parity.As for the de facto exchange rate, it is different from both the real equilibrium exchange rate and the purchasing power parity.

(End of this chapter)