Bradley in DC
10-10-2007, 07:37 AM
http://www.kitco.com/ind/Ip/oct092007.html
Kitco In Focus: The Basics of Exchange Rates
By Wendy Lynn Ip
Oct 9 2007 10:04AM
www.kitco.com
Kitco In Focus1: The Basics of Exchange Rates
Some of the volatility in the spot price of gold has been traditionally attributed to changes in the valuation of the US dollar. You might have read or heard that the spot price is expected to rise with a continued depreciation of the dollar. Since its peak on February 27th 2002, the dollar has fallen by nearly 23 percent2. In the past month alone, the dollar has fallen by 2.9 percent. The rationale is that gold is viewed as good protection against such depreciation. The underlying reasoning is similar to that on inflation except the loss in purchasing power, now, is external instead of internal. The discussion on exchange rates is also one that considers the economy in the long run, just as the discussion on inflation3.
Saying that the price of gold is dependent on the valuation of the US dollar suggests that there should be a strong correlation between the US dollar exchange rate and the gold price. If this is true, then an understanding of the US dollar valuation is essential to our understanding of the price of gold. Here lies the purpose of this article, to introduce the basics behind exchange rates in an open economy. This will set the stage for the analysis of data that will come in next week’s article.
Nominal and Real Exchange Rates
Exchange rates are nothing more than prices. Prices can be either in currency terms or ‘commodity’ terms. The former refers to the nominal exchange rate and the latter refers to the real exchange rate. The nominal rate is what is usually reported in the news. It can be expressed as the number of foreign currency units per domestic unit. The real exchange rate gives us the relative price of ‘commodities’ or goods between two countries. It is sometimes referred to as the terms of trade. For example, suppose that a Canadian car costs $25,000 and a comparable Japanese car costs 2,975,000 yen. If one Canadian dollar is worth 119 yen, then the Canadian car costs 2,975,000 yen. Clearly, at current prices, we can exchange 1 Canadian car for 1 Japanese car. The real exchange rate, E, is equal to the nominal exchange rate times the ratio of the domestic to the foreign price level.
Real Exchange Rate = Nominal Exchange Rate * (Domestic Price/ Foreign Price)
Now, the nominal exchange rate will be defined as the number of foreign currency units per one domestic unit so that an increase in the nominal exchange rate implies an appreciation of the domestic currency and an increase in the real exchange rate means that foreign goods are relatively cheap while domestic goods are relatively expensive. When people discuss the effects of a country’s trade balance or net foreign investment on its exchange rate, they are referring to the real exchange rate, since it is the real exchange rate that will balance the two out. The discussion below will make this clear and will allow you to follow along with the rationale presented in the news.
The Trade Balance, Net Foreign Investment, and the Real Exchange Rate
The trade balance and net foreign investment determine the real exchange rate. The trade balance is simply the difference between exports (the amount sold to foreigners) and imports (the amount bought from foreigners). It is also referred to as net exports. Now, if the real rate of exchange is low, then domestic goods will be relatively cheap. There will be enhanced competition in favour of the domestic economy. As a result, the quantity of net exports demanded will rise. On the other hand, if the real rate of exchange is high, then domestic residents will want to buy more imported goods, and foreigners will want to buy fewer of our goods. As a result, the quantity of net exports demanded will be fall. What this means is that there exists a negative relationship between the real exchange rate and net exports and that net exports is determined by the real exchange rate. This relationship is summarized in the downward sloping curved labelled NX(E) in Figure 1. Net exports represent the net demand for domestic currency from foreigners who want to use this currency to buy domestic goods (i.e. in the form of exports). Loosely speaking, exporting more implies that there will be more demand of that domestic currency to be in circulation to pay for those goods. This can help drive the value of the currency down, but the story is not complete without considering the supply of domestic currency.
Net foreign investment is the excess of domestic saving over domestic investment. The level of net foreign investment is not determined by net exports; hence, it represented by a vertical line. If a country saves more than it invests, then it will be in a position to be a lender to countries that need to finance their spending. For example, we could buy debt issued by a foreign government or by foreign corporations. It may also take the form of us purchasing foreign assets. In all cases, we would be obtaining a claim to future returns on foreign capital. Net foreign investment naturally represents the supply of domestic currency to be exchanged into foreign currency and invested abroad.
From the national accounts identity we have:
Net Foreign Investment (S –I) = Net Exports (NX)
As we can see from Figure 1, the equality of net foreign investment and net exports determine the real exchange rate. For practical purposes, this basically means that the real exchange rate is stable when the equality approximately holds true.
Changes in the Real Exchange Rate
The real exchange rate can be influenced by domestic and foreign fiscal policy, policies that affect investment demand, and trade policies. As we will see, changes in foreign fiscal policy may affect the real exchange rate by changing world interest rates4. The effect of monetary policy5 will only be realized on the nominal exchange rate by influencing the overall price level6. It will not impact the real exchange rate.
For right now, let us consider the effect of domestic fiscal policy and a domestic policy that would influence investment demand. Any policy that would shift the S-I curve inward, as shown in Figure 2, will have the essential effect of reducing the supply of a domestic currency to be sent abroad. Let’s suppose that the domestic currency is the dollar. Essentially, what we are looking for are policies that would reduce the level of domestic saving or increase the level of domestic investment. Domestic saving can be reduced if the government implements expansionary fiscal policy. If domestic saving is reduced, then residents will have a reduced opportunity to lend their dollars abroad. The same will be true if domestic investment is increased through some sort of tax incentive. Again, more dollars will be kept within the domestic economy.
The effect can be summarized as follows:
The supply of dollars to be exchanged into foreign currency and invested abroad is reduced by expansionary fiscal policy or policies that give residents the incentive to save less and invest more.
A reduction in the supply of dollars will raise the real exchange rate. The dollar will appreciate causing domestic goods to become more expensive relative to foreign goods.
Net exports fall as a result of a reduction in exports and a rise in imports. The result of these policies will yield a trade deficit.
Alternatively, if domestic fiscal policy is contractionary or if fiscal policy abroad is expansionary, we could have a depreciation of the dollar. This situation is presented in Figure 3 below. Contrationary domestic policy would raise the level of domestic saving; thereby, increasing the supply of dollars to be exchanged and invested abroad. This increase in the supply of dollars will reduce its value on the international market.
Expansionary foreign fiscal policy can potentially affect domestic investments through a reduction in world saving resulting in an increased world interest rate. This would make domestic investment less attractive. A reduction in domestic investment would increase the difference between domestic savings and investment.
The effect can be summarized as follows:
The supply of dollars to be exchanged into foreign currency and invested abroad is increased by contrationary domestic fiscal policy or expansionary foreign fiscal policy, both of which give domestic residents the incentive to save more and invest less.
A reduction in the supply of dollars will reduce the real exchange rate. The dollar will depreciate causing domestic goods to become less expensive relative to foreign goods.
Net exports rise as a result of a reduction in imports and a rise in exports. The result of these policies will yield a trade surplus.
Finally, let’s consider the impact of protectionist trade policies, which can take the form of a ban on some imported good (an import quota) or a tax on foreign imports (a tariff). The goal of these policies is to try and ‘protect’ domestic firms from foreign competition.
The effect can be summarized as follows:
At every real exchange rate, the amount of imports is reduced. This will increase net exports at every exchange rate. This is represented by an outward shift in the NX curve.
Fewer dollars are used to purchase foreign goods. As a result the dollar appreciates.
Since the policy does not affect domestic saving and investment and the increase in the real exchange rate offsets any gains from a reduction in imports in the trade balance, there should be no change in net exports. This is a point that is often overlooked in popular debate over trade policies.
Another point against protectionist policies is that they tend to make society worse off by reducing the amount of goods available to them. Both the quantity of goods imported and exported has been reduced as a result of these policies. Their difference, a given by net exports, remains unchanged. Of course, this is only an approximation to reality. It is clear that gains from trade are essentially diminished.
In next week’s article, I will be incorporating gold price data and exchange rate data into a brief analysis.
Until then, take care and I wish you a really great week,
Wendy
1 The purpose of Kitco In Focus is to bring to our viewers a perspective regarding the precious metals market with the hope of shedding clarity on the complex nature of this market. At least initially, the aim for this series of articles is to pull out those relevant factors that play some role in the market and explain them each in turn so that we can gain a better understanding of key concepts introduced by various authors who have worked diligently within the precious metals industry.
It is in my hope that Kitco In Focus will also be inspired by our readers in terms of what they would like explained or the questions they would like to bring to the table. In regards to this, I am sure we all know that there are various ways to understand, explain, and analyze any given topic and that these various ways can be competing bodies of knowledge. I really want to be clear on this because there is no universal or agreed upon way of understanding all of those important and not so important factors that influence the precious metals market. I hope to bring most of these perspectives to the table, although not all at once or within one article, so that our readers can have a comprehensive understanding of the dialogue that exists within this industry. I want to stress that even in my attempts to do this, others may not share the perspective that is presented and that I think this is completely natural and healthy in any honest dialogue that exists on any given topic. We all want to arrive at the best understanding of the market we are all so very passionate about, myself included.
With this said, Kitco In Focus is written as a tribute to all of those who frequent our site and for those who would like a deeper understanding of those economic factors that are commonly assumed to play some role in our market.
2 The valuation of the US dollar was defined by the Broad US Dollar Index. The index measures movements of the dollar against the currencies of 26 of the United States’ most significant trading partners.
3 For my discussion on inflation, please see The Consumer Price Index and Spot Price of Gold.
4 Briefly, interest rates determine the level of investment. It is essentially the price of an asset so that the higher the interest rate, the lower the level of investment.
5 Fiscal policies refer to those that directly influence government spending and taxes. If the government implements a policy to spend more or to cut taxes, we say that the policy is expansionary. Monetary policies refer to those that directly influence interest rates, such as the federal funds rate and discount rates, or the money supply. We say monetary policy is expansionary if interest rates are lowered or the money supply is increased.
6 Consider the nominal exchange rate over time, which is the percentage change in the nominal exchange rate:
% Change in the Nominal Exchange Rate =
% Change in the Real Exchange Rate + % Change in Foreign Prices - % Change in Domestic prices
Expansionary domestic monetary policy can lead to inflation, a rise in the domestic price level. From the equation above it is clear that an increase in inflation will reduce the nominal exchange rate over time. It can depreciate the value of the domestic currency.
****
Feedback: Ever had questions regarding the precious metals market? Have you ever wanted an explanation regarding the usefulness of an economic variable? If so, then please send us your questions and they may be addressed in up and upcoming articles found exclusively at Kitco In Focus.
Submit Your Feedback
Please note that you will not be contacted with a response directly and that your question may be posted on www.kitco.com. By sending us your questions, you automatically give Kitco Metals Inc. the right to publish your question.
Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
Copyright © 2007 Kitco Inc.
Kitco In Focus: The Basics of Exchange Rates
By Wendy Lynn Ip
Oct 9 2007 10:04AM
www.kitco.com
Kitco In Focus1: The Basics of Exchange Rates
Some of the volatility in the spot price of gold has been traditionally attributed to changes in the valuation of the US dollar. You might have read or heard that the spot price is expected to rise with a continued depreciation of the dollar. Since its peak on February 27th 2002, the dollar has fallen by nearly 23 percent2. In the past month alone, the dollar has fallen by 2.9 percent. The rationale is that gold is viewed as good protection against such depreciation. The underlying reasoning is similar to that on inflation except the loss in purchasing power, now, is external instead of internal. The discussion on exchange rates is also one that considers the economy in the long run, just as the discussion on inflation3.
Saying that the price of gold is dependent on the valuation of the US dollar suggests that there should be a strong correlation between the US dollar exchange rate and the gold price. If this is true, then an understanding of the US dollar valuation is essential to our understanding of the price of gold. Here lies the purpose of this article, to introduce the basics behind exchange rates in an open economy. This will set the stage for the analysis of data that will come in next week’s article.
Nominal and Real Exchange Rates
Exchange rates are nothing more than prices. Prices can be either in currency terms or ‘commodity’ terms. The former refers to the nominal exchange rate and the latter refers to the real exchange rate. The nominal rate is what is usually reported in the news. It can be expressed as the number of foreign currency units per domestic unit. The real exchange rate gives us the relative price of ‘commodities’ or goods between two countries. It is sometimes referred to as the terms of trade. For example, suppose that a Canadian car costs $25,000 and a comparable Japanese car costs 2,975,000 yen. If one Canadian dollar is worth 119 yen, then the Canadian car costs 2,975,000 yen. Clearly, at current prices, we can exchange 1 Canadian car for 1 Japanese car. The real exchange rate, E, is equal to the nominal exchange rate times the ratio of the domestic to the foreign price level.
Real Exchange Rate = Nominal Exchange Rate * (Domestic Price/ Foreign Price)
Now, the nominal exchange rate will be defined as the number of foreign currency units per one domestic unit so that an increase in the nominal exchange rate implies an appreciation of the domestic currency and an increase in the real exchange rate means that foreign goods are relatively cheap while domestic goods are relatively expensive. When people discuss the effects of a country’s trade balance or net foreign investment on its exchange rate, they are referring to the real exchange rate, since it is the real exchange rate that will balance the two out. The discussion below will make this clear and will allow you to follow along with the rationale presented in the news.
The Trade Balance, Net Foreign Investment, and the Real Exchange Rate
The trade balance and net foreign investment determine the real exchange rate. The trade balance is simply the difference between exports (the amount sold to foreigners) and imports (the amount bought from foreigners). It is also referred to as net exports. Now, if the real rate of exchange is low, then domestic goods will be relatively cheap. There will be enhanced competition in favour of the domestic economy. As a result, the quantity of net exports demanded will rise. On the other hand, if the real rate of exchange is high, then domestic residents will want to buy more imported goods, and foreigners will want to buy fewer of our goods. As a result, the quantity of net exports demanded will be fall. What this means is that there exists a negative relationship between the real exchange rate and net exports and that net exports is determined by the real exchange rate. This relationship is summarized in the downward sloping curved labelled NX(E) in Figure 1. Net exports represent the net demand for domestic currency from foreigners who want to use this currency to buy domestic goods (i.e. in the form of exports). Loosely speaking, exporting more implies that there will be more demand of that domestic currency to be in circulation to pay for those goods. This can help drive the value of the currency down, but the story is not complete without considering the supply of domestic currency.
Net foreign investment is the excess of domestic saving over domestic investment. The level of net foreign investment is not determined by net exports; hence, it represented by a vertical line. If a country saves more than it invests, then it will be in a position to be a lender to countries that need to finance their spending. For example, we could buy debt issued by a foreign government or by foreign corporations. It may also take the form of us purchasing foreign assets. In all cases, we would be obtaining a claim to future returns on foreign capital. Net foreign investment naturally represents the supply of domestic currency to be exchanged into foreign currency and invested abroad.
From the national accounts identity we have:
Net Foreign Investment (S –I) = Net Exports (NX)
As we can see from Figure 1, the equality of net foreign investment and net exports determine the real exchange rate. For practical purposes, this basically means that the real exchange rate is stable when the equality approximately holds true.
Changes in the Real Exchange Rate
The real exchange rate can be influenced by domestic and foreign fiscal policy, policies that affect investment demand, and trade policies. As we will see, changes in foreign fiscal policy may affect the real exchange rate by changing world interest rates4. The effect of monetary policy5 will only be realized on the nominal exchange rate by influencing the overall price level6. It will not impact the real exchange rate.
For right now, let us consider the effect of domestic fiscal policy and a domestic policy that would influence investment demand. Any policy that would shift the S-I curve inward, as shown in Figure 2, will have the essential effect of reducing the supply of a domestic currency to be sent abroad. Let’s suppose that the domestic currency is the dollar. Essentially, what we are looking for are policies that would reduce the level of domestic saving or increase the level of domestic investment. Domestic saving can be reduced if the government implements expansionary fiscal policy. If domestic saving is reduced, then residents will have a reduced opportunity to lend their dollars abroad. The same will be true if domestic investment is increased through some sort of tax incentive. Again, more dollars will be kept within the domestic economy.
The effect can be summarized as follows:
The supply of dollars to be exchanged into foreign currency and invested abroad is reduced by expansionary fiscal policy or policies that give residents the incentive to save less and invest more.
A reduction in the supply of dollars will raise the real exchange rate. The dollar will appreciate causing domestic goods to become more expensive relative to foreign goods.
Net exports fall as a result of a reduction in exports and a rise in imports. The result of these policies will yield a trade deficit.
Alternatively, if domestic fiscal policy is contractionary or if fiscal policy abroad is expansionary, we could have a depreciation of the dollar. This situation is presented in Figure 3 below. Contrationary domestic policy would raise the level of domestic saving; thereby, increasing the supply of dollars to be exchanged and invested abroad. This increase in the supply of dollars will reduce its value on the international market.
Expansionary foreign fiscal policy can potentially affect domestic investments through a reduction in world saving resulting in an increased world interest rate. This would make domestic investment less attractive. A reduction in domestic investment would increase the difference between domestic savings and investment.
The effect can be summarized as follows:
The supply of dollars to be exchanged into foreign currency and invested abroad is increased by contrationary domestic fiscal policy or expansionary foreign fiscal policy, both of which give domestic residents the incentive to save more and invest less.
A reduction in the supply of dollars will reduce the real exchange rate. The dollar will depreciate causing domestic goods to become less expensive relative to foreign goods.
Net exports rise as a result of a reduction in imports and a rise in exports. The result of these policies will yield a trade surplus.
Finally, let’s consider the impact of protectionist trade policies, which can take the form of a ban on some imported good (an import quota) or a tax on foreign imports (a tariff). The goal of these policies is to try and ‘protect’ domestic firms from foreign competition.
The effect can be summarized as follows:
At every real exchange rate, the amount of imports is reduced. This will increase net exports at every exchange rate. This is represented by an outward shift in the NX curve.
Fewer dollars are used to purchase foreign goods. As a result the dollar appreciates.
Since the policy does not affect domestic saving and investment and the increase in the real exchange rate offsets any gains from a reduction in imports in the trade balance, there should be no change in net exports. This is a point that is often overlooked in popular debate over trade policies.
Another point against protectionist policies is that they tend to make society worse off by reducing the amount of goods available to them. Both the quantity of goods imported and exported has been reduced as a result of these policies. Their difference, a given by net exports, remains unchanged. Of course, this is only an approximation to reality. It is clear that gains from trade are essentially diminished.
In next week’s article, I will be incorporating gold price data and exchange rate data into a brief analysis.
Until then, take care and I wish you a really great week,
Wendy
1 The purpose of Kitco In Focus is to bring to our viewers a perspective regarding the precious metals market with the hope of shedding clarity on the complex nature of this market. At least initially, the aim for this series of articles is to pull out those relevant factors that play some role in the market and explain them each in turn so that we can gain a better understanding of key concepts introduced by various authors who have worked diligently within the precious metals industry.
It is in my hope that Kitco In Focus will also be inspired by our readers in terms of what they would like explained or the questions they would like to bring to the table. In regards to this, I am sure we all know that there are various ways to understand, explain, and analyze any given topic and that these various ways can be competing bodies of knowledge. I really want to be clear on this because there is no universal or agreed upon way of understanding all of those important and not so important factors that influence the precious metals market. I hope to bring most of these perspectives to the table, although not all at once or within one article, so that our readers can have a comprehensive understanding of the dialogue that exists within this industry. I want to stress that even in my attempts to do this, others may not share the perspective that is presented and that I think this is completely natural and healthy in any honest dialogue that exists on any given topic. We all want to arrive at the best understanding of the market we are all so very passionate about, myself included.
With this said, Kitco In Focus is written as a tribute to all of those who frequent our site and for those who would like a deeper understanding of those economic factors that are commonly assumed to play some role in our market.
2 The valuation of the US dollar was defined by the Broad US Dollar Index. The index measures movements of the dollar against the currencies of 26 of the United States’ most significant trading partners.
3 For my discussion on inflation, please see The Consumer Price Index and Spot Price of Gold.
4 Briefly, interest rates determine the level of investment. It is essentially the price of an asset so that the higher the interest rate, the lower the level of investment.
5 Fiscal policies refer to those that directly influence government spending and taxes. If the government implements a policy to spend more or to cut taxes, we say that the policy is expansionary. Monetary policies refer to those that directly influence interest rates, such as the federal funds rate and discount rates, or the money supply. We say monetary policy is expansionary if interest rates are lowered or the money supply is increased.
6 Consider the nominal exchange rate over time, which is the percentage change in the nominal exchange rate:
% Change in the Nominal Exchange Rate =
% Change in the Real Exchange Rate + % Change in Foreign Prices - % Change in Domestic prices
Expansionary domestic monetary policy can lead to inflation, a rise in the domestic price level. From the equation above it is clear that an increase in inflation will reduce the nominal exchange rate over time. It can depreciate the value of the domestic currency.
****
Feedback: Ever had questions regarding the precious metals market? Have you ever wanted an explanation regarding the usefulness of an economic variable? If so, then please send us your questions and they may be addressed in up and upcoming articles found exclusively at Kitco In Focus.
Submit Your Feedback
Please note that you will not be contacted with a response directly and that your question may be posted on www.kitco.com. By sending us your questions, you automatically give Kitco Metals Inc. the right to publish your question.
Disclaimer: The views expressed in this article are those of the author and may not reflect those of Kitco Inc. The author has made every effort to ensure accuracy of information provided; however, neither Kitco Inc. nor the author can guarantee such accuracy. This article is strictly for informational purposes only. It is not a solicitation to make any exchange in precious metal products, commodities, securities or other financial instruments. Kitco Inc. and the author of this article do not accept culpability for losses and/ or damages arising from the use of this publication.
Copyright © 2007 Kitco Inc.