International Finance

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In H. Kent Baker and Leigh A. Riddick (eds.) Survey of International Finance, Oxford University Press, 2012

2
A Primer on Exchange Rate Behavior
JAMES R. LOTHIAN

Distinguished Professor of Finance, Fordham University
M A R K P. T A Y L O R

Dean, Warwick Business School; Professor of Finance, University of Warwick

Introduction
An exchange rate is the relative price of one country’s money in terms of another. What is being exchanged as money has varied over time with the particular assets that served as monies. For most of recorded history up until the early part of the last century, money generally consisted of a metallic coinage of one sort or another. Since then money has come increasingly to consist of currency notes and, more importantly, bank deposits. Economists’ key insight with regard to exchange rate behavior centers on the concept of purchasing power parity (PPP). Stated simply, the PPP exchange rate is the nominal exchange rate that equates the purchasing power of a unit of currency in the foreign economy and the domestic economy. So, for example, suppose the PPP exchange rate between the U.S. dollar and the British pound sterling is two dollars ($) per pound (£). Then, if the exchange rate that actually prevails in the market also is two dollars per pound, the same basket of goods that can be bought for $100 in the United States can be bought for £50 in the United Kingdom. Over the past several decades the literature investigating PPP has become voluminous, according to one set of estimates growing at an average rate of 15 percent per annum over the period 1974 to 2003 (Clements and Lan 2004). The upshot of these studies is that over long periods, and for countries that have substantial differences in price-level behavior, the PPP hypothesis provides a tolerably good fi rst approximation to actual behavior. The fourth section of this chapter reviews the major empirical fi ndings from the literature supporting that interpretation. The second and third sections of this chapter set the stage for

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E XC H A N GE R AT E BE H AV IO R A ND R I SK M A N AGE ME N T

that discussion by presenting a brief overview of the theory underlying the PPP hypothesis and a review of its historical origins. The fi ft h section of the chapter discusses problems surrounding shorter-term exchange rate behavior—the PPP puzzle and the exchange rate disconnect puzzle—and the recent attempts by researchers to solve both. The last section of the chapter provides some summary remarks.

Absolute and Relative PPP
The PPP relation described verbally above can be written in algebraic terms as: Pt = Pt*St, (2.1)

where Pt and Pt* are the domestic and foreign prices of identical market baskets of goods, respectively; and St is the nominal exchange rate, the price in domestic currency of a unit of the foreign currency. Taking logarithms of both sides of Equation 2.1 results in the alternate linear form: pt = pt* + st, (2.2)

where lowercase letters represent the natural logarithms of the variables denoted by the uppercase letters in Equation 2.1. The relationship as stated in either of these two forms is known as absolute PPP. Another way to think about PPP is in terms of the real exchange rate, which is the nominal exchange rate (again defi ned in units of domestic to foreign currency) divided by the ratio of the domestic to foreign price levels. Th is can be written in arithmetic form as: Qt = St/(Pt/Pt*), or in logarithmic form as: qt = st − (pt − pt*), (2.4) (2.3)

where Qt denotes the real exchange rate and qt denotes its logarithmic counterpart. The two are measures of the purchasing power of the foreign currency in the foreign economy relative to the purchasing power of the domestic currency in the domestic economy. If absolute PPP holds, Qt would be one and qt would be zero. In actual empirical work researchers generally use price indices such as the consumer price index (CPI), which is based on an...
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