Chapter 1
Chapter 1
Chapter 1
The Ethiopian importer will generally have to pay to the Japanese exporter in yen, to US
exporter in USD and to Germen exporter in Euro. For these reasons, the Ethiopian importers will
have to buy these currencies with birr in foreign exchange market. The foreign exchange market
is not a single physical place rather it is defined as a market where the various national
currencies are bought and sold. In this chapter, we will try to look at some of the basic issues
like, the participants in the foreign exchange market and the basic force that operate in the
market.
Generally, exchange rate is simply the price of one currency in terms of another. There are two
methods of expressing the price of one country’s currency. These are,
• Domestic currency unit per unit of foreign exchange. For instance, taking birr as the domestic
currency, on February 15, 2008 there was approximately 9.22 birr required to purchase one US
dollar. Thus, Exchange rate between birr & US dollar (USD) is 9.22 to 1 USD.
• Foreign currency units per unit of the domestic currency. That is, how much USD can one
Ethiopian birr buy? For example, again taking Ethiopian birr as domestic currency, on February
15, 2008, One Eth. Birr can only buy 0.11 USD.
We can easily observe that the second method is just the reciprocal of the former. It is not as
such important which method of expressing the exchange rate is employed. What important is to
be careful when talking about a rise or fall in the exchange rate. This is because the meaning will
be very different depending up on which definition is used.
A rise in the Eth birr per dollar exchange rate, say from 9.22 to 9.30 means that more birr have to
be given up in order to obtain a dollar. This means that the birr has depreciated in value or
equivalently the dollar has appreciated in value.
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Whereas if the second definition is employed, a rise in the exchange rate from USD 0.11/ 1 birr
to say 0.12 / birr would mean that more dollars are obtained per birr, so that the birr has
appreciated or equivalently the dollar has deprecated.
To avoid unnecessary confusion the rest of this material will refer to exchange rate as the price
of the foreign currency in terms of domestic currency. That is the price paid in the home
currency for a unit of foreign currency.
These groups are kept in close and continuous contact with one another through the available
means of communications like, telephone, on line computers, telex and fax and video conference
and the like. The current development in Information Communication Technology has further
made easy the communication among different foreign exchange participant and economic
agents. Among the most important foreign exchange centers are London, New York, Tokyo,
Singapore and Frankfurt.
The most widely traded currency is the US dollar which knows as a vehicle currency- because it
is widely used to denominate international transaction. Oil and many other important primary
products such as tin, coffee and gold all are priced in dollars. However, since its existence Euro
(European currency unit) is becoming attractive and getting wider range of acceptability as well.
Retail Clients: - These are made up of business investors, multi-national corporations and so on.
These need foreign exchange for the purpose of operating their business. Commonly they do not
directly purchase or sell foreign currency themselves; rather they operate by placing buy/sell
orders with the commercial banks.
Commercial Banks: – The commercial banks carry out buy/sell orders from their retail clients
and buy/sell currencies on their own account so as to alter the structure of their assets and
liabilities in different currencies. Banks may deal either directly with other banks or through
foreign exchange brokers.
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Foreign exchange brokers: - Commonly banks do not trade directly with one another, rather
they offer to buy and sell currencies via foreign exchange brokers. Brokers intermediate the
exchange currencies between different clients. The benefits of brokers is that, they collect, buy
and sell order for most currencies from different banks around the world thereby the most
favorable quotation can be obtained quickly and at lower cost.
A small brokerage fee is paid when banks are dealing through a broker which can be avoided in a
straight bank to bank deal. Each financial center has just a few authorized brokers through which
commercial banks conduct their exchange.
Central banks frequently intervene by buying /selling their currencies to influence the rate at
which their currency is traded. Under a fixed exchange rate system the authorities are obliged to
purchase their currencies when there is excess supply and sell the currency when there is excess
demand.
But if the speculator expects the dollar (spot or forward) to depreciate in the future he is said to
be “bearish” about the currency in which case it would be better for the speculator to take short
position on the currency. That is, to sell the dollar at what he believed to be a relatively high
price today in the hope of buying it back at a cheap rate sometimes in the future.
Speculation is the opposite of hedging and it is the act of taking a net asset position (long
position) or a net liability position (short – position) in a foreign currency. Speculation means
committing one – self to uncertain future value of one’s net worth in terms of home currency.
Most of these commitments are based on conscious, expectations about the future prices of the
foreign currency.
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Arbitrage is the exploitation of price differentials for risk less guaranteed profit. There are two
types of arbitrage, financial center and cross – currency arbitrage. To explain these two forms of
arbitrage let us assume that transaction costs are negligible and that there is only a single
exchange rate quotation ignoring the bid – off spread.
Financial center arbitrage:- This type of arbitrage ensure that the birr – dollar exchange rate
quoted in New York will be the same as that quoted in Addis and other financial centers
(assuming that birr is freely traded currency and Addis is one of the finical centers).
This is because if exchange rate is birr 9.22 in Addis but only birr 9.20 in New- York, it would
be profitable for banks to buy birr in New York and simultaneously sell them in Addis and make
a guaranteed profit of 2 cents on every dollar sold and bought. Such process of buying birr in
New York and selling it in Addis continues until the rate quoted in the two center concedes to
equal level. Such action of buying a currency from a financial center that offers it at lower rate
and selling it at higher rate in other financial centers is called financial center arbitrage.
Cross–Currency arbitrage: - This form of arbitrage can be better explained with the help of
simple and hypothetical example. Suppose the exchange rate of birr is 9.20 birr/1 USD. And the
exchange rate of dollar against Euro is 1.5 USD/1Euro. Currency arbitrage implies that the
exchange rate of birr against Euro will be 13.8 birr/ Euro (1.5 x 9.2). If this were not the case and
the actual exchange rate was for example, 14 birr /Euro, then the US dealer wanting birr would
do better to first obtain Euro with 13.8 birr/Euro (1.5x9.2) which will then buy birr 14, making
0.2 cents per each Euro sold.
The increase in demand for Euro would quickly appreciate its rate against the Euro to 1.5217
USD/Euro level at which level the advantage to the US dealer in buying Euro first to then
convert into birr disappears.
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The exchange rate is measured on the vertical axis and quantity of the foreign currency (US$) is
measured on the X-axis. The exchange rate R is a measure of the price of the foreign currency
(US$) in terms of domestic currency (Ethiopia Birr).
Exchange
rate
B1
B2
B3
Demand for
foreign
exchange
foreign
Dollar (Dollar)
1000 2000 3000
An increase in R implies a decline in the value of Birr and an increase in the value of US$. In
other words, a movement up on the vertical axis represents an increase in the price of foreign
currency (which is equivalent to a fall in the price of Birr). For Ethiopians, American goods are
less expensive when the Dollar is cheaper and the Birr is stronger. Hence, at the depreciated
values for the dollar, Ethiopians will switch from homemade or third-party supplies of goods and
service to American suppliers. Before they can purchase goods made in USA, however, they
must first exchange Birr for US$. Consequently, the increased demand for US goods is
simultaneously an increase in the quantity of US $ demanded.
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Supply of
Dollar
Figure 1.3 shows (combines) the supply and demand curves of foreign currency. The intersection
of the curves in the Ethio-US foreign exchange market determines the exchange rate R1 at which
the quantity of demand and supply of foreign currency to the Ethiopian Economy are equal.
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Supply of
Dollar
R3
R2
R3
Demand for Dollar
Q0 Quantity of Dollar
There are three major reasons why people hold foreign currency rather than their own. These are:
For reasons related to trade and direct investment (like business cycle, inflation and
expectation of future economic growth)
to take advantage of interest rate changes
to speculate
Changes in one or more of these three motives for holding foreign currencies can lead to a shift
in the demand and supply curves of foreign currency indicating in change in demand and change
in supply of foreign currency. The following table is an illustrative example on the determinants
of demand and supply of USD in Ethiopia.
Table 1.1 Major determinates of the supply and demand for foreign currency in Ethiopia
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From the point of view of tourists and business people who use foreign exchange, the key item of
interest is the purchasing power that they get when they convert their dollars, not the number of
units of a foreign currency. An American importer trying to decide between Ethiopia and
Kenyan textiles does not care if he or she gets 8.7 birr per dollar or 73.2 KES per dollar. The
biggest concern is the volume of textiles that can be purchased in Ethiopia with 8.7 Birr and in
Kenya with 73.2 KES.
Real Exchange Rate is the market exchange rate (nominal exchange rate) adjusted for inflation.
A base year is arbitrary chosen as a standard for comparison, and PL and PF are both equal to
100 at the base year. Thus, the base year real exchange rate is:
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Over time, if inflation is higher at home than in the foreign country, then PH rises more than PF,
and Rr falls if Rn is constant. This means:
Example: The base year nominal or market exchange rate in the Ethio-US foreign exchange
market is 8.7 birr per USD. After a year there has been 10% inflation in Ethiopia while the
inflation in USA is zero percent. Calculate the real exchange rate.
Rr = Rn (PF/PH)
Tourists, investors, and business people can still trade birr and USD at the nominal rate
(8.7B/USD) plus whatever commissions they must pay to the sellers). After the price increase
(inflation) in Ethiopia, the real purchasing power of the Birr has risen in USA compared to what
it buys at home. The real exchange rate of 7.91 Birr/USD tells us that US goods are now 10
percent cheaper than Ethiopian goods that have risen in price. As long as the nominal exchange
rate remains unchanged, US goods remain less expensive to both Ethiopian and American
purchasers. In real terms the USD has depreciated and the Birr has appreciated. The real
exchange rate is useful for examining changes over time in the relative purchasing power of
foreign currencies.
Few tasks in economics are more difficult and riskier than trying to predict exchange rate.
Currency markets are as volatile as stock markets, and no one yet has been able to devise a
system to consistently forecast exchange rates. Nevertheless, there is substantial evidence that
over the very long run (periods of a decade or more), exchange rates are determined by two main
factors.
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Purchasing power parity also termed as law of one price, states that a currency should buy the
same quantity of goods when converted to another currency as it can buy at home. If a unit of
home currency can buy a certain quantity of market baskets of goods in the home market, the
same unit of home currency converted to its equivalent foreign currency must buy equal quantity
of markets baskets of goods from the foreign market. In other words, the exchange rate should be
at a level that keeps the real purchasing power of money constant when it is converted to another
currency.
If the law of one price does not hold, a birr in Ethiopia buys a different (larger or smaller) bundle
of goods than it buys from USA when the Birr is converted into Dollar. If birr buys more in
Ethiopia than its dollar equivalent buys in USA, then business people could make profit buy
shipping goods from Ethiopia where they are relatively cheap and sell them in USA where they
are relatively expensive. If a birr worth of dollar buys more in USA, goods will flow in the
opposite direction, from USA to Ethiopia.
The law of one price can be thought of as a long-run tendency for the real exchange rate to
remain constant. Since the real exchange rate equals the nominal rate times the relative price
levels, the law of one price essentially states that if foreign prices rise more than domestic prices
(∆PF > ∆PH), then the nominal rate decrease by the same percentage (Rn falls and it takes fewer
Birr to buy a unit of foreign currency). These forces can take highly variable and sometimes very
long periods of time to materialize, however, so the law of one price does not permit anyone to
forecast tomorrow’s or next year’s Birr- dollar exchange rate. In addition, even over the long-
run, there can be substantial deviations in a nation’s currency from the law of one price.
Faster productivity growth is equivalent to a relative decline in prices and leads to a real
appreciation in currency values over the long run. Let us take a historical data on US – Japanese
and US-German exchange rate over the period 1980 – 1994 as shown in table 5.1. The higher
productivity growth in Japan and Germany relative to the US productivity growth over the period
1980 to 1994 resulted in an increase in the market exchange rate in the US-Japan and US-
Germany foreign exchange market. For example of the 4.9% increase in USD-Yen market
exchange rate, 2.1% of the increase was due to higher productivity growth in Japan relative to
USA, 0.9% of the increase was due to higher inflation in USA relative to the inflation in Japan
over the indicated period. The remaining 1.9% increase was due to unexplained or stochastic
factors that may have effect on exchange rate.
Table 1.2 Determinants of long-run charges in exchange rate, US-Japan and US-Germany, 1980-1994
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US – Japan
US –Germany
(∆PH - ∆PF) in percent where PH is price 0.9% 1.9%
in US and PF is price level in foreign
Differences in productivity growth (foreign 2.1% 1.1%
minus US) in percent )
Source: Kenneth Kasa “Understanding Trends in foreign exchange rates’” FRBSF weekly letter,
FRB of San Francisco, h. 9, 1995
At the Breton Wood conference of 1948 the major nations of the western world agreed to a
pegged exchange rate system. Each country fixes its exchange rate against the US dollar with a
small margin of fluctuation around the par value. In 1973 the Breton Woods system broke down
and the major currencies were left to be determined by market forces in a floating exchange rate
world. The basic difference between the two systems can be explained using the supply and
demand frame –work.
Under the floating exchange rate regime the authority do not intervene to buy or sell their
currency in the foreign exchange, market rather, they allow the value of their currency to change
due to fluctuations in the supply and demand of the currency, and this is illustrated in figure
below.
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If there is an increase in the demand for US exports, there will be a shift in the demand curve for
dollar from D1 to D2, this increase in demand for dollar will lead to an appreciation of the dollar from
9.5 say, to 9.70 or depreciation of birr Figure 1.4 (b) shows the impact of increase in supply of dollar
due to an increase demand for Ethiopian export and thus for birr. The increased supply of dollar
shifts the supply curve S1 to the right to S2, resulting in a depreciation of dollar from 9.50 to 9.40 .or
appreciation of birr In general, the essence of a floating exchange rate is that the exchange rate
adjusts in response to any changes in the supply and demand for currency.
In fixed exchange rate regime, exchange rate is fixed by the authorities and cannot adjust in response
to the change in supply and demand for currency. Figure 1.5 illustrates the mechanism of fixing
exchange rate.
In figure 1.5 (a) the exchange rate is assumed to be fixed by monetary authorities at the point where
demand intersect the supply curve at birr 9.50. If there is an increased demand for dollar which shifts
the demand curve from D1 to D2, there is a resulting pressure for the dollar to be revaluated. To
control the appreciation of dollar, the National Bank of Ethiopia will sell Q1 Q2 amount of dollar to
purchase birr with dollars in the foreign exchange market. This save of dollar by National Bank of
Ethiopia shifts the supply curve of dollar from S1 to S2. Such intervention eliminate the excess
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demand for dollar so that exchange rate will remain fixed at birr 9.5. This intervention will decrease
the amount of birr in circulation and decreases the National Bank’s dollar reserve.
Similarly figure 1.5 (b) presents a situation where the exchange rate is pegged by the National Bank
at the point where S1 intersects D1 at birr 9.50 per dollar.
If there is an increase in demand for Ethiopian export, there will be an increased demand for birr
and increased supply of dollar which shifts the supply curve to S2. That is excess supply of dollar at
the prevailing exchange rates and there will be a pressure on the dollar to be devaluated or domestic
currency to be revalued. To avoid this the National (Central) Bank of Ethiopia has to intervene in
the foreign exchange market by purchasing Q1 Q2 amount of dollar to keep the exchange rate fixed
at birr 9.50 per dollar. This intervention is shown by a right ward shit of the demand curve from D1
to D2. Such intervention removes the excess supply of dollar so that the exchange rate remain
pegged at birr 9.50 per pound and it leads to an increase in the Ethiopian National Bank’s reserves
of dollar and in the amount of birr in circulation.
Historically, fixed exchange rate systems have usually been a gold standard or a modified gold
standard and have been far more common than a floating exchange rate system. Both fixed and
floating exchange rate systems have advantages and disadvantages. The weight of economic
opinion has probably tended to favor floating exchange rates, although this is by no means
unanimous.
Gold standards are a form of fixed exchange rates. Under a pure gold standard, nations keep gold as
their international reserve. Gold is used to settle most international obligations, and nations must be
prepared to trade it for their own currency whenever foreigners attempt to "redeem" the home
currency they earned when they sold goods and services. In this sense, the nation's money is backed
by gold.
There are essentially three rules that countries need to follow in order to maintain a gold exchange
standard.
Rule 1: Nations must fix the value of their currency unit in terms of gold
Fixing the value of a nation’s currency in terms of gold fixes the exchange rate. For example, under
the modified gold standard of the Bretton Woods System (1947-1971) the U.S. dollar was fixed at
$35 per ounce, and the British pound was set at £12.5 per ounce. The exchange rate was $35/£12.5,
or $2.80 per pound. If in Ethiopian case, government may fix Ethiopian Birr at Birr 120 per ounce
of gold. Thus the exchange rate for Birr to Dollar would be Birr 120/$35, or Birr 3.43 per USD.
Rule 2: Nations keep the supply of their domestic money fixed in some constant proportion
to their supply of gold
This requirement or rule is an informal one, but it is necessary in order to insure that the domestic
money supply does not grow beyond the capacity of the gold supply to support it. Consider what
would happen if a country decided to print large quantities of money for which there was no gold
backing. In the short run, purchases of domestically produced goods would rise; in the medium to
long run, domestic prices would follow them up. As domestic prices rise, foreign goods become
more attractive, since a fixed exchange rate means that they have not increased in price. As imports
in the home country increase, foreigners accumulate an unwanted supply of the home country's
currency. This is the point at which the gold standard would begin to become unhinged.
Rule 3: Nations must be willing to redeem their own currency with payments in gold, and
they must freely allow gold to be imported and exported
If gold supplies are low in relation to the supply of domestic currency, gold reserves will run out
when the nation tries to redeem its currency from foreigners. This spells crisis and a possible end to
the gold standard.
Note: Under any fixed exchange rate system, whether it is based on gold or not, the national supply
and demand for foreign currency may vary, but the nominal exchange does not. It is the
responsibility of the government or monetary authorities (i.e. the central bank or treasury
department) to keep the exchange rate fixed.
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Figure 1.6 shows an increase in the Ethiopia’s demand for US dollar. In the short run, a rise in
demand is caused by one of the factors. These factors include, for example, increased Ethiopia’s
demand for US goods, higher US interest rates, or the expectation that the value of the Birr will fall
against the dollar. If R1 is the fixed Birr-USD exchange rate, then Central Bank of Ethiopia must
counter the weakening Birr and prevent the rate from rising to R 2. (Remember, R2 represents more
Birr per USD than Rl; therefore, the Birr is worth less.)
One option is to sell the Ethiopia’s reserves of USD. This shifts the supply curve out, from S 1 to S2
and keeps the exchange rate at RI.
Under a pure gold standard, nations hold gold as a reserve instead of foreign currencies and Ethiopia
sells its gold reserves in exchange for Birr. This action increases the demand for Birr and offsets the
pressure on the Birr to fall in value.
As Ethiopia sells its gold reserves, one of two things can happen. Either the demand for gold by
people supplying Birr is satisfied or the pressure on the Birr eases or Ethiopia begins to run out of
gold. If the latter happens, Ethiopia may be forced to devalue the Birr. Under a gold standard,
devaluation is accomplished by changing the gold price of the Birr. If the Birr was set at Birr 120 per
ounce of gold, devaluation would shift the price of gold to something more than Birr 120, and each
ounce of gold sold by Ethiopia buys back a greater quantity of Birr.
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Note: Devaluation and revaluation are equivalent to depreciation and appreciation, except that the
first group refers to changes in a currency's value under a fixed exchange rate system.
Devaluation is a decline in the value of a currency under a fixed exchange rate system, while
depreciation is a decline under a flexible system.
Revaluation is an increase in the value of currency under a fixed exchange rate system while an
appreciation is an increase in the value of currency under a flexible exchange rate.
Fixed exchange rates under a gold standard are one extreme in the spectrum of possible exchange
rate systems. At the other extreme are floating (or flexible) exchange rates. Under a floating
exchange rate system, the value of a nation's currency "floats" up and down in response to changes
in its supply and demand. When demand for domestic currency exceeds its supply, the domestic
currency appreciates in value (Rn, the nominal exchange rate falls), and when supply is greater than
demand, the domestic currency depreciates (Rn rises).
Between fixed and floating exchange rates, there are a number of other types of exchange rate
systems. The simplest way to categorize these systems is on a scale that measures the amount of
flexibility each allows.
Freely floating rates: At one end are freely floating rates, which are the most flexible and
determined purely by the forces of demand and supply of the foreign exchange market
Managed floating rate: One step down the spectrum of flexibility is a managed floating rate. The
difference between a managed floating rate and a purely floating exchange rate is that the national
government occasionally intervenes in international currency markets in an attempt to "manage" the
direction of change. Intervention takes the form of buying the home currency in order to increase its
demand and prop up its value, or selling the home currency in order to en-courage depreciation.
Countries with floating exchange rates use these tactics whenever policy makers think there is a need
to nudge their currency up or down, or to stop an ongoing change. Nearly all governments try to
manage their exchange rate at some point in time. Consequently, most of the nations that have
adopted floating exchange rate systems are in fact using a managed floating system.
A target zone exchange rate system: this is similar to a managed floating system. The most
prominent example is the European Monetary System of the fifteen-member European Union, prior
to the single currency (Euro) of 1999. With a target zone, exchange rates are allowed to float freely
within some well-defined range, or band. The band defines a line of intervention; that is, it is like a
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managed float except the limits of a currency's flexibility are precisely defined.
Adjustable peg exchange rate: An adjustable peg is a fixed exchange rate that is adjusted
periodically. Developing nations often use an adjustable peg or something very similar as a way to
keep their exchange rate more or less fixed in real terms.
Given that Rr = Rn(PF/PH), regular adjustment to Rn keeps the real exchange rate, Rr, from
appreciating when domestic inflation is greater than the inflation rate of the country's
The forward exchange-market is a market where buyers and sellers agree to exchange currencies at
some specified date in the future. For example, Ethiopian importer who has to pay $10,000 to his US
supplier at the end of August, may decide on June 1 to buy $ 10,000 for delivery on August 31 of the
same year at a forward exchange rate of say birr 9.40 per dollar. The question that commonly arises
is that, why should anyone wish to agree today to exchange currencies at some future date?
To answer this question we need to look at different participants in the forward exchange market.
Traditionally, economic agents involved in the forward exchange market are divided into three
groups based on their motives for participation in the foreign exchange market. These are
• Hedgers
• Speculators
• Arbitrageurs
Hedger: These are agents (usually firms) that enter the forward exchange market to protect
themselves against exchange rate fluctuation, which entail exchange rate risk.
Exchange risk is the risk of loss due to adverse exchange rate movements. We will explain why a
firm may engage in a forward exchange rate transaction using the following illustrative example.
Consider the Ethiopian importer who is going to pay for goods imported from the US to the value of
US $ 10,000 in one year time. Suppose the spot exchange rate is 9.5 birr while the one year forward
exchange rate is birr 9.4. By buying dollars forward at this rate the importer can be sure that he only
has to pay birr 94000. If he does not buy forward today, he might run the risk that in one year’s time
the spot exchange rate may be higher that birr 9.4 such as birr 9.50 which would mean he has to pay
birr 95000. Of course, the spot exchange rate in one year’s time may be changed in favor of the
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importer and may be birr 9.20 in which case he would only has to pay birr 92000. But by engaging
in a forward exchange contract the importer can be sure of the amount of birr he have to pay for the
imports, and therefore can protect himself against the risk of exchange rate fluctuation.
One may ask why the importer does not immediately by US $10,000 at spot at birr 9.40 and hold for
1 year. One reason is that he may not at present have the necessary funds for such a spot purchase
and is reluctant to borrow the money, knowing that he will have the funds in one year’s time from
sales of goods. By engaging in a forward contract he can be sure of getting the dollars he requires at
known exchange – rate even though he does not yet have the necessary birr.
In effect, hedgers avoid exchange risk by matching their asset and liability in the foreign currency. In
the above example, the Ethiopian importer buys 10,000 USD forward (his asset) and will have to pay
10,000 for imported goods (his liability).
Arbitrageurs: - These are agents (usually banks) that aim to make a risk less profit out of
discrepancies between exchange rates differences and what is known as the forward discount or
forward premium.
The forward discount or premium is usually expressed as a percentage of the spot exchange rate.
That is,
Where F is the forward exchange rate quotation and S is the spot exchange rate quotation.
The presence of arbitrageurs ensures that the covered interest parity (CIP) condition holds
continuously.
CIP is the formula used by banks to calculate their exchange quotation and is given by the following
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Where,
• F is the one - year forward exchange rate quotation in domestic currency per unit of foreign
currency,
• S is the spot exchange rate quotation in domestic currency, per unit of foreign currency, r is the
one year foreign interest rate and
The above formula has to be amended by dividing the three months interest rate by 4 to determine
the three – month forward exchange rate quotation and dividing by 2 to calculate the six month
forward exchange rate.
As an illustrative example of the determination of the forward exchange rate, suppose that the Euro
interest rate is 5%, and the birr interest rate is 3%, and the spot rate birr against Euro is birr 10 per
euro. The one year forward exchange rate can be calculate as follows.
To understand why covered interest parity (CIP) must be used to determine the forward exchange
rate, consider what would happen if the forward rate was different from that of calculated in the
above example, for example birr 10.1/Euro. In this instance an Ethiopian investor with birr 1000
could earn 1050 birr at the end of the year, but by buying Euro spot at birr 10 per euro, and
simultaneously selling pounds forward at birr 10.10 at spot exchange rate he would buy 100 Euro
(1000/10) and will earn 105 at the end of the year at 5% Euro interest rate (1.05x100=105). Selling
105 at forward rate of 10.1 giving him birr 1060.5 (105x10.1).
Clearly, it pays Ethiopian investor to buy Euro at spot and sell Euro forward. With sufficient
numbers of investors doing this, the forward rate would gradually depreciate until such arbitrage
possibilities were eliminated. With a spot rate of investors doing this, the forward rate would
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gradually depreciate until such arbitrage possibilities were eliminated. With a spot rate of birr
10/Euro, only the forward rate is at 9.81 birr will yield in Ethiopia and in European Union time
deposit be identical (since 105x9.81=1030). Only at this forward rate there is no risk-less arbitrage
profits to be made.
Since the denominator in the above equation is very close to one (unity), the equation can be
modified to yield an approximate expression for forward premium /discount
This approximate version of CLP says that, if the country interest rate is higher than the foreign
interest rate, then its currency be at forward premium by equivalent percentage; while if the
domestic interest rate is lower than the foreign interest rate, the currency will be at forward discount
by an equivalent parentage. In our example, the Ethiopian, interest rate of 3% less than Euro interest
rate of 5% indicate an annual forward discount on Euro of 2%, which is an approximation to the
actual 1.9 percent discount obtained using the full CLP formula.
Speculators: - speculators are agents that hope to make a profit by accepting exchange rate risk.
They engage in the forward exchange market because they believe that the future spot rate
corresponding to the date of the quoted forward exchange rate will be different from the quoted
forward rate.
Consider the situation where the one year forward rate is quoted at birr 9.40/ USD and a speculator
fells that the dollar will be rather birr 9.20 /USD in one year's time. In this case he may sell $1000
forward at birr 9.40 so as to obtain birr 9400 one year and hope to change them back into dollar in
one year’s time at birr 9.20 /USD, and so obtain US $1021.74 making $21.74 profit.
In fact the speculators may be wrong in his expectation and find that in one year’s time spot
exchange rate are rather above 9.40, say birr 9.50 /USD, in which case his 9400 birr are worth only
989.47 USD implying a loss of USD 10.53
Generally, speculator hops to make money by taking and open position in the foreign currency. In
our example, he has a forward asset in Birr which is not matched by a corresponding liability of
equivalent value.
Why spot and forward exchange rate are different in most cases?
The answer is that, the spot and forward exchange rate should differ by about as much as interest
rate differs in the two countries' currencies as explained earlier.
Here is an explanation for difference between spot and forward rates. A country with one percent
higher interest rate will tend to have a one percent forward discount (short fall of the forward rate
below the spot rate) on its currency. In fact, Euro did have a forward discount in our previous
example (and this is a forward premium to birr).
The relationship between spot and forward rate is thus, dictated by the international interest rate
gap. As long as this gap stays the same, the spot and forward rates will keep differing by the same
percentage, and whatever moves the spot rate up and down will do the same to the forward rate.
Interest rate parity :- The forward exchange value of a currency will tend to exceed its spot value
by as much (in percent) as its interest rate are lower than the foreign interest rate.
For our better understanding how interest rate parity condition works let us have one more example.
i. We can convert present dollar into future birr by selling them at the spot exchange rate
(rs, measures birr per dollar) and investing those birr at the
Or
ii. We can convert present dollar into future birr by investing the dollar in US at the interest rate
ib and selling the later earnings right now at the forward exchange rate r f again measured in
birr per dollar.
If you can get from present dollar to future birr in either of the two ways, you will take the more
profitable way. But everybody thinks the same way. Since investors have choices, the exchange
rates and interest rates will adjust so that the two future dollar values are equal. That is.
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Arbitrageurs
Arbitrage is the simultaneous purchase and sale of equivalent assets at prices which guarantee a
fixed profit at the time of the transactions, although the life of the assets and, hence, the
consummation of the profit may be delayed until some future date. The key element in the
definition is that the amount of profit be determined with certainty. It specifically excludes
transactions which guarantee a minimum rate of return but which also offer an option for
increased profits. Arbitrageurs are in business to take advantage of a discrepancy between prices
in two different markets (Eg: NSE and BSE). If, for example, they see the futures price of an
asset getting out of line with the cash price, they will take offsetting positions in the two markets
to lock in a profit.
”Arbitrage is exploiting the price difference of a product in different markets. I buy at a lower
price and sell at a higher price. The price of onions at location X is $2 and is $4 at location Y. I
exploit this price difference by buying at $2 and selling at $4, thus making a profit of $2.”
Hedgers
Hedging is the simultaneous purchase and sale of two assets in the expectation of a gain from
different subsequent movements in the price of those assets. Usually the two assets are
equivalent in all respects except maturity. Hedgers face risk associated with the price of an asset.
They use futures or options markets to reduce or eliminate this risk.
“Hedging is essentially risk management. Your goal is to reduce risk. Here's an example. Let's
say that I own a local fast food restaurant. I am afraid that the prices of potatoes is going to
increase in the future. This would severely affect my business as the cost of manufacturing
French fries would increase substantially. To hedge against this, I will enter into a forwards
contract with a potato supplier to buy potatoes at a pre-decided rate. Thus, even if the price of
potatoes increase, I will still buy it at the lower, pre-decided rate and thus will have successfully
hedged my losses and managed risk.”
Speculators
Speculation is the purchase or sale of an asset in the expectation of a gain from changes in the
price of that asset. Speculators wish to bet on future movements in the price of an asset.
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Futures and options contracts can give them an extra leverage; that is, they can increase both the
potential gains and potential losses in a speculative venture. Day traders are speculators.
NB: While Hedgers look to protect against a price change, speculators look to make profit from a
price change. Also, the hedger gives up some opportunity in exchange for reduced risk. The
speculator on the other hand acquires opportunity in exchange for taking on risk.
“Speculation is trying to make money by the price of something increasing or decreasing in the
short term. I buy a stock at $10. I think that it will increase to $12 tomorrow and thus I will make
a $2 profit. I am speculating.”
NB: Speculation involves high risk. Arbitrage involves limited risk. Hedging is done to avoid
risk.
EXCHANGE CONTROL
It should be noted at the very outset that, exchange controls, like currency devaluations, form a
part of expenditure-switching policy package. Because, they too, like devaluation, aim at
directing domestic spending away from foreign supplies and investment. Exchange controls try
to divert domestic spending into consumption of domestically produced goods and services on
the one hand and into domestic investment on the other.
The object of controlling exchange is to fix it at a level different from what it would be if the
economic forces were permitted free interplay. The objectives of exchange control could be to:
correct a serious imbalance in the economy of the country relatively to the outside world;
or
permit national economies and policy architects a broad freedom of action both in
emergency and normal economic situations and warranty the decision to pursue domestic
policies of economic growth and development; or
correct a persistently adverse balance of payments; or
prevent a flight of capital from the country; or
conserve foreign exchange reserves for large payments abroad, i.e facilitate servicing of
foreign debt; or
maintain stable exchange rate, or to ensure growth with stability, and so on
In all these circumstances, a free exchange would be either embarrassing or prejudicial to the
object in view, and exchange control becomes an imperative necessity.
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Exchange controls may be broadly classified into two groups - direct and indirect exchange
controls. Among the direct methods mention may be made of intervention and regulation in
matters concerning exchange rates, foreign exchange restrictions, multiple exchange rate policies
etc. Indirect methods of exchange control include import tariffs, export subsidies, bilateral &
multilateral clearing arrangements, etc.
The government may intervene in the foreign exchange market with a view to raise or reduce the
external value of its home currency. This intervention takes the form of large-scale buying or
selling of home currency by the government in the foreign exchange market. The idea is to
support or "peg" the external value of the currency to a chosen rate of exchange. In the absence
of such pegging or government support through intervention, there is a risk that the free market
rate of foreign exchange would diverge from the pegged rate. Put simply, government will sell
foreign exchange when the price of foreign exchange is rising excessively on the foreign
exchange market; and government will buy foreign exchange when the foreign exchange rate is
going down excessively causing appreciation of domestic currency in terms of foreign currency.
Since both depreciation and appreciation of currency are regarded as undesirable, there is need
for government intervention in keeping exchange rates relatively stable. Exchange rate stability
is necessary to facilitate and promote healthy growth of international trade and capital
movements.
Exchange rate stability is threatened off and on by BOP deficit and surplus pressures on the one
hand and by the speculative buying and selling of foreign exchange of a destabilizing type, on
the other. Hence, the need for government intervention to "smoothen out" such ups and downs in
the exchange rate movement from time to time. It is relatively easier for a country to sell its
home currency and buy excess amount of foreign exchange to prevent depreciation of foreign
exchange (or appreciation of its own currency), because every country has unlimited supplies of
its own currency. All that the governments have to do is to go to the printing press and get more
currency notes. On the other hand, the foreign exchange reserves at the disposal of a country are
rather strictly limited. Therefore, if the foreign exchange rate is appreciating due to scarcity of
foreign exchange (i.e. the domestic currency is depreciating against foreign currency), it would
not be easy for governments to sell unlimited quantities of foreign exchange to prevent a rise in
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the foreign exchange rate. Government intervention, however, has to be of both the types
pegging up or pegging down. The complexity or the case with which they can be undertaken are,
however, quite different.
2. Exchange restrictions
This is another, and perhaps more severe, form of exchange controls. In this case, all foreign
exchange earnings and receipts must be surrendered to the government and exchanged for home
currency; and foreign exchange can be purchased only from the government authorities. Non-
compliance with currency transactions and regulations laid down by the governments are a crime
even punishable with death as in Germany in 1931.
Government will acquire all foreign exchange coming into the country, and it will allocate or sell
that foreign exchange to buyers on the basis of predetermined national priorities. For example,
foreign exchange may not be made available for all kinds of foreign tour, travel or study or for
non-essential import of goods and services, and so forth. A country may practice a system of
what is called as "blocked accounts" i.e. not allowing the creditors of these blocked accounts to
use their currency holdings in their accounts. Foreign investment by nationals may not be
permitted due to shortage of foreign exchange. One can visualize any number of measures which
governments may take to cop serve scarce foreign exchange, and they all constitute foreign
exchange restrictions as a form of exchange controls.
Multiple exchange rates were first employed by Germany and later they were followed by other
countries like Argentina, Brazil, and Chile, Ecuador, Peru and many others. In the case of this
policy, different exchange rates are fixed for imports and exports of different goods. Even for
different categories of imports, different exchange rates are applied. Argentina maintained a
higher complex system of multiple exchange rates, because she was not a member of the IMF.
The system was administered quite efficiently for a long time.
The mechanism of multiple exchange rates is very simple. Suppose for example, the government
considered imports of some raw materials and capital goods as essential to the economic
development of the country; then the foreign exchange rate used in the case of such imports
would be lower, say 1USD= 5 Birr rather than the standard exchange rate of, say 1 USD= 8.70
Birr. In terms of Birr (home currency) the importer pays a lower price for obtaining a given
amount of USD (foreign exchange). This would make imports of such goods cheaper, because
the Birr price of USD fixed for their imports is lower. On the other hand, imports of non-
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essential luxury goods may be subjected to a higher foreign exchange rate, say 1USD =15 Birr.
This would raise value of USD in terms of Birr and make import of the luxury goods rather very
expensive. The same discriminatory exchange rate policy could be applied to export goods as
well to encourage exports of certain types of goods and services more than others.
The policy of multiple exchange rates is also called selective devaluation policy as opposed to
general devaluation policy. In the case of general devaluation policy, imports of all goods and
services are made expensive, regardless of whether they are essential or nonessential types of
imports. Similarly, generally devaluation would make all the exports attractive regardless of
what the export commodity is. Multiple exchange rate policy undertakes selective devaluation
i.e. it would make essential imports cheaper and nonessential imports expensive, and it would
make some exports attractive and other exports unattractive.
Multiple exchange rate policy will have different exchange rates not only for different goods
(imported and exported) but also for different countries with which the home country is trading.
The advantage of multiple exchange rate policy to the practicing country lies in the fact that it
eliminates the need for employing quantitative restrictions on imports (or exports) and licensing
of imports (or exports). To that extent, this system can eliminate inefficiency and corruption that
usually go with import licensing and quantitative restrictions on imports. This is perhaps the
great merit of multiple exchange rates vis-a-vis physical controls on imports. However, there are
several shortcomings associated with the multiple exchange rate systems. For example, the
system introduces complexity and lot of confusion with regard to the number of exchange rates
applicable to number of commodities in relation to number of countries. Sometimes, they can
harm healthy economic development of a country.
Among the indirect methods of exchange control to mention are: exchange clearing agreements,
import restrictions, tariffs and import quotas are the chief instruments of indirect methods of
exchange control.
Exchange clearing agreements can be bilateral or multilateral, private or official. The world has
witnessed all such different types of agreements over the past several years. Bilateral clearing
arrangements lead to a system of international trade and payments of a barter nature. Among the
earliest forms of bilateral trade were barter deals undertaken by private firms. If all exports and
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imports of a country are carried out in such a bilateral barter fashion, there would be no BOP
deficits or surpluses in any country. There would even be no need to use money or foreign
exchange in settling international trade and payment obligations. Such bilateral clearing
arrangements are employed by Communist countries in trading with one another.
One problem with such arrangements is that the exporter has to play the role of an importer as
well, and exporters may not be accustomed to playing such dual roles. Germany evolved a novel
device of exchange clearing which had the advantage of relieving the exporter from also
performing the unaccustomed functions of an importer. This led to a system of barter clearing
agreements between governments i.e. the central banks of the two trading nations. Such
arrangements of BOP settlement are strictly limited to commodity trade between countries.
Tariffs and quotas on imports are indirect exchange control methods insofar as they become
necessary as soon as direct exchange control methods are adopted in a country. To the extent that
tariffs and quotas succeed in cutting down import expenditures, without materially reducing
export receipts, they will contribute towards an improvement in the BOP balance of a country.
Import duties levied for revenue consideration or to stimulate domestic industrialization, can be
considered as indirect exchange control methods. Similarly, export subsidies with a view to
expand exports need not necessarily fall into the category of exchange controls. Only when the
objective of import duties or quotas or export duties or subsidies is explicitly to support the
foreign exchange rate or improve the BOP situation, can they be truly considered as indirect
methods of exchanges control. In reality, however, it is very difficult to identify whether a given
important tariff or export subsidy is introduced for considerations of revenue or foreign exchange
earnings (saving to improve BOP situation). The same kind of difficulty extends also to non-
tariff barriers which a country may impose. Their objectives are so numerous that is almost
impossible to identify with certainty that they are meant solely to improve the BOP situation of a
country.
A financial market is a market in which people trade financial securities, commodities, and
other fungible items of value at low transaction costs and at prices that reflect supply and
demand. Securities include stocks and bonds, and commodities include precious metals or
agricultural products. In economics, typically, the term market means the aggregate of possible
buyers and sellers of a certain good or service and the transactions between them.
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The term "market" is sometimes used for what are more strictly exchanges, organizations that
facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This
may be a physical location (like the NYSE, BSE, and NSE) or an electronic system (like
NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger,
spinoff) are outside an exchange, while any two companies or people, for whatever reason, may
agree to sell stock from the one to the other without using an exchange.
Within the financial sector, the term "financial markets" is often used to refer just to the markets
that are used to raise finance: for long term finance, the Capital markets; for short term finance,
the Money markets. Another common use of the term is as a general for all the markets in the
financial sector, as per examples in the breakdown below.
o Bond markets, which provide financing through the issuance of bonds, and enable
the subsequent trading thereof.
Money markets, which provide short term debt financing and investment.
Derivatives markets, which provide instruments for the management of financial risk.
Futures markets, which provide standardized forward contracts for trading products at
some future date.
The foreign exchange market (forex, FX, or currency market) is a global decentralized market
for the trading of currencies. This includes all aspects of buying, selling and exchanging
currencies at current or determined prices. In terms of volume of trading, it is by far the largest
market in the world. The main participants in this market are the larger international banks.
Financial centers around the world function as anchors of trading between a wide range of
multiple types of buyers and sellers around the clock. The foreign exchange market does not
determine the relative values of different currencies, but sets the current market price of the value
of one currency as demanded against another.
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Chapter II
The law of one price state that in the presence of a competitive market structure and the absence
of transport costs and other barriers to trade, identical products which are sold in different
markets will be sold at the same price when expressed in terms of a common currency . The law
of one price is based up on the idea of perfect goods arbitrage.
Arbitrage occurs when economic agents exploit price differences to provide a risk less profit.
Examples
If a car costs birr 180,000 in Ethiopia 20,000 in US and the identical model, then according to
the law of one price the exchange rate should be 180,000/ 20,000, which is birr 9/USD.
Suppose the actual exchange rate were higher than this at birr 9.20 /USD, then it would pay US
citizens to buy a car in Ethiopia, because with 19565 USD he can buy a car (180, 000/9.20) by
doing so he will save 435 USD compared to purchasing the car in the US market.
According to the law of one price, US residents will exploit this arbitrage possibility and start
purchasing birr and selling dollars. Such a process will continue until the birr appreciates to birr
9/USD at which point arbitrage profit opportunities are eliminated.
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Conversely, if the exchange rate is birr 8.50/USD then US car cost the Ethiopian residents 21176
USD if he purchases the car in Ethiopia. But if he purchases in US the Ethiopian resident may
save 1176 USD. Thus, Ethiopian residents will purchase dollar and sell birr until the dollar
appreciates and exchange rate becomes 9 birr/USD.
The proponents of PPP argue that the exchange rate must adjust to ensure that the law of one
price which applies, to individual good, also holds internationally for identical bundles of goods.
Purchasing power parity (PPP) theory comes in two forms on the basis of strict interpretation of
the law of one price
This is a strict form of interpretation of the law of one price. In this approach, if one takes a
bundle of goods in one country and compares the price of that bundle with an identical bundle of
goods sold in a foreign country converted by the exchange into a common currency
measurement, then the price will be equal.
For example, if a bundle of goods costs birr 20 in 2 in the US, then the exchange rate Ethiopian
and the same bundle costs defined as birr per dollar will be 20 birr/2 USD = birr 10/USD .
Algebraically, the absolute version of PPP can expressed as S= p/*p
Where,
• S represents the exchange rate defined by domestic currency units (birr) per unit of foreign
Currency (USD)
• P – is the price of bundles of goods expressed in the domestic currency (price in birr)
• P*- is the price of identical bundle of goods expressed in the foreign currency (USD).
According to the absolute PPP a rise in the home price level relative to the foreign price level
will lead to a proportional depreciation of the home currency against the foreign currency.
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In the above example, if the price of Ethiopian bundle of goods rise say to 21 birr while the price
of the same bundle remain 2 then the birr will depreciate to birr 10.5 / USD (unchanged , that
is 21/2)
Many economists are somehow skeptical as to the application of the absolute version of PPP,
According to them the absolute version of PPP is unlikely to hold precisely because of the
existence of transportation cost, imperfect information and the distorting effect of tariffs and
other forms of protectionism.
However, it is argued that a weaker form of PPP known as relative PPP can hold even in the
presents of such distortions. In other words, the relative version of the theory of PPP argues that
the exchange rate will adjust by the amount of the inflation differentials between two economies.
This can be expressed as follows
%ΔS=% Δp−Δ*p
Where,
According to the relative version of PPP, if the inflation rate in the US is 10 percent that of
Ethiopia is 5 percent, the birr per dollar exchange rate should be expected to appreciate by the
approximately 5 percent.
The absolute version of PPP does not have to hold for this to be the case. For example, the
exchange rate may be birr 10/ USD while the Ethiopia bundle of goods costs birr 120 and the US
bundle of identical goods cost, USD 10 so that absolute PPP to hold it would require (120/10)
=12/US. But if Eth price goes up 10 percent to birr 132 and the US bundle of goods goes up 5
Percent to 10.5 USD, the relative version of PPP predicts the birr will deprecate by 5% to birr
10.5 /USD.
One of the major problems with PPP is that it is supposed to hold for all types of goods.
However, a more generalized version of PPP provides some useful insights and makes
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distinction among goods traded. According to general version of PPP goods can be categorized
into traded goods and non-traded goods.
Traded goods: - These are goods which are susceptible to international competition. Here
belongs most manufacturing goods like.
• Automobile
Non traded goods: - are those that cannot be traded internationally at a profit. Their price will
not be affected by the international competition. These includes different goods and services like
Houses, etc
The distinction between them is due to the fact that the price of traded goods will tend to be kept
in line with the international competition, while the price of non-traded goods will be determined
predominantly by domestic supply and demand considerations.
For instant, if a car costs 15,000 Pound in the UK and $ 30,000 in US arbitrage will tend to keep
the pound-dollar rates at 2 USD/Pound. However, arbitrage forces do not play a role in the case
of house trade. Similarly, if a hair-cut cost birr 10 in Ethiopia but $10 in US and the exchange
rate is birr 10/USD. No one in the US will travel to the Ethiopia for a haircut knowing that they
can save $9 because of the time and transport costs involved.
When aggregate price-indices is determined both tradable and non-tradable are considered.
Assuming that PPP holds for tradable we have the following locations.
pT=spT *
Where,
• pT− price of traded goods in the domestic country measured in terms of the domestic
currency
• P*T−the price of traded goods in the foreign country measured in-terms of the foreign
currency.
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• S - The exchange rate defined as domestic currency units per unit of foreign currency.
The aggregate price index (pI) for the domestic economy is made up of a weighted average of
the price of both tradable (pT) and non-tradable goods (PN), priced in the domestic currency.
Likewise, the foreign aggregate price index (pI*) is made up of a weighted average of the prices
on tradable (PN *), priced in the foreign currency. This is shown as
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The above equation is an important modification to the initial PPP equation. This is because PPP
no longer necessary holds in terms of aggregate price indices due to the terms on the right hand
side. Furthermore, the equation suggests that the relative price of non –tradable relative to
tradable will influence the exchange-rate.
Testing for PPP using price indices based on tradable goods prices is likely to lead to better
results than when using aggregate price indices made up of both types of goods.
Many of the proponents of PPP argued prior the adoption of floating exchange rate changes
would be in line with those predicted by the theory of PPP. However, there are problems faced
when it is applied practically. One of such problems is that, whether the theory is applicable to
both traded and non-traded goods.
At the beginning PPP seems readily applicable to traded goods. However, some people argued
that the distinction between tradable and non-tradable is fuzzy, because in most cases they are
linked to each other. Moreover tradable goods are used as input into the production of non-
tradable goods.
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Money researchers have tried to test whether PPP can be used to predict exchange rate or not.
They used graphical evidence, simplistic data analysis and more sophisticated econometric
evidences and the results are summarized as follows.
• PPP performs better for countries that are geographically close to one another and
where trade linkages are high
• Exchange rates have been much volatile than the corresponding national prices level.
This is against the PPP hypothesis in which exchange rates are only expected to be as volatile as
relative price.
• The currencies of countries with very high inflation rates relative to their trading
partners, mostly likely would experience depreciation reflecting their high inflation
rate. This suggests that PPP is the dominant force in determining their exchange rate.
• Overall, PPP holds better for traded goods than non-traded goods
• Strikingly, it was observed that the price of non-traded goods tends to be more
expensive in rich countries than in poor countries once they are converted into a
common currency.
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