The current paper consists of two parts: the first part relates effective real and nominal exchange rates of four countries (US, UK, Japan, and Germany) for the period from 1964 to 2012; the second part relates the structure of foreign exchange market and the theory of purchasing power parity theory. This paper relates the issues of nominal and real effective exchange rates, particularities of their construction, and the structure of foreign exchange markets, its participants, and their motivations. Besides, it touches upon purchasing power parity theory, considers arguments for and against the theory, and provides empirical evidence of testing a proposed hypothesis. Besides, the tests conducted to receive evidence of the validity of purchasing power parity theory were described in detail. The actual evidence of the PPP theory was provided.
The information related a nominal and real effective exchange rate is in the Appendices 1-4. The Appendices are attached in Excel files.
Nominal and Real Effective Exchange Rates
The relative value of national currency compared to other major traded currencies that are traded (U.S. dollar, euro, or Japanese yen) is called the nominal effective exchange rate or NEER in short. NEER measures approximate relative price paid for imported goods. The relative value of a currency to other major traded currencies adjusted for inflation rate is called the real effective exchange rate or REER. The REER measures the cost of foreign goods relatively to domestic goods. The REER measures relative price of goods produced in different countries. Hence, fluctuations of the REER can affect the competitiveness of the goods traded (Canjels, Gauri and Taylor, 2004).
The Structure of Foreign Exchange Markets
The foreign exchange market is characterized by the decentralized structure where participants are separated from each other and transactions are fulfilled with the help of electronic media (telephone and Internet). Decentralization of the foreign exchange market means that is fragmented, but there is a lack of transparency. Fragmentation of the foreign exchange market means that the transactions do not occur simultaneously (Sarno and Taylor, 2002). The foreign exchange market is considered the most liquid market in the world. Almost 90% of daily transactions in the foreign exchange market are represented by dollar exchange. Approximately 37% of daily transactions are connected with euro turnover, 20% of daily transactions fall at yen and sterling (BIS, 2004).
The participants of foreign exchange market are divided into two groups, namely: dealers and customers. Approximately 59% of daily market turnover occurs within interdealer market while customers contribute 41% of the market. The interdealer market is subdivided into leverage traders, risk-takers, market-makers, and proprietary traders (Sager and Taylor, 2006). Market-makers facilitate customer trades whose attention is focused on book exchange rate. Recently, they tend to pay more attention to one side of the market. Proprietary traders can use a short time span measured by minutes and hours that cannot run overnight positions. Proprietary traders are usually encouraged to allocate risk budgets upon longer periods of time than leverage traders. Leverage traders’ trading activity is based on the order flow executed by the bank using time horizon from several hours to several days. Total market volatility is represented by the short-term activity of these traders. Risk-takers perform the functions similar to proprietary traders, but they are allocated a larger risk budget. Risk-takers are encouraged to focus on longer investment horizons (Bjonnes and Rime, 2003).
Customers are interacting with dealers in the foreign exchange market aiming to access the liquidity of the interbank market. Customers’ trades are accounted with the help of electronic systems. Electronic systems were created to reduce the risk of human errors. Customers can be subdivided into two types – active and passive. Active customers introduce foreign exchange exposure. Active currency programmes make portfolios of active customers. Passive customers obtain foreign exchange exposure from trading underlying assets, such as bonds and equities (Bjonnes and Rime, 2003).
There is an alternative classification of the customers under which they are subdivided into informed and uninformed customers. Belonging to a particular group reflects the ability of the customer to interpret the impact of data upon future returns from exchange rate fluctuations. Among informed customers are central banks that observe data innovations and compare it to data series relevant to the national currency (Sager and Taylor, 2006).
Purchasing Power Parity Theory
Purchasing power parity (PPP) is a theory which explains the equality between the nominal exchange rate of two currencies and the ratio of aggregate price levels in two countries. Thus, purchasing power of a unit of the currency of one country is equal to purchasing power of a unit of the currency in another country. PPP theory has been widely used since the World War II, but the history of this theory counts more than two centuries. It is important for any country to implement an appropriate exchange rate policy. The central question in this process is how to adjust exchange rates. The countries use fixed and variable exchange rates (Taylor and Taylor, 2004). Countries using fixed exchange rates want to know what the equilibrium is to be and the countries using variable exchange rates need to know the magnitude of expected variation in nominal and real exchange rates (Hall, 2010). Thus, PPP helps determine the extent of self-equilibration of international economic system. The main idea of PPP is that it means a unit of one currency in one country can buy the same basket of goods in another country. There can be discrepancies when comparing prices of identical goods from the baskets because may not be similar goods traded in two countries. This is a serious objection because countries tend to produce products that differentiate (Carlson and Osler, 2005). Since PPP is based on traded goods, it would be more useful to test with indices of producers’ prices containing prices of more manufactured goods for trade. The most recent problem of PPP is how to retain PPP in a long-run equilibrium (Engel, 2000).
Arguments for and against PPP Theory
The theory is subject to several arguments. Some of them are for the theory and some of them are against it. There is an assertion that PPP theory of exchange rates holds because of international goods arbitrage (Canjels, Gauri and Taylor, 2004). PPP hypothesis may hold in two senses, namely: absolute and relative purchasing power. Absolute purchasing power can hold when a unit of currency in domestic economy equals to a unit of currency in a foreign economy when it is converted into foreign currency at the rate defined by the exchange market. However, it has been already determined that it is difficult to find the same basket of goods in both countries for comparison (Taylor, 2002). Relative PPP holds when percentage change in the exchange rate during a given period of time offsets the difference in inflation rates. There is a correlation between absolute and relative PPP: if absolute parity holds, then relative parity holds, but if relative parity holds, then absolute parity may not hold. Taylor and Taylor (2004) stated that while relative PPP does not hold in the short-run, it holds in the long-run sense.
However, absolute parity holds neither perfectly nor continuously meaning that there are short-run deviations. The level of prices in two chosen countries does not tend to move simultaneously over long periods. In addition, correlation between price levels of two countries is greater with manufacturer prices than with the prices paid by consumers. There are two senses when the hypothesis of PPP may hold, namely: absolute PPP holds when the purchasing power of units of domestic and foreign currencies is equal (Taylor and Taylor, 2004).
Proof of Validity of PPP Theory
The theory of exchange rate overshooting was a result of the failure of PPP in the short-run period. In this theory PPP is retained in a long-run while it is subject to deviations long-run implications of PPP. The tests were based on an empirical examination of real exchange rates (Taylor and Sarno, 2004). The test had to prove that if the real exchange rate can be settled on any level, it has to display reversion toward its mean. Thus, the necessary condition for long-run PPP is mean reversion (Lothian and Taylor, 1997). The mean toward which PPP is reverting is the real exchange rate. The research conducted by Taylor and Taylor (2004) failed to reject the hypothesis that the necessary condition does not hold.
Other empirical studies described by Taylor and Taylor (2004) also tested the null hypothesis stating that the real exchange rate does not necessarily means reversion. It appeared that the mean follows random walk where changes that occur in any period of time are independent in accord to time series process (Shiller and Perron, 1985). A concept of efficient markets PPP appeared. The developers of this concept argued that the real exchange rate effectively measured real return of one period from the goods between countries that were arbitraged. An expected value in this case must be zero since the markets are efficient (Taylor and Taylor, 2004).
However, early test were deprived of appropriate logical and econometric support. The theoretical concept of efficient markets PPP did not succeed to adjust the expected return to the real cost of financing arbitrage (Taylor and Taylor, 2004). The evidence of a random walk was mixed and the results depended on the criteria used. The researchers failed to reject the null hypothesis even if it was false because they did not have enough econometric tools (Roll, 1979).
Evidence of Validity of PPP Theory
The PPP theory is lively debated starting from the early 1970s. The theoretical researchers suggested that exchange rates are linked to the changes in price levels and deviations are temporary and insignificant. Empirical researchers failed to find firm evidence supporting the PPP theory. According to the evidence that was received, the rate of reversion to PPP was very slow equaling three to five years. The latest works related this issue combined nonlinearity and works on transaction costs explaining volatility. These studies also added to explanation of stability of the real exchange rate. Besides, Harrod-Balassa-Samuelson represented a modified view on PPP where the real exchange rate changes with time (Taylor and Taylor, 2004).
Currently, the PPP theory aims to resolve two important issues: allowance for taxation of imported and exported goods and transport charges; estimation of purchasing power of the goods that are not traded in the international market. Taking into consideration the issues that arose, including Harrod-Balassa-Samuelson and nonlinearities could help get better estimates of speeds of convergence. Another direction is to introduce real shocks and trade costs into the model of Clarida and Gali. To sum up, if short-run parity does not hold, the long-run parity may hold showing significant mean reversion in real exchange rate. However, there are factors that disturb equilibrium of the real exchange rate through time (Sarno and Taylor, 2002).
This paper relates theoretical and empirical research of effective exchange rates. The mechanism of formation of effective exchange rates was considered. Theoretical implications of purchasing power parity of were supported by the empirical evidence. The empirical evidence was based on analysis of the effective exchange rates of four countries. The issue of effective exchange rates needs further research because a unique exchange rate policy cannot be developed due to the particularities of the economies of different countries. Recently, a lot of adjustments were made to the early developed concepts of the PPP theory. The most recent adjustments were the hypothesis about nonlinearity and Harrod-Balassa-Samuelson model (Cushman and Nils, 2011). Further research may touch upon integration of nonlinear hypothesis and Harrod-Balassa-Samuelson model (Sarno, Chowdhury and Taylor, 2004). Also, the concepts of trade costs and real shocks may contribute to advancement of reconciliation.
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