Monday, August 31, 2009

Why The Excessive Exchange Rate Over-Shooting?

Economists often use two theories to explain exchange rates: the purchasing power parity theory and the interest parity theory. These two theories are in fact mutually exclusive (at least one of them can't be true) if real interest rates are different in different countries.

To see why that is the case consider a case of country A with an interest rate of 6% and an inflation rate of 2% while country B has an interest rate of 3% and an inflation rate of 1%.

If the prediction of the purchasing power parity is true, then the currency of country B should appreciate with 1% per year relative to the currency of country A. But that would mean that the return of investments in country B would have a return of only 4% while investments in country A would have a return of 6% (in terms of the country A currency), clearly contradicting the predictions of the interest parity theory.

If on the other hand the prediction of the interest parity theory would hold true, then we would see the currency of country B appreciate with about 3% per year relative to the currency of country A. But that would mean that the real exchange rate of currency B would appreciate by 2% per year, contradicting the predictions of the purchasing power parity theory.

But despite the fact the interest parity theory and the purchasing power theory cannot possibly both be true in a world with different real interest rates, they are both presented as more or less true in books on international economics.

One theory that tries to combine the two is theory of exchange rate overshooting. This theory was presented after the new area of fluctuating fiat exchange rates began after Nixon ended the Bretton-Woods System in 1971. Exchange rates fluctuated much more wildly than the advocates of fluctuating exchange rates, like Milton Friedman, said they would.

The theory that was put forward to explain these seemingly excessive exchange rate movements was the theory of exchange rate over-shooting. This theory essentially says that if some country increases its money supply this will in the long run cause its price level to increase proportionately, which according to the purchasing power parity theory would also lower its relative exchange rate proportionately in the long run . At the same time it will push down local interest rates, meaning that according to the interest parity theory, investors will require a future appreciation of the currency, meaning that given a certain expected future exchange rate, the current exchange rate must fall. Because both theories in the case of more inflationary policies in one country predict currency depreciation, then this combined theory says that the currency will depreciate more than what either theory alone says.

There is a limited degree of truth in this theory, but it suffers from several shortcomings. The most important is that it really doesn't explain the actual cases of "exchange rate overshootings" in the theory. According to the theory, the more inflationary currency would depreciate with the cumulative purchasing power reduction and interest rate differential, and then appreciate gradually by the difference in annual interest rates. If say an inflationary policy would reduce local purchasing power by 10% and also mean that interest rates were 1 percentage points lower during 10 years, then the currency would immediately depreciate by approximately 20% and the appreciate by 1% per year during 10 years.

Yet real life exchange rate overshootings behave differently. Consider 3 cases. First the U.K. pound versus the euro. Between June 2008 and late December 2008, it fell from about €1.40 to €1.02, a 27% drop in value. But during the first half of 2009, it recovered to about €1.15. Based on interest rates differentials, the pound should have just appreciated 0.5%, while in reality it appreciated nearly 15%.

Secondly, the Swedish krona. Between June 2008 and March 2009, it depreciated from nearly 11 euro cents to just 8.5 euro cents (which means the euro appreciated from 9.3 SEK to 11.7 SEK). Based on interest rate differentials it should have appreciated just a few tenths of a per cent since then. Yet in reality it has appreciated some 15% to 9.8 euro cents

And for an even more extreme example, the New Zealand dollar. It fell from a high of nearly 82 U.S. cents in February 2008 to a low of 49 U.S. cents in early March 2009. Since interest rates in New Zealand always remained significantly above U.S. levels, the interest parity theory would have predicted continued depreciation of the New Zealand dollar. But in fact, it has appreciated about 40% in the less than 6 months that has passed since then.

These dramatic ups and downs are not consistent with the prediction of the official "overshooting" theory where a dramatic depreciation would be followed by a gradual appreciation.

How can the dramatic drops to excessively low levels for the pound of just €1.02, the Swedish krona of just €0.085 and New Zealand dollar to just US$ 0.49 be explained then?

I am quite frankly not sure, but the most likely explanation are the financial market mechanisms that I explained here, which in short says that momentum and quant traders will make market movements greater than what fundamentals would justify.


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