Foreign Exchange Rate Determination and Related Issues

Custom Student Mr. Teacher ENG 1001-04 18 September 2016

Foreign Exchange Rate Determination and Related Issues

According to economists the US economy had been in recession since March 2001 and the September 11th terrorist attacks only deepened this recession. Despite the fact that the attacks had a massive localized impact on New York City, the impact on the entire economy was not large enough to affect the productive capacity of the United States (Makinen, 2002). However, an immediate aggregate demand shock was felt – retail sales slumped and were much lower in the weeks following September 11th than they would normally have been; consumer confidence and business confidence indices were on the decline as well.

But after three consecutive quarters of contraction in 2001, the economy showed signs of resurgence in the 4th quarter by showing positive growth (Makinen, 2002). Therefore, any effects on aggregate demand that the terrorist attacks may have had were quite evidently, temporary. Demand and supply of currency is the core determinant of foreign exchange rates. Hence it follows that all the factors that affect demand and supply of currency also influence foreign exchange rates. Financial, political or social instability are such factors and the 9/11 terrorist attacks are a perfect example.

This document will seek to analyze the economic impact of the 9/11 terrorist attacks and the influence they had on exchange rates at the time. A comparison of pre and post 9/11 situation would also be made to demonstrate the exact effect of the event on exchange rates and the difficulties faced in determining them. Empirical evidence will be used to substantiate claims and special focus will be given to the three most often used theories of exchange rate determination: Purchasing Power Parity Approach, Balance of Payments Approach, and the Asset Market Approach.

Finally, all evidence will be based on secondary research conducted by consulting past research papers, documents, journal articles, empirical studies etc. Introduction On September 11th, 2001 four commercial airplanes were hijacked and crashed on American soil creating chaos and panic throughout the world. There were no survivors on any of the 4 airlines and huge losses of life and property were witnessed – notably close to 3000 casualties (Alfano,2006), the complete destruction of the Twin Towers of the World Trade Center in New York City, and the damages to the Pentagon.

The threat of Bin Laden’s band of terrorists had loomed long before September 11th and as we now know, both President Clinton and President Bush were well aware of it. However, the threat at the time didn’t seem compelling enough to take action on it (Kean, et al. , 2004). Political Impact of September 11th The response by the United States was almost immediate. The War on Terrorism was launched and Afghanistan was invaded. The USA Patriot Act was enforced and anti-terrorist measures were taken throughout the world (Kean, et al. , 2004). Economic Impact of September 11th

As mentioned earlier, the economic effects of September 11th were kept in check as economists were already aware of the recession in the economy, and measures had been taken to tackle it. These measures helped the United States adequately cope with any post-September 11th economic effects. When recessionary signs were seen in the first half of 2001, the Federal Reserve eased interest rates to stimulate aggregate demand. Since all policies take some time to show results, the complete effect of this change in policy was felt post-September 11th.

Thus, it seemed as if aggregate demand was minutely affected by the terrorist attacks (Makinen, 2002). Then there were measures taken by the Federal Reserve immediately after 9/11 to boost liquidity in the economy and avoid any form of financial panic (Ferguson, 2003) Therefore, all or most short run economic effects were limited due to the immediate response of the policy makers. However, long run effects of 9/11 were felt and US productivity growth slowed down as resources were now being used for security purposes (Makinen, 2002).

For an illustration of overall economic effects and indicators comparing pre and post-9/11 scenario in the US economy, refer to Table 1 in the Appendix. Consumer Confidence and Unemployment Consumer confidence is considered a very important indicator for consumption spending and since, consumption spending is 2/3rd of the GDP; it is used to determine business cycles (Makinen, 2002). Consumer confidence fell dramatically right after the September 11th attacks going from 114. 0 in August 2001 to 97. 0 in September 2001.

However, economic analysts contend that the US economy was already in a recession when the terrorist attacks took place (Jackson, 2008). This reduction in consumer spending was further pushed down due to increased unemployment which reached its highest point in 4 years in August 2001 and then took a further downward trend as demonstrated in Table 1 of the Appendix. Foreign Direct Investment Foreign Direct Investment (FDI) fared relatively better than other economic indicators after the 9/11 terrorist attacks. While, there was no mass exit from the US economy, slight decline in FDI was seen right after the event (Jackson, 2008).

Since, the terrorists targeted the financial hub of the United States; there was massive infrastructural damage to equipment and machinery required for everyday financial transactions. This along with the closure of stock exchanges and temporary ceasing of trading in U. S. Treasury securities could have created mass fears of a financial crisis. However, most facilities were back to normal by 17th September and markets had started functioning normally albeit significant slumps (Makinen, 2002). For further illustration of the effect of September 11th terrorist attacks on U. S.

FDI refer to Tables 3 and 4 in the Appendix. Asset Trading International flows of capital greatly impact exchange rates and inflows of capital into the U. S. economy allow trade deficit to be financed. The September 11th attacks created concerns that investors would start selling their U. S. financial assets and move their funds elsewhere. This capital outflow would cause the dollar to depreciate making interest rates move upwards. Therefore, this was an issue that had to be solved immediately. In order to keep the dollar stabilized numerous measures were taken. Some of them were:

• A voluntary gentleman’s agreement between currency traders to not profit from September 11th. This would keep the dollar stabilized and reduce speculation. However, this only lasted till September 14th and currency traders started pushing down the value of the dollar; • Coordinated action and intervention by the Federal Reserve with other international Central Banks to increase liquidity of the dollar in the market; • Intervention by the Bank of Japan (on 5 occasions between September 11th and 27th) in the foreign exchange market to negate the appreciate of the Japanese Yen; and

• Lowering of key interest rates by the Federal Reserve. The combined effect of these efforts was that panic selling of the dollar never took place and the currency and financial markets regained their pre-attack values within weeks. This shows the amount of global confidence in the value of the dollar (Makinen, 2002). Determination and Issues As mentioned earlier, three of the most often used theories in exchange rate determination will be considered to analyze the September 11th situation and its impact on exchange rates, and the issues faced through each of the approaches.

The discussion that follows takes these theories in to consideration. Purchasing Power Parity (PPP) Approach Purchasing Power Parity (PPP) is one of the most influential approaches in exchange rate determination. The theory postulates that the exchange rate change between two currencies over any period of time is determined by the change in the two countries’ relative price levels (Dornbusch, 1987). The PPP approach is based on the law of one price which simply states that identical goods should be sold at identical prices (while not considering transaction and other costs).

Therefore, the exchange rate will adjust to compensate for any difference in prices. For example, if an apple is sold for 1 dollar in the United States and 40 rupees in India, then the exchange rate must be 40 rupees to a dollar in order to satisfy the law of one price. This leads us to the absolute to the absolute PPP approach: PDOM = P*FOR / e Where PDOM is the price in the domestic market, PFOR is the price in the foreign market and e is the equilibrium exchange rate as stated through the absolute PPP theory.

This law applies to a particular basket of goods that is representative of consumption trends in both countries and is based on a particular time period. Another variation of the PPP theory exists and as compared to the Absolute PPP theory, it provides a more dynamic outlook to exchange rates determination. Relative PPP takes into account price movements i. e. inflation, and also carries a provision for market imperfections such as transaction costs and trade barriers (Officer, n. d. ). The Relative PPP theory can be expressed as follows: Where ? t is domestic inflation; ?

*t is foreign inflation; and et is depreciation. Therefore, for the exchange rate to remain at equilibrium it must compensate for change in inflation rates of both countries in consideration. PPP theory, while applicable for perfectly traded goods markets in the long-run becomes biased due to international differences in various factor endowments and productivity. This is known as the Harrod-Balassa-Samuelson (HBS) hypothesis (Officer, n. d. ). It states that the currency of the country with the higher relative productivity rate will appreciate regardless of PPP based equilibrium (Chong, et al.

, 2010). Keeping the HBS hypothesis in perspective, it can be assumed that since the U. S. productivity started declining post 9/11 due to reasons mentioned earlier in the paper, concerns over the biasedness of the PPP began. However, since a global economic slowdown was already predicted before the 9/11 attacks, the biasedness of the PPP was not felt as much because most major economies were also in recession. The PPP theory does hold true in the long run where the differences between the PPP-exchange rate and the actual exchange rate are seen to be negligible. A long-run trend between the U.

S. Dollar and the U. K. Pound can be seen in Figure 1 of the Appendix. A relationship quite evidently exists between the two as it can be seen that when the relative prices in U. K. are higher, the pound depreciates against the dollar as predicted by the PPP theory (Wright & Quadrini, n. d. ). However, there is a difference in magnitude which can be attributed to the following shortcomings of the PPP Theory: 1. Not all goods and services can be traded internationally. 2. Transaction and other costs as well as trade barriers in some instances are quite significant to be ignored. 3.

All good will not have competitive markets in all countries. 4. The model of PPP is based on everyone having perfect information which in most cases is not possible. Balance of Payments Approach The Balance of Payments Approach is the second most popular approach used for determining exchange rates. According to this approach the equilibrium exchange rate is found when both internal and external equilibrium exist in an economy i. e. unemployment is at the natural rate and balance of payments is in equilibrium. If any of the two is not in equilibrium, the exchange rate will adjust to reach a state of equilibrium.

Apart from being used to determine the exchange rate, this theory is also used to explain why actual exchange rates deviate from PPP-derived exchange rates. As illustrated by Table 1 of the Appendix, unemployment rate was on the rise even before September 11th. Therefore, according to this theory it explains the slight depreciation in the value of the dollar immediately after 9/11. However, as measures were taken to increase liquidity and reduce employment, the Dollar regained its pre-9/11 exchange rate before the end of 2001.

Despite being quite adequate for exchange rate determination, the Balance of Payments approach does have issues and problems. Some of them are: 1. It is extremely difficult to calculate the natural rate of unemployment. 2. It is of very little use to account for short-term fluctuations in the exchange rate. 3. Because it is so difficult to calculate the internal and external equilibrium points, most of the time this approach may just lead to an educated guess of the long run exchange rate. Asset Market Approach

Demand and supply of financial assets can also be used to determine exchange rates and that is the premise behind the Asset Market Approach. This approach takes into account the demand and supply of currencies (which are considered as financial assets) in different countries and uses it to reach the equilibrium exchange rate. Since this approach takes currency as a financial asset and derives the equilibrium rate through the interaction of demand and supply; numerous factors must be taken into account that may cause changes in exchange rates. Some of them are: 1.

Demand shifts for a currency due to investor speculation and future expectations about various financial assets. 2. Changes in monetary and fiscal policies which might change interest rates, returns, and hence, exchange rates. 3. General changes in demand and supply of financial assets including currencies. A variation of the Asset Market Approach is the Portfolio Approach which simply states that investors must decide which portfolio of financial assets to invest in. These financial assets may range from bonds to stocks and the decision to invest in a particular asset will be based on the expected rate of return.

This provides the investor with an arbitrage opportunity and this in turn determines the exchange rate. At times, this concept has been given the name of “hot-money” inflow or outflow. It can be expressed in terms of an interest rate (rate of return) parity equation: If an interest rate differential exists between two economies and if the exchange rate does not adjust, an arbitrage opportunity will be available and money will either move in or out of the economy until the differential ceases to exist assuming that PPP holds true.

Referring to Figure 2 in the Appendix, the interest rate in the US had been declining in 2001 as the government took steps to combat the recession. An expansionary monetary policy followed and the interest rate continued its downward trend. According to the above mentioned equation, the lower interest rates offered in the U. S. were counterbalanced by depreciation in the currency after 9/11. As mentioned earlier, the U. S. Dollar regained its pre-9/11 position by the end of 2001, and this was due to the introduction of expansionary fiscal policies and increased expected returns on U.

S. financial assets. Problems with this approach are: 1. Getting accurate and complete information about different financial assets is difficult. 2. It is dependent on the PPP Theory and hence does not apply in short and medium run. Conclusion Timely action by the Federal Reserve and other policy makers in the U. S. stopped a financial crisis from developing after the 9/11 Attacks. Since, the economy had taken a recessionary trend already in the first three quarters of 2001, the situation right after 9/11 cannot be completely attributed to it.

However, it definitely had some effect. The U. S. Dollar proved to be extremely resilient and it holds a lot of international credibility because of which it didn’t depreciate as much as would have been expected after a situation like the 9/11. In conclusion, further literature and study about the different exchange rate determination models is required. While, literature on PPP is abundant, there is very little on the other two theories which limit their usefulness and understanding. Therefore, more research is required on them.


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