Foreign Exchange Market

Introduction to the Japanese Economy

Lecture 6: Foreign Exchange Rates and External Balances

Date: November 4, 2023
Presenter: Shigenori SHIRATSUKA

Today’s Lecture Overview

  • Exchange Rates
  • Determinants of Exchange Rates
    • Short-run: Interest Rate Parity
    • Long-run: Purchasing Power Parity
  • Benefits of International Trade
  • External Balances
  • Yen-Dollar Exchange Rate Data
    • Source: Bank of Japan
  • Historical Trends and Events:
    • Nixon Shock
      • Initially $1= 360 yen
      • Yen had a fixed exchange rate
      • After the Nixon Shock, most countries adopt the floating exchange rate
    • Plaza Accord
      • Appreciation?— you spend less for a dollar, once you spent 250 yen now you spend only 150 yen for 1 dollar
      • 250 to 150
    • Louvre Accord
    • Clinton Administration
    • Global Financial Crisis (GFC)
    • Abenomics

FX Rates and Economic Activity

  • Yen 160 to 150, means Yen Appreciate (though it is still a weak exchange rate)
  • People are so concerned about the exchange rate
  • they want the exchange rate to be in a stabilized level

Appreciation of yen —> Higher External Value

Economic Fundamentals Affecting FX Rates

  • Direction of Monetary Policy:
    • The stance of the central bank, whether dovish or hawkish, significantly impacts exchange rates, influencing investor confidence and capital flows.
  • Political Environment:
    • Political stability and governance issues can lead to uncertainty, affecting investment and the stability of the currency.
  • Exchange Rates Influenced by Economic Activity:
    • Economic growth or contraction directly correlates with currency strength; stronger economies typically see stronger currencies.
  • Stabilization Within an Allowance Range:
    • Governments might target a specific exchange rate range to stabilize the economy and encourage trade.
  • Implications of Excessive Overvaluation and Undervaluation:
    • Overvalued currencies can harm exports, while undervalued currencies might lead to inflation pressures.

Definition of Exchange Rates

  • Example Values:
    • 100¥/$, 80¥/$, 120¥/$
  • Depreciation of Yen:
    • Illustrative data:
      • From 0.01$/¥ to 0.0125$/¥ to 0.0083$/¥
    • Appreciation of Yen:
    • Leads to higher external value, affecting import prices positively but challenging for exporters.

Absolute and Relative Prices

  • Absolute Prices:
    • Example: Apple = ¥50, Grape = ¥100
  • Relative Prices:
    • Relation of currency unit prices; changes in exchange rates impact the competitiveness of goods.
    • Apple is 0.5 relative to Grape
    • Grape is 2 relative to Apple
    • Exchange rate is relative prices

Real Exchange Rates Formula Representation

  • To know the value of exchange rate
  • we need to adjust the inflation rate
  • thus the price differences between countries
  • when you adjusted it, then there is the real exchange rate
  • Real exchange rate use nominal exchange rate
  • Real exchange rate = Nominal exchange rate x (CPI Domestic / CPI Foreign)
  • Japan’s real exchange rate kept on depreciating over time (in the table the value kept on increasing)
    • The inflation kept on increasing overtime
    • Can talk about important economic issue
Definitions for Currency Evaluations
  • Foreign Currency Unit vs. Domestic Currency Unit:
    • Importance in trade negotiations and competitiveness assessments.
  • Effective Exchange Rates (EER):
    • Concepts:
      • Define appreciation and depreciation relative to multiple currencies.
      • Effective rates are weighted averages based on trade volume.
      • Both nominal and real EERs contribute to understanding effective exchange rates.

Formulation of Effective Exchange Rates

  • Effective Exchange Rate
    • Calculating Japan currency with other currencies, not just one currency like USD
    • Sum of export and import (trade volume)
    • Have both nominal and real effective exchange rate
    • In this table, if the graph increases, then the yen appreciates
    • Real exchange rate kept on depreciating (just like the table before this)
    • People mistaken this table with the usual exchange rate
    • Early 2000, Yen started to keep on depreciating.
    • Weaking of Japanese economy
    • This is a log scale table
  • Terms of Trade Calculation:
    • Export Prices/Import Prices: showing price competitiveness over time.
    • Smaller number, terms of trade is declining, thus higher import prices
    • Japan declining overtime: import prices are higher than exports (Ex. importing crude oil)
    • Overtime Japan lost its competitiveness

Determinants of Exchange Rate

Equilibrium in FX Markets

  • Dynamics of Nominal Exchange Rates
    • Influenced by supply-demand curves.
    • Increased transaction volumes can lead to currency depreciation or appreciation.
    • Relationship between Yen Depreciation and Exports/Imports:
    • A weaker yen can boost exports by making them cheaper for foreign buyers, while imports become more expensive.

Interest Rate Parity

  • Relationships between currencies and returns from investments, with adjustments for expected rates of return, indicate future exchange rate movements based on interest differentials.
  • Interest rate differentials between two countries

Purchasing Power Parity (PPP)

  • Long-term determinants of exchange rates impacting purchasing power of currencies.
  • More related to goods and services
  • Example utilizing the Big Mac Index to analyze the relative undervaluation of the Japanese Yen globally.
    • BIG MAC INDEX
      • The implied exchange rate is 84.36
      • The actual exchange rate is 150.46
      • Thus the Japanese yen is 43.9% undervalued
  • Formal Definitions:
    • Law of One Price in a global context: identical goods should have the same price when expressed in a common currency.
  • Absolute and Relative PPP Definitions for Currency Movements:
    • Exchange rate for higher inflation countries, will depreciate overtime
    • Market exchange rate:
    • In the short run PPP may cause substantial deviation
    • If deviation is getting larger, then the market rate will mendekati the PPP
    • PPP level is the indicator of the equilibrium level of the exchange rate

CPI Inflation Rates (US & Japan)

  • Comparative trends in Consumer Price Index (CPI) reflecting inflationary pressures across decades and their effects on purchasing power and exchange rates.
  • Japan inflation was higher in 1960, higher growth rate too. PPP depreciates.
  • Since then, Japan inflation rate continues to lower, thus PPP long run appreciates

Comparative Advantage in Trade

  • Analyses illustrating specialization and gain from international trading, emphasizing the importance of competitive sectors in both economies.
  • Based on the illustration, country B has Absolute productivity
  • Countries should produce goods and services with relatively good productivity, not absolute productivity
  • Growth of World Trade:
  • Trends demonstrating the increasing share of global trade in GDP, reflecting interdependence of economies.
  • Production network kept on increasing ever since there is CA
  • Recently, people thought of the weakening of globalization, because of recent fluctuations

External Balances

  • Ratios of export, import, and net export relative to nominal GDP over time.
  • Analysis of Japan’s current account balances, segmented into goods, services, and income, providing insights into overall economic health.
  • Current account: goods and service
  • Primary Income: FDI
  • Current account positive: Japan have current account surplus
  • Components of current account changing
  • Goods: Net export of goods initially have been positive overtime, but then it became negative after 2010s. —> Japan’s weakening of the manufacturing sectors
  • Primary income getting larger: including return from Foreign financial investment, foreign loans, foreign direct investment, money abroad profit coming back to Japan.
  • Exporting goods getting weaker, but Japan’s foreign businesses are producing much more profit to Japanese economies
  • Service getting smaller before covid 19, but post-covid 19 getting larger

Service Account (Part of External Balance)

  • Travel compoenent negative: Japanese people travel more compared to tourists coming to Japan, but the travel component is declining
    • Thus more tourists are coming to Japan compared to Japanese going abroad
  • Mid 2010s, travel component become surplus
  • Intellectual property: Patents.
  • Information Services: deficit getting larger recently, Japanese users paying foreign based services, compared to local services. Like google, amazon, shein

International Investment Position

  • Representation of assets versus liabilities in Japan over time based on investments, highlighting the country's financial stability.
  • Japan have big assets in foreign countries, and have liabilities from abroad
  • Japan has more assets compared to liabilities
  • Japan companies open factories abroad, thus increasing primary income in the current account
  • Japan have a large portfolio investment: Japan investors purchasing foreign bonds, foreign equities
  • Reserve assets: government have foreign assets reserve
  • FDI negative: inward FDI to Japan
  • Japanese countries invest a lot to foreign countries, but foreign companies do not invest in Japanese so much

Trade Balance and FX Rates

  • Key equations to understand the fundamentals of export and import trade balance signals, showing interactions between currency strength and trade performance.
  • Japanese yen getting weaker, thus export getting better, thus trade surplus
  • Trade Balance= export-import
  • Yen depreciation, moving opposite directions
  • When yen depreciate, it is expected that export increase, meanwhile import does not increase nor decrease (Even if it increases, then hopefully the increase in imports is less than the increase in export). But the trade balance is positive

J-Curve Effect

  • Graphical depiction of trade balance dynamics post-depreciation, illustrating adjustments over time as economies respond to currency changes.
  • In the short run, the quantity of import export won’t change much when the yen appreciates/depreciates, but in the long run they do
  • Depreciation of yen may cause trade deficit in the short run
  • But overtime trade balance will become trade surplus

Overseas Production Shift

  • Trends illustrating the increase in overseas production by Japanese companies, impacting domestic job markets and trade balances.
  • Much more efficient allocation from the company
  • Foreign Direct Investment:
  • Comparisons between Japan and other countries in terms of outward and inward investment percentages, demonstrating Japan’s global economic engagement.

Lecture Schedule

  • A structured timeline of topics covered in lectures leading up to the mid-term exam and final review, emphasizing comprehensive understanding of the Japanese economy.