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January 1, 1998

Federal Reserve Bank of Cleveland

A Hitchhiker’s Guide to
Understanding Exchange Rates
by Owen F. Humpage

E

ach day, more than $1.2 trillion
worth of foreign exchange changes
hands around the globe, an amount
that far exceeds the daily value of
world trade. Approximately 83 percent of these transactions involve U.S.
dollars, but not all involve U.S. citizens.1

Relatively small changes in the prices at
which these trades occur—exchange
rates—can have immediate and profound effects on economic events, ranging from family vacations to corporate
profits. Large changes can shake governments, as recently demonstrated in
Southeast Asia. Yet, despite the importance of exchange rates, most people
find their behavior unfathomable.
Economists often view the nominal exchange rate (the foreign currency price
of a dollar typically quoted in The Wall
Street Journal ) as the product of the
real exchange rate and a component reflecting the difference between domestic
and foreign inflation. Unlike their nominal counterparts, real exchange rates are
not directly observable, but economists
estimate them because of their influence
on international competitiveness (see figure 1). This dichotomy between a real
exchange rate and an inflation differential has proved useful for understanding
the complex connections between economic fundamentals and nominal exchange rates, and especially for appreciating the role of monetary policy in
determining exchange rates.
This Economic Commentary offers a
nontechnical guide for those seeking a
quick tour of exchange rates. The first
part considers the role of inflation
and monetary policy in determining
ISSN 0428-1276

exchange-rate movements. The next
section utilizes balance-of-payments
concepts to illustrate the economic role
of the real exchange rate. The final,
but perhaps most important, part of the
narrative introduces the crucial role
of expectations.

■ Inflation Differentials
An exchange rate is the relative price
of one nation’s money versus another’s.
Currently, for example, 1.82 German
marks exchange for one U.S. dollar. If
the Federal Reserve creates excessive
amounts of dollars (that is, more than
people currently wish to hold) at a faster
pace than the Bundesbank issues excessive amounts of marks, the value of
the dollar will fall relative to the mark,
say to 1.75.
Ignoring the difficulties associated with
expectations and perceptions of monetary policy, the dynamics underlying the
dollar’s depreciation might proceed as
follows: Faster money growth creates
inflationary pressures in the United
States, causing people to shift their purchases away from U.S. goods toward the
now relatively less expensive German
goods. To acquire German goods, however, people must first convert their dollars to marks. The increased demand for
marks (and the greater supply of dollars)
will bid up the value of the mark relative
to the dollar in the foreign exchange
market; that is, the dollar will depreciate
against the mark. Holding others things
constant, this dollar depreciation will
continue as long as the U.S. inflation
rate exceeds the German inflation rate,
and will tend to match the inflation differential between the two countries. If,
for example, Germany’s inflation rate is

To understand the behavior of exchange rates, it is often useful to view
them as consisting of two parts—a
real exchange rate and a component
reflecting domestic and foreign inflation differentials. Most important,
however, is an appreciation of the
crucial role that expectations play.

2 percent per year and the U.S. inflation
rate is 3 percent per year, the dollar will
depreciate 1 percent per year against the
mark, other things being equal.
The explanation above contains two important implications for monetary policy:
First, because monetary policy ultimately
determines only the domestic inflation
rate, a central bank that wants to engineer
a depreciation of its currency must create
more money than its trading partners and
thereby generate a higher inflation rate.
Second, because any resulting exchangerate depreciation will ultimately offset
the inflation differential, a monetaryinduced depreciation cannot secure a
competitive trade advantage. The real
exchange rate, which I discuss below,
will remain unaffected in the long term.
Any trading gains from engineering a
dollar depreciation are purely transitory,
lasting only until prices fully adjust.
Economists refer to the relationship linking exchange-rate movements and inflation rates across countries as relative
purchasing power parity (PPP). Recent
estimates suggest that once disturbed,
PPP takes an average of eight years to
become reestablished.2

One interpretation of this finding is that
goods prices adjust slowly to monetary
shocks, implying that monetary policy
may be able to affect the real exchange
rate in the interim. A second interpretation is that nonmonetary events, such as
productivity shocks or changes in preferences for domestic versus foreign goods,
are important determinants of exchangerate movements. The latter perspective
draws attention to the determination of
real exchange rates.3

■ Real Exchange Rates
and the Balance of Payments
By assuming that world inflation rates
and expectations are constant, we can
focus on the real component of the
nominal exchange rate. This will change
in response to any economic event that
affects the real (inflation-constant)
demand for, or supply of, traded goods
and international investments. To
understand the connection, however,
one must first understand balance-ofpayments accounting.
The balance of payments records all
transactions between residents of the
United States and residents of the rest of
the world.4 Anything that creates a debit
item in the U.S. balance of payments
creates a supply of dollars (and a demand for foreign currency). When we
import a German car or invest in German stocks—both debits in balance-ofpayments accounting—we must first
acquire marks in the foreign exchange
market. Likewise, anything that creates
a credit item in the U.S. balance of payments, such as the sale of domestic
wheat or U.S. Treasury bonds, generates
a demand for dollars (and a supply of
foreign currency).
A country that incurs a current account
deficit—like the United States—is consuming more of the world’s output than it
is producing. Its imports are a debit item
in its current account, creating a supply
of its own currency. Such a country must
pay for its extra current consumption
(that is, its surfeit of imports) by giving
foreigners financial claims on its future
output (stocks, bonds, bank deposits, and
so on). The resulting foreign capital inflows are credit items in the balance of
payments and represent a demand for
dollars. As table 1 indicates, current account and capital account balances must
offset each other exactly (assuming that
everything is measured correctly). In
sum, then, neither an excess supply nor
an excess demand for dollars exists.

FIGURE 1 MARK/DOLLAR EXCHANGE RATES

SOURCES: DRI/McGraw–Hill; and author’s calculations.

TABLE 1 U.S. BALANCE OF PAYMENTS
(Billions of dollars)

Current account balance
Trade in goods and services
Investment income
Unilateral transfers
Capital account balance
Official capital flows
Private capital flows
Statistical discrepancy

1997 a

1995

1996

–129
–102
7
–34

–148
–111
3
–40

–160
–113
–11
–36

129
101
43
–15

148
129
66
–47

160
66
166
–72

a. Based on three quarters of data expressed at an annual rate.
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

The capital account does not passively
respond to the current account, as the
previous paragraph implies. Myriad
individuals make separate decisions
about importing, exporting, and investing abroad, and each of these decisions
affects the balance of payments independently. If at any time the collective
intentions are not consistent with equilibrium in the accounts, attempts to
enact these plans will cause the real
exchange rate to change. The exchangerate adjustment in turn forces people to
reevaluate their plans in such a way as
to pull the current and capital accounts
into balance. (Other economic variables,
like real interest rates, might also shift
and contribute to the process.)
Contrary to popular belief, the mere
existence of a current account surplus or
deficit implies nothing about how dollar
exchange rates will behave. A country
may incur a current account deficit
through various routes, each with different implications for its exchange rates.
If, for example, domestic demand for
foreign goods initially increases, imports
will expand, the current account deficit
will grow, and the dollar will depreciate.
The dollar depreciation will encourage a
counterbalancing inflow of foreign capi-

tal by making U.S. financial securities
more attractive to foreigners. This—the
standard view—holds that the dollar
depreciates when the U.S. trade deficit
widens. Alternatively, suppose that an
improved domestic investment climate
draws an inflow of foreign capital. The
dollar will appreciate, making domestic
goods expensive relative to foreign
goods and striking a balance between
increased capital inflows and the larger
trade deficit. This second case connects a
dollar appreciation to a U.S. trade deficit.
All economic events that affect the real
demand for, or supply of, traded goods
and financial investments can potentially
determine the level of real exchange
rates. While almost any economic
variable would seem a possible candidate, real interest-rate differentials, productivity differentials, trade restraints,
tax rates, and relative preferences for
domestic versus foreign goods seem key.
I have discussed nominal exchange rates
as the product of a real component and
an inflation differential, identifying or
alluding to fundamental economic variables that most economists regard as
important to the determination of
exchange rates. Nevertheless, empirical

FIGURE 2 DAILY MARK/DOLLAR EXCHANGE RATES, 1995–97

SOURCE: Federal Reserve Bank of New York.

HOW TO CREATE
A REAL MARK/DOLLAR
EXCHANGE RATE
First, divide the German Consumer Price Index (CPI) by the U.S.
CPI. Second, construct an index
number for this ratio. If possible,
choose a base year for the index
that represents an equilibrium.
(This is difficult and arbitrary;
I chose February 1987 only because German and U.S. officials
expressed satisfaction with the
nominal exchange rate at the
time.) The index will fall when
U.S. inflation exceeds German inflation. Finally, multiply the nominal exchange rate by this index
of consumer prices to obtain the
real exchange rate. The real exchange rate equals the nominal
exchange rate in the base year.

models have typically failed to explain
past exchange-rate movements or to
predict future exchange-rate paths in
terms of combinations of these fundamentals. Although exchange rates bear
some long-term correspondence to fundamentals, the relationship is not close
in the short or medium term. Instead,
research suggests that the best guess of
tomorrow’s (or next week’s or next
month’s) exchange rate is today’s (or
this week’s or this month’s) exchange
rate, and even this projection is not very
good. This peculiarity has never been
fully explained, but expectations seem
to play a crucial role.

■ Expectations
Economists typically view exchange
rates as very similar to asset prices. The

current price of an asset reflects the present discounted value of the income
stream that investors expect it to generate over its lifetime. Similarly, an
exchange rate reflects the present discounted value of all relevant fundamentals, including current fundamentals and
their expected future values. Foreign
exchange traders face strong incentives
to acquire every piece of information
about current and anticipated economic
developments that could possibly influence exchange rates. If these dealers are
successful, their current quotations will
incorporate all available, relevant data,
and only new information that causes
revisions in traders’ expectations will
influence exchange rates. This implies,
for example, that previously anticipated
changes in monetary policies or other
fundamentals will not affect current
exchange rates; only unanticipated
changes will.
One might expect profit-seeking exchange dealers to formulate their expectations, and therefore their exchange
quotations, without making systematic
errors. To the extent that they can do so,
revisions to their quotes will be fairly
random and will impart a zigzag pattern
to exchange-rate movements. Over
time, a net change in one direction or
the other may emerge as exchange rates
adjust to persistent shifts in underlying
fundamentals. On a day-to-day basis,
the exchange rate will bounce—in a
seemingly random manner—around
any such path.
Figure 2 illustrates such a pattern for
daily movements in the mark/dollar
exchange rate. Over the period displayed (January 1, 1995 to December
31, 1997), the average daily change in
the exchange rate was 0.02 percent,

suggesting a slight trend toward dollar
appreciation. Daily movements about
this average seem fairly random, with
appreciations or depreciations of almost
1 percent being quite common. The
largest single-day appreciation was 2.7
percent, and the largest single-day
depreciation was 2.5 percent.
The foregoing discussion is based on
the implicit assumption that expectations
are fairly uniform and remain firmly anchored to a set of generally recognized
fundamentals. The seemingly random
pattern of figure 2, together with the
small size of day-to-day changes, appears
consistent with that view. Nevertheless,
other evidence conflicts with it. The
aforementioned poor performance of
exchange-rate models, for example, undermines the validity of this assumption.
Particularly damaging is the fact that
since the inception of floating exchange
rates, both nominal and real exchange
rates have increased substantially, but the
volatility of their underlying fundamentals has changed little.5
Although exchange traders are highly
effective users of information, they
probably are not perfectly efficient.
Indeed, why would trade occur, especially in such large volumes, if all
traders had identical information at all
times? For one thing, information about
economic fundamentals (both its acquisition and its interpretation) is costly,
which may explain why many foreign
exchange traders generate profits from
technical trading rules—essentially
rules of thumb—instead of from models
based on economic fundamentals. Many
of these rules project past trends into the
future. One, for example, requires that a
trader buy when the exchange rate rises
by some fixed percentage above its past
trough, and sell when it falls some fixed
amount below its past peak.
Such trading rules could increase shortterm volatility. As time passes and as
information becomes freely accessible,
traders may increasingly respond to fundamentals; initially, however, traders
may not be linked to fundamentals in a
fixed or even consistent way.6 Figure 2
demonstrates striking periods of high
and low exchange-rate volatility. The
standard deviation of exchange-rate
changes in 1995, for example, is almost
twice as large as in 1996, suggesting
more market uncertainty about exchange
rates in the former period.

■ Conclusion
Over the 25 years since dollar exchange
rates began to float, economists have
learned to garnish their exchange-rate
predictions with humility. Most probably feel secure in betting that a country
with a relatively high inflation rate will
eventually see its currency depreciate in
foreign exchange markets. Few, however, would venture a guess about the
time path of the adjustment, or gamble
with equal confidence on the long-run
exchange-rate implications of most
other economic variables, or even speculate about the short run. Nevertheless,
international trade and capital flows
continue to grow, despite the periodic
trepidation about movements in dollar
exchange rates.

■ Footnotes
1. See Bank for International Settlements,
Central Bank Survey of Foreign Exchange
and Derivatives Market Activity. Basle: BIS,
May 1996; and International Monetary Fund,
Direction of Trade Statistics Yearbook, 1997.
Washington, D.C.: IMF, 1997, p. 2.

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Cleveland, OH 44101
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2. See Kenneth A. Froot and Kenneth
Rogoff, “Perspectives on PPP and LongRun Real Exchange Rates,” in Gene M.
Grossman and Kenneth Rogoff, eds., Handbook of International Economics, vol. 3,
part 2. Amsterdam: North-Holland, 1995,
pp. 1647–88.
3. The price indexes used to calculate PPP
usually include traded and nontraded goods.
Deviations between the prices of these
goods within a single country can affect calculated values of the real exchange rate.
4. The balance of payments, as presented in
table 1, records international transactions on
a nominal basis. I assume throughout this
section that all transactions are measured on
a real (constant-price) basis.

Owen F. Humpage is an economic advisor
at the Federal Reserve Bank of Cleveland.
The views stated herein are those of the
author and not necessarily those of the Federal Reserve Bank of Cleveland or of the
Board of Governors of the Federal Reserve
System.
Economic Commentary is available electronically through the Cleveland Fed’s site on
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5. See Jeffrey A. Frankel and Andrew K.
Rose, “Empirical Research on Nominal
Exchange Rates,” in Gene M. Grossman and
Kenneth Rogoff, eds., Handbook of International Economics, vol. 3, part 2. Amsterdam:
North-Holland, 1995, pp. 1689–729.
6. See Gregory P. Hopper, “What Determines the Exchange Rate: Economic Factors
or Market Sentiment?” Federal Reserve
Bank of Philadelphia, Business Review
(September/October 1997), pp. 17–29.

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