Driving in Reverse

Driving in Reverse
How the U.S. dollar took a turn

By Maurice Levi, Bank of Montreal Professor of International Finance, Sauder School of Business, University of British Columbia.

The price of a country’s currency, that is, its exchange rate, is important because it affects the price of all tradable goods in the country. For example, imports aren’t the only things that cost more after depreciation -- so do domestic goods, which can be sold in world markets. Indeed, the exchange rate affects the standard of living of a country’s citizens because they command a larger or smaller share of the world pie as their country’s currency goes up or down. We can see this in tables ranking countries’ national incomes in a common measure such as the U.S. dollar: countries move up the income table as their currency appreciates. The strong Canadian dollar has made us wealthier overall, although there are those who have lost through damaged exports or domestic markets to cheaper imports.

Currencies also have a huge impact on international investment returns. The change in exchange rates affects realized returns, and also risk by adding volatility directly and through covariance of exchange rates with local returns. Given the importance of exchange rates for standards of living and investments it is important to know whether recent exchange rate readjustments are likely to persist. Will the euro and Canadian dollar, for example, stay high relative to the greenback, or have exchange rates overshot their long-run equilibrium?

Driving in reverse

Casual evidence that supports recent overshooting of the U.S. dollar is the length of lineups at the border crossings. It used to be that Americans would line up in the morning to shop in Canada, returning in the evening to face lengthy lines re-entering the U.S.. More recently the lineups have reversed, so the morning queues are going into the U.S. with evening queues for returning to Canada. More evidence can be found in the direction of empty freight cars between U.S. inland cities and U.S. ports. The empty cars used to travel in the direction of U.S. ports after dropping off their full loads of imports. Today, more and more empty freight cars are moving inland from U.S. ports to pickup export loads.

The exchange rate swings we have experienced cannot be explained by inflation differentials between countries as predicted by the Purchasing Power Parity Principle. This suggests the possibility of rates overshooting long-run equilibrium levels on the upside and the downside. Could it be that the U.S. dollar rose too high when it reached €0.80 and Cdn$1.60, and has since gone too low? What type of theory would fit this possibility of exchange rate overshooting?

A simple theory that generates overshooting is based on the principle that investors decide on the currency composition of their portfolios, and that conditions sometimes occur when they decide to revise the composition. For example, suppose the original chosen U.S. dollar and non-U.S. dollar portfolio proportions are 50% each, with $1,000 of investments in each currency. Suppose also that additions to each of the portfolios each year are $100. Then, suppose investors decide to switch from 50-50 U.S. dollar assets vs. other currency assets, to 60-40 U.S. dollars versus other currencies. Suppose also that the readjustment is done in one year. This requires buying $200 that year, plus the $100 that goes into dollars every year, that is, $300. After adjustment of the portfolio, U.S. dollar purchases drop to $120 per year. That is, the demand for U.S. dollars over a three-year interval goes from $100 to $300 to $120. We see there is a temporary surge in the dollar that is subsequently largely reversed. The effect, which is similar to the so-called Accelerator Model of the business cycle in macroeconomics, occurs because small changes in portfolio compositions mean large changes in flows of money, and exchange rates are determined by flows.

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