Foreign exchange rates ; Prices ; Dollar, American

Elizabeth Christensen

English

Research Papers in Economics

January 14, 1983
Transportation Cost. One difficulty with
examining prices lies in the cost ofmoving
goods across national boundaries. Research-
ers whohaveexaminedthis issue run intothe
problem that good information on transpor-
tation costs is not available. However,
anyone who has shipped anything, even
The shadow
As T.S. Eliot putit: "Betweenthe idea and the
reality...falls theshadow."The evidencethat
the common currency prices for the same
internationallytraded goods are notthesame
suggests that there are other considerations.
Abstracting from the notion that the ratios of
international prices should equal the
exchange rate-the ultimate result of
arbitrage-wemightexpectthat theeffective
exchange rate and the ratio offoreign to U.5.
prices would move in much the same way.
The chart indicates that while the long-
term movement is similar, there are many
short-term differences that give evidence
ofa fractured link between exchange rates
and prices.
Afractured link
One type ofexchange rate is a bilateral
exchange rate such as the dollarprice ofyen
or francs. However, ifwe are interested in
howthe dollarperforms against the yen, the
deutschemark and the pound sterling simul-
taneously, we would lookat the U.5. rate
against a weighted basket offoreign cur-
rencies (shown in the chart). Similarly, we
can relate U.S. prices to world prices by
comparing the U.5. price index (here,
wholesale prices) to a weighted basket of
indexes offoreign prices.
ferent currencies. Ifexchange rates among
different currencies behave differently from
the prices ofthe traded commodities,.then
we would have reason to believe that the
relationship between individual prices and
exchange rates had been violated.
To answerthe question, we mustexamine
the relationship between exchange rates and
prices because exchange rates convert the
purchasing powerofone currency into the
purchasing powerofanother.
Exchange rates and prices
Imagine a world where there ere few goods
produced by several different countries. In
such a world, intheabsenceoftransportation
costs and otherbarriers to trade, goods would
be priced uniformly in different markets. In
general, itmakes sense thatpeoplewill value
currencies for whatthey will buy and will
therefore tend to exchange them at rates
which roughly express their relative pur-
chasing power. In otherwords, the dollar
that buys a dozen eggs should be exchanged
for foreign currency that buys the same
dozen eggs.
A major tenet ofthis theoretical view is the
existence ofcommodity arbitrage. Arbitrage
is the purchaseand saleofagood foraprofit.,
It is arbitrage that suggests thatprices of
similar goods should be the same across
countries as any difference in prices would
represent a potential for profit. Since people
are motivated by profits, it stands to reason
that arbitrage will play an important role in
linking prices and exchange rates.
Evidence for this theoretical relationship
should lie in the relationships among prices
ofvarious commodities as measured in dif-
The current level ofthe dollar as measured
againstmanyforeign currencies has led many
people to exclaim that the dollar is over-
valued. Whatdoes this mean?The value of
thedollarshouldadjustto the "correct" level
automatically with freely floating exchange
rates. Although many industrial countries
either intervene in the foreign exchange
marketor narrowly float their currency
against a basketofcurrencies, they generally
floattheir currency freely against the dollar.
An Overvalued Dollar?IP®C9J®1f©\ll ~®;§)®1fW~
IE1©\10:lm (\5)~
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Opinions expre::::ised in this newslE:tter do not
necessarilv reflect the vie\,vs of the management
of the Federal f~eserv<.:' Bank of San Francisco,
or of the Board of Covernors of fhe. Federal
Reserve System.
.through the U.S. mail, knows that the trans-
port cost can be high.
The presence oftransportation costs means
.that two prices for the same commodity, sold
in different countries, would have to differ by
slightly more than the transportation costs to
induce arbitrageurs to enter the market. Ifthe
dollar price differences were less than trans-
portation costs, goods arbitrage could only
result in a loss for the arbitrageur.
Risk premium. Furthermore, anyone engag-
ing in moving goods across national borders
is undergoing acertain amount ofrisk. One
risk is that by the time the goods are moved
from one market to another, their prices may
have changed. Another is that, over the same
period, the exchange rate may have changed.
Eitherofthese events cou Id resuIt in havingto
sell the goods at less than the price that was
originallypaid plus the cost oftransportation.
This risk is acommon feature ofany traded
commodity and it is possible, by using for-
ward contracts, to hedge some orall ofthe
risk. However, formal markets for forward
contracts do not exist for many traded goods.
When contracts do exist, they are frequently
ofthe wrong duration. This means that any
trader would haveto make asubstantial effort
to arrange aforward contract that would
cover him for just the time the goods are in
transit. Given the amountofwork involved in
such arrangements, traders may prefer not to
insure themselves fully against price and
exchange rate changes. Instead, traders may
ask higher prices for their goods as compen-
sation for their uninsured risk.
Other factors. Barriers t01rade in the form of
tariffs and quotas Can also present difficulties
when looking at international prices. These
trade restrictions can cause disparities
between different sets of prices, such as
wholesale and export prices.
Another problem comes from whether items
can be substituted for one another. For
example, apound ofcopper from one coun-
try would be virtually indistinguishable from
2
a pound ofcopper from another country. But
another item, different tractors, for example,
may not be good substitutes. Apparently, the
more narrowlyaproduct is defined, the better
the chance offinding identical goods across
countries.
Sti II another reason that aconsumer may be
willingto pay ahigher price for the same
good is the uncertainty regarding the relia-
bilityofsuppliers. A customer mayhave
established agood working relationship with
a supplier, or commitments to certain equip-
ment, as the result ofprior purchases.
Price differences in different markets may be
the result ofafew sellers whose strategies
are to maintain acertain price position re.\a-
tive to rivals. Such behavior mightexist ifthe
firm's long-term profit maximization would
suffer from a loss ofmarket share. A firm may
also optto sell at lowerprices overaperiod of
time to break into amarket orto expand its
market share.
Evidence
Different researchers' have examined the
prices ofthe U.S., W. Germany, Canada and
France and reached considerably different
conclusions. But, at least some oftheitdiffer-
ences can be explained by the difficulty of
taking into account some ofthe problems
mentioned before.
In order to avoid the problem ofcomparing
apples with oranges, the researchers selected
products from the most disaggregated
commodity list for which prices could be
matched across countries. All researchers
found evidence that certain commodities are
uniformly priced in common currency units
across countries. The results held especially
well for the most homogeneous commodities
such as coffee, cocoa and, in the earlier
example, copper. The general conclusions
* Work in this area has been conducted by Peter Isard
of the Federal Reserve Board, J. David Richardson of
the University of Wisconsin and Liliane Crouche-
Veyrac, Michel (raucy and jacques Melitz of Centre
d'Enseignement Superieur des Affaires and I.N.S.E.E.u.s. EFFECTIVE EXCHANGE RATE
1975"100 AND RELATIVE PRICES 1975"100
125,----------- ---,125
95
saved. Furthermore, jobs will be destroyed in
the export industries, which for the u.s. are
the most productive.
100
115
-110
105
120
110
115
120
105 Relative Prices
100 ''« ..., .~'~',
......"./..-... . .~.....~.... ~._..... ~.~.~.,
95 ~ '._/ -.~./-.....
Effective Exchange Rate
90 LW-'-LJ...LLU..L.LLU-'-LJ...Ll..L.C..L.LLU-'-L.w.JLLLJ...LLJ...L.J 90
1974 1975 1976 1977 1978 1979 1980 1981 1982 1983
are that when disparities in prices are
observed, the disparities tend to last for a
period ofnotmore than two years.
Generally, the resu Its indicate that com-
modityarbitrage does take place but not
significantly for every commoditygroup.
When it does take place, it is never perfect.
Although evidence exists that for. many inter-
nationallytraded commodities the common
currency (dollar equivalent) prices are the
same orvery similaracross countries, there is
little to suggest that the composition ofprice
indexes is the same across countries. Even
in the extreme case where the price indexes
consist ofitems that have displayed the same
price across countries, the indexes them-
selves will only be the same in common
currency when the relative consumption
shares offoreign and domestic goods are
the same.
Protectionism
What happens when the exchange rate gets
"outofIine"?Since theexchange rate is such
an important price, itaffects almost all
aspects ofthe economy. Ifthe U.s. dollar
were "outofline", say higher than what we
might expect it to be (in the sense that itbuys
more ofa foreign currency), then the level of
foreign prices wouId appear lower. American
goods would become expensive relative to
foreign goods and both Americans and
foreigners wouId buy fewer American goods
and moreforeign goods. The situationcan, at
times, lead to calls for protectionist measures
for American industries.
Any government is concerned with the
national expansion ofits export and import
industries which depend directlyon one
another. Limiting imports by tariffs orquotas
also limits exports because it reduces the
purchasingpowerofcustomers and raises the
costs ofdomestic producers dependent on
foreign materials, making them less competi-
tive. If, to save jobs, many countries simul-
taneously follow a program ofrestricting
imports, more jobs may be destroyed than
3
Concerns about protectionism resulted in the
establishmentofthe General Agreement on
Tariffs and Trade known as the GAIT in the
1940s. Although GAIT has achieved sub-
stantial reductions in tariffs since its incep-
tion, trade growth has slowed in recent
years and protectionist pressures have
increased. Furthermore, trade restrictions
have resulted in tensions in the international
financial system.
There are multiple links between interna-
tional tradeand financial markets. Oneis that
an exporting country must keep an open
marketfor imports so thatforeign debtorscan
earn the foreign exchange needed to service
theirdebts. Anotheris thatdomesticfirms are
increasingly organized on aglobal scale.
Since the majorityofthe banking system's
assets are loans to domestic firms, the quality
ofthose assets mustdepend on their profit-
abilitywhich, in turn,depends onthe stability
of international business.
Conclusion
Although there appears to be no "good"
measure for a long-term exchange rate, the
evidence suggests that prices and exchange
rates cannot be divorced from one another.
Furthermore, perceptions that the exchange
rate is "outofline"-based on whatever
measure-carrywith them the possibility
that industrieswill feel threatened and ask for
protection. Granting protection, however,
has far-reaching consequences and may
produce more devastating results than
the originally perceived evil-an over-
valued dollar.
Elizabeth ChristensenUo~8u!4Sl?M. 4l?1n • uo8aJO • l?pl:1AaN • 04l:1PI
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)
Selected Assets and liabilmes
Large Commercial Banks
Amount
Outstanding
12/29/82
Change
from
12/22/82
Change from
year ago
Dollar Percent
Loans (gross, adjusted) and investments* 163,668 668 7,061 4.5
loans (gross, adjusted) -total# 143,376 579 7,976 5.9
Commercial and industrial 45,826 373 4,416 10.7
Real estate 57,331 - 13 1,436 2.6
Loans to individuals 24,005 172 183 0.8
Securities loans 2,827 91 800 39.5
U.s. Treasury securities* 6,996 10 1,153 19.7
Othersecurities'" 13,296 99 - 2.068 - 13.5
Demand deposits - total# . 43,144 1,075 - 750 - 1.7
Demand deposits - adjusted 29,684 888 21 0.0
Savings deposits ~total 44,376 2,874 14,201 47.1
Time deposits - total# 88,242 -1,987 - 1,735 - 1.9
Individuals, part. &corp. 78,303 -2,020 - 2,538 - 3.1
(Large negotiableCD's) 30,503 - 818 - 5,908 - 16.2
Weekly Averages
of Daily Figures
Member Bank Reserve Position
Excess Reserves (+)/Oeficiency(-)
Borrowings
Net free reserves (+)/Net borrowed(-)
Weekended
12/29/82
115
, 9
106
Weekended
12/22/82
134
25
109
Comparable
year-ago periocl
- 352
14
338
*Excludes trading accountsecuntles.
# Includes items not shown separately.
Editorial comments may be addressed to the editor (Gregory Tong) 07to theauthor.... Freecopies of this
andotherFederal Reserve publicationscan beobtainedbycallingorwritingthePublicInfonnationSection,
Federal Reserve Bank ofSan Francisco, P.O. Box 7702, San Francisco 94120. Phone (415) 974-2246.

An overvalued dollar?

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An overvalued dollar?

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