3.4. TRANSLATING FC FIGURES: NOMINAL RATES, PPP RATES, AND DEVIATIONS
FROM PPP 113
markets where you sell your output.
For this reason, deviations fromRPPPare important. Are they large? Figure 3.17
shows time-series data, taking Jan 1965 as the base period, on relative real rates
againstusd, for thedem-eur,jpy,gbp,sar, andthb. We note four facts.
- First, there are huge swings in the medium run, with the real rate appreciating
by 50% and then going back—and occasionally even doubling or halving— in a
matter of years not decades. Imagine you being caught in this as an exporter. - Second, in the short run there is lots of inertia: once the rate is above its mean,
it tends to stay there for years. Statistical analysis shows that the average half
life is three to five years, meaning that it takes three to five years, on average,
for a deviation to shrink to half its original size. Thus, when you get into
a bad patch, you can expect that this will be a matter of years rather than
weeks or months. - Third, when we look at theRPPPrates and the actual ones separately (Figure
3.18), we see that, almost always, in the short run most of the variation in
the real rate stems from the nominal rate; theRPPPrate is usually smooth
relative to the actual, except of course under a fixed-exchange-rate regime
(see graphs) and in hyperinflation cases (not shown). The fall, rise, & fall of
theusdagainst thedemunder presidents Carter and Reagan had nothing
to do with inflation. In a way, that’s good, because there are good hedge
instruments against swings in nominal rates. Hedging nominal rates, in the
short run, almost stabilizes the real rate too. - Even though deviations between actual andRPPPrates are huge, there often
does seem to be a link, in the long run. As a result, the long-run variability of
the inflation-corrected rate is somewhat lower than that in the nominal rate. - A last fact, impossible to infer from the graphs but to be substantiated in
Chapter 10, is that changes in both nominal and real exchange rates seem
hard to predict.
Should you care? If exchange risk would just lead to capitals gains and losses
on assets or liabilities denominated infc, most (but not all) firms would be able
to shrug it off as a nuisance, perhaps, but no more than that. However, there
is more: real-rate moves may also make your production sites incompetitive or
your export markets unprofitable, and it is harder for a firm to just shrug this off.
Another implication worth mentioning is that when two investors from different
countries hold the same asset, they will nevertheless realize different real returns
if the real exchange rate is changing—which it does all the time. Thus, exchange
risk undermines one of the basic assumptions of thecapm, namely that investors
all agree on expected returns and risks. These implications explain why exchange
risk gets so much attention in this text.