Exchange Rate Economics: Theories and Evidence

or in natural logs:
Introduction 3
q = s + p ∗ − p,(1.1)
where P denotes the price level in the home country, ∗ denotes a foreign magnitude
and lower case letter denote log values.
All of the earlier exchange rate measures are bilateral in nature – the home currency
price of one unit of foreign currency (e.g. Japanese yen against US dollars).
There are a number of exchange rates which define the home currency against a
basket of foreign currencies and these are usually used when trying to obtain an
overall measure of a country’s external competitiveness,and especially when relating
exchange rates to international trade balances. A nominal effective exchange
rate (NEER) in essence sums all of a country’s bilateral exchange rates using trade
weights (NEER = ∑ n
i=1 α i S i where α denotes a trade weight, i represents a bilateral
paring and,in this context,S is defined as the foreign currency price of a unit
of home currency) and these are expressed as an index. With effective exchange
rates,the convention is that a rise above 100 represents an exchange rate appreciation,while
a fall below 100 represents a depreciation. As in expression (1.1),for
the real bilateral exchange rate,a real effective exchange rate (REER) adjusts the
NEER by the appropriate composite ‘foreign’ price level and deflates by the home
price level,(REER = ∑ n
i=1 α i [(S i P j )/P i ],where again S is the foreign currency
price of a unit of home currency and j represents the home country). 1 A multilateral
exchange rate model (MERM),as constructed by the IMF,incorporates
trade elasticities,in addition to trade weights,into the calculation of a real effective
exchange rate. The idea here is that it is not just the size of trade between two
countries that matters,it is also how responsive trade is between two countries with
respect to the exchange rate.
1.2 The players in the foreign exchange market
The foreign exchange market differs from some other financial markets in having
a role for three types of trade: interbank trade,which accounts for the majority –
between 60% and 80% – of foreign exchange trade; trade conducted through
brokers (which accounts for between 15% and 35% of trade); and trade undertaken
by private customers (e.g. corporate trade),which makes up around 5%
of trade in the foreign exchange market. The latter group have to make their
transactions through banks since their credit-worthiness cannot be detected by
brokers.
The agents within banks who conduct trade are referred to as market makers,
so-called because they make a market in one or more currencies by providing bid
and ask spreads for the currencies. The market makers can trade for their own
account (i.e. go long or short in a currency) or on behalf of a client,a term which
encompasses an array of players from central banks,to financial firms and traders
involved in international trade. A foreign exchange broker on the other hand
does not trade on her own behalf but keeps a book of market makers limit orders