NCO and NX correlation. Or, alternatively, One more than the model

Can't wait my next post will be titled economists do it with models. Now though, I have one more idea to bring about and it is pretty much the same idea as real interest rates or real purchasing power. Now it is real versus nominal exchange rates. As a well known economist said Par- tee! (OK it was Bart Simpson)

Nominal exchange rates would be the ones when you check in to a foreign country. I go to Thailand and the bank will give me 33.69 baht for every OG G-Dub I give them. Probably not as there will be a bid-ask spread, so the bank can make their crumbs off of me and some other schnook.

To complicate matters you can express the rate in two ways that both mean the same thing. That is, you can express it in your home currency per foreign currency or you can do it the opposite with foreign currency per your dollar. Unfortunately, places use them interchangeably or if it has become established market practice than it can go either way. If you follow the link you can see that Great Britain's pounds and the European Union's Euros are both quoted as X dollars per 1 unit of either of them. On the other hand most other currencies are quoted as X _____ per dollar.

Now then there is kind of a sticky point which needs bearing out. So if I say that the dollar has appreciated with regard to the Canadian Loonie, that is one dollar will now by more loonies. One could erroneously believe that because you have more loonies you can buy more things, thus the Loonie has appreciated. This is wrong. The fact is that it now takes more Loonies to buy the same American dollar. If you want to remove the dollar from the equation think about it this way. I have an apple grown in upstate NY that I am going to sell to a Canadian. Yesterday I sold an apple for .9 Loonies. Now today because the dollar appreciated, it will cost a Canadian a full Loonie to buy my apple. Thus, the Canadians have lost purchasing power.

Now to determine the real exchange rate we must observe another input, similarly to the example just provided. We need to put goods into the equation. So the Canadian from above is considering purchasing an apple. He can buy one from a Canadian farmer or an American one, and both apples have the same quality. To determine which price is best he must Use this formula:

Real exchange rate = (Nominal Exchange Rate x Domestic Price)/Foreign Price.

Let us state that the nominal exchange rate is 1.1 Loonies per dollar, the price of the Canadian apple is 1.0 and the American apple is 1.23.

Entering those variables into the equation we find:

Real exchange rate = (1.1 x 1)/1.23 = 0.89 Canadian apples per American apple. This real exchange rate will decide how much a country imports and exports. That is, economists look at price levels on a whole to decide how exchange rates should move to reflect the underlying trading reality.

So if you were interested in taking a medical vacation to Thailand, you might base your decision by using the real exchange rate. You would compare the price of a surgery stay in your hometown measured in dollars and compare it to the cost of the medical stay in Thailand in baht and then include the exchange rate between the two countries.

An interesting side shoot of this has been work done by The Economist magazine. They have what they call the Big Mac index. Positing that McDonald's is a large multinational and that the inputs to a Big Mac are the same the world over, the Big Mac Index should work to predict real exchange rates and tell you what countries' currency is over or under-valued.



So what this chart does is tell you America is the base case. A Big Mac costs $3.57 locally. It then compares the price in local currency and then it does the conversion for you by using the local currency price and converting it into dollars per the exchange rate. This can then be compared to the actual exchange rate for nationwide goods/services giving the reader a proxy for over and under-valued currencies. As of this edition of the index July 16, 2009 the worst place for Americans to spend their dollars is in Norway or Switzerland whose currencies are overvalued by 72 and 68%, respectively. The best places to spend your Uncle Sam's would be in Asia with Hong Kong, China, Malaysia and other leading the pack.

One reason this occurred in such a specific region, excluding the Ukraines of the world, it is theorized is that China pursues a mercantilist trade policy to keep its currency value down (dollars can buy more Yuan than they should) and other mercantilist countries, like the rest of Asia follow suit. This creates a large instability because to keep these currency valuations down the countries respective NCO must follow their NX up. Thus, they must purchase lots of US dollars. This intertwines the economies of Asia and America to a degree with which a contortionist could be proud.

These last three paragraphs and the chart have been using an idea called both purchasing power parity and the law of one price. I start with the latter.

The law of one price states that goods traded in different places must be priced the same otherwise arbitrageurs would buy in the cheaper market and sell in the other market. Imagine a tycoon buying up Big Macs in China to ship them over to the US. Of course, there is more to the argument than that, prices can differ slightly as there would be shipping and spoilage charges incurred in practicing this arbitrage. Because of the law of one price, which applies to currencies as well as Big Macs, it follows that a US dollar should trade for the same in all markets and we reach purchasing power parity. From these two ideas we can then see that nominal exchange rates should reflect the price levels ratios of any two countries.

One interesting fallacy that can be exposed in this model is expressed in the following idea first proposed by Larry Summers. People get so tied up into this idea of parity that imagine we have two bottles of ketchup that measure 12 ounces a piece. Then we have a third ketchup bottle from the same brand that measures 24 ounces. Economists will get so caught up in making sure that the two smaller bottles price together reflects the cost of the larger bottle. This causes a problem in that ... can you guess ...

that one is not looking into whether the input prices are over or under-valued. This is especially prevalent in financial assets and may be the reason we had such a spectacular blow off in 2008 in the financial sector. Everyone kept taking note of the fact that one house with 2400 square feet cost exactly double a house with 1200 square feet keeping all other factors constant. No one asked whether the price of the smaller home should have been selling for 3 times as much as the place could be rented for over the period of the mortgage.