The Japanese Yen - Research Paper Example

The Japanese Yen INTRODUCTION The purpose of this paper is to investigate into the co-integration between the nominal exchange rates and the Japanese Yen, and the foreign price levels. As such, the paper will primarily focus on examining the validity of the Purchasing Power Parity (PPP) Theory in the context of the performance of the Japanese Yen on the global currency market. The key concern of the study is to be able to find any possible common stochastic trend(s) between relative prices and exchange rates. The purchasing power parity theory states that the nominal exchange rate between two currencies must be equal to the ratio of the total price levels between the two countries (Laurentiu). Precisely, this theory argues that a unit current, for instance, the Yen must have the same purchasing power in a foreign country. The study uses the Japanese Yen together with other currencies in testing the PPP hypothesis and focuses on the empirical analysis from 1980 up to March 2013. This period is divided into three windows. The first window is what is referred to as the complete sample; the pre-crisis sample, which began in January 1980 and ended in August 2008, is the second window. The third window is referred to as the crisis sample, starting from September 2008 up to March 2013. The Japanese Yen among other currencies such as the Euro, the British pound and the U.S dollar are key currencies of the recent floating exchange rate period. In this regard, the first step of the study was to check for the stability of the real exchange rate prior to and after Lehman Brother’s crash in 2008. The empirical results showed that the real exchange rate is not constant for Japanese yen. For a proper evaluation of the problem under study this paper will comprise of various sections, including a brief literature review, the econometric methodology, data and empirical evidence, and lastly a summary of the findings and concluding remarks. LITERATURE REVIEW OF THE TOPIC The purchasing power theory dates back to several centuries ago, beginning with the Spanish doctors and the ‘Salamanca School’ of the 16th century who had crucial contributions to the economic theory (Laurentiu). They designed a quantitative money theory of the foreign exchange, which was based on diversity in purchasing power in various countries from observing the general effects on price levels, exchange rates and money supplies of large inflows of gold from the newly discovered continent, America. The celebrated Augustinian doctor, called ‘Doctor Navarrus came up with some outstanding contributions in introducing the theory of purchasing power of money by looking at the phenomena of prices and money in a new vision of the microeconomic framework (Yotopoulos). Navarrus equated the purchasing power of money to the value of money, from which he managed to discover that the ‘estimation’ or ‘value’ of money is determined in certain circumstances by the purchasing power of money (Yotopoulos). Gustav Cassel, a Swedish economist, introduced the Purchasing Power Parity (PPP) in the twentieth century. Gustav observed that during and after the first world war, countries like the Soviet Union, Hungary, and Germany not only underwent hyperinflation, but also their currencies purchasing power reduced sharply. Their currencies depreciated drastically against more stable currencies such as the US dollar. Out of this observation, he proposed a model of the Purchasing Power Parity. Later, this theory became the benchmark for the long-run nominal exchange rate determination in post years of the First World War (MacDonald and Marsh). This theory is based on the law of one price, which states that in the absence of the official trade barriers and transaction costs, similar goods will be able to have the same price in various markets when prices are expressed in the same currency (Laurentiu). The theory of Purchasing Power Parity hold because the international goods arbitrage is closely related to the law of one price, whose argument is that the price of any internationally traded goods should be equal everywhere in the world, once the price is expressed in any common currency. People could make some riskless profit by just shipping goods from locations where the price is very low to other locations where the price is high, thus gaining from arbitraging. If the same goods and services are put in every country’s market basket, which is used in constructing the aggregate price level with similar weight, then the law of one price indicates that PPP exchange rate should be able to hold between the countries which are concerned (Nam). Thus, no evidence will be available to show why and when the price is converted into the same currency. At the market exchange rate, price levels should vary across economically integrated countries. Goods and services that are tradable across countries should have same prices charged on them in these different countries by the virtue of the law of one price. Any price difference should be as a result of tariffs, transportation costs and market imperfection or monopolistic power. The Law of One Price as the underlying mechanism behind the PPP theory is weakened by governmental trade restrictions and transport costs imposed by the Japanese government. As a result, prices of goods increases to create price differential across borders (Taylor). The transport costs and trade restrictions break the link between the exchange rates and the prices of services and goods implied by the Law of One Price. THE ECONOMETRIC SPECIFICATION Let’s take the Law of One Price between the Japanese Yen and the US dollar as follows; treat the Japanese Yen as the domestic currency and the U.S dollar be the foreign currency. We have PiYen, the price of goods i when they are sold in the Japanese market zone, and PiUS, which is the corresponding price of goods in the dollar zone. As per the Law of One Price, the two prices should be equal (Laurentiu). PiYen=EYen/$*PiUS (1) At the same time, the Yen/Dollar exchange rate is the ratio of goods i, in Japanese Yen and U.S money prices; EYen/$=PiYen/PiUS (2) For PPP theory to hold, let PYen be the price of the reference goods basket sold in the Japanese market, and PUS be the price of a similar basket of goods in the US market. The PPP theory has to predict the Yen/US Dollar exchange rate of: EYen/$=PYen*PUS (3) Equation 3 above can be rearranged to facilitate the establishment of an alternative interpretation of the PPP theory Pyen=Eyen/$*PUS (4) The left side of equation one can see the Yen price of goods baskets in the zone where the Japanese yen is being used, while on the right-hand side, we have the Yen price multiplied by the Yen price of the dollar and that is the Japanese Yen price of the basket when bought in the United States. At the same time, the right-hand side measures the purchasing power of the Japanese Yen when exchanged for the dollar and spend in the United States (Schweigert). Based on expression (3), one can deduce that the purchasing power parity describes the changes in the rate of exchange between the two countries’ currencies by the changes in countries price level. The theory of PPP, as a result, holds when at the going exchange rates, then the domestic purchasing power of currencies is equivalent to its foreign purchasing power. The Two Variants of the PPP Theory for the Japanese Yen The hypothesis theory has two variants in which the PPP hypothesis might hold; the relative variant and absolute variant. The absolute purchasing power parity hypothesis could be resumed in a formula of price ratio equals the exchange rate (Laurentiu). The hypothesis could hold only when the nominal foreign exchange rate between the Yen currency and any other currency, for instance, the U.S dollar such that the purchasing power of unit of currency is the same in foreign economy as in domestic economy, once it is changed into the foreign currency at the prevailing rate. The relative hypothesis only holds when the percentage change in the exchange rate over any given period just offsets the variance in the rate of inflation in the countries concerned over that same period. In such a context, the purchasing power of a unit of the Japanese Yen currency in the domestic economy, which is relative to its purchasing power in foreign when converted at a the prevailing rate of exchange is similar at the end of the period as at the start of the period. This hypothesis states that any changes in the exchange rate should be the same as the difference in the rate of inflation. The real exchange rate, in this case, should be constant over time (Schweigert). The absolute PPP is able to hold only when the purchasing power of any unit of currency is equal in the Japanese economy and the foreign economy only when it is changed into another country’s currency at the current market exchange rate. The PPP exchange rate calculation is hard since there are problems in finding the comparable baskets of commodities to compare the purchasing power of Japan and other foreign countries. The variances from the parity shows the differences in the purchasing power of any basket of commodities across countries, which means that to compare prices of goods being sold in Japan and those sold in other countries, the national income statistics should adjust the PPP and be converted into a standard unit of measurement. DATA DESCRIPTION AND RESULTS The International Monetary Financial Statistic (IFS) is the source of data used in this paper. The data used includes the monthly averages of the exchange rate in the local currency as per the Japanese Yen and the consumer price indices proxying for the price levels. The Japan and the United States data sample used contain the observation from the year 1980 to March 2013. The consumers price indices are the given indices form, whereas the exchange rates are the exchange rates for Japanese Yen/US Dollar. Table 1 indicates the descriptive statistics of the real exchange rate in the first difference. The Japanese Yen indicates low standard in the period of crisis than in the pre-crisis period (Laurentiu). The skewness of the Japanese Yen is negative for the pre-crisis period and turning positive during the crisis period. According to an analysis done by this paper’s researcher, the Japanese Yen was stationary at 5% confidence interval. Table 1 Descriptive Statistic of the real exchange rate Source:International Monetary Fund Figure 1 below is a graphical representation of the nominal and real exchange rates for Japanese yen and other currencies analyzed against the U.S dollar. From this graph, each and every exchange rate has indicated a significant deviation around the mean. At the same time, the exchange rates seem to stabilize around the lowest mean with the lowest standard deviation. Figure 1 Nominal and real exchange rate relative to the US dollar (January 1980-March 2013) Source:International Monetary Fund CONCLUSION This paper aimed at establishing the validity of PPP hypothesis for the Japanese Yen together with other currencies of the recent floating exchange rate period. From this analysis, the purchasing power parity holds during the crisis period for the Japanese Yen, implying that the exchange rate and prices of goods in Japan are equal to the same basket of goods in foreign countries (Taylor). The traditional purchasing power parity hypothesis argued that the exchange rate is equally proportional to the domestic money supply and inversely proportional to the foreign price level, with the factors of proportionality being +1 and -1, hence cannot be rejected for the Japanese Yen. The theory also showed that money supply, exchange rate and the foreign price level in Japan appeared to follow a random walk with a drift, and all were co-integrated, showing a stationary real exchange rate for the Japanese Yen. This stable exchange rate of the currency is attributed to the stationary behavior of the term of trade in Japan. Finally, the results from this paper confirmed that the two traditional approaches, which are used for testing purchasing power parity among t different exchange rates and prices could be able to solve the issue of the purchasing power parity. The finding would be able to validate the hypothesis that relative prices and nominal exchange rate share some common trends in order to ensure that the real exchange rate is the mean-reverting stationary process. Thus, the variances attributed to the transitory monetary shocks would translate into the real exchange rate difference among countries (Schweigert). However, the exchange rate comprises of the exchange rate and price levels, implying that any shock as a result of financial market and with a capacity to move the nominal exchange rate moved to the real exchange rate courtesy of the sticky prices. Works Cited Laurentiu, Guinea, Voinea. "The Purchasing Power Parity: Evidence from the great financial crisis." Academic Business Journal (2013): 1-35. MacDonald, Ronald and Ian Marsh. Exchange Rate Modelling. Berlin: Springer Science & Business Media, 2013. Nam, Deokwoo. Three Essays on Dynamics of Real Exchange Rate. Michigan: ProQuest, 2008. Schweigert, Thomas. "Nominal and real exchange rates." Journal of Economic development (2002): 127-147. Taylor, Mark P. Purchasing Power Parity and Real Exchange Rates. London: Routledge, 2013. Yotopoulos, Pan A. Exchange Rate Parity for Trade and Development: Theory, Tests, and Case Studies. Cambridge: Cambridge University Press, 2005. Read More