Univesity of St.

Gallen
Monetary Economics

Swiss Franc (CHF), United States Dollar (USD) and British Pound (GBP)
Exchange rates and purchasing power
(1991 2011)

Written by: Onyekachi Agu | Norbert Juhsz Pablo Ordonez Saenz | Andreas Werner

November 30th, 2011

Introduction
The relationship between exchange rates and PPP has been a long debated topic in international economics. The crux of PPP is that the price level of any two countries should be the same when denominated in a single currency. As a determinant of exchange rates, the consensus is that PPP is only partially successful in the very long run. Most scholars expect deviations from PPP in the short run and convergence in the very long run. Several empirical studies have thus been carried out in order to find and show this relationship between the exchange rates and the PPP, However, the results show a lot of deviations from PPP, with PPP failing to hold in the short run (Rogoff, 1996) and recently in the long run (Engel, 2000). Many reasons have been given for the divergence from PPP such as prices of goods being sticky while capital flows are more or less instantaneous; shocks from interest rate as well as political decisions; Balessa Samuelson effect1; limitations in international arbitrage; wage differentials between various countries. In our paper, we attempt to compare the nominal exchange rates of the United States Dollar (USD), the Switzerland Franc (CHF) and the British Pound (GBP) with the respective PPP ratios and see if there is any convergence to PPP within a 20year period. Our approach is very simplistic and involves determining if the trend of the exchange rate is in line with the PPP expectations in the long run, i.e. 20 years in our case. We have calculated the PPP from the Consumer Price Index (CPI) index of the various countries by multiplying the base year s PPP(which is 2005 for all countries) with the ratio of the two countries CPI. The exchange rate and CPI for all countries has been collected monthly to ensure that the fluctuations are observable and due to its availability for the period in which we are interested in. In passing we would like to mention a bit the other factors that could have determined the exchange rates within these three countries in the 20year period. They include; interest rate decisions, government policies, a specialized niche (as in the case of Switzerland s banking industry, and the U.K S and U.S. positions as international financial centres), trade between the countries, differences in the wage levels among other factors. The above mentioned factors could be reasons for the deviation from PPP in the short and medium term and we shall fit some of them as factors that might have influenced the deviation from PPP during this period.

The hypothesis is that when denominated in a common currency, rich countries tend to have higher price levels than poor countries. Bela Belassa (1964) The Purchasing Power Parity Doctrine: A Reappraisal Paul A. Samuelson (1964) Theoretical Notes on Trade Problems

COUNTRY BACKGROUNDS
200 150 100 50 0 1991/9 1995/9 CPI (USA) 1999/9 2003/9 2007/9 CPI (UK)

CPI (CH)

Figure 1. Consumer price indexes in PPP of USA, CH and UK (1991-2011)

10 % 5 0 1991/9 1995/9 1999/9 2003/9 2007/9 CH UK USA

Figure 2. Short-term interest rates of USA, CH and UK (1991-2011)

The United States Dollar (USD) and the Swiss Franc (CHF)
As figure 2. clearly shows, the Swiss franc (CHF) has been generally strongly overvalued against the United States Dollar (USD) over the last 20 years (1991-2011). During this period, the American and 2.3 the Swiss Consumer Price Index (CPI) has augmented by 65% and 1.8 24% respectively, which produced a 1.3 decrease of about 25% in the 0.8 norminal USD/CHF PPP rate. This 1991/9 1995/9 1999/9 2003/9 2007/9 stable long-term trend has been very well followed by the linear USD / CHF PPP (CH/US) Linear (USD / CHF) regression line of the exhange rate time series. However, the standard Figure 3. Historical exchange rates and PPP of USD and CHF (1991-2011) deviation of the exchange rate has been rather high, showing a fundamental overvaluation peaking around +80-90% in value (1995) and having its lowest overvaluation around +10-20% (2001) during the analysed period. Although a slight convergence in the trendlines is observable, recently the overvaluation rate has passed the +70% level again (2011). Looking at the evolution of the central bank base interest rates between the two countries (see figure 2.), further explanations can be found for the evolution of the exchange rate. Figure 3. compares the relative evolution of the difference between base rates (US-CH) and the difference of the exchange rate vs. its trendline. The conclusion is quite visible on the figure with an observable impact delay of the interest rate gap on the exchange rate of about 1-3 years. The interest rates thus offer a rough explanation for mid-term evolution of the exchange rate, but it does not 150% seem to offer an explanation for the 100% overvaluation of the CHF. In order 50% for the exchange rate to approach the 0% -50% PPP, a strong and long-term positive -100% difference of about 3-5% in favour 1991/9 1995/9 1999/9 2003/9 2007/9 of the US rate was necessary between 1994 and 2001. When this i (USA-CH) / Max EX-TrendEX / Max difference diminished, gradually the CHF regained its position. Figure 4. Analysis of interest rates impacting exchange rate (US & CH)

Moreover, other short-term factors need to be considered since the analysed chart does not even offer an explanation for the phenomenons varied impact and potentially even lack of impact, as seen during the second part of the analysed period.

THE BRITISH POUND (GBP) AND THE SWISS FRANC (CHF)

THE BRITISH POUND (GBP) AND THE UNITED STATES DOLLAR (USD)

CONCLUSIONS

LIST OF REFERENCES

LIST OF FIGURES
Figure 1. Figure 2. Figure 3. Figure 4. Consumer price indexes in PPP of USA, CH and UK (1991-2011) Source: IMF IFS & World Bank ICP (2011) Short-term interest rates of USA, CH and UK (1991-2011) Source: IMF IFS (2011) Historical exchange rates and PPP of USD and CHF (1991-2011) Source: Oanda fxTrade, IMF IFS & World Bank ICP (2011) Analysis of interest rates impacting exchange rate (US & CH) Source: same as for Figure 1 & 2.