International Finance — Check the Quotation Convention First

The $\text{won}/\text{dollar}$ exchange rate is the number of won needed to buy one dollar. If it rises from 1,300 to 1,400, the dollar becomes dearer and the won depreciates. Reading “a rising exchange rate = a stronger home currency” is an error that comes from not checking which currency is in the numerator.

1. Distinguish the nominal from the real exchange rate

With $E$ the nominal won/dollar rate, $P^*$ the US price level and $P$ the Korean price level, the real exchange rate can be defined as follows.

Real exchange rate

q=E\frac{P^*}{P}

Under this convention, a rise in q means a fall in the price of domestic goods relative to foreign goods, that is, a real depreciation.

With $E=1300$ , a US price of 100 dollars and a price of 156,000 won for the same Korean good, $q=1300×100/156000≈0.833$ . Even if the nominal rate rises 10%, the real exchange rate may barely change if Korean prices rise by that much more than US prices.

2. Purchasing power parity is a long-run anchor, not a short-run forecaster

Absolute purchasing power parity is the exchange rate at which the price of the same basket of goods is equal once converted. Relative purchasing power parity holds that the inflation differential between two countries is reflected in the rate of change of the exchange rate.

Approximation of relative PPP

\frac{\Delta E}{E}\approx \pi-\pi^*

If domestic inflation is higher than foreign inflation, the won/foreign-currency rate rises, in the direction of a depreciation of the domestic currency.

Transport costs, tariffs, non-traded goods, quality differences and market power mean that the law of one price holds poorly in the short run. The Balassa–Samuelson effect — non-traded goods are dearer in high-productivity countries — also explains deviations from simple PPP.

3. Short-run exchange rates are sensitive to asset returns and expectations

Under covered interest parity, the return on domestic bonds must equal the currency-hedged return on foreign bonds for arbitrage opportunities to disappear.

Covered interest parity

1+i=(1+i^*)\frac{F}{E}

F is the forward rate. The condition requires no transaction costs and no credit or funding constraints.

With a US rate of 4%, a Korean rate of 3% and a spot rate of 1,300 won, the approximate forward rate is $1300×1.03/1.04≈1287.5$ won. If the forward rate strays far from this relation, arbitrage kicks in, but in a crisis the gap can persist because of dollar funding costs and balance-sheet constraints.

4. The link between a rate hike and the value of the currency is conditional

If the expected exchange rate and the risk premium are fixed, a rise in domestic interest rates increases demand for domestic assets and creates pressure for the currency to appreciate. But if the rate hike is a response to rising country risk, the risk premium can rise by more and the currency may even weaken. Look at the cause of the policy and the market reaction together.

Different shocks that move exchange rates
Shock	Short-run channel	Long-run check
Higher domestic inflation	Depends on expectations and the rate response	Depreciation pressure under PPP
Higher domestic interest rates	Possible capital inflows	Cause of the policy, risk premium
Higher export demand	More foreign-currency supply	Capacity, induced imports
Stronger risk aversion	Flight to safe assets	Each currency's safe-asset status

Check your understanding

A move in won/dollar from 1,300 to 1,430 is a 10% nominal depreciation. If Korean prices rise 4% more than US prices, the real depreciation is about 6%. Do not write that competitiveness improved 10% on the basis of the nominal rate alone.

References

Bank of Korea, Economic Statistics System ECOS
Bank for International Settlements, Effective exchange rates
IMF, International Financial Statistics

International Finance — Exchange Rate Determination: Real Exchange Rates, PPP and Interest Parity