KEY POINTS

  1. Purchasing power parity does not hold between rich and poor countries, in either relative or absolute form. Prices of goods are systematically higher in rich countries. As countries become relatively richer, we can therefore expect their price levels to rise and, hence, their real exchange rates to appreciate. Exchange rate forecasts (real and nominal) need to be adjusted accordingly, as do judgments as to whether a country’s exchange rate is under- or overvalued.
  2. The Balassa-Samuelson theory explains price differences across countries as a result of differences in the wage (labor) costs embodied in nontraded goods. It assumes that nontraded goods have zero (or small) productivity differences. Under those assumptions, large differences in traded goods productivity are associated with large differences in income per capita, wages, and the prices of nontraded goods.
  3. Uncovered interest parity (UIP) appears to hold when market expectations are measured directly using data from surveys of traders. But the joint hypothesis of UIP and rational expectations (the efficient markets hypothesis) appears to be invalid because exchange rate forecasts seem to be systematically and predictably wrong.
  4. On average, exchange rate movements have been smaller than predicted by UIP, so a carry trade strategy of borrowing in the low-yield currency and investing in the high-yield currency delivers profits or excess returns. However, these excess returns are risky, with a Sharpe ratio well below 1, and typically close to 0.4 to 0.5. As with the stock market, few investors are willing to devote speculative capital to such risky investments.
  5. Default is as old as capital markets. Sovereign defaults on international lending have been widely documented for several centuries. In the modern era, defaults are associated with economic downturns, and a good deal of this pain seems to be a result of default. This “punishment” for the defaulter creates one important benefit—it makes lending possible in the first place, since sovereigns otherwise face no incentive to repay.
  6. A simple model of default can explain why countries default in bad times. They need to insure against really painful outcomes and default allows them to do this. The price of such insurance is the risk premium they must pay on top of the risk-free rate when they borrow, so that the lender breaks even. This kind of model explains the existence of default as an equilibrium outcome. Nonetheless, many other factors can precipitate default crises, including complex feedback between default, banking crises, and exchange rate crises.
  7. Before 2008, large capital flows from EM to DM created global imbalances, and some similar imbalances could be found within the DM world. Some of these flows ended up financing unsustainable private or public consumption or failed housing investments in certain DM economies (United States, Britain, Ireland, Spain, etc.) and as the malinvestment contaminated balance sheets of banks globally the stage was set for the Global Financial Crisis.
  8. The subsequent Great Recession saw contractions in aggregate demand and credit, and ballooning government debts and deficits in many DM countries. The financial crisis now created a fiscal problem, and in some cases, brought governments to a near-insolvent position, in some cases necessitating rescue packages (the euro periphery). EM economies bounced back quickly, but the DM economies had a deep slump, making the global recovery weak and doubtful.