A GAME OF EXCHANGE RATE DETERMINATION TO ILLUSTRATE THE CONCEPT OF PPP EMRE OZSOZ, PHD FASHION INSTITUTE OF TECHNOLOGY - SUNY CHALLENGE: HOW TO ILLUSTRATE THE CONCEPT OF FX RATE DETERMINATION AND PPP CONCEPT PRINCIPLES COURSES • Textbook reading • Real World Examples • School Trips • HWs Or …. • In-class game on the concept OVERVIEW OF THE GAME FX Determination Game designed by following the work of • Rebelein et al. (2008) – corn and wheat purchasing game; • Hazlett and Ganje (1999) – official and parallel FX markets in a Dev. Economies Goal of the game: • Demonstrate to the students how exchange rates are determined in a market environment. • Illustrate the concept of law of one price and PPP in the case of floating currencies. • Demonstrate the concepts of inflation, shipping costs and capital controls as part of the game through modifications (treatments.) OVERVIEW OF THE GAME • Setting up the game • Groups of 2-3, each group acting in self interest for a reward – minimum 8 groups for best results • Minimum 2 different currencies with different denominations • Several independent treatments to emphasize different concepts (i.e. inflation, shipping costs) THE RULES • Students are given equal amounts of all currencies used Ex: For a two currency game(green & blue) each group gets 40 units of green currency + 20 units of blue currency • A benchmark price for an international commodity is established. Ex: Price of 1 oz. gold in green currency= 4 green currency; price of 1 oz. gold in blue currency=2 blue currency • Students are then reminded that their initial purchasing power is the same in both currencies. Ex: 40 green currency = 10 oz. of gold (at the green currency exchange rate) and 20 blue currency= 10 oz gold (at the blue currency/ gold exchange rate. • The groups than instructed to increase their purchasing power at the end of a certain number of rounds (10-12) through exchanging currency in the market. • Reward necessary to reduce noise DESIGNING MARKET EXCHANGE Exchange mechanism Free exchange Best implementation results achieved in rounds close to convergence Centralized Exchange Block of currency auctioned by the instructor, measure of randomness used to break ties SCORE BOARD Randomly selected auction amounts Consistent FX rate monitoring enables students to keep track more easily SCORE BOARD Different Ways to record the FX rate: -Average of the highest 3 bids -The highest bid Randomly selected auction amounts ACUAL RESULTS FROM A GAME Exchange rate converges to 2 Green = 1 Blue at the end of the game CONVERGENCE USUALLY ACHIEVED 60% INTO THE GAME FOR 2 CURRENCY GAMES AND 80% INTO THE GAME FOR 3 CURRENCY GAMES WITHIN MY SAMPLE LIMITATIONS • Assumes the law of one price as the only determinant of FX rate. Interest rates or expectations ignored. • Non-tradable goods hard to implement • In the case of centralized exchange type applications, randomness might determine the winner. POST CONVERGENCE TREATMENTS • INFLATION: By raising cost of commodity in a currency • SHIPPING COSTS: By establishing separate countries and imposing a shipping cost for purchasing commodity from the other country. CAPITAL CONTROLS Restriction on the amount of commodity that can be purchased with one of the currencies. DISCUSSION FOLLOWING THE GAME • Better to lecture PPP discussion following the game not before. • Big Mac Index appropriate for discussion following the game.