economic EXAM

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Exam 5

There will be 2 questions.

Current US economic policy – I have answered this question in class at least 5 times this semester for fiscal and monetary policy. Trade policy will also be queried.

Each student will be assigned a different country to answer a question similar to #1. The country assignments are on the next slide. https://data.worldbank.org/country

The exam will be posted on Blackboard May 3, and you are expected to work on it during class time that day. Class does not meet that day.

You must turn in your assignment to me before noon on Tuesday, May 7. I will have office hours that day from 9-noon.

INTERNATIONAL TRADE:
THE MACROECONOMIC VIEW

PPF, SIC analysis

Basic Trade Theory

  • In its simplest form, trade theory explains international trade through comparative advantage, relying on the Hecksher-Ohlin theorem – a country will export the good that uses relative intensely its relatively abundant resource.

  • Show these:

  • Factor Price Equalization
  • Show Gains from trade with PPF, SIC
  • Tariffs, Quotas, PPF/SIC, S/D
  • Growth and Trade

Copyright © 2012 Pearson Addison-Wesley. All rights reserved.

Chapter 7

International Trade, Exchange
Rates, and Macroeconomic Policy

Topics

  • International Finance
  • Exchange Rates
  • Interest rates
  • Prices

GDP = Expenditure on a Country’s Goods and Services

Y = Cd + Id + Gd + EX

= (C-Cf) + (I-If) + (G-Gf) + EX

= C + I + G + EX – (Cf + If +Gf)

= C + I + G + EX – IM

= C + I + G + CA

Expenditure on domestic production

National income = value of domestic

production

Expenditure by domestic individuals and institutions

Net expenditure by foreign individuals and institutions

Balance of Payments Accounts

  • The balance of payments accounts are separated into 3 broad accounts:
  • current account: accounts for flows of goods and services (imports and exports).
  • financial account: accounts for flows of financial assets (financial capital).
  • capital account: flows of special categories of assets (capital): typically non-market, non-produced, or intangible assets like debt forgiveness, copyrights and trademarks.

How Do the Balance of Payments Accounts Balance?

  • Due to the double entry of each transaction, the balance of payments accounts will balance by the following equation:

current account +

financial account +

capital account = 0

Balance of Payments Accounts

  • The 3 broad accounts are more finely divided:
  • Current account: imports and exports

merchandise (goods like DVDs)

services (payments for legal services, shipping services, tourist meals,…)

income receipts (interest and dividend payments, earnings of firms and workers operating in foreign countries)

  • Current account: net unilateral transfers
  • gifts (transfers) across countries that do not purchase a good or service nor serve as income for goods and services produced

Balance of Payments Accounts (cont.)

  • Capital account: records special transfers of assets, but this is a minor account for the U.S.

Balance of Payments Accounts (cont.)

  • Financial account: the difference between sales of domestic assets to foreigners and purchases of foreign assets by domestic citizens.
  • Financial inflow
  • Foreigners loan to domestic citizens by buying domestic assets
  • Domestic assets sold to foreigners are a credit (+) because the domestic economy acquires money during the transaction
  • Financial outflow
  • Domestic citizens loan to foreigners by buying foreign assets
  • Foreign assets purchased by domestic citizens are a debit (-) because the domestic economy gives up money during the transaction

U.S. Balance of Payments Accounts (cont.)

  • About 70% of foreign assets held by the U.S. are denominated in foreign currencies and almost all of U.S. liabilities (debt) are denominated in dollars.
  • Changes in the exchange rate influence value of net foreign wealth (gross foreign assets minus gross foreign liabilities).
  • Appreciation of the value of foreign currencies makes foreign assets held by the U.S. more valuable, but does not change the dollar value of dollar-denominated debt for the U.S.

Definitions of Exchange Rates

  • Exchange rates are quoted as foreign currency per unit of domestic currency or domestic currency per unit of foreign currency.
  • How much can be exchanged for one dollar? ¥97.385/$
  • How much can be exchanged for one yen? $$0.01027/¥
  • Exchange rates allow us to denominate the cost or price of a good or service in a common currency.
  • How much does a Nissan cost? ¥2,500,000
  • Or, ¥2,500,000 x $0.01027/¥ = $25,672.50

Exchange Rate Quotations

Depreciation and Appreciation

  • Depreciation is a decrease in the value of a currency relative to another currency.
  • A depreciated currency is less valuable (less expensive) and therefore can be exchanged for (can buy) a smaller amount of foreign currency.
  • $1/€ → $1.20/€ means that the dollar has depreciated relative to the euro. It now takes $1.20 to buy one euro, so that the dollar is less valuable.
  • The euro has appreciated relative to the dollar:
    it is now more valuable.

Depreciation and Appreciation (cont.)

  • Appreciation is an increase in the value of a currency relative to another currency.
  • An appreciated currency is more valuable (more expensive) and therefore can be exchanged for (can buy) a larger amount of foreign currency.
  • $1/€ → $0.90/€ means that the dollar has appreciated relative to the euro. It now takes
    only $0.90 to buy one euro, so that the dollar is more valuable.
  • The euro has depreciated relative to the dollar:
    it is now less valuable.

Foreign Exchange Markets

  • The set of markets where foreign currencies and other assets are exchanged for domestic ones
  • Institutions buy and sell deposits of currencies or other assets for investment purposes.
  • The daily volume of foreign exchange transactions was about $5.0 trillion in 2017
  • Most transactions exchange foreign currencies for U.S. dollars.

Spot Rates and Forward Rates

  • Spot rates are exchange rates for currency exchanges “on the spot,” or when trading is executed in the present.
  • Forward rates are exchange rates for currency exchanges that will occur at a future (“forward”) date.
  • Forward dates are typically 30, 90, 180, or 360 days in the future.
  • Rates are negotiated between two parties in the present, but the exchange occurs in the future.

Dollar/Pound Spot and Forward Exchange Rates, 1983–2013

The Demand of Currency Deposits

  • What influences the demand of (willingness to buy) deposits denominated in domestic or foreign currency?
  • Factors that influence the return on assets determine the demand of those assets.

The Demand of Currency Deposits (cont.)

  • Rate of return: the percentage change in value that an asset offers during a time period.
  • The annual return for $100 savings deposit with an interest rate of 2% is $100 x 1.02 = $102, so that the rate of return = ($102 – $100)/$100 = 2%.
  • Real rate of return: inflation-adjusted rate of return,
  • which represents the additional amount of goods & services that can be purchased with earnings from the asset.
  • The real rate of return for the above savings deposit when inflation is 1.5% is 2% – 1.5% = 0.5%. After accounting for the rise in the prices of goods and services, the asset can purchase 0.5% more goods and services after 1 year.

The Demand of Currency Deposits (cont.)

  • If prices are fixed, the inflation rate is 0% and (nominal) rates of return = real rates of return.
  • Because trading of deposits in different currencies occurs on a daily basis, we often assume that prices do not change from day to day.
  • A good assumption to make for the short run.

The Demand of Currency Deposits (cont.)

  • Risk of holding assets also influences decisions about whether to buy them.
  • Liquidity of an asset, or ease of using the asset to buy goods and services, also influences the willingness to buy assets.

The Demand of Currency Deposits (cont.)

  • But we assume that risk and liquidity of currency
    deposits in foreign exchange markets are essentially the same, regardless of their currency denomination.
  • Risk and liquidity are only of secondary importance when deciding to buy or sell currency deposits.
  • Importers and exporters may be concerned about risk and liquidity, but they make up a small fraction of the market.

The Demand of Currency Deposits (cont.)

  • We therefore say that investors are primarily concerned about the rates of return on currency deposits.
  • Rates of return that investors expect to earn are determined by
  • interest rates that the assets will earn
  • expectations about appreciation or depreciation

The Demand of Currency Deposits (cont.)

  • A currency deposit’s interest rate is the amount of a currency that an individual or institution can earn by lending a unit of the currency for a year.
  • The rate of return for a deposit in domestic currency is the interest rate that the deposit earns.
  • To compare the rate of return on a deposit in domestic currency with one in foreign currency, consider
  • the interest rate for the foreign currency deposit
  • the expected rate of appreciation or depreciation of the foreign currency relative to the domestic currency.

The Demand of Currency Deposits (cont.)

  • Suppose the interest rate on a dollar deposit is 2%.
  • Suppose the interest rate on a euro deposit is 4%.
  • Does a euro deposit yield a higher expected rate
    of return?
  • Suppose today the exchange rate is $1/€1, and the expected rate one year in the future is $0.97/€1.
  • $100 can be exchanged today for €100.
  • These €100 will yield €104 after one year.
  • These €104 are expected to be worth $0.97/€1 x €104 = $100.88 in one year.

The Demand of Currency Deposits (cont.)

  • The rate of return in terms of dollars from investing in euro deposits is

($100.88 – $100)/$100 = 0.88%.

  • Let’s compare this rate of return with the rate of return from a dollar deposit.
  • The rate of return is simply the interest rate.
  • After 1 year the $100 is expected to yield $102:
    ($102 – $100)/$100 = 2%
  • The euro deposit has a lower expected rate of return: thus, all investors should be willing to dollar deposits and none should be willing to hold euro deposits.

The Demand of Currency Deposits (cont.)

  • Note that the expected rate of appreciation of the euro was ($0.97 – $1)/$1 = –0.03 = –3%.
  • We simplify the analysis by saying that the dollar rate of return on euro deposits approximately equals
  • the interest rate on euro deposits
  • plus the expected rate of appreciation of euro deposits
  • 4% + –3% = 1% ≈ 0.88%
  • R€ + (Ee$/€ – E$/€)/E$/€

The Demand of Currency Deposits (cont.)

  • The difference in the rate of return on dollar deposits and euro deposits is

R$ – (R€ + (Ee$/€ – E$/€)/E$/€ ) =

R$ –R€ –(Ee$/€ – E$/€)/E$/€

expected rate of return = interest rate on dollar deposits

interest rate

on euro deposits

expected rate of return on euro deposits

expected

exchange rate

current

exchange rate

expected rate of appreciation of the euro

Model of Foreign Exchange Markets

  • We use the
  • demand of (rate of return on) dollar denominated deposits
  • and the demand of (rate of return on) foreign currency denominated deposits

to construct a model of foreign exchange markets.

  • This model is in equilibrium when deposits of all currencies offer the same expected rate of return: interest parity.
  • Interest parity implies that deposits in all currencies are equally desirable assets.
  • Interest parity implies that arbitrage in the foreign exchange market is not possible.

*

Model of Foreign Exchange Markets (cont.)

  • Interest parity says:

R$ = R€ + (Ee$/€ – E$/€)/E$/€

  • Why should this condition hold? Suppose it didn’t.
  • Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€
  • Then no investor would want to hold euro deposits, driving down the demand and price of euros.
  • Then all investors would want to hold dollar deposits, driving up the demand and price of dollars.
  • The dollar would appreciate and the euro would depreciate, increasing the right side until equality was achieved:

R$ > R€ + (Ee$/€ – E$/€)/E$/€

*

Model of Foreign Exchange Markets (cont.)

  • How do changes in the current exchange rate affect the expected rate of return of foreign currency deposits?

*

Model of Foreign Exchange Markets (cont.)

  • Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. Why?
  • When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits.

Model of Foreign Exchange Markets (cont.)

  • Appreciation of the domestic currency today raises the expected return of deposits on foreign currency deposits. Why?
  • When the domestic currency appreciates, the initial cost of investing in foreign currency deposits decreases, thereby increasing the expected rate of return of foreign currency deposits.

Today’s Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits When Ee$/€ = $1.05 per Euro

The Relation between the Current Dollar/Euro Exchange Rate and the Expected Dollar Return on Euro Deposits

Determination of the Equilibrium Dollar/Euro Exchange Rate

Model of Foreign Exchange Markets (cont.)

  • The effects of changing interest rates:
  • an increase in the interest rate paid on deposits denominated in a particular currency will increase the rate of return on those deposits.
  • This leads to an appreciation of the currency.
  • Higher interest rates on dollar-denominated assets cause the dollar to appreciate.
  • Higher interest rates on euro-denominated assets cause the dollar to depreciate.

Effect of a Rise in the Dollar Interest Rate

Effect of a Rise in the Euro Interest Rate

The Effect of an Expected Appreciation of the Euro

  • If people expect the euro to appreciate in the future, then euro-denominated assets will pay in valuable euros, so that these future euros will be able to buy many dollars and many dollar-denominated goods.
  • The expected rate of return on euros therefore increases.
  • An expected appreciation of a currency leads to an actual appreciation (a self-fulfilling prophecy).
  • An expected depreciation of a currency leads to an actual depreciation (a self-fulfilling prophecy).

Determination of the Equilibrium Interest Rate

Effect of an Increase in the Money Supply on the Interest Rate

Effect on the Interest
Rate of a Rise in Real Income

Simultaneous Equilibrium in the U.S. Money Market and the Foreign Exchange Market

Money Market/Exchange Rate Linkages

Effect on the Dollar/Euro Exchange Rate and Dollar Interest Rate of an Increase in the U.S. Money Supply

Changes in the Domestic Money Supply

  • An increase in a country’s money supply causes interest rates to fall, rates of return on domestic currency deposits to fall, and the domestic currency to depreciate.
  • A decrease in a country’s money supply causes interest rates to rise, rates of return on domestic currency deposits to rise, and the domestic currency to appreciate.

Changes in the Foreign Money Supply

  • How would a change in the supply of euros affect the U.S. money market and foreign exchange markets?
  • An increase in the supply of euros causes a depreciation of the euro (an appreciation of
    the dollar).
  • A decrease in the supply of euros causes an appreciation of the euro (a depreciation of the dollar).

Effect of an Increase in the European Money Supply on the Dollar/Euro Exchange Rate

Changes in the Foreign Money Supply (cont.)

  • The increase in the supply of euros reduces interest rates in the EU, reducing the expected rate of return on euro deposits.
  • This reduction in the expected rate of return on euro deposits causes the euro to depreciate.
  • We predict no change in the U.S. money market due to the change in the supply of euros.

Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given Real Output, Y)

Law of One Price

  • The law of one price simply says that the same good in different competitive markets must sell for the same price, when transportation costs and barriers between those markets are not important.
  • Why? Suppose the price of pizza at one restaurant is $20, while the price of the same pizza at an identical restaurant across the street is $40.
  • What do you predict will happen? Many people will buy the $20 pizza, few will buy the $40 one.

Law of One Price (cont.)

  • Due to the price difference, entrepreneurs would have an incentive to buy pizza at the cheap location and sell it at the expensive location for an easy profit.
  • Due to strong demand and decreased supply, the price of the $20 pizza would tend to increase.
  • Due to weak demand and increased supply, the price of the $40 pizza would tend to decrease.
  • People would have an incentive to adjust their behavior and prices would tend to adjust until one price is achieved across markets (across restaurants).

Law of One Price (cont.)

  • Consider a pizza restaurant in Seattle and one across the border in Vancouver.
  • The law of one price says that the price of the same pizza (using a common currency to measure the price) in the two cities must be the same if markets are competitive and transportation costs and barriers between markets are not important.

PpizzaUS = (EUS$/C$) x (PpizzaCanada)

PpizzaUS = price of pizza in Seattle

PpizzaCanada = price of pizza in Vancouver

EUS$/C$ = U.S. dollar/Canadian dollar exchange rate

Purchasing Power Parity

  • Purchasing power parity is the application of the law of one price across countries for all goods and services, or for representative groups (“baskets”) of goods and services.

PUS = (EUS$/C$) x (PCanada)

PUS = level of average prices in the U.S.

PCanada = level of average prices in Canada

EUS$/C$ = U.S. dollar/Canadian dollar exchange rate

Purchasing Power Parity (cont.)

  • Purchasing power parity (PPP) implies that the exchange rate is determined by levels of average prices

EUS$/C$ = PUS/PCanada

  • If the price level in the U.S. is US$200 per basket, while the price level in Canada is C$400 per basket, PPP implies that the C$/US$ exchange rate should be C$400/US$200 = C$2/US$1.
  • Predicts that people in all countries have the same purchasing power with their currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar, since prices in Canada are twice as high.

Purchasing Power Parity (cont.)

  • Purchasing power parity (PPP) comes in 2 forms:
  • Absolute PPP: purchasing power parity that has already been discussed. Exchange rates equal the level of relative average prices across countries.

E$/€ = PUS/PEU

  • Relative PPP: changes in exchange rates equal changes in prices (inflation) between two periods:

(E$/€,t – E$/€, t –1)/E$/€, t –1 = US, t – EU, t

where t = inflation rate from period t –1 to t

A Quick Recap

  • Exchange rate determination has two main schools of thought.

  • Interest rates – Interest Parity Condition
  • R$ = R€ + (Ee$/€ – E$/€)/E$/€

  • Prices – Purchasing Power Parity
  • Absolute PPP: E$/€ = PUS/PEU
  • Relative PPP: (E$/€,t – E$/€, t –1)/E$/€, t –1 = US, t – EU, t

Monetary Approach to Exchange Rates

  • Monetary approach to the exchange rate: uses monetary factors to predict how exchange rates adjust in the long run, based on the absolute version of PPP.
  • It predicts that levels of average prices across countries adjust so that the quantity of real monetary assets supplied will equal the quantity of real monetary assets demanded:

PUS = MsUS/L (R$, YUS)

PEU = MsEU/L (R€, YEU)

Monetary Approach
to Exchange Rates (cont.)

  • To the degree that PPP holds and to the degree that prices adjust to equate the quantity of real monetary assets supplied with the quantity of real monetary assets demanded, we have the following prediction:
  • The exchange rate is determined in the long run by prices, which are determined by the relative supply and demand of real monetary assets in money markets across countries.

Monetary Approach
to Exchange Rates (cont.)

Predictions about changes in

Money supply: a permanent rise in the domestic money supply

  • causes a proportional increase in the domestic price level,
  • thus causing a proportional depreciation in the domestic currency (through PPP).
  • This is same prediction as long-run model without PPP.

Interest rates: a rise in domestic interest rates

  • lowers the demand of real monetary assets,
  • and is associated with a rise in domestic prices,
  • thus causing a proportional depreciation of the domestic currency (through PPP).

Monetary Approach
to Exchange Rates (cont.)

Output level: a rise in the domestic level of production and income (output)

  • raises domestic demand of real monetary assets,
  • and is associated with a decreasing level of average domestic prices (for a fixed quantity of money supplied),
  • thus causing a proportional appreciation of the domestic currency (through PPP).
  • All 3 changes affect money supply or money demand, and cause prices to adjust so that the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded, and cause exchange rates to adjust according to PPP.

Monetary Approach
to Exchange Rates (cont.)

  • A change in the money supply results in a change in the level of average prices.
  • A change in the growth rate of the money supply results in a change in the growth rate of prices (inflation).
  • A constant growth rate in the money supply results in a persistent growth rate in prices (persistent inflation) at the same constant rate, when other factors are constant.
  • Inflation does not affect the productive capacity of the economy and real income from production in the long run.
  • Inflation, however, does affect nominal interest rates.

The Fisher Effect

  • The Fisher effect (named affect Irving Fisher) describes the relationship between nominal interest rates and inflation.
  • Derive the Fisher effect from the interest parity condition:
    R$ – R€ = (Ee$/€ – E$/€)/E$/€
  • If financial markets expect (relative) PPP to hold, then expected exchange rate changes will equal expected inflation between countries: (Ee$/€ – E$/€)/E$/€ = eUS – eEU
  • Therefore, R$ – R€ = eUS – eEU
  • The Fisher effect: a rise in the domestic inflation rate causes an equal rise in the interest rate on deposits of domestic currency in the long run, when other factors remain constant.

Monetary Approach to Exchange Rates

  • Suppose that the U.S. central bank unexpectedly increases the growth rate of the money supply at time t0.
  • Suppose also that the inflation rate is  in the US before t0 and  +  after this time, but that the European inflation rate remains at 0%.
  • According to the Fisher effect, the interest rate in the U.S. will adjust to the higher inflation rate.

Fig. 16-1: Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply

Fig. 16-1: Long-Run Time Paths of U.S. Economic Variables After a Permanent Increase in the Growth Rate of the U.S. Money Supply (cont.)

Monetary Approach to Exchange Rates (cont.)

  • The increase in nominal interest rates decreases the demand of real monetary assets.
  • In order for the money market to maintain equilibrium in the long run, prices must jump so that

PUS = MsUS/L (R$, YUS)

  • In order to maintain PPP, the exchange rate must jump (the dollar must depreciate) so that

E$/€ = PUS/PEU

  • Thereafter, the money supply and prices are predicted to grow at rate  +  and the domestic currency is predicted to depreciate at the same rate.

The Role of Inflation and Expectations

In the long-run model without PPP:

  • Changes in money supply lead to changes in the level of average prices.
  • No inflation is predict to occur in the long run, but only during the transition to the long-run equilibrium.
  • During the transition, inflation causes the nominal interest rate to increase to its long-run value.
  • Expectations of higher domestic inflation cause the expected return on foreign currency deposits to increase, making the domestic currency depreciate before the transition period.

Short-Run and Long-Run Effects of an Increase in the U.S. Money Supply (Given Real Output, Y)

The Role of Inflation and Expectations (cont.)

  • In the monetary approach (with PPP), the rate of inflation increases permanently when the growth rate of the money supply increases permanently.
  • With persistent domestic inflation (above foreign inflation), the monetary approach also predicts an increase in the domestic nominal interest rate.
  • Expectations of higher domestic inflation cause the expected purchasing power of domestic currency to decrease relative to the expected purchasing power of foreign currency, thereby making the domestic currency depreciate.

How a Rise in U.S. Monetary Growth Affects Dollar Interest Rates and the Dollar/Euro Exchange Rate When Goods Prices Are Flexible

The Role of Inflation and Expectations (cont.)

  • In the long-run model without PPP, the level of average prices does not immediately adjust even if expectations of inflation adjust,
  • causing the exchange rate to overshoot (causing the domestic currency to depreciate more than) its long-run value.
  • In the monetary approach (with PPP), the level of average prices adjusts with expectations of inflation,
  • causing the domestic currency to depreciate, but with no overshooting.

Shortcomings of PPP

  • There is little empirical support for absolute purchasing power parity.
  • The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries.
  • Relative PPP is more consistent with data, but it also performs poorly to predict exchange rates.

Fig. 16-2: The Yen/Dollar Exchange Rate and Relative Japan-U.S. Price Levels, 1980–2012

Shortcomings of PPP (cont.)

Reasons why PPP may not be accurate: the law of one price may not hold because of

Trade barriers and nontradable products

Imperfect competition

Differences in measures of average prices for baskets of goods and services

Shortcomings of PPP (cont.)

  • Trade barriers and nontradable products
  • Transport costs and governmental trade restrictions make trade expensive and in some cases create nontradable goods or services.
  • Services are often not tradable: services are generally offered within a limited geographic region (for example, haircuts).
  • The greater the transport costs, the greater the range over which the exchange rate can deviate from its PPP value.
  • One price need not hold in two markets.

Shortcomings of PPP (cont.)

  • Imperfect competition may result in price discrimination: “pricing to market.”
  • A firm sells the same product for different prices in different markets to maximize profits, based on expectations about what consumers are willing to pay.
  • One price need not hold in two markets.

Shortcomings of PPP (cont.)

  • Differences in the measure of average prices for goods and services
  • levels of average prices differ across countries because of differences in how representative groups (“baskets”) of goods and services are measured.
  • Because measures of groups of goods and services are different, the measure of their average prices need not be the same.
  • One price need not hold in two markets.

The Real Exchange Rate Approach to Exchange Rates

  • Because of the shortcomings of PPP, economists have tried to generalize the monetary approach to PPP to make a better theory.
  • The real exchange rate is the rate of exchange for goods and services across countries.
  • In other words, it is the relative value/price/cost of goods and services across countries.
  • For example, it is the dollar price of a European group of goods and services relative to the dollar price of an American group of goods and services:

qUS/EU = (E$/€ x PEU)/PUS

Note: E$/€ = qUS/EU x PUS/PEU

The Real Exchange Rate Approach to Exchange Rates (cont.)

  • According to PPP, exchange rates are determined by relative average prices:

E$/€ = PUS/PEU

  • According to the more general real exchange rate approach, exchange rates may also be influenced by the real exchange rate:

E$/€ = qUS/EU x PUS/PEU

Exchange Rate Regimes

  • Initial assumption is that exchange rates are flexible

  • Fixed is the special case

Exchange Rate Systems

  • In a (pure) flexible exchange rate system, the foreign exchange rate is free to change every day in order to establish an equilibrium between QS and QD of a nation’s currency
  • In a fixed exchange rate system, the foreign exchange rate is fixed for long periods of time
  • Maintained by central bank purchases and sales of the nation’s currency
  • If there is an excess demand of the home currency  CB sells currency / buys USD
  • If there is an excess supply of the home currency  CB buys currency / sells USD
  • When the CB purchases (sells) foreign currency, its holdings of foreign exchange reserves increase (decrease)
  • Under a fixed exchange rate system, an increase (decrease) in the value of the currency is known as a revaluation (devaluation)
  • The current system of exchange rates is not a pure flexible exchange rate system because of CB intervention in FX markets
  • 1986-2009: Foreign CB’s intervened by buying over $4 trillion USD

17-*

Introduction

  • Many countries try to fix or “peg” their exchange rate to a currency or group of currencies by intervening in the foreign exchange markets.
  • Many with a flexible or “floating” exchange rate in fact practice a managed floating exchange rate.
  • The central bank “manages” the exchange rate from time to time by buying and selling currency and assets, especially in periods of exchange rate volatility.
  • How do central banks intervene in the foreign exchange markets?

17-*

Assets, Liabilities
and the Money Supply

  • A purchase of any asset by the central bank will be paid for with currency or a check written from the central bank,
  • both of which are denominated in domestic currency, and
  • both of which increase the supply of money in circulation.
  • The transaction leads to equal increases of assets and liabilities.
  • When the central bank buys domestic bonds or foreign bonds, the domestic money supply increases.

17-*

Assets, Liabilities
and the Money Supply (cont.)

  • A sale of any asset by the central bank will be paid for with currency or a check written to the central bank,
  • both of which are denominated in domestic currency.
  • The central bank puts the currency into its vault or reduces the amount of deposits of banks,
  • causing the supply of money in circulation to shrink.
  • The transaction leads to equal decreases of assets
    and liabilities.
  • When the central bank sells domestic bonds or foreign bonds, the domestic money supply decreases.

17-*

Foreign Exchange Markets

  • Central banks trade foreign government bonds in the foreign exchange markets.
  • Foreign currency deposits and foreign government bonds are often substitutes: both are fairly liquid assets denominated in foreign currency.
  • Quantities of both foreign currency deposits and foreign government bonds that are bought and sold influence the exchange rate.

17-*

Fixed Exchange Rates

  • To fix the exchange rate, a central bank influences the quantities supplied and demanded of currency by trading domestic and foreign assets, so that the exchange rate (the price of foreign currency in terms of domestic currency) stays constant.
  • Foreign exchange markets are in equilibrium when

R = R* + (Ee – E)/E

  • When the exchange rate is fixed at some level E0 and the market expects it to stay fixed at that level, then

R = R*

17-*

Fixed Exchange Rates (cont.)

  • To fix the exchange rate, the central bank must trade foreign and domestic assets in the foreign exchange market until R = R*.
  • Alternatively, we can say that it adjusts the quantity of monetary assets in the money market until the domestic interest rate equals the foreign interest rate, given the level of average prices and real output:

Ms/P = L(R*,Y)

17-*

Fixed Exchange Rates (cont.)

  • Suppose that the central bank has fixed the exchange rate at E0 but the level of output rises, raising the demand of real monetary assets.
  • This is predicted put upward pressure on interest rates and the value of the domestic currency.
  • How should the central bank respond if it wants to fix exchange rates?

17-*

Fixed Exchange Rates (cont.)

  • The central bank should buy foreign assets in the foreign exchange markets,
  • thereby increasing the domestic money supply,
  • thereby reducing interest rates in the short run.
  • Alternatively, by demanding (buying) assets denominated in foreign currency and by supplying (selling) domestic currency, the price/value of foreign currency is increased and the price/value of domestic currency is decreased.

17-*

Asset Market Equilibrium
with a Fixed Exchange Rate, E0

17-*

Monetary Policy and Fixed Exchange Rates

  • When the central bank buys and sells foreign assets to keep the exchange rate fixed and to maintain domestic interest rates equal to foreign interest rates, it is not able to adjust domestic interest rates to attain other goals.
  • In particular, monetary policy is ineffective in influencing output and employment.

16-*

IS-LM Model

  • The amount of investment expenditure depends on the interest rate.
  • Investment projects use saved or borrowed funds, and the relevant interest rate represents the (real) cost of spending or borrowing those funds.
  • A higher interest rate means less investment expenditure.
  • The IS-LM model predicts that investment expenditure is inversely related to the relevant interest rate.

16-*

IS-LM Model (cont.)

  • The IS-LM model expresses aggregate demand as:

D = C(Y – T, R-πe ) + I(R-πe)+ G + CA(EP*/P, Y – T, R-πe )

  • Or more simply:

D = D(EP*/P, Y – T, R-πe, G)

Investment

as a function

of the real

interest rate

R-πe

Current account as

a function of the real

exchange rate,

disposable income

and the real interest

rate R-πe

Consumption

as a function

of disposable

income and the

real interest

rate R-πe

Government

purchases are

exogenous

16-*

IS-LM Model (cont.)

  • Instead of relating exchange rates and output, the IS-LM relates interest rates and output.
  • In equilibrium, aggregate output = aggregate demand
  • Y = D(EP*/P, Y – T, R-πe, G)
  • In equilibrium, interest parity holds
  • R = R* + (Ee-E)/E
  • E(1+R) = ER* + Ee
  • E(1+R–R*) = Ee
  • E = Ee/(1+R–R*)

16-*

IS-LM Model (cont.)

  • Y = D(EeP*/P(1+R–R*) , Y – T, R-πe, G)
  • This equation describes the IS curve: combinations of interest rates and output such that aggregate demand equals aggregate output, given values of exogenous variables Ee,P*,P, R*,T, πe, and G.
  • Lower interest rates increase investment demand (and consumption and import demand), leading to higher aggregate demand and higher aggregate output in equilibrium.
  • The IS curve slopes down.

16-*

IS-LM Model (cont.)

  • In equilibrium, the quantity of real monetary assets supplied matches the quantity of real monetary assets demanded: Ms/P = L(R,Y)
  • This equation describes the LM curve: combinations of interest rates and output such that the money market is in equilibrium, given values of exogenous values P and Ms.
  • Higher income is predicted to cause higher demand of real monetary assets and higher interest rates in the money market.
  • The LM curve slopes up.

16-*

IS-LM Model (cont.)

Both the output

markets and money

market are in

equilibrium at R1

and Y1

1

R1

Y1

LM

IS

Output, Y

Interest

rate, R

Output markets

are in equilibrium

Money market

is in equilibrium

16-*

Effects of Temporary Changes in the Money Supply (cont.)

Exchange rate, E ( increasing)

Expected return

on foreign currency

deposits

R2

LM2

Interest rate, R

Output, Y

LM1

2

Y2

1

Y1

R1

2´

E2

1´

E1

IS1

Temporary increase

in money

supply

16-*

Effects of Permanent Changes
in the Money Supply in the Short Run

Exchange rate, E ( increasing)

Expected return

on foreign currency

deposits

R3

R2

LM2

Interest rate, R

Output, Y

LM1

2

Y2

3

Y3

1

Y1

R1

2´

E2

1´

E1

E3

3´

IS1

IS2

Domestic currency

is expected

to depreciate

Permanent increase

in money

supply

16-*

Effects of Temporary Changes in Fiscal Policy

Exchange rate, E ( increasing)

Expected return

on foreign currency

deposits

R2

R1

Interest rate, R

Output, Y

LM

1

Y1

2

Y2

2´

E2

E1

1´

IS1

IS2

Temporary

fiscal

expansion

16-*

Effects of Permanent Changes in Fiscal Policy

Exchange rate, E ( increasing)

Expected return

on foreign currency

deposits

R2

R1

Interest rate, R

Output, Y

LM

1

Y1

2

Y2

2´

E2

E1

1´

E3

3´

IS1

IS2

Permanent

fiscal

expansion

Domestic currency

is expected to appreciate

IS/LM/BP MODEL

The International Trilemma

  • The international “trilemma” is the impossibility of any nation to simultaneously maintain all of the following:
  • Independent control of domestic monetary policy
  • Fixed exchange rates
  • Free flows of capital with other nations
  • The EU’s common currency (the Euro) and free flows of capital between countries prevent individual EU countries from pursuing independent monetary policies
  • The US has flexible exchange rates and free flows of capital, so it can run an independent monetary policy
  • But countries like Japan and China can buy USD to keep their own currencies undervalued to promote their exports

The Monetary Trilemma for Open Economies

COUNTRYSTUDENT

Afghanistan

Ao, Muyu

Algeria

Bol, Jonah S.

Argentina

Bush, John W.

Australia

Chen, Dingsheng

Austria

Clark, Anthony R.

Bangladesh

Cummins III, Tommy J.

Belgium

Deckers, Claire G.

Bolivia

Donovan, Eric J.

Brazil

Ferrier, Lucas J.

Brunei

Gordon, Tyler R.

Bulgaria

Gu, Xinzong

Burma

Hobbs, Forester S.

Burundi

Huang, Yu

Cambodia

Huo, Shiyun

Cameroon

Jones, Alec P.

Canada

Keller, Chris L.

Chad

Kleitsch, Noah

Chile

Kpedi, Ra

China

Kuchimanchi, Karthik

Colombia

Labinger, Jonathan P.

Costa Rica

Li, Zihao

Denmark

Lin, Xinhao

Ecuador

Logue Jr., Mike P.

Egypt

Lospinoso, Madison K.

Finland

Luo, Chenying

France

Luo, Xin

Georgia

Miller, Sean

Germany

Pitaniello, Luna A.

Ghana

Qi, Haoyue

Greece

Renaud, Zachary

Grenada

Smith, Christopher T.

Guatemala

Suler, Erin

Hungary

Thibault, Caleb S.

Iceland

Wei, Wei

India

Werth, Sara L.

Indonesia

Wittmeier, Nick D.

Iran

Xiong, Jiawei

Iraq

Yan, Tao

Ireland

Yao, Yuanke

Israel

Yu, Chengji

Italy

Zandvoort, Nathan

Jamaica

Zhang, Qianfeng

Japan

Zhang, Qicheng

Jordan

Zhang, Yifan

Kenya

Zhu, Qianwei

COUNTRY

STUDENT

Korea, South

Andrews, Zack N.

Kuwait

Arliss, Will F.

Luxembourg

Baum, Will D.

Madagascar

Cai, Ying

Malaysia

Calcaterra, Katie

Mali

Cameron, Carter T.

Mauritania

Carpenter, Hunter

Mauritius

Chen, Hancong

Mexico

Chen, Zilu

Montenegro

Cianciola, Joseph C.

Morocco

Croxford, Ryan F.

Mozambique

Curtis, Ray V.

Netherlands

Draper, Meghan E.

New Zealand

Fino-Theuer, Tyler J.

Nicaragua

Flaherty, James M.

Niger

Frangiosa, Cole A.

Nigeria

Fusco, Katherine C.

Norway

Gosselin, Sam L.

Oman

Hackett, Finn F.

Pakistan

Halilovic, Hamza

Palestinian Territories

Hall, Aryn E.

Panama

Heon, Emily R.

Paraguay

Hogan, Bill T.

Peru

Jeffers, Sean

Philippines

Kiel-Zabel, Ryan

Poland

Krassnig-Plass, Nora

Portugal

Lee, Tyler D.

Qatar

Lennon, Cat V.

Romania

Mandigo, Janelle F.

Russia

Mason, Oliver M.

Saudi Arabia

Pare, Luke

Senegal

Pelon, Ben M.

Serbia

Raymond, Daniel

Singapore

Redmond, Catherine

South Africa

Repka, Wil R.

South Korea

Rider, William M.

Spain

Rodenhauser, Mark G.

Sri Lanka

Sherpa, Ringin N.

Sudan

Smith, Jake P.

Sweden

Swanke, Hope A.

Switzerland

Turek, Jackson W.

Syria

Van de Graaf, Sarah J.

Thailand

von Hagke, Henry G.

Turkey

Waine, Doug H.

Uganda

Zhang, Qijie