Open Economy Macroeconomics Lecture Notes - · PDF fileOpen Economy Macroeconomics Lecture Notes Open Economy Macroeconomics Ozan Hatipoglu Department of Economics, Bogazici

Open Economy Macroeconomics Lecture NotesOpen Economy Macroeconomics

Ozan Hatipoglu

Department of Economics, Bogazici University

Spring 2014

Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2014 1 / 93

Foreign Exchange (FX) Markets -Definition, Functions andFeatures

Definition: A market where national currencies are bought and sold

Transfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



Definition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.

Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



Definition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign trade

Facilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



Definition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocks

Largest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



Definition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)

24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



Definition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)24 hours trading and no trading limit

No commissions by brokers but bid-ask spread required by dealers



Definition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $6 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers


International Transactions

Occur between individuals, firms, governments, international agencies.

Trade : Turkish firm sells a good to a US firm. Either the US firm paysin TL by converting $ into TL or pays in $ and the Turkish firmconverts it to TL. Trade practice of exporting Turkish firms: get paid inforeign currency if it is Euro or $ otherwise TL.Foreign Direct Investment(FDI). Example : US definition: ForeignDirect Investment is defined as whenever a US citizen, organization, oraffiliated group takes an interest of 10 percent or more in a foreignbusiness entity. It includes setting up a business, buying an office blocketc.



Occur between individuals, firms, governments, international agencies.Trade : Turkish firm sells a good to a US firm. Either the US firm paysin TL by converting $ into TL or pays in $ and the Turkish firmconverts it to TL. Trade practice of exporting Turkish firms: get paid inforeign currency if it is Euro or $ otherwise TL.

Foreign Direct Investment(FDI). Example : US definition: ForeignDirect Investment is defined as whenever a US citizen, organization, oraffiliated group takes an interest of 10 percent or more in a foreignbusiness entity. It includes setting up a business, buying an office blocketc.



Occur between individuals, firms, governments, international agencies.Trade : Turkish firm sells a good to a US firm. Either the US firm paysin TL by converting $ into TL or pays in $ and the Turkish firmconverts it to TL. Trade practice of exporting Turkish firms: get paid inforeign currency if it is Euro or $ otherwise TL.Foreign Direct Investment(FDI). Example : US definition: ForeignDirect Investment is defined as whenever a US citizen, organization, oraffiliated group takes an interest of 10 percent or more in a foreignbusiness entity. It includes setting up a business, buying an office blocketc.



Portfolio Investments:This is an investment by individuals, firms orpublic bodies (ex. national and local governments) in foreign financialinstruments. Foreign financial instruments include government bondsand foreign stock.

The biggest difference between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a significantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances”Foreign” in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign firm.



Portfolio Investments:This is an investment by individuals, firms orpublic bodies (ex. national and local governments) in foreign financialinstruments. Foreign financial instruments include government bondsand foreign stock.The biggest difference between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a significantequity stake or in other words management privileges.

Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances”Foreign” in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign firm.



Portfolio Investments:This is an investment by individuals, firms orpublic bodies (ex. national and local governments) in foreign financialinstruments. Foreign financial instruments include government bondsand foreign stock.The biggest difference between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a significantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education Aid

Remittances : Ex: Workers Remittances”Foreign” in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign firm.



Portfolio Investments:This is an investment by individuals, firms orpublic bodies (ex. national and local governments) in foreign financialinstruments. Foreign financial instruments include government bondsand foreign stock.The biggest difference between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a significantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances

”Foreign” in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign firm.



Portfolio Investments:This is an investment by individuals, firms orpublic bodies (ex. national and local governments) in foreign financialinstruments. Foreign financial instruments include government bondsand foreign stock.The biggest difference between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a significantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances”Foreign” in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign firm.


Types of FX Rate

Bilateral: Between two countries

Effective or trade-weighted (Multilateral): Weighted by the proportionof each country’s trade volume in total trade volume.

Nominal FX Rates: Actual Rates

Real FX rates: Adjusted by price differentials in two countries

Real Effective FX rates: Adjusted by price differentials in the set oftrade partners. TCMB reports two types of Real Effective FX rate (vs. Developed and vs. Developing Countries)


Types of FX Rate







Types of FX Rate







Types of FX Rate







Types of FX Rate







Types of FX Rate

Real FX Rate is a sign of the degree of competitiveness.

Spot vs. forward rates.

Buying vs. Selling ( Bid vs. Ask). Spread=Bid-Ask¿0 Spreadincreases during weekends, holidays, turbulent times.


Types of FX Rate





Types of FX Rate





Definitions:

A bilateral spot exchange rate, St , is domestic currency price of unitof foreign currency FX, so a rise in S (S ↑), is a fall in value ofdomestic currency. (Except for US and UK other than pound vs.dollar)

Cross exchange rate, Scrosst is bilateral exchange rate between two

currencies other than Turkish Lira. e.g.

Cross exchange rate = ratio of two bilateral exchange rates againstthe TL, Scross

t = Set / S$t

Let SBt = Bid Rate and SA

t = Ask Rate.

Suppose the buyer wants to buy $. Dealer asks SAt for 1 $ and Buyer

asks 1/SAt for 1TL.

Suppose the buyer wants to buy TL. Dealer asks 1/SBt for 1 TL and

Buyer asks SBt for 1$.


Definitions:





t = Set / S$t


t = Ask Rate.


asks 1/SAt for 1TL.




Definitions:





t = Set / S$t


t = Ask Rate.


asks 1/SAt for 1TL.




Definitions:





t = Set / S$t


t = Ask Rate.


asks 1/SAt for 1TL.




Definitions:





t = Set / S$t


t = Ask Rate.


asks 1/SAt for 1TL.




Definitions:





t = Set / S$t


t = Ask Rate.


asks 1/SAt for 1TL.




Demand for FX

Turkish establishments demand $ in exchange for TL in order toimport from or invest in USA (and all other international transactionsmentioned above)

US establishments demand TL in exchange for $ in order to importfrom or invest in Turkey(and all other international transactionsmentioned above)

Speculators buy or sell TL (sell or buy $)

Total excess demand/supply eliminated instantaneously by exchange ratemovement


Demand for FX






Demand for FX






Equilibrium in FX Market: UK Example


Appreciation and Depreciation

S ↑: means depreciation

S ↓: means appreciation

Exception: Real Effective Exchange Rates reported by TCMB

Suppose S$ ↓, there are two possibilities:

1 International Value of TL has gone up or TL has appreciated.2 US$ vs. TL has gone down.(or Lira gained value against $)

Theorem

If S$ ↓ while all other currencies in terms of TL remain the same → 2If S$ ↓ while all other currencies in terms of TL ↓ → 1








Theorem









Theorem









Theorem







Suppose S$ ↓, there are two possibilities:1 International Value of TL has gone up or TL has appreciated.

2 US$ vs. TL has gone down.(or Lira gained value against $)

Theorem







Suppose S$ ↓, there are two possibilities:1 International Value of TL has gone up or TL has appreciated.2 US$ vs. TL has gone down.(or Lira gained value against $)

Theorem








Theorem








Theorem

If S$ ↓ while all other currencies in terms of TL remain the same → 2

If S$ ↓ while all other currencies in terms of TL ↓ → 1







Theorem



Balance of Payments (BOP)

Definition

All transactions between Turkey and the rest of the world(ROW) in agiven year. It serves as flow of demand and supply for TL.

It consists of

1 Current Account,

2 Capital and/or Financial Account

3 Balancing Item.



Definition


It consists of

1 Current Account,


3 Balancing Item.



Definition


It consists of

1 Current Account,


3 Balancing Item.


BOP Items: Current Account

Current account (CRA): Here and now. Export receipts (X) ascredits, import payments (M) as debits, net = current accountbalance (goods, services including financial services, interest anddividends, rent, tourism)

1 Visibles (merchandise account): traded goods, processed goods,repairs on goods, gold, purchase of capital goods such as machinery,aircrafts

2 Invisibles (service account): rights, licenses, insurance, tourism andother intangibles

3 Interests, Profits and Dividends: rents from capital services, e.g.rental income, interest on deposit accounts, dividend payments onstocks, other profits transfers.

4 Transfers: worker’s remittances, aid.






























BOP Items: Capital Account

Capital/financial account(CPA): net capital inflows = net purchasesof TL by foreigners in order to acquire claims on Turkey residents lessnet sales of TL by Turkey residents in order to acquire claims onforeigners (Long term including securities – equities, bonds, real estateetc + short term including bank deposits, short term securities)

1 FDI : real estate, buying a Turkish company by foreigners or foreigncompany by Turkish residents, setting up a factory, purchase ofmachinery and factory in order to produce within that country.

2 Portfolio Investment: equities, bonds, securities.3 Other investment: commercial credit lending by banks, nonbank

institutions, individuals, IMF loans.4 Change in Official Reserves: ∆CB FX reserves

Balancing Item: Current Account+Capital Account=-Balancing Item

visit http://tcmb.gov.tr/odemedenge/odmain.html for Turkishpractice.













2 Portfolio Investment: equities, bonds, securities.

3 Other investment: commercial credit lending by banks, nonbankinstitutions, individuals, IMF loans.

4 Change in Official Reserves: ∆CB FX reserves








institutions, individuals, IMF loans.

4 Change in Official Reserves: ∆CB FX reserves





























While the overall BOP accounts will always balance when all types ofpayments are included, imbalances are possible on individual elementsof the BOP, such as the current account, the capital accountexcluding the central bank’s reserve account.

BOP deficit refers to a situation when current account plus thecapital account (except the reserves) is negative. In other wordssources of funds ( all exports, bonds sold) is less than uses of funds(imports, bonds purchases)BOP Deficit 6= Current Account Deficit 6= Capital Account DeficitBOP imbalances are due to: the exchange rate, the government’sfiscal deficit, business competitiveness, and private behaviour such asthe willingness of consumers to go into debt to finance extraconsumption. Ben Bernanke argues that the primary driver is thecapital account, where a global savings glut caused by savers insurplus countries, runs ahead of the available investmentopportunities, and is pushed into the US resulting in excessconsumption and asset price inflationvisit http://tcmb.gov.tr/odemedenge/odmain.html for Turkishpractice.



While the overall BOP accounts will always balance when all types ofpayments are included, imbalances are possible on individual elementsof the BOP, such as the current account, the capital accountexcluding the central bank’s reserve account.BOP deficit refers to a situation when current account plus thecapital account (except the reserves) is negative. In other wordssources of funds ( all exports, bonds sold) is less than uses of funds(imports, bonds purchases)

BOP Deficit 6= Current Account Deficit 6= Capital Account DeficitBOP imbalances are due to: the exchange rate, the government’sfiscal deficit, business competitiveness, and private behaviour such asthe willingness of consumers to go into debt to finance extraconsumption. Ben Bernanke argues that the primary driver is thecapital account, where a global savings glut caused by savers insurplus countries, runs ahead of the available investmentopportunities, and is pushed into the US resulting in excessconsumption and asset price inflationvisit http://tcmb.gov.tr/odemedenge/odmain.html for Turkishpractice.



While the overall BOP accounts will always balance when all types ofpayments are included, imbalances are possible on individual elementsof the BOP, such as the current account, the capital accountexcluding the central bank’s reserve account.BOP deficit refers to a situation when current account plus thecapital account (except the reserves) is negative. In other wordssources of funds ( all exports, bonds sold) is less than uses of funds(imports, bonds purchases)BOP Deficit 6= Current Account Deficit 6= Capital Account Deficit

BOP imbalances are due to: the exchange rate, the government’sfiscal deficit, business competitiveness, and private behaviour such asthe willingness of consumers to go into debt to finance extraconsumption. Ben Bernanke argues that the primary driver is thecapital account, where a global savings glut caused by savers insurplus countries, runs ahead of the available investmentopportunities, and is pushed into the US resulting in excessconsumption and asset price inflationvisit http://tcmb.gov.tr/odemedenge/odmain.html for Turkishpractice.



While the overall BOP accounts will always balance when all types ofpayments are included, imbalances are possible on individual elementsof the BOP, such as the current account, the capital accountexcluding the central bank’s reserve account.BOP deficit refers to a situation when current account plus thecapital account (except the reserves) is negative. In other wordssources of funds ( all exports, bonds sold) is less than uses of funds(imports, bonds purchases)BOP Deficit 6= Current Account Deficit 6= Capital Account DeficitBOP imbalances are due to: the exchange rate, the government’sfiscal deficit, business competitiveness, and private behaviour such asthe willingness of consumers to go into debt to finance extraconsumption. Ben Bernanke argues that the primary driver is thecapital account, where a global savings glut caused by savers insurplus countries, runs ahead of the available investmentopportunities, and is pushed into the US resulting in excessconsumption and asset price inflation




While the overall BOP accounts will always balance when all types ofpayments are included, imbalances are possible on individual elementsof the BOP, such as the current account, the capital accountexcluding the central bank’s reserve account.BOP deficit refers to a situation when current account plus thecapital account (except the reserves) is negative. In other wordssources of funds ( all exports, bonds sold) is less than uses of funds(imports, bonds purchases)BOP Deficit 6= Current Account Deficit 6= Capital Account DeficitBOP imbalances are due to: the exchange rate, the government’sfiscal deficit, business competitiveness, and private behaviour such asthe willingness of consumers to go into debt to finance extraconsumption. Ben Bernanke argues that the primary driver is thecapital account, where a global savings glut caused by savers insurplus countries, runs ahead of the available investmentopportunities, and is pushed into the US resulting in excessconsumption and asset price inflationvisit http://tcmb.gov.tr/odemedenge/odmain.html for Turkishpractice.


Relationship Between BOP and FX rate regime

Under pure float: Total net underlying demand for TL = CRAsurplus+CPA surplus =Basic balance is equated to zero by exchangerate movement, unless

Under fixed rates: Government intervenes to fix exchange rate, inwhich case. Item for 4 in CPA :∆CB FX reserves= CRA+CPA toprevent basic balance causing exchange rate to move


Relationship Between BOP and FX rate regime

Under pure float: Total net underlying demand for TL = CRAsurplus+CPA surplus =Basic balance is equated to zero by exchangerate movement, unless

Under fixed rates: Government intervenes to fix exchange rate, inwhich case. Item for 4 in CPA :∆CB FX reserves= CRA+CPA toprevent basic balance causing exchange rate to move


Balance of Payments: Crisis and Balancing Mechanisms

A BOP crisis (currency crisis) occurs when a nation is unable toservice its debt repayments and/or to pay for essential imports. Itgenerally is coupled with a fast depreciation of home currency.

General Mechanism: Large Capital Inflows over Time (either due tofinance high economic growth, in this case to finance investment / ordue to excessive consumption, in this case to finance consumption (and lower savings)) → unsustainable levels of debt creates a chain ofevents: → investors pull out their funds by selling domestic currencydenominated assets causing rapid depreciation of home currency →Local banks and firms run in to sudden debt problems because theirrevenues are in local currency but their existing debt is in foreigncurrency → the central bank can support the currency as long as ithas enough FXreserves, but once reserves fall below a certain levelchooses to increase interest rates to prevent outflows → preventscurrency depreciation and reduces the value of debt in domesticcurrency→ however, the domestic economy is depressed → recessionfollows.


Balance of Payments: Crisis and Balancing Mechanisms

A BOP crisis (currency crisis) occurs when a nation is unable toservice its debt repayments and/or to pay for essential imports. Itgenerally is coupled with a fast depreciation of home currency.General Mechanism: Large Capital Inflows over Time (either due tofinance high economic growth, in this case to finance investment / ordue to excessive consumption, in this case to finance consumption (and lower savings)) → unsustainable levels of debt creates a chain ofevents: → investors pull out their funds by selling domestic currencydenominated assets causing rapid depreciation of home currency →Local banks and firms run in to sudden debt problems because theirrevenues are in local currency but their existing debt is in foreigncurrency → the central bank can support the currency as long as ithas enough FXreserves, but once reserves fall below a certain levelchooses to increase interest rates to prevent outflows → preventscurrency depreciation and reduces the value of debt in domesticcurrency→ however, the domestic economy is depressed → recessionfollows.


Theories about Exchange Rate Determination

Purchasing Power Parity (PPP)

1 Law of One Price2 PPP Extensions

1 Harrod-Balassa-Samuelson2 Trade Costs(Iceberg) Model3 Incomplete Pass-Through

Uncovered Interest Rate Parity

Covered Interest Rate Parity



Purchasing Power Parity (PPP)1 Law of One Price

2 PPP Extensions






Purchasing Power Parity (PPP)1 Law of One Price2 PPP Extensions







1 Harrod-Balassa-Samuelson

2 Trade Costs(Iceberg) Model3 Incomplete Pass-Through






1 Harrod-Balassa-Samuelson2 Trade Costs(Iceberg) Model

3 Incomplete Pass-Through






















Law of One Price

Definition

The law of one price: Two goods, if they are identical, must sell for thesame price.

Domestic Economy

The law of one price in the context of domestic economy – therelationship holds if transaction costs are allowed: e.g.,PI = PA + C where PI , PA is the price of the same good in Istanbuland Ankara respectively and C is the transaction cost (transportation,local taxes, etc.).

Open Economy PI = SPP + C where PI , PP is the price of the samegood in Istanbul and Paris respectively and S is the TL/Euroexchange rate.


Law of One Price

Definition


Domestic Economy

The law of one price in the context of domestic economy – therelationship holds if transaction costs are allowed: e.g.,

PI = PA + C where PI , PA is the price of the same good in Istanbuland Ankara respectively and C is the transaction cost (transportation,local taxes, etc.).



Law of One Price

Definition


Domestic Economy




Law of One Price

Definition


Domestic Economy




PPP and Real Exchange Rate

Definition

The PPP relation is given by Pi = SP∗i for i = 1, ..., N where Pi is thedomestic price of good i and P∗i is the foreign price of good i and S is theexchange rate or P = SP∗ where P is domestic price index and P∗ is theforeign price index

Definition

The real exchange rate, Q, between two countries is given by Q = SP∗

P .

Corollary

If PPP holds then Q = 1.

Example: When PPP adjusted India s GDP is 3,608 billion dollars asopposed to 1,704 billion dollars calculated with nominal exchangerates. Denmark GDP per head: PPP adjusted: $37,500 vs. NominalExch Rate: $62,100


PPP and Inflation

Theorem

If PPP holds then the rate of home currency depreciation rate is equal todifference between home and foreign inflation rates.

Proof.

Taking logarithms and derivatives of both sides of P = SP∗

log(P) = log(S) + log(P∗)

dP/P = dS/S + dP∗/P∗

dS/S︸︷︷︸ = dP/P︸︷︷︸ − dP∗/P∗︸︷︷︸depreciation = inflation− inflation∗

In reality PPP fails most of the time.


PPP and Transaction Costs

Let K be a constant that represents the total costs of conductinginternational trade including tariffs, etc.

P = KSP∗

log(P) = log(K ) + log(S) + log(P∗)

Theorem

If trade costs are constant, then they do not affect the currencydepreciation rate

Proof.

Taking the derivative above yields

dS/S︸︷︷︸ = dP/P︸︷︷︸ − dP∗/P∗︸︷︷︸− dK /K︸︷︷︸depreciation = inflation− inflation∗ − change in trade costs

but dK = 0


Harrod, Balassa and Samuelson Effect

Definition

The observation that consumer price levels in wealthier countries aresystematically higher than in poorer ones (the ”Penn effect”).

Definition

An economic model predicting the above, based on the assumption thatproductivity or productivity growth-rates vary more by country in thetraded goods’ sectors than in other sectors (the Balassa–Samuelsonhypothesis)

Workers in some countries have higher productivity than in others.

Certain labour-intensive jobs such as those in services are lessresponsive to productivity innovations than others.

Some of the fixed-productivity sectors are also the ones producingnon-transportable goods (for instance haircuts) - this must be thecase or the labour intensive work would have been off-shored.



Definition


Definition







Definition


Definition






Harrod, Balassa and Samuelson Effect(cont’d)

To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.

The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn effect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:

local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn effect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)

Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn effect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhere

The (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn effect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn effect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.


PPP Extensions- Arbitrage in goods.

Goods arbitrage only profitable when price deviation exceedstransactions costs, C , so:

If price deviation P − P∗ < C , no trade

If price deviation P − P∗ > C , trade.

But C different for each trader and each type of good

When price deviation large (small), arbitrage (not) profitable for mosttraders/goods

In general, larger the price deviation, greater volume of arbitrage andmore rapid is real exchange rate adjustment










































Iceberg Model

Does the importer or the exporter pay the shipping cost?

PC =SP∗C1− τ

where

P∗C : price of Brie cheese (produced in France) in France

PC : price of Brie cheese (produced in France) in Turkey

τ: proportion of every unit of goods lost due to shipping cost(“melting iceberg”)

similarly

PH = (1− τ) SP∗H

P∗H :price of hazelnut(produced in Turkey)in France

PH : price of hazelnut(produced in Turkey) in Turkey.


Iceberg Model


PC =SP∗C1− τ

where




similarly

PH = (1− τ) SP∗H




Iceberg Model


PC =SP∗C1− τ

where




similarly

PH = (1− τ) SP∗H




Iceberg Model


PC =SP∗C1− τ

where




similarly

PH = (1− τ) SP∗H




Iceberg Model


PC =SP∗C1− τ

where




similarly

PH = (1− τ) SP∗H




Iceberg Model


PC =SP∗C1− τ

where




similarly

PH = (1− τ) SP∗H




Iceberg Model


PC =SP∗C1− τ

where




similarly

PH = (1− τ) SP∗H




Trade Costs and Iceberg Model(cont’d) and IncompletePass-Through

Combining the above

PH

PC= (1− τ)2

P∗HP∗C

Result: Hazelnuts (Brie) are (1− τ)2 % expensive relative toBrie(Hazelnuts) in Turkey(France). Price distortions multiply

Incomplete Pass Through: Exporters and/or importers do not reflectchanging costs to prices.



Combining the above

PH

PC= (1− τ)2

P∗HP∗C





Combining the above

PH

PC= (1− τ)2

P∗HP∗C




Uncovered Interest Rate Parity(UIRP)

Assume investors are risk neutral, i.e. they are indifferent between asafe bet and a lottery that offer the same expected return.

Let r be the domestic interest rate of a financial instrument with Nperiods to maturity.

Let r ∗ be the foreign interest rate of the same financial instrumentwith N periods to maturity.

Definition

In the absence of hedging opportunities, the relationship between domesticand foreign interest rates are given by

(1 + r) =Et(St+N)

St(1 + r ∗)

where Et(St+N) is the expected spot exchange rate at t + N as of time t.






Definition


(1 + r) =Et(St+N)

St(1 + r ∗)







Definition


(1 + r) =Et(St+N)

St(1 + r ∗)







Definition


(1 + r) =Et(St+N)

St(1 + r ∗)



UIRP Example

Ayse has 10TL. Let St = 1.6(TL/$), r = 8%, r ∗ = 5%(US),Et(St+1) = 1.8. Should Ayse invest in Turkey or US?

If Ayse is risk neutral than she will pick the bet with higher return.

10× (1 + 0.08) = 10. 8TL Return from investing in Turkey

10× 11.6 (1 + 0.05)× 1.8 = 11. 813TL Expected Return from

investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP example(cont’d)

Et (St+N )St

= (1+r )(1+r ∗) , subtract 1 from both sides

Et (St+N )−StSt

= (1+r )(1+r ∗) − 1 = expected depreciation rate

= ∆Se ....Given r ∗ = 5%

An increase in r results in either Et(St+N) ↑ or St ↓ or both. Iflong-run equilibrium is fixed Et(St+N), then only St ↓ .



Et (St+N )St


Et (St+N )−StSt


= ∆Se ....Given r ∗ = 5%




Et (St+N )St


Et (St+N )−StSt


= ∆Se ....Given r ∗ = 5%




Find the expected spot rate that leaves Ayse indifferent betweeninvesting in US and Turkey.

Et(St+N) =(1+r )(1+r ∗)St =

1.081.05 × 1.60 = 1. 645 7

An alternative formulation of the UIRP:

LetEt (St+N )−St

St= ∆Se

(1 + r) = (1 + r∗)(1 + ∆Se) or (1 + r) = 1 + r∗ + ∆Se + r∗∆Se

but r∗∆Se ≈ 0 therefore r = r∗ + ∆Se (UIRP approximate version)




Et(St+N) =(1+r )(1+r ∗)St =

1.081.05 × 1.60 = 1. 645 7


LetEt (St+N )−St

St= ∆Se

(1 + r) = (1 + r∗)(1 + ∆Se) or (1 + r) = 1 + r∗ + ∆Se + r∗∆Se





Et(St+N) =(1+r )(1+r ∗)St =

1.081.05 × 1.60 = 1. 645 7


LetEt (St+N )−St

St= ∆Se

(1 + r) = (1 + r∗)(1 + ∆Se) or (1 + r) = 1 + r∗ + ∆Se + r∗∆Se





Et(St+N) =(1+r )(1+r ∗)St =

1.081.05 × 1.60 = 1. 645 7


LetEt (St+N )−St

St= ∆Se

(1 + r) = (1 + r∗)(1 + ∆Se) or (1 + r) = 1 + r∗ + ∆Se + r∗∆Se





Et(St+N) =(1+r )(1+r ∗)St =

1.081.05 × 1.60 = 1. 645 7


LetEt (St+N )−St

St= ∆Se

(1 + r) = (1 + r∗)(1 + ∆Se) or (1 + r) = 1 + r∗ + ∆Se + r∗∆Se





Et(St+N) =(1+r )(1+r ∗)St =

1.081.05 × 1.60 = 1. 645 7


LetEt (St+N )−St

St= ∆Se

(1 + r) = (1 + r∗)(1 + ∆Se) or (1 + r) = 1 + r∗ + ∆Se + r∗∆Se



Risk Premium

In general, agents demand a reward (risk premium) for the risks theytake.

Definition

Risk premium is the anticipated excess return.agents demand in return fortaking the risk. A risk averter requires positive risk premium. A riskneutral is willing to undertake the risk for zero risk premium. A risk loveris willing to pay a premium in order to take the risk.

For a risk lover U(100) < 12U(150) + 1

2U(50) : convex U

For a risk neutral U(100) = 12U(150) + 1

2U(50) :linearU

For a risk averse U(100) > 12U(150) + 1

2U(50) :concaveU


Risk Premium


Definition



2U(50) : convex U


2U(50) :linearU


2U(50) :concaveU


Risk Premium


Definition



2U(50) : convex U


2U(50) :linearU


2U(50) :concaveU


Risk Premium


Definition



2U(50) : convex U


2U(50) :linearU


2U(50) :concaveU


Risk Premium


Definition



2U(50) : convex U


2U(50) :linearU


2U(50) :concaveU


Forward and Futures Contracts

Definition

A forward contract (or a forward) is a non-standardized contract betweentwo parties to buy or sell an asset at a specified future time at a priceagreed today. The party agreeing to buy the underlying asset in the futureassumes a long position, and the party agreeing to sell the asset in thefuture assumes a short position. The price agreed upon is called thedelivery price, which is equal to the forward price at the time thecontract is entered into.

Definition

A futures contract is a standardized financial contract, in which twoparties agree to transact a set of standardized financial instruments orphysical commodities for future delivery at a particular price. In futurescontracts parties can exchange additional property securing the party atgain (margin call) and the entire unrealized gain or loss builds up while thecontract is open.


Forward and Futures Contracts

Definition

A forward contract (or a forward) is a non-standardized contract betweentwo parties to buy or sell an asset at a specified future time at a priceagreed today. The party agreeing to buy the underlying asset in the futureassumes a long position, and the party agreeing to sell the asset in thefuture assumes a short position. The price agreed upon is called thedelivery price, which is equal to the forward price at the time thecontract is entered into.

Definition

A futures contract is a standardized financial contract, in which twoparties agree to transact a set of standardized financial instruments orphysical commodities for future delivery at a particular price. In futurescontracts parties can exchange additional property securing the party atgain (margin call) and the entire unrealized gain or loss builds up while thecontract is open.


Futures Example


Futures Example


Futures Example


Futures Example


Futures Example



With hedging opportunities, the relationship between domestic and foreigninterest rates are given by

(1 + r) =Ft

St(1 + r ∗)

where Ft is the forward rate at t + 1 as of time t. Note that Ft = St atthe maturity date.

FtSt

= (1+r )(1+r ∗) , subtract 1 from both sides to get covered interest rate

parity (CIRP)

Ft−StSt

= (1+r )(1+r ∗) − 1 = f =forward premium (discount) if f > 0 (< 0)

A forward premium is the proportion by which a country’s forwardexchange rate exceeds its spot rate.

Rewriting (1 + r) = (1 + r ∗)(1+ f ), r ∗f ≈ 0

r = r ∗ + f (CIRP approximate version)




(1 + r) =Ft

St(1 + r ∗)


FtSt


parity (CIRP)

Ft−StSt



Rewriting (1 + r) = (1 + r ∗)(1+ f ), r ∗f ≈ 0





(1 + r) =Ft

St(1 + r ∗)


FtSt


parity (CIRP)

Ft−StSt



Rewriting (1 + r) = (1 + r ∗)(1+ f ), r ∗f ≈ 0





(1 + r) =Ft

St(1 + r ∗)


FtSt


parity (CIRP)

Ft−StSt



Rewriting (1 + r) = (1 + r ∗)(1+ f ), r ∗f ≈ 0





(1 + r) =Ft

St(1 + r ∗)


FtSt


parity (CIRP)

Ft−StSt



Rewriting (1 + r) = (1 + r ∗)(1+ f ), r ∗f ≈ 0



Borrowing and Lending

Consider an importer who has to make a payment of X in foreign currencyat some future date: His options are:

1. pay immediately (i.e. buy foreign exchange spot) and settle hisdebt. Costs: If he already has the funds: opportunity cost of notholding domestic funds : itX . If he does not have any funds: interestrate payment when he pays back itX . (Assume for now borrowing andlending costs are the same) Benefits: discount that he will get becausehe pays now, which will be related to foreign interested rate: X − X

1+i∗t.

2. buy foreign exchange spot and invest in foreign country : Costs:Same as above.Benefits: He will earn foreign interest payment i∗t X3. buy foreign exchange forward : The settlement is in the futuretherefore there is no payment now. His costs will depend on theforward premium (or discount) . His total costs are: FtX





1+i∗t.

2. buy foreign exchange spot and invest in foreign country : Costs:Same as above.Benefits: He will earn foreign interest payment i∗t X

3. buy foreign exchange forward : The settlement is in the futuretherefore there is no payment now. His costs will depend on theforward premium (or discount) . His total costs are: FtX





1+i∗t.

2. buy foreign exchange spot and invest in foreign country : Costs:Same as above.Benefits: He will earn foreign interest payment i∗t X3. buy foreign exchange forward : The settlement is in the futuretherefore there is no payment now. His costs will depend on theforward premium (or discount) . His total costs are: FtX




pay immediately (i.e. buy foreign exchange spot) and settle his debt.Total opportunity cost: St

X1+i∗t

(1 + it) Why? StX

1+i∗tis the amount he

needs to raise now due to discount and (1 + it) is the cost of notholding domestic funds.

buy foreign exchange spot and invest in foreign country : Totalopportunity cost: St

X1+i∗t

(1 + it) Why? because he will only need to

invest StX

1+i∗tnow in a foreign bank to raise StX = St

X1+i∗t

(1 + i∗t ) in

the future and (1 + it) is the cost of not holding domestic funds.Decision : Note 1 and 2 are equivalent so the choice is between (1 or2 ) and 3. FtX QSt

X1+i∗t

(1 + it) If Ft <St 1+i∗t (1+it )choose 3

otherwise (1 or 2). Rearranging this condition: Ft−StSt

= (1+r )(1+r ∗) − 1 =





X1+i∗t

(1 + it) Why? StX


needs to raise now due to discount and (1 + it) is the cost of notholding domestic funds.buy foreign exchange spot and invest in foreign country : Totalopportunity cost: St

X1+i∗t


invest StX


X1+i∗t

(1 + i∗t ) in

the future and (1 + it) is the cost of not holding domestic funds.

Decision : Note 1 and 2 are equivalent so the choice is between (1 or2 ) and 3. FtX QSt

X1+i∗t



= (1+r )(1+r ∗) − 1 =





X1+i∗t

(1 + it) Why? StX


needs to raise now due to discount and (1 + it) is the cost of notholding domestic funds.buy foreign exchange spot and invest in foreign country : Totalopportunity cost: St

X1+i∗t


invest StX


X1+i∗t

(1 + i∗t ) in

the future and (1 + it) is the cost of not holding domestic funds.Decision : Note 1 and 2 are equivalent so the choice is between (1 or2 ) and 3. FtX QSt

X1+i∗t



= (1+r )(1+r ∗) − 1 =



An investor who has a liability(an asset) denominated is said to havea short (long) position in that currency. The net position is given bythe difference between long and short positions. There are two typesof arbitrages

Uncovered

example: investing in US or Turkey for interest arbitrage withoutforward contracts

1 January1: Investing in Turkey: Borrow 1.60TL(short TL) at 8% andplace on one year deposit(long TL) with 8% interest. Investing in US:Borrow 1.60TL(short TL) at 8%, buy $ at 1.60, deposit(long $) in USfor a year with 5% interest.

2 Net position in Turkey=long(1.60x1.08)-short(1.60x1.08)=0. Net

position in US=Et (St+1)

St× 1.60× 1.05− (1.60× 1.08) 6= 0

3 December 31. Investing in Turkey: Liquidatedeposit(1.60TL× 1.08 = 1. 728TL) pay back loan (1.60× 1.08 = 1.728TL) Net profit=0TL Investing in US: Liquidatedeposit($1× 1.05 = $1. 05), convert it to TL at the spot price(e.g.1.70),$1.05× 1.70 = 1. 785TL , pay back loan (1.60× 1.08 = 1.728TL) Net profit=1.785− 1.728 = 0.057TL



An investor who has a liability(an asset) denominated is said to havea short (long) position in that currency. The net position is given bythe difference between long and short positions. There are two typesof arbitragesUncovered





St× 1.60× 1.05− (1.60× 1.08) 6= 0









St× 1.60× 1.05− (1.60× 1.08) 6= 0









St× 1.60× 1.05− (1.60× 1.08) 6= 0









St× 1.60× 1.05− (1.60× 1.08) 6= 0









St× 1.60× 1.05− (1.60× 1.08) 6= 0



Borrowing and Lending(cont’d)

Covered.

example: investing in US or Turkey for interest arbitrage with forwardcontracts

1 January1: Investing in Turkey: Borrow 1.60TL(short TL) at 8% andplace on one year deposit(long TL) with 8% interest. Investing in US:Short 1.60TL at 8%, buy 1$ at 1.60, deposit(long $) in US for a yearwith 5% interest and enter a short forward contract in $

2 Net position in Turkey=long(1.60× 1.08)-short(1.60× 1.08)=0. Netposition in US= Ft

St× 1.60× 1.05− 1.60× 1.08 If CIRP holds then

Ft =(1+r )(1+r ∗)

St =1.081.05 × St and the net position in US=0.

3 December 31. Investing in Turkey: Liquidatedeposit(1.60TL× 1.08 = 1. 728TL) pay back loan (1.60× 1.08 = 1.728TL) Net profit=0TL Investing in US: Liquidatedeposit($1× 1.08 = $1. 05), convert it to TL at the forwardprice( 1.081.05 × 1.60 = 1.645 7) ,$1.05× 1.645 7 = 1.728 , pay back loan(1.60× 1.08 = 1. 728TL) Net profit=1.728− 1.728 = 0TL



Covered.





Ft =(1+r )(1+r ∗)





Covered.





Ft =(1+r )(1+r ∗)





Covered.





Ft =(1+r )(1+r ∗)





Covered.





Ft =(1+r )(1+r ∗)





In the UIRP example the currency risk associated with investing inTurkey is 0, and in US it isAt × (1 + r)− At × (1 + r ∗)× Et(St+1)/St where At is the initialasset.

In the CIRP example the currency risk associated with investing inTurkey and US is 0. In the above example the currency risk is 0because of the assumption that CIRP holds. In reality,

the forward rates reflect the risk premium associated with investing inthat particular country.While the currency risk is zero, the profits are still uncertain. IfSt+1 > Ft then investing in US without hedging would have resulted ingreater profits










the forward rates reflect the risk premium associated with investing inthat particular country.

While the currency risk is zero, the profits are still uncertain. IfSt+1 > Ft then investing in US without hedging would have resulted ingreater profits







Real Interest Rate

Future sacrifice required per unit of extra consumption today

Definition

The relationship between real, r , and nominal interest rate, i , is given by(1 + i) = (1 + r)(1 + ∆pe) or in approximate form by i = r + ∆pe (Fisherequation) where ∆pe is the expected inflation rate.

Corollary

Take two countries i − i∗ = (r − r ∗) + (∆pe − ∆pe∗) by UIRPi − i∗ = ∆Se therefore ∆Se = (r − r ∗) + (∆pe − ∆pe∗).If there is fullcapital mobility, r = r ∗ therefore ∆Se = (∆pe − ∆pe∗) (PPP inexpectations).

Note that ∆pe is unobservable therefore at any given time R is alsounobservable.Methods of estimating ∆pe : Use surveys, or econometric forecastmethods.


Real Interest Rate


Definition


Corollary




Real Interest Rate


Definition


Corollary




Real Interest Rate


Definition


Corollary


Note that ∆pe is unobservable therefore at any given time R is alsounobservable.

Methods of estimating ∆pe : Use surveys, or econometric forecastmethods.


Real Interest Rate


Definition


Corollary




Efficient Market Hypothesis

If all investors are fully informed about market conditions all the time,then prices fully reflect all available information and there are no arbitrageopportunities. For example, if the markets are efficient, f = ∆Se .


National Income Accounting in Open Economy

C : Consumption Expenditure on Domestic and Foreign Goods andServices

G : Government Expenditure of Domestic and Foreign Goods andServices

I : Investment Expenditure on Domestic and Foreign Goods andServices.

1 Business fixed investment spending on plant and equipment that firmswill use to produce other goods and services

2 Residential fixed investment spending on housing units by consumersand landlords

3 Inventory investment: the change in the value of all firms’ inventories

X :Exports

M:Imports (Consumption, Government and Investment Expenditureon Foreign Goods and Services)

S : Savings

T : Taxes and TR : transfers









X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings










X :Exports


S : Savings




Three Approaches To Calculate National Income

1 Expenditure2 Income3 Production




1 Expenditure

2 Income3 Production




1 Expenditure2 Income

3 Production




1 Expenditure2 Income3 Production


Expenditure Approach

Households, Business, Government and Foreign Sector Expenditures.

National Income Identity in an open economy is given by:Y = C + I + G + X −M where Y is gross domestic product.(GDP). Imports, M, are subtracted to prevent double counting.

Spri = Yd − C is private savings where Yd is the disposable income.Yd = Y − T + TR. T is taxes collected by the government, TRtransfers made by the government to private sector.

Spri − I︸︷︷︸ = G − T + TR︸︷︷︸ + X −M︸︷︷︸Private Surplus = Gov. Deficit + CA Balance

Note GDP is a flow variable and not a stock variable.

GDP is product produced within a country’s borders; GNP (GrossNational Product) is product produced by enterprises owned by acountry’s citizens.






















Spri − I︸︷︷︸ = G − T + TR︸︷︷︸ + X −M︸︷︷︸

Private Surplus = Gov. Deficit + CA Balance




























Income Approach

The income approach divides GDP according to types of incomegenerated. GDP consists of:

Wages and salaries, Corporate profits (dividens, corporate incometaxes, undistributed profits), Proprietors income (the profits ofpartnerships and soley owned businesses, like a family restaurant),Farm income, Rent, Interest (interest payments by businesses only),Sales taxes (it is an income but later get paid to the gov’t),Depreciation (the amount of capital that has worn out during theyear)

GDP = compensation of employees + gross operating surplus + grossmixed income + taxes less subsidies on production and imports


Income Approach





Income Approach





Production Approach

The production approach looks at GDP from the standpoint of valueadded by each input in the production process

Example

1 Farmer buys seeds and produces wheat. Value added#1= Sale ofWheat = Value of producing and collecting wheat

2 Whole retailer packages wheat and transports the wheat to factoryValue added#2=Sale of Wheat-Cost of Wheat= Value of packagingand shipping wheat

3 Baker cooks bread. Value added#3=Sale of Bread-Cost of Wheat=Value of baking a bread.

4 GDP= ∑i

Value addedi


Production Approach


Example




4 GDP= ∑i

Value addedi


Production Approach


Example




4 GDP= ∑i

Value addedi


Production Approach


Example




4 GDP= ∑i

Value addedi


Production Approach


Example




4 GDP= ∑i

Value addedi


Production Approach


Example




4 GDP= ∑i

Value addedi


Expenditure Approach revisited

Examples of GDP component variables

C, I, G, and NX(net exports): If a person spends money to renovate ahotel to increase occupancy, the spending represents privateinvestment, but if he buys shares in a consortium to execute therenovation, it is saving. The former is included when measuring GDP(in I), the latter is not. However, when the consortium conducted itsown expenditure on renovation, that expenditure would be included inGDP.

If a hotel is a private home, spending for renovation would bemeasured as consumption, but if a government agency converts thehotel into an office for civil servants, the spending would be includedin the public sector spending, or G.













If the renovation involves the purchase of a chandelier from abroad,that spending would be counted as C, G, or I (depending on whethera private individual, the government, or a business is doing therenovation), but then counted again as an import and subtracted fromthe GDP so that GDP counts only goods produced within the country.

If a domestic producer is paid to make the chandelier for a foreignhotel, the payment would not be counted as C, G, or I, but would becounted as an export.



If the renovation involves the purchase of a chandelier from abroad,that spending would be counted as C, G, or I (depending on whethera private individual, the government, or a business is doing therenovation), but then counted again as an import and subtracted fromthe GDP so that GDP counts only goods produced within the country.

If a domestic producer is paid to make the chandelier for a foreignhotel, the payment would not be counted as C, G, or I, but would becounted as an export.



Snational = Spri + Sgov = (Y − T + TR)− C + (T − G − TR) =Y − C − G

therefore Snational − I = Y − C − G − I = X −M = CA

By BOP equilibrium: Snational − I =net foreign investment.

Is CA < 0 necessarily a bad thing?

Comparison between ability to consume more today and paying morelater.

Spri vs. Sgov

Investment and Growth vs. Consumption

Decisions on Sgov makes taxpayers part of the deal!








Spri vs. Sgov










Spri vs. Sgov










Spri vs. Sgov










Spri vs. Sgov










Spri vs. Sgov










Spri vs. Sgov










Spri vs. Sgov




Defining Variables of Interest

Assumptions

Define B = X (Q)−M(Q, y)

B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0

G + TR − T is exogenously given



Assumptions


B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0




Assumptions


B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0




Assumptions


B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0




Assumptions


B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0




Assumptions


B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0




Assumptions


B ≡ B(Q, y)

where Q = SP∗

P and ∂B∂Q > 0, ∂B

∂y < 0

S ≡ S(y , r), ∂S∂y > 0, ∂S

∂r > 0

I ≡ I (r), ∂I∂r < 0



IS Curve

S(y , r)− I (r) = G + TR − T + B(Q, y) (IS curve).

Definition

IS curve is the combination of income and interest rate pairs such that thenet private savings cover the financing requirements of government andthe foreign sector.LEAKAGES (T + S + M) out of the system must equalINJECTIONS (G + TR+ I + X) for the circular flow to balance (be inEQUILIBRIUM)


IS Curve

S(y , r)− I (r) = G + TR − T + B(Q, y) (IS curve).

Definition

IS curve is the combination of income and interest rate pairs such that thenet private savings cover the financing requirements of government andthe foreign sector.LEAKAGES (T + S + M) out of the system must equalINJECTIONS (G + TR+ I + X) for the circular flow to balance (be inEQUILIBRIUM)


IS Curve


IS Curve


IS Curve


IS Curve


An increase in Government Expenditure


An increase in Real Exchange Rate.


LM Curve

Relationship between the demand for money and national income

(ignoring the opportunity cost)

Md = kY

where Md is the demand for money and Y national income, bothmeasured in nominal terms.

k positive constant.


LM Curve



Md = kY




LM Curve



Md = kY




LM Curve



Md = kY




LM Curve

Define nominal national income Y as follows:

Y = Py where y is real income and P is the price level.

We can also introduce opportunity costsMdP = ky − lr

orMdP ≡

MdP (y , r) Note that

∂MdP (y ,r )

∂y > 0,∂MdP (y ,r )

∂r < 0


LM Curve




orMdP ≡


∂MdP (y ,r )

∂y > 0,∂MdP (y ,r )

∂r < 0


LM Curve



We can also introduce opportunity costs

MdP = ky − lr

orMdP ≡


∂MdP (y ,r )

∂y > 0,∂MdP (y ,r )

∂r < 0


LM Curve




orMdP ≡


∂MdP (y ,r )

∂y > 0,∂MdP (y ,r )

∂r < 0


LM Curve




orMdP ≡


∂MdP (y ,r )

∂y > 0,∂MdP (y ,r )

∂r < 0


LM Curve

Let Ms be the nominal money supply and ms =MsP be the real money

supply.

Definition

The Equilibrium condition in the money market is given by ms = ky − lror ms = m(y , r)


LM Curve

Let Ms be the nominal money supply and ms =MsP be the real money

supply.

Definition

The Equilibrium condition in the money market is given by ms = ky − lror ms = m(y , r)


LM Curve


LM Curve


LM Curve


LM Curve


An increase in Money Supply.

.


Monetary System and the Banking Sector



For the Central Bank: FX + LG = MB

For Commercial Banks MBb + L = D, Given D, L is determined byMBb.

The reserve requirement, RR, is the percentage of Commercial Banksdeposits to be held with Central Bank as a precaution or the thepercent of deposits banks are not allowed to lend

Combining both balance sheets FX + LG + MBb + L = MB + D

or FX + DC = MBp + D where DC = L + LG is total domesticcredit and MBp = MB −MBb is currency circulation.






























Assets of Major Central Banks as a Percentage of GDP


European Central Bank


Control of Money Supply

FX + DC = MBp + D = Money Supply = Ms

∆FX + ∆DC = ∆Ms

Money supply can be controlled by Central Bank via changes in

1 Reserve/Borrowing Requirements (through reserve requirement ratio(DC and MBp) or discount interest rate (MBp))

2 Open Market Operations (selling and buying Reserves (FX ), or viabuying and selling Treasury Bills (MBp))

3 Public Cash Holding (not really a policy tool but CB may pursuepolicies to increase confidence in the banking system)










































Central Bank Roles

monetary policy (control inflation, economic growth, employment,financial stability)

There might be conflicts among roles such as controlling infation andcreating employment or growth.

control money supply

managing FX and gold reserves

setting official interest rates

lender of last resort

issue currency

regulator and supervisor of commercial banks (now BDDK settingcapital requirements for banks)


Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Exchange Rate Regimes and The Central Bank

Under pure float: ∆FX = 0 only DC affects Ms , therefore ∆DC= ∆Ms .Ms is exogenous and St is endogenous.

Under fixed rates: ∆FX 6= 0, CA balance-CAP balance determine∆FX therefore Ms is endogenous and St is exogenous and ∆St = 0.Under fixed rates independent (independent of exchange ratemovements) monetary policy is impossible.


Exchange Rate Regimes and The Central Bank

Under pure float: ∆FX = 0 only DC affects Ms , therefore ∆DC= ∆Ms .Ms is exogenous and St is endogenous.

Under fixed rates: ∆FX 6= 0, CA balance-CAP balance determine∆FX therefore Ms is endogenous and St is exogenous and ∆St = 0.Under fixed rates independent (independent of exchange ratemovements) monetary policy is impossible.


Deriving Aggregate Demand

The equilibrium on the demand side is given by (y , P) pairs such that

1 S(y , r)− I (r) = (G − T + TR) + B(Q, y) (IS)2 Ms

P = m(y , r) (LM)

3 Ms

P = (G − T + TR) + B(Q, y) where Q = SP∗P

We want to express the equilibrium in (y , P) plane because prices willfrom the link between aggregae demand and aggregate supply.




1 S(y , r)− I (r) = (G − T + TR) + B(Q, y) (IS)

2 Ms

P = m(y , r) (LM)

3 Ms







P = m(y , r) (LM)

3 Ms







P = m(y , r) (LM)

3 Ms







P = m(y , r) (LM)

3 Ms




Deriving Aggregate Demand (Ex: A reduction in prices)








Policy Analysis: Relaxation of Monetary Policy

Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s

P > ky − lr , : Excess money supply, So quantity of moneydemanded has to increase, money demanded increases when r ↓ ory ↑ or both.

If y = y0 is constant than r1 < r0 where r0 is the original interest rate

and M1s

P = ky0 − lr1

But y0, r1 can not be an equilibrium in goods market because:

S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)

Therefore y0 → y1 where y1 > y0 and r1 → r2 where r2 > r1

This is a movement on LM. M1s

P = ky1 − lr2 = ky0 − lr1

No shift in IS curve becauseS(y , r)− I (r) = G −T + TR + B(Q, y). No exogenous change here.

The exact change in r and y is determined by the slopes of IS andLM curves.



Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1





Suppose M0s ↑, M0

s → M1s where M1

s > M0s

M1s



and M1s

P = ky0 − lr1


S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)



P = ky1 − lr2 = ky0 − lr1








Policy Analysis: Increase in G

Suppose G ↑, G 0 → G 1 where G 1 > G 0

S(y0, r0)− I (r0) < G 1 − T + TR + B(Q, y0).IS curve shifts right. To retain eq., r ↑ or y ↑ or both.

If r = r0 is constant than y1 > y0 where y0 is the original interest rateand S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1).But yo , r1 can not be an equilibrium in money market because:MsP < ky1 − lr0 therefore r0 → r1 where r1 > r0 and y1 → y2 where

y2 < y1This is a movement on IS

S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1) == S(y2, r1)− I (r1) = G 1 − T + TR + B(Q, y2)As r ↑ investment crowds out.I (r1) < I (r0)S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)No shift in LM curve there is no exogenous change.





S(y0, r0)− I (r0) < G 1 − T + TR + B(Q, y0).

IS curve shifts right. To retain eq., r ↑ or y ↑ or both.

















If r = r0 is constant than y1 > y0 where y0 is the original interest rateand S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1).

But yo , r1 can not be an equilibrium in money market because:MsP < ky1 − lr0 therefore r0 → r1 where r1 > r0 and y1 → y2 where








If r = r0 is constant than y1 > y0 where y0 is the original interest rateand S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1).But yo , r1 can not be an equilibrium in money market because:

MsP < ky1 − lr0 therefore r0 → r1 where r1 > r0 and y1 → y2 where









y2 < y1

This is a movement on IS

















S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1) =

= S(y2, r1)− I (r1) = G 1 − T + TR + B(Q, y2)As r ↑ investment crowds out.I (r1) < I (r0)S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)No shift in LM curve there is no exogenous change.








S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1) == S(y2, r1)− I (r1) = G 1 − T + TR + B(Q, y2)

As r ↑ investment crowds out.I (r1) < I (r0)S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)No shift in LM curve there is no exogenous change.








S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1) == S(y2, r1)− I (r1) = G 1 − T + TR + B(Q, y2)As r ↑ investment crowds out.I (r1) < I (r0)

S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)No shift in LM curve there is no exogenous change.








S(y1, r0)− I (r0) = G 1 − T + TR + B(Q, y1) == S(y2, r1)− I (r1) = G 1 − T + TR + B(Q, y2)As r ↑ investment crowds out.I (r1) < I (r0)S(y0, r1)− I (r1) < G − T + TR + B(Q, y0)

No shift in LM curve there is no exogenous change.





















Exchange Rate Regimes

Pure float (∆CB reserves=0)

Managed Float (∆CB reserves 6=0)

Target Zone

Fixed

Currency Board (Domestic currency backed 100% by foreign currency)

Full Dollarization





Target Zone

Fixed


Full Dollarization





Target Zone

Fixed


Full Dollarization





Target Zone

Fixed


Full Dollarization





Target Zone

Fixed


Full Dollarization





Target Zone

Fixed


Full Dollarization


Pure Float


Some Exchange Rate Regimes

1 Pure float(Flexible Float): exchange rate at any moment determinedby net demand for currency.

2 Fixed exchange rate: central bank(CB) intervenes by

buying up excess supply of $ with TL (when TL strong, $ weak). Thisoperation adds $ to FX reserves, adds to TL in circulation orsatisfying excess demand for $ by selling $ for TL (when TL weak, $strong), so as to prevent excess demand /supply affecting the rate.This operation takes $ out of FX reserves, reduces TL in circulation.Sometimes fixed rate regimes are associated with restrictions on FXtransactions such as a ban on FX holdings.

3 Managed Float(Dirty Float): CB intervenes at its discretion.











buying up excess supply of $ with TL (when TL strong, $ weak). Thisoperation adds $ to FX reserves, adds to TL in circulation or

satisfying excess demand for $ by selling $ for TL (when TL weak, $strong), so as to prevent excess demand /supply affecting the rate.This operation takes $ out of FX reserves, reduces TL in circulation.Sometimes fixed rate regimes are associated with restrictions on FXtransactions such as a ban on FX holdings.















Exchange Rates in 20th Century

Prior to 1939: Gold Standard. Change in money supply=Change ingold reserves. Huge increases in gold reserves after 1890.Perioddescribed by high inflation, protectionism and competitivedevaluation.

1944: Bretton Woods: Fixed FX rate system.

Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US$ fixed at 1 oz gold = $35, all other currencies fixed to $ with 1%fluctuation bands, devaluations to correct persistent deficits.(GoldWindow) Other currencies fixed to dollar. Foundation of IMF topolice FX rate system to assure convertibility.

Breakdown of Bretton Woods: 1968-73 Parities set at war levels.Rapid expansion of Europe and Japan caused huge pressures onexchange rate. US printed excess $ (Vietnam, Public Spending), $became overvalued and gold became undervalued causing worldwideinflation and flight into gold, other currencies (DM, Yen). Francehoarded gold. In 1971 Nixon closed the Gold Window.




















Exchange Rates in 20th Century (cont’d)

Floating Era 1973 onward managed floats for most convertiblecurrencies at first, but later experiments with limited fixed systemse.g. EMS in Europe, currency boards in Hong Kong, Argentina,

EMS tied to a basket of currency.(DM, Fr) EMU 1998 onwardresponse to failure of fixed exchange rates

Increasing importance of Asian exchange rates 2000 onward especiallyRMB, Won, Rupee (varying degrees of flexibility/convertibility,increasingly linked to $/e/Yen currency basket)












Before and After EMU


Exchange Rates in Turkey

1923-1929 Floating Rates: Reference Currency is £. March 1929:0.88TL/£. December 1929: 1.25TL/£. 1929-1946 Fixed Rates.

1946 onwards fixed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.

24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.

1988 Switch to full convertibility and CB starts managed floating

5 April 1994. Switch to managed floating with inflation expectationsas an anchor

Starting from 2000.Target zone with up to 22.% bandwidth withinflation target as an anchor.

Free float with CB intervention compatible with inflation target.
























































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Open Economy Macroeconomics Lecture Notes - · PDF fileOpen Economy Macroeconomics Lecture Notes Open Economy Macroeconomics Ozan Hatipoglu Department of Economics, Bogazici