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Lecture 18 1
Macroeconomic Analysis 2003
Exchange Rate:PPP, UIP and CIPTheories of exchange rate
Advantages and disadvantages of fixed and flexible exchange rate system
Impacts of Fiscal and Monetary Policy in fixed and Flexible Exchange rate system
(Readings: (Miles & Scott 9,18) or Blanchard (18-21) or Mankiw(12))
Lecture 18 2
Fundamental Macroeconomic Identity for an open economy
Main Features of an open economy a. exports and imports with the rest
of the world b. Capital inflow and outflow c. Exchange rate system
Fixed -pegged Flexible –floating d. External shocks affect income
and employment at home – risks e. Exchange rate stability
arrangements –(monetary union, dollarisation)
f. Policy coordination
Aggregate demand in an open economy
)*
,,(),()(P
ePfYYNXGeiYITYCY
Income = demand
XGICMTSC Economy wide saving = Trade balance
),(),()()()( eyMefyxGyTrIyS Balance of payment condition Current account +capital account =0
0)(),(),( ff rrFeyMeyX
Lecture 18 3
Three GAPs: Investment-Saving, Budget and Trade Gaps
i
Saving and Investment
I(r)
S(Y)
TrwLrKXGICMTSCYcall :Re
FlowCapNX
MXGTIS
IS
Private saving +public saving = net export
IS
0NXTrade Surplus
Trade deficit0NX
0
i0 GT
K-outflow
K-inflow
Lecture 18 4
NX(λ)
λ
Real ExchangeRate
Net export
45.1£$
60.1£$
S-INet capital outflow
FlowCapMXIS
Net capital inflow
Why is not appreciation of domestic currency not good for Foreign Investment?
0 FlowCapMX
Lecture 18 5
Exchange Rate and the Demand and Supply of Foreign Currency
E
FDemand and supply of Foreign Currency
Exports: X(E,Y*)
Imports: M(E,Y)
0
E1
E2
Depreciation
Appreciation
Excess Demand for FC
Excess supply of FC
A
69.0$£
63.0$£
2002:
2003:
0.66NX
e
Lecture 18 6
Sterling Pound
1001£
t
tt
EEE
AR = %7.810069.0
69.063.0£
AR
Euro also appreciated
1001
t
tt
EEE
AR = %7.1110011.1
11.198.0
AR
Euro also appreciated
1001
t
ttY E
EEAR = %47.5100
128128121
YAR
Depreciation of Dollar against Pound or Appreciation of Pounds against dollar in 2002
Lecture 18 7
Initial exchange rates End of 2002 1.11 0.98 £0.69 $1 £0.63 $1
2001 2002 In 2002 one dollar in terms of pound and Euro is
64.098.063.0
In 2001 one dollar in terms of pound and Euro is
621.011.169.0
This implies that Euro has become stronger by 0.021 percent (0.64 - 0.621) against the pound.
Triangular Exchange Rates and Appreciation and Depreciation with respect to the Third Currency
Lecture 18 8
0
+
-Y
Y0
AD
Tradebalance
Keynesian Open Economy ModelHow an Expansion in Income causes Trade Deficit?
)*
,,(),()(P
ePfYYNXGeiYITYCY
X=X0M=M(Y)
Surplus
Deficit
Lecture 18 9
Derivation of Net Exports and Investment Saving in an Open Economy
ΔNXAD
Y
e
Y1 Y2
e2
e1 IS*(e)
y1 Y2
AD
NX (e)
NX2 NX1
(a)
(b)(c)
Note:• Shows reduction in ADfollowing an increase in ER(b) Shows investment savingBalance in an open economy(c) Shows net export as a function of the exchange rate
Lecture 18 10
IS-LM Model in an Open Economy
IS*
e*
LM (y, i)
Output
Exch
ange
R
ate
o y
Lecture 18 11
Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
IS*
IS*’
e1
e2
YNo Impact of Fiscal Policy under Flexible Exchange Rate System
LM LM1LM2
Effectiveness of Fiscal PolicyUnder the Fixed Exchange Rate System
Y1 Y2
e
IS*IS*’
Lecture 18 12
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems
IS*
IS*’
e1
e2
Effectiveness of Monetary Policy under Flexible Exchange Rate System
LM LM1LM2
Ineffectiveness of monetary PolicyUnder the Fixed Exchange Rate System
Y1 Y2
e
IS*
Y1 Y2
Lecture 18 13
Macro Indicators and Trade Balances December 2002
Macro Economic Indicators UK EURO-Area
USA Japan
Budget deficit as % of GDP -1.4 -2.2 -3.1 -7.9
Inflation rate (% change in CPI) 2.1 2.2 2.6 -0.9
Interest rate (% per year on 3-month money market)
3.97 2.94 1.34 0.02
Trade balance (in billion US $) -49.0 95.6 -456.6 89.3
Current Account balance (in billion US $)
25.8 38.0 -462.2 113.9
Exchange rate (per US $) 0.63 0.98 1 121
Growth rate of GDP (annual %) 1.8 0.8 3.2 1.3
Growth rate of money supply (%)
5.8 7.0 6.6 3.2
Lecture 18 14
Macro Economic Indicators UK EURO-Area
USA Japan
Budget deficit as % of GDP 1.1 -1.2 0.6 -6.0Inflation rate (% change in CPI)
1.6 2.1 2.2 -0.8
Unemployment rate (%) 5.2 8.1 5.6 5.3Interest rate (% per year on 3-month money market)
3.97 3.35 1.84 0.02
Trade balance (in billion US $)
-47.2 24.9 -438.9 74.9
Current Account balance (in billion US $)
17.7 -31.2 -430.7 3.2
Exchange rate (per US $) 0.69 1.11 1 128Growth rate of GDP (annual %)
2.2 1.3 0.6 -0.5
Growth rate of money supply (%)
8.2 8.0 14.0 3.2
Mac
ro In
dica
tors
200
1Macro Indicators and Trade Balances 2003
Lecture 18 15
Exchange Rate of Sterling Pound with Dollar, Euro and Yen
$/£
Y/£
1975 1985 1995 2000 2002 2003
US$ 2.22 1.298 1.578 1.515 1.44 1.6
Eff. Rate 129.6 111.3 84.8 107.5 107.3
Euro-area 1.697 1.71 1.191 1.642 1.63 1.46
Yen 658.1 307.1 148.4 163.3 191 188
Value of one US Dollar in Terms of Local Currency
Ghana India Italy Brazil Turkey UK
1955 0.7146 4.764 625 4.3E-11 2.831 0.3571
1965 0.7146 4.763 625.1 2E-09 9.102 0.3571
1975 1.15 8.653 652.8 8.1E-09 14.44 0.452
1985 54.37 12.24 1909 6.2E-06 522 0.7792
1990 326.3 17.95 1198 0.0683 2609 0.5632
2000 5231 45.7 2101 1.8 625,208 0.7 Source: http:/www.worldbank.org/data/countrydata/countrydata.htm, And Penn World Table.
Lecture 18 16
Competitive Open Economy Need Right Exchange Rate• Overvalued exchange rate reduces volume of exports
and raises volume of imports• Overvalued exchange rate raises the production cost• A stable exchange rate is helpful for investors• Macro fundamentals for right exchange rates
– Balanced government budget over time– balanced trade over time– Reasonable domestic and external debt ratios– Controlled money supply – Positive real interest rate
Lecture 18 17
Real exchange rate : PEP*
PPP-hypothesis: tPtP
tPtP
tete
tt
*
*
0tt
**** ggtete
Where P* is foreign price level, P is the domestic price
level, te is the change in the nominal exchange rate te is
the nominal exchange rate * = foreign inflation, * =
growth rate of money supply abroad, *g = growth rate of economy abroad; = domestic inflation, = growth rate of money supply at home, g = growth rate of income at home
Purchasing Power Parity Theory of the Exchange Rate: Long Run
Lecture 18 18
%5.0%6.2%1.2 USAUKtt
Since %5.0%7.8 tt
Similarly for Euro
%1.11%4.0%6.2%2.2 USAEurott
PPP is Valid in the Long run
PPP is not valid in the short run 2001- 2002
Ghana India Italy Brazil Turkey UK
1955 0.7146 4.764 625 4.3E-11 2.831 0.3571
1965 0.7146 4.763 625.1 2E-09 9.102 0.3571
1975 1.15 8.653 652.8 8.1E-09 14.44 0.452
1985 54.37 12.24 1909 6.2E-06 522 0.7792
1990 326.3 17.95 1198 0.0683 2609 0.5632
2000 5231 45.7 2101 1.8 625,208 0.7
Lecture 18 19
Fundamentals of A Stable Exchange Rate according to the PPP Theory
Change in the exchange rate must equal the inflation deferential between home and foreign
countries.
**** ggtete
Inflation both at home and abroad equals differences in the growth rate of money supply and growth in money demand due to income growth.
Liberal economies have free capital mobility: there
is no control in inflow and outflow of capital; exchange rate is determined endogenously
weaker economies cannot commit to free capital
mobility and have controls in the mobility of capital. They fix the exchange rate arbitrarily to ration the foreign exchange.
Lecture 18 20
Covered and Uncovered interest parityCovered Interest Parity (no risk)
EEFii *
where F is forward exchange rate, i = domestic interest rate i* = foreign interest rate, E = actual exchange rate. Uncovered interest parity condition (interest differences are due to expected appreciation or depreciation):
tE
tEetEii 11*11
tEtE
etEii
1*
Compare CIP and UIP etEtF 1 is the forward Exchange
rate
Lecture 18 21
i
Y1
i
E1
LM
IS
i1
IS2
i2
E2AppreciationDepreciation
UIP
Impact of Fiscal Policy on the Exchange Rate,
Interest Rate and Output: ISLM Model
Y2
i
Lecture 18 22
Uncovered Interest Parity Theory of the Exchange Rate
Rates of returns (interest rates) across countries are equalised once expected exchange rate changes are taken into account.
etEti
tEti 1
*111
etE 1 Exchange rate expected in the next period.
Applying rule of log for small numbers it can be written as
tE
tEet
Etiti
1* ;
Adjustment in interest parity condition: domestic interest rate must be equal to foreign interest plus the expected change in the value of the currency.
Lecture 18 23
Appreciation or Depreciation of Currency According to the Differences in the Domestic and Foreign Interest Rates
tEtE
etE
titi 1*
*11
titi
etE
tE
Higher domestic interest rate => higher demand for domestic currency => currency appreciates to make up the difference Higher foreign interest rate => more demand for foreign currency and less demand for domestic currency => currency will depreciates. If currency is expected to depreciate in the next period, exchange rate will be higher today.
t
ttt e
eii
*
Lecture 18 24
Purchasing Power Parity: *ttte
te
(1)
Uncovered Interest Parity: t
ttt e
eii
*
(2)
Using the Fisher equation (2) becomes
t
ttttt e
err
**
(3)
Slight rearrangement:
**tt
t
ttt rr
ee
(4)
From PPP 0*
tt
ttt e
e
*tt rr
When both PPP and UIP hold exactly the domestic and foreign real interest rates are equal.
Lecture 18 25
tEtE
et
EUSiuki
1*
7.834.197.3
Like the PPP, UIP is also valid only in the long run
Compare the interest rates and Exchange Rates between 2001 and 2002
Lecture 18 26
Exchange Rate Systems: Capital Mobility Flexible exchange rates: The UK, U.S. and
Japan, EURO: Free Mobility of Capital Fixed exchange rates: Controlled Mobility - Gold standard (19 th and early 20th century) -Pegs: Setting the exchange rate to the dollar or some other currencies. Adjust by ( revaluation and devaluation. Franco-phone countries in Africa now peg to Euro -Crawling Peg: Setting an exchange rate target (allowed change in narrow bands) Monetary union (Single Currency, Free Mobility
of Capital): EURO
Lecture 18 27
The Problems of Flexible Exchange RatesThe exchange rate can move for many other reasons than changes in the domestic interest rate. Expectations play a large role in the determination of the exchange rate. Flexible exchange rate may be subject to large fluctuations which, in turn, require large movements in the interest rate which can make the economy unstable. Exchange rate may overshoot for a long time
Lecture 18 28
Countries with poor reputation for controlling inflation It is better to fix exchange rate with a country with a
heavy trade link Country which has relatively little involvement in the
global capital market Coutries with high level of foreign reserves. Countries with flexible labour market.
Which countries should have fixed exchange rates?
Lecture 18 29
Disadvantages of Fixed Exchange Rate System
Giving up the powerful exchange rate tool for external stabilisation. Sacrifice of domestic stability for external balance. Gives up control of its interest rate, no independent monetary policy Widespread speculation of a devaluation or shift to a flexible exchange rate system particularly when
Economy is with higher inflation Or the currency is overvalued
Fear of Speculative attacks require an increase in the interest rate. Frequent devaluation creates uncertainty and overvalued currency causes BOP problem.
Lecture 18 30
Which countries benefit from a monetary union?
Criteria for an optimal currency area
Higher Degree of Trade Link
Common shocks
Degree of labour mobility
Degree of fiscal transfers.
Benefits and cost of a Monetary Union and Optimal Liberalisation?
Impossible trilogy: fixed exchange ratefree capital mobility
monetary independence
Optimal Order of Liberalization1st goods market (subsidies)
2nd Trade (Tariffs)Financial market (no control on r)
Full convertibility
Lecture 18 31
Given these theories of Exchange Rate
Should UK join the European Monetary Union?
Five Economic Tests: Issues for Referendum1. Cyclical Convergence2. Flexibility3. Investment4. Financial Services5. Employment and Growth
What Do YOU Think?
Lecture 18 32
ExercisesTriangular exchange rateReal and nominal exchange ratesTrade weighted exchange rateExchange rate changes according to the PPPExchange rate according to the UIPRelation between fiscal and monetary policy and the
exchange rateAdvantages and disadvantages of joining the
monetary union.