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by: Bethany Conn


Bethany Conn
GPA 3.71

F. Koray

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F. Koray
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This 144 page Class Notes was uploaded by Bethany Conn on Tuesday October 13, 2015. The Class Notes belongs to ECON 4550 at Louisiana State University taught by F. Koray in Fall. Since its upload, it has received 17 views. For similar materials see /class/223015/econ-4550-louisiana-state-university in Economcs at Louisiana State University.




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Date Created: 10/13/15
EXCHANGE RATES THE FOREIGN EXCHANGE MARKET AN ASSET APPROACH In quot o transactions require exchanging domestic J I Did ll Hilidi dm Examples from the WSJ CHANGE AND INTERNATIONAL 68 US it 0 g o a 39 an services produced in di 39erent countries Example Exchange rates can be reported in two ways 1 Diract American USlf0reign currency 63 12599euro 2 Indirect foreign currency unitsUS mg 079376111 0083 An appreciation of the USS makes the US goods more expensive for foreigners and reduces US exports Likewise foreign goods become cheaper for US residents Example Depreciation of the U83 increases US exports and reduces US imports THEIFOREIGN EXCHANGE MARKET i H K 9 and other shorttam claims on foreigners xpress in foreign currencies Th 1 Co arcial Banks 2 Corporations 3 Nonbank Financial Institutions 4 Retail Customers 5 Foreign Exchange Broken 6 Central Banks actaa Daily value Around 4 trillion The nancial centers are over 24 hours Financial integration implies that there can be no signi cant di erenee between the USESeuro rate quoted in NY at 900 AM and the USleure rate quoted in London at 300 PM If there is arbitrage would eliminate the di erenee Example p i G i t G D i Q SPO RATES AND FORWARD the resulting rate is the spot exchang e rate The term spat however is somewhat misleading e If the foreign exchange deal speci es a value date of 30 days days 180 days or even several days the exchange rate quoted is called the forward exchange rate Look at the W3 for forward and spot exchange rates Question Why would anyone buy and sell currencies in the fomard foreign exchange market F gm rd Framing Fore y A Swap 0011M is a spot sale of a currency combined with a forward repurchase of the emeney Example The swap rate is equal to F e e i 1 where F is the forward rate 2 is the spot exchange rate 139 is the domestic interest rate and i is the foreign interest A ltm es contract from a forward contract One has to ll ll a forward contract but can sell a contract at a pro t or loss A foreign exchange option gives its owner the right to buy or sell a speci ed amount of foreign currency at a speci ed price at any tims up to a speci ed expiration date THEZDEMAND FOR FOREIGN CURRENCY ASS 39 nu owexc anger WA can we N ow 7 w the demand for dip erent currencies are The two most important factors the demand for foreign are the interest paid on foreign deposits and the change in the s wachange rate factors play a very irnportant role in determining the value ofthe exchange Exghigge Rates and Asset Returns Suppose you want to deposit your money in Germany for a year and bring it back to the 118 In this case you need to calculate the dollar rate of return of euro deposits To calculate the dollar rate of on euro deposits you need the follewing information the interest rate on euro deposits the spot exchange rate and the expected spot exchange rate one year from now Example skandretumarealsoim rtantfactors in quot ingasset demand To simplify our we will assume that foreign currencies do not di er in terms of risk and liquidity EQUILIBRIUM IN THE FOREIGN EXCHANGE The 7 raga exc angemar lsmequ l en eposx all currencies o er the same expected of Interes tePari39 The 39 39icE m Candi quotn The condition that the expected returns 0 depo its of any two currencies are equal when measured in the same cmency is called the interest parity condition which is expressed as follows depositslttheexpected 39 9 7 n a 31 e I new If the Expected return on dollar on a d3 39a39 Minus skim iw 1 into euros Example How Changes in the Current Exchange Rate A eet Egg ected Returns How does a change in the current spot exchange rate all else held constant the expected return on euro deposits Example artaoa Figur The librium RAM gt ye Rate Exchange rate always adjusts to in a rate parity Figure T RATES EXPECTATIONS AND quot39V IL39 l 1 magma u Lem 143111mquot liLLB llii Equot Lu exchange rate When US interest rates fall Eeuro 16 the U33 depreciates Figure rat ta When the USS is expected to depreciate Eeuro increases ie the U83 depreciates OPTIMUM CURRENCY AREAS 39 AND 7 EUROPEAN THE EVO 391 tng LUTION OF THE EUROPEAN SINGLE us the ne of thir currencies each other These e 39orts resulted in the birth of euro on January 1 1999 Enm can Curren Reform Initiatives 19691978 The evolution of euro can be traced to the Hague meeting in December 1969 A oomn ttee headed by Pierre Werner prime minister and nance of Luxembourg proposed a program that weuld result in locked EU exchange rates and the establishment of a federated system of European central a w r t a a a a Ireland Luxembourg and the Netherlands gan operating a formal network of mutually pegged exchange in March 1979 Most exchange rates xed by the EMS until August 1979 could uctuate up or down as much as 225 relative to an assigned par value Between March 1979 and January 1987 11 currency alignments occurred The scal expansion during the uni cation and the policies followed after that led to speculative attacks on on the EMS exchange parities starting in September 1992 In August 1993 all EMS bands except the DM and the Dutch guilder were widened to 15 war aowa Eum39 can Economic and Monm Union too for na onal monetary policies In 1989 a committee headed by Jacques Delors president of the EC set the goal of economic and monetary union EMU a European Union in which national currencies are replaced by a single EU currency managed by a sole central This mad map was approved by the Maastricht Treaty The result was the introduction of euro in January 1999 The existing national currencies will be withdrawn from circulation by 2002 Currently all monetary policy actions and most largedenomination private payments and most foreign exchange vansaetions are carried out in euros a a r t a o v a THE THEORY OF CURRENCY AREAS Floatingexchange rates cushion the economy against disruptive shocks but also have harmful c ects Example Joining a xed exchange rate area such as the has both costs and bene ts The theory of optimum currency areas shows us when it would be appropriate for a country to join a xed exchan e ram area Conceptnally this questien can be by illustrating the costs LL schedule and bene ts 66 schedule of joining the optimum currency area The monetary e eiency gain by joining the xed exchange rate system equals the savings from avoiding the uncertainty eonfusion and transaction costs that arise when exchange rates oat The gain will be higher the higher the degree of economic integration behneen the joining country and the optimum currency area Figure artaa ability 3 t 39 L f 39 39 e purpose of stabilizing output and employmenL Example A high degrae of economic integration between the joining counts and the optimum currency area reduces the econamic stability loss due to output market dismbances Figure wactwo The 2 ecision to Join a Cumngx Am Shifts in GG and LL Schedules A rise in the sizc and of mummyspeci c disturbances to tleoining country 3 product markets ie shocks that shift the DD curve sl s LL right Deregulation 0f labor and product markets elimination of political and cultural barriers within the optimum currency area shifts GG left IS EUROPE AN OPTIMUM CURRENCY AREA 7 u mob ty ere e ece es are x ong I members Most EU members export om 10 to 20 percent of their output to other EU members This is relatively small Di 39erences in culture and lmge discourage labor mobility Regional di enences in labor and capital endowments make the adjustment process di erent in each region Practice of scal federalism is limited in scale war aowa MONEY RATES EXCHANGE RATES A I r quotin 111 I e39 quot39 39 r 7 CTION OF MONEY SUPPLYAND DEMAND The interest rate is by the interaction of money supply and money demand Mg nex mg 9 lg refers to the monetary aggregate that the Federal Reserve calls M1 currency and checking deposits The money supply is assumed to be under the control of the Fed the central bank rate a This 39 I on e Mg ngx39 Demand is determined by three factors 1 the interest The Eguilibrinm Interest Rate The equilibrimn interest rate is determined when money supply is equal to money demand Figure An increase in money supply holding else censtant reduces the interest Figure An increase in real output holding everything else constant increases the interest rate THE MONEY SUPPLY AND RATE IN increase in the US may supply lowers US interest rates A decrease in the rate of retum on US relative to that of European assets increases the Slemo exchange rate tel depreciates the US dollar and appreciates the euro A 3939 in thg Egmm39 39 Money 8522 1x An increase in the European money supply lowers European rates and hence the rate of return on European assets The result is a in the exchange rate in appreciation of the US dollar and depreciation of the euro MOBEY THE PRICE LEVEL RA39I39E IN THE LONG RUN H n1 w a r a 7 employment Using the money condition le long run equilibrium price level can be expressed as follows Everything else remaining constant a permanent increase in the money supply causes a proportional increase in the price level Example INFIEATION AND EXCHANGE RATE DYNAMICS a I 39 3 relative juries levels Figure 1511 This observatien can be explained by the er en r MW Many prices in the economy are written into longterm contracts and cannot be changed immediately when changes in the money supply occur A permanent increase in M holding P constant increases the real money supply WP and lowers the nominal 3911 39 e gone retym scheguleble A I perm39anent increase in M also creates the expectation that in the w c int 2 In the long the price level adjusts and rises proportionately with the money supply Therefore WP and R return to their initial levels in the long run and the equilibrimn exchange rate is at point 3 In other words the exchange rate rst overshoots and then returns to its long level Therefnre the uctuations in E are much stronger than those 0f P Figure Run 7 Model OE EXCRQDSB Radic beenmjnai n 80594 9n Ja rfeL LLQRQh 9arit7 Assump on Pr aresare UM 99820 In e shon ML 34 L uSR J us V us R5 Lonj Run Moief 0VExampan e gRateDeferWM Ox gaaedon Pi Hand 4 MobeMrWVAPPmGCKH 3 L95ltg yU5gtw TM 05 M6 L LU5 Me y we 7 r Egg5 If 391 39mWR flyduarff o an 7 7T 6 us HE 9376 5 i i 35 dqe b ccnf n I 3 Gamma11mg M0014 w Hm PPR does ad Hold Tag6 7 ilHL onEg 15 1 33ng 7 H K M w 439 1 M957 K Le Rwa k LU5 2705 12 227 s GNP GDP HZ VCAzV LC1G fCAiF A tKA 139 O lnTheooy BOP O ic1al SeNQvwnfs Bola3amp5 QMCA Non RESQNe Penhon h MMCquotAwak pin gmglw a59 iinfQ1 9aI gm WW of FA KA 4 Stahlsh39cal DiSCPEPOHCY quot ExMA fatumcA4xzmiumm F E z MELF swap rate E wiryth 9101th 1 R4 a R E Ee Y C E4 75 Absv3ujcg PPP Ve i 4 75ft 73631 E I J 1 etl lni enbs39 1300512 gt R Exchangp Rate 7 u k m f I 70 F P d O as 325 1 GPS Ag d s P r i 7 2mw13155 R 6 mg r5 V Ang 1 l I r k ANSWERS To Rewaw Quesnons FOR TEST 1 I Y gt 4 m 7 y CA surp us or T CA depic z Y t t msk 4 Ex g CA SUrpius or 4 CA depicih s 4 cs T H 32 M A Surplm or de edJ BOP Ogida SQ Hemens Balance CA KA Nonreserw P003600 09 we Sfa HS Hcal Disuerqncy Any quotJ I QOSQC HOG Fesu kln 39m a Payment 0 PoreiJnms is erHere as a deb An 4rqnsac ion rosuHiclg M a receipiL Pnom 790m 0913 is Qn negl a a Cream 3 a q atheory since any in rnq ona 4raoac5m automa ricall 83V95 r353 0 w0 o se m g QH39NQSJ in We BOP Use CA balance 4he FA balance and Um KA bodanm auoma3coJl7z odd UP 0 zero CA F39A KA O b In PrueHeel 530cc data 43mm different Scurces r007 d ger 3910 Coverage accuracy and Emma Jhe E30 accounts JeHom balance Aacoun c keefers yorce 52 mam 0 balance 5 adam he accour s the rm m35 CaJ dbcrefomcf whenHue U5 50rrow5 Pmm yor nw 1 1535 a captoJ in ow Wen U6 lends d L00 0 4330915 H133 3933 o 9394 Ot ow 4 The PNCE 0 one Currency in terms 0 anoHer ef When Eye 4 HR U apfrecjaJcs when Eggeh m Jng deprec w rs E8 rg 94 139quot1 5 Skip DOHOF rate by rgium on ePoAAs e t E tQ Q 5 23 Gwen R ooa Kg 004 E3 05 5155 whorlquot quot5 EKKQJ Ol 1525 E 3 OLIS D uar T Od t 05 Peth on Ea i defos l Ra USL 4kg IRP conc H ion 3902 OLISEEE 7 E OJ48le um E39 The shoot run model 35 ch0 on inferes Perky P is assumed to be Med 3910 we Jkon cI ua Money maokd Equilibrium determines Px When K is equa 0 ERRQM 32 woken v eresi Dark hows E is de ermmed HOI J 5 P C 5quot t R LS determined when Fen mom supply NIP is Eqqu to the demand 4 read mow balances LLQY TL9Y7 NL m Mam gt UK gtTE e 30 Mus hoHing P constant reduces Kai I K increases 4h demand 30 yom an mach cdrrencies 27 1 Ecge J Ke 3M Re M Eye ke 7Emg 7 lite IA RERK 11 R n 2 shod PUn P 3915 EEKEJ r A yermaneni T 39m M ea I MP 00m I MP h Mtl avlk A150 0 Parmme If m M 9 TEE 7 ERK6 39 n we shod mm Equ39dibrium 35 ack nweJ ad 15 n 39er 03 No fM 39 a Propoohona 1 in P P4 03 Nova I Mquot3 MLf l Thaiquot 35 MJJP back 0 H5 ln39n39ha 1703mm In C OQp run RR1 MHnd39 PQN39LY requires 10 E2E in 4 log run I2 P ma ween dl ncky an M M mm mm a PFOPQDHOOQ in 39P and MP wouH M 39 Change R would rema39m Cons cqn c On 2ng woulAde E would rom o 1 9 and V E wouH be froporHona 0M3 E won UC ua e as much as Una r do cjva P ces 6 Law a one price orphes 0 a single 300d Puts Ei le 3 agp ies 40 e SQOPJ QI Price Wd VPus 5 Fe A Abso uie PW Eye PusPE Re ohv P9 EDM1 quot Elle rut l 1105 quotVEgt 5471 4 E E K Mus Le 76 1 M Lu NJYUS Mus me We Wuquot Ewe qHLls D Hus E f i How Q change in RJI or quec fs Aqua1amp5 O Wht39l htr Jho Change is due 0 o chath 0 Oquot O the 3n TT T in Q 3gt Mn 111 a IraE I in US money onw rk 3 If 5 9 R3 3 PduHVe FPP hoHs TVSSTF R4 K5 An 1 39m R5 cause b7 an q m money 5mm causes Ee 0 T 545 a R ER w TVOOSfOP ta39Hon C055 an re5richms on H owle MonoPohJ m or olUmfxsjishc Frock AQ oA mn data are 130L693 0n d geren r Commod3L7 bashls Ev euPe 339 We Pm whm 1W hous 4 q is He he dwe gtch a na donoA ComModl Lj baskejrs E n U n Cuu encies qiE Pw2 E39J E39 0 Yub Mus LQR DIG M e Lus Kt Yus3 PMus 3 rE Me H gtTL1gtT5 2 e 7 16 Hi E msglmms aggf 9ql a TD gt qyLE 03920 US03 30km PgriLy R4Reiampamp wln q e Q e e m U Res m Rem e E rues r M q xe when W 56143 u1 9 rug as who W353 C ocs no hohlj UJ gt4 he ACI39IONAL INCOME ACCOUNTS GNP is the value of nal goods and services produced by the factors of production of a nation and sold on the market at a given time period W YCI G EXIM GDP is the value of nal goods and produced by the factors of production within borders and sold on the market at a given time period GNP GDP R where R net income from abroad The divergence of GNP and GDP in some countries Pakistan Saudi Arabia Brazil The E a onal Income Identity When CA gt0 CA surplus When CA lt 0 CA de cit CA lt 0 the country s expenditures exceed its production Therefore the county must borrow the di 39erence from foreigners Remanging the national income identity yields CA Y C I G CA lt 0 the country is doing an intertemporal substimtim It is foregoing future consmnption in favor of current consumption 3 G i t G 0 i U saving be expressed Government saving is de ned as Case Study Do Government Budget De cits Women the CA THEzBALANCE OF PAYMENTS ACCOUNTS SCI VI 1 i L I 39 a j aquot lg 1 39 2 foreigners is entered in the BOP accounts as a debit and is given a negative 3 Sign Any u ansaction resulting in a receipt from foreigners is entered in the BOP accounts as a cmdit and is giver a positive sign Three types of transactions are recorded in the BOP 1 Export or import of goods and sarvices gt CA 2 or sale of nancial assets gt FA 3 Activities resulting in transfer of wealth countries KA as aawa Exa lnles of Paired Transactions EMF credltan onceas a c It Examples Capital In ows ouy Iaws The Fundamental BOP Identig Because any international transaction automatically gives rise to o 39setting cuties in the BOB CA E4I 43 0 The Statistical Discrepancy accuracy and timing The two sides of the BOP are bal by adding statistical scle See Table 132 cial Res This is a nancial account transaction involving purchase or sale of o ici39al reserve assets by banks Central banks often buy or sell international reserves in private asset markets to a ect macroeconomic conditions in their economies Of cial transactions of this type are called a cial foreim T 1 39 f f39 quot f 39 Dr F Koray Department of Economics Summer 2011 Louisiana State University ECON 4550 REVIEW QUESTIONS FOR TEST 1 1 How is the current account related to changes in income domestic and foreign saving investment and the government budget de cit 2 What does the balance of payment account consist of Which transactions are recorded as debits and which ones are recorded as credits 3 How is the current account related to the financial account and capital account a in theory b in practice What is a capital in ow out ow 4 What is the de nition of the exchange rate How does appreciation of the exchange rate affect exports and imports gt7 4 5 Define arbitrage vehicle currency spot exchange rates and forward exchange rates and foreign exchange swaps 6 GivenRRsESandEz 35 how would you calculate the dollar rates of return Numerical example 7 Given R3 R5 andEgs how would you calculate the equilibrium exchange rate Numerical example 8 Using the shortrun model of exchange rate determination explain how the equilibrium exchange rate is determined 9 Using the money market equilibrium condition liquidity preference model explain how the nominal interest rate R is determined in the shortrun How does R change in response to an increase in money supply or money demand 10 Using the shortrun model of exchange rate determination explain how the equilibrium exchange rate changes in response to an increase in domestic or foreign money supply 11 Explain why exchange rates uctuate more than relative prices 12 Why is the assumption of price rigidity important in explaining the overshooting hypothesis 13 What makes the law of one price different from purchasing power parity PPP 14 What is the difference between relative and absolute PPP 15 According to the longrun exchange rate model based on PPP how does a change in M53MSS YE YUSRs orRE affect the nominal exchange rate in the long run 16 Why does the exchange rate depreciate in the long run when an increase in money growth causes the expected in ation to rise 17 Why doesn t the PPP hold in the real world 18 What is the difference between real and nominal exchange rates 19 How do the real and nominal exchange rates respond to an increase in a the level of the US money supply b the level of the European money supply c the US money growth d the European money growth e world demand for US products f the US output supply according to the generalized model of exchange rate determination 20 Explain why the expected real interest rates differ from one country to the other Note These questions cover the basics To answer the questions successfully in the exam you must know the basics but you must also know how to apply this knowledge to specific cases To improve your analytical skills I recommend going over the problems that I assigned to you very carefully CHAPTER 16 PRICE LEVELS AND THE EXCHANGE RATE IN THE LONG RUN Wh beenomic factors lie behind lang term movements in the U C m 1 7 quotii39lilllk movem ts in the exchange rate two comuies currencies by changes in the cunntriesquot price levels To have a good lmderstanding of PPP we need to know how the law of one price works THEILAW OF ONE PRICE trade barriers tari s 39 r quotas identical goods sold in di erent countries must sell for the same price when their prices are expressed in terms of the same currency r Example The law of one price can be expressed as follows PURCHASING POWER The g quot This can be expressed as follows Th Relati 11 hi etween PPP and the La The law of one price applies to individual commodities while PPP applies to the general price level Ab lute PPP 11d j e P Absolute and relative PPP can be expressed as follows A LONGRUN GE RATE MODEL BASED ON 399 9 with the money market equilibrium condition as follows Therefore in the long run the exchange rate is a ected by the following variables in the following way 1 Mung Sign lies An in US money supply depreciaxes Eeuro An increase in European money supply appreciates RSIcum 2 Money Demand E rises 3 011mm Levels A rise in US output raises real US money demmd and appreciates the U83 ie Eeuro falls A rise in European output raises real European money demand and depreciates the U83 ie Eeuro Ifthe rise in RCU S is due to a rise in US in ation rate US depreciates Em RIV CAL EVIDENCE ON PPP ANDTHELAW L39QP Examples The Law of One Price The Hamburger Prices p3 99 Absolute PPP Comparing the dollar price of consumer baskets Relative PPP Fig162 a a a v a o G THE PROBLEMS WITH PPP Contrary to the assumption of the law of one price transportation msts and restrictions on trade continue to exist 39Iherefore some goods are not traded mmma onally These nonnaded goods however are included in the price indexes which are used in testing PPR 2 De artmes from Com 7 tition Monopolistic or oligopolistic practices result in di 39erent prices in di erent countries This can cause the PP tests to fail PPP in the Short Run and in the Long Run Due to sticky prices departures om PPP are more pronounced in the short However national price levels still diverge after all prices adjust and markets clear in the long run A GENERAL MODEL OF LONGRUN Nominal Exchange Eeuro The prica of one national currency in terms of another currency ie the relative price of two national currencies Real Exchange Rate qeur0 Relative price of Mo output baskets de ned in terms of nominal exchange rates and output levels Example wocwoowo g lt ation of the US dolar Demand Sun 911 and the LongRun Real Exchgge Rate Longrun values of the real exchange rate change in response to 1 A change in world relative demand for American products Example 2 A change in relative output supply Example The above equation takes into account possible deviations from PPP by the real exchange rate as an additional deteminant of the nominal archng Taking into consideration the factors qeuro NUS and PEu ESleuro be expressed as follows Combining PPP and IRP we can show that the di erence between US and European interest rates is the sum of two components 1 the expected rate of real depreciation against the euro and 2 the expected in ation di emnce between the LS and Europe This relationship can be derived as follows OUTPUT AND EXCHANGE RATE IN SHORT RUN Ci Previous anal 1 sis Y is heated as an exo enous variable in Purpose To develop a shortrun model B and Y are simultaneously output equals aggregate demand Aggregate demand D can be as follows Increases in BPP YT I and G increasss D The equality of Y and D detennines the shortrun equilibrium output level Figural w a c v a a Simultaneous determination of E and Y 2 Equilibrium in the Asset Market The schedule On It Market E uilibrium and the DD Schedule increase in E holding P and P constant EPP which increases D That is D shifts up and Y increases The positive correlation between E and Y is shown by the upward sloping DD curve 2 Faictors that shift the DD schedule 1 An increase in G increases Wm o holding E constant and shifts DD right Figure 3 2 increase in T shifts the DD curve left 3 An incwase in I shi s the DD curve right 4 increase in P shifts the DD curve left w a a n a o w 6 An increase in consumer and business optimism shifts the DD curve right 7 increase in demand for home goods change in tastes shifts the DD curve right For asset markets to in equilibrium 9 rise in Y must be acmmpanied by an appreciation of E This can be shown as follows Figure 4 Example Increase in M increases MP reduces R at each output level and increases E shifts up Figure 5 2 increase in P shifts the AA schedule down 3 An incwase in expected E shifts up 4 increase in foreign interest rates shi s up i 0 039 0 O i 5 An increase in LRY shi sAA down SHORTRUN FOR AN OPEN ECONOMY DD SCHEDULES Shortrun is achieved when the output and markets are both in equilibrium That is when AADDw Figure 6 TEMPORARY GES IN MONETARY AND FISCAL 7 3quot I quot I 39 z i z E Th answer to question depends on wheth the change is or permanent In our analysis we assume P is xed in the short run and R and P are not by domestic events and policies The basic di erence between temporary and permanent changes is that tempormy changes in policy do not a 39ect the expected E but permanent manages do M A a ect the DD curve Both E and Y increase in the short run Figure 7 chaer0 Atempomry increaseinGoradccrease inTshi stheDD curve right but does not a iect theAA curve While Y increases E falls ie the USS appreciates Figure8 wacvaow Poli es to Maintain Full Emnlom cut Suppose the economy is initially at full employment but a temporary fall in world demand shifts the DD le causing a recession In this case either a temporary monetary or a scal expansion restores full employment The two policies di er in their exchange rate effects Figure 9 I faced Su pose the Economy is at full employment an I II I 1 I will nsIIiLAzIION BIAS AND omen PROBLEMS OF r expectations expanswnary mes may cause an in prices with no change in output 2 In it is hard to know whether the dismtbance originates in the asset market or the goods market 3 There is a bias towards using monetary policy even though the using scal policy 4 Policy reversal may not be politically feasible 5 The time lag between the time the disturbance occurs and the time the policy affects the eeonemy is variable and lung SHIFTS IN MONETARYAND FISCAL m 1 quotu A the expected exchange rate A Permanent Increase in the Mon Sn 39 A permanent increase in the money supply increases the expected exchange rate Therefore a permanent increase in M of the same magnitude as a temporary increase sl fts the AA curve further to the right Figure 11 In th 7 r M output beyond the full employment level In the long the economy to its full employment level How Figure 12 AP If th G or a decrease in T no e ect on output neither in the short run 110139 in the lung run For example a permanent increase in G shi s DD right It also reduces the expected exchange rate which AA 1311 Therefore E appreciates but output remains at full employment level Figure 13 CHAPTER 19 SYSTE39 MS if HISTORICAL OVERVIEW Gcals of macroeconom c policies internal and external balance Gold standard era 18701914 International monetary system during interwar period 1918 1939 0 Bretton Woods system of xed exchange rates 19441973 Collapse of the Bretton Woods system Arguments for oating exchange rates Macroeconomic mterdependence under a oating exchange Fowign exchange markets since 1973 0 balance producing at potential output at full employment and price stability low in ation 0 External balance achieved when a current account is neither so deeply in de cit that the country may be unable to rapay its tbrcigl debts not so strongly in surplus that tbrcigiers are put in that position 0 An intertcmporal budget constraint limits each country s spending over time to levels that it repay with 0 A counuy that xes its currency s exchange rate while free intemational capital gives up control over domestic monetary policy 0 Acoutmy that xes its exchangeratc canhave control over domestic monetary policy ifit restricts intemational nancial ows so that interest parity R R not hold 0 Or a can allow international capital to ow freely and have control over domestic monetary policy ifit allows the exchange rate to oat 0 Impossible for a country to achieve more than two items om the following list 1 Exchange rate stability 2 Monetary policy oriented toward domestic goals 3 Freedom of international capital movements Monetary policy autonomy Exchange rate stability Floating exchange rate Freedom of financial flows The gnld fmm 1870 to 1914 and a er 1918 had mechanisms prevented ows of gold reserves the balance of payments om becoming too positive or too negative Paicastmdedtoadjustmmding mamomtofgoldaim a ngin an economy whichhade 39nctsontha mofgoodsmdmm the WW Carma hanks in uenced nancial asth aws 90111me W partof le nancial mmlmatched ne min m39dertomducegold out ows orin owa 0 0 P cespecie uw mecth is the of prjces as gnl specxp ows mto or cut of a country causmg an adjusuncnt m the ow of goods An afgoldtendstoin awmim An ofgold to de atu pitices Efadmnsstic hasnmmtawmmtmptusinmafthe W 6mm quot Wgoldmad omemm owsiqm the prices in that country and lowering polices m foreign mg 39 Wampum from fwdgncmmtriasbwmwhwpmducing mummmmauplm ofthsdmnes wmmtrynndthedc citsofthefmaignemmt esi I39hus pricespecie ow mechanism of the gold standard could automatically reduce current account surpluses and de cits achieving a measure of external balance for all countries 0 The Rules of the Game under the gold standard re t to another pmcess that was theoretically carried outby central mew mgofdmes cmmmqmmwwhmgoldmdwd thecountryaspaymems orimmm hisdemmdthemomy matchacumntaacountde cit Thebuyingofdom cassctswhmgoldenmthewmas mmmmms mgialin owsmmm Wamunt Thismdorredmedgald in ow actaa Banks with decreasing gold reservo s had a strong incentive to practice the rules of the game they could not redeem currency without sumcient gold 0 Banks with increasing gold reserves had a weak incentive to practice the rules of the game gold did not earn interest but domestic assets did 0 In practice contral banks with increasing gold reserves seldom followed the rules And central banks o en sterilized gold ows trying to prevent any effect on money supplies and O The gold standard s record for internal was mixed The US su 39ered from deflation recessions and nancial instability during the 18708 18808 and 18903 while trying to to a gold The US unemployment rate was 68 on average from 1890 to 1913 but it was less than 57 on average from 1946 to 1992 0 The gold standard was stopped in 1914 due to warquot but after 1918 itwas attempted Thu U08 reinstamd the 301de nal 1919 In 1933 at 206 peromcamd 39om l934ta 1944 at S3500 peronnma devaluation ofthe dollar MUK teinstawdthagnldstandatd fom 1925 1121931 39 But countries that adhered to the gold standard for the longcst time without dcvaluing their currencies suffered must 39om reduced output and employment during the 19303 0 In Jl y1944 44 countries met in Bretton Woods NH to design the Bretton Woods system a xed exchange rate against the 118 dollar and a xed dollar price of gold 35 per ounce 0 They also established other instimtions 18 The Intemational Monetary Fwd 2 The World Bank 3 General Agreement on Trade and Tari s GATT the predecessor to the World Trade Organization WTO 0 The IMF was constructed to lend to countries with persistent balance of payments de cits or cumant account de cits and to approve of valuations Imsmmada ama mdpaidforbymm ingoldand gt had a quomwhich damn neditswn bu ontoths fund and the amountit could bonnw Lugeloans waxemails on msuparvi onofdmms c policicsby m EMF IMF 39 E s zedthatthceconm disothbnnm wasmcpc enci nga f mdmnmml39 0 Due to borrowing and occasional dcvaluations the was believed to give countries enough exibility to an external balance yet allaw them to maintain an internal balance and stable exchange rates The volatility ofcxchange rates during 1918 1939 caused by devaluations and the vagaries of the gold standard was viewed as a sumac of economic instabilityi 0 In order to avoid sudden changes inthe nancial account possibly a balance of payments crisis mmtries in the Bretton Woods system often prevented of nancial assets across countries 0 Yet they encom39aged ows of goods and setviees because ofthe View thatttadebene ts all economies Cmcies wen gradually convertible exchangeable betwm munbet comm to enconrageuadein goodsand 0 Under a system of xed exchange rates all counuies but the US had ine eetive monetary policies for internal balance 0 The principal tool for intetnal balance was scal policy government or taxes The p ncipal tools for maternal balance were borrowing rm the restrictions on nancial asset ows and infrequent changes in exchange rams 0 Suppose balance in the shortrun occurs when production is at potential output or when full employment equals mate demand YT C I G CdEPP A A CAEPP A 191 0 An increase in govelmnent purchases or a decrease in taxes inmasw aggregate demand and output above its full employment leveL 0 To restore balance in the short run a revaluation a fall in E must occur a c t a a o 39 Suppose external balance in the short run occurs when the current account achieves some value CAEPP Y 1 X 192 0 An increase in government purchases or a decrease in taxes increases aggregate demand output and income decreasing the account To restore external balance in the short run a devaluation a rise in E must occur 0 But under the xed exchange rates of the Bretton Woods system devaluations were supposed to be in equent and scal policy was supposed to be the main policy tool to achieve both internal and balance 0 But in general scal policy cannot attain both internal balance and external balance at the same time 0 A devaluation however can attain both internal 39 quot al nczattyeemesime 1 My I rig Frill 0 Under the Bretton policy makers generally used scal policy to try to achieve intemal balance for political reasons 0 Thus an inability to adjust exchange rates left countries facing external imbalances aver In equcnt davaluations orrevahlations and but spbeulalmsalsohied muu cipata mm which mid cm sweater or mum The collapse of the Brettun Woods system was caused primarily by imbalances of the US during the 1960s and 19708 T115113 mIrpIusbecame adn cit in 1971 Rapidly increasing govmmt pmchasm aggregate ouMasm asp ces g mime and a growing money simply 18 dollar m overvaluedin teams carme and in terms of orcign m 0 Another problem was that as feteign economies grew their need for o eial intemational reserves to xed exchange rates grew as well 0 Butthlsrateofgrow lwasfasterthanthe growthrateof the gold reserves held Supply ofgoldfmmnew waegmwingslowly Holdinng U N in 5quotquot139 mike WWW 0 At some point dollardenominated assets held by foreign central would be gleam than the ofgold held by the Federal Reserve 0 The Federal Resorvewould eventually not have enough gold foreigners would lose con dence in the ability ofthe Federal Reserve to the xed price of gold at 35ounec and therefore would to nedcem their dollar assets before the gold out Thisproblemissimilartowhatany connalbmkmay cewhcnit tries to maintain a xed exchange rate doasnothmmugh a ma 39 m assemtomaimain a xodratma balance of aids is inevitable 0 The Us was not willing to reduce gnvemment purchases or increase taxes signi cantly not reduce money supply 0 These policies would have reduced aggregate demand output and in ation and increased unemployment The U3 wald have attained some semblance of cinema balance at a cost of a slcwer economy 0 A devaluation however could have avoided the costs of low output and high memploymctu and still have attained external balance an increased current amount and o cial international reserves a a a a a a 0 The imbalances ofthc 118 in turn caused speculation about the value 40me US dollar which caused imbalances for other annuities and made the system of xed exchange rates harder to Financial markets had the perception that the US economy was experiencing a fundamental disequilibrium and that a devaluatiun would be necessary Firsgspecx a ogabomadwalna onof ledo arcauscdinvemto TheFedadRmvnmldlmgnqum uaafgolthamhl S Mclmmarkcma matdm gt 111m individuals and private wanna lama allowedwmgold om mFedualRemeorothm 39mualbanks 39I39baFadm39alReservcwould sellonlytomhercannalbanksat 3 olmm Meventhis Wentdidmhold 61113 devalnodits dollar in quottams ofgold in member 197m to 38 oumced 1 Smaispacn a onabomadcvalna onofthsdn arinmwfathm Wammdinvmmbuylm gaqum esof wignmcy 888618 Acomdinawddcvalua anof mdollaragaimtfmcignmcies ofabout 80ccmmdinDeeember 1971 Spem a onabMano xetdevalna tionocmEumpeancmml bmksmldhngequm tiemf mnpeanmeiasinaady 17 me 1973me0306 maxim W ofdollm in Maw 1973 and allbwed danandmdsupplyofcmencicsmpushthevalueof mdo ar downward 0 The Bretton Woods systemcollapsed in 1973 because central were unwilling to continue to buy overvalued dollardenominated assets and to sell undervalued tbreigl cwency denomiuated assets 0 In 1973 central banks thought they would temporarily stop trading in the foreign exchange market and would let exchange rates adjust to supply and demand and then would reimpese xed exchange rates scene 0 But no new global af xed was started THEE CASE FOR FLOATING EXCHANGE RATES 1 Monetary poiicy autonomy 2 Symmetxy 3 Exchange rates as automatic stabilizers M n Poli gutonom 0 WI quot i restore monetary policy as a power ll tool Example ii allaw each country to choose its longmm in ation rate Example ii inSI aIe economies from foreign in aiian Example waataowa W i The Fed could set a target for the US money supply but the banks of other countries could not detexmme a target for their money supply ii The other countries could devalue their currency but the US could not It was argued that a system of oating exchange rate would get rid of these asymmeoies Excl ang e Rates as Automatic Stabilizers f t Example Figure THE CASE AGAINST FLOATING EXCHANGE RATES The 2 1 Discipline 2 Destabilizing speculation and money market disturbances 339 Injury to international trade and investment 4 Uncoordinated emnomic policies 5 The illusion of greater autonomy I 39 63 0 2quot O quotI A f 9 exchange reserves This makes it wsy to foil w over expansionary monetary and scal policies and fall in ation bias Question value of th39 change ra would i decrease e vole f international trade and ii create a vicious circle of depreciation and in ation Example Question Also it was argued that a xed exchange rate regime would handle money demand shocks better than a oating exchange regime Figure a w r a o i a MW investors This may decrease international trade and capital aws Question Unm u ordinated Economic Policies Se Example of monetary policy on the exchange rate Example Insulating properties of oating exchange rates are also limited due to sticky prices EXCHANGE EXPERIENCE 19731980 from 3 to 12 Since oil is usad as an input this ledto an in prices by increasing the cost of productiong Thu result was a decline in C and I It also increased the CA de cits of oil importing countries Oil price shocks together with other supply shocks resulted in stag ation The oating exchange rate regime was successful in mitigating the negative effects of oil shocks Figure actaa MACR ECONOMIC INTERDEPENDENCE UNDER 391 1 I L i 39 39 i l hf I Assume two countries of equal size such as the US and Europe Expansionary monetary policy in the US reducesquot US interest rates and depreciates the value of the dollar Depreciation of the US dollar improves the US current account by increasing exports and reducing imports The reduction in interest rates increases investment and consumption expendimres Together with the improvement in the current account this leads to an increase in the US GDP aua Depr39eciation of the US dollarm eansappreciati 39 iglv39 in l on of the I M umquot In this case monetary policy is beggar thy neighbor type of policy Example Contractionary U s monetary policy during 1981 1983 reduced the ma in ation but increasedthe European in ation Fisc Pong EXP PP depreciation of the Euro improves the European current account and increases the European GDP Thus expansionaly scal policy is helpful to both the US and Europe if both countries are in a recession m ZOHHZmSMmHZH mmuzgoxm ZOHmMOm D24 mag DEG CENTRAL INTERVENTION AND THE To understand the effects of bank intervention in the foreign exchange market we have to understand how central bank transactions the money supply transactions can be traced by leaking at the central bank balance sheet Central Bank Balance Sheet wocwoowo Chan ges in central bank s assets and liabilities cause changes n uquot f V n f The of bank intervention which the monetary base and thus the money supply is called foreig exchange intervention Steri zed Intervention W11 as foreign exchange intervention Example HOW THE CENTRAL BANK FIXES EXCHANGE quot a i I nquot a v 39 i 39 39 7quot to mencies at the M ed exc ange rate with the private actors in the foreign exchange market The foreign exchange market is in equilibrium when the interest parity holds This implies R R Suppose the foreign exchange market is in equilibrium at the xed exchange rate If there is an increase in Y which increases the money demand what must the central bank do to keep E xed Figure STAiHLIZATION POLICIES A FIXED 1 Monetary policy is ine icient xed exchange rates Figure Fiscal Pong 39 Fiscal policy is completely e cien t under xed exchange tales Fign e A devaluation an increase in E increases decreases imports and thus increases ate demand causing a movement along the DD curve The increase in Y leads to an increase in LCRY which puts 13mm on R to risei To keep E xed the bank must buy foreign This increases M AA shifts right Governments choose devaluation because it 1 can be used to ght mmployment 2 improves the CA and 3 increases the s 3 I 1 3m erves BAIL kNCE 0F PAYIWENTS CRISIS AND CAPITAL is facing high domestic unemployment the public may expect a devaluation leads to a BOP crisis which can be explained as follows Figure The expectation of a future devaluation causes a BOP crisis marked by a sharp fall in foreign exchange reserves and a rise in R above R The reserve loss is called capital ight By pushing the reserves even lower capital ight may force the central bank to devalue sooner a a c as a a a o WAGE DATING AND STERILIZED Undermanag eating 39 e een sometimes a between domestic objectives such as employment or the in a on rate and exchange rate stability To this end the central bank performs sterilized intervention Example What is the e ectiveness of intervention The answer to this question depends on whether domestic and foreign assets are perfect or substitutes with each other a o c cv o o a o money supply and hence the interest rate R and hence the exchange rate E una ected This msult is based on parity which assumes that foreign and domestic assets are substitutes r quot y 5 WI 7 equilibrium condition is as follows How does sterilized intervention the exchange rate E without a ecting the domestic interest R ExatIIple Figure o


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