International Dimensions of Macro Policy Fixed Exchange Rates In this case, the central bank (the...

International Dimensions of Macro Policy

• Fixed Exchange Rates

In this case, the central bank (the government) decides the value of the currency.


• Flexible Exchange Rates:

• In this case demand and supply of the dollar determine the value of the dollar

$/&

Quantity of & demanded and supplied

Re




$/&


Re

Surplus

R’




$/&


Re

Deficits

R’’

There are three sources of risk:• accounting risk:Anytime there is a change in

the value of the dollar, value foreign currency denominated assets change in the same direction. Assume an American owns a Bond with a face value of 1000 pound sterling. Its value in dollar is:

at $1.50/& = $1500.00

at $1.60/& = $1600.00 Devaluation of the $

at $1.40/& = $ 1,400.00 appreciation of the $

Foreign Exchange Risk

There are three sources of risk:

• Transaction risk: Assume you buy a BMW for 45000 DM

Its Dollar price:

@ $.8/DM = $36000

@ $.88/DM = $39,600 Devaluation of the $

@ $.72/DM = $32.400 Appreciation of the $


There are three sources of risk:

• Currency risk: The higher the variability of a currency, the higher is the possibility that the value of an asset denominated in that currency will change. This means that assets denominated in that currency are riskier than others.


Macro adjustment Under the fixed ER regime

• Increase the money supply

i

income

IS

LM

LM’

i1

i2

y1 y2

a

b

BP


• Real income increases which leads to increase in imports. Lower interest rates will lead to outflow of money. LM will shift back where it was.


i

income

IS

LM

LM’

i1

i2

y1 y2

a

b

BP

International Dimensions of Macro Policy Fixed Exchange Rates In this case, the central bank (the...

Documents

Transcript of International Dimensions of Macro Policy Fixed Exchange Rates In this case, the central bank (the...