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

ePfYYNXG

eiYITYCY

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

i

0 GTK-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

E

EEAR = %7.8100

69.0

69.063.0£

AR

Euro also appreciated

1001

t

tt

E

EEAR = %7.11100

11.1

11.198.0

AR

Euro also appreciated

1001

t

ttY E

EEAR = %47.5100

128

128121

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

64.098.0

63.0

In 2001 one dollar in terms of pound and Euro is

621.011.1

69.0

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

ePfYYNXG

eiYITYCY

X=X0M=M(Y)

Surplus

Deficit

Lecture 18 9

Derivation of Net Exports and Investment Saving in an Open Economy

ΔNX

AD

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

Exc

hang

e 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 -6.0

Inflation rate (% change in CPI)

1.6 2.1 2.2 -0.8

Unemployment rate (%) 5.2 8.1 5.6 5.3

Interest 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 1 128

Growth 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 I

ndic

ator

s 20

01Macro 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

t

t

*

*

0t

t

**** 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

tEet

Eii 11*11

tEtE

et

Eii

1*

Compare CIP and UIP et

EtF 1 is the forward Exchange

rate

Lecture 18 21

i

Y1

i

E1

LM

IS

i1

IS2

i2

E2Appreciation

Depreciation

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.

et

EtitE

ti 1*111

et

E1 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

et

Etiti

1* *1

1

titi

et

EtE

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: *tt

tete

(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

e

e

(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

E

USi

uki

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 Rates

The 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 rate

Real and nominal exchange rates

Trade weighted exchange rate

Exchange rate changes according to the PPP

Exchange rate according to the UIP

Relation between fiscal and monetary policy and the exchange rate

Advantages and disadvantages of joining the monetary union.