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									Macroeconomic Analysis 2003

   Exchange Rate:PPP, UIP and CIP
            Theories 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                        1
Fundamental Macroeconomic Identity for an open economy
  Main Features of an open economy         Aggregate demand in an open economy
a. exports and imports with the rest                                                           *
                                                                       e                  f eP
                                           Y  C (Y  T )  I (Y , i   )  G  NX (Y , Y ,     )
   of the world                                                                              P
b. Capital inflow and outflow
c. Exchange rate system                             Income = demand
       Fixed -pegged                       C  S T  M  C  I G  X
        Flexible –floating
d. External shocks affect income           Economy wide saving = Trade balance
   and employment at home – risks                                             f
                                            S ( y ) I ( r )T ( y )G  x ( y ,e)M ( y ,e)
e. Exchange rate stability                 Balance of payment condition
   arrangements –(monetary union,          Current account +capital account =0
   dollarisation)                           X ( y f , e)  M ( y, e)  F (r  r f )  0
f. Policy coordination



                                       Lecture 18                                              2
Three GAPs: Investment-Saving, Budget and Trade Gaps
                                     S(Y)
                        SI
                      Trade Surplus         S  I   T  G   X  M
                           NX  0  NX  Cap Flow
     i                       K-outflow
                    T G  0                   Private saving +public saving
            i                                  = net export
                                       SI
                                        Trade deficit I(r)
                                         K-inflow NX  0
                0
                                            Saving and Investment

Re call : Y  C  S  T  M  C  I  G  X  rK  wL  Tr
                               Lecture 18                            3
       Why is not appreciation of domestic currency
       not good for Foreign Investment?
$                  Net capital
   1.60           outflow
                                       S-I

£ Real                            S  I   X  M   Cap Flow
     Exchange
     Rate                                 X  M   Cap Flow  0
 λ


$
   1.45
£                                  Net capital inflow NX(λ)

                                             Net export

                          Lecture 18                          4
   Exchange Rate and the Demand and Supply of Foreign Currency
     £
2002:  0.69
                           Excess supply of FC       Exports: X(E,Y*)
     $     E1
    Depreciation
       E    0.66                          A      e
                                                               NX
    Appreciation
             E2
     £
2003:  0.63                Excess Demand for FC Imports: M(E,Y)
     $
               0                   F
                     Demand and supply of Foreign Currency

                             Lecture 18                        5
   Depreciation of Dollar against Pound
    or Appreciation of Pounds against dollar in 2002
Sterling Pound
         Et 1  Et               0.63  0.69
  AR£               100 = AR£               100  8.7%
             Et                      0.69

Euro also appreciated
         Et 1  Et               0.98  1.11
   AR              100 = AR               100  11.7%
             Et                      1.11
Euro also appreciated

      Et 1  Et               121  128
ARY              100 = ARY             100  5.47%
          Et                     128
                             Lecture 18                        6
   Triangular Exchange Rates and Appreciation
   and Depreciation with respect to the Third Currency
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
0.63
      0.64
0.98

In 2001 one dollar in terms of pound and Euro is
0.69
      0.621
1.11

This implies that Euro has become stronger by 0.021
percent (0.64 - 0.621) against the pound.


                         Lecture 18                      7
                     Keynesian Open Economy Model
              How an Expansion in Income causes Trade Deficit?
   AD

                                                                                        *
                                                                 e                 f eP
                                    Y  C (Y  T )  I (Y , i   )  G  NX (Y , Y , )
                                                                                      P

              0
                                                              Y

          +                                             X=X0
Trade                                                   M=M(Y)
balance           Surplus
              0
                                                         Y
                                              Deficit
          -                      Lecture 18                                    8
Derivation of Net Exports and Investment Saving in an Open Economy

Note:                       AD            (a)                      AD
• Shows reduction in AD
                                                            ΔNX
following an increase in ER
(b) Shows investment saving
Balance in an open economy
(c) Shows net export as
 a function of the exchange                     Y1         Y2 Y
rate
               (c)
                                                     (b)
                             e
e2

 e1                                                             IS*(e)
                       NX (e)
                                            y1             Y2
            NX2     NX1      Lecture 18                             9
               IS-LM Model in an Open Economy

                         LM (y, i)
Exchange
Rate




      e*



                                                  IS*

           o            y                Output



                            Lecture 18                  10
Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
                                   Effectiveness of Fiscal Policy
                                 Under the Fixed Exchange Rate System
                         LM                        LM1
                                                                LM2

  e2
                                IS*’
                                       e

   e1                                                          IS*’
                              IS*                       IS*

                                                   Y1          Y2
                       Y
No Impact of Fiscal Policy under
Flexible Exchange Rate System Lecture 18                       11
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
                                     Ineffectiveness of monetary Policy
                                   Under the Fixed Exchange Rate System
                          LM                         LM1
                                                                 LM2
  e2

                                        e
                                 IS*’
  e1


                                      IS*                            IS*

             Y1           Y2                         Y1         Y2
  Effectiveness of Monetary Policy
  under Flexible Exchange Rate
  System                        Lecture 18                      12
    Macro Indicators and Trade Balances December 2002
Macro Economic Indicators          UK        EURO-       USA      Japan
                                             Area
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       3.97           2.94    1.34     0.02
3-month money market)
Trade balance (in billion US $)    -49.0          95.6   -456.6    89.3

Current Account balance            25.8           38.0   -462.2    113.9
(in billion US $)
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                       13
                                    Macro Indicators and Trade Balances 2003
                        Macro Economic Indicators      UK           EURO-     USA      Japan
                                                                    Area
                        Budget deficit as % of GDP       1.1          -1.2     0.6      -6.0
                        Inflation rate (% change in      1.6           2.1     2.2      -0.8
Macro Indicators 2001




                        CPI)
                        Unemployment rate (%)            5.2           8.1     5.6      5.3
                        Interest rate (% per year on    3.97          3.35    1.84      0.02
                        3-month money market)
                        Trade balance (in billion US $) -47.2         24.9    -438.9    74.9
                        Current Account balance         17.7          -31.2   -430.7    3.2
                        (in billion US $)
                        Exchange rate (per US $)        0.69          1.11      1       128
                        Growth rate of GDP (annual       2.2           1.3     0.6      -0.5
                        %)
                        Growth rate of money supply      8.2           8.0    14.0      3.2
                        (%)                            Lecture 18                              14
Exchange Rate of Sterling Pound with Dollar, Euro and Yen
                               1975         1985      1995        2000       2002     2003
          US$                  2.22 1.298 1.578 1.515                        1.44      1.6
$/£
          Eff. Rate          129.6          111.3      84.8 107.5 107.3

Y/£       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                                    15
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                 16
Purchasing Power Parity Theory of the Exchange Rate: Long Run
                         EP*
 Real exchange rate :   P

                                    
                                  t et Pt* Pt
                                             
                  PPP-hypothesis:   e  *  P
                                    t  t P    tt
  
 t        
           et                                 
     0        *   g    * *g* 
 t        et                      
                                   
                                               
                                               

 Where P* is foreign price level, P is the domestic price

 level,
          
          et                                             e
               is the change in the nominal exchange rate t 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
                                 Lecture 18                      17
                PPP is Valid in the Long run
        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

       PPP is not valid in the short run 2001- 2002
  t
  
  t   UK  USA  2.1%  2.6%  0.5%
      t
      
Since
      t  8.7%  0.5%
Similarly for Euro

t

t 
      Euro  USA  2.2%  2.6%  0.4%  11.1%
                                     Lecture 18                      18
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
            
            et       *   g    * *g* 
 countries. e                  
                                   
                                               
                                               
             t                                
 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. 18
                           Lecture                        19
Covered and Uncovered interest parity
Covered Interest Parity (no risk)
                        i  i*  F  E
                                   E
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):
           
          
                E e  Et 
                                      E e  Et
1 i  1 i* 1 t 1      i  i*  t 1
       
          
                 Et                   Et
                      
                        

Compare CIP and UIP Ft  Ee is the forward Exchange
                                  t 1
rate
                         Lecture 18                     20
         Impact of Fiscal Policy on the Exchange Rate,
            Interest Rate and Output: ISLM Model

             IS2
                               LM                 UIP

                                        i
i   i2

    i1


                                            i
                               IS

                      Y1 Y2             Appreciation
                                                       E2   E1
                                                            Depreciation
                           Lecture 18                            21
  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.
                  1 it  1 1 i*  Ee
                                    
                           E  t  t 1
                            t      

Ee Exchange rate expected in the next period.
  t 1
Applying rule of log for small numbers it can be
written as
                             Ee  E
                   it  it  t 1 t ;
                         *
                                E
                                  t
 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                   22
Appreciation or Depreciation of Currency According to the
 Differences in the Domestic and Foreign Interest Rates

           E e  Et         Ee
  it  it  t 1
        *            E 
                              t 1  i  i *  et
                       t 1 i  i*
                                               
               Et                       t  t
                                               et
                              t t
 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.
                         Lecture 18                         23
                         
                         et
Purchasing Power Parity: e    *                     (1)
                               t  t
                          t
                                    
                                    et
                           it  i *
                                   t
Uncovered Interest Parity:          et           (2)
Using the Fisher equation (2) becomes
                                 
                                 et
               t  rt    r 
                            *
                            t      t
                                    *

                                 et              (3)
Slight rearrangement:
                       
                       et
               t     rt   rt*
                        *
                        t
                       et                        (4)



From PPP
         t  
                 
                 et
                  *
                  t
                 et t
                      0
                                         
                                             rt  r    t
                                                        *

When both PPP and UIP hold exactly the domestic and foreign real
interest rates are equal.
                            Lecture 18                        24
     Like the PPP, UIP is also valid only in the long run

Compare the interest rates and Exchange Rates between 2001 and 2002

           Ee  E
   i  i*  t 1 t
    uk US      E
                t


   3.97 1.34  8.7

                               Lecture 18                     25
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                     26
 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                  27
      Which countries should have
        fixed exchange rates?
 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.
                            Lecture 18                       28
  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                           29
        Benefits and cost of a Monetary Union and
                  Optimal Liberalisation?

Which countries benefit from a monetary union?        Impossible trilogy:
Criteria for an optimal currency area
                                                      fixed exchange rate
                                                      free capital mobility
 Higher Degree of Trade Link                        monetary independence

 Common shocks                                Optimal Order of Liberalization
                                                 1st goods market (subsidies)
 Degree of labour mobility
                                                       2nd Trade (Tariffs)
 Degree of fiscal transfers.                 Financial market (no control on r)
                                                       Full convertibility

                                        Lecture 18                      30
Given these theories of Exchange Rate
     Should UK join the European
          Monetary Union?

    Five Economic Tests: Issues for Referendum
    1. Cyclical Convergence
    2. Flexibility
    3. Investment
    4. Financial Services
    5. Employment and Growth

    What Do YOU Think?
                      Lecture 18                 31
                  Exercises
Triangular 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.
                       Lecture 18                 32

								
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