Lecture 18 1
Macroeconomic Analysis 2003
Exchange Rate:PPP, UIP and CIP
Theories of exchange rate
Advantages and disadvant...
Lecture 18 2
Fundamental Macroeconomic Identity for an open economy
Main Features of an open economy
a. exports and import...
Lecture 18 3
Three GAPs: Investment-Saving, Budget and Trade Gaps
i
Saving and Investment
I(r)
S(Y)
TrwLrKXGICMTSCYcall ++...
Lecture 18 4
NX(λ)
λ
Real
Exchange
Rate
Net export
45.1
£
$
=
60.1
£
$
= S-I
Net capital
outflow
( ) ( ) FlowCapMXIS =−−−
...
Lecture 18 5
Exchange Rate and the Demand and Supply of Foreign Currency
E
F
Demand and supply of Foreign Currency
Exports...
Lecture 18 6
Sterling Pound
=
Euro also appreciated
=
Euro also appreciated
=
Depreciation of Dollar against Pound
or Appr...
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 pou...
Lecture 18 8
0
+
-
Y
Y
0
AD
Trade
balance
Keynesian Open Economy Model
How an Expansion in Income causes Trade 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 ...
Lecture 18 10
IS-LM Model in an Open Economy
IS*
e*
LM (y, i)
Output
Exchange
Rate
o y
Lecture 18 11
Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
IS*
IS*’
e1
e2
Y
No Impact of Fiscal ...
Lecture 18 12
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
IS*
IS*’
e1
e2
Effectiveness of Monet...
Lecture 18 13
Macro Indicators and Trade Balances December 2002
Macro Economic Indicators UK EURO-
Area
USA Japan
Budget d...
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 rat...
Lecture 18 15
Exchange Rate of Sterling Pound with Dollar, Euro and Yen
$/£
Y/£
1975 1985 1995 2000 2002 2003
US$ 2.22 1.2...
Lecture 18 16
Competitive Open Economy Need Right Exchange Rate
• Overvalued exchange rate reduces volume of exports
and r...
Lecture 18 17
Real exchange rate :
PPP-hypothesis:
Where P* is foreign price level, P is the domestic price
level, is the ...
Lecture 18 18
Since
Similarly for Euro
PPP is Valid in the Long run
PPP is not valid in the short run 2001- 2002
Ghana Ind...
Lecture 18 19
Fundamentals of A Stable Exchange Rate according to the
PPP Theory
• Change in the exchange rate must equal ...
Lecture 18 20
Covered and Uncovered interest parity
Covered Interest Parity (no risk)
where F is forward exchange rate, i ...
Lecture 18 21
i
Y1
i
E1
LM
IS
i1
IS2
i2
E2
Appreciation
Depreciatio
n
UIP
Impact of Fiscal Policy on the Exchange
Rate,
In...
Lecture 18 22
Uncovered Interest Parity Theory of the
Exchange Rate
Rates of returns (interest rates) across countries are...
Lecture 18 23
Appreciation or Depreciation of Currency According to the
Differences in the Domestic and Foreign Interest R...
Lecture 18 24
Purchasing Power Parity: (1)
Uncovered Interest Parity: (2)
Using the Fisher equation (2) becomes
(3)
Slight...
Lecture 18 25
Like the PPP, UIP is also valid only in the long run
Compare the interest rates and Exchange Rates between 2...
Lecture 18 26
Exchange Rate Systems: Capital Mobility
• Flexible exchange rates: The UK, U.S. and
Japan, EURO: Free Mobili...
Lecture 18 27
The Problems of Flexible Exchange Rates
The exchange rate can move for many other reasons
than changes in th...
Lecture 18 28
• Countries with poor reputation for controlling inflation
• It is better to fix exchange rate with a countr...
Lecture 18 29
Disadvantages of Fixed Exchange Rate System
Giving up the powerful exchange rate tool for external
stabilisa...
Lecture 18 30
Which countries benefit from a monetary union?
Criteria for an optimal currency area
• Higher Degree of Trad...
Lecture 18 31
Given these theories of Exchange Rate
Should UK join the European
Monetary Union?
Five Economic Tests: Issue...
Lecture 18 32
Exercises
Triangular exchange rate
Real and nominal exchange rates
Trade weighted exchange rate
Exchange rat...
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Exchangerate 18exchange rates-explanation

  1. 1. Lecture 18 1 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))
  2. 2. 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 Income = demand Economy wide saving = Trade balance Balance of payment condition Current account +capital account =0
  3. 3. 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 < 0>NX Trade Surplus Trade deficit 0<NX 0 i 0=−GT K-outflow K-inflow
  4. 4. Lecture 18 4 NX(λ) λ Real Exchange Rate Net export 45.1 £ $ = 60.1 £ $ = S-I Net capital outflow ( ) ( ) FlowCapMXIS =−−− Net capital inflow Why is not appreciation of domestic currency not good for Foreign Investment? ( ) 0=+− FlowCapMX
  5. 5. Lecture 18 5 Exchange Rate and the Demand and Supply of Foreign Currency E F Demand 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: 0.66 NX e
  6. 6. Lecture 18 6 Sterling Pound = Euro also appreciated = Euro also appreciated = Depreciation of Dollar against Pound or Appreciation of Pounds against dollar in 2002
  7. 7. 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 In 2001 one dollar in terms of pound and Euro is 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
  8. 8. Lecture 18 8 0 + - Y Y 0 AD Trade balance Keynesian Open Economy Model How an Expansion in Income causes Trade Deficit? ) * ,,(),()( P ePf YYNXG e iYITYCY ++−+−= π X=X0 M=M(Y) Surplus Deficit
  9. 9. 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 AD ollowing an increase in ER b) Shows investment saving Balance in an open economy c) Shows net export as a function of the exchange ate
  10. 10. Lecture 18 10 IS-LM Model in an Open Economy IS* e* LM (y, i) Output Exchange Rate o y
  11. 11. Lecture 18 11 Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems IS* IS*’ e1 e2 Y No Impact of Fiscal Policy under Flexible Exchange Rate System LM LM1 LM2 Effectiveness of Fiscal Policy Under the Fixed Exchange Rate System Y1 Y2 e IS* IS*’
  12. 12. Lecture 18 12 Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste IS* IS*’ e1 e2 Effectiveness of Monetary Policy under Flexible Exchange Rate System LM LM1 LM2 Ineffectiveness of monetary Policy Under the Fixed Exchange Rate System Y1 Y2 e IS* Y1 Y2
  13. 13. 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
  14. 14. 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 MacroIndicators2001 Macro Indicators and Trade Balances 2003
  15. 15. 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.
  16. 16. 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
  17. 17. Lecture 18 17 Real exchange rate : PPP-hypothesis: Where P* is foreign price level, P is the domestic price level, is the change in the nominal exchange rate is the nominal exchange rate = foreign inflation, = growth rate of money supply abroad, = growth rate of economy abroad; = domestic inflation, = growth rate of money supply at home, = growth rate of income at home Purchasing Power Parity Theory of the Exchange Rate: Long Run
  18. 18. Lecture 18 18 Since Similarly for Euro 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
  19. 19. 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. • 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.
  20. 20. Lecture 18 20 Covered and Uncovered interest parity Covered Interest Parity (no risk) 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):  Compare CIP and UIP is the forward Exchange rate
  21. 21. Lecture 18 21 i Y1 i E1 LM IS i1 IS2 i2 E2 Appreciation Depreciatio n UIP Impact of Fiscal Policy on the Exchange Rate, Interest Rate and Output: ISLM Model Y2 i
  22. 22. 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. Exchange rate expected in the next period. Applying rule of log for small numbers it can be written as ; • Adjustment in interest parity condition: domestic interest rate must be equal to foreign interest plus the expected change in the value of the currency.
  23. 23. Lecture 18 23 Appreciation or Depreciation of Currency According to the Differences in the Domestic and Foreign Interest Rates   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.
  24. 24. Lecture 18 24 Purchasing Power Parity: (1) Uncovered Interest Parity: (2) Using the Fisher equation (2) becomes (3) Slight rearrangement: (4) From PPP  When both PPP and UIP hold exactly the domestic and foreign real interest rates are equal.
  25. 25. Lecture 18 25 Like the PPP, UIP is also valid only in the long run Compare the interest rates and Exchange Rates between 2001 and 2002
  26. 26. 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
  27. 27. 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
  28. 28. 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?
  29. 29. 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.
  30. 30. 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 rate free capital mobility monetary independence Optimal Order of Liberalization 1st goods market (subsidies) 2nd Trade (Tariffs) Financial market (no control on r) Full convertibility
  31. 31. Lecture 18 31 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?
  32. 32. Lecture 18 32 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.
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