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))
Lecture 18

2. Fundamental Macroeconomic Identity for an open economy
Lecture 18

3. Three GAPs: Investment-Saving, Budget and Trade Gaps
S(Y)
Trade Surplus
K-outflow i
Private saving +public saving
= net export i
I(r)
Trade deficit
K-inflow
Saving and Investment
Lecture 18

4. Why is not appreciation of domestic currency
not good for Foreign Investment?
Net capital outflow
S-I
Real
Exchange
Rate λ
Net capital inflow
NX(λ)
Net export
Lecture 18

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

6. Depreciation of Dollar against Pound
or Appreciation of Pounds against dollar in 2002
Lecture 18

7. Triangular Exchange Rates and Appreciation
and Depreciation with respect to the Third Currency
Lecture 18

8. Keynesian Open Economy Model
How an Expansion in Income causes Trade Deficit? AD Y +
X=X0
M=M(Y)
Trade
balance
Surplus Y
Deficit -
Lecture 18

9. Derivation of Net Exports and Investment Saving in an Open Economy
Note:
Shows reduction in AD
following an increase in ER
(b) Shows investment saving
Balance in an open economy
(c) Shows net export as
a function of the exchange
rate AD
(a) AD
ΔNX Y1 Y2 Y
(c)
(b) e e2 e1
IS*(e)
NX (e) Y2 y1
NX2
NX1
Lecture 18

10. IS-LM Model in an Open Economy
LM (y, i)
Exchange Rate e*
IS* o
Output y
Lecture 18

11. 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

12. Ineffectiveness of monetary Policy
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems
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

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
Lecture 18

14. Macro Indicators and Trade Balances 2003
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 %)
1.3
-0.5
Growth rate of money supply (%)
8.2
8.0
14.0
Macro Indicators 2001
Lecture 18

15. 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
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
$/£
Y/£
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
4.763
625.1
2E-09
9.102
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:
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. Purchasing Power Parity Theory of the Exchange Rate: Long Run
Lecture 18

18. 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
4.763
625.1
2E-09
9.102
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
Lecture 18

19. Fundamentals of A Stable Exchange Rate according to the PPP Theory
Lecture 18

20. Covered and Uncovered interest parity
Lecture 18

21. Impact of Fiscal Policy on the Exchange Rate,
Interest Rate and Output: ISLM Model
IS2
UIP LM i i i2 i1 i IS Y2 E1 E2 Y1
Appreciation
Depreciation
Lecture 18

22. Uncovered Interest Parity Theory of the Exchange Rate
Lecture 18

23. Appreciation or Depreciation of Currency According to the Differences in the Domestic and Foreign Interest Rates
Lecture 18

24. 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
Lecture 18

26. Exchange Rate Systems: Capital Mobility
Lecture 18

27. The Problems of Flexible Exchange Rates
Lecture 18

28. Which countries should have fixed exchange rates?
Lecture 18

29. Disadvantages of Fixed Exchange Rate System
Lecture 18

30. 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
Lecture 18

31. Given these theories of Exchange Rate
Should UK join the European Monetary Union?
Five Economic Tests: Issues for Referendum
Cyclical Convergence
Flexibility
Investment
Financial Services
Employment and Growth
What Do YOU Think?
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.
Lecture 18