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1 Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity Uncovered Interest Parity Fixed or Flexible ER?

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Presentation on theme: "1 Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity Uncovered Interest Parity Fixed or Flexible ER?"— Presentation transcript:

1 1 Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity Uncovered Interest Parity Fixed or Flexible ER?

2 2 NX(λ) λ Real Exchange Rate Net export S-I Net capital outflow Net capital inflow Why is not appreciation of domestic currency not good for Foreign Investment? Current A/C bal +capital A/C bal =0 Appreciation of Pound When £ appreciate you get more $ per £

3 3 Exchange Rate and the Demand and Supply of Foreign Currency E F Demand and supply of Foreign Currency [($) in UK] Exports: X(E,Y*) Imports: M(E,Y) 0 E1 E2 Depreciation Appreciation Excess Demand for FC Excess supply of FC A 2001: 2004: 0.66 NX e Dollar depreciated 23 percent between 2002 and 2004

4 4 Exchange Rate and the Demand and Supply of Foreign Currency E F Demand and supply of Foreign Currency [($) in UK] Exports: X(E,Y*) Imports: M(E,Y) 0 E1 E2 Depreciation Appreciation Excess Demand for FC Excess supply of FC A 2003: 2004: 0.66 NX e Dollar depreciated 23 percent between 2002 and 2004

5 5 Musa (1979) s seven stylised facts on exchange rates ( from p.486 of the Burda and Wyplosz) On daily basis changes in foreign are largely unpredictable. On month to month basis over 90% are unpredictable, only 10% predictable. Countries with high inflation have depreciating currencies. And the rate of deprecation approximately is equals the differences in the national inflation rates Countries with rapidly expanding money supply have depreciation exchange rates and countries with expanding money demand have appreciating currencies In the long run, excess of domestic interest rate over foreign interest rate equals the expected appreciation of the foreign currency. Spot exchange rate tends to overshoot any smoothly adjusting measure of equilibrium exchange rate Countries with persistent trade deficits have depreciating currencies and countries with trade surplus have appreciating currencies in the long run. This relation is not obvious in the short run.

6 6 Purchasing Power Parity Theory of the Exchange Rate: Long Run Real Exchange Rate: Change in the real exchange rate: Stable real exchange rate implies: PPP-hypothesis:

7 7 Purchasing Power Parity Theory : Notations

8 8 Fundamentals of A Stable Exchange Rate according to the PPP Theory

9 9 Covered and Uncovered interest parity

10 10 i Y1 i E1 LM IS i1 IS2 i2 E2 Appreciation Depreciation UIP Impact of Fiscal Policy on the Exchange Rate, Interest Rate and Output: ISLM Model Y2 i Fiscal expansion raises output and Interest rate and an appreciation

11 11

12 12 Depreciation of Dollar or Appreciation of Pounds Between December 2001 and February 2004

13 13 Triangular Exchange Rates and Appreciation and Depreciation with respect to the Third Currency

14 14 The Problems of Flexible Exchange Rates

15 15 Which countries should have fixed exchange rates?

16 16 Disadvantages of Fixed Exchange Rate System

17 17 Benefits and cost of a Monetary Union and Optimal Liberalisation? Impossible trilogy: fixed exchange rate free capital mobility monetary independence Optimal Order of Liberalization 1 st goods market (subsidies) 2 nd Trade (Tariffs) Financial market (no control on r) Full convertibility

18 18 References Britain in Euro Blanchard (19,20) Mankiw (2) M&S (20) Dornbusch R. (1976) Expectations and Exchange Rate Dynamics, Journal of Political Economy, vol. 84, no.6. Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating exchange rates, IMF staff paper 9, November, Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money Credit and Banking, 11, Aug. Mundell Robert (1961) A Theory of Optimal Currency Areas, American Economic Review, September. Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and flexible exchange rates, Canadian Journal of Economic and Political Science, 29, Mussa Micheal Empirical Regularities in the Behaviour of Exchange Rates and Rogoff, K (1999) "International institutions for reducing global financial instability", Journal of Economic Perspectives, 1999 or NBER WP Rogoff K and M Obstfeld (1996) Foundation of International Macroeconomics, MIT Press. Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33, No. 1, pp


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