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Lecture 181 Macroeconomic Analysis 2003 Exchange Rate:PPP, UIP and CIP Theories of exchange rate Advantages and disadvantages of fixed and flexible exchange.

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Presentation on theme: "Lecture 181 Macroeconomic Analysis 2003 Exchange Rate:PPP, UIP and CIP Theories of exchange rate Advantages and disadvantages of fixed and flexible exchange."— Presentation transcript:

1 Lecture 181 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 Lecture 182 Fundamental Macroeconomic Identity for an open economy

3 Lecture 183 Three GAPs: Investment-Saving, Budget and Trade Gaps i Saving and Investment I(r) S(Y) Private saving +public saving = net export Trade Surplus Trade deficit 0 i K-outflow K-inflow

4 Lecture 184 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?

5 Lecture 185 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 2002: 2003: 0.66 NX e

6 Lecture 186 Depreciation of Dollar against Pound or Appreciation of Pounds against dollar in 2002

7 Lecture 187 Triangular Exchange Rates and Appreciation and Depreciation with respect to the Third Currency

8 Lecture Y Y 0 AD Trade balance Keynesian Open Economy Model How an Expansion in Income causes Trade Deficit? X=X0 M=M(Y) Surplus Deficit

9 Lecture 189 Derivation of Net Exports and Investment Saving in an Open Economy ΔNX AD Y e Y1Y2 e2 e1 IS*(e) y1 Y2 AD NX (e) NX2NX1 (a) (b) (c) 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

10 Lecture 1810 IS-LM Model in an Open Economy IS* e* LM (y, i) Output Exchange Rate o y

11 Lecture 1811 Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems 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 Y1Y2 e IS*

12 Lecture 1812 Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems 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 Y1Y2 e IS* Y1Y2

13 Lecture 1813 Macro Indicators and Trade Balances December 2002 Macro Economic IndicatorsUKEURO- Area USAJapan Budget deficit as % of GDP Inflation rate (% change in CPI) Interest rate (% per year on 3-month money market) Trade balance (in billion US $) Current Account balance (in billion US $) Exchange rate (per US $) Growth rate of GDP (annual %) Growth rate of money supply (%)

14 Lecture 1814 Macro Economic IndicatorsUKEURO- Area USAJapan Budget deficit as % of GDP Inflation rate (% change in CPI) Unemployment rate (%) Interest rate (% per year on 3-month money market) Trade balance (in billion US $) Current Account balance (in billion US $) Exchange rate (per US $) Growth rate of GDP (annual %) Growth rate of money supply (%) Macro Indicators 2001 Macro Indicators and Trade Balances 2003

15 Lecture 1815 Exchange Rate of Sterling Pound with Dollar, Euro and Yen $/£ Y/£ US$ Eff. Rate Euro-area Yen Value of one US Dollar in Terms of Local Currency GhanaIndiaItalyBrazilTurkeyUK E E E E , Source: And Penn World Table.

16 Lecture 1816 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 Lecture 1817 Purchasing Power Parity Theory of the Exchange Rate: Long Run

18 Lecture 1818 PPP is Valid in the Long run PPP is not valid in the short run GhanaIndiaItalyBrazilTurkeyUK E E E E ,2080.7

19 Lecture 1819 Fundamentals of A Stable Exchange Rate according to the PPP Theory

20 Lecture 1820 Covered and Uncovered interest parity

21 Lecture 1821 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

22 Lecture 1822 Uncovered Interest Parity Theory of the Exchange Rate

23 Lecture 1823 Appreciation or Depreciation of Currency According to the Differences in the Domestic and Foreign Interest Rates

24 Lecture 1824

25 Lecture 1825 Like the PPP, UIP is also valid only in the long run Compare the interest rates and Exchange Rates between 2001 and 2002

26 Lecture 1826 Exchange Rate Systems: Capital Mobility

27 Lecture 1827 The Problems of Flexible Exchange Rates

28 Lecture 1828 Which countries should have fixed exchange rates?

29 Lecture 1829 Disadvantages of Fixed Exchange Rate System

30 Lecture 1830 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

31 Lecture 1831 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 Lecture 1832 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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