Review Schedule (check web page for room numbers) Tomorrow 8 or 10am: meet with your TAs Tomorrow 7-8pm: usual weekly review Saturday: 12-2 Macro review, 2-4 Micro review Sunday: 12-2 Macro review, 2-4 Micro review Monday, 9am-5pm: office hours –Taylor: “Open house” style in Econ building Tuesday: Exam for Gates lecture people Wednesday: Exam for Kresge lecture people Everyday: on “ alert”

Exchange rate determination Exchange rate is the price of one currency in terms of another –example: the price of a dollar is 120 yen, or 1.6 DM, or 1.05 euros Like any price, the exchange rate is determined in markets by the forces of supply and demand But foreign exchange markets are quick moving, like bond or stock markets Hence, to determine the price we use “arbitrage type” reasoning

Purchasing power parity (PPP) Based on Law of One Price –Basic idea: the price of the same commodity should be about the same in different countries Example: Golf ball $1.50 in U.S. (P US = 1.50 dollars) Golf ball 200 yen in Japan (P F = 200 yen) –Implies that purchasing power parity exchange rate is 133 yen per dollar (133x 1.50 = 200) In general, E x P US = P F

How well does PPP work? Very well for large differences in inflation in different countries (large differences in P US versus P F ) –German mark depreciated sharply during hyperinflation of 1920s –Russian ruble depreciates sharply today during current inflation in Russia Very well for long periods of time –(see chart)

31_04 PERCENT JapanFranceItalyU.K.Germany  2  4  6 Inflation rate in each country minus U.S. inflation rate Appreciation (+) or depreciation (–) of the dollar compared with each currency (percent per year)

But PPP does not explain exchange rates very well over shorter periods of time Short-run deviations of exchange rates from PPP are due to interest rate differentials. If U.S. interest rate rises (falls) relative to interest rate in Japan or Europe, then the dollar will tend to appreciate (depreciate) Reason: Financial capital is highly mobile –People move their funds around quickly to get the highest rate of return: “hot money”

Some evidence that interest rate differentials help explain exchange rate movements

Major policy question: Fixed versus flexible exchange rates Examples of fixed exchange rate systems – Bretton Woods, Argentina today, European monetary system from mid 1980s till Jan ‘99 –common feature: country fixes (pegs) exchange rate to another currency Key Idea: Keeping exchange rates fixed requires that interest rates move together in different countries (car with 2 steering wheels) –loss of international monetary independence Example: U.K. dropping out of peg with Germany –but advantages of certainty and credibility

Marks and franks per dollar before and after Bretton Woods

Marks per frank before and after Bretton Woods

WELCOME TO A school for central bankers. Dedicated to teaching the science and art of monetary policy.

Listen again to how Kelly McGillis explains monetary policy to Tom Cruise

Monetary policy rule

Trying to affect the exchange rate without changing the interest rate Exchange market intervention –Example, U.S. government buys yen to keep the yen from depreciating –But capital flows are so quick and large these interventions are not very effective Resorting to capital controls –China, and now Malaysia

European Monetary Union Goal is to permanently fix exchange rates within Europe by moving to a single currency: the Euro Eleven countries participating: Germany, France, Italy, Spain, Netherlands, Ireland,... –U.K., Sweden not in Euroland will have one central bank: –the ECB will set interest rates just like the Fed –Starts operation in January 1999 Biggest challenge for ECB will be political

Stages: Euro deposits will exist in January 1999, but paper money does not come until 2002

Five parts of macro

END OF COURSE GOOD LUCK and LOVE ECON