1 Welcome to EC 382: International Economics By: Dr. Jacqueline Khorassani Week Eleven

2 Week Eleven: Class 1 Tuesday, November 13 Tuesday, November 13 14:10-15:00 AC :10-15:00 AC 202

3 I received a question Can you please explain again with some examples the open market operations? thank you Can you please explain again with some examples the open market operations? thank you

4 Answer Bank of Ireland has some government bonds. Bank of Ireland has some government bonds. If the central bank wants to increase the supply of money If the central bank wants to increase the supply of money –Offer higher than normal prices for bonds –Bank of Ireland sell their €1000 bond to the central bank –Central bank makes a €1000 deposit into their Bank of Ireland Reserve Account at the central bank. –Bank of Ireland’s reserves goes up  Bank of Ireland make more loans  that means the people (borrowers) will have more money in their checking accounts (borrowed)  M1 goes up  MS goes up

5 Firms Firms individuals individuals The central bank supplies money. Who demands money?

6 1)To buy goods and services. Transactions demand for money Transactions demand for money Varies directly with nominal GDP Varies directly with nominal GDP 2)In case of emergencies that require purchases above normal spending levels  Precautionary demand for money 3) As an asset Why do we demand money (M1)?

7 If interest rates go up, do we demand more or less money? If interest rates go up, do we demand more or less money? –Less interest rate is the opportunity cost of holding money interest rate is the opportunity cost of holding money If the price level goes up, do we demand more or less money? If the price level goes up, do we demand more or less money? –More need more money to cover our purchases need more money to cover our purchases Three motivations for holding money combine to create the aggregate demand for money

8 If our income goes up, will we demand more or less money? If our income goes up, will we demand more or less money? –More Can afford to buy more goods and services Can afford to buy more goods and services Money demand related to interest rate, price level and real income as: Money demand related to interest rate, price level and real income as: MD = f(-i, +P, +Y) MD = f(-i, +P, +Y) i = Interest rate P = Price level Y = Real GDP

9 Money Demand Curve Interest Rate (i) Money (M) Demand for Money (MD) Shows the relationship between interest rate and the quantity of money demanded holding everything else constant

10 What shifts the Money Demand Curve? Interest Rate (i) Money (M) Demand for Money (MD) D1 D2 Increase to D1 if P ↑ or Y↑ Decrease to D2 if P ↓ or Y↓

11 i The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand Interest Rate (i) Money (M) Demand for Money (MD) Supply for Money (MS)

12 i How does an increase in the price level affect the interest rates? Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) MD 2 i2i2 G E MD ↑ i↑

13 i How does a economic recession affect the interest rate? Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) MD1 i1i1 E F MD ↓ i↓

14 i How does an open market sale by the central bank affect the interest rate? Interest Rate (i) Money (M) Supply for Money (MS) Demand for Money (MD) i2i2 MS 2 MS ↓ i↑ This is a contractionary monetary policy

15 Another Question I'm trying to understand the example in page 329 about appreciation and depreciation but I think there's something wrong in it. Can you do it in class? I'm trying to understand the example in page 329 about appreciation and depreciation but I think there's something wrong in it. Can you do it in class?

16 My answer Let go over it together Let go over it together

17 How does the interest rate relate to the exchange rate? How does the interest rate relate to the exchange rate? Interest Arbitrage: Interest Arbitrage: –Relationship between interest rates and the exchange rate in the short run

18 International Economics Week Eleven –Class 2 Week Eleven –Class 2 –Wednesday, November 14 –11:10-12:00 –Tyndall

19 Final Exam Is a 2 hour exam Is a 2 hour exam Covers everything Covers everything –Chapters 1 through 8 –Chapters 11, 13, 14, and 15 –Notes/Slides/Assignments Has 3 parts: Has 3 parts: 1.15 MCQ (3 points for correct answers and -0.5 point for incorrect answers.)  total = 45 points 2.Choose 2 of 4 essay questions for 20 points each  total = 40 points 3.Three problems  total = 65 points

20 Remember yesterday’s question: I'm trying to understand the example in page 329 about appreciation and depreciation but I think there's something wrong in it. Can you do it in class? I'm trying to understand the example in page 329 about appreciation and depreciation but I think there's something wrong in it. Can you do it in class?

21 Example: Example: –You own a company in U.S. looking to invest $10,000 cash. –Assume U.K. has the best rate of 12%. –You must first buy pounds in the foreign exchange market, then invest pounds in U.K. market. –If spot exchange rate is $2/pound, which gives you £5000 to invest The Interest Rate And the Exchange Rate in the Short Run

22 Example (continued): Example (continued): –In 3 months the money will be worth 5000 (1+0.12/4) = £5, (1+0.12/4) = £5,150 1.If the exchange rate is the same, you will get 5,150 * 2 = $10,300 5,150 * 2 = $10,300 The Interest Rate And the Exchange Rate in the Short Run

23 The Interest Rate And the Exchange Rate in the Short Run 2. If pound drops to $1.975/pound –By how much has pound depreciated? [( ) / 2] * 100 = %1.25 in 3 months the books says 5% (that is the annual rate)  1.25 * 4 = 5% depreciation the books says 5% (that is the annual rate)  1.25 * 4 = 5% depreciation –You end up with £5,150 * = $10, –So what is your rate of return? [(10, ,000)/10,000] * 4 = 7%

24 So your total rate of return is the difference between annual interest rate in U.K. (12%) and depreciation of the pound (5%) = approx. 7%. difference between annual interest rate in U.K. (12%) and depreciation of the pound (5%) = approx. 7%.

25 If the pound appreciates by 5% If the pound appreciates by 5% –Total return is sum of annual interest rate in U.K. (12%) and appreciation of the pound (5%) = approx. 17% Similarly

26 Buy foreign currency in spot exchange market Buy foreign currency in spot exchange market At same time sell pound in forward exchange market delivering on date of investment’s maturity At same time sell pound in forward exchange market delivering on date of investment’s maturity 1. If forward rate > current spot rate (pound is selling at a forward premium) –more profitable to invest in U.K. 2. If forward rate < current spot rate (pound is selling at forward discount) – must compare the gain in favorable interest rate to loss suffered by exchange rate To eliminate exchange- rate risk

27 Annual yield (interest rate) on US bond = 10% Annual yield (interest rate) on US bond = 10% Annual yield (interest rate) on Irish bond = 6% Annual yield (interest rate) on Irish bond = 6% Spot exchange rate  $1 = €1 Spot exchange rate  $1 = €1 Forward exchange rate  $1 = €1 Forward exchange rate  $1 = €1 But really the story is more complicated than that. Here is a rough numerical example to show the interest rate parity

28 So Irish will want to invest in the US Spot demand for dollar goes up  dollar appreciates by 1 % Spot demand for dollar goes up  dollar appreciates by 1 % Demand for US bonds goes up  price of bonds goes up  interest rate goes down by 1% point. Demand for US bonds goes up  price of bonds goes up  interest rate goes down by 1% point. Demand for Irish bonds goes down  price of bond goes down  interest rate goes up by 1% point. Demand for Irish bonds goes down  price of bond goes down  interest rate goes up by 1% point. Forwards supply of dollar goes up  dollar depreciates by 1% Forwards supply of dollar goes up  dollar depreciates by 1% Now Now –Dollar sells at 2% forward discount = Interest rate in US is 2% point higher than in Ireland

29 Interest rate parity Funds continue moving between the two countries until Funds continue moving between the two countries until –forward premium or discount equals the interest rate differential

30 International Economics Week Eleven - Class 3 Week Eleven - Class 3 –Wednesday, November 14 –15:10-16:00 –AC 201 Online grades were updated today. Online grades were updated today. ICA5 is graded and ready to be picked up ICA5 is graded and ready to be picked up

31 What does tightening of money in Ireland do to interest rates? What does tightening of money in Ireland do to interest rates? – MS declines  interest rates go up What does this do in the market for euro? What does this do in the market for euro? –Demand goes up  euro appreciates –Supply goes down  euro appreciates This process continues until interest parity is achieved. This process continues until interest parity is achieved. The Interest Rate And the Exchange Rate in the Short Run

32 Changes in Interest Rates: Changes in Interest Rates: –Increasing a country’s interest rate: Causes capital inflow Causes capital inflow Appreciation of a country’s currency Appreciation of a country’s currency –Decreasing a country’s interest rate: Causes capital outflow Causes capital outflow Depreciates a country’s currency Depreciates a country’s currency –Movement of capital causes change exchange rates –Interest rate volatility  exchange rate volatility Interest Rates, the Exchange Rate, and the Balance of Payments

33 Suppose there is no capital inflow or outflow S1 (imports of G & S) $/Euro Euros D1 (exports of G $ S) E At E, quantity demanded for euros = quantity supplied  current account balance D & S are due current account activities

34 Assume U.S. interest rates increase Assume U.S. interest rates increase –Capital moves into US. –Supply of euro increases –Does demand for euro decrease? No there was no capital inflow before. No there was no capital inflow before. What happens if there are now capital flows between countries?

35 S1 (imports of G & S) $/Euro Euros D1 (exports of G $ S) E1 S2 =S1 + capital outflow Supply shift right euro depreciates imports of goods and services go down to less than 200 exports of goods and services go up to more than 400 current account surplus = net capital outflow E2

36 Price Levels and Exchange Rates in the Long Run CHAPTER 15

37 Law of One Price: Law of One Price: –Identical goods sold in competitive markets should cost the same in all countries when prices are expressed in terms of the same currency Example: Example: –If exchange is 2$/Pound and a pair of shoes costs £200, then the same pair of shoes should cost $400 in U.S. (same price). The Law of One Price

38 It leaves room for arbitrage between the countries. It leaves room for arbitrage between the countries. Example: Example: Using the pair of shoes from U.K. Using the pair of shoes from U.K. –Exchange is $2/Pound, P U.K. = £200, and P U.S = $400 –If the price in U.S. rose to $500 and the exchange rate did not change, what would happen? What if The Law of One Price does not hold?

39 what would happen? Demand for Pounds would increase – U.S. importers need Pounds to buy shoes. Demand for Pounds would increase – U.S. importers need Pounds to buy shoes. –The $/Pound exchange rate would rise. Demand for UK shoes rise Demand for UK shoes rise – increasing price of shoes in UK Supply of shoes in the US will go up Supply of shoes in the US will go up –decreasing price of shoes in US Continues until prices are the same again. Continues until prices are the same again.

40 1. Transportation costs 2. Some goods are not tradable 3. Barriers to trade 4. Differences in tax rates and regulations But over time  market forces tend to push prices toward equality But over time  market forces tend to push prices toward equality But prices in most countries are not usually equal. Why?