12-1 Exchange Rate in the Long Run In the long run, exchange rate is determined by the relative purchasing power of the two currencies in their respective countries.

12-2 Exchange Rate in the Long Run Two currencies are considered to be at purchasing power parity (PPP) when one unit of either one of them buys the same basket of goods in both countries.

Real exchange rate Real exchange rate (R) shows the relative purchasing power of two currencies. (3) where P f : Price level in the foreign country P : Price level in the home country 12-3

Real exchange rate If R = 1, currencies are at PPP. If R > 1, goods abroad are more expensive than at home If R < 1, goods abroad are cheaper than those at home 12-4

PPP facts Today, it takes about 4 years to reduce deviations from PPP by half. PPP holds in the LR, but it is only one of the determinants of the exchange rate 12-5

12-6 Domestic spending in an open economy For an open economy, foreign trade must be incorporated into the IS-LM model With foreign trade, domestic spending no longer solely determines domestic output  spending on domestic goods determines domestic output  Spending by domestic residents is (4)  Spending on domestic goods is (5)  Assume DS depends on the interest rate and income: (6)

12-7 Net Exports Net exports = X - Q (when X > Q) NX is a function of  domestic income  foreign income, Y f (7)  R (real exch rate)  A rise in home income raises import spending and worsens the trade balance, decreasing AD  A rise in foreign income improves the home country’s trade balance and raises their AD  A real depreciation by the home country improves the trade balance and increases AD

12-8 Goods Market Equilibrium Marginal propensity to import = Fraction of an extra dollar of income spent on imports IS curve will be steeper in an open economy compared to a closed economy For a given reduction in interest rates, it takes a smaller increase in output and income to restore equilibrium in the goods market IS curve now includes NX as a component of AD (8) level of competitiveness (R) affects the IS curve A real depreciation increases the demand for domestic goods  shifts IS to the right An increase in Y f results in an increase in foreign spending on domestic goods  shifts IS to the right

12-9 Goods Market Equilibrium When foreign income increases, so does AD for home goods. This means higher output at the same level interest. IS shifts to the right, and the market reaches equil at a higher i-higher Y pt. Same dynamic occurs as a result of a real depreciation in the exchange rate Figure 12-3

12-10 Capital Mobility Assumption: Perfectly integrated financial markets = Perfect capital mobility ( = Investors can purchase in any country for low transaction costs in unlimited amounts) Result: No country can have abnormal interest rates (Capital flows in and out of the country would bring the rates to normal levels)

12-11 Capital Flows and Balance of Payments Balance of payments surplus = BP = NX + CF (9) where NX: f(Y, Y f, R) CF (Cap acct surp): f(i – i f ) Discuss TR econ with respect to NX and CF.

12-12 Mundell-Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates Mundell-Fleming Model: IS-LM when foreign exchange under perfect capital mobility is factored in.

12-13 IS-LM Model Recap The graph that shows the level of GDP and interest rates at which both goods & services market and money market are at equilibrium.

12-14 IS Curve/Schedule. In “real” markets (goods or services = Non-financial markets). IS curve shows equilibrium points between Investments and Savings (points where total private investment equals total savings of consumers, government and foreign trade). Y = C+I+G+NX. In IS curve, i is the independent variable.

12-15 LM Curve/Schedule. In money (financial) markets. LM curve shows equilibrium points between Liquidity Preference and Money Supply (points where demand and supply of money intersects).. In LM curve, Y is the independent variable.. When Y increases, liq pref function moves right, and interest rates increase.

12-16 Mundell-Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates Mundell-Fleming Model says: Under perfect capital mobility, any interest differential attracts infinite capital inflows, which disallows the central bank to conduct an independent monetary policy. Because: In order to prevent the exchange rate to go off, Central Bank has to follow only one type of strategy (but not any other)

12-17 Mundell-Fleming Model: Perfect Capital Mobility Under Fixed Exchange Rates For ex: Suppose the bank tightens money supply to increase interest rates. International investors would shift their money into the country Balance of payments registers a surplus Demand for domestic currency exceeds its supply, and domestic currency appreciates To prevent it to hurt exports and trade balance, central bank intervenes to keep the exchange rate fixed The central bank buys foreign currency with domestic currency Domestic money stock increases, and interest rates drop Interest rates continue to drop until they return to the original level

12-18 Monetary Expansion BP schedule is horizontal under perfect capital mobility (i = i f ) A monetary expansion shifts LM to right (E’ becomes the new equil pt) At E’, there is a payments deficit. It applies pressure for exchange rate to depreciate Central bank intervenes, and sells foreign currency to bring in domestic currency Money supply falls, pushes interest rates up, and moves LM back to the original position Figure 12-5

12-19 Fiscal Expansion Under fixed exchange rate and perfect capital mobility, monetary policy is infeasible, but fiscal expansion is effective Fiscal expansion shifts the IS curve to the right (Interest rates and output increases) Due to higher interest rates, capital inflow increases, which appreciates the domestic currency To prevent it hurt exports and trade balance, central bank expands the money supply. (LM shifts to the right) Interest rates comes back to initial level, but output continues to increase.

12-20 Perfect Capital Mobility and Flexible Exchange Rates (Flexible exchange rate system: Central bank does not intervene in the market to control the exchange rate) When central bank cannot intervene, BP must equal zero Central bank cannot intervene in currency markets, but it can change the money supply. (Because there is no automatic link between money supply and BP)

12-21 Perfect capital mobility implies that BP = 0 when i = i f (10) If i > i f, demand for domestic currency exceeds its supply, which causes the currency to appreciate. Domestic goods become more expensive (IS shifts to left) Figure 12-6 Perfect Capital Mobility and Flexible Exchange Rates

12-22 How do various changes in foreign trade affect the output, interest rate, and exchange rate? If exports increase  Demand for domestic goods increases  IS shifts to the right  The new equilibrium (E’) moves towards forming at a higher income and interest levels  But it doesn’t reach there, because E’ is a disequilibrium pt (BP surplus) that appreciates the domestic currency, and bring the economy back to E. Figure 12-7

12-23 If there is a fiscal expansion  Same dynamic as the last slide. (Pressure for an increase in demand is countered by exchange appreciation) That is… Figure 12-7 Real disturbances to demand do not affect equilibrium output under flexible exchange rates with capital mobility. How do various changes in foreign trade affect the output, interest rate, and exchange rate?

12-24 If nominal money supply increases  The real stock of money (M/P) increases since P is fixed  At E there will be an excess supply of real money balances  To restore equilibrium, interest rates will have to fall  LM shifts to the right  At point E’, goods market is in equilibrium, but i is below the world level  capital inflows depreciate the exchange rate Figure 12-8 How do various changes in foreign trade affect the output, interest rate, and exchange rate?

12-25  Import prices increase, domestic goods more competitive, and demand for home goods expands  IS shifts right to E”, where i = i f  Result: A monetary expansion leads to an increase in output and a depreciation of the exchange rate under flexible rates Figure 12-8 Under fixed rates, the central bank cannot control the nominal money stock. Under flexible rates, the central bank can control the nominal money stock, and is a key aspect of that exchange rate system. How do various changes in foreign trade affect the output, interest rate, and exchange rate?

12-26 CONCLUSION: “Unholy Trinity” Capital mobility, fixed exchange rate and independent monetary policy constitute an unholy/impossible trinity. A government cannot have all three of them at the same time. It has to prioritize them, and choose two of the three.