Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity Uncovered Interest Parity Fixed or Flexible ER? @Keshab R. Bhattarai, Business School, University of Hull, UK

Why is not appreciation of domestic currency not good for Foreign Investment? Net capital outflow S-I 2004 Real Exchange Rate Appreciation of Pound λ Current A/C bal +capital A/C bal =0 Net capital inflow NX(λ) 2001 Net export When £ appreciate you get more $ per £.

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

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

Musa (1979) ’s seven stylised facts on exchange rates ( from p 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.

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:

Purchasing Power Parity Theory : Notations

Fundamentals of A Stable Exchange Rate according to the PPP Theory

Covered and Uncovered interest parity

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

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

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

The Problems of Flexible Exchange Rates

Which countries should have fixed exchange rates?

Disadvantages of Fixed Exchange Rate System

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

References Britain in Euro http://www.britainineurope.org.uk/home.phtml 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 , 369-379. 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, 475-85. 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 7265. 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. 13-47.