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)) Lecture 18

Fundamental Macroeconomic Identity for an open economy Lecture 18

Three GAPs: Investment-Saving, Budget and Trade Gaps S(Y) Trade Surplus K-outflow i Private saving +public saving = net export i I(r) Trade deficit K-inflow Saving and Investment Lecture 18

Why is not appreciation of domestic currency not good for Foreign Investment? Net capital outflow S-I Real Exchange Rate λ Net capital inflow NX(λ) Net export Lecture 18

Exchange Rate and the Demand and Supply of Foreign Currency 2002: Exports: X(E,Y*) Excess supply of FC E1 Depreciation E e 0.66 A NX Appreciation E2 2003: Excess Demand for FC Imports: M(E,Y) F Demand and supply of Foreign Currency Lecture 18

Depreciation of Dollar against Pound or Appreciation of Pounds against dollar in 2002 Lecture 18

Triangular Exchange Rates and Appreciation and Depreciation with respect to the Third Currency Lecture 18

Keynesian Open Economy Model How an Expansion in Income causes Trade Deficit? AD Y + X=X0 M=M(Y) Trade balance Surplus Y Deficit - Lecture 18

Derivation of Net Exports and Investment Saving in an Open Economy 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 AD (a) AD ΔNX Y1 Y2 Y (c) (b) e e2 e1 IS*(e) NX (e) Y2 y1 NX2 NX1 Lecture 18

IS-LM Model in an Open Economy LM (y, i) Exchange Rate e* IS* o Output y Lecture 18

Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems Effectiveness of Fiscal Policy Under the Fixed Exchange Rate System LM LM1 LM2 e2 IS*’ e e1 IS*’ IS* IS* Y1 Y2 Y No Impact of Fiscal Policy under Flexible Exchange Rate System Lecture 18

Ineffectiveness of monetary Policy Impact of Monetary Policy under Fixed and Flexible Exchange Rate Systems Ineffectiveness of monetary Policy Under the Fixed Exchange Rate System LM LM1 LM2 e2 e IS*’ e1 IS* IS* Y1 Y2 Y1 Y2 Effectiveness of Monetary Policy under Flexible Exchange Rate System Lecture 18

Macro Indicators and Trade Balances December 2002 Macro Economic Indicators UK EURO-Area USA Japan Budget deficit as % of GDP -1.4 -2.2 -3.1 -7.9 Inflation rate (% change in CPI) 2.1 2.2 2.6 -0.9 Interest rate (% per year on 3-month money market) 3.97 2.94 1.34 0.02 Trade balance (in billion US $) -49.0 95.6 -456.6 89.3 Current Account balance (in billion US $) 25.8 38.0 -462.2 113.9 Exchange rate (per US $) 0.63 0.98 1 121 Growth rate of GDP (annual %) 1.8 0.8 3.2 1.3 Growth rate of money supply (%) 5.8 7.0 6.6 Lecture 18

Macro Indicators and Trade Balances 2003 Macro Economic Indicators UK EURO-Area USA Japan Budget deficit as % of GDP 1.1 -1.2 0.6 -6.0 Inflation rate (% change in CPI) 1.6 2.1 2.2 -0.8 Unemployment rate (%) 5.2 8.1 5.6 5.3 Interest rate (% per year on 3-month money market) 3.97 3.35 1.84 0.02 Trade balance (in billion US $) -47.2 24.9 -438.9 74.9 Current Account balance (in billion US $) 17.7 -31.2 -430.7 3.2 Exchange rate (per US $) 0.69 1.11 1 128 Growth rate of GDP (annual %) 1.3 -0.5 Growth rate of money supply (%) 8.2 8.0 14.0 Macro Indicators 2001 Lecture 18

Exchange Rate of Sterling Pound with Dollar, Euro and Yen 1975 1985 1995 2000 2002 2003 US$ 2.22 1.298 1.578 1.515 1.44 1.6 Eff. Rate 129.6 111.3 84.8 107.5 107.3 Euro-area 1.697 1.71 1.191 1.642 1.63 1.46 Yen 658.1 307.1 148.4 163.3 191 188 $/£ Y/£ Value of one US Dollar in Terms of Local Currency Ghana India Italy Brazil Turkey UK 1955 0.7146 4.764 625 4.3E-11 2.831 0.3571 1965 4.763 625.1 2E-09 9.102 1975 1.15 8.653 652.8 8.1E-09 14.44 0.452 1985 54.37 12.24 1909 6.2E-06 522 0.7792 1990 326.3 17.95 1198 0.0683 2609 0.5632 2000 5231 45.7 2101 1.8 625,208 0.7 Source: http:/www.worldbank.org/data/countrydata/countrydata.htm, And Penn World Table. Lecture 18

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 Lecture 18

Purchasing Power Parity Theory of the Exchange Rate: Long Run Lecture 18

PPP is Valid in the Long run Ghana India Italy Brazil Turkey UK 1955 0.7146 4.764 625 4.3E-11 2.831 0.3571 1965 4.763 625.1 2E-09 9.102 1975 1.15 8.653 652.8 8.1E-09 14.44 0.452 1985 54.37 12.24 1909 6.2E-06 522 0.7792 1990 326.3 17.95 1198 0.0683 2609 0.5632 2000 5231 45.7 2101 1.8 625,208 0.7 PPP is not valid in the short run 2001- 2002 Lecture 18

Fundamentals of A Stable Exchange Rate according to the PPP Theory Lecture 18

Covered and Uncovered interest parity Lecture 18

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 Lecture 18

Uncovered Interest Parity Theory of the Exchange Rate Lecture 18

Appreciation or Depreciation of Currency According to the Differences in the Domestic and Foreign Interest Rates Lecture 18

Lecture 18

Like the PPP, UIP is also valid only in the long run Compare the interest rates and Exchange Rates between 2001 and 2002 Lecture 18

Exchange Rate Systems: Capital Mobility Lecture 18

The Problems of Flexible Exchange Rates Lecture 18

Which countries should have fixed exchange rates? Lecture 18

Disadvantages of Fixed Exchange Rate System Lecture 18

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 Lecture 18

Given these theories of Exchange Rate Should UK join the European Monetary Union? Five Economic Tests: Issues for Referendum Cyclical Convergence Flexibility Investment Financial Services Employment and Growth What Do YOU Think? Lecture 18

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. Lecture 18