1. Classical Economics & Relative Prices

2. Classical Economics Classical economics relies on three main assumptions: Classical economics relies on three main assumptions:

3. Classical Economics Classical economics relies on three main assumptions: Classical economics relies on three main assumptions: Markets are perfectly competitive Markets are perfectly competitive All prices are flexible All prices are flexible Markets clear (equilibrium) Markets clear (equilibrium)

4. Classical Economics Classical economics relies on three main assumptions: Classical economics relies on three main assumptions: Markets are perfectly competitive Markets are perfectly competitive All prices are flexible All prices are flexible Markets clear (equilibrium) Markets clear (equilibrium) One key result is that all real variables are independent of monetary policy (money neutrality) One key result is that all real variables are independent of monetary policy (money neutrality)

5. Savings, Investment, and the Trade Balance Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities) Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities)

6. Savings, Investment, and the Trade Balance Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities) Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities) S = I + (G-T) S = Private Savings I = Private Investment (G-T) = Government Deficit/Surplus

7. Savings/Investment in a Closed Economy Without access to world capital markets, a country’s private saving is the sole source of funds. Therefore, the domestic interest rate must adjust to insure that S = I + (G-T) Without access to world capital markets, a country’s private saving is the sole source of funds. Therefore, the domestic interest rate must adjust to insure that S = I + (G-T) In this example, the domestic interest rate is equal to 10% and S = I +(G-T) = 300 In this example, the domestic interest rate is equal to 10% and S = I +(G-T) = 300 What will happen if we expose this country to trade? What will happen if we expose this country to trade?

8. Savings in the Open Economy In an open economy, the rest of the world becomes an added source of demand/supply of marketable securities In an open economy, the rest of the world becomes an added source of demand/supply of marketable securities S = I + (G-T) + NX Further, perfect capital mobility insures that all countries have the same (risk adjusted) real interest rate.

9. Savings in the Open Economy Again, a trade deficit implies NX<0 Again, a trade deficit implies NX<0 Therefore, S – (I – (G-T)) = NX < 0 Therefore, S – (I – (G-T)) = NX < 0

10. Savings in the Open Economy Again, a trade deficit implies NX<0 Again, a trade deficit implies NX<0 Therefore, S – (I – (G-T)) = NX < 0 Therefore, S – (I – (G-T)) = NX < 0 A country with a trade deficit is borrowing from the rest of the world A country with a trade deficit is borrowing from the rest of the world That is, domestic supply of marketable securities is greater than domestic demand That is, domestic supply of marketable securities is greater than domestic demand

11. Adding Net Exports to Capital Markets Suppose that the prevailing world (real) interest rate is 6% Suppose that the prevailing world (real) interest rate is 6%

12. Adding Net Exports to Capital Markets Suppose that the prevailing world (real) interest rate is 6% Suppose that the prevailing world (real) interest rate is 6% At 6%, At 6%, S = $100 S = $100 I + (G-T) = $500 I + (G-T) = $500 NX = $100 - $500 = - $400 NX = $100 - $500 = - $400

13. Adding Net Exports to Capital Markets Suppose that the prevailing world (real) interest rate is 14% Suppose that the prevailing world (real) interest rate is 14%

14. Adding Net Exports to Capital Markets Suppose that the prevailing world (real) interest rate is 14% Suppose that the prevailing world (real) interest rate is 14% S = $500 S = $500 I + (G-T) = $100 I + (G-T) = $100 NX = $500 - $100 = $400 NX = $500 - $100 = $400

15. Where does the world interest rate come from? Aggregate world savings is the sum of private savings across countries Aggregate world savings is the sum of private savings across countries Aggregate Private Investment and Government Deficits are also summed over all countries Aggregate Private Investment and Government Deficits are also summed over all countries By definition, NX summed over all countries must equal zero. Therefore, at the real world equilibrium interest rate, By definition, NX summed over all countries must equal zero. Therefore, at the real world equilibrium interest rate, S = I + (G-T) In this example, r = 11% In this example, r = 11%

16. Example: An increase in productivity Suppose that trade is initially balanced. A rise in productivity increases investment demand Suppose that trade is initially balanced. A rise in productivity increases investment demand

17. Example: An increase in productivity Suppose that trade is initially balanced. A rise in productivity increases investment demand Suppose that trade is initially balanced. A rise in productivity increases investment demand In a closed economy, interest rates would rise In a closed economy, interest rates would rise

18. Example: An increase in productivity Suppose that trade is initially balanced. A rise in productivity increases investment demand Suppose that trade is initially balanced. A rise in productivity increases investment demand In a closed economy, interest rates would rise In a closed economy, interest rates would rise In an open economy, the trade deficit would increase. In the case, the deficit increases from zero to - $15,000 In an open economy, the trade deficit would increase. In the case, the deficit increases from zero to - $15,000 Do interest rates rise at all? Do interest rates rise at all?

19. World Capital Markets A country’s ability to influence world interest rates depends on its size relative to the world economy (recall, global interest rates are determined such that global capital markets clear) A country’s ability to influence world interest rates depends on its size relative to the world economy (recall, global interest rates are determined such that global capital markets clear) The US makes up roughly 35% of the global economy. Therefore, the US can significantly influence global interest rates (as can Japan, EU, and China) The US makes up roughly 35% of the global economy. Therefore, the US can significantly influence global interest rates (as can Japan, EU, and China) The rest of the world has little influence unless it acts as a unified group (Latin American Financial Crisis, Asian Crisis) The rest of the world has little influence unless it acts as a unified group (Latin American Financial Crisis, Asian Crisis)

20. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E

21. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E P* = E190 (E Price in Europe)

22. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E What should happen here? What should happen here? P* = E190 (E Price in Europe) eP* = ($1.17/E)(E190) = $222.30

23. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E What should happen here? What should happen here? A profit can be made by buying TVs in the US and selling them in Europe. A profit can be made by buying TVs in the US and selling them in Europe. P* = E190 (E Price in Europe) eP* = ($1.17/E)(E190) = $222.30

24. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP*

25. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E

26. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E P = $200 P* = E190 P = eP*

27. Exchange Rates and Price Levels The Law of One Price (LOOP) states that the same product should cost the same in every location The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E P = $200 P* = E190 P = eP* e = P/P* = $200/E190 = $1.05/E

28. Purchasing Power Parity Purchasing power parity (PPP) is simply LOOP applied to general price indices Purchasing power parity (PPP) is simply LOOP applied to general price indices P = eP*

29. Purchasing Power Parity Purchasing power parity (PPP) is simply LOOP applied to general price indices Purchasing power parity (PPP) is simply LOOP applied to general price indices P = eP* A more useful form of PPP is A more useful form of PPP is %Change in e = Inflation – Inflation*

30. Purchasing Power Parity Purchasing power parity (PPP) is simply LOOP applied to general price indices Purchasing power parity (PPP) is simply LOOP applied to general price indices P = eP* A more useful form of PPP is A more useful form of PPP is %Change in e = Inflation – Inflation* For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year. For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year.

31. PPP and the “Fundamentals” Again, recall that PPP gives the following formula for the nominal exchange rate: Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P*

32. PPP and the “Fundamentals” Again, recall that PPP gives the following formula for the nominal exchange rate: Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P* Further, the quantity theory give the price level as a function of money and output Further, the quantity theory give the price level as a function of money and output P = MV/Y

33. PPP and the “Fundamentals” Again, recall that PPP gives the following formula for the nominal exchange rate: Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P* Further, the quantity theory give the price level as a function of money and output Further, the quantity theory give the price level as a function of money and output P = MV/Y Combining the two, Combining the two, e = (V/V*)(M/M*)(Y*/Y) V,M,and Y are exchange rate “fundamentals” V,M,and Y are exchange rate “fundamentals”

34. PPP and the Real Exchange Rate While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods q = eP*/P

35. PPP and the Real Exchange Rate While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods q = eP*/P PPP implies that the real exchange is always constant (actually, its equal to 1) PPP implies that the real exchange is always constant (actually, its equal to 1)

36. Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E

37. Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Each $1 invested in the US will be worth $1.05 in a year. How about each $ invested in Europe?

38. Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Each $1 invested in the US will be worth $1.05 in a year. How about each $1 invested in Europe? $1 = (1/1.15) =.87E.87E(1.07) =.93E.93E ($1.10/E) = $1.02

39. Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Each $1 invested in the US will be worth $1.05 in a year. How about each $1 invested in Europe? $1 = (1/1.15) =.87E.87E(1.07) =.93E.93E ($1.10/E) = $1.02 Even with the higher return in Europe, the 5% appreciation of the dollar makes the US asset a better investment. Therefore, funds will flow to the US.

40. Interest Rate Parity Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e)

41. Interest Rate Parity Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e) A more useful form is A more useful form is i – i* = % change in e For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen

42. Interest Rate Parity Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e) A more useful form is A more useful form is i – i* = % change in e For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen Interest rate parity fails just as badly as PPP. Interest rate parity fails just as badly as PPP.

43. Interest Rate Parity & PPP Recall that PPP gives the following: Recall that PPP gives the following: % change in e = Inflation – Inflation*

44. Interest Rate Parity & PPP Recall that PPP gives the following: Recall that PPP gives the following: % change in e = Inflation – Inflation* Interest Parity gives the following: Interest Parity gives the following: i – i* = % change in e

45. Interest Rate Parity & PPP Recall that PPP gives the following: Recall that PPP gives the following: % change in e = Inflation – Inflation* Interest Parity gives the following: Interest Parity gives the following: i – i* = % change in e Combining them gives us Combining them gives us i – i* = Inflation – Inflation*

46. Interest Rate Parity & PPP Recall that PPP gives the following: Recall that PPP gives the following: % change in e = Inflation – Inflation* Interest Parity gives the following: Interest Parity gives the following: i – i* = % change in e Combining them gives us Combining them gives us i – i* = Inflation – Inflation* i – Inflation = i* - Inflation*

47. Interest Rate Parity & PPP Recall that PPP gives the following: Recall that PPP gives the following: % change in e = Inflation – Inflation* Interest Parity gives the following: Interest Parity gives the following: i – i* = % change in e Combining them gives us Combining them gives us i – i* = Inflation – Inflation* i – Inflation = i* - Inflation* r = r* r = r*

48. Summary of Classical Exchange Rate Theory Real interest differentials across countries are zero. Real interest differentials across countries are zero. The trade balance is equal to S – (I + (G-T)) at the world interest rate The trade balance is equal to S – (I + (G-T)) at the world interest rate Real exchange rates are constant Real exchange rates are constant Nominal Exchange rates are related to the “fundamentals” Nominal Exchange rates are related to the “fundamentals” e = (V/V*)(M/M*)(Y*/Y) There is no obvious correlation between trade balances, interest rates and exchange rates There is no obvious correlation between trade balances, interest rates and exchange rates

49. Exchange Rates & the Fundamentals (JPY/USD)

50. Exchange Rates & the Fundamentals (GBP/USD)

51. Nominal/Real Exchange Rates

54. Explaining Deviations from PPP Transportation costs, tariffs, taxes, etc. interfere with LOOP Transportation costs, tariffs, taxes, etc. interfere with LOOP Non-Traded goods Non-Traded goods Changes in Terms of Trade Changes in Terms of Trade Price indices are constructed differently Price indices are constructed differently Fixed prices in the short run (Keynesian Economics) Fixed prices in the short run (Keynesian Economics)

55. Trading Costs: An Example Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300

56. Trading Costs: An Example Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 The LOOP exchange rate (GBP/USD)will be equal to The LOOP exchange rate (GBP/USD)will be equal to e = P*/P = L 210 / $300 = L.7/$

57. Trading Costs: An Example Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 Suppose that the price of gold in Britain is L 210 while the price of gold in the US is $300 The LOOP exchange rate (USD/GBP) will be equal to The LOOP exchange rate (USD/GBP) will be equal to e = P/P* = $300 / L210 = $1.43/L If the exchange rate deviates from.1.43, profits from arbitrage would be If the exchange rate deviates from.1.43, profits from arbitrage would be P – eP* (Buy in GB, sell in US) eP* - P (Buy in US, sell in GB)

58. Trading Costs: An Example Now, assume a $10 trading cost Now, assume a $10 trading cost Profits from arbitrage would now be Profits from arbitrage would now be P – (eP*+10) (Buy in GB, sell in US) eP* - (P+10) (Buy in US, sell in GB)

59. Trading Costs: An Example Now, assume a $10 trading cost Now, assume a $10 trading cost Profits from arbitrage would now be Profits from arbitrage would now be P – (eP*+10) (Buy in GB, sell in US) eP* - (P+10) (Buy in US, sell in GB) Solving for the exchange rate gives us a range in which arbitrage is not profitable Solving for the exchange rate gives us a range in which arbitrage is not profitable (P-10)/P* < e < (P+10)/P* 1.38 < e < 1.47

60. Trading Costs: An Example

61. Non-Traded Goods: An Example Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined (in both Britain and the US) as P =.3(Tickets) +.7(Gold) Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined (in both Britain and the US) as P =.3(Tickets) +.7(Gold)

62. Non-Traded Goods: An Example Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined (in both Britain and the US) as P =.3(Tickets) +.7(Gold) Suppose that in addition to gold, we add theatre tickets. Theatre tickets in the US cost $40 while in Britain, similar tickets cost L 30. Further, assume that the price index is defined (in both Britain and the US) as P =.3(Tickets) +.7(Gold) CPI =.3(40) +.7(300) = $222 CPI =.3(40) +.7(300) = $222 CPI* =.3(30) +.7(210) = L156 CPI* =.3(30) +.7(210) = L156

63. Non-Traded Goods: An Example CPI* =.3(30) +.7(210) = L156 CPI* =.3(30) +.7(210) = L156 CPI =.3(40) +.7(300) = $222 CPI =.3(40) +.7(300) = $222 Arbitrage will insure the nominal exchange rate will equal Arbitrage will insure the nominal exchange rate will equal E = P/P* = 300/210 = $1.43/L E = P/P* = 300/210 = $1.43/L

64. Non-Traded Goods: An Example CPI* =.3(30) +.7(210) = L156 CPI* =.3(30) +.7(210) = L156 CPI =.3(40) +.7(300) = $222 CPI =.3(40) +.7(300) = $222 Arbitrage will insure the nominal exchange rate will equal Arbitrage will insure the nominal exchange rate will equal e = P/P* = 300/210 = $1.43/L e = P/P* = 300/210 = $1.43/L The real exchange rate equals The real exchange rate equals q = e(CPI*/CPI) = 1.43(156/222) = 1 q = e(CPI*/CPI) = 1.43(156/222) = 1

65. Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. Suppose that the price of a theatre ticket in the US increases to $50.

66. Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. Suppose that the price of a theatre ticket in the US increases to $50. CPI* =.3(30) +.7(210) = L156 CPI* =.3(30) +.7(210) = L156 CPI =.3(50) +.7(300) = $225 CPI =.3(50) +.7(300) = $225

67. Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. Suppose that the price of a theatre ticket in the US increases to $50. CPI* =.3(30) +.7(210) = L156 CPI* =.3(30) +.7(210) = L156 CPI =.3(50) +.7(300) = $225 CPI =.3(50) +.7(300) = $225 the nominal exchange rate stays at the nominal exchange rate stays at e = P/P* = 300/210 = $1.43/L e = P/P* = 300/210 = $1.43/L

68. Non-Traded Goods: An Example Suppose that the price of a theatre ticket in the US increases to $50. Suppose that the price of a theatre ticket in the US increases to $50. CPI* =.3(30) +.7(210) = L156 CPI* =.3(30) +.7(210) = L156 CPI =.3(50) +.7(300) = $225 CPI =.3(50) +.7(300) = $225 the nominal exchange rate stays at the nominal exchange rate stays at e = P/P* = 300/210 = $1.43/L e = P/P* = 300/210 = $1.43/L The real exchange rate equals The real exchange rate equals q = e(CPI*/CPI) = 1.43(156/225) =.991 (A real appreciation) q = e(CPI*/CPI) = 1.43(156/225) =.991 (A real appreciation)

69. Relative Prices and Classical Economics Classical theory begins with the real exchange rate (q) Classical theory begins with the real exchange rate (q)

70. Relative Prices and Classical Economics Classical theory begins with the real exchange rate (q) Classical theory begins with the real exchange rate (q) Given movements of the real exchange rate, the nominal exchange rate evolves according to Given movements of the real exchange rate, the nominal exchange rate evolves according to e = q(Fundamentals) e = q(Fundamentals) = q(V/V*)(M/M*)(Y*/Y) = q(V/V*)(M/M*)(Y*/Y)

71. Example The US dollar experienced a sharp appreciation during the eighties. The US dollar experienced a sharp appreciation during the eighties.

72. Example

73. Example This could be explained by an increase in the relative price of non-tradeables This could be explained by an increase in the relative price of non-tradeables Globalization lowered manufactured goods prices Globalization lowered manufactured goods prices Falling equipment prices (computers) Falling equipment prices (computers) Rising cost of services (healthcare) Rising cost of services (healthcare) This, however, can’t explain the decline in the dollar in the late eighties This, however, can’t explain the decline in the dollar in the late eighties

74. Real exchange rates and real interest differentials Recall the interest parity condition Recall the interest parity condition (i-i*) = %change in e (i-i*) = %change in e Subtracting inflation from both sides gives us a real interest parity condition Subtracting inflation from both sides gives us a real interest parity condition (r-r*) = %change in q (r-r*) = %change in q

75. Relative Prices and the Trade Balance (r-r*) = %change in q (r-r*) = %change in q Therefore, a real depreciation (an increase in q) forces a rise in domestic interest rates (to compensate for declining dollar values) Therefore, a real depreciation (an increase in q) forces a rise in domestic interest rates (to compensate for declining dollar values)

76. Relative Prices and the Trade Balance Higher interest rates increase domestic savings while lowering domestic investment. This improves the trade balance Higher interest rates increase domestic savings while lowering domestic investment. This improves the trade balance

77. Classical Exchange Rate Theory and Relative Prices Real exchange rates are determined by relative price changes Real exchange rates are determined by relative price changes Nominal Exchange rates are related to the real exchange rate plus the “fundamentals” Nominal Exchange rates are related to the real exchange rate plus the “fundamentals” e = q (V/V*)(M/M*)(Y*/Y) Real interest differentials across countries are positively related to real exchange rate changes Real interest differentials across countries are positively related to real exchange rate changes Real depreciations (appreciations) will improve (worsen) the trade balances. Real depreciations (appreciations) will improve (worsen) the trade balances.