Presentation on theme: "Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity"— Presentation transcript:
1 Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity Uncovered Interest ParityFixed or Flexible ER?@Keshab R. Bhattarai, Business School, University of Hull, UK
2 Why is not appreciation of domestic currency not good for Foreign Investment?Net capital outflowS-I2004RealExchangeRateAppreciation of PoundλCurrent A/C bal +capital A/C bal =0Net capital inflowNX(λ)2001Net exportWhen £ appreciate you get more $ per £.
3 Exchange Rate and the Demand and Supply of Foreign Currency 2001:Exports: X(E,Y*)Excess supply of FCE1DepreciationEe0.66ANXAppreciationE22004:Excess Demand for FCImports: M(E,Y)FDemand and supply of Foreign Currency [($) in UK]Dollar depreciated 23 percent between 2002 and 2004
4 Exchange Rate and the Demand and Supply of Foreign Currency 2003:Exports: X(E,Y*)Excess supply of FCE1DepreciationEe0.66ANXAppreciationE22004:Excess Demand for FCImports: M(E,Y)FDemand and supply of Foreign Currency [($) in UK]Dollar depreciated 23 percent between 2002 and 2004
5 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 ratesCountries with rapidly expanding money supply have depreciation exchange rates and countries with expanding money demand have appreciating currenciesIn 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 rateCountries 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.
6 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:
10 Impact of Fiscal Policy on the Exchange Rate, Interest Rate and Output: ISLM ModelIS2UIPLMiii2i1iISY2E1E2Y1AppreciationDepreciationFiscal expansion raises output andInterest rate and an appreciation
17 Benefits and cost of a Monetary Union and Optimal Liberalisation? Impossible trilogy:fixed exchange ratefree capital mobilitymonetary independenceOptimal Order of Liberalization1st goods market (subsidies)2nd Trade (Tariffs)Financial market (no control on r)Full convertibility
18 ReferencesBritain in EuroBlanchard (19,20) Mankiw (2) M&S (20)Dornbusch R. (1976) Expectations and Exchange Rate Dynamics, Journal of PoliticalEconomy, vol. 84, no.6.Fleming J. Marcus (1962) Domestic financial policies under fixed and under floatingexchange rates, IMF staff paper 9, November ,Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of MoneyCredit and Banking, 11, Aug.Mundell Robert (1961) A Theory of Optimal Currency Areas, American EconomicReview, September.Mundell R. A (1962) Capital mobility and stabilisation policy under fixed andflexible exchange rates, Canadian Journal of Economic and Political Science, 29,Mussa Micheal Empirical Regularities in the Behaviour of Exchange Rates andRogoff, 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, MITPress.Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33, No. 1, pp