1

International Economics Final Exam Review

Chapter 10 : Intro to Exchange Rates & Forex Market

Exchange Rate:
the price of some foreign currency expressed in terms of a home or domestic currency

Reading the Dollar-Euro Exchange rate

1.15 $/euro means, to buy one euro, you would have to pay $1.15
United States is the Home Country or American Terms

Appreciation:
if one currency buys more of another currency
value has risen, appreciated, or strengthened

Depreciation:
if a currency buys less of another currency
value has fallen or weakened

Appreciation vs. Depreciation Example:

when the US/Euro exchange rate rises, more dollars are needed to buy one euro
the price of one euro goes up in terms of dollars
The US experiences depreciation & Euro against dollar appreciates
If the dollar is depreciating against the euro, the euro must be simultaneously appreciating against the
dollar

Bilateral Exchange Rate:

simplest type of exchange rate btw two countries
Multilateral is for a basket of currencies

Effective Exchange Rate:

Average of all the bilateral changes for each currency in the basket
important to see how currency has been affected to several countries, not just bilaterally

Generalization: Exchange Rate Changes

To make comparisons of prices across nations, must convert prices to a common cause changes in prices
of foreign goods expressed in the home currency
causes changes in prices of foreign goods, expressed in home currency
causes changes in the exchange rate in relative prices of goods produced in the home and foreign
countries
Home Country Ex.
(ER Depreciates) home exports become less expensive as imports to foreigners, and foreign exports
become more expensive as imports to home residents (Exports More)
(ER Appreciates) home exports become more expensive as imports to foreign countries, and foreign
exports become less expensive as imports to home residents (Import More)

Exchange Rate Regimes: Fixed vs. Floating

1. Fixed/Pegged
a. countrys exchange rate fluctuates in a narrow range (or not at all) against some base currency

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2. Floating/Flexible
a. countrys exchange rates fluctuate in wider range and govt makes no attempt to fix it against any base
currency
b. appreciations/depreciations may occur year to year, by the day, or minute

Free Float:
SR volatility, flexible with lots of ups and down day to day
peaks and troughs can take months
variations between countries about the same
Euro floats against the yen and the pound

Band:
fixed regime
tiny variation around a rate

Managed Float/Dirty Float/ Limited Flexibility:

middle ground btw fixed rate and free float
sometimes permitted to act like a float
sometimes govt acted to prevent abrupt currency movements

Exchange Rate Crises:

Sudden depreciation of currency
more common in developing countries

1.
2.
a.
3.
a.

Crawl:
Steadily depreciating at almost constant rate for several years
Crawling Peg
if ER follows a simple trend
Crawling Band
if ER has some variation about the trend
Currency Unions & Dollarization

Currency Union/Monetary Union:

there is some form of transnational structure such as central bank or monetary authority that is
accountable to member nations (Eurozone)

Dollarization:
One country unilaterally adopts the currency of another country
reasons vary: high costs of own central bank, poor record of managing currency, etc

Currency Board:
7 countries using ultra hard peg
fixed regime that has special legal and procedural rules designed to make peg harder or more durable
Most fixed are developing countries, while most floating are advanced countries
The Market For Foreign Exchange

Foreign Exchange Market (Forex or FX Mkt):

like any market, a collection of private individuals, corporations, and some public institutions that buy and
sell
This is the market that sets minute by minute Exchange rates all over the world
Prices determined by market forces
not an organized exchange, over the counter trades

Spot Contract:
happens on the spot
exchange rate always refers to the spot rate

Transaction Costs

Spreads:
difference btw buying and selling prices
fees an commissions that go to middlemen on retail channels
larger institutions have much smaller spreads
spreads are examples of markets frictions or transaction costs
Derivatives

called derivatives bc the contracts and their pricing are derived from the spot rate

1.
a.
b.
c.
2.
a.
b.
c.
3.
a.

Forwards
two parties make the contract today
but the settlement date for the delivery of the currencies is in the future, or forward
bc price is fixed today, the contract carries no risk
Swap
combines a spot sale of currency w/ a forward repurchase of the same currency
common for counterparties dealing with same currency over and over again
lower transaction costs bc fees and commissions are lower than spot & forward purchased separately
Futures
contract is a promise that two parties holding the contract will deliver currencies to each other at some
future date at a pre-specified exchange rate
unlike the forwards contract, futures contracts are standardized, mature at certain regular dates, and can
be traded on organized futures exchanges
futures contract does not require that the parties involved at the delivery date be the same two parties that
originally made the deal
Option
contract provides one party, the buyer, with the right to buy(call) or sell(put) a currency in exchange for
another at a pre-specified exchange rate at a future date
seller must perform the trade if asked to do so by the buyer
buyer has no obligation to make trade

b.
c.
4.
a.
b.
c.

Hedging:
risk avoidance
Speculation:
risk taking
Private Actors

Commercial Banks:
trade for themselves in search of profit
also serve clients who want to import or export goods, services, or assets
such transactions involve change of currency in which these banks are the principal financial intermediary
key actors in forex market

Interbank Trading:
profit driven interbank trades
75%of all forex market transactions globally are handled by just 10 banks
profit driven trading is key force in forex market that affects the determination of the spot exchange rate

Corporations:
may trade in market if they are engaged in extensive transactions either to buy inputs or sell products in
foreign markets
costly but can bypass fees and commissions charged by commercial banks
Nonbank Financial Institution:
such as mutual fund companies may invest so much overseas that they can justify setting up their own
forex trading operations
Government Actions

Capital Control:
policies, restriction on cross-border financial transactions

Official Market:
govt set up for foreign exchange
issue by a law requiring ppl to buy and sell in that market at set rates

Black Markets:
or parallel markets
individuals trade at exchange rates determined by market forces and not set by the government
Government Intervention: to maintain a fixed or pegged exchange rate, the central bank must
stand ready to buy or sell its own currency, keeping foreign currencies as a buffer
These buffers do run out, then market forces will determine the exchange rate

Arbitrage & Spot Exchange Rates

Arbitrage:
exploiting any profit opportunities arising from price differences
buy low, sell high for profit, simplest terms
If profit opportunities exist in the market, there is no equilibrium

Equilibrium/No-Arbitrage Condition:
no such profit opportunities exist in the market

Vehicle Currency:
3rd currency used in transactions, it is not of the home party or other party involved in the trade

Riskless Arbitrage: Covered Interest Parity

Forward Exchange Rate:

allows investors to be absolutely sure of the price at which they can trade forex in the future

Covered Interest Parity:

all exchange risk on the euro side has been covered by use of the forward contract
the price of the forward contract is derived from the pricing of the underlying spot contract
Risky Arbitrage: Uncovered Interest Parity
Use spot contracts and accept that the future exchange rate is subject to risk
Expected Exchange Rate: the forecast

Uncovered Interest Parity (UIP):

exchange rate risk has been left uncovered by the decision to not hedge against exchange rate risk by
using a forward contract and instead simply wait to use a spot contract in a years time
no arbitrage condition that describes an equilibrium where investors are indifferent between the returns on
unhedged interest-bearing deposits in two currencies (where forwards contracts are not employed)
helps determine spot rates

Expected Rate of Depreciation:

btw today and the future period

Forward Premium:
the proportional difference btw the forward and spot rate

Conclusion
Through expectations, news about the future can affect expected returns.
Govt intervention in this market determines nature of regimes in operation
Key Points
1. exchange rate in a country is the price of a unit of foreign currency, expressed in home currency, price
determined in spot market for forex
2. Home exchange rises, less foreign currency bought/sold per unit home currency; vice versa
3. Exchange rate used to convert prices into common currency for price comparisons
4. Forex dominated by spot contracts

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5.
6.
7.
8.
9.

Main actors are private investors & govt

CIP says that dollar return on dollar deposits must equal dollar return on euro deposits
CIP says forward rate is determined by home and foreign interest rates & spot exchange rate
UIP says dollar return on dollar deposits must equal the expected dollar returns on euro deposits
UIP explains how spot rate is determined by the home & foreign interest rates and the expected future
spot exchange rate

Chapter 11: Exchange Rates I | The Monetary Approach (LR)

Monetary Approach to Exchange Rates -- Long Run Theory
Exchange Rates & Prices in LR: Purchasing Power Parity & Goods Mkt Equilibrium

The Law of One Price (LOOP):

in the absence of trade frictions (such as transports costs and tariffs) and under conditions of free
competition and price flexibility (where no individual seller or buyer has the power to manipulate prices
and prices can adjust freely), identical goods sold in different locations must sell for the same price when
prices are expressed in a common currency
Relative Price:
ratio of the goods prices in one country relative to a foreign countrys price where both prices are
expressed in a common currency
Integrated Market:
two markets offer the good for the same price
ex. diamonds moved freely btw New York and Amsterdam
law of one holds
* If law of one holds -- the exchange rate must equal the ratio of the goods prices expressed in
two currencies
Purchasing Power Parity

Purchasing Power Parity (PPP):

macroeconomic counterpart to the microeconomic law of one
PPP relates exchange rates to the prices of a basket of goods
PPP is more relevant concept than LOOP

Price Level:
weighted average of all goods g in a basket, using the same goods and weights in both locations
If the law of one holds for each good in the basket, it will also hold for the price of the basket as
a whole

Absolute PPP:
when the price levels in two countries are equal when expressed in a common currency

Real Exchange Rate:

tells us how many US baskets are needed to purchase one European basket
exchange rates for currencies is a nominal concept
real ER is a real concept
Fluctuations:
If Real ER rises, we say Home has experienced a Real Depreciation (more home goods needed for
foreign goods)
If Real ER falls, opposite Real Appreciation (Less to buy more)
We can restate Absolute PPP in terms of real exchange rates: purchasing power parity states
that the real exchange rate is equal to 1.
Under Absolute PPP, all baskets have the same price when expressed in common currency, so
their relative price is 1.

1. If Real Exchange Rate (qUS/EU) is below 1 by x%, then Foreign goods are relatively cheaper: x%
cheaper than Home goods
a. Dollar is said to be Strong, Euro is Weak
b. Euro is undervalued at x%
2. If Real Exchange Rate (qUS/EU) is above 1 by x%, then Foreign goods are relatively expensive: x% more
expensive than Home goods
a. Dollar is said to be weak, Euro is Strong
b. Euro is overvalued by x%
Purchasing Power Parity implies that the exchange rate at which two countries trade equals the
relative price levels of the two countries
If we know the price levels in different locations, we can use PPP to determine an implied
exchange rate
If we can forecast future price levels, we can also use PPP to forecast the expected future
exchange rate implied by those forecasted future price levels

Inflation:
the rate of growth of the price level is known as the rate of inflation
Relative PPP:
implies that the rate of depreciation of the nominal exchange rate equals the difference between the
inflation rates of two countries (the inflation differential)
unlike absolute PPP, relative predicts a relationship in changes in prices and changes in exchange rates,
rather than a relationship in levels
Relative is derived from absolute
Hence, if absolute PPP holds, implies that relative PPP must also hold
converse not necessarily true
How Slow is Convergence to PPP

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PPP works better in the LR, but how long?
Speed of Convergence: rate at which price differences and deviations from PPP converge
What Explains Deviations From PPP
1.
a.
b.
c.
2.
a.
b.
3.
a.
b.
c.
d.
e.
4.
a.

Transaction Costs
trade is not frictionless
costs of international transportation are significant for most goods
tariffs and duties
Nontraded Goods
some goods are inherently non-tradable goods, infinitely high transaction costs
ex. the work of a chef
Imperfect Competition & Legal Obstacles
Many goods are not simple undifferentiated commodities
brand names, copyrights, legal protection
Generic acetaminophen vs Tylenol not seen as perfect substitutes
this mkt power allows firms to charge different prices in countries
cant buy tylenol in one country and redistribute it, lawyers
Price Stickiness
prices are sticky in the SR, they do not or cannot adjust quickly and flexibly to changes in mkt conditions
Money, Prices, Exchange Rates in the Long Run: Money Mkt Equilibrium

1.
a.
b.
2.
a.
3.
a.
b.
c.

What is Money?
Store of Value
as with any asset, money held today until tmrw still can be used to buy goods
there is opportunity cost to holding money, low rate of return
Unit of Account
allows us to set prices
Medium of Exchange
allows us to buy and sell without barter
money is most liquid of all assets
widely accepted

1.
a.
b.
2.
a.
b.
3.
a.

Money in Circulation
M0
narrowest, known as base money
includes currency in circulation and reserves of commercial banks
M1
currency in circulation, demand deposits in checking accounts and travelers checks
excludes banks reserves (better gauge of money for transactions)
M2
slightly less liquid assets such as savings and time deposits

Money:
defined as the stock of liquid assets that are routinely used to finance transactions, as implied by medium
of exchange by money
The Supply of Money

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A countrys central bank controls the money supply, central banks policy tools are sufficient to allow it to
control the level of M1 indirectly, but accurately
The Demand for Money
Simple theory of household money demand is motivated by the assumption that the need to conduct
transactions is in proportion to an individuals income
Infer that Aggregate Money Demands behaves similarly
* All else equal, a rise in national dollar income (nominal income) will cause a proportional increase in
transactions and hence in aggregate money demand

Quantity Theory of Money:

demand for money is proportional to dollar income
the more real income we have, the more real transactions we have to perform, and the more real money
we need
Mkt Equilibrium:
When money demanded equals money supply
Price level is determined by how much nominal money is issued relative to the demand for real
money balances

Fundamental Equation of the Monetary Model of Price Level:

In the LR we assume prices are flexible and adjust to equilibrium
ex. If amount of money in circulation rises by factor of 100, and real income stays the same, then
there will be more money chasing the same quantity of goods
this leads to inflation
in LR price level will rise by factor of 100
same economy as before with more zeros
Fundamental Equation of the Monetary Approach to Exchange Rates:
suppose US money supply increases
causes exchange rate to increase (US depreciates against EU)
ex. US money supply doubles, price level doubles
more US money supply leads to weaker dollar
makes sense, more dollars so each is worth less
now suppose real income increases
causes exchange rate to decrease (US appreciates against EU)
ex. US income doubles, price level falls by half
stronger US economy leads to stronger dollar
more demand for same quantity of dollars, worth more
Money, Growth, Inflation, and Depreciation
When money growth is higher than real income growth, we have more money chasing fewer
goods -- leading to inflation

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If the US runs a looser monetary policy in the LR measured by a faster money growth rate,
the dollar will depreciate more rapidly
If the US economy grows faster in the LR, the dollar will appreciate more rapidly
The Monetary Approach: Implications & Evidence
Forecasting Exchange Rates
1.
a.
b.
c.
d.
e.
2.
a.
b.
c.
d.
e.

One Time, Unanticipated Increase in the Money Supply

10% increase in MS
Real income is constant
Price Level and Money Supply must move in same proportion, so 10% increase in price levels
PPP implies that the exchange rate E and price level P must move in the same proportion, so there is
10% increase in E
thus dollar depreciates by 10%
Unanticipated increase in the rate of money growth
Money supply M is growing at constant rate
real money balances constant
Implies that price level P and money supply M must move in same proportion, so P is always a constant
multiple of M
PPP implies that the exchange rate E and Price level P must move in the same proportion
hence, E is always a constant multiple of P (and hence of M)
Monetary approach to prices and exchange rates suggests that, increases in the rate of money supply
growth should be the same size as increase in the rate of inflation and rate of exchange rate depreciation

Money, Interest Rates, and Prices in the Long Run

Quantity Theory:
simple LR model that links price levels in each country to money supply and demand
problem is that the theorys assumption that demand for money is stable, is implausible
Demand for Money: General Theory

1.
a.
2.
a.

There is a benefit from holding money

can conduct transactions with it
There is a cost to holding money
opportunity of earning zero interest

Can infer:
A rise in national dollar income (nominal) will cause a proportional increase in transactions, and hence, in
aggregate money demand
A rise in nominal interest rate will cause the aggregate demand for money to fall

Real Money Demand Function:

downward slope

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-

reflects inverse relationship btw demand for real money balances and the nominal interest rate at a given
level of real income
LR Equilibrium in the Money Market
Equilibrium when real money supply (determined by central bank) equals demand for real money
balances (determined by interest rate and real income)

Inflation and Interest Rates in the LR

PPP links prices and exchange rates
UIP links exchange rates and interest rates
The Fisher Effect

Fisher Effect:
a rise in the expected inflation rate in a country will lead to an equal rise its nominal interest rate
only holds in the LR
links inflation and interest rates under flexible prices
predicts that the change in the opportunity cost of money is equal not just the change in nominal interest
rate but also to the change in the inflation rate
Therefore in times of high inflation, people should therefore want to reduce their money holdings
Real Interest Parity

Real Interest Rate:

the inflation-adjusted return on an interest bearing asset
Real Interest Parity:
if PPP and UIP hold, then expected real interest rates are equalized across countries
implies: arbitrage in goods and financial markets alone is sufficient, in the LR, to cause the equalization of
real interest rates across countries
Exchange Rate Forecasts Using the General Model
Lesson: even if actual economic conditions today are completely unchanged, news about
the future affects todays exchange rates

Monetary Regimes and Exchange Rate Regimes

Monetary Approach shows that in LR, all nominal variable linked -- money supply, interest
rate, price level, and exchange rate

Nominal Anchors:
policy makers be subject to some kind of constraint in the LR

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-

attempt to tie down a nominal variable that is potentially under policy makers control (inflation)

Monetary Regime:
LR nominal anchoring and SR flexibility are the characteristics of policy framework
The Long Run: The Nominal Anchor
Which variables can policy makers use as anchors to achieve an inflation objective in the LR?

1.
a.
2.
a.
b.
c.
d.
3.
a.

Exchange Rate Target

Set the rate of depreciation equal to a constant, peg to a country with rep for price stability
Money Supply Target
inflation equals the excess of the rate of money supply growth over and above the rate of real income
growth
set the growth rate of money supply to a constant 2% per year
real income growth can be unstable
money supply targets waning in popularity, EU bank uses it tho
Inflation Target + Interest Rate Policy
as long as the home nominal interest rate is kept stable, inflation can also be kept stable
The Choice of Nominal Anchor & Its Implications
Using more than one target can be problematic.
But nominal anchoring is possible with a variety of exchange rate regimes.
A country with a nominal anchor sacrifices monetary policy autonomy in the LR.

Central Bank Independence:

Independent central banks stand apart from the interference of politicians
they have operations freedom to try to achieve the inflation target
may play a role in setting that target
Key Points

1.
a.
2.
a.
3.
a.
4.
a.
5.
a.
b.
6.
a.

PPP implies that the exchange rate should equal the relative price level in two countries
real exchange rate should equal 1
Evidence for PPP in SR is weak, but favorable in LR
PPP failure in SR due to market frictions, imperfections that limit arbitrage, and price stickiness
Simple Monetary Model (Quantity Theory) explains price levels in terms of money supply and real income
bc PPP can explain ER in terms of price levels two together can develop monetary approach to the ER
If we can forecast money supply and income, we can use the Monetary approach to forecast the level of
the exchange rate at anytime in the future
valid only under assumption prices are flexible (LR)
PPP + UIP = Fisher Effect
inflation rates pass through one for one into changes in local nominal interest rates.
implies real interest parity (expected real interest rates should be equalized across countries)
Quantity Theory allows for the demand for real money balances to decrease as the nominal interest rate
rises
leads to general monetary model: one time rise in money growth rate leads to one time rise in inflation,
which leads to a one time drop in real money demand, which in turn causes a one time jump in the price
level and exchange rate

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7. Policy makers and public generally prefer low inflation environment

Chapter 12: Exchange Rates II | The Asset Approach in the SR

Asset approach is based on the idea that currencies are assets.
Price of the asset is the spot exchange rate
Exchange Rates and Interest Rates in the Short Run: UIP and FX Mkt Equilibrium
Risky Arbitrage

Fundamental Equation of the Asset Approach to Exchange Rates:

UIP equation to determine todays spot exchange rate
only useful if we know the future expected exchange rate and the short term interest rate
Forex Mkt Equilibrium
When the domestic dollar return equals the expected foreign dollar return, UIP holds
Adjustment to Forex Mkt Equilibrium
Arbitrage automatically pushes the level of the Exchange rate to its equilibrium
FX Market Diagram Summary
Domestic returns depend only on the home interest rate, but foreign returns depend on both foreign
interest rates and the expected future rate
Remember: Any change that raises(lowers) the foreign return relative to the domestic return makes euro
deposits more(less) attractive to investors so that traders will buy(sell) euro deposits
Interest Rates in the SR: Money Mkt Equilibrium

LR Assumptions:
Price level P is fully flexible and adjusts to bring the money mkt to equilibrium
the nominal interest rate I equals the world real interest rate plus domestic inflation

SR Assumptions:
In the SR, price level is sticky; it is a known predetermined value fixed
In the SR, the nominal interest rate i is fully flexible and adjusts to bring the money mkt to equilibrium

Sticky prices also called nominal rigidity

sticky bc of long term labor contracts
sticky bc of contracts and menu costs (costly to frequently change output prices)
Adjustment to Money Mkt Equilibrium in SR

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1. Real money demand less than real money supply

2. the central bank has to put more money in the hands of the public than the public wishes to hold
3. the public will want to reduce its cash holdings by exchanging money for interest bearing assets such as
bonds, savings accounts, etc
4. They will save more, and seek to lend their money to borrowers
5. Interest rate will be driven down as eager lenders compete to attract scarce borrowers
(opposite)
1.
2.
3.
4.
5.
6.

Excess demand for money

public wishes to reduce savings by turning interest bearing assets into cash
now fewer loans are extended
The loan market will suffer excess demand
but borrowers will not want to borrow less unless the cost of borrowing rises
interest rate will be driven up as eager borrowers compete to attract scarce lenders
Changes in Money Supply and the Interest Rate
Remember: (Sheflin) interest is the price of money
Money Supply and Nominal Interest rate are inversely proportional
In SR, an increase in a countrys money supply will lower the countrys nominal interest rate;
a decrease in the countrys money supply will raise the countrys nominal interest rate

The money supply, or the interest rate may be used as a policy instrument
most central banks tend to use the interest rate as their policy instrument bc money demand curve not
stable
if money supply were set at a given rate, the demand instability would lead to unstable interest rates
Changes in Real Income & the Nominal Interest Rate
In the SR:
An increase in a countrys real income will raise the countrys nominal interest rate.
A decrease in a countrys real income will lower the countrys nominal interest rate.

Monetary Model: SR vs LR
Scenario: Money supply was constant but now expansionary policy; allows MS to grow at 5% rate
1. LR: 5% change in home money growth causes 5 percentage point increase in home inflation and a five
5% increase in home nominal interest rate (interest rises bc prices flexible)
2. SR: Home money supply expands, so excess supply of real money balances, causing home interest rate
to fall (interest falls bc prices sticky)
Capital Mobility is Crucial:

15
arbitrage and UIP will hold as long as capital can move freely btw home and foreign capital
markets
Short Run Policy Analysis
Temporary Shock to Home Money Supply: Expansion
1. Home monetary expansion lowers the home nominal interest rate, which is also the domestic return in a
foreign market
2. This makes foreign deposits more attracts
3. Traders wish to sell their home deposits and buy foreign deposits
4. This makes the home exchange rate increase (depreciate) *
5. However, this depreciation makes foreign deposits less attract until equality of foreign and domestic
returns are equal

1.
2.
3.
4.
5.
6.

Temporary Shock to Foreign Money Supply: Expansion

Foreign Monetary expansion lowers the foreign nominal interest rate
Lowers the foreign return in forex markets
makes foreign less attractive
Traders wish to sell foreign and buy home
Makes the home exchange rate decrease (appreciate) *
However, this makes foreign deposits more attractive, until returns are equalized
Permanent Shock to Money Supply: Expansion
In SR, the permanent shock causes the exchange rate to depreciate more than it would under a
temporary shock and more than it will end up depreciating in the LR
Overshooting
In the SR, the interest rate and exchange rate effects combine to create an instantaneous double
whammy for the dollar

Under permanent shock conditions:

- domestic returns go down and foreign returns go up; traders want to sell the dollar for two reasons
1. temporarily lower dollar interest rates
2. expected dollar depreciation
* makes dollar deposits much less attractive
argument: w/o long run nominal anchor, exchange rates are likely to be more volatile
creating instability in forex market and possibly wider economy

Inflation Targeting:
shift to new form of anchoring, might be helping to bring down exchange rate volatility in recent years
Fixed Exchange Rates and the Trilemma
Country w/ fixed exchange rate faces monetary policy constraints not just in the long run but also in the
short run.
Float vs. Fixed

16

1.
a.
2.
a.

SR:
Float
home monetary authority picks the money supply, MS determines the exchange rate
Fixed
home monetary authority picks the exchange rate, ER determines the MS

1.
a.
2.
a.

LR:
Float
MS input, ER output
Fixed
ER input, MS output

The Trilemma

1.
a.
b.
2.
a.
b.
3.
a.
b.

Policy Goals:
Fixed Exchange Rate
may be desired to promote stability
zero expected depreciation
International Capital Mobility
desired as means to promote integration, efficiency, risk sharing
UIP from arbitrage
Monetary Policy Autonomy
a means to manage the home countrys business cycle
ability to set home interest rate independently of foreign interest rate

***Cannot have all 3 at once: Mathematically impossible

Can choose to drop one of the three OR can adopt one of the 3 pairs
Key Points

1. in SR, prices sticky, arbitrage determines spot rate, forex in eq when UIP condition holds, to apply UIP
need a forecast of expected exchange rate in LR

Chapter 13: Natl Wealth and Intl Accounts: Income, Wealth, B. of Payments
The Flow of Payments in a Closed Economy: Natl Income and Product Accounts

Gross National Expenditure (GNE):

total expenditure on final goods and services by home entities in any given period of measurement
3 Parts: GNE = Personal Consumption (C) + Investment (I) + Government spending (G)
Gross Domestic Product (GDP):
the value of all (intermediate & final) goods and service produced as output by firms, minus the value of
all intermediate goods and services purchased as inputs by firms
Also known as value added
GDP is a product measure, where GNE is expenditure measure
GDP = GNE

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Gross National Income (GNI):

total income resources in economy
In a closed economy, all economic aggregate measures are equal: GNE = GDP = GNI
Expenditure is the same as product, which is the same as income

The Flow of Payments in an Open Economy: Incorporating Balance of Payments

Balance of Payments (BOP):

all of the extra payment flows to and from the rest of the world

Trade Balance (TB):

the difference btw payments made for imports and payment received for exports
equals net payments to domestic firms due to trade
GDP = GNE + TB

Factor Service Imports:

domestic payments to capital, labor, and land owned by foreign entities
bc this income is not paid to factors at home, it is subtracted when computing home income

Factor Service Exports:

foreign payments to capital, labor, and land owned by domestic entities
bc this income is paid to factors at home, it is added when computing home income

Net Factor Income From Abroad (NFIA):

the value of factor service exports minus factor service imports
GNI = GDP + NFIA

Net Unilateral Transfers (NUT):

equals the value of unilateral transfers the country receives from the rest of the world minus those it gives
to the rest of the world (gifts considered non market transactions)
Gross National Disposable Income (GNDI):
total income resources available to the home country
GNDI = GNI + NUT

Current Account (CA):

a tally of all international transactions in goods, services, and income that occur through market
transaction or transfers
the balance of payment accounts collect the trade balance, net factor income from abroad, and net
unilateral transfers and reports their sum as this
A countrys capacity to spend is not restricted to be equal to its GNDI, but instead can be

18
increased or decreased by trading assets with other countries

Financial Account (FA):

the value of asset exports minus asset imports
the value of asset imports decreases resources available for spending

Capital Account (KA):

value of capital transfers from the rest of the world minus those to the rest of the world
GNE + TB GDP +NFIA GNI + NUT GNDI + FA + KA GNE
Net sum of all cross border flows = 0; the balance of payments does balance

Income, Product, and Expenditure

3 Approaches to Measuring Economic Activity:
1. Expenditure Approach (GNE)
2. Product Approach (GDP)
3. Income Approach (GNI/GNDI)
in closed economy all 3 are equal, but not in open economy

From GNE to GDP: Accounting for Trade in Goods and Services

GNE = C + I + G
Bc of trade, not all of GNE payment goes to GDP
Subtract the the value of final goods imported (spending to foreign firm)
Add the value of final goods exported
Subtract the value of imported intermediates
Add the value of exported intermediates (count as home produced output)
Add value of EX - IM

Thus GDP = C + I + G + NX
says that GDP is equal to GNE + TB(also called NX)
If TB>0 ; EX > IM (Trade Surplus)
If TB<0 ; EX < IM (Trade Deficit)
From GDP to GNI: Accounting in Trade in Factor Services

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Trade in factor services occurs when the home country is paid income by a foreign country for use of
labor, capital, and land owned by home .. but in service for the foreign country
^say foreign country is exporting factor services, and receiving factor income in return

Foreign Direct Investment (FDI):

trade in capital services
Income Receipts (services exported) - Income Payments (services imported) = NFIA
Gross National Income (GNI) = GDP + Net Factor Income from Abroad (NFIA)
From GNI to GNDI: Accounting for Transfer of Income

Official Development Assistance (ODA):

international non market transfer of goods, services, and income in foreign aid gifts
Unilateral Transfers
GNDI/Y = GNE + NX/TB + NFIA + NUT (UTin -UTout)
* Full measure of gross national disposable income

GNDI prefered by economists to measure natl income, why?

GDP does not include net factor income from abroad
GNI leaves out international transfers

What National Economic Aggregates Tell Us

TB + NFIA + NUT called the Current Account (CA)
CA measures all net payment to the home country arising from the full range of international transactions
Consumption 70% of GNE
What the Current Account Tells Us
Spending more or less than its income?

National Income Identity:

Y = C + I + G + CA
current account represents difference btw National income (Y) and GNE

1. GNDI is greater than GNE if and only if CA is positive, or in surplus

2. GNDI is less than GNE if and only if CA is negative, or in deficit

National Saving:
S = Y- C - G
CA is also difference btw national saving and investment (I)

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Current Account Identity:

difference btw national saving and investment

1. S is greater than I if and only if CA is positive, or in surplus

2. S is less than I if and only if CA is negative, or in deficit
Current Account is media measure of how a country is spending more than it earns or living beyond its
means

Government Saving/Public Saving:

Sg = T - G
Tax revenue minus government purchases
Budget Surplus (T>G)
Budget Deficit (G>T)
Private Saving + Govt Spending = National Saving

Ricardian Equivalence:
you will & other households will save tax cut this year to pay next years tax increase
any fall in public savings will be fully offset by a rise in private saving
CA would be unchanged
but no correlation btw Govt deficit and CA deficit
The Balance of Payments
Accounting for Asset Transactions: The Financial Account

Financial Account (FA):

measures all movements of financial assets across the international border
movement from home to foreign ownership
all financial assets
FA = EX - IM
Negative FA means country has imported more assets than it has export
Positive vice versa
Account for Asset Transactions: The Capital Account

Capital Account (KA):

covers some remaining, minor activities in the balance of payments account
nonfinancial assets included here, can still be bought and sold
capital transfers (gifts of assets) ex. forgiveness of debt
KA = KAin - KAout

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Capital account usually close to zero, minor
Accounting for Home and Foreign Assets
(Home Perspective)
Foreign asset is claim on foreign asset External Asset, when home entity owns foreign
asset
Represents an obligation owed to the home country by the rest of the world
Home asset is a claim on the home country External Liability when foreign entity owns
home asset
Represent an obligation owed by the home country to the rest of the world
How the Balance of Payments Works: Microeconomics
CA + KA + FA = 0 (balanced)
+BOP credit, -BOP debit
Every Market Transaction has two parts. Both parties receive item of given value
Understanding Data for Balance of Payment Accounts
Current Account Surplus Country is a Net (Lender)
Must have deficits in its assets accounts
Buying assets (acquiring IOUs from borrowers)
Current Account Deficit Country is a Net (Borrower)
Must have surplus in asset accounts
Selling assets (issuing IOUs to lenders)
What the Balance of Payments Account Tells Us
1.
a.
2.
a.

Current Account
measures external imbalances in goods, services, factor services, and unilateral transfers
Financial and Capital Account
measure asset trades
Surpluses on CA side must be offset by deficits on asset side; vice versa
External Wealth
w/ respect to rest of the world (ROW)
External Wealth (W) = ROW Assets owned by Home (A) - Home Assets owned by ROW (L)

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1.
a.
b.
c.
2.
a.
b.
c.

W>0
home country is net (Creditor)
External assets exceed external liabilities
what world owes home country is greater than what it owes the world
W<0
home country is a net (Debtor)
External liabilities exceed assets
home country owes world more than what world owes home country
2 Reasons a Countrys Level of Wealth Changes over time

1.
a.
2.
a.

Financial Flows
result of asset trades
Valuation Effects
existing external assets and liabilities may change over time bc of capital gains or losses
3 ways Country can increase its External Wealth

1. Through its own thrift (CA surplus, expenditure less than income)
2. Charity of Others (KA surplus, receiving gifts of wealth)
3. Help of Windfalls (positive capital gains)
can reduce by opposites
The net export (import) of assets lowers (raises) a countrys external wealth

Chapter 14: Output, Exchange Rates, and Macroeconomic Policies in the SR

Demand in the Open Economy
Assumptions about output and employment are valid only in the Long Run
Preliminaries and Assumptions
Short Run

1.
a.
2.
3.
4.
a.
b.

Key Assumptions:
Home and Foreign price levels are fixed due to price stickiness
as a result of this, expected inflation is 0
Government Spending and Taxes are fixed at constant levels, which are subject to policy change
Conditions in foreign countries such as output (Y) and the foreign interest rate (I) are fixed and taken as
given
Assume that income (Y) is equivalent to output
GDP = GNDI
NFIA and NUT are 0
Consumption

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Aggregate price consumption relates household consumption C disposable income Y

Consumers tend to consume more as their disposable income rises. (Upward Sloping)
Private Consumption expenditure is sensitive to changes in current income
Marginal Effects

Marginal Propensity to Consume (MPC):

the slope of the consumption function
tells us how much of every extra $1 of disposable income received by households is spent on
consumption

Marginal Propensity to Save (MPS):

how much of every extra $1 of disposable income received by households is saved
MPS = 1 - MPC

Consumption function:
relates levels of consumption to levels of disposable income

Investment

Aggregate Investment make 2 Assumption:

firms can choose from many possible investment project, each of which earns a different real return
a firm will invest capital in a project only if the real returns exceed the firms cost of borrowing capital

Expected Real Interest Rate:

firms borrowing cost
equals nominal interest rate minus expected inflation
here since expected inflation is 0, nominal = real rate
When Expected Real Interest Rate in economy falls, we expect more investment projects to be
undertaken
Investment is decreasing function of real interest rate
Investment falls as interest rate rises (Investment function slopes downward)

The Government
Governments role is simple: Collects amount (T) in taxes in private households and spends an
amount (G) on government consumption of goods and services
(spending on the public sector)

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Excluded here is transfer programs:

social security, medical care, unemployment benefits, etc
assume that in aggregate they do not generate any change in total expenditure
(T=G) Balanced budget
(T>G | T-G) Budget Surplus
(G>T | G-T) Budget Deficit
The Trade Balance

3 Key determinates:
1. Real Exchange Rate
2. Level of Home Income
3. Level of Foreign Income
The Role of the Exchange Rate

Expenditure Switching:
when spending patterns change in response to changes in the real exchange rate
foreign purchases to domestic purchases
A rise in the home real exchange rate (real depreciation) signifies that foreign goods have become more
expensive relative to home goods.
As exchange rate rises, both home and foreign consumers will respond by expenditure switiching,
home country will import less (switch to buying home goods) and export more (foreign consumers
switch to buying home goods)

We Expect the trade balance of the home country to be an increasing function of the home countrys real
exchange rate. that is, as home countrys real exchange rate rises (depreciates) it will export more and
import less, and the trade balance rises
Trade balance is an increasing function of the real exchange rate (upward sloping)
The Role of Income Levels
We expect an increase in home income to be associated with an increase in home imports and a fall in
the home countrys trade balance
We expect an increase in the rest of the world income to be associated with an increase in home exports
and a rise in the home countrys trade balance
At any level of the real exchange rates, an increase in home output leads to more spending on imports,
lowering the trade balance (results in downward shift)

Exogenous Changes in Demand

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Exogenous Change in Consumption:

changes in wealth increases consumption
this change in consumption demand unrelated to disposable income

Exogenous Change in Investment:

belief in change in technology
unrelated to interest rate

Exogenous Change in Trade Balance:

Tastes shift away large domestic entity towards foreign
switch from domestic to foreign unrelated to exchange rates
Goods Market Equilibrium: The Keynesian Cross
Total Aggregate Supply is equal to total national output measured by GDP
Supply = GDP = Y
Demand = D = C + I + G + NX

Factors that Shift the Demand Curve

Change in Government Spending

G up, increases levels of demand at every level of output
Any change in G will cause demand curve to shift

Change in Taxes
More disposable income, more consumption
Higher taxes means less to spend
Any change in C causes shifts in demand curves

Change in Home Interest rates

A fall in interest rate, leads to increase in investment
investment up, demand up

Change in Home Exchange rates

A rise in nominal exchange rate implies rise in real exchange rate
this is real depreciation, increases TB/NX
Spending switches from foreign goods to home goods, exports rise when dollar depreciates
exchange rate up, demand up

Change in Home or Foreign Price Level

if prices are flexible
a rise in foreign prices or fall in domestic prices causes a home real depreciation
real depreciation causes TB/NX to rise
same as ER
Goods and Forex Market Equilibria: Deriving the IS Curve

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Equilibrium in Two Markets

IS-LM Diagram
IS curve shows combinations of output Y and the interest rate I for which the goods and forex market are
in equilibrium
Expected return on foreign deport measured in home currency equals the foreign interest rate plus the
expected rate of depreciation of the home currency
Inverse relationship btw exchange rate and expected foreign returns (downward sloping)
When home interest falls, domestic deposits have lower returns and look less attractive to customers
Deriving the IS Curve
the fall in interest rates indirectly boosts demand via exchange rate effects felt through the trade balance
in an open economy, lower interest rates stimulate demand through the traditional closed-economy
investment channel and through the trade balance. The trade balance effect occurs bc lower interest
rates because nominal depreciation, which in the short run is also real, which stimulate external demand
via trade
When interest rate falls, output rises
Factors that Shift the IS Curve

change in government spending

a rise in government spending shifts the curve out

change in taxes
a reduction in taxes shifts the IS curve out

change in foreign interest rate or expected future exchange rate

increase in foreign return via (E or I) shifts the IS curve out

change in foreign price level

a rise in foreign prices or fall in domestic prices
shifts the IS curve out
Increase in demand shifts IS curve out, vice versa
Money Market Equilibrium
LM curve, describes money market equilibrium (upward sloping)

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Factors that Shift the LM Curve
Money supply up, interest down, LM curve out (right)
MS down, interest up, LM curve in (left)
The Short Run IS-LM-FX Model of An Open Economy
Macroeconomic Policies in the Short Run

Monetary Policy:
implemented through changes in the money supply

Fiscal Policy:
involving changes in government spending or taxes
Monetary Policy under Floating Exchange Rate Regimes
Money supply up, interest rate down, domestic returns fall, the lower interest rate implies exchange rate
must depreciate (rising) as interest rate falls, demand increases
Temporary Expansion

Interest Rate fall affects demand in 2 ways:

1. causes investment to increase
2. indirectly affects exchange rates, causes expenditure switching causing trade balance to increase
Monetary Policy Under Fixed Exchange Rates
under fixed exchange rate, autonomous monetary policy is not an option
Monetary policy under fixed exchange rates is impossible
Fiscal Policy Under Floating Exchange Rates
Fiscal expansion raises, raises output, results in higher interest rates, which will reduce investment bc of
more government spending -- Crowding Out (rise in demand less than the increase in government
spending) bc of fixed MS
Also expansion of fiscal policy, raises home output, raises interest rate, appreciation of exchange rate,
decreases trade balance -- Crowds out net exports (contraction causes opposite)
Crowding out of both Investment & Net Exports
Fiscal Policy Under Fixed Exchange Rates
home interest rate must remain equal to foreign interest rate for the peg to hold.

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When a country is operating under a fixed exchange, fiscal policy is super-effective because any fiscal
expansion by the government forces and immediate monetary expansion by the government forces and
immediate monetary expansion by the central bank to keep the exchange rate steady.
The double simultaneous expansion of demand by the fiscal and monetary authorities
imposes a huge stimulus on the economy. raises output by a considerable amount
Stabilization Policy
Authorities can use changes in policies to try to keep the economy at or near its full employment level of
output
Problems in Policy Design and Implementation

Policy Constraints:
fixed exchange rate rules out any use of monetary policy

Incomplete Information & Inside Lag:

macroeconomic data compiled slowly
takes time to formulate a policy response
monetary side, delay btw policy meeting
fiscal side, time for legislation
Inside/Implementation Lag (lag btw shock and policy actions)

Policy Response and the Outside Lag

it takes time for policies enacted to take effect on the economy
Outside lag (lag btw policy actions and its effects)

Long-Horizons Plan
if private sector knows policy change is temporary, may not be reason to change consumption or
investment expenditure