Economia Internacional. 9ed. Krugman, 2012

Chapter 7
International Factor Movements
Prepared by Iordanis Petsas

To Accompany
International Economics: Theory and Policy, Sixth Edition
by Paul R. Krugman and Maurice Obstfeld
Chapter Organization
 Introduction
 International Labor Mobility
 International Borrowing and Lending
 Direct Foreign Investment and Multinational Firms
 Summary
 Appendix: More on Intertemporal Trade
Copyright © 2003 Pearson Education, Inc. Slide 7-2

Introduction
 Movement of goods and services is one form of
international integration.
 Another form of integration is international
movements of factors of production (factor
movements).
 Factor movements include:
• Labor migration
• Transfer of capital via international borrowing and
lending
• International linkages involved in the formation of
multinational corporations
International Labor Mobility
 A One-Good Model Without Factor Mobility
• Assumptions of the model:
– There are two countries (Home and Foreign).
– There are two factors of production: Land (T) and Labor
(L).
– Both countries produce only one good (refer to it as
“output”).
– Both countries have the same technology but different
overall land-labor ratios.
– Home is the labor-abundant country and Foreign is the
land-abundant country.
– Perfect competition prevails in all markets.
Figure 7-1: An Economy’s Production Function
Output, Q
Q (T, L)
Labor, L

Figure 7-2: The Marginal Product of Labor
Marginal Product of
labor, MPL
Rents
Real
wage
Wages
MPL
Labor, L

 International Labor Movement
• Suppose that workers are able to move between the
two countries.
– Home workers would like to move to Foreign until the
marginal product of labor is the same in the two
countries.
– This movement will reduce the Home labor force and thus
raise the real wage in Home.
– This movement will increase the Foreign labor force and
reduce the real wage in Foreign.

Figure 7-3: Causes and Effects of International Labor Mobility
MPL Marginal product MPL*
of labor
B
A
C
MPL
MPL*
O Home L2 L1 Foreign O*
employment employment
Migration of labor
from Home to Foreign
Total world labor force
 The redistribution of the world’s labor force:
• Leads to a convergence of real wage rates
• Increases the world’s output as a whole
• Leaves some groups worse off
 Extending the Analysis
• Modifying the model by adding some complications:
– Suppose the countries produce two goods, one labor-
intensive and one land-intensive.
– Trade offers an alternative to factor mobility: Home can export
labor and import land by exporting the labor-intensive good
and importing the land-intensive good.
International Borrowing and Lending
 International movements of capital
• Refer to borrowing and lending between countries
– Example: A U.S. bank lends to a Mexican firm.
• Can be interpreted as intertemporal trade
– Refers to trade of goods today for goods in the
future

 Intertemporal Production Possibilities and Trade
• Imagine an economy that consumes only one good and
will exist for only two periods, which we will call
present and future.
• Intertemporal production possibility frontier
– It represents a trade-off between present and future
production of the consumption good.
– Its shape will differ among countries:
– Some countries will be biased toward present output.
– Some countries will be biased toward future output.

Figure 7-4: The Intertemporal Production Possibility Frontier
Future
consumption
Present
consumption
 The Real Interest Rate
• How does a country trade over time?
– A country can trade over time by borrowing or lending.
– When a country borrows, it gets the right to purchase
some quantity of consumption at present in return for
repayment of some larger quantity in the future.
– The quantity of repayment in future will be (1 + r) times the
quantity borrowed in present, where r is the real interest rate
on borrowing.
– The relative price of future consumption is 1/(1 + r).

 Intertemporal Comparative Advantage
• Assume that Home’s intertemporal production
possibilities are biased toward present production.
– A country that has a comparative advantage in future
production of consumption goods is one that in the
absence of international borrowing and lending would
have a low relative price of future consumption (i.e.,
high real interest rate).
– High interest rate corresponds to a high return on investment.

Direct Foreign Investment
and Multinational Firms
 Direct foreign investment
• Refers to international capital flows in which a firm in
one country creates or expands a subsidiary in another
• Involves not only a transfer of resources but also the
acquisition of control
– The subsidiary does not simply have a financial
obligation to the parent company; it is part of the same
organizational structure.

 Multinational firms
• A vehicle for international borrowing and lending
• They provide financing to their foreign subsidiaries
 Why is direct foreign investment rather than some
other way of transferring funds chosen?
• To allow the formation of multinational organization
(extension of control)
 Why do firms seek to extend control?
• The answer is summarized under the theory of
multinational enterprise.
 The Theory of Multinational Enterprise
• Two elements explain the existence of a multinational:
– Location motive
– A good is produced in two (or more) different countries rather
than one because of:
» Resources
» Transport costs
» Barriers of trade
– Internalization motive
– A good is produced in different locations by the same firm rather
than by separate firms because it is more profitable to carry
transactions on technology and management.
» Technology transfer
» Vertical integration
 Multinational Firms in Practice
• Multinational firms play an important part in world
trade and investment.
– Example: Half of U.S. imports can be regarded as
transactions between branches of multinational firms,
and 24% of U.S. assets abroad consist of the value of
foreign subsidiaries of U.S. firms.
• Multinational firms may be either domestic or foreign-
owned.
– Foreign-owned multinational firms play an important
role in most economies, especially in the United States.
Table 7-1: France, United Kingdom, and United States: Shares of
Foreign-Owned Firms in Manufacturing Sales, Value
Added, and Employment, 1985 and 1990 (percentages)

Figure 7-5: Foreign Direct Investment in the United States

Summary
 International factor movements can sometimes
substitute for trade.
 International borrowing and lending can be viewed
as a kind of international trade of present
consumption for future consumption rather than
trade of one good for another.
 Multinational firms primarily exist as ways of
extending control over activities taking place in two
or more different countries.

Summary
 Two elements explain the existence of a
multinational:
• A location motive.
• An internalization motive.

Appendix:
More on Intertemporal Trade
Figure 7A-1: Determining Home’s Intertemporal Production Pattern
Future
consumption
Isovalue lines with slope – (1 + r)
Q
QF
Intertemporal
production
possibility
frontier
QP Present
consumption
Investment
Appendix:
Figure 7A-2: Determining Home’s Intertemporal Consumption Pattern
Future
consumption
Indifference curves
D
DF
Imports
Q
QF
Intertemporal budget constraint,
DP + DF/(1 + r) = QP +QF/(1 + r)
DP QP Present
consumption
Exports
Appendix:
Figure 7A-3: Determining Foreign’s Intertemporal Production and
Consumption Patterns
Future
consumption
Q*
Q* F
Exports
D*
D* F Intertemporal budget constraint,
D*P + D*F/(1 + r) = Q*P +Q*F/(1 + r)
Q*P D *P Present
consumption
Imports
Appendix:
Figure 7A-4: International Intertemporal Equilibrium in Terms of Offer
Curves
Foreign exports of future
consumption (Q*F – D*F) and Home
imports of future consumption (DF – QF) P
(Q*F – D*F) =
(DF – QF) E F
slope = (1 + r1)
O (QP – DP) = (D*P – Q*P)
Home exports of present consumption
(QP – DP) and Foreign imports of future
Copyright © 2003 Pearson Education, Inc. consumption (D*P – Q*P) Slide 7-26
Chapter 8
The Instruments of Trade Policy

To Accompany
 Introduction
 Basic Tariff Analysis
 Costs and Benefits of a Tariff
 Other Instruments of Trade Policy
 The Effects of Trade Policy: A Summary
 Summary
 Appendix I: Tariff Analysis in General Equilibrium
 Appendix II: Tariffs and Import Quotas in the
Presence of Monopoly
Introduction
 This chapter is focused on the following questions:
• What are the effects of various trade policy
instruments?
– Who will benefit and who will lose from these trade
policy instruments?
• What are the costs and benefits of protection?
– Will the benefits outweigh the costs?
• What should a nation’s trade policy be?
– For example, should the United States use a tariff or an
import quota to protect its automobile industry against
competition from Japan and South Korea?

Introduction
Classification of Commercial Policy Instruments
Commercial Policy Instruments
Trade Contraction Trade Expansion
Price Quantity Price Quantity
Tariff Import quota Import subsidy Voluntary

Export tax Voluntary Export subsidy Import
Export Expansion
Restraint (VIE)
(VER)
Basic Tariff Analysis
 Tariffs can be classified as:
• Specific tariffs
– Taxes that are levied as a fixed charge for each unit of
goods imported
– Example: A specific tariff of $10 on each imported bicycle
with an international price of $100 means that customs
officials collect the fixed sum of $10.
• Ad valorem tariffs
– Taxes that are levied as a fraction of the value of the
imported goods
– Example: A 20% ad valorem tariff on bicycles generates a $20
payment on each $100 imported bicycle.
• A compound duty (tariff) is a combination of an ad valorem
and a specific tariff.
• Modern governments usually prefer to protect domestic
industries through a variety of nontariff barriers, such as:
– Import quotas
– Limit the quantity of imports
– Export restraints
– Limit the quantity of exports

 Supply, Demand, and Trade in a Single Industry
• Suppose that there are two countries (Home and
Foreign).
• Both countries consume and produce wheat, which can
be costless transported between the countries.
• In each country, wheat is a competitive industry.
• Suppose that in the absence of trade the price of wheat
at Home exceeds the corresponding price at Foreign.
– This implies that shippers begin to move wheat from
Foreign to Home.
– The export of wheat raises its price in Foreign and lowers its
price in Home until the initial difference in prices has been
eliminated.
 To determine the world price (Pw) and the quantity
trade (Qw), two curves are defined:
• Home import demand curve
– Shows the maximum quantity of imports the Home
country would like to consume at each price of the
imported good.
– That is, the excess of what Home consumers demand over
what Home producers supply: MD = D(P) – S(P)
• Foreign export supply curve
– Shows the maximum quantity of exports Foreign would
like to provide the rest of the world at each price.
– That is, the excess of what Foreign producers supply over what
foreign consumers demand: XS = S*(P*) – D*(P*)
Figure 8-1: Deriving Home’s Import Demand Curve
S Price, P
Price, P
A
PA
2
P2
1
P1
MD
D
S1 S2 D2 D1 Quantity, Q D2 – S2 D1 – S1 Quantity, Q

 Properties of the import demand curve:
• It intersects the vertical axis at the closed economy
price of the importing country.
• It is downward sloping.
• It is flatter than the domestic demand curve in the
importing country.

Figure 8-2: Deriving Foreign’s Export Supply Curve
Price, P S* Price, P
XS
P2
P1
P*A
D*
D*2 D*1 S*1 S*2 Quantity, Q S*1 – D*1 S*2 – D*2 Quantity, Q

 Properties of the export supply curve:
• It intersects the vertical axis at the closed economy
price of the exporting country.
• It is upward sloping.
• It is flatter that the domestic supply curve in the
exporting country.

Figure 8-3: World Equilibrium
Price, P
XS
1
PW
MD
QW Quantity, Q
 Useful definitions:
• The terms of trade is the relative price of the
exportable good expressed in units of the importable
good.
• A small country is a country that cannot affect its
terms of trade no matter how much it trades with the
rest of the world.
 The analytical framework will be based on either of
the following:
• Two large countries trading with each other
• A small country trading with the rest of the world
 Effects of a Tariff
• Assume that two large countries trade with each other.
• Suppose Home imposes a tax of $2 on every bushel of
wheat imported.
– Then shippers will be unwilling to move the wheat
unless the price difference between the two markets is at
least $2.
• Figure 8-4 illustrates the effects of a specific tariff of
$t per unit of wheat.

Figure 8-4: Effects of a Tariff
Home market
Home market World
World market
market Foreign
Foreign market
market
Price, P Price, P Price, P
S S*
XS
2
PT 1
PW
t P*T
3
MD
D*
D
Quantity, Q QT QW Quantity, Q Quantity, Q

• In the absence of tariff, the world price of wheat (Pw)
would be equalized in both countries.
• With the tariff in place, the price of wheat rises to PT at
Home and falls to P*T (= PT – t) at Foreign until the
price difference is $t.
– In Home: producers supply more and consumers demand
less due to the higher price, so that fewer imports are
demanded.
– In Foreign: producers supply less and consumers demand
more due to the lower price, so that fewer exports are
supplied.
– Thus, the volume of wheat traded declines due to the
imposition of the tariff.
• The increase in the domestic Home price is less
than the tariff, because part of the tariff is reflected
in a decline in Foreign’ s export price.
– If Home is a small country and imposes a tariff, the
foreign export prices are unaffected and the
domestic price at Home (the importing country)
rises by the full amount of the tariff.

Figure 8-5: A Tariff in a Small Country
Price, P S
PW + t
PW
D
S1 S2 D2 D1 Quantity, Q
Imports after tariff
Imports before tariff
 Measuring the Amount of Protection
• In analyzing trade policy in practice, it is important
to know how much protection a trade policy
actually provides.
– One can express the amount of protection as a
percentage of the price that would prevail under free
trade.
– Two problems arise from this method of measurement:
» In the large country case, the tariff will lower the foreign
export price.
» Tariffs may have different effects on different stages of
production of a good.

 Effective rate of protection
• One must consider both the effects of tariffs on the
final price of a good, and the effects of tariffs on the
costs of inputs used in production.
– The actual protection provided by a tariff will not equal
the tariff rate if imported intermediate goods are used in
the production of the protected good.
– Example: A European airplane that sells for $50 million has
cost $60 million to produce. Half of the purchase price of the
aircraft represents the cost of components purchased from
other countries. A subsidy of $10 million from the European
government cuts the cost of the value added to purchasers of
the airplane from $30 to $20 million. Thus, the effective rate of
protection is (30-20)/20 = 50%.
Costs and Benefits of a Tariff
 A tariff raises the price of a good in the importing
country and lowers it in the exporting country.
 As a result of these price changes:
• Consumers lose in the importing country and gain in
the exporting country
• Producers gain in the importing country and lose in the
exporting country
• Government imposing the tariff gains revenue
 To measure and compare these costs and benefits, we
need to define consumer and producer surplus.
 Consumer and Producer Surplus
• Consumer surplus
– It measures the amount a consumer gains from a purchase
by the difference between the price he actually pays and
the price he would have been willing to pay.
– It can be derived from the market demand curve.
– Graphically, it is equal to the area under the demand curve
and above the price.
– Example: Suppose a person is willing to pay $20 per
packet of pills, but the price is only $5. Then, the
consumer surplus gained by the purchase of a packet of
pills is $15.
Figure 8-6: Deriving Consumer Surplus from the Demand Curve
Price, P
$12
$10
$9
D
8 9 10 11 Quantity, Q
Figure 8-7: Geometry of Consumer Surplus
Price, P
P1
b
P2
Q1 Q2 Quantity, Q
• Producer surplus
– It measures the amount a producer gains from a sale by
the difference between the price he actually receives and
the price at which he would have been willing to sell.
– It can be derived from the market supply curve.
– Graphically, it is equal to the area above the supply
curve and below the price.
– Example: A producer willing to sell a good for $2 but
receiving a price of $5 gains a producer surplus of $3.

Figure 8-8: Geometry of Producer Surplus
Price, P
P2
d
P1
c
Q1 Q2 Quantity, Q
 Measuring the Cost and Benefits
• Is it possible to add consumer and producer surplus?
– We can (algebraically) add consumer and producer
surplus because any change in price affects each
individual in two ways:
– As a consumer
– As a worker
– We assume that at the margin a dollar’s worth of gain or
loss to each group is of the same social worth.

Figure 8-9: Costs and Benefits of a Tariff for the Importing Country
Price, P S
= consumer loss (a + b + c + d)
= producer gain (a)
PT = government revenue gain (c + e)
a b c d
PW
e
P*T
D
S1 S2 D2 D1 Quantity, Q
QT
• The areas of the two triangles b and d measure the loss
to the nation as a whole (efficiency loss) and the area
of the rectangle e measures an offsetting gain (terms of
trade gain).
– The efficiency loss arises because a tariff distorts
incentives to consume and produce.
– Producers and consumers act as if imports were more
expensive than they actually are.
– Triangle b is the production distortion loss and triangle d is
the consumption distortion loss.
– The terms of trade gain arises because a tariff lowers
foreign export prices.
• If the terms of trade gain is greater than the efficiency
loss, the tariff increases welfare for the importing
country.
– In the case of a small country, the tariff reduces welfare
for the importing country.

Figure 8-10: Net Welfare Effects of a Tariff
Price, P S
= efficiency loss (b + d)
= terms of trade gain (e)

PT
b d
PW
e
P*T
D
Quantity, Q
Imports
Other Instruments of Trade Policy
 Export Subsidies: Theory
• Export subsidy
– A payment by the government to a firm or individual
that ships a good abroad
– When the government offers an export subsidy, shippers will
export the good up to the point where the domestic price
exceeds the foreign price by the amount of the subsidy.
– It can be either specific or ad valorem.

Figure 8-11: Effects of an Export Subsidy
Price, P
S
PS
Subsidy P a b c = producer gain
W d
(a + b + c)
P*S e f g = consumer loss (a + b)
= cost of
government subsidy
(b + c + d + e + f + g)
Quantity, Q
Exports

• An export subsidy raises prices in the exporting
country while lowering them in the importing country.
• In addition, and in contrast to a tariff, the export
subsidy worsens the terms of trade.
• An export subsidy unambiguously leads to costs that
exceed its benefits.

Figure 8-12: Europe’s Common Agricultural Program
Price, P S
Support price
EU = cost of government
price subsidy
without
imports
World price
Quantity, Q
Copyright © 2003 Pearson Education, Inc. Exports Slide 8-36

 Import Quotas: Theory
• An import quota is a direct restriction on the quantity
of a good that is imported.
– Example: The United States has a quota on imports of
foreign cheese.
• The restriction is usually enforced by issuing licenses
to some group of individuals or firms.
– Example: The only firms allowed to import cheese are
certain trading companies.
• In some cases (e.g. sugar and apparel), the right to sell
in the United States is given directly to the
governments of exporting countries.
• An import quota always raises the domestic price of
the imported good.
• License holders are able to buy imports and resell
them at a higher price in the domestic market.
– The profits received by the holders of import licenses
are known as quota rents.

• Welfare analysis of import quotas versus of that of
tariffs
– The difference between a quota and a tariff is that
with a quota the government receives no revenue.
– In assessing the costs and benefits of an import
quota, it is crucial to determine who gets the rents.
– When the rights to sell in the domestic market are
assigned to governments of exporting countries, the
transfer of rents abroad makes the costs of a quota
substantially higher than the equivalent tariff.

Figure 8-13: Effects of the U.S. Import Quota on Sugar
Price, $/ton Supply
= consumer loss
(a + b + c + d)
= producer gain (a)
Price in U.S. Market 466
a c = quota rents (c)
b d
World Price 280
Demand
5.14 6.32 8.45 9.26 Quantity of sugar,
million tons
Import quota:
Copyright © 2003 Pearson Education, Inc. 2.13 million tons Slide 8-40
 Voluntary Export Restraints
• A voluntary export restraint (VER) is an export
quota administered by the exporting country.
– It is also known as a voluntary restraint agreement
(VRA).
• VERs are imposed at the request of the importer and
are agreed to by the exporter to forestall other trade
restrictions.

• A VER is exactly like an import quota where the
licenses are assigned to foreign governments and is
therefore very costly to the importing country.
• A VER is always more costly to the importing country
than a tariff that limits imports by the same amount.
– The tariff equivalent revenue becomes rents earned by
foreigners under the VER.
– Example: About 2/3 of the cost to consumers of the three major
U.S. voluntary restraints in textiles and apparel, steel, and
automobiles is accounted for by the rents earned by foreigners.
• A VER produces a loss for the importing country.
 Local Content Requirements
• A local content requirement is a regulation that
requires that some specified fraction of a final good be
produced domestically.
– This fraction can be specified in physical units or in value
terms.
• Local content laws have been widely used by
developing countries trying to shift their manufacturing
base from assembly back into intermediate goods.

• Local content laws do not produce either government
revenue or quota rents.
– Instead, the difference between the prices of imports and
domestic goods gets averaged in the final price and is
passed on to consumers.
– Example: Suppose that auto assembly firms are required to use
50% domestic parts. The cost of imported parts is $6000 and
the cost of the same parts domestically is $10,000. Then the
average cost of parts is $8000 (0.5 x $6000 + 0.5 x $10,000).
• Firms are allowed to satisfy their local content
requirement by exporting instead of using parts
domestically.

 Other Trade Policy Instruments
• Export credit subsidies
– A form of a subsidized loan to the buyer of exports.
– They have the same effect as regular export
subsidies.
• National procurement
– Purchases by the government (or public firms) can
be directed towards domestic goods, even if they are
more expensive than imports.
• Red-tape barriers
– Sometimes governments place substantial barriers
based on health, safety and customs procedures.
The Effects of Trade Policy:
A Summary
Table 8-1: Effects of Alternative Trade Policies

Summary
 A tariff drives a wedge between foreign and domestic
prices, raising the domestic price but by less than the
tariff rate (except in the “small” country case).
• In the small country case, a tariff is fully reflected in
domestic prices.
 The costs and benefits of a tariff or other trade policy
instruments may be measured using the concepts of
consumer and producer surplus.
• The domestic producers of a good gain
• The domestic consumers lose
• The government collects tariff revenue
Summary
 The net welfare effect of a tariff can be separated into
two parts:
• Efficiency (consumption and production) loss
• Terms of trade gain (is zero in the case of a small
country)
 An export subsidy causes efficiency losses similar to
a tariff but compounds these losses by causing a
deterioration of the terms of trade.
 Under import quotas and voluntary export restraints
the government of the importing country receives no
revenue.
Appendix I: Tariff Analysis in
General Equilibrium
Table 8AI-1: Free Trade Equilibrium for a Small Country
Food production and
consumption, QF, DF
D1
Q1 Slope = - P*M/P*F
Manufactures production and

consumption, QM, DM
General Equilibrium
Table 8AI-2: A Tariff in a Small Country
QF, DF
D2
Slope = - P*M/P*F (1 + t)
Q2
QM, DM

General Equilibrium
Table 8AI-3: Effect of a Tariff on the Terms of Trade
Home imports of food, DF - QF
Foreign exports of food, Q*F - D*F
M1
Slope = (P*M/P*F)2 Slope = (P*M/P*F)1
M2 F
1
3
O Home exports of manufactures, QM - DM

Foreign imports of manufactures, D*M - Q*M
Appendix II: Tariffs and Import
Quotas in the Presence of Monopoly
Table 8AII-1: A Monopolist Under Free Trade
Price, P
MC
PM
PW D
MR
Qf QM Df Quality, Q

Table 8AII-2: A Monopolist Protected by a Tariff
Price, P
MC
PM
PW + t
PW D
MR
Qf QtQM Dt Df Quality, Q

Table 8AII-3: A Monopolist Protected by an Import Quota
Price, P
MC
Pq
PW
Dq D
MRq
Qq Quality, Q

Table 8AII-4: Comparing a Tariff and a Quota
Price, P
MC
Pq
PW + t
PW
Dq D
MRq
Qq Qt Quality, Q

Chapter 13
Exchange Rates and the Foreign Exchange Market:
An Asset Approach

To Accompany
 Introduction
 Exchange Rates and International Transactions
 The Foreign Exchange Market
 The Demand for Foreign Currency Assets
 Equilibrium in the Foreign Exchange Market
 Interest Rates, Expectations, and Equilibrium
 Summary

Introduction
 Exchange rates are important because they enable us
to translate different counties’ prices into comparable
terms.
 Exchange rates are determined in the same way as
other asset prices.
 The general goal of this chapter is to show:
• How exchange rates are determined
• The role of exchange rates in international trade

Exchange Rates and
International Transactions
 An exchange rate can be quoted in two ways:
• Direct
– The price of the foreign currency in terms of dollars
• Indirect
– The price of dollars in terms of the foreign currency

Exchange Rates and
Table 13-1: Exchange Rate Quotations

Exchange Rates and
 Domestic and Foreign Prices
• If we know the exchange rate between two countries’
currencies, we can compute the price of one country’s
exports in terms of the other country’s money.
– Example: The dollar price of a £50 sweater with a dollar
exchange rate of $1.50 per pound is (1.50 $/£) x (£50) =
$75.

Exchange Rates and
• Two types of changes in exchange rates:
– Depreciation of home country’s currency
– A rise in the home currency prices of a foreign currency
– It makes home goods cheaper for foreigners and foreign goods
more expensive for domestic residents.
– Appreciation of home country’s currency
– A fall in the home price of a foreign currency
– It makes home goods more expensive for foreigners and
foreign goods cheaper for domestic residents.

Exchange Rates and
 Exchange Rates and Relative Prices
• Import and export demands are influenced by relative
prices.
• Appreciation of a country’s currency:
– Raises the relative price of its exports
– Lowers the relative price of its imports
• Depreciation of a country’s currency:
– Lowers the relative price of its exports
– Raises the relative price of its imports

Exchange Rates and
Table 13-2: $/£ Exchange Rates and the Relative Price of American
Designer Jeans and British Sweaters

The Foreign Exchange Market
 Exchange rates are determined in the foreign
exchange market.
• The market in which international currency trades take
place
 The Actors
• The major participants in the foreign exchange market
are:
– Commercial banks
– International corporations
– Nonbank financial institutions
– Central banks

Exchange Rates and
• Interbank trading
– Foreign currency trading among banks
– It accounts for most of the activity in the foreign
exchange market.

Exchange Rates and
 Characteristics of the Market
• The worldwide volume of foreign exchange trading is
enormous, and it has ballooned in recent years.
• New technologies, such as Internet links, are used
among the major foreign exchange trading centers
(London, New York, Tokyo, Frankfurt, and
Singapore).
• The integration of financial centers implies that there
can be no significant arbitrage.
– The process of buying a currency cheap and selling it
dear.
Exchange Rates and
• Vehicle currency
– A currency that is widely used to denominate
international contracts made by parties who do not
reside in the country that issues the vehicle currency.
– Example: In 2001, around 90% of transactions between banks
involved exchanges of foreign currencies for U.S. dollars.

Exchange Rates and
 Spot Rates and Forward Rates
• Spot exchange rates
– Apply to exchange currencies “on the spot”
• Forward exchange rates
– Apply to exchange currencies on some future date at a
prenegotiated exchange rate
• Forward and spot exchange rates, while not necessarily
equal, do move closely together.

Exchange Rates and
Figure 13-1: Dollar/Pound Spot and Forward Exchange Rates,
1981-2001

Exchange Rates and
 Foreign Exchange Swaps
• Spot sales of a currency combined with a forward
repurchase of the currency.
• They make up a significant proportion of all foreign
exchange trading.

Exchange Rates and
 Futures and Options
• Futures contract
– The buyer buys a promise that a specified amount of
foreign currency will be delivered on a specified date in
the future.
• Foreign exchange option
– The owner has the right to buy or sell a specified
amount of foreign currency at a specified price at any
time up to a specified expiration date.

The Demand for
Foreign Currency Assets
 The demand for a foreign currency bank deposit is
influenced by the same considerations that influence
the demand for any other asset.
 Assets and Asset Returns
• Defining Asset Returns
– The percentage increase in value an asset offers over
some time period.
• The Real Rate of Return
– The rate of return computed by measuring asset values
in terms of some broad representative basket of products
that savers regularly purchase.

The Demand for
 Risk and Liquidity
• Savers care about two main characteristics of an asset
other than its return:
– Risk
– The variability it contributes to savers’ wealth
– Liquidity
– The ease with which it can be sold or exchanged for goods

The Demand for
 Interest Rates
• Market participants need two pieces of information in
order to compare returns on different deposits:
– How the money values of the deposits will change
– How exchange rates will change
• A currency’s interest rate is the amount of that
currency an individual can earn by lending a unit of
the currency for a year.
– Example: At a dollar interest rate of 10% per year, the
lender of $1 receives $1.10 at the end of the year.

The Demand for
Figure 13-2: Interest Rates on Dollar and Deutschemark Deposits,
1975-1998

The Demand for
 Exchange Rates and Asset Returns
• The returns on deposits traded in the foreign exchange
market depend on interest rates and expected exchange
rate changes.
• In order to decide whether to buy a euro or a dollar
deposit, one must calculate the dollar return on a euro
deposit.

The Demand for
 A Simple Rule
• The dollar rate of return on euro deposits is
approximately the euro interest rate plus the rate of
depreciation of the dollar against the euro.
– The rate of depreciation of the dollar against the euro is
the percentage increase in the dollar/euro exchange rate
over a year.

The Demand for
• The expected rate of return difference between dollar
and euro deposits is:
R$ - [R€ + (Ee$/ € - E$/€ )/E$/€ ]= R$ - R€ - (Ee$/€ -E$/€ )/E$/€ (13-1)
where:
R$ = interest rate on one-year dollar deposits
R€ = today’s interest rate on one-year euro deposits
E$/€ = today’s dollar/euro exchange rate (number of
dollars per euro)
Ee$/€ = dollar/euro exchange rate (number of dollars per
euro) expected to prevail a year from today
The Demand for
• When the difference in Equation (13-1) is positive,
dollar deposits yield the higher expected rate of return.
When it is negative, euro deposits yield the higher
expected rate of return.

The Demand for
Table 13-3: Comparing Dollar Rates of Return on Dollar and
Euro Deposits

The Demand for
 Return, Risk, and Liquidity in the Foreign Exchange
Market
• The demand for foreign currency assets depends not
only on returns but on risk and liquidity.
– There is no consensus among economists about the
importance of risk in the foreign exchange market.
– Most of the market participants that are influenced by
liquidity factors are involved in international trade.
– Payments connected with international trade make up a very
small fraction of total foreign exchange transactions.
• Therefore, we ignore the risk and liquidity motives for
holding foreign currencies.
Equilibrium in the
Foreign Exchange Market
 Interest Parity: The Basic Equilibrium Condition
• The foreign exchange market is in equilibrium when
deposits of all currencies offer the same expected rate
of return.
• Interest parity condition
– The expected returns on deposits of any two currencies
are equal when measured in the same currency.
– It implies that potential holders of foreign currency
deposits view them all as equally desirable assets.
– The expected rates of return are equal when:
R$ = R€ + (Ee$/€ - E$/€)/E$/€ (13-2)
Equilibrium in the
 How Changes in the Current Exchange Rate Affect
Expected Returns
• Depreciation of a country’s currency today lowers the
expected domestic currency return on foreign currency
deposits.
• Appreciation of the domestic currency today raises the
domestic currency return expected of foreign currency
deposits.

Equilibrium in the
Table 13-4: Today’s Dollar/Euro Exchange Rate and the Expected Dollar
Return on Euro Deposits When Ee$/€ = $1.05 per Euro

Equilibrium in the
Figure 13-3: The Relation Between the Current Dollar/Euro Exchange Rate
and the Expected Dollar Return on Euro Deposits
Today’s dollar/euro
exchange rate, E$/€
1.07
1.05
1.03
1.02
1.00
0.031 0.050 0.069 0.079 0.100
Expected dollar return on
euro deposits, R€ + (Ee$/€ -
Copyright © 2003 Pearson Education, Inc. E$/€)/(E$/€) Slide 13-31
Equilibrium in the
 The Equilibrium Exchange Rate
• Exchange rates always adjust to maintain interest
parity.
• Assume that the dollar interest rate R$, the euro interest
rate R€, and the expected future dollar/euro exchange
rate Ee$/€, are all given.

Equilibrium in the
Figure 13-4: Determination of the Equilibrium Dollar/Euro Exchange Rate
Exchange rate, E$/€
Return on
dollar deposits
E2$/€ 2
E1$/€ 1
3
E3$/€
Expected return
on euro deposits
R$ Rates of return
(in dollar terms)
Interest Rates, Expectations,
and Equilibrium
 The Effect of Changing Interest Rates on the Current
Exchange Rate
• An increase in the interest rate paid on deposits of a
currency causes that currency to appreciate against
foreign currencies.
– A rise in dollar interest rates causes the dollar to
appreciate against the euro.
– A rise in euro interest rates causes the dollar to
depreciate against the euro.

and Equilibrium
Figure 13-5: Effect of a Rise in the Dollar Interest Rate
Dollar return
E1$/€ 1 1'
E2$/€ 2
Expected
euro return
R1$ R2$ Rates of return

(in dollar terms)
and Equilibrium
Figure 13-6: Effect of a Rise in the Euro Interest Rate
Dollar return
Rise in euro
interest rate
E2$/€ 2
E1$/€ 1
Expected
euro return
R$ Rates of return
(in dollar terms)
and Equilibrium
 The Effect of Changing Expectations on the Current
Exchange Rate
• A rise in the expected future exchange rate causes a
rise in the current exchange rate.
• A fall in the expected future exchange rate causes a fall
in the current exchange rate.

Summary
 Exchange rates play a role in spending decisions
because they enable us to translate different countries’
prices into comparable terms.
 A depreciation (appreciation) of a country’s currency
against foreign currencies makes its exports cheaper
(more expensive) and its imports more expensive
(cheaper).
 Exchange rates are determined in the foreign
exchange market.

Summary
 An important category of foreign exchange trading is
forward trading.
 The exchange rate is most appropriately thought of as
being an asset price itself.
 The returns on deposits traded in the foreign
exchange market depend on interest rates and
expected exchange rate changes.

Summary
 Equilibrium in the foreign exchange market requires
interest parity.
• For given interest rates and a given expectation of the
future exchange rate, the interest parity condition tells
us the current equilibrium exchange rate.
 A rise in dollar (euro) interest rates causes the dollar
to appreciate (depreciate) against the euro.
 Today’s exchange rate is altered by changes in its
expected future level.

Chapter 14
Money, Interest Rates, and Exchange Rates

To Accompany
 Introduction
 Money Defined: A Brief Review
 The Demand for Money by Individuals
 Aggregate Money Demand
 The Equilibrium Interest Rate: The Interaction of
Money Supply and Demand

 The Money Supply and the Exchange Rate in the
Short Run
 Money, the Price Level, and the Exchange Rate in the
Long Run
 Inflation and Exchange Rate Dynamics
 Summary

Introduction
 Factors that affect a country’s money supply or
demand are among the most powerful determinants of
its currency’s exchange rate against foreign
currencies.
 This chapter combines the foreign-exchange market
with the money market to determine the exchange
rate in the short run.
• It analyzes the long-term effects of monetary changes
on output prices and expected future exchange rates.

Money Defined: A Brief Review
 Money as a Medium of Exchange
• A generally accepted means of payment
 Money as a Unit of Account
• A widely recognized measure of value
 Money as a Store of Value
• A transfer of purchasing power from the present into
the future

 What Is Money?
• Assets widely used and accepted as a means of
payment.
• Money is very liquid, but pays little or no return.
– All other assets are less liquid but pay higher return.
• Money Supply (Ms)
Ms = Currency + Checkable Deposits

 How the Money Supply Is Determined
• An economy’s money supply is controlled by its
central bank.
– The central bank:
– Directly regulates the amount of currency in existence
– Indirectly controls the amount of checking deposits issued by
private banks

The Demand for
Money by Individuals
 Three factors influence money demand:
• Expected return
• Risk
• Liquidity
 Expected Return
• The interest rate measures the opportunity cost of
holding money rather than interest-bearing bonds.
– A rise in the interest rate raises the cost of holding
money and causes money demand to fall.

The Demand for
 Risk
• Holding money is risky.
– An unexpected increase in the prices of goods and
services could reduce the value of money in terms of the
commodities consumed.
• Changes in the risk of holding money need not cause
individuals to reduce their demand for money.
– Any change in the riskiness of money causes an equal
change in the riskiness of bonds.

The Demand for
 Liquidity
• The main benefit of holding money comes from its
liquidity.
– Households and firms hold money because it is the
easiest way of financing their everyday purchases.
• A rise in the average value of transactions carried out
by a household or firm causes its demand for money to
rise.

Aggregate Money Demand
 Aggregate money demand
• The total demand for money by all households and
firms in the economy.
• It is determined by three main factors:
– Interest rate
– It reduces the demand for money.
– Price level
– It raises the demand for money.
– Real national income
– It raises the demand for money.

 The aggregate demand for money can be expressed by:
Md = P x L(R,Y) (14-1)
where:
P is the price level
Y is real national income
L(R,Y) is the aggregate real money demand
 Equation (14-1) can also be written as:
Md/P = L(R,Y) (14-2)

Figure 14-1: Aggregate Real Money Demand and the Interest Rate
Interest
rate, R
L(R,Y)
Aggregate real
money demand
Figure 14-2: Effect on the Aggregate Real Money Demand Schedule of
a Rise in Real Income
Interest
rate, R
Increase in
real income
L(R,Y2)
L(R,Y1)
Aggregate real
Copyright © 2003 Pearson Education, Inc. money demand Slide 14-14
The Equilibrium Interest Rate: The
Interaction of Money Supply and Demand
 Equilibrium in the Money Market
• The condition for equilibrium in the money market is:
Ms = M d (14-
3)
• The money market equilibrium condition can be
expressed in terms of aggregate real money demand
as:
Ms/P = L(R,Y) (14-4)

Figure 14-3: Determination of the Equilibrium Interest Rate
Interest
rate, R
Real money supply
2
R2
1 Aggregate real
R1 money demand,
3 L(R,Y)
R3
Q2 MS ( = Q1) Q3 Real money

P holdings
 Interest Rates and the Money Supply

• An increase (fall) in the money supply lowers (raises)
the interest rate, given the price level and output.
– The effect of increasing the money supply at a given
price level is illustrated in Figure 14-4.

Figure 14-4: Effect of an Increase in the Money Supply on the Interest
Rate
Interest
rate, R
Real money
supply Real money
supply increase
1
R1
R2 2
L(R,Y1)
M1 M2 Real money
P P holdings
 Output and the Interest Rate

• An increase (fall) in real output raises (lowers) the
interest rate, given the price level and the money
supply.
– Figure 14-5 shows the effect on the interest rate of a rise
in the level of output, given the money supply and the
price level.

Figure 14-5: Effect on the Interest Rate of a Rise in Real Income
Interest
rate, R
Real money supply
Increase in
real income
2
R2
1 1'
R1 L(R,Y2)
L(R,Y1)
MS ( = Q1) Q2 Real money

P holdings
The Money Supply and the
Exchange Rate in the Short Run
 Short run analysis
• The price level and the real output are given.
 Long run analysis
• The price level is perfectly flexible and always
adjusted immediately to preserve full employment.

The Money Supply and the
Exchange Rate in the Short Run
 Linking Money, the Interest Rate, and the Exchange
Rate
• The U.S. money market determines the dollar interest
rate, which in turn affects the exchange rate that
maintains the interest parity.
– Figure 14-6 links the U.S. money market (bottom) and
the foreign exchange market (top).

Figure 14-6: Simultaneous Equilibrium in the U.S. Money Market
and the Foreign-Exchange Market
Dollar/euro
exchange Rate, E$/€
Return on
dollar deposits
Foreign
exchange 1'
E1$/€ Expected
market return on
euro deposits Rates of
return
0
R1$ L(R$, YUS) (in dollar
terms)
Money MSUS U.S. real
market PUS 1 money
(increasing) supply
U.S. real money holdings

Figure 14-7: Money-Market/Exchange Rate Linkages
United States Europe
Federal Reserve System European System
of Central Banks
MSUS (United States MSE (European

money supply) money supply)
United States European

money market money market
Foreign R€
R$
exchange (Euro interest rate)
(Dollar interest rate)
market
E$/€
(Dollar/Euro exchange rate)
 U.S. Money Supply and the Dollar/Euro Exchange

Rate
• What happens when the Federal Reserve changes the
U.S. money supply?
– An increase (decrease) in a country’s money supply
causes its currency to depreciate (appreciate) in the
foreign exchange market.

Figure 14-8: Effect on the Dollar/Euro Exchange Rate and Dollar
Interest Rate of an Increase in the U.S. Money Supply
Dollar/euro
Return on
dollar deposits
E2$/€ 2'
1'
E1$/€ Expected
return on
euro deposits Rates of
return
0
R2$ R1$ L(R$, YUS) (in dollar
M1US terms)
PUS Increase in U.S.
1 real money supply
M2US
PUS 2

 Europe’s Money Supply and the Dollar/Euro
Exchange Rate
• An increase in Europe’s money supply causes a
depreciation of the euro (i.e., appreciation of the
dollar).
• A reduction in Europe’s money supply causes an
appreciation of the euro (i.e., a depreciation of the
dollar).
• The change in the European money supply does not
disturb the U.S. money market equilibrium.

Figure 14-9: Effect of an Increase in the European Money Supply
on the Dollar/Euro Exchange Rate
Dollar/euro
Dollar return
1'
E1$/€ Increase in European
2' money supply
E2$/€
Expected Rates of
euro return return
0
R1$ (in dollar
L(R$, YUS)
terms)
MSUS U.S. real
PUS 1 money
supply

Money, the Price Level, and the
Exchange Rate in the Long Run
 Long-run equilibrium
• Prices are perfectly flexible and always adjusted
immediately to preserve full employment.
 Money and Money Prices
• The money market equilibrium (Equation 14-4) can be
rearranged to give the long-run equilibrium price level:
P = Ms/L(R,Y) (14-5)
• An increase in a country’s money supply causes a
proportional increase in its price level.

 The Long-Run Effects of Money Supply Changes
• A change in the supply of money has no effect on the
long-run values of the interest rate or real output.
• A permanent increase in the money supply causes a
proportional increase in the price level’s long-run
value.
– This prediction is based on the money market
equilibrium condition: Ms/P = L or P = Ms/L.
– This condition implies that ∆P/P = ∆Ms/Ms - ∆L/L.
– The inflation rate equals the monetary growth rate less the
growth rate for money demand.

 Empirical Evidence on Money Supplies and Price
Levels
• In a cross-section of countries, long-term changes in
money supplies and price levels show a clear positive
correlation.

Figure 14-10: Monetary Growth and Price-Level Change in the Seven
Main Industrial Countries, 1973-1997

 Money and the Exchange Rate in the Long Run
• A permanent increase (decrease) in a country’s money
supply causes a proportional long-run depreciation
(appreciation) of its currency against foreign
currencies.

Inflation and
Exchange Rate Dynamics
 Inflation
• A situation where an economy’s price level rises.
 Deflation
• A situation where an economy’s price level falls.
 Short-Run Price Rigidity versus Long-Run Price
Flexibility
• The short-run “stickiness” of price levels is illustrated
in Figure 14-11.

Inflation and
Figure 14-11: Month-to-Month Variability of the Dollar/DM Exchange
Rate and of the U.S./German Price-Level Ratio, 1974-2001

Inflation and
• A change in the money supply creates demand and
cost pressures that lead to future increases in the price
level from three main sources:
– Excess demand for output and labor
– Inflationary expectations
– Raw materials prices

Inflation and
 Permanent Money Supply Changes and the Exchange
Rate
• How does the dollar/euro exchange rate adjust to a
permanent increase in the U.S. money supply?
– Figure 14-12 shows both the short-run and long-run
effects of the increase in the U.S. money supply.

Inflation and
Figure 14-12: Effects of an Increase in the U.S.Money Supply
Dollar/euro exchange Dollar/euro exchange
Rate, E$/€ Rate, E$/€
Dollar return Dollar return
2'
E2$/€ E2$/€ 2'
Expected
euro return 4' Expected
3' E3$/€ euro return
E1$/€ 1'
Rates of return
0 (in dollar 0
R2$ R1$ L(R , Y ) terms) R2$ R1$
M1US $ US
2
M US L(R$, YUS)
1
P US P2US 4
1 U.S. real money supply
M2US M2US
2 P1US 2
P1US
(a) Short-run effects (b) Adjustment to long-

U.S. real U.S. real run equilibrium
money holdings money holdings
Inflation and
Figure 14-13: Time Paths of U.S. Economic Variables After a Permanent
Increase in the U.S. Money Supply
(a) U.S. money supply, MUS (b) Dollar interest rate, R$
M2US R1$
M1US R2$
t0 Time t0 Time
(c) U.S. price level, PUS (d) Dollar/euro exchange rate, E$/€
E2$/€
P2US E3$/€
P1US E1$/€
t0 Time t0 Time
Inflation and
 Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a disturbance is greater than its
long-run response.
• It helps explain why exchange rates move so sharply
form day to day.
• It is a direct result of sluggish short-run price level
adjustment and the interest parity condition.

Summary
 Money is held because of its liquidity.
 Aggregate real money demand depends negatively on
the opportunity cost of holding money and positively
on the volume of transactions in the economy.
 The money market is in equilibrium when the real
money supply equals aggregate real money demand.
 By lowering the domestic interest rate, an increase in
the money supply causes the domestic currency to
depreciate in the foreign exchange market.

Summary
 Permanent changes in the money supply push the
long-run equilibrium price level proportionally in the
same direction.
• These changes do not influence the long-run values of
output, the interest rate, or any relative prices.
 An increase in the money supply can cause the
exchange rate to overshoot its long-run level in the
short run.

Price Levels and the Exchange Rate in the Long Run
Chapter 15

To Accompany
 Introduction
 The Law of One Price
 Purchasing Power Parity
 A Long-Run Exchange Rate Model Based on PPP
 Empirical Evidence on PPP and the Law of One Price
 Explaining the Problems with PPP

 Beyond Purchasing Power Parity: A General Model
of Long-Run Exchange Rates
 International Interest Rate Differences and the Real
Exchange Rate
 Real Interest Parity
 Summary
 Appendix: The Fisher Effect, the Interest Rate, and
the Exchange Rate Under the Flexible-Price
Monetary Approach

Introduction
 The model of long-run exchange rate behavior
provides the framework that actors in asset markets
use to forecast future exchange rates.
 Predictions about long-run movements in exchange
rates are important even in the short run.
 In the long run, national price levels play a key role in
determining both interest rates and the relative prices
at which countries’ products are traded.
• The theory of purchasing power parity (PPP)
explains movements in the exchange rate between two
countries’ currencies by changes in the countries’ price
levels.
The Law of One Price
 Law of one price
• Identical goods sold in different countries must sell for
the same price when their prices are expressed in terms
of the same currency.
– This law applies only in competitive markets free of
transport costs and official barriers to trade.
– Example: If the dollar/pound exchange rate is $1.50 per pound,
a sweater that sells for $45 in New York must sell for £30 in
London.

The Law of One Price
– It implies that the dollar price of good i is the same
wherever it is sold:
PiUS = (E$/€) x (PiE)
where:
PiUS is the dollar price of good i when sold
in the U.S.
PiE is the corresponding euro price in
Europe
E$/€ is the dollar/euro exchange rate

Purchasing Power Parity
 Theory of Purchasing Power Parity (PPP)
• The exchange rate between two counties’ currencies
equals the ratio of the counties’ price levels.
• It compares average prices across countries.
• It predicts a dollar/euro exchange rate of:
E$/€ = PUS/PE (15-

1)
where:
PUS is the dollar price of a reference commodity
basket sold in the United States
PE is the euro price of the same basket in Europe
 By rearranging Equation (15-1), one can obtain:
PUS = (E$/€) x (PE)
 PPP asserts that all countries’ price levels are equal

when measured in terms of the same currency.

 The Relationship Between PPP and the Law of One
Price
• The law of one price applies to individual
commodities, while PPP applies to the general price
level.
• If the law of one price holds true for every commodity,
PPP must hold automatically for the same reference
baskets across countries.
• Proponents of the PPP theory argue that its validity
does not require the law of one price to hold exactly.

 Absolute PPP and Relative PPP
• Absolute PPP
– It states that exchange rates equal relative price levels.
• Relative PPP
– It states that the percentage change in the exchange rate
between two currencies over any period equals the
difference between the percentage changes in national
price levels.
– Relative PPP between the United States and Europe
would be:
(E$/€,t - E$/€, t –1)/E$/€, t –1 = πUS, t - πE, t (15-2)
where:
πt = inflation rate
A Long-Run Exchange Rate
Model Based on PPP
 Monetary approach to the exchange rate
• A theory of how exchange rates and monetary factors
interact in the long run.
 The Fundamental Equation of the Monetary
Approach
• Price levels can be expressed in terms of domestic
money demand and supplies:
– In the United States:
PUS = MsUS/L (R$, YUS) (15-3)
– In Europe:
PE = MsE/L (R€, YE) (15-4)
Model Based on PPP
• The monetary approach makes a number of specific
predictions about the long-run effects on the exchange
rate of changes in:
– Money supplies
– An increase in the U.S. (European) money supply causes a
proportional long-run depreciation (appreciation) of the dollar
against the euro.
– Interest rates
– A rise in the interest rate on dollar (euro) denominated assets
causes a depreciation (appreciation) of the dollar against the euro.
– Output levels
– A rise in U.S. (European) output causes an appreciation
(depreciation) of the dollar against the euro.
Model Based on PPP
 Ongoing Inflation, Interest Parity, and PPP
• Money supply growth at a constant rate eventually
results in ongoing inflation (i.e., continuing rise in the
price level) at the same rate.
– Changes in this long-run inflation rate do not affect the
full-employment output level or the long-run relative
prices of goods and services.
• The interest rate is not independent of the money
supply growth rate in the long run.

Model Based on PPP
• The international interest rate difference is the
difference between expected national inflation
rates:
R$ - R€ = πeUS - πe (15-5)

Model Based on PPP
 The Fisher Effect
• A rise (fall) in a country’s expected inflation rate will
eventually cause an equal rise (fall) in the interest rate
that deposits of its currency offer.
– Figure 15-1 illustrates an example, where at time t0 the
Federal Reserve unexpectedly increases the growth rate
of the U.S. money supply to a higher level.

Model Based on PPP
Figure 15-1: Long-Run Time Paths of U.S. Economic Variables after a
Permanent Increase in the Growth Rate of the U.S. Money
Supply
(a) U.S. money supply, MUS (b) Dollar interest rate, R$
R$2 = R$1 + ∆π
Slope = π + ∆π
MUS, t0
R$1
Slope = π
t0 Time t0 Time
(c) U.S. price level, PUS (d) Dollar/euro exchange rate, E$/€
Slope = π + ∆π Slope = π + ∆π
Slope = π Slope = π
t0 Time t0 Time
Model Based on PPP
• In this example, the dollar interest rate rises because
people expect more rapid future money supply growth
and dollar depreciation.
• The interest rate increase is associated with higher
expected inflation and an immediate currency
depreciation.
• Figure 15-2 confirms the main long-run prediction of
the Fisher effect.

Model Based on PPP
Figure 15-2: Inflation and Interest Rates in Switzerland, the United
States, and Italy, 1970-2000

Model Based on PPP
Figure 15-2: Continued

Model Based on PPP
Figure 15-2: Continued

Empirical Evidence on PPP
and the Law of One Price
 The empirical support for PPP and the law of one
price is weak in recent data.
• The prices of identical commodity baskets, when
converted to a single currency, differ substantially
across countries.
• Relative PPP is sometimes a reasonable approximation
to the data, but it performs poorly.

Empirical Evidence on PPP
and the Law of One Price
Figure 15-3: The Dollar/DM Exchange Rate and Relative U.S./German
Price Levels, 1964-2000

Explaining the Problems with PPP
 The failure of the empirical evidence to support the
PPP and the law of one price is related to:
• Trade barriers and nontradables
• Departures from free competition
• International differences in price level measurement

 Trade Barriers and Nontradables
• Transport costs and governmental trade restrictions
make trade expensive and in some cases create
nontradable goods.
– The greater the transport costs, the greater the range
over which the exchange rate can move.

 Departures from Free Competition
• When trade barriers and imperfectly competitive
market structures occur together, linkages between
national price levels are weakened further.
• Pricing to market
– When a firm sells the same product for different prices
in different markets.
– It reflects different demand conditions in different
countries.
– Example: Countries where demand is more price-inelastic will
tend to be charged higher markups over a monopolistic seller’s
production cost.
 International Differences in Price Level Measurement
• Government measures of the price level differ from
country to country because people living in different
counties spend their income in different ways.
 PPP in the Short Run and in the Long Run
• Departures from PPP may be even greater in the short-
run than in the long run.
– Example: An abrupt depreciation of the dollar against
foreign currencies causes the price of farm equipment in
the U.S. to differ from that of foreign’s until markets
adjust to the exchange rate change.
Figure 15-4: Price Levels and Real Incomes, 1992

Beyond Purchasing Power Parity: A General
Model of Long-Run Exchange Rates
 The Real Exchange Rate

• It is a broad summary measure of the prices of one
country’s goods and services relative to the other's.
• It is defined in terms of nominal exchange rates and
price levels.
• The real dollar/euro exchange rate is the dollar price of
the European basket relative to that of the American:
q$/€ = (E$/€ x PE)/PUS (15-6)
– Example: If the European reference commodity basket
costs €100, the U.S. basket costs $120, and the nominal
exchange rate is $1.20 per euro, then the real dollar/euro
exchange rate is 1 U.S. basket per European basket.
• Real depreciation of the dollar against the euro

– A rise in the real dollar/euro exchange rate
– That is, a fall in the purchasing power of a dollar within
Europe’s borders relative to its purchasing power within the
United States
– Or alternatively, a fall in the purchasing power of America’s
products in general over Europe’s.
• A real appreciation of the dollar against the euro is
the opposite of a real depreciation.

 Demand, Supply, and the Long-Run Real Exchange

Rate
• In a world where PPP does not hold, the long-run values
of real exchange rates depend on demand and supply
conditions.

• There are two specific causes that explain why the

long-run values of real exchange rates can change:
– A change in world relative demand for American
products
– An increase (fall) in world relative demand for U.S. output
causes a long-run real appreciation (depreciation) of the dollar
against the euro.
– A change in relative output supply
– A relative expansion of U.S (European) output causes a long-
run real depreciation (appreciation) of the dollar against the
euro.

 Nominal and Real Exchange Rates in Long-Run

Equilibrium
• Changes in national money supplies and demands give
rise to the proportional long-run movements in
nominal exchange rates and international price level
ratios predicted by the relative PPP theory.
• From Equation (15-6), one can obtain the nominal
dollar/euro exchange rate, which is the real dollar/euro
exchange rate times the U.S.-Europe price level ratio:
E $/€ = q$/€ x (PUS/PE) (15-7)

• Equation (15-7) implies that for a given real

dollar/euro exchange rate, changes in money demand
or supply in Europe or the U.S. affect the long-run
nominal dollar/euro exchange rate as in the monetary
approach.
– Changes in the long-run real exchange rate, however,
also affect the long-run nominal exchange rate.

 The most important determinants of long-run swings

in nominal exchange rates (assuming that all variables
start out at their long-run levels):
• A shift in relative money supply levels
• A shift in relative money supply growth rates
• A change in relative output demand
• A change in relative output supply

 When all disturbances are monetary in nature,

exchange rates obey relative PPP in the long run.
• In the long run, a monetary disturbance affects only
the general purchasing power of a currency.
– This change in purchasing power changes equally the
currency’s value in terms of domestic and foreign
goods.
• When disturbances occur in output markets, the
exchange rate is unlikely to obey relative PPP, even in
the long run.

Table 15-1: Effects of Money Market and Output Market Changes on the
Long-Run Nominal Dollar/Euro Exchange Rate, E$/€

Figure 15-5: The Real Dollar/Yen Exchange Rate, 1950-2000

Figure 15-6: Sectoral Productivity Growth Differences and the Change in
the Relative Price of Nontraded Goods, 1970-1985

International Interest Rate Differences
and the Real Exchange Rate
 In general, interest rate differences between countries
depend not only on differences in expected inflation,
but also on expected changes in the real exchange
rate.
 Relationship between the expected change in the real
exchange rate, the expected change in the nominal
rate, and expected inflation:
(qe$/€ - q$/€)/q$/€ = [(Ee$/€ - E$/€)/E$/€] – (πeUS - πeE) (15-8)

International Interest Rate Differences
and the Real Exchange Rate
 Combining Equation (15-8) with the interest parity
condition, the international interest gap is equal to:
R$ - R€ = [(qe$/€ - q$/€)/q$/€] + (πeUS - πeE) (15-9)
• Thus, the dollar-euro interest difference is the sum of
two components:
– The expected rate of real dollar depreciation against the
euro
– The expected inflation difference between the U.S. and
Europe
• When the market expects relative PPP to prevail, the
dollar-euro interest difference is just the expected
inflation difference between U.S. and Europe.
Real Interest Parity
 Economics makes an important distinction between
two types of interest rates:
• Nominal interest rates
– Measured in monetary terms
• Real interest rates
– Measured in real terms (in terms of a country’s output)
– Referred to as expected real interest rates

 The expected real interest rate (re) is the nominal
interest rate (r) less the expected inflation rate (πe).
 Thus, the difference in expected real interest rates
between U.S. and Europe is equal to:
reUS – reE = (R$ - πeUS) - (R € - πeE)
 By combining this equation with Equation (15-9), one
can obtain the desired real interest parity condition:
reUS – reE = (qe$/€ - q$/€)/q$/€ (15-10)

 The real interest parity condition explains differences
in expected real interest rates between two countries
by expected movements in the real exchange rates.
 Expected real interest rates in different countries need
not be equal, even in the long run, if continuing
change in output markets is expected.

Summary
 Absolute PPP states that the purchasing power of any
currency is the same in any country and implies
relative PPP.
 Relative PPP predicts that percentage changes in
exchange rates equal differences in national inflation
rates.
 The law of one price is a building block of the PPP
theory.
• It states that under free competition and in the absence
of trade impediments, a good must sell for a single
price regardless of where in the world it is sold.
Summary
 The monetary approach to the exchange rate uses PPP
to explain long-term exchange rate behavior
exclusively in terms of money supply and demand.
• The Fisher effect predicts that long-run international
interest differentials result from different national rates
of ongoing inflation.
 The empirical support for PPP and the law of one
price is weak in recent data.
• The failure of these propositions in the real world is
related to trade barriers, departure from free
competition and international differences in price level
measurement.
Summary
 Deviations from relative PPP can be viewed as
changes in a country’s real exchange rate.
 A stepwise increase in a country’s money stock leads
to a proportional increase in its price level and a
proportional fall in its currency’s foreign exchange
value.
 The (real) interest parity condition equates
international differences in nominal (real) interest
rates to the expected percentage change in the
nominal (real) exchange rate.
Appendix: The Fisher Effect, the Interest Rate,
and the Exchange Rate Under
the Flexible-Price Monetary Approach
Figure 15A-1: How a Rise in U.S. Monetary Growth Affects When
Goods Prices are Flexible
Dollar/euro exchange rate, E$/€ Expected return on euro
45° line deposits after rise in
E2$/€ expected dollar depreciation
2'
E1$/€ 1'
Initial expected return
on euro deposits
Dollar/euro
Rates of return
exchange E2$/€ E1$/€ R$1 R$2 = R$1 + ∆π (in dollar terms)
rate, E$/€ Money demand,
M1US
L(R$, YUS)
PPP relation P2US 2
M1US
P1US 1
Chapter 16
Output and the Exchange Rate in the Short Run

To Accompany
 Determinants of Aggregate Demand in an Open
Economy
 The Equation of Aggregate Demand
 How Output Is Determined in the Short Run
 Output Market Equilibrium in the Sort Run: The DD
Schedule
 Asset Market Equilibrium in the Short Run: The AA
Schedule
 Short-Run Equilibrium for an Open Economy:
Putting the DD and AA Schedules Together
 Temporary Changes in Monetary and Fiscal Policy
 Inflation Bias and Other Problems of Policy
Formulation
 Permanent Shifts in Monetary and Fiscal Policy
 Macroeconomic Policies and the Current Account
 Gradual Trade Flow Adjustment and Current Account
Dynamics
 Summary

 Appendix I: The IS-LM Model and the DD-AA Model
 Appendix II: Intertemporal Trade and Consumption
Demand
 Appendix III: The Marshall-Lerner Condition and
Empirical Estimates of Trade Elasticities

Introduction
 Macroeconomic changes that affect exchange rates,
interest rates, and price levels may also affect output.
• This chapter introduces a new theory of how the
output market adjusts to demand changes when
product prices are themselves slow to adjust.
 A short-run model of the output market in an open
economy will be utilized to analyze:
• The effects of macroeconomic policy tools on output
and the current account
• The use of macroeconomic policy tools to maintain
full employment
Determinants of Aggregate
Demand in an Open Economy
 Aggregate demand
• The amount of a country’s goods and services
demanded by households and firms throughout the
world.
 The aggregate demand for an open economy’s output
consists of four components:
• Consumption demand (C)
• Investment demand (I)
• Government demand (G)
• Current account (CA)
 Determinants of Consumption Demand
• Consumption demand increases as disposable income
(i.e., national income less taxes) increases at the
aggregate level.
– The increase in consumption demand is less than the
increase in the disposable income because part of the
income increase is saved.

 Determinants of the Current Account
• The CA balance is viewed as the demand for a
country’s exports (EX) less that country's own demand
for imports (IM).
• The CA balance is determined by two main factors:
– The domestic currency’s real exchange rate against
foreign currency (q = EP*/P)
– Domestic disposable income (Yd)

 How Real Exchange Rate Changes Affect the Current
Account
• An increase in q raises EX and improves the domestic
country’s CA.
– Each unit of domestic output now purchases fewer units
of foreign output, therefore, foreign will demand more
exports.
• An increase q can raise or lower IM and has an
ambiguous effect on CA.
– IM denotes the value of imports measured in terms of
domestic output.
 There are two effects of a real exchange rate:
• Volume effect
– The effect of consumer spending shifts on export and
import quantities
• Value effect
– It changes the domestic output worth of a given volume
of foreign imports.
 Whether the CA improves or worsens depends on
which effect of a real exchange rate change is
dominant.
 We assume that the volume effect of a real exchange
rate change always outweighs the value effect.
 How Disposable Income Changes Affect the Current
Account
• An increase in disposable income (Yd) worsens the CA.
• A rise in Yd causes domestic consumers to increase
their spending on all goods.

Table 16-1: Factors Determining the Current Account

The Equation of Aggregate Demand
 The four components of aggregate demand are
combined to get the total aggregate demand:
D = C(Y – T) + I + G + CA(EP*/P, Y – T)
 This equation shows that aggregate demand for home
output can be written as:
D = D(EP*/P, Y – T, I, G)

 The Real Exchange Rate and Aggregate Demand
• An increase in q raises CA and D.
– It makes domestic goods and services cheaper relative
to foreign goods and services.
– It shifts both domestic and foreign spending from
foreign goods to domestic goods.
– A real depreciation of the home currency raises
aggregate demand for home output.
– A real appreciation lowers aggregate demand for home output.

 Real Income and Aggregate Demand
• A rise in domestic real income raises aggregate
demand for home output.
• A fall in domestic real income lowers aggregate
demand for home output.

Figure 16-1: Aggregate Demand as a Function of Output
Aggregate
demand, D
Aggregate demand function,

D(EP*/P, Y – T, I, G)
45°
Output (real income), Y

How Output Is
Determined in the Short Run
 Output market is in equilibrium in the short-run when
real output, Y, equals the aggregate demand for
domestic output:
Y = D(EP*/P, Y – T, I, G) (16-1)

How Output Is
Determined in the Short Run
Figure 16-2: The Determination of Output in the Short Run
Aggregate
demand, D
Aggregate demand =
aggregate output, D = Y
Aggregate demand
1 3
D1
2
45°
Y2 Y1 Y3 Output, Y
Output Market Equilibrium in the
Short Run: The DD Schedule
 Output, the Exchange Rate, and Output Market
Equilibrium
• With fixed price levels at home and abroad, a rise in
the nominal exchange rate makes foreign goods and
services more expensive relative to domestic goods
and services.
– Any rise in q will cause an upward shift in the aggregate
demand function and an expansion of output.
– Any fall in q will cause output to contract.

Figure 16-3: Output Effect of a Currency Depreciation with Fixed
Output Prices
Aggregate
demand, D D=Y
Currency Aggregate demand (E2)
depreciates 2
Aggregate demand (E1)
1
45°
Y1 Y2 Output, Y
 Deriving the DD Schedule
• DD schedule
– It shows all combinations of output and the exchange
rate for which the output market is in short-run
equilibrium (aggregate demand = aggregate output).
– It slopes upward because a rise in the exchange rate
causes output to rise.

Figure 16-4: Deriving the DD Schedule
Aggregate demand, D D=Y
Exchange rate, E Y1 Y2 Output, Y
DD
E2
2
E1
1
Copyright © 2003 Pearson Education, Inc. Y1 Y2 Output, Y Slide 16-22

 Factors that Shift the DD Schedule
• Government purchases
• Taxes
• Investment
• Domestic price levels
• Foreign price levels
• Domestic consumption
• Demand shift between foreign and domestic goods
 A disturbance that raises (lowers) aggregate demand for
domestic output shifts the DD schedule to the right (left).
Figure 16-5: Government Demand and the Position of the DD Schedule
Aggregate demand, D D=Y
Government D(E0P*/P, Y – T, I, G2)
spending rises Aggregate demand curves
D(E0P*/P, Y – T, I, G1)
Exchange rate, E Y1 Y2 Output, Y

DD1
DD2
1 2
E0
Copyright © 2003 Pearson Education, Inc. Y1 Y2 Output, Y Slide 16-24

Asset Market Equilibrium in the
Short Run: The AA Schedule
 AA Schedule
• It shows all combinations of exchange rate and output
that are consistent with equilibrium in the domestic
money market and the foreign exchange market.

 Output, the Exchange Rate, and Asset Market
Equilibrium
• We will combine the interest parity condition with the
money market to derive the asset market equilibrium
in the short-run.
• The interest parity condition describing foreign
exchange market equilibrium is:
R = R* + (Ee – E)/E
where: Ee is the expected future exchange rate
R is the interest rate on domestic currency deposits
R* is the interest rate on foreign currency deposits
• The R satisfying the interest parity condition must also
equate the real domestic money supply to aggregate
real money demand:
Ms/P = L(R, Y)
• Aggregate real money demand L(R, Y) rises when the
interest rate falls because a fall in R makes interest-
bearing nonmoney assets less attractive to hold.

Figure 16-6: Output and the Exchange Rate in Asset Market Equilibrium
Exchange Rate, E
Foreign E1 1'
exchange 2'
E2 Domestic-currency
market return on foreign-
currency deposits Domestic
interest
0
R1 R2 rate, R
L(R, Y1)
Money L(R, Y2)
market MS Output rises
Real money
P 2
1 supply
Real domestic money holdings

 For asset markets to remain in equilibrium:
• A rise in domestic output must be accompanied by an
appreciation of the domestic currency.
• A fall in domestic output must be accompanied by a
depreciation of the domestic currency.

 Deriving the AA Schedule
• It relates exchange rates and output levels that keep the
money and foreign exchange markets in equilibrium.
• It slopes downward because a rise in output causes a
rise in the home interest rate and a domestic currency
appreciation.

Figure 16-7: The AA Schedule
Exchange
Rate, E
1
E1
2
E2
AA
Y1 Y2 Output, Y
 Factors that Shift the AA Schedule
• Domestic money supply
• Domestic price level
• Expected future exchange rate
• Foreign interest rate
• Shifts in the aggregate real money demand schedule

Short-Run Equilibrium for an Open Economy:
 A short-run equilibrium for the economy as a whole

must bring equilibrium simultaneously in the output
and asset markets.
• That is, it must lie on both DD and AA schedules.

Figure 16-8: Short-Run Equilibrium: The Intersection of DD and AA
Exchange
Rate, E DD
1
E1
Y1 Output, Y
Figure 16-9: How the Economy Reaches Its Short-Run Equilibrium
Exchange
Rate, E DD
E2 2
E3
3 1
E1
AA
Y1 Output, Y
Temporary Changes
in Monetary and Fiscal Policy
 Two types of government policy:
• Monetary policy
– It works through changes in the money supply.
• Fiscal policy
– It works through changes in government spending or
taxes.
• Temporary policy shifts are those that the public
expects to be reversed in the near future and do not
affect the long-run expected exchange rate.
• Assume that policy shifts do not influence the foreign
interest rate and the foreign price level.

Temporary Changes
 Monetary Policy
• An increase in money supply (i.e., expansionary
monetary policy) raises the economy’s output.
– The increase in money supply creates an excess supply
of money, which lowers the home interest rate.
– As a result, the domestic currency must depreciate (i.e., home
products become cheaper relative to foreign products) and
aggregate demand increases.

Temporary Changes
Figure 16-10: Effects of a Temporary Increase in the Money Supply
Exchange
Rate, E DD
2
E2
1
E1
AA2
AA1
Y1 Y2 Output, Y
Temporary Changes
 Fiscal Policy
• An increase in government spending, a cut in taxes, or
some combination of the two (i.e, expansionary fiscal
policy) raises output.
– The increase in output raises the transactions demand
for real money holdings, which in turn increases the
home interest rate.
– As a result, the domestic currency must appreciate.

Temporary Changes
Figure 16-11: Effects of a Temporary Fiscal Expansion
Exchange
Rate, E DD1
DD2
1
E1
2
E2
AA
Y1 Y2 Output, Y
Temporary Changes
 Policies to Maintain Full Employment
• Temporary disturbances that lead to recession can be
offset through expansionary monetary or fiscal
policies.
– Temporary disturbances that lead to overemployment
can be offset through contractionary monetary or fiscal
policies.

Temporary Changes
Figure 16-12: Maintaining Full Employment After a Temporary Fall in
World Demand for Domestic Products
Exchange
Rate, E DD2
DD1
E3 3
2
E2
AA2
E1 1
AA1
Y2 Yf Output, Y
Temporary Changes
Figure 16-13: Policies to Maintain Full Employment After
a Money-Demand Increase
Exchange
Rate, E DD1
DD2
E1 1
2
E2
AA1
E3 3
AA2
Y2 Yf Output, Y
Inflation Bias and Other
Problems of Policy Formulation
 Problems of policy formulation:
• Inflation bias
– High inflation with no average gain in output that
results from governments’ policies to prevent recession
• Identifying the sources of economic changes
• Identifying the durations of economic changes
• The impact of fiscal policy on the government budget
• Time lags in implementing policies

Permanent Shifts in
Monetary and Fiscal Policy
 A permanent policy shift affects not only the current
value of the government’s policy instrument but also
the long-run exchange rate.
• This affects expectations about future exchange rates.
 A Permanent Increase in the Money Supply
• A permanent increase in the money supply causes the
expected future exchange rate to rise proportionally.
– As a result, the upward shift in the AA schedule is
greater than that caused by an equal, but transitory,
increase (compare point 2 with point 3 in Figure 16-14).

Permanent Shifts in
Figure 16-14: Short-Run Effects of a Permanent Increase in the Money
Supply
Exchange
Rate, E DD1
2
E2
3
E1 1
AA2
AA1
Yf Y2 Output, Y
Permanent Shifts in
 Adjustment to a Permanent Increase in the Money
Supply
• The permanent increase in the money supply raises
output above its full-employment level.
– As a result, the price level increases to bring the
economy back to full employment.
• Figure 16-15 shows the adjustment back to full
employment.

Permanent Shifts in
Figure 16-15: Long-Run Adjustment to a Permanent Increase in the
Money Supply
Exchange
Rate, E DD2
DD1
2
E2
3
E3
E1 1 AA2
AA3
AA1
Yf Y2 Output, Y
Permanent Shifts in
 A Permanent Fiscal Expansion
• A permanent fiscal expansion changes the long-run
expected exchange rate.
– If the economy starts at long-run equilibrium, a
permanent change in fiscal policy has no effect on
output.
– It causes an immediate and permanent exchange rate jump that
offsets exactly the fiscal policy’s direct effect on aggregate
demand.

Permanent Shifts in
Figure 16-16: Effects of a Permanent Fiscal Expansion Changing
the Capital Stock
Exchange
Rate, E DD1
DD2
E1 1
AA1
E2 2
AA2
Yf Output, Y
Macroeconomic Policies
and the Current Account
 XX schedule
• It shows combinations of the exchange rate and output
at which the CA balance would be equal to some
desired level.
• It slopes upward because a rise in output encourages
spending on imports and thus worsens the current
account (if it is not accompanied by a currency
depreciation).
• It is flatter than DD.

• Monetary expansion causes the CA balance to increase
in the short run (point 2 in Figure 16-17).
• Expansionary fiscal policy reduces the CA balance.
– If it is temporary, the DD schedule shifts to the right
(point 3 in Figure 16-17).
– If it is permanent, both AA and DD schedules shift
(point 4 in Figure 16-17).

Figure 16-17: How Macroeconomic Policies Affect the Current Account
Exchange
Rate, E DD
XX
2
1
E1
3
Yf Output, Y
Gradual Trade Flow Adjustment
and Current Account Dynamics
 The J-Curve
• If imports and exports adjust gradually to real
exchange rate changes, the CA may follow a J-curve
pattern after a real currency depreciation, first
worsening and then improving.
– Currency depreciation may have a contractionary initial
effect on output, and exchange rate overshooting will be
amplified.
• It describes the time lag with which a real currency
depreciation improves the CA.

Figure 16-18: The J-Curve
Current account (in
domestic output units)
Long-run
effect of real
depreciation
on the current 1 3
account
Time
Real depreciation takes End of J-curve
place and J-curve begins
 Exchange Rate Pass-Through and Inflation
• The CA in the DD-AA model has assumed that
nominal exchange rate changes cause proportional
changes in the real exchange rates in the short run.
• Degree of Pass-through
– It is the percentage by which import prices rise when the
home currency depreciates by 1%.
– In the DD-AA model, the degree of pass-through is 1.
– Exchange rate pass-through can be incomplete because
of international market segmentation.
– Currency movements have less-than-proportional effects on the
relative prices determining trade volumes.
Summary
 The aggregate demand for an open economy’s output
consists of four components: consumption demand,
investment demand, government demand, and the
current account.
 Output is determined in the short run by the equality
of aggregate demand and aggregate supply.
 The economy’s short-run equilibrium occurs at the
exchange rate and output level.

Summary
 A temporary increase in the money supply causes a
depreciation of the currency and a rise in output.
 Permanent shifts in the money supply cause sharper
exchange rate movements and therefore have stronger
short-run effects on output than transitory shifts.
 If exports and imports adjust gradually to real
exchange rate changes, the current account may
follow a J-curve pattern after a real currency
depreciation, first worsening and then improving.

Appendix I: The IS-LM Model
and the DD-AA Model
Figure 16AI-1: Short-Run Equilibrium in the IS-LM Model
Interest
rate, R
LM
1
R1
Y1 Output, Y
Appendix I: The IS-LM Model
and the DD-AA Model
Figure 16AI-2: Effects of Permanent and Temporary Increases in the
Money Supply in the IS-LM Model 1
Expected LM
Interest rate, R
domestic-currency
return on
foreign-currency LM2
1
deposits 1´
R1
2
2´ R2
3
R3
3´
E2 E3 E1 Y1 Y3 Y2 Output, Y
Exchange rate, E (← increasing)

Appendix I: The IS-LM Model and
the DD-AA Model
Figure 16AI-3: Effects of Permanent and Temporary Fiscal
Expansions in the IS-LM Model
Interest rate, R LM
Expected
domestic-currency
return on
foreign-currency 2´ R2 2
deposits
1´ 3´ 1
R1
E1 E2 E3 Yf Y2 Output, Y
Exchange rate, E (← increasing)

Appendix II: Intertemporal Trade
and Consumption Demand
Figure 16AII-1: Change in Output and Saving
Future
consumption Intertemporal
budget constraints
2
D2F
1
D1F = Q1F
2´
Indifference
curves
D1P = Q1P D2P Q2P Present

consumption
Appendix III: The Marshall-Lerner Condition
and Empirical Estimates of Trade Elasticities
Table 16AIII-1: Estimated Price Elasticities for International Trade
in Manufactured Goods

Chapter 17
Fixed Exchange Rates and
Foreign Exchange Intervention

To Accompany
 Why Study Fixed Exchange Rates?
 Central Bank Intervention and the Money Supply
 How the Central Bank Fixes the Exchange Rates
 Stabilization Policies with a Fixed Exchange Rate
 Balance of Payments Crises and Capital Flight
 Managed Floating and Sterilized Intervention
 Reserve Currencies in the World Monetary System
 The Gold Standard

 Summary
 Appendix I: Equilibrium in the Foreign Exchange
Market with Imperfect Asset Substitutability
 Appendix III: The Timing of Balance of Payments
Crises

Introduction
 In reality, the assumption of complete exchange rate
flexibility is rarely accurate.
• Industrialized countries operate under a hybrid system
of managed floating exchange rates.
– A system in which governments attempt to moderate
exchange rate movements without keeping exchange
rates rigidly fixed.
• A number of developing countries have retained some
form of government exchange rate fixing.
 How do central banks intervene in the foreign
exchange market?
Why Study Fixed Exchange Rates?
 Four reasons to study fixed exchange rates:
• Managed floating
• Regional currency arrangements
• Developing countries and countries in transition
• Lessons of the past for the future

Table 17-1: Exchange Rate Arrangements (As of March 31, 2001)

Table 17-1: Continued






Central Bank Intervention
and the Money Supply
 The Central Bank Balance Sheet and the Money
Supply
• Central bank balance sheet
– It records the assets held by the central bank and its
liabilities.
– It is organized according to the principles of double-
entry bookkeeping.
– Any acquisition of an asset by the central bank results in a +
change on the assets side of the balance sheet.
– Any increase in the bank’s liabilities results in a + change on
the balance sheet’s liabilities side.

• The assets side of a balance sheet lists two types of
assets:
– Foreign assets
– Mainly foreign currency bonds owned by the central bank (its
official international reserves)
– Domestic assets
– Central bank holdings of claims to future payments by its own
citizens and domestic institutions
• The liabilities side of a balance sheet lists as liabilities:
– Deposits of private banks
– Currency in circulation
• Total assets = total liabilities + net worth
• Net worth is constant.
– The changes in central bank assets cause equal changes
in central bank liabilities.
• Any central bank purchase of assets automatically
results in an increase in the domestic money supply.
• Any central bank sale of assets automatically causes
the money supply to decline.

 Foreign Exchange Intervention and the Money
Supply
• The central bank balance sheet shows how foreign
exchange intervention affects the money supply
because the central bank’s liabilities are the base of the
domestic money supply process.
• The central bank can negate the money supply effect
of intervention though sterilization.

 Sterilization
• Sterilized foreign exchange intervention
– Central banks sometimes carry out equal foreign and
domestic asset transactions in opposite directions to
nullify the impact of their foreign exchange operations
on the domestic money supply.
– With no sterilization, there is a link between the balance
of payments and national money supplies that depends
on how central banks share the burden of financing
payments gaps.

Table 17-2: Effects of a $100 Foreign Exchange Intervention: Summary

 The Balance of Payments and the Money Supply
• If central banks are not sterilizing and the home
country has a balance of payments surplus:
– An increase in the home central bank’s foreign assets
implies an increased home money supply.
– A decrease in a foreign central bank’s claims on the
home country implies a decreased foreign money
supply.

How the Central Bank
Fixes the Exchange Rate
 Foreign Exchange Market Equilibrium Under a
Fixed Exchange Rate
• The foreign exchange market is in equilibrium when:
R = R* + (Ee – E)/E
– When the central bank fixes E at E0, the expected rate
of domestic currency depreciation is zero.
– The interest parity condition implies that E0 is today’s
equilibrium exchange rate only if: R = R*.

 Money Market Equilibrium Under a Fixed Exchange
Rate
• To hold the domestic interest rate at R*, the central
bank’s foreign exchange intervention must adjust the
money supply so that:
MS/P = L(R*, Y)
– Example: Suppose the central bank has been fixing E at
E0 and that asset markets are in equilibrium. An
increase in output would raise the money demand and
thus lead to a higher interest rate and an appreciation of
the home currency.
– The central bank must intervene in the foreign exchange
market by buying foreign assets in order to prevent this
appreciation.
– If the central bank does not purchase foreign assets
when output increases but instead holds the money
stock constant, it cannot keep the exchange rate fixed at
E0.

 A Diagrammatic Analysis
• To hold the exchange rate fixed at E0 when output
rises, the central bank must purchase foreign assets and
thereby raise the money supply.

Figure 17-1: Asset Market Equilibrium with a Fixed Exchange Rate, E0
Exchange
rate, E
Domestic-currency return
1' on foreign-currency deposits,
E0 3'
R* + (E0 – E)/E
Domestic
0 Interest rate, R
R* Real money demand, L(R, Y1)
M1
P 1 Real money supply
3
M2
P 2
Real domestic
money holdings
Stabilization Policies
With a Fixed Exchange Rate
 Monetary Policy
• Under a fixed exchange rate, central bank monetary
policy tools are powerless to affect the economy’s
money supply or its output.
– Figure 17-2 shows the economy’s short-run equilibrium
as point 1 when the central bank fixes the exchange rate
at the level E0.

Figure 17-2: Monetary Expansion Is Ineffective Under a Fixed
Exchange Rate
Exchange
rate, E
DD
2
E2
1
E0
AA2
AA1
Y1 Y2 Output, Y
 Fiscal Policy
• How does the central bank intervention hold the
exchange rate fixed after the fiscal expansion?
– The rise in output due to expansionary fiscal policy
raises money demand.
– To prevent an increase in the home interest rate and an
appreciation of the currency, the central bank must buy foreign
assets with money (i.e., increasing the money supply).
• The effects of expansionary fiscal policy when the
economy’s initial equilibrium is at point 1 are
illustrated in Figure 17-3.

Figure 17-3: Fiscal Expansion Under a Fixed Exchange Rate
Exchange
rate, E
DD1
DD2
1 3
E0
2
E2
AA2
AA1
Y1 Y2 Y3 Output, Y
 Changes in the Exchange Rate
• Devaluation
– It occurs when the central bank raises the domestic
currency price of foreign currency, E.
– It causes:
– A rise in output
– A rise in official reserves
– An expansion of the money supply
– It is chosen by governments to:
– Fight domestic unemployment
– Improve the current account
– Affect the central bank's foreign reserves
• Revaluation
– It occurs when the central bank lowers E.
• In order to devalue or revalue, the central bank has to
announce its willingness to trade domestic against
foreign currency, in unlimited amounts, at the new
exchange rate.

Figure 17-4: Effects of a Currency Devaluation
Exchange
rate, E
DD
2
E1
1
E0
AA2
AA1
Y1 Y2 Output, Y
 Adjustment to Fiscal Policy and Exchange Rate
Changes
• Fiscal expansion causes P to rise.
– There is no real appreciation in the short-run
– There is real appreciation in the long-run
• Devaluation is neutral in the long-run.

Figure 17-5: A Low-Output Liquidity Trap
Exchange
Rate, E
DD
1
Ee
1 – R*
AA1
Y1 Yf Output, Y
Figure 17-6: Fixing the Exchange Rate to Restore Full Employment
Exchange
Rate, E
DD
E0 2
1 – R*
1
Ee
1 – R*
AA2
AA1
Y1 Yf Output, Y
Balance of Payments
Crises and Capital Flight
 Balance of payments crisis
• It is a sharp change in official foreign reserves
sparked by a change in expectations about the future
exchange rate.

Balance of Payments
Figure 17-7: Capital Flight, the Money Supply, and the Interest Rate
Exchange
rate, E
1' 2'
E0
R* + (E1– E)/E
R* + (E0 – E)/E Domestic
0 R* R* + (E1 – E0)/E0 Interest rate, R
M2
P 2
M1 Real money supply
P 1
Real domestic
money holdings
Balance of Payments
 The expectation of a future devaluation causes:
• A balance of payments crisis marked by a sharp fall in
reserves
• A rise in the home interest rate above the world
interest rate
 An expected revaluation causes the opposite effects
of an expected devaluation.

Balance of Payments
 Capital flight
• The reserve loss accompanying a devaluation scare
– The associated debit in the balance of payments
accounts is a private capital outflow.
 Self-fulfilling currency crises
• It occurs when an economy is vulnerable to
speculation.
• The government may be responsible for such crises by
creating or tolerating domestic economic weaknesses
that invite speculators to attack the currency.

Managed Floating
and Sterilized Intervention
 Under managed floating, monetary policy is
influenced by exchange rate change.
 Perfect Asset Substitutability and the Ineffectiveness
of Sterilized Intervention
• When a central bank carries out a sterilized foreign
exchange intervention, its transactions leave the
domestic money supply unchanged.

Managed Floating
• Perfect asset substitutability
– The foreign exchange market is in equilibrium only
when the expected return on domestic and foreign
currency bonds are the same.
– Central banks cannot control the money supply and the
exchange rate through sterilized foreign exchange
intervention.

Managed Floating
• Imperfect asset substitutability
– Assets’ expected returns can differ in equilibrium.
– Risk is the main factor that may lead to imperfect asset
substitutability in foreign exchange markets.
– Central banks may be able to control both the money
supply and the exchange rate through sterilized foreign
exchange intervention.

Managed Floating
 Foreign Exchange Market Equilibrium Under
Imperfect Asset Substitutability
• When domestic and foreign currency bonds are perfect
substitutes, the foreign exchange market is in
equilibrium only if the interest parity condition holds:
R = R* + (Ee – E)/E (17-1)
– This condition does not hold when domestic and foreign
currency bonds are imperfects substitutes.

Managed Floating
• Equilibrium in the foreign exchange market requires
that:
R = R* + (Ee – E)/E + ρ (17-2)
where:
ρ is a risk premium that reflects the difference
between the riskiness of domestic and foreign bonds
• The risk premium depends positively on the stock of
domestic government debt:
ρ = ρ(B – A) (17-3)
where:
B is the stock of domestic government debt
A is domestic assets of the central bank
Managed Floating
 The Effects of Sterilized Intervention with Imperfect
Asset Substitutability
• A sterilized purchase of foreign assets leaves the
money supply unchanged but raises the risk adjusted
return that domestic currency deposits must offer in
equilibrium.
• Figure 17-8 illustrates the effects of a sterilized
purchase of foreign assets by the central bank.
– The purchase of foreign assets is matched by a sale of
domestic assets (from A1 to A2).

Managed Floating
Figure 17-8: Effect of a Sterilized Central Bank Purchase of Foreign
Assets Under Imperfect Asset Substitutability
Exchange
rate, E Sterilized purchase
2' of foreign assets Risk-adjusted domestic-
E2 currency return on foreign
currency deposits,
1' R* + (Ee– E)/E + ρ(B –A2)
E1
R* + (Ee – E)/E + ρ(B –A1)
Domestic
0 Interest rate, R
R1
Ms
Real money supply
P 1
Real domestic
money holdings
Managed Floating
 Evidence on the Effects of Sterilized Intervention
• Empirical evidence provides little support for the idea
that sterilized intervention has a significant direct
effect on exchange rates.

Managed Floating
 The Signaling Effect of Intervention
• Signaling effect of foreign exchange intervention
– An important complicating factor in econometric efforts
to study the effects of sterilization
– Sterilized intervention may give an indication of where
the central bank expects (or desires) the exchange rate
to move.
– This signal can change market views of future policies even
when domestic and foreign bonds are perfect substitutes.

Reserve Currencies in
the World Monetary System
 Two possible systems for fixing the exchange rates:
• Reserve currency standard
– Central banks peg the prices of their currencies in terms
of a reserve currency.
– The currency central banks hold in their international reserves.
• Gold standard
– Central banks peg the prices of their currencies in terms
of gold.

• The two systems have very different implications
about:
– How countries share the burden of balance of payments
financing
– The growth and control of national money supplies

 The Mechanics of a Reserve Currency Standard
• The workings of a reserve currency system can be
illustrated by the system based on the U.S. dollar set
up at the end of World War II.
– Every central bank fixed the dollar exchange rate of its
currency through foreign exchange market trades of
domestic currency for dollar assets.
– Exchange rates between any two currencies were fixed.

 The Asymmetric Position of the Reserve Center
• The reserve-issuing country can use its monetary
policy for macroeconomic stabilization even though it
has fixed exchange rates.
• The purchase of domestic assets by the central bank of
the reverse currency country leads to:
– Excess demand for foreign currencies in the foreign
exchange market
– Expansionary monetary policies by all other central
banks
– Higher world output
The Gold Standard
 Each country fixes the price of its currency in terms
of gold.
 No single country occupies a privileged position
within the system.
 The Mechanics of a Gold Standard
• Exchange rates between any two currencies were
fixed.
– Example: If the dollar price of gold is pegged at $35 per
ounce by the Federal Reserve while the pound price of
gold is pegged at £14.58 per ounce by the Bank of
England, the dollar/pound exchange rate must be
constant at $2.40 per pound.
The Gold Standard
 Symmetric Monetary Adjustment Under a Gold
Standard
• Whenever a country is losing reserves and its money
supply shrinks as a consequence, foreign countries are
gaining reserves and their money supplies expand.
 Benefits and Drawbacks of the Gold Standard
• Benefits:
– It avoids the asymmetry inherent in a reserve currency
standard.
– It places constraints on the growth of countries’ money
supplies.
The Gold Standard
• Drawbacks:
– It places undesirable constraints on the use of monetary
policy to fight unemployment.
– It ensures a stable overall price level only if the relative
price of gold and other goods and services is stable.
– It makes central banks compete for reserves and bring
about world unemployment.
– It could give gold producing countries (like Russia and
South Africa) too much power.

The Gold Standard
 Bimetallic standard
• The currency was based on both silver and gold.
• The U.S. was bimetallic from 1837 until the Civil War.
• In a bimetallic system, a country’s mint will coin
specified amounts of gold or silver into the national
currency unit.
– Example: 371.25 grains of silver or 23.22 grains of gold
could be turned into a silver or a gold dollar. This made
gold worth 371.25/23.22 = 16 times as much as silver.
• It might reduce the price-level instability resulting
from use of one of the metals alone.
The Gold Standard
 The Gold Exchange Standard
• Central banks’ reserves consist of gold and currencies
whose prices in terms of gold are fixed.
– Each central bank fixes its exchange rate to a currency
with a fixed gold price.
• It can operate like a gold standard in restraining
excessive monetary growth throughout the world, but
it allows more flexibility in the growth of international
reserves.

Summary
 There is a direct link between central bank
intervention in the foreign exchange market and the
domestic money supply.
• When a country’s central bank purchases (sells)
foreign assets, the country's money supply
automatically increases (decreases).
 The central bank balance sheet shows how foreign
exchange intervention affects the money supply.
 The central bank can negate the money supply effect
of intervention through sterilization.
Summary
 A central bank can fix the exchange rate of its
currency against foreign currency if it trades
unlimited amounts of domestic money against foreign
assets at that rate.
 A commitment to fix the exchange rate forces the
central bank to sacrifice its ability to use monetary
policy for stabilization.
 Fiscal policy has a more powerful effect on output
under fixed exchange rates than under floating rates.
 Balance of payments crises occur when market
participants expect the central bank to change the
exchange rate from its current level.
Summary
 Self-fulfilling currency crises can occur when an
economy is vulnerable to speculation.
 A system of managed floating allows the central bank
to retain some ability to control the domestic money
supply.
 A world system of fixed exchange rates in which
countries peg the prices of their currencies in terms of
a reserve currency involves a striking asymmetry.
 A gold standard avoids the asymmetry inherent in a
reserve currency standard.
• A related arrangement was the bimetallic standard
based on both silver and gold.
Appendix I: Equilibrium in the Foreign Exchange
Market with Imperfect Asset Substitutability
Figure 17AI-1: The Domestic Bond Supply and the Foreign Exchange
Risk Premium Under Imperfect Asset Substitutability
Risk premium on domestic
Bonds, ρ ( = R - R* - (Ee– E)/E)
Demand for
Supply of
domestic bonds, Bd
domestic bonds
ρ 2
ρ1
1
B – A1 B – A2 Quantity of domestic bonds

Copyright © 2003 Pearson Education, Inc. (A2 < A1) Slide 17-60
Appendix III: The Timing of
Balance of Payments Crises
Figure 17AIII-1: The Timing of a Balance of Payments Crisis
Exchange rate, E
Shadow floating
EST ´ exchange rate, ESt
EST = E0
EST ´´
Drop in Time
0
reserves T´´ T T´
caused by
speculative
attack F*t
Remaining reserve
(increasing ↓) stock, F*t
Foreign reserves, F*

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Chapter 7

International Factor Movements

Prepared by Iordanis Petsas

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Prepared by Iordanis Petsas

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Trade Contraction Trade Expansion

Price Quantity Price Quantity

Tariff Import quota Import subsidy Voluntary

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= terms of trade gain (e)

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Manufactures production and

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O Home exports of manufactures, QM - DM

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Prepared by Iordanis Petsas

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