THE ECONOMICS OF MONEY AND MONETARY POLICY William D. Lastrapes

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THE ECONOMICS OF MONEY AND MONETARY
POLICYWilliam D. Lastrapes

• Terry at OxfordSummer 2008

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The Nature of Money

• The basic functions of money
• medium of exchange
• medium or unit of account, standard of value
• With n goods, n(n-1)/2 relative prices.n 5 10
  relative prices with money, 5 prices n 100
  implies 4950 relative prices with money, 100
  prices

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The Nature of Money

• Money in the modern economy
• Paper currency
• Checking accounts
• Stored-value (smart) cards
• Local currencies
• http//www.berkshares.org/

Berkshares
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The Nature of Money

• Alternatives to money
• CreditLiquid assetsGold and silver?

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The Nature of Money

• Alternatives to money
• CreditLiquid assetsGold and silver?
• Purchasing power of money and inflation
• ...the number of monetary units (units of
  account) it takes to buy the average good or
  service in the economy.The price level is the
  reciprocal of the purchasing power of money.
  Inflation measures the rate of depreciation in
  value of money.

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The Nature of Money

• Suppose that gold serves as the medium of
  exchange, and ounces of gold are the unit of
  account. Lump all the other goods and services in
  the economy together in a basket. The purchasing
  power of gold is the amount of these baskets that
  can be purchased with an ounce of gold. Suppose
  that 1 ounce buys 1/10 of a basket. Then the
  price level the ounces of gold needed to buy
  one basket is 10 ounces. Finally, suppose that
  at the beginning of next year, the basket costs
  11 ounces. Then the rate of inflation during the
  year is 10.

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US Price level (CPI)
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US Inflation (CPI)
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Recent US inflation
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The Nature of Money

• Hyperinflation average monthly rate was 322
  from August 1922 to November 1923. In Hungary
  after WWII, prices rose 19,000 per month from
  August 1945 to July 1946.German wholesale price
  index
•                         Index                 
  monthly rate
                              
• 12/1914           125                             
              
• 12/1921           3,490                           
              4.3
• 12/1922           147,480                         
            36.6
• 12/1923           126,160,000,000,000             
     455

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The Nature of Money

•  Inflation occurs when the quantity of money is
  produced at rates that exceed the desire to
  accumulate it.

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The Nature of Money

• Measuring moneyIn the US
• Monetary base currency in circulation (banks
  and public)  bank deposits at central bank.
•  
• M1   Currency held outside of banks checkable
  deposits issued by financial institutions
  travelers checks
• M2 M1 plus savings deposits
• MZM M2 institutional money market mutual
  funds small denomination time deposits.

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The Nature of Money

• Measuring moneyIn the UK
• M2 currency in circulation and sterling retail
  deposits with U.K. banks and building societies.
• M4  M2  wholesale deposits with the U.K.
  banks and building societies.

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The Nature of Money
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The Nature of Money
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The Nature of Money
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The Nature of Money

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The Nature of Money

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The Nature of Money

• Real money balances M/P
• M is nominal money
• P is price level
• Coincidence of wants and indirect barter
•  

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The Nature of Money
Preference Endowment First trade Final trade
Butcher Beer Meat Bread (from baker) Beer (from brewer)
Brewer Bread Beer Bread (from butcher)
Baker Meat Bread Meat (from butcher)
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The Nature of Money

• Carl Menger

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The Nature of Money

• A model of time and transactions costs
• Types of money
• Base money
• Commodity money
• Yap stone money
• Cigarette money
• Commodity Standard
• Fiat money

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The Nature of Money
Yap stone money
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The Nature of Money

• Modern fiat money systems
• Case A commodity money/standard.
• Central Bank
• ____________________________
• Assets Base money
• Commercial Banks
• ____________________________
• Base money Notes/receipts

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The Nature of Money

• Modern fiat money systems
• Case B a modern fiat system with credit money
  and fractional reserves
• Central Bank
• ____________________________
• Assets Base money
• Commercial Banks
• ____________________________
• Base money Deposits
• Loans

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Commodity money systems

• A stock-flow model of prices under a gold
  standard
• M nominal money supply in pounds
• Pg nominal price of gold (pounds per ounce)
  set by central bank authority
• G stock of gold in ounces that has been mined
  and is available for use as money or other
  purposes in the economy
• Gm gold held by central banks as monetary
  reserves
• P price level in pounds per composite good.
• y real quantity of composite good produced
  during the year (real GDP).
• p expected inflation (expected rate of change
  of P).
• k gold reserve ratio the amount of gold held
  in the central bank as a fraction of
• nominal money supply. Determined by the central
  bank. k PgGm/M. If klt1, then we have a
  fractional reserve gold standard.
• Pg/P relative price or purchasing power of
  gold the quantity of composite
• good per ounce of gold. The model essentially
  determines this price in short run and long run
  equilibrium.

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Commodity money systems

• Basic assumptions
• G is the stock of gold outside of the ground, and
  thus usable. At a point in time, this stock is
  fixed.
• The economy obtains gold from two sources a)
  mining and b) flows from international trade
  when the economy exports goods, it receives
  payment in the form of gold. It loses gold for
  two reasons a) consumption or loss from use, and
  b) when it imports goods, it pays gold. Both
  sources provide and use gold only gradually over
  time, and are thus flows. The stock of gold
  adjusts gradually over time according to
  conditions of flow demand and supply. Note,
  international capital flows are ignored, which
  could buffer the gold stock from trade flows.
• Although gold is a commodity with inherent value,
  we ignore the non-monetary use of gold to
  simplify (nothing of essence changes by this
  assumption).
• At a point in time, the relative price of gold
  quickly adjusts so that the existing stock of
  gold (G) equals the stock demand for gold.
  However, because Pg is fixed by the nature of the
  gold standard, the adjustment comes solely
  through P, the price level.
• The focus of the model is on price level
  adjustments, so we suppose that the economy is in
  full employment the level of output is taken as
  fixed and independent of price level adjustment.
  This makes the model a theory of the price level.

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Commodity money systems

• Stock demand for gold
• M/P m(y, p)
• kM PgG ? M (1/k)PgG
• G k(P/Pg)m(y, p)

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Commodity money systems

• Flow demand for gold consumption per unit of
  time of gold and loss of gold to purchase
  imports. We assume that the flow demand for gold
  is negatively related to the real price of gold.
• Flow supply of gold. Production or inflow from
  trade per unit of time. We assume it depends
  positively on real price of gold incentives for
  mining gold when its price is high increase
  supply of exports and thus inflow of gold when
  price of gold is high.

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Commodity money systems

• Equilibrium P adjusts immediately so that stock
  demand equals existing gold stock at all points
  in time (because Pg is fixed by the nature of the
  standard.)
• Long-run stock equilibrium when stock demand
  equals existing stock of gold (G) and flow supply
  equal flow demand. Given the latter condition,
  the stock of gold is stationary over time the
  amount of gold flowing into the central bank
  equals the amount flowing out.
• Short-run adjustment/transition to long-run stock
  equilibrium if relative gold price is high (P is
  low), flow supply will exceed flow demand and the
  stock of gold will gradually grow, reducing real
  gold price (increasing P) according to stock
  demand and supply if real gold price is low (P
  high), then flow demand will exceed flow supply,
  the gold stock will gradually fall and real gold
  price will rise (as P falls).

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Commodity money systems

• Analysis and implications
• Gold discovery
• Reduction in gold reserve
• Devaluation

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Commodity money systems

• Bimetallism
• Greshams Law bad money drives out good money.
  

Sir Thomas Gresham, 1519-1579
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Commodity money systems

• Bimetallism
• Example A gold coin is defined to be worth 10,
  while a silver coin is defined to be 0.5. The
  relative price of gold in terms of silver
  implicitly guaranteed by the central bank is thus
  Pg/Ps i.e. 20 oz silver per oz gold. Suppose an
  increase in the demand for gold (relative to
  silver) raises the market price of gold to 25 oz
  silver. Since the market price of gold is 25 oz
  silver and the mint price of gold is 20 oz
  silver, gold is the good (undervalued at mint
  price) money and silver the bad. Suppose you
  want to buy something that cost 10 one option
  is to offer a gold coin. The other is to melt
  down the gold coin and sell the gold in the
  market for 25 oz silver. Convert this silver to
  12.5 of silver coins at the central bank. Pay
  the 10 debt with silver coins and have 2.5 left
  over.

Sir Thomas Gresham, 1519-1579
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Commodity money systems

• Bimetallism
• The law works when governments enforced two
  prices with legal tender laws which required
  acceptability at par values.

Sir Thomas Gresham, 1519-1579
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Commodity money systems
Assignats Accept or die.
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Commodity money systems

• International exchange under commodity money
  standards
• Price-specie flow mechanism.
• Central bank control
• Interest rates and capital flows. Suppose that
  during a trade deficit, the central bank acts to
  raise interest rates (by selling assets) to
  encourage lending by foreigners to domestic
  citizens. This lending could help finance the
  trade deficit without the necessity of official
  gold outflows, thus bringing external adjusts
  more quickly. With a trade surplus, the central
  bank could buy assets to reduce interest rates
  and therefore relieve the pressure on gold
  inflows. This was called the rules of the game
  by Keynes in describing the post WWI gold
  standard.
• Gold sterilization. Central bank can sterilize
  gold flows, selling assets as gold flowed in a
  vice versa. In effect, the central bank could
  alter k in the same direction as the change in
  gold to buffer the money supply by adjusting the
  amount of gold held. This would offset the
  effects of gold flows on the money supply, at
  least temporarily.
• Suspension. To counter this natural mechanism
  they could also suspend convertibility of paper
  money i.e. temporarily (or permanently) go off
  the gold standard.

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Commodity money systems

• International exchange under commodity money
  standards
• Foreign exchange
• When two countries are on the gold standard, but
  have different currencies (i.e. media of exchange
  and unit of account), there currencies will have
  a fixed rate of exchange. The price of one
  currency in terms of another is called the
  exchange rate. Suppose for example that in the
  US, the fixed nominal price of gold (the price in
  terms of the dollar unit of account) is 35 per
  ounce, while in the UK it is fixed by the central
  bank at 20 per ounce. If we assume there are no
  transactions costs in converting to gold, to
  gold, and to , then the / exchange rate will
  be 1.75 per . Suppose that you could convert
  pounds to dollars at a rate of 2 per pound. Then
  you could profit by arbitrage convert an ounce
  of gold into 20 pounds, with the 20 pounds buy
  40, and convert the 40 to 1.143 ounces of gold.
  Since there is no risk involved or transactions
  costs, many would attempt to sell pounds to buy
  dollars (the supply of pounds would rise),
  causing the pound to fall from 2 until there are
  no profit opportunities i.e. when the exchange
  rate returns to 1.75.

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Banking institutions

• The establishment of commercial banks
• A banks balance sheet prior to lending
• ______________________________________
• 1000 coins 1000 receipts

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Banking institutions

• The establishment of commercial banks
• A banks balance sheet prior to lending
• ______________________________________
• 1000 coins 1000 receipts
• Balance sheet after lending 300 of coins
• ______________________________________
• 700 coins 1000 receipts
• 300 loans

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Banking institutions

• The establishment of commercial banks
• A banks balance sheet prior to lending
• ______________________________________
• 1000 coins 1000 receipts
• Balance sheet after lending 300 of coins
• ______________________________________
• 700 coins 1000 receipts
• 300 loans
• Balance sheet after lending with a smaller need
  for reserves
• __________________________________________________
  ______
• 100 coins 1000 notes/checkable deposits
• 900 loans

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Banking institutions

• Comments
• 1) System-wide, this fractional reserve banking
  system led to a large increase in
  money/liquidity. The payments system has evolved
  to one of bank or credit (or inside) money,
  leading to a large expansion in liquidity, since
  banks liabilities are part of the money supply.
  For example, if there were 1000 coins in the
  economy as a whole, and bankers kept 10 on
  reserve, this could support a total money supply
  (the value of notes and checkable deposits) of
  10,000. This expansion could occur because
  bankers could simply make new loans not with
  coins, but with notes or checkable deposits.
• 2) The system is potentially vulnerable or
  fragile what happens if all depositors want to
  claim base (gold) money. Under fractional
  reserves, this cant be done systematically. Such
  a system is very dependent on trustworthiness of
  the banks. If not, we might expect bank
  panics/runs.

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Banking institutions
Banknote redemption and clearinghouses
Issued by A Issued by B Issued by C Total claim
Held by A 1000 2000 3000
Held by B 4000 2000 6000
Held by C 2000 2000 4000
Total debt 6000 3000 4000
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Banking institutions

• Implications for money and prices
• Banking panics and runs money stock falls
  deflation. Potential solutions 1) deposit
  insurance 2) central bank (lender of last
  resort)
• Banknote over-issue too much money inflation.
  But note redemption is a natural discipline
  limiting excess monetary expansion.

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Banking institutions

• Central banks
• Bank for other banks private commercial banks
  can hold deposits and borrow from the central
  bank, but others (besides the government)
  generally cannot
• Reserves centralized at the central bank
  private banks hold claims on the central bank.
• Note and deposit issue serve as high-powered
  money, and are not typically redeemed (but could
  be under commodity standards). They have a
  monopoly over note issue, and the notes are
  usually legal tender. Without adverse clearings,
  this is very profitable.
• Other special privileges from the government (if
  they are not actually part of the government)
  e.g. they keep government deposits.
• Because of their large holding of reserves and
  ability to issue high-powered money they can
  determine liquidity and the quantity of money,
  and therefore are responsible for monetary
  policy.
• Lender of last resort make loans to other banks
  in times of liquidity crises
• Authority to regulate banks and the financial
  system.

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Banking institutions

• Origins and rationale of central banking
• Seignorage revenues earned from the creation of
  money/issue of currency
• Banking panics and the lender of last resort
• Thornton and Bagehot lend to any healthy bank,
  at a penalty rate, that is need of liquidity, by
  buying (discounting) their assets.

Walter Bagehot, 1826-1877
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Banking institutions

• Other ways to prevent banking panics
• Deposit insurance
• Branch banking
• Temporary suspension of convertibility
• Clearinghouses
• Free Banking versus Goodhart
• Bear-Stearns, 2008

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Banking institutions

• The Bank of England
• Monetary background
• April 25, 1694 Chartered as private bank to buy
  public debt
• 1697 Monopoly of chartered banking and limited
  liability
• 1708 Allowable capital doubled, and note issue
  was prohibited to any bank (except the Bank of
  England) with more than six partners
• 1797 War-time suspension of convertibility
• 1797-1821 Inflation discovery of monetary
  policy
• 1821 Resumption to gold (after much to do)
• 1826 Joint-stock banks (non-partnerships) 65
  miles away from London were allowed note issue to
  provide some financial stability outside London.

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Banking institutions

• The Bank of England
• 1833 Bank of England notes made legal tender
• 1844 Bank Charter Act split BoE into Issue and
  Banking departments. BoE becomes a central
  bank.
• Private (profit-maximizing) bank until
  nationalization in 1946.
• http//www.bankofengland.co.uk/banknotes/denom_gui
  de/index.htm

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The evolution of money and banking in the US

• The colonial and revolutionary war periods
• Colonial period monetary standards bimetallic
  (gold and silver) pounds, shilling, pence
• Revolutionary War Finance and the Continentals
• The first US Banks The Pennsylvania Bank and the
  Bank of North America
• Constitutional money standards US dollar equal
  to 371.25 grains (0.7734 ounces) of pure silver
  or 24.75 grains (0.05156 ounces) of pure gold,
  free coinage (nominal silver price was 1.29 per
  ounce and that of gold 19.39 per ounce.) mint
  ratio 15 to 1.

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33 cent US Note a Continental. Issued February
1776
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Spanish dollars, 1776 and 1739
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The evolution of money and banking in the US

• Early 19th century and antebellum money and
  banking
• (First) Bank of the United States. Private bank
  with 20 year charter, 1791-1811. Hamiltons
  motivation a) finance new government b)
  facilitate payment of taxes c) convenience and
  resource saving of paper money. Privileges a)
  Convertible notes accepted by government for
  taxes and payments b) government depository c)
  could branch in any state d) no other banks to
  be established during life. Charter lapsed in
  1811.

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The evolution of money and banking in the US

• Early 19th century and antebellum money and
  banking
• Suspension of convertibility during War of 1812
  resumption in 1821
• Second Bank of the United States 1816 to 1836
• Coinage Act of 1834 gold in, silver out.
• The Suffolk Bank System 1824-1866.
• The Free-Banking Period

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The evolution of money and banking in the US

• Early 19th century and antebellum money and
  banking
• Composition of the money stock and high-powered
  money, pre-Civil War By 1859, the money stock in
  the US (M1, essentially) was just over 670
  million 40 specie in circulation (gold and
  silver coin and bullion), 27 state bank notes,
  33 bank checking deposits. During this period,
  bank reserves of specie fluctuated between 20 and
  35 of note and deposit liabilities.

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The evolution of money and banking in the US

• From the Civil War to the Founding of the Fed
• The monetary standard during and after the Civil
  War the Greenback period
• The Crime (Coinage Act) of 1873
• The National Banking System
• The Founding of the Federal Reserve System
• Federal Reserve Act
• Elastic currency
• Federal Reserve notes

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The evolution of money and banking in the US

• From the Civil War to the Founding of the Fed
• The monetary standard during and after the Civil
  War the Greenback period
• The Crime (Coinage Act) of 1873
• The National Banking System

Bank note issued by Quakertown National Bank 1897
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The evolution of money and banking in the US

• From the Civil War to the Founding of the Fed
• The Founding of the Federal Reserve System
• Federal Reserve Act
• Elastic currency
• Federal Reserve notes

Woodrow Wilson
Nelson Aldrich
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The evolution of money and banking in the US

• World War I and beyond
• Gold standard during WWI
• The Great Depression
• Banking Holiday reforms
• The Bretton Woods system
• and its collapse

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The Financial System

• Overview of the financial system
• Intertemporal exchange trading current
  consumption for future consumption i.e. lending
  and borrowing
• Services provided by the financial system
• Reducing transactions costs.
• Risk-sharing intertemporal exchange entails
  uncertainty since it deals with time and the
  future. The financial system provides a way for
  lenders especially to manage risk, primarily
  through diversification and the ability to trade
  risk.
• Liquidity the ability to quickly convert wealth
  to money.
• Information provision financial transactions are
  fraught with asymmetric (private) information
  borrowers and lenders have different information
  about how funds will be used. The financial
  system can help alleviate the costs of asymmetric
  information.

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The Financial System

• Overview of the financial system
• Financial markets
• Securities
• Primary vs secondary
• Debt vs equity
• Financial Intermediation and asymmetric
  information
• Adverse selection
• Moral hazard

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The Financial System

• Understanding interest rates
• Interest rates are prices determined in financial
  markets that measure the trade-offs of
  intertemporal exchange rate of increase in
  wealth (future consumption) that lenders get for
  sacrificing current consumption, and the rate of
  borrowers decline in wealth (future consumption)
  to get current consumption.
• A bond or debt security is a contract
  characterized by 1) price 2) payoff and 3) the
  timing of the payoff/payments (maturity).

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The Financial System

• Understanding interest rates
• 1) Discount bond a bond without an explicit
  interest payment, but that sells at a price below
  its face value.
• i (F P) / P
• Example
• P 98
• F 100.
• ? i (100-98)/98 0.0204 2.04.

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The Financial System

• Understanding interest rates
• 2) Multi-period debt with fixed interest
  payments
• P C/(1i) C/(1i)² C/(1i)T
  F/(1i)T

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The Financial System

• Understanding interest rates
• 2) Multi-period debt with fixed interest
  payments
• P C/(1i) C/(1i)² C/(1i)T
  F/(1i)T
• Example
• P 975
• F 1000
• T 10
• x 5 (0.05)
• C 50
• ? i 5.329

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The Financial System

• Understanding interest rates
• (web calculator on http//www.moneychimp.com/calcu
  lator/bond_yield_calculator.htm )
• Example
• P 980 (all else the same)
• ? i 5.262

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The Financial System

• Understanding interest rates
• 3) Rate of return. Measures an interest rate over
  a given holding period. Rate of return over one
  holding period (t is the date)
• R P(t1) C(t1) P(t) / P(t)
• where C is a payment received during the period,
  and t denotes the particular time. P is the price
  of the security.

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The Financial System

• Understanding interest rates
• 3) Rate of return. Measures an interest rate over
  a given holding period. Rate of return over one
  holding period (t is the date)
• R P(t1) C(t1) P(t) / P(t)
• Example Initial purchase price of the 10 year
  bond is 980, the coupon received is 50, and
  the sales price after a year is 990.
• R (990 50 980)/ 980 6.12

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The Financial System

• Understanding interest rates
• 3) Rate of return. Measures an interest rate over
  a given holding period. Rate of return over one
  holding period (t is the date)
• R P(t1) C(t1) P(t) / P(t)
• Example Stock return
• Buy shares for 100, receive dividend of 5, sell
  for 110 after one year.
• R 110 5 100 / 100 15.

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The Financial System

• Understanding interest rates
• 3) Rate of return. Measures an interest rate over
  a given holding period. Rate of return over one
  holding period (t is the date)
• R P(t1) C(t1) P(t) / P(t)
• Example Consider purchasing a two period
  discount bond, P 90, F 100 (the annual ytm
  when purchased is 5.41). After one period,
  yields on debt rise so the price of the discount
  bond falls to 85 and you need to sell. R (85
  90) / 90 5.56.

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The Financial System

• Understanding interest rates
• 4) Amortized (fixed payment) securities. This
  example does not solve for the yield to maturity,
  but uses the concept of present value to show how
  fixed payment securities are determined. Instead
  of the principal being repaid at maturity, the
  principal is amortized over the payment period.
  Use the present value formula to solve for the
  payment, which is constant.
• C 1/(1i) 1/(1i)2 1/(1i)T-1P

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The Financial System

• Understanding interest rates
• Real versus nominal interest rates
• r i p
• Indexed bonds TIPS and indexed-linked gilts.
• 1000 TIP (face value), 2 year maturity, coupon
  rate 5. Inflation rate 3 each year
• First interest payment 0.051000(1.03)
  51.50
• Second interest payment .0510001.031.03
  53.045
• Adjusted principal received at maturity
  1060.90
• Real yield 5 (since purchased at face value)

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The Financial System

• Understanding interest rates
• Determining interest rates the loanable funds
  model

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The Financial System

• Understanding interest rates
• Determining interest rates the loanable funds
  model
• Key behavioral assumptions. 1) Lenders (say
  households) interest rates have a positive
  effect on the quantity of saving anything
  besides the interest rate that effects desired
  saving will shift loanable funds supply. 2)
  Borrowers (say firms, government) the interest
  rate reflects future consumption given up to be
  able to spend now thus, there is a negative
  relationship between the interest rate and the
  demand for loanable funds. Anything else besides
  the interest rate that affects demand shifts
  demand curve.

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The Financial System

• Understanding interest rates
• Determining interest rates the loanable funds
  model
• Equilibrium real interest rate such that supply
  of loanable funds equals demand for loanable
  funds.

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The Financial System

• Understanding interest rates
• Determining interest rates the loanable funds
  model
• Factors explaining fluctuations and spreads in
  interest rates
• Change in Default risk
• Difference in default risk (risk premium)
• Government deficits
• Financial intermediation
• Expected inflation (the Fisher effect)

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Irving Fisher, 1867-1947
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The Financial System

• Understanding interest rates
• The term structure of interest rates yield
  curves and the expectations hypothesis.
• Example 2-year planning horizon
• 1) buy a two-year discount bond (T2)
• 2) buy a discount bond with T1, then when that
  bond matures after one year, buy another one-year
  bond.
• Expectations hypothesis
• 1 2i i² 1 r1 Er2 r1 Er2
• i ½ (r1 Er2)

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The Financial System

• Understanding exchange rates
• Exchange rates and trade
• Assume the price (p) of the wine from California
  is 200 (per case) and the price (q) of the
  French wine is 120. If the dollar-euro exchange
  rate (s) is 1.50/, then the dollar price of
  French wine is p_e qs 1201.5 180. The
  real exchange rate (relative price of French wine
  in terms of California wine) is then z p_e/p
  180/200 0.9 cases of California wine for a case
  of French wine.

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The Financial System

• Understanding exchange rates
• Exchange rates and trade
• Assume the price (p) of the wine from California
  is 200 (per case) and the price (q) of the
  French wine is 120. If the dollar-euro exchange
  rate (s) is 1.50/, then the dollar price of
  French wine is p_e qs 1201.5 180. The
  real exchange rate (relative price of French wine
  in terms of California wine) is then z p_e/p
  180/200 0.9 cases of California wine for a case
  of French wine.
• The Law of One Price prices of perfect
  substitutes should be the same in terms of a
  given currency, no matter where they are sold.

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The Financial System

• Understanding exchange rates
• Purchasing power parity real exchange rates are
  independent of changes in national price levels
  that are caused by changes in money supplies
• Z SQ/P (/)(/UK)/(/US) US/UK
• Z real US/UK exchange rate
• S /
• Q price level in UK
• P price level in US
• Z is the relative price of average goods in the
  UK in terms of average goods in the US. The real
  exchange rate depends on the nominal exchange
  rate,
• S (P/Q)Z

89
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90
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92
The Financial System

• Understanding exchange rates
• Comments
• Smooth price level ratio
• Base year for both CPIs is 2005, In base year,
  nominal real exchange rate by construction.
• Since the price levels are based on an index, all
  we can really do is compare over time. Relative
  price of UK goods to US citizens is high, but not
  unprecedented UK goods were actually more
  expensive in 2007, late 2004, 1988, and mostly
  from 1990 through 1992/

93
The Financial System

• Understanding exchange rates
• PPP measures of GDP
• Current GDP in the US 14 trillion (45,000 per
  capita)
• Current GDP in the UK 1.5 trillion (25,000
  per capita)

94
The Financial System

• Understanding exchange rates
• PPP measures of GDP
• Current GDP in the US 14 trillion (45,000 per
  capita)
• Current GDP in the UK 1.5 trillion (25,000
  per capita)
• Must convert to common currency, but how?
• 1) Use market rates (e.g. multiply UK GDP by
  current / rate)
• 2) Use exchange rate implied by PPP (z1) S
  P/Q
• Country list https//www.cia.gov/library/publicat
  ions/the-world-factbook/rankorder/2001rank.html

95
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96
The Financial System

• Understanding exchange rates
• Exchange rate determination in the short-run
• Interest parity condition rates of return on all
  assets must be the same, regardless of currency
  or country.
• ius iuk (?S/S)

97
The Financial System

• Understanding exchange rates
• Exchange rate determination in the short-run
• 1) Increase in US interest rates ? pound
  depreciation/dollar appreciation
• 2) Increase in the expected appreciation of the
  pound ? pound will appreciate immediately