Exchange Rate

1
Macroeconomic Analysis 2003
Exchange RatePPP, UIP and CIP Theories of
exchange rate Advantages and disadvantages of
fixed and flexible exchange rate system Impacts
of Fiscal and Monetary Policy in fixed and
Flexible Exchange rate system (Readings (Miles
Scott 9,18) or Blanchard (18-21) or Mankiw(12))
2
Fundamental Macroeconomic Identity for an open
economy
3
Three GAPs Investment-Saving, Budget and Trade
Gaps
S(Y)
Trade Surplus
K-outflow
i
Private saving public saving net export
i
I(r)
Trade deficit
K-inflow
0
Saving and Investment
4
Why is not appreciation of domestic currency not
good for Foreign Investment?
Net capital outflow
S-I
Real Exchange Rate
?
Net capital inflow
NX(?)
Net export
5
Exchange Rate and the Demand and Supply of
Foreign Currency
2002
Exports X(E,Y)
Excess supply of FC
E1
Depreciation
E
e
A
0.66
NX
Appreciation
E2
2003
Imports M(E,Y)
Excess Demand for FC
F
0
Demand and supply of Foreign Currency
6
Depreciation of Dollar against Pound or
Appreciation of Pounds against dollar in 2002
7
Triangular Exchange Rates and Appreciation and
Depreciation with respect to the Third Currency
8
Keynesian Open Economy Model How an Expansion in
Income causes Trade Deficit?
AD
0
Y

XX0 MM(Y)
Trade balance
Surplus
0
Y
Deficit
-
9
Derivation of Net Exports and Investment Saving
in an Open Economy
AD

• Note
• Shows reduction in AD
• following an increase in ER
• (b) Shows investment saving
• Balance in an open economy
• (c) Shows net export as
• a function of the exchange
• rate

(a)
AD
?NX
Y
Y1
Y2
(c)
(b)
e
e2
e1
IS(e)
NX (e)
Y2
y1
NX2
NX1
10
IS-LM Model in an Open Economy
LM (y, i)
Exchange Rate
e
IS
o
Output
y
11
Impact of Fiscal Policy under Fixed and Flexible
Exchange Rate Systems
Effectiveness of Fiscal Policy Under the
Fixed Exchange Rate System
LM
LM1
LM2
e2
IS
e
e1
IS
IS
IS
Y1
Y2
Y
No Impact of Fiscal Policy under Flexible
Exchange Rate System
12
Impact of Monetary Policy under Fixed and
Flexible Exchange Rate Systems
Ineffectiveness of monetary Policy Under the
Fixed Exchange Rate System
LM
LM1
LM2
e2
e
IS
e1
IS
IS
Y1
Y2
Y1
Y2
Effectiveness of Monetary Policy under Flexible
Exchange Rate System
13
Macro Indicators and Trade Balances December 2002
14
Macro Indicators and Trade Balances 2003
Macro Indicators 2001
15
Exchange Rate of Sterling Pound with Dollar, Euro
and Yen
/
Y/
Value of one US Dollar in Terms of Local Currency
Source http/www.worldbank.org/data/countrydata
/countrydata.htm, And
Penn World Table.
16
Competitive Open Economy Need Right Exchange Rate

• Overvalued exchange rate reduces volume of
  exports and raises volume of imports
• Overvalued exchange rate raises the production
  cost
• A stable exchange rate is helpful for investors
• Macro fundamentals for right exchange rates
• Balanced government budget over time
• balanced trade over time
• Reasonable domestic and external debt ratios
• Controlled money supply
• Positive real interest rate

17
Purchasing Power Parity Theory of the Exchange
Rate Long Run
18
PPP is Valid in the Long run
PPP is not valid in the short run 2001- 2002
19
Fundamentals of A Stable Exchange Rate according
to the PPP Theory
20
Covered and Uncovered interest parity
21
Impact of Fiscal Policy on the Exchange Rate,
Interest Rate and Output ISLM Model
IS2
UIP
LM
i
i
i2
i1
i
IS
E1
Y2
E2
Y1
Appreciation
Depreciation
22
Uncovered Interest Parity Theory of the Exchange
Rate
23
Appreciation or Depreciation of Currency
According to the Differences in the Domestic and
Foreign Interest Rates
24
(No Transcript)
25
Like the PPP, UIP is also valid only in the long
run
Compare the interest rates and Exchange Rates
between 2001 and 2002
26
Exchange Rate Systems Capital Mobility
27
The Problems of Flexible Exchange Rates
28
Which countries should have fixed exchange rates?
29
Disadvantages of Fixed Exchange Rate System
30
Benefits and cost of a Monetary Union and Optimal
Liberalisation?
Impossible trilogy fixed exchange rate free
capital mobility monetary independence Optimal
Order of Liberalization 1st goods market
(subsidies) 2nd Trade (Tariffs) Financial market
(no control on r) Full convertibility
31
Given these theories of Exchange Rate
Should UK join the European Monetary Union?

• Five Economic Tests Issues for Referendum
• Cyclical Convergence
• Flexibility
• Investment
• Financial Services
• Employment and Growth
• What Do YOU Think?

32
Exercises

• Triangular exchange rate
• Real and nominal exchange rates
• Trade weighted exchange rate
• Exchange rate changes according to the PPP
• Exchange rate according to the UIP
• Relation between fiscal and monetary policy and
  the exchange rate
• Advantages and disadvantages of joining the
  monetary union.