ECONOMICS 3150C Lecture 3 September 30

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ECONOMICS 3150CLecture 3September 30
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Purchasing Power Parity Big Mac or Tall Latte
Theory of Exchange Rates

• Law of one price arbitrage, no transactions
  costs
• Exchange rate between two countries currencies
  ratio of currencies purchasing power as measured
  by national price levels
• Money prices of typical basket of consumption
  goods
• E(t) PUS,t/PC,t
• E ? (?) PUS ? (?) and/or PC ? (?)
• Relative purchasing power parity
• ?E ?PUS - ?PC
• Since ?E - ?E ? ?E ?PC - ?PUS

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PPP Exchange Rates
PPP Actual
2001 2008 2001 2008
A 1.33 1.48 1.93 1.19
Real 1.02 1.46 2.35 1.83
C 1.22 1.23 1.55 1.07
Yuan 3.29 3.79 8.28 6.95
Rupee 13.8 15.9 47.2 43.5
Yen 149 116 122 103
Won 757 762 1291 1102
Peso 6.31 7.82 9.34 11.13
Rouble 8.32 18.42 29.17 24.85
Rand 3.32 4.63 8.61 8.26
Pound 0.63 0.66 0.69 0.54
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Limitations of PPP

• Trade barriers and non-tradables
• Distortions in prices of traded goods and
  services
• Non-traded goods and services
• Imperfect competition
• Distortions in prices
• Composition of consumption baskets
• Differ between/among countries
• Ignore capital flows

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Central Banks

• Monetary policy conducted by central banks
• U.S. Federal Reserve
• Most important
• Created in 1913
• Bank of Canada created in 1935
• Riksbank (Sweden) 1668
• Bank of England 1694
• Bank of France 1800
• Bundesbank (Germany) re-established in 1946
• European Central Bank 1998

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Classical Monetary Theory

• M(t)V(t) P(t)Y(t)
• M supply of money
• V income velocity of money
• P price deflator for GDP
• Y GDP
• V L(R)
• Real interest rates matter
• ?M ?V ?P ?Y

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Classical Monetary Theory

• Short run
• Changes in V depend on changes in R
• Price rigidity
• Changes in M can affect Y and R

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Classical Monetary Theory

• Long run
• Flexible prices
• Assume ?V k ? n (determined by rate of
  growth in factors of production and multi-factor
  productivity growth rate)
• ?P ?M k - n
• Assume further that k 0 and cause-effect runs
  from the supply of money to the rate of inflation
• ? inflation a monetary phenomenon
• ?P ?M - n

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Canadian Experience
M1 M2 Core CPI
2001 10.3 6.6 2.1
2002 10.9 7.2 2.4
2003 5.0 4.8 2.2
2004 8.9 4.9 1.5
2005 6.9 4.7 1.6
2006 8.2 6.3 1.9
2007 8.9 8.1 2.1
2008 8.9 10.2 1.7
2009 13.4 11.6 1.8
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Traditional Balance Sheet

• US Federal Reserve _at_ 08/13/08
• Assets
• U.S Treasury securities 479 B
• Gold, SDRs, other 52 B
• Repos, term auction credits 255.8B
• Total 935 B

• Liabilities
• Currency in circulation 831 B
• Bank deposits 12 B

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Monetary Policy

• In U.S., Federal Reserve must balance rate of
  inflation and growth inflation not sole
  objective as in Canada
• Innovations by U.S. Federal Reserve Chair Ben
  Bernanke in response to financial market crisis
  starting in summer 2008 quantitative easing
• Provision of short-term liquidity to banks and
  other financial institutions
• Provision of liquidity directly to borrowers and
  investors in key credit markets
• Expanded traditional tool of open market
  operations to support the functioning of credit
  markets through the purchase of longer-term
  securities
• Interest on reserve balances with Fed

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New Monetary Policy

• Innovations
• Term Auction Facility expanded size and term to
  84 days
• Primary Dealer Credit Facility expanded
  collateral
• Asset-Backed Commercial Paper Facility
• Money Market Mutual Fund Liquidity Facility
• Term Asset-Backed Securities Loan Facility
• Commercial Paper Funding Facility (CPFF)
• Central bank liquidity swaps
• Interest on reserve balances

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Changes in Fed Balance SheetAugust 1, 2007 to
December 17, 2008

• Assets
• Treasury securities 340B
• Mortgage-backed securities 18B
• Lending to banks 538B
• Credit extended to AIG 82 B
• Lending to primary dealers 47B
• Lending for purchase of Commercial Paper 346B
• Assets purchased from Bear Stearns 27B
• Swaps with central banks 572B
• Total 1.4 T

• Liabilities
• Currency in circulation 64B
• Bank deposits 785B
• Treasury cash deposits 475B

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Current Balance Sheet

• Assets _at_ 08/11/10
• US Treasury securities 777 B
• Mortgage-backed securities 1,120 B
• Federal agency debt securities 159 B
• Credit extended to AIG 26 B
• Total 2.3 T

• Liabilities _at_ 08/11/10
• Currency in circulation 907 B
• Bank deposits 1,058 B

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Nominal and Real Interest Rates

• R(t) r(t) ?P(e,t) r(t) ?M(e,t) n
• assume n 0 for both C and US
• R(t) r(t) ?M(e,t)
• Covered interest rate parity condition
• R(C,t) R(US,t) E(e,t)-E(t)/E(t) ?(t)
• ? R(C) R(US) ?M(e,C) - ?M(e,US) ?
• ? r(C,t) r(US,t) ?(t)
• With unimpeded capital mobility, real interest
  rates in Canada are determined by real interest
  rates in US and the liquidity premium
• B. of C. can only affect real interest rates in
  Canada if actions have some effect on liquidity
  premium, otherwise, monetary policy in Canada
  ineffective in impacting Y in short run

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Real Interest Rates

• Clientele effects provide scope for central banks
  to have some effect
• Clientele effects
• Preference by investors for financial instruments
  supplied locally
• Better informed
• Tax policies
• Regulations RRSPs, pension funds and foreign
  investments
• Currency risks

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Real Exchange Rates

• Real Exchange rate Q
• Q P(US)E/P(C)
• Real depreciation (appreciation) Q ? (?)
• When relative PPP holds, real exchange rate
  cannot change in value
• ?E ?PC - ?PUS
• ?Q ?PUS ?E - ?PC
• Real exchange rate can only change when relative
  PPP does not hold

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Long-run Real Exchange Rate

• Real exchange rate determined by relative demand
  for and relative supply of Canadian goods and
  services current account only matters in long
  run for real exchange rate
• 1/Q relative price of Canadian
• ? in relative D ? ? relative price of C
  (appreciation of real exchange rate ? ? Q
• ? in relative S ? ? relative price of C
  (depreciation of real exchange rate ? ? Q

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1/Q
Relative S of Canadian g s
2
Q2 lt Q1
1/Q2
1/Q1
1
Relative D for Canadian g s
C
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Long-run Real Exchange Rate

• E(t)Q(t)/P(C, t)/(US,t) ? from definition of
  real exchange rate
• Changes in real exchange rate also result in
  changes in nominal exchange rate in long run
• Effects of change in relative S consider the
  case of an increase
• ? Q (depreciation of real exchange rate)
• ? P(C) because MV PY, so if M and V constant as
  result of change in relative supply, ? as Y ?, P
  ?
• Ambiguous effect on E (nominal exchange rate)

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Exchange Rate Regimes

• Bank of Canada intervention in currency market
• Direct intervention buying or selling C
  selling or buying US ? official reserve
  transactions in B. of P.
• Indirect intervention increase or decrease R(C)
  ? capital account transactions
• Increase in R(C) ? increase demand for C
  financial assets increase in exports of
  financial assets, decrease in imports of
  financial assets
• Two models
• Covered interest rate parity model indirect
  intervention only
• Traditional D/S model incorporating B. of P.
  both direct and indirect intervention

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Bank of Canada Balance Sheet

• Assets
• Domestic assets Government of Canada bonds
• Foreign assets Foreign currencies, gold, foreign
  Government Treasury Bills (T-bills)

• Liabilities
• Deposits held by private banks
• Currency in circulation

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Canadas International Reserves ( billions)
2001 34.2
2002 37.2
2003 36.3
2004 34.5
2005 33.0
2006 35.1
2007 41.1
2008 43.9
2009 54.4
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B. of C. Intervention

• Indirect Buy (sell) domestic assets
• ? (?) R(C) in short run, assuming no perfect
  capital flows ? B. of C. has some control over
  real interest rates
• ? (?) M(C) ? consider impact on expected
  inflation rate and hence on nominal interest
  rates resulting from change in expected inflation
  rate
• Direct Buy (sell) foreign assets
• No short-run impact on R
• ? (?) M(C) ? consider impact on expected
  inflation rate and hence on nominal interest
  rates resulting from change in expected inflation
  rate
• Sterilized direct intervention buy foreign
  assets, sell domestic assets ? no change in M, ?
  R ? results in indirect intervention as well

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Indirect Intervention Covered Interest Rate
Parity Model
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Indirect Intervention ? R(C)
E
1
E0
2
E1
R(1,US)0, ?0, E(e)0
R(1,C)
R0
R1
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Indirect Intervention Traditional D/S Model
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Indirect Intervention ? R(C)
E
S of C imports
E1
2
E0
1
D for C exports
Q(C)
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Spot Rate

• Spot rate determined by interaction between D for
  and S of C
• D Exports
• S Imports
• Bank of Canada intervention
• In short run, capital flows dominate trade flows
  in affecting exchange rates
• Role of expectations
• Momentum trading

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Spot Rate

• D for C
• exchange rate (relative price of Canadian
  dollar),
• real income levels in US (exchange rate is
  between Canadian dollar and US dollar),
• price levels in Canada,
• price levels in US,
• trade barriers,
• competitiveness of Canadian and US companies,
• interest rates in Canada and US,
• profit expectations in Canada and US,
• expectations regarding movements in equity prices
  in Canada and US,
• transactions by Bank of Canada in currency market
  
• perceptions of risk and attitudes toward risk

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Spot Rate

• S of C
• exchange rate (relative price of Canadian
  dollar),
• real income levels in Canada,
• price levels in Canada,
• price levels in US,
• trade barriers,
• competitiveness of Canadian and US companies,
• interest rates in Canada and US,
• profit expectations in Canada and US,
• expectations regarding movements in equity prices
  in Canada and US,
• transactions by Bank of Canada in currency market
• perceptions of risk and attitudes toward risk