Final (Critical) Flashcards
What is uncovered interest parity?
When does it occur?
What is the formula?
- UIP is when expected rates of return are equal
- UIP occurs when there are no remaining arbitage opportunities in the f/x market
Of critical importance, know that in the asset approach to the exchange rate, the exchange rate is determined by asset arbitrage between currencies, that is, that the equilibrium is when markets adjust so that the rates of return on the domestic and foreign currencies are equalized. This will be determined by the relationship between the return on domestic currencies (the domestic interest rate) and the return on foreign currencies in domestic terms (see previous bullet point). That is to say, the market is in equilibrium when there is interest parity (also called uncovered interest parity or UIP), which is when the following equation holds: [3:36, 39-40]
How do you graph the interest parity condition?
How does the graph change if the domestic interest rate increases?
How does the graph change if the foreign interest rate increaes?
How does the graph change if there is a change in expected exchange rates?
Book explanationn:
How do you graph the interest parity condition? See image
How does the graph change if the domestic interest rate increases/decreases?
- Figure 14-5 shows a rise in the interest rate on dollars, from to R$ as a rightward shift of the vertical dollar deposits return schedule.
- At the initial exchange rate £$/€, the expected return on dollar deposits is now higher than that on euro deposits by an amount equal to the distance between points 1 and 1’.
- As we have seen, this difference causes the dollar to appreciate to E$/€ (point 2).
- Because there has been no change in the euro interest rate or in the expected future exchange rate, the dollar’s appreciation today raises the expected dollar return on euro deposits by increasing the rate at which the dollar is expected to depreciate in the future.
How does the graph change if the foreign interest rate increasesdecreases?
- Figure 14-6 shows the effect of a rise in the euro interest rate R€.
- This change causes the downward-sloping schedule (which measures the expected dollar return on euro deposits) to shift rightward. (To see why, ask yourself how a rise in the euro interest rate alters the dollar return on euro deposits, given the current exchange rate and the expected future rate.)
- At the initial exchange rate £$/€, the expected depreciation rate of the dollar is the same as before the rise in R€, so the expected return on euro deposits now exceeds that on dollar deposits.
- The dollar/euro exchange rate rises (from El$/€ to E$/€ to eliminate the excess supply of dollar assets at point 1.
- As before, the dollar’s depreciation against the euro eliminates the excess supply of dollar assets by lowering the expected dollar rate of return on euro deposits.
- A rise in European interest rates therefore leads. to a depreciation of the dollar against the euro or, looked at from the European perspective, an appreciation of the euro against the dollar.
How does the graph change if the expected exchange rate increases/decreases?
- If people expect the euro to appreciate in the future, then euro denominated asset will now be converted in the future at a more valuable rate, i.e., compared to before, euros can now buy more dollars in the future.
- The expected rate of return on euros therefore increases, shifting the curve right.
- An expected appreciation of a currency leads to an actual appreciation (a self fulfilling prophecy).
- An expected depreciation of a currency leads to an actual depreciation (a self fulfilling prophecy).
Of critical importance, know how to graph the interest parity condition by showing the returns on both the domestic currency and foreign currency (both returns being expressed in domestic currency terms), with equilibrium being at the intersection between the two. Know how to manipulate the graph with changes in interest rates and the future expected exchange rate [3:44, 46-49]
How is equilibrium determined in the money market?
How is equilibrium achieved in the money market starting from a position of either excess money supply or money demand?
What is the effect of a rise/fall in the money supply on interest rate?
What is the effect of a rise/fall in real income on the interest rate?
How would you show these changes graphically?
How is equilibrium determined in the money market? Graph?
- equilibrium determined by equality of real money suppy (money supply / price level) and real money demand (function of interest rate and income) –> Ms / P = L (R,Y)
How is equilibrium achieved in the money market starting from a position of either excess money supply or money demand? Graph?
- if there is excess money supply, then people try to exchange money for bonds
If Ms > Md, then people want bonds not liquid $ b/c R is high
So Bd > Bs, i.e., more people want bonds at the high R then there are bonds on the market
So Bp rise and R drops as bond prices rise
- if there is excess money demand, then people try to exchange bonds for money
If Md > Ms, then people want liquid $ not bonds b/c R is low
So Bd
So Bp bond prices drop to entice buyers / clear the market
And R rises as bond prices drop
What is the effect of a rise/fall in the money supply on interest rate? Graph?
What is the effect of a rise/fall in real income on the interest rate? Graph?
Of critical importance. Understand that equilibrium in the money market is determined by the equality of real money supply (money supply divided by the price level) and real money demand, which is a function of interest rates and income. [4:20,23]
Understand how equilibrium is achieved in the money market starting from a position of non-equilibrium (whether excess money supply or money demand). The basic mechanism is that people either try to exchange money for bonds (starting from excess money supply) or try to sell bonds for money (starting from excess money demand). The resulting change in bond prices leads to the equilibrating change in interest rates. In other words, we generally take the money supply and income as exogenous in the money market and the interest rate as endogenous [4:21-22]
Be able to manipulate the graph of money market equilibrium for changes in money supply and income [4:24-25]
How would you graph the combined money market and foreign exchange equilibrium?
What determines the exchange rate?
What determines the interest rate?
How do changes in domestic/foreign money supplies affect the interest rate and therefore the exchange rate? How would you graph these changes?
How would you graph the combined money market and foreign exchange equilibrium?
See graph
What determines the exchange rate?
uncovered interest parity in the foreign exchange market
What determines the interest rate?
domestic money market
How do changes in domestic/foreign money supplies affect the interest rate and therefore the exchange rate? How would you graph these changes?
- Think of the direction of causality from domestic Ms, to domestic R, to the exchange rate
- Increase in domestic Ms, lowers domestic R, domestic currency depreciates, and exchange rate rises
- Decrease in domestic Ms, raises domestic R, domestic currency appreciates, and exchange rate falls
- Increase in foreign Ms, lowers foreign R, foreign currency depreciates (expected euro return curve shifts left), and exchange rate rises
- Decrease in foreign Ms, raises foreign R, foreign currency appreciates, and exchange rate falls (expected euro curve shifts right)
Of critical importance. Be very familiar with the diagram showing combined money market and foreign exchange market equilibrium. This is one of the central models of the class. [4:29-34]. In particular:
Understand the relationship with the interest parity diagram of the previous chapter, that is, that the foreign exchange market is still determined by interest parity, but now the interest rate is determined in the money market.
Understand how changes in the domestic and foreign money supplies affect the interest rate, and therefore the exchange rate. Be able to show this diagrammatically. [4:31-34]
How do you graphically depict the short-run and long-run adjustments to money supply changes in the long-run model?
Why does overshooting occur?
How do you graphically depict the short-run and long-run adjustments to money supply changes in the long-run model?
- See graphs 4:44-49
Why does overshooting occur?
- the differential speed of adjustment of asset markets and goods/services/labor markets
- asset markets can adjust instantly (i.e., exchange rates, exchange rate expectations, and interest rates)
- but goods/services/labor markets adjust gradually (i.e. goods/service prices and wages)
Of critical importance. Understand and be able to show graphically the short-run and long-run adjustments to money supply changes in the long-run model. Do not be confused by the difference between the short-run model (in which exchange rate expectations do not change) and the short-run in the long-run model (in which exchange rate expectations do change, with immediate implications for the exchange rate given the interest parity condition). [4:44-48]
Understand that the long-run model displays exchange rate overshooting and be able to show that graphically, both in terms of the exchange market/money market graph and the chart in 4:49 that shows how variables evolve over time. [4:44-48]. Note that I demonstrated this both with a long-run monetary contraction in Japan (4:44-46) and a long-run monetary expansion in the U.S. (4:47-48), just so you could get extra practice with the idea.
Be sure you understand the difference between charts like those in 4:47 or 4:48 which show equilibriums under various assumptions (e.g. what is happening with the money supply, or whether prices are or are not sticky) versus a dynamic chart like that in 4:49 that explicitly shows how variables will evolve over time (that’s what dynamics are … how variables evolve over time) in response to a specific shock (e.g. a change in money supply). Be sure you are using the right type of chart in an exam.
Understand and be able to explain that the exchange rate overshooting occurs because of the differential speed of adjustment of asset markets (i.e. exchange rates, exchange rate expectations and interest rates can adjust instantly) and goods/services/labor markets (i.e. goods and service prices and wages adjust gradually)
What are the effects of a temporary increase in the money supply on the AA-DD curve?
How do you determine the rate of return on a foreign currency deposit (in domestic currency terms)?
the rate of return on a foreign currency in domestic currency terms = rate of return in foreign currency terms + rate of appreciation of the foreign currency
see image below
Of critical importance, know that the rate of return on a foreign currency in domestic currency terms is determined by the rate of return in foreign currency terms plus the rate of appreciation of the foreign currency, e.g. the rate of return in dollars for a euro-denominated deposit is: [3:30, 32-35]
How do you calculate balance of payments?
See HW #1 and practice problems.
Why is a rise in interest rates associated with currency appreciation in the asset approach to the exchange rate, but with a currency depreciation in the monetary approach to the exchange rate?
- asset approach:
- rise in R is associated with appreciation
- when Ms increases, R must fall, and E must rise to maintian UIP
- discrete changes in the level of the Ms change the price-level
- monetary approach:
- rise in R associated with depreciation (higher than expected inflation requires currency to depreciate to maintain goods parity)
- when rate of change of Ms increases (inflation), R must rise, and E must rise to maintain PPP
- rate of change of Ms changes rate of price inflation
- Thus, there is a key difference b/t…
- …the short-term effect of a one-time increase in the level of the Ms (which reduces interest rates and deprectiates the currency) and…
- …a permanent increase in the rate of money growth (which raises interest rates and depreciates the currency)
- Of critical importance. Be able to understand why in our asset approach to the exchange rate, a rise in interest rates is associated with currency appreciation, whereas in the monetary approach, it is associated with currency depreciation. [5:19-32]
- The difference is that in the asset approach, we thought of discrete changes in the level of the money supply that led to price level changes.
- In the monetary approach, we introduced the idea of thinking of the rate of change of money supply and relating that to the rate of price inflation. [5:20, 22] This gives a key as to how we can get a permanently higher interest rate, specifically, by a higher rate of money growth that causes higher inflation. [5:22]
- The Fisher effect says that higher inflation rates will generally be compensated by higher nominal interest rates, keeping the real interest rate broadly unchanged. [5:23]
- You should be able to combine relative PPP with the interest parity condition to show that long-run interest rate differentials across countries should reflect inflation differentials. [5:24]
- This implies that countries with higher nominal interest rates have higher inflation, and in accordance with relative PPP, their currency will depreciate relative to the lower interest rate country. [5:25]
- Be able to show this graphically through time [5:26-31]
- Note that because the monetary approach is a long-run approach in which we are not considering short-run price stickiness, we don’t get exchange rate overshooting. [5:32]
What is the formula for the real exchange rate?
q = E P* / P
—–original text—–
- Of critical importance. Be aware that the real exchange rate approach allows both monetary factors and real factors to influence the nominal exchange rate, and be familiar with the results below, which are summarized in the table on slide 5:60. [5:56-60]
- If only monetary factors change and PPP holds, we get the same results as before, i.e. the nominal exchange rate changes in line with relative price level changes [5:56]
- If only real factors change (demand or supply), then the real exchange rate changes, impacting the nominal exchange rate but not price levels [5:56]
- If real demand changes, the impact is unambiguous and the nominal exchange rate changes in the same direction as the real exchange rate [5:56-57]
- If real supply changes, the impact is ambiguous because both the real exchange rate changes and the domestic price level (via the output effect on money demand), with the two effects offsetting [5:58]. It is not clear which effect will dominate.
What is the short-run impact of monetary and fiscal changes on the AA-DD equilibrium?
What policy options are appropriate in the short-run to restore full employment after either a real shock or a monetary shock?
What are the implications for each type of policy?
- If Ms increases: R drops, currency depreciates (shift from domestic to foreign bonds), E rises, and AA shifts right along DD; currency depreciation increases demand (AD) for output, i.e., EX become less expensive, volume rises, CA rises, AD rises, Y rises, movement right along DD (see slide 6.45)
- If G increases (or T decreases): AD rises, Y rises, and DD shifts right; when Y rises, L rises, R rises, currency appreciates, and E falls (remember, you need to work through the short-term changes until something changes E directly)
- Real shock = demand shock, i.e., change in demand for real goods
- Monetary shock = change in money demand
- Expansionary monetary policy depreciates the currency and increases net foreign demand
- Expansionary fiscal policy appreciates the currency and partially crowds out net foreign demand
Of critical importance, know the short-run impact that monetary and fiscal changes have on AA-DD equilibrium [6:45-46], and be able to discuss therefore what policies are appropriate in the short-run to restore full employment after either a real shock (a shock to demand) or a monetary shock [6:48-49]. Understand the implications for the exchange rate of each type of policy (expansionary monetary policy depreciates the currency and increases net foreign demand while expansionary fiscal policy impacts demand directly and appreciates the exchange rate, partially crowding out net foreign demand).
What are the effects of a temporary fiscal expansion?
See slide 6.49
What policies could you use to return to full employment after a temporary fall in world demand for domestic products?
See slide 6.48
What policies could you use to maintain full employment after a money demand increase?
See slide 6.49
What are the long-run effects of a peranent monetary expansion?
See slide 6.55
Of critical importance Be able to demonstrate graphically the exchange rate overshooting result from Lecture 4 with the AA-DD model. [6:54-55]
What are the effects of a permanent fiscal expansion?
See slide 6.58
- Of critical importance Understand and be able to show graphically that permanent changes in fiscal policy have offsetting impacts on domestic demand and net foreign demand. [6:56-58]
How does a country with a fixed exchange rate respond to an increase in output?
What determines the interest rate in a fixed exchange rate regime?
What does this mean about the money supply? Do countries with a fixed exchange rate have an independent monetary policy?
See slide 7.27
- Of critical importance, understand that the interest parity condition becomes very simple with a credible fixed exchange rate regime: the domestic interest rate must equal the foreign interest rate. Importantly, understand that this means the monetary authority cannot determine the domestic interest rate independently of the foreign interest rate, and therefore the money supply becomes endogenous. Therefore, there is no such thing as an independent monetary policy under a fixed exchange rate regime.[1] Be able to show this graphically. [7:22-27 and 30-31]
- *
[1] This presumes two things which we discussed in Lecture 8, which is open capital markets and that the fixed exchange rate regime is credible.
How does monetary expansion affect the AA-DD curve under a fixed exchange rate?
Do countries with a fixed exchange rate have an independent monetary policy? What does this look like graphically?
See slide 7.31
Of critical importance, understand that the interest parity condition becomes very simple with a credible fixed exchange rate regime: the domestic interest rate must equal the foreign interest rate. Importantly, understand that this means the monetary authority cannot determine the domestic interest rate independently of the foreign interest rate, and therefore the money supply becomes endogenous. Therefore, there is no such thing as an independent monetary policy under a fixed exchange rate regime.[1] Be able to show this graphically. [7:22-27 and 30-31]
How does fiscal expansion affect the AA-DD curve in the short-run under a fixed exchange rate?
See slide 7.33
How does fiscal policy affect the AA-DD curve in the long run under a fixed exchange rate?
What is the final result equivalent to?
See slide 7.34-36
- Of critical importance Understand the process by which output returns to the full-employment level in the long-run after the use of discretionary fiscal policy. Specifically, the increase in money supply needed to keep the exchange rate fixed after a fiscal expansion will eventually lead to an increase in the price level by the same percentage as the increase in the money supply. Remember that price increases shift both the AA and DD schedules to the left (see Lecture 6 above). Understand and be able to show graphically that the final result is equivalent to the long-run neutrality of the money supply in lecture 4.[1] [7:34, 36]
- *
[1] Be able to show this for both a fiscal expansion (as in the lecture) and a fiscal contraction. You may have to figure out the latter on your own, but it’s the opposite of an expansion.
What is the short-run effect of a currency devaluation on the AA-DD curve?
See slide 7.39
- Of critical importance Be able to demonstrate graphically the impact of a currency devaluation and currency revaluation under a fixed exchange rate regime in the short and long runs. Note that we only showed explicitly the short-run impact of a devaluation. [7:39-40]
What is the long-run effect of a currency devaluation on the AA-DD curve under a fixed exchange rate?
See slide 7.40
- Of critical importance Be able to demonstrate graphically the impact of a currency devaluation and currency revaluation under a fixed exchange rate regime in the short and long runs. Note that we only showed explicitly the short-run impact of a devaluation. [7:39-40]
How do you draw the external/internal balance diagram?
What is it telling you?
- Of critical importance Understand the external/internal balance diagram and what it is telling you, specifically, that depending on a country’s deviations from internal and external balance, it may face a tradeoff, under a fixed exchange rate regime, of using fiscal policy to achieve internal or external balance. Be able to answer questions about such fiscal policy tradeoffs under a fixed exchange rate. Understand that it sets the basis for understanding virtually the entire history of the international monetary system from the advent of the gold standard in 1870 to the breakdown of Bretton Woods in 1971. [8:14-16]
How did changes in social conditions and geopolitical and economic influences render the interwar gold-exchange standard unstable?
- Of critical importance: Be able to discuss, also at a general level, how changes in social conditions and geopolitical and economic influences rendered the interwar gold-exchange standard unstable, including such factors as [8:23-28, summarized in 8:32]:
- social conditions forced more of a focus on internal balance, making the maintenance of external balance and a fixed exchange rate less credible, including that countries such as Britain that did pursue policies focused on external balance found maintaining those policies unsustainable;
- the rules of the game were no longer being imposed on the system by Britain, and the US and France, in particular, did not obey them;
- the distribution of monetary gold was now concentrated in the US and France
- a lack of international cooperation contributed greatly to the failure of the gold-exchange standard. Such failures manifested in beggar-thy-neighbor policies such as competitive devaluations, trade wars, and monetary policies that prioritized domestic conditions over maintenance of exchange rate pegs
- banking crises that led countries to prioritize financial stability over exchange rate pegs
