week 9 Flashcards
a) about exchange rate b) open economies more broadly
Nominal exchange rates vary over time,
WHY do nominal exchange rates vary as much as they do?
A big part of the answer is:
different rates of inflation
To explain this: theory of exchange rates
What is Purchasing Power Parity [PPP]?
☆ The first (long run) theory of exchange rates ☆
“a unit of any given currency should be able to buy the same quantity of goods in all countries”
Purchasing power parity means that so the real exchange rate E must be equal to ___?
1
The reason that 1 = eP/P* should hold is —?
Arbitrage
If real exchange rates differ:
Someone can buy in one country, sell in another + make a profit.
Such arbitrage would continue until equality (parity) in prices sets in
theory of PPP tells us that the nominal exchange rate between 2 countries…
— nominal exchange rate between 2 countries reflects the price levels in those countries.
This is clear since:
1 = eP/P*
1 = eP/P* if and only if — ?
e = P* / P
When relative prices change — MUST change!
When relative prices change e MUST change!
e.g. if domestic prices P rise faster than prices abroad P*
then e must decline and you get fewer dollars per pound
(Depreciation)
an increase in the money supply → increase in prices, so when a country increases its money supply faster than other countries…
its exchange rate should depreciate
2 classical exchange rate theories
- quantity theory of money→ explains how the money supply affects the price level
- purchasing power parity→ explains how price level affects nominal exchange rate
money, prices + nominal exchange rate during german hyperinflation
Notice how similarly these three variables move.
When the quantity of money started growing quickly, the price level followed, and the mark depreciated relative to the dollar.
When the German central bank stabilised the money supply, the price level and exchange rate stabilised as well.
limitations of PPP? [4]
- Doesn’t always happen in practice, especially in the short run.
- Real exchange rates are not constant over time
- many goods (services, like haircuts) are not easily traded
- even tradable goods are not always perfect substitutes(bmw vs toyota) → diff. characteristics
== transaction costs inhibit profitable arbitrage
Nonetheless, theory of PPP:
Is a good starting point for understanding currency movements in the long run
What PPP theory doesn’t do is …
say much about trade deficits or the currency market in the SR
Over the last many years, the UK + US have run persistent trade deficits.
why?
to answer: we introduce a model of how net exports, net capital outflow + the exchange rate are determined to relate to each other
open economy model assumptions
model assumptions
1) GDP taken as given
— **Real GDP** determined by supplies of the factors of production + technology that converts these inputs → outputs
2) economy’s price level is also taken as given
(a model of the short run)
An open economy model has 2 markets, which are:
- supply and demand for loanable funds
- supply and demand for foreign currency
what does supply and demand for loanable funds coordinate?
— coordinates a country’s saving, investment + NCO. now in an open economy
what does **supply and demand for foreign currency* coordinate?
— coordinates people who want to exchange the domestic currency for foreign currency
MODEL: how net exports, net capital outflow + the exchange rate are determined to relate to each other
The market for loanable funds. In an open economy, Savings =?
S = I + NCO
What does S = I + NCO mean?
- Saving = Domestic Investment + Net capital outflow
Saving can be used to finance domestic or foreign capital accumulation
- S is the supply of loanable funds (domestic savings)
- I + NCO is the demand for loanable funds
- asset demand may stem from investments at home (I) or abroad (NCO)
the real rate of interest r equilibrates the supply and demand for …?
loanable funds (precisely as in a closed economy).
The demand curve I(r)+NCO(r) is decreasing because …?
— A higher rate of interest discourages investments at home and makes foreign assets relatively less attractive hence discourages residents from buying foreign assets
The supply curve S(r) is increasing because …?
— A higher rate of interest encourages people to save more
Draw the market for loanable funds in an open economy
The market for loanable funds determines the ——?
equilibrium real rate of interest.
A new element is that this market also determines …
Net Capital Outflows!
This is because NCO = NCO (r), and declining in r
In the market for foreign-currency exchange (FOREX/FX) what do demand + supply for pounds equal?
— Demand for pounds equals NX (net exports) since net export is paid in pounds
— Supply of pounds equals NCO (net capital outflow) since people wanting to purchase foreign assets must sell pounds at the FX market to buy these.
the real exchange rate E equilibrates the ____________ in the forex market.
the real exchange rate E equilibrates the supply and demand for pounds in the forex market.
In the forex market, The supply NCO is _______ given the interest rate
fixed given the interest rate (supply curve vertical)
NCO is determined where?
In the market for loanable funds
- The demand for pounds NX is decreasing in the real exchange rate→ Higher real exchange rate decreases export and increases import.
Draw the forex market
the market for loanable funds determines _________
the market for loanable funds determines the equilibrium real rate of interest
the real rate of interest determines the ______________
the real rate of interest determines the Net Capital Outflow (NCO)
Which in turn determines the real exchange rate together with forex demand (NX)
Draw the real equilibrium in an open economy diagram and explain.
Two relative prices, e and r adjust to equilibrate the market for….
Market for Loanable funds (r) + The FOREX market (E)
These relative prices, e and r determine:
- National saving
- Domestic investment
- Net capital outflow
- Net exports
PPP long run where international trade fully responds to changes in P/P*, i.e. to changes in the relative price level
Implicitly this means that the
FOREX demand curve in Fig 3 is horizontal at E=1
The current model in contrast allows for _________________________ which is consistent with the facts.
real exchange rates different from what PPP would have
What is Trade Policy?
Government policy that directly influences the quantity of goods and services that a country imports or exports
Examples:
- Tariff (tax on imports)
- Import quota (limit on quantity of imports)
- Voluntary export restrictions
What is an Import Quota?
A cap on imports/exports from/to a certain country
Draw the effects of an import quota
Import quotas, surprisingly, as well as several other trade policies _______________ Trade balance
Do not affect the UK trade balance
Why import quotas not affecting UK Trade Balance NOT a surprise ?
NX = NCO
NX = S - I
Since trade policies do not alter S and I, the real exchange rate must adjust to keep the trade balance the same, regardless of any trade policies the government imposes.
While trade policies do not affect a country’s overall trade balance, they do affect ___________
specific firms and industries (micro)
E.g., UK car manufactures will benefit from quota on Japanese cars; but exporters will lose out due to appreciation of the pound
Political or economic instability ⇒ Leads to c_________
capital flight
Capital flight is?
large and sudden reduction in the demand for assets located in a country
examples of real world capital flight?
- Mexico in the mid 1990s
- East Asian (Thailand) banking crisis in 1997
- Russian government debt default of 1998
- Argentinian default of 2002
- Greece after the global financial crisis 2007-9
- UK after Brexit vote (though much less dramatically than the previous examples).
- Russia 2022
Draw the effects of capital flight diagram
Capital flight affects ____________
Both markets
What impacts does capital flight have on both markets?
- Causes real interest rate to rise
- Reduces domestic investment
- Slows capital accumulation
- Slows economic growth
- Causes the currency to depreciate
- Increases net exports which improves the trade balance all else being equal
Russia capital flight example
RUSSIA:
☆ Capital flight and direct sanctions on portfolio investments. As we have seen: Increase the real interest rate (hence reduce growth)
- Currency (ruble) depreciation
- To counter this, CB increased interest rate sharply.
☆ Note the many similarities with Mexico
…except, possibly, there may not be a counteracting increase in NX
How does increased budget deficits reduce supply of loanable funds?
☆ When government spending exceeds government revenue this reduces national savings
— And so it reduces the supply of loanable funds ☆
Effect of a government budget deficit on market for loanable funds, NCO + Real ER diagram
Government budget deficits raise _____ which: 1) ___________ 2) __________
Gov budget deficits raise r which
1☆: Crowds out domestic investment
2☆: Lowers Net Capital Outflows
This leads to appreciation in Real ER
– causes net export to fall thus pushing trade balance toward deficit
This close relationship between budget + trade deficits explains why they are often referred to as the ___________
Twin Deficits
What are the macroeconomic impacts of trade policy, say the Uk a UK quota on imports of Japanese cars?
- Directly lowers imports and so leads to an increase in net exports
- However, this effect is precisely offset by an increase in the real exchange rate which will lower net exports back to the level it started at (namely the NCO determined by the real exchange rate).
