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Macroeconomic Analysis 2003. Exchange Rate:PPP, 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

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Macroeconomic Analysis 2003

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Macroeconomic Analysis 2003

Exchange Rate:PPP, 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))

Lecture 18


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Fundamental Macroeconomic Identity for an open economy

Lecture 18


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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

Lecture 18


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Why is not appreciation of domestic currency

not good for Foreign Investment?

Net capital outflow

S-I

Real

Exchange

Rate

λ

Net capital inflow

NX(λ)

Net export

Lecture 18


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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:

Excess Demand for FC

Imports: M(E,Y)

0

F

Demand and supply of Foreign Currency

Lecture 18


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Depreciation of Dollar against Pound

or Appreciation of Pounds against dollar in 2002

Lecture 18


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Triangular Exchange Rates and Appreciation

and Depreciation with respect to the Third Currency

Lecture 18


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Keynesian Open Economy Model

How an Expansion in Income causes Trade Deficit?

AD

0

Y

+

X=X0

M=M(Y)

Trade

balance

Surplus

0

Y

Deficit

-

Lecture 18


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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

ΔNX

Y1

Y2

Y

(c)

(b)

e

e2

e1

IS*(e)

NX (e)

Y2

y1

NX2

NX1

Lecture 18


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IS-LM Model in an Open Economy

LM (y, i)

Exchange Rate

e*

IS*

o

Output

y

Lecture 18


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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

Lecture 18


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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

Lecture 18


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Macro Indicators and Trade Balances December 2002

Lecture 18


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Macro Indicators and Trade Balances 2003

Macro Indicators 2001

Lecture 18


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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.

Lecture 18


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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

Lecture 18


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Purchasing Power Parity Theory of the Exchange Rate: Long Run

Lecture 18


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PPP is Valid in the Long run

PPP is not valid in the short run 2001- 2002

Lecture 18


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Fundamentals of A Stable Exchange Rate according to the PPP Theory

Lecture 18


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Covered and Uncovered interest parity

Lecture 18


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Impact of Fiscal Policy on the Exchange Rate,

Interest Rate and Output: ISLM Model

IS2

UIP

LM

i

i

i2

i1

i

IS

Y2

E1

E2

Y1

Appreciation

Depreciation

Lecture 18


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Uncovered Interest Parity Theory of the Exchange Rate

Lecture 18


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Appreciation or Depreciation of Currency According to the Differences in the Domestic and Foreign Interest Rates

Lecture 18


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Lecture 18


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Like the PPP, UIP is also valid only in the long run

Compare the interest rates and Exchange Rates between 2001 and 2002

Lecture 18


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Exchange Rate Systems: Capital Mobility

Lecture 18


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The Problems of Flexible Exchange Rates

Lecture 18


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Which countries should have fixed exchange rates?

Lecture 18


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Disadvantages of Fixed Exchange Rate System

Lecture 18


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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

Lecture 18


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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?

Lecture 18


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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.

Lecture 18


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