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
1
Fundamental Macroeconomic Identity for an open economy
Main Features of an open economy
a. exports and imports with the rest
of the world
b. Capital inflow and outflow
c. Exchange rate system
Fixed -pegged
Flexible –floating
d. External shocks affect income
and employment at home – risks
e. Exchange rate stability
arrangements –(monetary union,
dollarisation)
f. Policy coordination
Aggregate demand in an open economy
*
f eP
Y  C (Y  T )  I (Y , i   )  G  NX (Y , Y ,
)
P
e
Income = demand
C  S T  M  C  I G  X
Economy wide saving = Trade balance
S ( y )  I ( r ) T ( y ) G  x ( y f ,e )  M ( y ,e )
Balance of payment condition
Current account +capital account =0
X ( y f , e)  M ( y, e)  F (r  r f )  0
Lecture 18
2
Three GAPs: Investment-Saving, Budget and Trade Gaps
SI
S(Y)
S  I   T  G   X  M
Trade Surplus
NX  0  NX  Cap Flow
K-outflow
i
T G  0
Private saving +public saving
= net export
i
SI
I(r)
Trade deficit
K-inflow NX  0
0
Saving and Investment
Re call : Y  C  S  T  M  C  I  G  X  rK  wL  Tr
Lecture 18
3
Why is not appreciation of domestic currency
not good for Foreign Investment?
$
 1.60
£ Real
Net capital
outflow
S-I
S  I   X  M   Cap Flow
X  M   Cap Flow  0
Exchange
Rate
λ
$
 1.45
£
Net capital inflow NX(λ)
Net export
Lecture 18
4
Exchange Rate and the Demand and Supply of Foreign Currency
£
2002:  0.69
$
E1
Exports: X(E,Y*)
Excess supply of FC
Depreciation
E
A
0.66
e
NX
Appreciation
E2
£
2003:  0.63
$
0
Excess Demand for FC Imports: M(E,Y)
F
Demand and supply of Foreign Currency
Lecture 18
5
Depreciation of Dollar against Pound
or Appreciation of Pounds against dollar in 2002
Sterling Pound
Et 1  Et
0.63  0.69
AR£ 
 100 = AR£ 
 100  8.7%
Et
0.69
Euro also appreciated
Et 1  Et
0.98  1.11
AR 
 100 = AR 
 100  11.7%
Et
1.11
Euro also appreciated
121  128
Et 1  Et
 100  5.47%
ARY 
 100 = ARY 
Et
128
Lecture 18
6
Triangular Exchange Rates and Appreciation
and Depreciation with respect to the Third Currency
Initial exchange rates
End of 2002
1.11
0.98
£0.69
$1
£0.63
$1
2001
2002
In 2002 one dollar in terms of pound and Euro is
0.63
 0.64
0.98
In 2001 one dollar in terms of pound and Euro is
0.69
 0.621
1.11
This implies that Euro has become stronger by 0.021
percent (0.64 - 0.621) against the pound.
Lecture 18
7
Keynesian Open Economy Model
How an Expansion in Income causes Trade Deficit?
AD
*
eP
f
e
Y  C (Y  T )  I (Y , i   )  G  NX (Y , Y , )
P
0
Y
+
X=X0
M=M(Y)
Trade
balance
Surplus
0
-
Deficit
Lecture 18
Y
8
Derivation of Net Exports and Investment Saving in an Open Economy
Note:
AD
• 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
(c)
AD
(a)
ΔNX
Y1
(b)
e
e2
Y2 Y
e1
IS*(e)
NX (e)
y1
NX2
NX1
Lecture 18
Y2
9
IS-LM Model in an Open Economy
Exchange
Rate
LM (y, i)
e*
IS*
o
Output
y
Lecture 18
10
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
IS*’
e1
IS*
IS*
Y
No Impact of Fiscal Policy under
Flexible Exchange Rate System Lecture 18
Y1
Y2
11
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
Ineffectiveness of monetary Policy
Under the Fixed Exchange Rate System
LM
LM1
LM2
e2
IS*’
e
e1
IS*
IS*
Y1
Y2
Effectiveness of Monetary Policy
under Flexible Exchange Rate
System
Lecture 18
Y1
Y2
12
Macro Indicators and Trade Balances December 2002
Macro Economic Indicators
UK
EUROArea
USA
Japan
Budget deficit as % of GDP
-1.4
-2.2
-3.1
-7.9
Inflation rate (% change in CPI)
2.1
2.2
2.6
-0.9
Interest rate (% per year on
3-month money market)
3.97
2.94
1.34
0.02
Trade balance (in billion US $)
-49.0
95.6
-456.6
89.3
Current Account balance
(in billion US $)
25.8
38.0
-462.2
113.9
Exchange rate (per US $)
0.63
0.98
1
121
Growth rate of GDP (annual %)
1.8
0.8
3.2
1.3
Growth rate of money supply
(%)
5.8
7.0
6.6
3.2
Lecture 18
13
Macro Indicators and Trade Balances 2003
Macro Indicators 2001
Macro Economic Indicators
UK
EUROArea
USA
Japan
Budget deficit as % of GDP
1.1
-1.2
0.6
-6.0
Inflation rate (% change in
CPI)
1.6
2.1
2.2
-0.8
Unemployment rate (%)
5.2
8.1
5.6
5.3
Interest rate (% per year on
3-month money market)
3.97
3.35
1.84
0.02
Trade balance (in billion US $) -47.2
24.9
-438.9
74.9
Current Account balance
(in billion US $)
17.7
-31.2
-430.7
3.2
Exchange rate (per US $)
0.69
1.11
1
128
Growth rate of GDP (annual
%)
2.2
1.3
0.6
-0.5
Growth rate of money supply
(%)
8.2
8.0
14.0
3.2
Lecture 18
14
Exchange Rate of Sterling Pound with Dollar, Euro and Yen
1975
US$
$/£
Y/£
1985
2000
2002
2003
2.22 1.298 1.578 1.515
1.44
1.6
111.3
1995
Eff. Rate
129.6
84.8 107.5 107.3
Euro-area
1.697
1.71 1.191 1.642
1.63
1.46
Yen
658.1 307.1 148.4 163.3
191
188
Value of one US Dollar in Terms of Local Currency
Ghana
India
Italy
Brazil
Turkey
UK
1955
0.7146
4.764
625
4.3E-11
2.831
0.3571
1965
0.7146
4.763
625.1
2E-09
9.102
0.3571
1975
1.15
8.653
652.8
8.1E-09
14.44
0.452
1985
54.37
12.24
1909
6.2E-06
522
0.7792
1990
326.3
17.95
1198
0.0683
2609
0.5632
2000
5231
45.7
2101
1.8
625,208
0.7
Source: http:/www.worldbank.org/data/countrydata/countrydata.htm,
And Penn World Table.
Lecture 18
15
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
16
Purchasing Power Parity Theory of the Exchange Rate: Long Run
*
EP
Real exchange rate :   P
t et Pt* Pt
PPP-hypothesis:   e  *  P
t P
t
t
t
t
et
*   g    * *g* 
 0 






et
t


Where P* is foreign price level, P is the domestic price
level,
et
e
is the change in the nominal exchange rate t is
the nominal exchange rate  * = foreign inflation, * =
*
growth rate of money supply abroad, g = growth rate of
economy abroad;  = domestic inflation,  = growth rate
of money supply at home, g = growth rate of income at
home
Lecture 18
17
PPP is Valid in the Long run
Ghana
India
Italy
Brazil
Turkey
UK
1955
0.7146
4.764
625
4.3E-11
2.831
0.3571
1965
0.7146
4.763
625.1
2E-09
9.102
0.3571
1975
1.15
8.653
652.8
8.1E-09
14.44
0.452
1985
54.37
12.24
1909
6.2E-06
522
0.7792
1990
326.3
17.95
1198
0.0683
2609
0.5632
2000
5231
45.7
2101
1.8
625,208
0.7
PPP is not valid in the short run 2001- 2002
t
UK  USA  2.1%  2.6%  0.5%


t
t
Since
t  8.7%  0.5%
Similarly for Euro
t
Euro  USA  2.2%  2.6%  0.4%  11.1%
t 
Lecture 18
18
Fundamentals of A Stable Exchange Rate according to the
PPP Theory
 Change in the exchange rate must equal the
inflation deferential between home and foreign
et

 *
*
*
*

countries. e      g     g 


t
 Inflation both at home and abroad equals
differences in the growth rate of money supply and
growth in money demand due to income growth.
 Liberal economies have free capital mobility: there
is no control in inflow and outflow of capital;
exchange rate is determined endogenously
 weaker economies cannot commit to free capital
mobility and have controls in the mobility of
capital. They fix the exchange rate arbitrarily to
ration the foreign exchange.
Lecture 18
19
Covered and Uncovered interest parity
Covered Interest Parity (no risk)
i  i*  F  E
E
where F is forward exchange rate, i = domestic interest
rate i* = foreign interest rate, E = actual exchange rate.
Uncovered interest parity condition (interest differences
are due to expected appreciation or depreciation):
e  E 
e E
E
E

1 i  1 i* 1 t 1 t   i  i*  t 1 t
Et
Et



Compare CIP and UIP Ft  E e is the forward Exchange
t 1
rate






Lecture 18
20
Impact of Fiscal Policy on the Exchange Rate,
Interest Rate and Output: ISLM Model
IS2
UIP
LM
i
i
i2
i1
IS
Y1 Y2
Lecture 18
i
Appreciation
E2
E1
Depreciation
21
Uncovered Interest Parity Theory of the
Exchange Rate
Rates of returns (interest rates) across countries are
equalised once expected exchange rate changes are
taken into account.


1
*

1 it  1 i  E e
E  t  t 1
t
E e Exchange rate expected in the next period.
t 1
Applying rule of log for small numbers it can be
written as
Ee  E
it  it*  t 1 t ;
E
t
 Adjustment in interest parity condition: domestic
interest rate must be equal to foreign interest plus
the expected change in the value of the currency.
Lecture 18
22
Appreciation or Depreciation of Currency According to the
Differences in the Domestic and Foreign Interest Rates
E e  Et
Ee
t 1  i  i *  et
it  it*  t 1
 E 
t
t
t 1 i  i*
Et
et
t t
Higher domestic interest rate => higher demand for
domestic currency => currency appreciates to make
up the difference
Higher foreign interest rate => more demand for
foreign currency and less demand for domestic
currency => currency will depreciates.
If currency is expected to depreciate in the next
period, exchange rate will be higher today.
Lecture 18
23
t
e
*




Purchasing Power Parity: e
t
t
t
Uncovered Interest Parity:
et
it  i 
et
*
t
(1)
(2)
Using the Fisher equation (2) becomes
et
 t  rt    r 
et
*
t
*
t
(3)
Slight rearrangement:
et
 t     rt   rt*
et
*
t
et
0
t  
From PPP
et t
*
t
(4)
r

r
t
t

*
When both PPP and UIP hold exactly the domestic and foreign real
interest rates are equal.
Lecture 18
24
Like the PPP, UIP is also valid only in the long run
Compare the interest rates and Exchange Rates between 2001 and 2002
Ee  E
i  i*  t 1 t
uk US
E
t
3.97  1.34  8.7
Lecture 18
25
Exchange Rate Systems: Capital Mobility

Flexible exchange rates: The UK, U.S. and
Japan, EURO: Free Mobility of Capital

Fixed exchange rates: Controlled Mobility
- Gold standard (19 th and early 20th century)
-Pegs: Setting the exchange rate to the dollar
or some other currencies. Adjust by ( revaluation
and devaluation. Franco-phone countries in
Africa now peg to Euro
-Crawling Peg: Setting an exchange rate target
(allowed change in narrow bands)
 Monetary union (Single Currency, Free Mobility
of Capital): EURO
Lecture 18
26
The Problems of Flexible Exchange Rates
The exchange rate can move for many other reasons
than changes in the domestic interest rate.
Expectations play a large role in the determination of
the exchange rate.
Flexible exchange rate may be subject to large
fluctuations which, in turn, require large movements
in the interest rate which can make the economy
unstable.
Exchange rate may overshoot for a long time
Lecture 18
27
Which countries should have
fixed exchange rates?
 Countries with poor reputation for controlling inflation
 It is better to fix exchange rate with a country with a
heavy trade link
 Country which has relatively little involvement in the
global capital market
 Coutries with high level of foreign reserves.
 Countries with flexible labour market.
Lecture 18
28
Disadvantages of Fixed Exchange Rate System
Giving up the powerful exchange rate tool for external
stabilisation.
Sacrifice of domestic stability for external balance.
Gives up control of its interest rate, no independent monetary
policy
Widespread speculation of a devaluation or shift to a flexible
exchange rate system particularly when
Economy is with higher inflation
Or the currency is overvalued
Fear of Speculative attacks require an increase in the interest rate.
Frequent devaluation creates uncertainty and overvalued
currency causes BOP problem.
Lecture 18
29
Benefits and cost of a Monetary Union and
Optimal Liberalisation?
Which countries benefit from a monetary union?
Criteria for an optimal currency area
 Higher Degree of Trade Link
 Common shocks
 Degree of labour mobility
 Degree of fiscal transfers.
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
30
Given these theories of Exchange Rate
Should UK join the European
Monetary Union?
Five Economic Tests: Issues for Referendum
1. Cyclical Convergence
2. Flexibility
3. Investment
4. Financial Services
5. Employment and Growth
What Do YOU Think?
Lecture 18
31
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
32