Midterm 2 topics GDP Cost of living, CPI, Inflation Unemployment Production and growth The financial system: saving and investment The open economy

MIDTERM 2 FRIDAY May 16 TIME & FORMAT The exam will start at 18:30 50 multiple choice questions, 60 minutes Closed book exam For each question/answer: Correct: 2 pts, Wrong: 0 pts, Unmarked: ½ point Bring your pocket calculator REVIEW OF PAST MIDTERM Cihan will do a review sessions at 18.30 in room SOS 103 He will solve the midterm exam 2013

Studying for the second midterm Do the midterms for 2013 and then 2012 (These are already posted on course webpage with answers) (re)Do the exercise sets Come to office hours Go to KOLT Read the slides Read the book (last resort if nothing else works)

Make up exam policy Same format, same topics, same level of difficulty as the regular midterm exam #2 Must have valid excuse Will be scheduled either before or during the first days of the final exam period, which is May 22 to June 1 Email Murat Usman (musman@ku.edu.tr) immediately! No make up for the make up!

Open-Economy Macroeconomics: Basic Concepts An Open Economy An open economy interacts with other countries in two ways: It buys and sells goods & services in world product markets. It buys and sells capital assets in world financial markets.

Exchange Rates Exchange rates are the most important “prices” that determine international trade (exports - imports). There are “two” exchange rates! the nominal exchange rate and the real exchange rate.

TL / USD rates, 2012 Jan - April

Exchange Rates What is reported daily in the news media is the nominal exchange rate But, the exchange rate that plays the crucial role in determining net exports is the real exchange rate.

Nominal Exchange Rates The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. e = nominal exchange rate, e is the relative price of domestic currency (say, TL) in terms of a foreign currency (say, US$).

The nominal exchange rate EXAMPLE with TL as the domestic currency against US$: e = 0,55 This means that 1 TL can be exchanged for 0,55 US$ But the current “kur” is 1.80! So what goes on here? Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.

The nominal exchange rate can be expressed in two ways: Domestic currency: TL; Foreign currency: US$ In units of foreign currency per 1 unit of domestic currency. We can say e = 0,55 We mean that 1TL = 0,55 US$ In units of domestic currency per 1 unit of the foreign currency. We can say e = 1,80 We mean that 1 US$ = 1,80TL ECON 100 will ALWAYS use the first method.

Real Exchange Rates The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another.

The real exchange rate ε = real exchange rate, the relative price of domestic goods in terms of foreign goods ε the lowercase Greek letter epsilon

Real Exchange Rates The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy. If a kilo of Swiss cheese beer is twice as expensive as a kilo of English cheese, the real exchange rate is 1/2 a kilo of Swiss cheese per kilo of English cheese. The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

The formula e x P P* Real exchange rate ε = e = nominal exchange rate P = domestic price of the good in domestic currency P* = foreign price of the good in foreign currency

Example with one good: big mac Home country: Turkey Foreign country: US Example with one good: big mac

Example with one good, Le BIG MAC Example with one good, Le BIG MAC 17

The real exchange rate with the bigmac The real exchange rate with the bigmac e x P P* ε = e = 0,55 (means 1TL = 0,55$) P = Price of the Big Mac in domestic country (Turkey) in TL P = 8,45TL P* = Price of the Big Mac in foreign country (US) in US$ P* = $4.37 e x P = 0.55 x 8.45= $ 4,65 (US) 18

The real exchange rate with the bigmac The real exchange rate with the bigmac e x P P* ε = e = 0,55 (means 1TL = 0,55$) P = Price of the Big Mac in domestic country (Turkey) in TL P = 8,45TL P* = Price of the Big Mac in foreign country (US) in US$ P* = $4.37 e x P = 0.55 x 8.45= 4,65  price of the Turkish BigMac in US$ Finally (e x P)/ P* = 4,65 / 4,37 = 1,06 ε = 19

Interpreting the Real Exchange Rate Interpreting the Real Exchange Rate The real exchange rate ε = 1,06 means what exactly? 1 Turkish Big Mac = 1.06 U.S. Big Macs This means that … To buy one Big Mac in Turkey a US citizen must pay an amount that could purchase 1.06 Big Macs in the US. Question: Which country has the cheaper Big Mac? 20

One more time: Interpreting the Real Exchange Rate One more time: Interpreting the Real Exchange Rate The real exchange rate ε = 1,06 means what exactly? 1 Turkish Big Mac = 1.06 U.S. Big Macs We can say that the “amount of money” that buys one Big Mac in Turkey buys 1.06 Big Macs in the US. 21

The Big Mac index around the world

The Big Mac Index Compute the real exchange rate with Norway as the domestic country and US as the foreign country. ε = 1,70

Compute a real exchange rate using a cup of Latte Home country US, foreign country Mexico The price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico Which country has the cheaper latte? What is the nominal exchange rate? e = 10 pesos per $ Calculate the real exchange rate, as the number of Mexican lattes per 1 units of US latte. Please determine which country has the more expensive latte.

24 pesos per Mexican latte Answers e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico The price of a US latte in pesos is e x P = (10 pesos per $) x (3 $ per US latte) = 30 pesos per US latte The real exchange rate is… 30 pesos per U.S. latte 24 pesos per Mexican latte = e x P P* = 1.25 Mexican lattes per US latte

A FIRST THEORY OF EXCHANGE RATE DETERMINATION: PURCHASING POWER PARITY The purchasing power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates: A unit of any given currency should be able to buy the same quantity of goods in all countries. The theory of purchasing power parity is based on a principle called the law of one price. According to the law of one price, a good must sell for the same price in all locations.

Basic Logic of Purchasing Power Parity If the law of one price were not true, unexploited profit opportunities (arbitrage) would exist. The process of taking advantage of differences in prices in different markets is called arbitrage.

Basic Logic of Purchasing Power Parity If arbitrage occurs, eventually prices that differed in two markets would necessarily converge. According to the theory of purchasing power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that.

Implications of Purchasing Power Parity If the purchasing power of the YTL is always the same at home and abroad, then the exchange rate cannot change. The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

Implications of Purchasing Power Parity When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy.

Limitations of Purchasing Power Parity Many goods are not easily traded or shipped from one country to another. Tradable goods are not always perfect substitutes when they are produced in different countries.