Exchange Rate Volatility and Keynesian Economics

Classical vs. Keynesian Economics Classical economics assumes that prices are flexible and that money is neutral (money doesn’t affect output). This is equivalent to a vertical supply curve. Classical economics assumes that prices are flexible and that money is neutral (money doesn’t affect output). This is equivalent to a vertical supply curve.

Classical vs. Keynesian Economics Classical economics assumes that prices are flexible and that money is neutral (money doesn’t affect output). This is equivalent to a vertical supply curve. Classical economics assumes that prices are flexible and that money is neutral (money doesn’t affect output). This is equivalent to a vertical supply curve. Therefore, changes in demand leave output unchanged, but raise prices. Therefore, changes in demand leave output unchanged, but raise prices.

Classical vs. Keynesian Economics Keynesians agree that the classical solution is correct in the long run Keynesians agree that the classical solution is correct in the long run Keynesians, however, argue that prices are fixed in the short run. This suggests a horizontal supply curve. Keynesians, however, argue that prices are fixed in the short run. This suggests a horizontal supply curve.

Classical vs. Keynesian Economics Keynesians, however, argue that prices are fixed in the short run. This suggests a horizontal supply curve. Keynesians, however, argue that prices are fixed in the short run. This suggests a horizontal supply curve. Therefore increases in demand increase output without raising prices. Therefore increases in demand increase output without raising prices.

Fixed Prices and the Real Exchange Rate Recall, that the real exchange rate is equal to Recall, that the real exchange rate is equal to q = eP*/P

Fixed Prices and the Real Exchange Rate Recall, that the real exchange rate is equal to Recall, that the real exchange rate is equal to q = eP*/P With flexible prices and PPP, the real exchange rate is constant (and equal to one). With flexible prices and PPP, the real exchange rate is constant (and equal to one).

Fixed Prices and the Real Exchange Rate Recall, that the real exchange rate is equal to Recall, that the real exchange rate is equal to q = eP*/P With flexible prices and PPP, the real exchange rate is constant (and equal to one). With flexible prices and PPP, the real exchange rate is constant (and equal to one). However, with prices fixed in the short run, changes in the nominal exchange rate are reflected in the real exchange rate However, with prices fixed in the short run, changes in the nominal exchange rate are reflected in the real exchange rate

Fixed Prices and the LM Curve As with classical theory, we start with the quantity theory of money As with classical theory, we start with the quantity theory of money MV = PY However, rather than solving for price, we now solve for output However, rather than solving for price, we now solve for output

Fixed Prices and the LM Curve As with classical theory, we start with the quantity theory of money As with classical theory, we start with the quantity theory of money MV = PY However, rather than solving for price, we now solve for output However, rather than solving for price, we now solve for output Y = MV/P Velocity is an increasing function of the interest rate. Therefore, higher interest rates are associated with higher output. This is the LM curve Velocity is an increasing function of the interest rate. Therefore, higher interest rates are associated with higher output. This is the LM curve

The LM Curve The LM curve describes a money market equilibrium with fixed prices (Y = MV/P) The LM curve describes a money market equilibrium with fixed prices (Y = MV/P)

The LM Curve The LM curve describes a money market equilibrium with fixed prices (Y = MV/P) The LM curve describes a money market equilibrium with fixed prices (Y = MV/P) Increasing the money supply shifts LM to the right, raising output and lowering interest rates. Increasing the money supply shifts LM to the right, raising output and lowering interest rates. Where does this extra output go? Where does this extra output go?

The IS Curve The IS curve describes an equilibrium in the goods market The IS curve describes an equilibrium in the goods market Y = C + I + G + NX Or, Equivalently, S = I + (G-T) + NX

The IS Curve Typical assumptions include: Typical assumptions include: Savings (S) is increasing in income and the interest rate Savings (S) is increasing in income and the interest rate Investment (I) is decreasing in the interest rate Investment (I) is decreasing in the interest rate The Government deficit (G-T) is independent of output and the interest rate The Government deficit (G-T) is independent of output and the interest rate Net Exports (NX) is decreasing in income Net Exports (NX) is decreasing in income

The IS Curve Given the previous assumptions and the equilibrium condition Given the previous assumptions and the equilibrium condition S = I + (G-T) + NX

The IS Curve Given the previous assumptions and the equilibrium condition Given the previous assumptions and the equilibrium condition S = I + (G-T) + NX A rise in income increases savings and lowers the trade balance. A rise in income increases savings and lowers the trade balance. To maintain equilibrium, interest rates must fall to stimulate domestic investment To maintain equilibrium, interest rates must fall to stimulate domestic investment

The IS Curve The IS curve reflects the negative relationship between output and interest rates in goods markets The IS curve reflects the negative relationship between output and interest rates in goods markets

The IS Curve The IS curve reflects the negative relationship between output and interest rates in goods markets The IS curve reflects the negative relationship between output and interest rates in goods markets An increase in the government deficit increases interest rates (to increase private savings and discourage private investment) and raises income (to further stimulate domestic savings) – IS curve shifts right An increase in the government deficit increases interest rates (to increase private savings and discourage private investment) and raises income (to further stimulate domestic savings) – IS curve shifts right

The Balance of Payments Recall, that the balance of payments equilibrium is given by Recall, that the balance of payments equilibrium is given by CA = KFA That is, a trade deficit (surplus) must be matched by an equal capital inflow (outflow) That is, a trade deficit (surplus) must be matched by an equal capital inflow (outflow) CA is increasing in income and decreasing in the interest rate while KFA is increasing in the interest rate CA is increasing in income and decreasing in the interest rate while KFA is increasing in the interest rate

The Balance of Payments Rising income worsens the trade deficit. To attract foreign capital, interest rates must increase – an upward sloping balance of payments curve Rising income worsens the trade deficit. To attract foreign capital, interest rates must increase – an upward sloping balance of payments curve

The Balance of Payments A currency depreciation improves the trade deficit and, hence, shifts the BOP curve to the right A currency depreciation improves the trade deficit and, hence, shifts the BOP curve to the right

Capital Mobility & BOP Low mobility of capital creates a very steep BOP curve (large interest rate increases are required to attract foreign capital) Low mobility of capital creates a very steep BOP curve (large interest rate increases are required to attract foreign capital)

Capital Mobility & BOP High mobility of capital creates a very flat BOP curve (small interest rate increases attract foreign capital) High mobility of capital creates a very flat BOP curve (small interest rate increases attract foreign capital)

Putting it all together An equilibrium is a combination of (e,r,and y) that clears all three markets. An equilibrium is a combination of (e,r,and y) that clears all three markets.

Exchange Rates & Money Shocks Suppose the Federal Reserve increases the Money Supply by 10% Suppose the Federal Reserve increases the Money Supply by 10% In the long run, the dollar will depreciate by 10% (the classical solution), but what about the short run? In the long run, the dollar will depreciate by 10% (the classical solution), but what about the short run?

Exchange Rates & Money Shocks The increase in money shifts LM to the right. This lowers interest rates and raises output The increase in money shifts LM to the right. This lowers interest rates and raises output

Exchange Rates & Money Shocks The increase in money shifts LM to the right. This lowers interest rates and raises output The increase in money shifts LM to the right. This lowers interest rates and raises output Further, the combination of lower interest rates (deters capital inflow) and increased income (induces more imports) creates a BOP Deficit Further, the combination of lower interest rates (deters capital inflow) and increased income (induces more imports) creates a BOP Deficit

Exchange Rates & Money Shocks Therefore, the dollar must depreciate to correct the imbalance – shifting the BOP curve to the right Therefore, the dollar must depreciate to correct the imbalance – shifting the BOP curve to the right

Interest Parity Recall that assets must always pay equal same currency returns. How should the exchange rate respond to a falling interest rate? Recall that assets must always pay equal same currency returns. How should the exchange rate respond to a falling interest rate?

Interest Parity Recall that assets must always pay equal same currency returns. How should the exchange rate respond to a falling interest rate? Recall that assets must always pay equal same currency returns. How should the exchange rate respond to a falling interest rate? (r – r*) = % change in e($/L)

Interest Parity Recall that assets must always pay equal same currency returns. How should the exchange rate respond to a falling interest rate? Recall that assets must always pay equal same currency returns. How should the exchange rate respond to a falling interest rate? (r – r*) = % change in e($/L) A falling interest rate should cause a dollar appreciation A falling interest rate should cause a dollar appreciation

Summing Up The 10% increase in the money supply creates a long run 10% depreciation of the dollar The 10% increase in the money supply creates a long run 10% depreciation of the dollar In the short run, low interest rates and rising output create a BOP deficit which depreciates the currency In the short run, low interest rates and rising output create a BOP deficit which depreciates the currency However, at some point, the dollar must appreciate. However, at some point, the dollar must appreciate. How do we reconcile these facts? How do we reconcile these facts?

Exchange Rate Dynamics

How about the real exchange rate? Recall that in the short run, the real exchange rate exactly mimics the nominal exchange rate. Recall that in the short run, the real exchange rate exactly mimics the nominal exchange rate. In the long run, however, as prices adjust, the real exchange rate returns to its long run value of one. In the long run, however, as prices adjust, the real exchange rate returns to its long run value of one.

Exchange Rate Dynamics

Keynesian Economics and Exchange Rates The strong correlation between real and nominal exchange rates is due to short run price rigidities. The strong correlation between real and nominal exchange rates is due to short run price rigidities. Exchange rate volatility is due to short run BOP changes and interest rate parity. Exchange rate volatility is due to short run BOP changes and interest rate parity.

Government Deficits Suppose that the government deficit increases. Suppose that the government deficit increases. The long run impact should be zero. The long run impact should be zero.

Government Deficits However, in the short run, the IS curve shifts right – output increases and interest rates rise. However, in the short run, the IS curve shifts right – output increases and interest rates rise. In this example, the worsening of the trade deficit is more than offset by higher interest rates attracting foreign capital. A balance of payments surplus is created. In this example, the worsening of the trade deficit is more than offset by higher interest rates attracting foreign capital. A balance of payments surplus is created.

Summing up The long run effect is zero The long run effect is zero In the short run, a BOP surplus is created causing a currency appreciation In the short run, a BOP surplus is created causing a currency appreciation However, interest parity suggests that higher domestic interest rates imply a currency depreciation However, interest parity suggests that higher domestic interest rates imply a currency depreciation

Exchange Rate Dynamics

Deficits and Low Capital Mobility Consider the previous example, but with a lower capital mobility. Consider the previous example, but with a lower capital mobility. Now, due to lower capital inflows, a short run BOP is created causing a currency depreciation. Now, due to lower capital inflows, a short run BOP is created causing a currency depreciation.

Exchange Rate Dynamics

Keynesian Economics and Exchange Rates The strong correlation between real and nominal exchange rates is due to short run price rigidities. The strong correlation between real and nominal exchange rates is due to short run price rigidities. Exchange rate volatility is due to short run BOP changes and interest rate parity. Exchange rate volatility is due to short run BOP changes and interest rate parity. Capital mobility is responsible for much of the exchange rate volatility Capital mobility is responsible for much of the exchange rate volatility