International Dimensions of Macro Policy Fixed Exchange Rates In this case, the central bank (the government) decides the value of the currency.

International Dimensions of Macro Policy Flexible Exchange Rates: In this case demand and supply of the dollar determine the value of the dollar $/& Quantity of & demanded and supplied Re

International Dimensions of Macro Policy Flexible Exchange Rates: In this case demand and supply of the dollar determine the value of the dollar $/& Quantity of & demanded and supplied Re Surplus R’

International Dimensions of Macro Policy Flexible Exchange Rates: In this case demand and supply of the dollar determine the value of the dollar $/& Quantity of & demanded and supplied Re Deficits R’’

There are three sources of risk: accounting risk:Anytime there is a change in the value of the dollar, value foreign currency denominated assets change in the same direction. Assume an American owns a Bond with a face value of 1000 pound sterling. Its value in dollar is: at $1.50/& = $ at $1.60/& = $ Devaluation of the $ at $1.40/& = $ 1, appreciation of the $ Foreign Exchange Risk

There are three sources of risk: Transaction risk: Assume you buy a BMW for DM Its Dollar $.8/DM = $.88/DM = $39,600 Devaluation of the $.72/DM = $ Appreciation of the $ Foreign Exchange Risk

There are three sources of risk: Currency risk: The higher the variability of a currency, the higher is the possibility that the value of an asset denominated in that currency will change. This means that assets denominated in that currency are riskier than others. Foreign Exchange Risk

Macro adjustment Under the fixed ER regime Increase the money supply i income IS LM LM’ i1i1 i2i2 y 1 y 2 a b BP

Macro adjustment Under the fixed ER regime Real income increases which leads to increase in imports. Lower interest rates will lead to outflow of money. LM will shift back where it was.

Macro adjustment Under the fixed ER regime i income IS LM LM’ i1i1 i2i2 y 1 y 2 a b BP