Macroeconomics Chapter 181 Exchange Rates C h a p t e r 1 8

Macroeconomics Chapter 182 Different Currencies and Exchange Rates  Each country issues and uses its own currency, instead of using a common currency.  To keep things simple, pretend that there are only two countries.  Think of the home country as the United States and the foreign country as China.  The China nominal quantity of money, M f, is measured in RMB. The U.S. nominal quantity of money, M, is in Dollars.

Macroeconomics Chapter 183 Different Currencies and Exchange Rates  Exchange market, on which participants trade the currency of one country for that of another.  the nominal exchange rate is the number of RMBs received for each dollar.  Let ε denote the nominal exchange rate between RMBs and dollars.

Macroeconomics Chapter 184 Example: Chinese Yuan

Macroeconomics Chapter 185

6 Different Currencies and Exchange Rates

Macroeconomics Chapter 187 Different Currencies and Exchange Rates

Macroeconomics Chapter 188 Purchasing-Power Parity  Sometimes countries allow their nominal exchange rates to move freely in response to market forces. These systems are called flexible exchange rates.  In other circumstances, countries try to maintain a constant nominal exchange rate with respect to another currency, often the U.S. dollar. These systems are called fixed exchange rates.

Macroeconomics Chapter 189 Purchasing-Power Parity

Macroeconomics Chapter 1810 Purchasing-Power Parity

Macroeconomics Chapter 1811 Purchasing-Power Parity

Macroeconomics Chapter 1812 Purchasing-Power Parity  The PPP Condition and the Real Exchange Rate The U.S. price level, P, is measured in dollars per unit of goods. We denote the Chinese price level (or foreign price level) by P f, measured in RMB per unit of goods. Assume that the goods produced and used in both countries are physically identical. We also ignore any transportation or other transaction costs for buying and selling goods in the two countries.

Macroeconomics Chapter 1813 Purchasing-Power Parity  The PPP Condition and the Real Exchange Rate 1/P = ε · (1/P f ) quantity of goods that can be bought in U.S. = quantity of goods that can be bought in China

Macroeconomics Chapter 1814 Purchasing-Power Parity purchasing-power parity ε = P f /P nominal exchange rate = ratio of foreign price to home price

Macroeconomics Chapter 1815 Purchasing-Power Parity  The PPP Condition and the Real Exchange Rate purchasing-power parity (PPP). This condition means that the purchasing power in terms of goods for dollars (or RMB) is the same regardless of whether households buy goods in the United States or China.

Macroeconomics Chapter 1816 Purchasing-Power Parity  什么时候 PPP Condition 不一定成立？ 各国产品不一样。  （想一想，上海的麦当劳和波恩的麦当劳产品真 的是一样的吗？） 非贸易商品的存在。  （例如，住房）

Macroeconomics Chapter 1817 Purchasing-Power Parity  The PPP Condition and the Real Exchange Rate real exchange rate= (ε/P f ) / (1/P) real exchange rate is the ratio of goods that can be bought in China (say, with $1) to goods that can be bought in the United States (also with $1).

Macroeconomics Chapter 1818

Macroeconomics Chapter 1819 Purchasing-Power Parity  GDP 的国际比较 中国 2004 年的名义人均 GDP 是 元 按照 1 ： 8 计算，折合 1542 美元 这样的计算有什么问题？ 如果考虑 PPP 呢？ 这样的计算又有什么问题？

Macroeconomics Chapter 1820 Purchasing-Power Parity  The PPP Condition in long run ε = P f / P real exchange rate= ε/(P f /P)  1 预测一下人民币汇率的走势： 4.3  1  ε 下降  P f /P 上升

Macroeconomics Chapter 1821 Purchasing-Power Parity  growth rate of P f /P = ∆P f /P f − ∆P/P  growth rate of P f /P = π f − π  growth rate of real exchange rate = ∆ε/ε − (π f − π ) E.g. 30years from 4.3 to 1 implies -4.8%

Macroeconomics Chapter 1822 Purchasing-Power Parity  The Relative PPP Condition purchasing-power parity, relative form: ∆ε/ε = π f − π growth rate of nominal exchange rate = foreign inflation rate− home inflation rate

Macroeconomics Chapter 1823 Purchasing-Power Parity

Macroeconomics Chapter 1824 Purchasing-Power Parity

Macroeconomics Chapter 1825 Interest-Rate Parity  Option 1: Hold U.S. bond dollars received in year t+ 1 = 1 + i  Option 2: Use exchange market and hold Chinese bond dollars received in year t+ 1 = ε t · (1+i f )/ε t+1

Macroeconomics Chapter 1826 Interest-Rate Parity  1+i =ε t · (1+i f )/ε t+1 return on holding U.S. bond = return on using exchange market and holding Chinese bond

Macroeconomics Chapter 1827 Interest-Rate Parity  1+i f = (1+ i) · (ε t+1 /ε t )  The growth rate of the nominal exchange rate is ∆ε t /ε t = (ε t+1 − ε t )/ε t ∆ε t /ε t = (ε t+1 /ε t )− i f = (1 + i) · (1 + ∆ε t /ε t )

Macroeconomics Chapter 1828 Interest-Rate Parity  i f − i = ∆ε t /ε t interest-rate differential = growth rate of nominal exchange rate  i f − i = ∆(ε t /ε t ) e

Macroeconomics Chapter 1829 Interest-Rate Parity  Real interest-rate ∆ε/ε = π f − π  In terms as expected rates of change: ∆(ε t /ε t ) e = (π f ) e −π e

Macroeconomics Chapter 1830 Interest-Rate Parity  i f − i = (π f ) e −π e interest-rate differential = difference in expected inflation rates  i f − (π f ) e = i− π e foreign expected real interest rate = home expected real interest rate

Macroeconomics Chapter 1831 Interest-Rate Parity  real exchange rate= ε/(P f /P) If it is smaller than 1: The expected growth rate of the nominal exchange rate, (∆ε t /ε t ) e, must be greater than the expected growth of P f /P, which equals the difference between the expected inflation rates, (π f ) e − π e

Macroeconomics Chapter 1832 Interest-Rate Parity  Instead of the equality in equation we have the inequality: ∆(ε t /ε t ) e > (π f ) e − π e  If we substitute this inequality into the interest-rate parity condition in equation  i f − i > (π f ) e − π e

Macroeconomics Chapter 1833 Interest-Rate Parity  i f − (π f ) e > i− π foreign expected real interest rate > home expected real interest rate  i.e., we expect that the price level in those countries whose real exchange rate smaller than 1 will decreases.

Macroeconomics Chapter 1834 Fixed Exchange Rates  The fixed-exchange-rate regime that applied to most advanced countries from World War II until the early 1970s was called the Bretton Woods  Under this system, the participating countries established narrow bands within which they pegged the nominal exchange rate, ε, between their currency and the U.S. dollar.  Each country ’ s central bank stood ready to buy or sell its currency at the rate of ε units per U.S. dollar.

Macroeconomics Chapter 1835 Fixed Exchange Rates  Purchasing Power Parity Under Fixed Exchange Rates ε = P f /P P f = εP if the nominal exchange rate, ε, is fixed, π f = π

Macroeconomics Chapter 1836 Fixed Exchange Rates  Purchasing Power Parity Under Fixed Exchange Rates i f − i = ∆ε t /ε t Under fixed exchange rates: i f = i

Macroeconomics Chapter 1837 Fixed Exchange Rates  The Nominal Quantity of Money Under Fixed Exchange Rates M f = P f · L(Y f,i f ) P f = εP. M f = ε P · L(Y f, i)

Macroeconomics Chapter 1838 Fixed Exchange Rates

Macroeconomics Chapter 1839 Fixed Exchange Rates Two possible results of increasing M under fixed exchange rate regime: 1.The decline of the international reserves, even devaluation. 2.Trade barriers to limit free trade.

Macroeconomics Chapter 1840 Fixed Exchange Rates  a devaluation, which is a reduction in the value of RMB compared to the dollar.

Macroeconomics Chapter 1841 Fixed Exchange Rates  Devaluation and Revaluation An appreciation of the Chinese currency — an increase in 1/ε, the number of dollars that exchange for each yuan — is called a revaluation.

Macroeconomics Chapter 1842 Flexible Exchange Rates  Since the early 1970s, most advanced countries have allowed their currencies to vary more or less freely to clear the markets for foreign exchange.  The difference from the fixed-exchange- rate setup is that the nominal exchange rate, ε, is not a fixed number. Because of adjustments of ε in a flexible-rate regime, P f need not move in lockstep with P even if the absolute PPP condition always holds.

Macroeconomics Chapter 1843 Fixed and Flexible Exchange Rates: A Comparison  An extreme form of fixed nominal exchange rate is a common currency.  a fixed-exchange rate system precludes an independent monetary policy, at least in the long run.

Macroeconomics Chapter 1844 Fixed and Flexible Exchange Rates: A Comparison  One advantage of a flexible nominal exchange rate is that it introduces an additional way to satisfy the PPP condition, P f = εP  The independence of monetary policy under flexible exchange rates is not always desirable.

Macroeconomics Chapter 1845 Extra: Mundell-Fleming Model  Open economy NX(e) is net export e is the exchange rate  Small country r=r f  Fixed price

Macroeconomics Chapter 1846 Extra: Mundell-Fleming Model  IS : r=r f Y=C(Y)+I(r f )+NX(e) e Y

Macroeconomics Chapter 1847 Extra: Mundell-Fleming Model  LM: M/P=L(Y,r f ) e Y r Y r=r f

Macroeconomics Chapter 1848 Extra: Mundell-Fleming Model  IS : r=r f Y=C(Y)+I(r f )+NX(e)  LM: M/P=L(Y,r f ) e Y

Macroeconomics Chapter 1849 Extra: Mundell-Fleming Model with floating exchange rate  LM: M/P=L(Y,r f ) M increases e Y

Macroeconomics Chapter 1850 Extra: Mundell-Fleming Model with floating exchange rate  M increases Closed economy: r decreases and Investment rises. Y increases. Open economy: r is fixed, hence, capital flows out. e decreases and net export rises. Y increases.

Macroeconomics Chapter 1851 Extra: Mundell-Fleming Model with fixed exchange rate  e=e * e Y

Macroeconomics Chapter 1852 Extra: Mundell-Fleming Model with fixed exchange rate  e=e * M increases ?? e Y

Macroeconomics Chapter 1853 Extra: Mundell-Fleming Model with fixed exchange rate  Summary FloatingFixed Y e NX Monetary policy M