1. Chapter 9

2. Chapter 9 Essential macroeconomic tools

3. Background theory A quick refresher on basic macroeconomic principles
Application of these principles to the question of exchange rate regimes

4. Output and prices
Economic activity is measured by the GDP (gross domestic product)
GDP = sum of all production = sum of all sales = sum of all incomes
Nominal GDP (measured) vs. Real GDP (computed taking into account inflation)
GDP trend is increasing
Actual GDP is above or below trend, according to business cycles

5. Output gap: the difference between trend and actual GDP

6. Output gap and aggregate demand and supply: short run
Aggregate supply (AS): upwards sloping
As output gap increases threat of unemployment moderates wages and firms cut price
Aggregate demand (AD): downward sloping
Higher prices erode purchasing power and external competitiveness and output gap decreases
Changes in aggregate demand, e.g. a boom abroad:
shifts aggregate demand up (AD’)

7. The AD-AS diagram

8. Long run vs short run effects
Short term: non-neutrality of money (output gap moves to B in diagram)
Long term: neutrality of money
(output gap moves to C in diagram)

9. Long Term: Neutrality of Money
In the long run:
Vertical aggregate supply
Money, the price level and the exchange rate tend to move proportionately
Rationale:
prices double overnight public requires double the amount of money to maintain purchasing power once both double up we are back to start in real terms (see point C on diagram)

10. PPP: An Implication of Long Term Neutrality
PPP (purchasing power parity) principle:
(Nominal) Exchange rate appreciation =
= foreign inflation rate – domestic inflation rate
The real exchange rate (measure of competitiveness):  = E x P/P*
Where E is nominal exchange rate; P and P* are prices of basket of goods at home and abroad

11. The real exchange rate
Example: real exchange rate of euro in terms of dollar
Price of basket of European goods: P= €100
Nominal exchange rate ($/€): E = 1.3$/€
Price of basket of American goods: P*= $130
real exchange rate:
= E x P/P* = €100x 1.3$/€ : $130 = 1 basket of American goods for 1 basket of European goods
NOTE: when real exchange rate appreciates, competitiveness declines as more baskets of goods in the USA would need to be traded for 1 basket of European goods.

12. Real versus nominal exchange rate appreciation

13. The Balassa-Samuelson Effect
Increasing real exchange rates in new EU members
(Annual % change, )
Bulgaria
Czech R.
Estonia
Latvia
Lithuania
Inflation differential
29.0
1.6
3.2
3.7
1.4
Nominal appreciation
-19.7
2.6
-0.2
0.0
Real appreciation
9.3
4.2
3.0
4.6
Hungary
Poland
Romania
Slovenia
Slovakia
6.2
3.3
28.3
3.8
4.1
-2.4
-20.6
-2.8
1.5
3.1
7.7
1.0
5.6

14. The Short Run: IS-LM Interpretation
IS-LM shows interaction of money and goods market
The short run goods market (AD focus)
Assumption: prices constant
What happens to output when interest rates increase?
Discourages borrowing and spending
Reduces aggregate demand (output gap)
Equilibrium requires supply to drop (IS curve)

15. IS-LM framework

16. The Short Run: IS-LM Interpretation
The Money market
Banks grant loans creating Money Supply
Public Demand Money for payment
Central bank might expand money supply partially
Increase in output increases demand for money and interest rates (upward sloping LM curve)

17. where goods and money markets are simultaneously in equilibrium
IS-LM framework
Initial Equilibrium:
where goods and money markets are simultaneously in equilibrium

18. Fiscal and Monetary Policy in IS-LM
(Expansionary) Fiscal Policy effects
IS shifts right to IS’ as aggregate demand strengthens
Economy moves equilibrium to A’
Consequence: output and interest rate rise
(Expansionary) Monetary Policy effects
Central bank increases money supply
Interest rates decline at initial output (B)
LM shifts down to LM’
Economy moves equilibrium to C

19. Fiscal and Monetary Policy in IS-LM
Equilibrium with fiscal expansion

20. Fiscal and Monetary Policy in IS-LM
Equilibrium with monetary expansion

21. Open economy and exchange rates
Integration and significance of exchange rate regime!
Trade integration
Foreign conditions and real exchange rate effects
Higher prices result in a reduction in competitiveness and AD with unchanged exchange rate

22. Open economy and interest rate parity condition
Financial integration
Free capital mobility
Lower interest rates at home than abroad cause financial outflows and nominal exchange rate drops
HENCE,
Interest rate parity condition:
Domestic interest rate = Foreign interest rate + expected exchange rate depreciation

23. Exchange Rate Regimes and Policy Effectiveness
Fixed exchange rate:
government keeps exchange rate fixed through reserves and buying and selling currency
Flexible exchange rate:
currencies continuously priced by foreign exchange markets
Monetary policy with capital flows
Works with floating exchange rates
No autonomy in fixed exchange rate regimes

24. Monetary policy and free floating (open economy)
Increase in money supply
LM shift to right and economy moves to C with lower interest rates
In open economy, capitals flow out and exchange rate depreciates
Result: higher exports and demand
IS shifts right and economy moves to D, where interest parity is re-established

25. Monetary Policy with floating exchange rates

26. Monetary Policy with floating exchange rates (cont.)

27. Monetary policy and fixed exchange rates (open economy)
Increase in money supply
LM shift to right and economy moves to C, with lower interest rates
Capitals flow out and government intervenes against currency depreciation
Result: money supply shrinks and LM shifts back
IS does not move as competitiveness is unchanged (economy is back to initial point A)
Conclusion: monetary policy ineffective given offsetting exchange market operation!

28. Monetary Policy with fixed exchange rates

29. Monetary Policy with fixed exchange rates (cont.)