1. Lecture 10 Exchange rate Chapter 12 covers a lot of material.
First, it develops the Mundell-Fleming open-economy IS-LM model for a small open economy with perfect capital mobility. The model is used to analyze the effects of fiscal, monetary, and trade policy under floating and flexible exchange rates.
Then, the chapter explores interest rate differentials, or risk premia that arise due to country risk or expected changes in exchange rates. The Mundell-Fleming model is used to analyze the effects of a change in the risk premium. The Mexican Peso Crisis is an important real-world example of this.
The chapter summarizes the debate over fixed vs. floating exchange rates.
Following that discussion, the Mundell-Fleming model is used to derive the aggregate demand curve for a small open economy.
And finally, the chapter discusses how the results it derives would be different in a large open economy.
To reinforce this material, I strongly recommend you to allow a bit of class time for a few in-class exercises (I’ve suggested several in the lecture notes accompanying some of the slides in this presentation), and that you assign a homework consisting of several of the end-of-chapter “Questions for Review” and “Problems and Applications” in the textbook.

2. What you will learn... About the foreign exchange market
The determinants of foreign exchange rate
The Mundell-Fleming model

3. The foreign exchange market: Closest to the idea of perfect competition

4. The foreign exchange market
It is unique because of
Its huge trading volume, extreme liquidity
Its large number of, and variety of, traders in the market,
Its geographical dispersion,
Its long trading hours:24 hours a day (except on weekends).
the variety of factors that affect exchange rates

5. The Mundell-Fleming model IS-LM-BP

6. Goods market equilibrium: the IS curve
Y = a1e – a2i + a3G + a4Y*
Goods market equilibrium is attained when the supply of domestic goods (Y on LHS) is equal to the aggregate demand for domestic goods (RHS).
The demand is
positively related to the exchange rate, e (#units of domestic currency per foreign currency), the level of domestic government spending (G) and the level of foreign economic activity (Y*)
Negatively related to the domestic interest rate (i)

7. Money-market equilibrium: the LM curve
M/P = b1Y – b2i
Money-market equilibrium is attained when the supply of real money (LHS) equals the demand for money (RHS).
The demand for money varies
positively with the level of domestic economic activity (Y)
Negatively with the level of domestic interest rate (i)

8. The Impossible Trinity (cont.)
A nation cannot have free capital flows, independent monetary policy, and a fixed exchange rate simultaneously.
A nation must choose one side of this triangle and give up the opposite corner.
Free capital flows
Independent monetary policy
Fixed exchange rate
Option 1 (U.S.)
Option 2 (Hong Kong)
This slide corresponds to new material in the 6th edition, on pp
“Option 1” is allowing free capital flows and maintaining independent monetary policy, but giving up a fixed exchange rate. An example of a country that chooses this option is the United States.
“Option 2” is allowing free capital flows keeping a fixed exchange rate, but giving up independent monetary policy. A country that chooses this option is Hong Kong.
“Option 3” is keeping monetary policy independent, yet fixing the exchange rate. Doing this requires limiting capital flows. An example of a country that practices this option is China.
Option 3 (China)

9. Interest-rate differentials
Two reasons why i may differ from i*
country risk: The risk that the country’s borrowers will default on their loan repayments because of political or economic turmoil.
Lenders require a higher interest rate to compensate them for this risk.
expected exchange rate changes: If a country’s exchange rate is expected to fall, then its borrowers must pay a higher interest rate to compensate lenders for the expected currency depreciation.
i = i* +  where  is a risk premium

10. Summary of the Mundell-Fleming model

11. How monetary policy impact exchange rates (The IS-LM-BP model)
Increase in domestic economic activity
Deterioration of trade balance
Expansionary
monetary
policy
Depreciation of domestic currency
Decline in domestic interest rates
Capital outflow

12. How fiscal policy impact exchange rates (The IS-LM-BP model)
Increase in domestic economic activity
Deterioration of trade balance
Depreciation of domestic currency
Expansionary
fiscal
policy
Overall balance of payments (?)
Increase in domestic interest rates
Capital
inflow
Appreciation of domestic currency

13. Summary notes on the determinants of foreign exchange rates

14. Economic factors Economic policy (capital movement allowed)
Expansionary monetary policy: depreciate domestic currency’s value
Expansionary fiscal policy: depends on level of capital mobility
Government budget deficits or surpluses
Markets usually react negatively to budget deficit, causing the domestic currency value to fall.

15. Economic factors (cont.)
Balance of trade levels
Surpluses (deficits) in trade of goods and services reflect the competitiveness (non-competitiveness) of a nation's economy, and thus exert a positive (negative) impact on a nation’s currency.
Inflation levels
A currency will lose value if there is a high level of inflation because inflation erodes purchasing power and thus demand for the currency

16. Economic factors (cont.)
Economic growth
GDP, employment levels, retail sales, capacity utilization
The strength of an economy generally determines the performance of its currency
Productivity of an economy
Increasing productivity has positive influence on the value of its currency
Effects are more prominent if the increase in productivity is in the traded sector

17. Reading list
Rosenberg, M.R., 1996, Currency Forecasting: A Guide to Fundamental and Technical Models of Exchange Rate Determination, Irwin., Chap 5.
Mankiw, Macroeconomics 6th Ed., Chap 10.