1. Open Economies Exchange Rate Determination Lecture 25
Dr. Jennifer P. Wissink
©2019 Jennifer P. Wissink, all rights reserved.
April 29, 2019 1

2. Announcements Macro Spring 2019
Next MEL quiz is due on Sunday May 5 at 11pm.
About our final exam…It’s cumulative but will stress macro model.
Official Exam is Friday May 17 at 2:00pm.
We will be in Kennedy Hall 116-Call Aud. More info the last week of classes.
Note: The other two dates on the Cornell final exam page are for the OTHER two econ1120 lectures. Not this one!
Sign up link, if you have the Cornell policy for the makeup OR have received permission from me personally, is up on Bb. See our syllabus for more info.
Makeup is on Wednesday May 15 at 7pm, Barton Field House – East and Center area.
Note: Just fyi, this location is where my econ1110 final is at the same time.
More Wissink Office Hours Posted!
I will have my regularly scheduled Tuesday office hours April 30, May 7 and May 14.
I will add Wednesday office hours on May 1 and May 8.  Econ1110 will have priority from 2:30-3:30, Econ1120 will have priority from 3:30-4:30. Hours will be at my 468 Uris Hall office unless there is a note on my door directing you elsewhere in Uris.

3. Economic Integration
Economic integration occurs when two or more nations join to form a free-trade zone.
Two Examples:
The European Union (EU)
Initially, the EU consisted of just six countries: Belgium, Germany, France, Italy, Luxembourg and the Netherlands. (EEC, aka the “common market” in 1957)
Then over time more countries joined!
In 1991 they signed the Maastricht Treaty  the EU was born (1993) and the EURO, which 16 of the EU countries adopted. See:
The North American Free-Trade Agreement (NAFTA)
An agreement signed by the United States, Mexico, and Canada in 1994 in which the 3 countries agreed to establish all North America as a free-trade zone.
President Trump and Trade
NAFTA
Trans-Pacific Partnership

4. The EU Today
The European Union is now composed of 28 independent sovereign countries which are known as member states, they are:
Members: Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden, and the United Kingdom.
BREXIT VOTE on June 23, 2016
Candidates: Albania, FYROM, Iceland, Montenegro, Serbia, Turkey

5. Our Model and Simple Policy Prescriptions…?
So... AEd = C + Id + G + EX – IM and to get equilibirum set Y* = AEd(Y*) and solve for Y*
So… it’s good to EX and IM to make your Y* as large as possible…
…however, this implies another country’s exports may go and its imports may go which might not be good for them.
Get beggar thy neighbor policies
Exporting unemployment
Retaliation via tariffs and quotas, etc
Bad for international trade overall
GOOD QUESTION: What really determines EX and IM?

6. Determinants of Exports & Imports
The determinants of imports include the same factors that affect consumption and investment.
i.e., Y or Yd, r, wealth and any other stuff you think belongs in the model
i>clicker question: Do YOU check for where what you buy is produced? A. Yes. B. No.
Imports also depend on the prices of domestically-produced goods relative to foreign-produced goods.
prices at home relative to abroad
exchange rates matter a lot here
The determinants of exports are the same – just from the position of the rest of the world.
US exports depend on economic activity in the rest of the world.
I.e., If foreign output increases, U.S. exports tend to increase.

7. Exports and Imports and the so-called “Trade Feedback Effect”
The trade feedback effect is the tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that original country.
Suppose the U.S. economy starts to grow  Y*  IM 
Because U.S. imports are somebody else’s exports, the extra import demand from the United States raises the exports of the rest of the world, expanding their economies.
Some of the desire for those countries to import creates exports for the US!  a trade feedback effect back in the U.S.
In good times, this might appear nice, but in bad times, not so much.

8. Exports and Imports and the so-called “Price Feedback Effect”
The price feedback effect is the process by which a domestic price increase in one country can “feed back” on itself through export and import prices.
Suppose...
Inflation picks up in Italy 
shoe prices and olive oil prices in Italy go up 
Italian imported shoes and olive oil are now more expensive in the U.S. and elsewhere 
in the U.S., IM and its EX 
AD shifts right and SR-AS eventually shifts left in the U.S.
upward pressure on prices in the U.S. 
a tendency for even higher prices back in Italy.
Inflation can be “exportable” and it might “boomerang” back on you.
Need to address exchange rate determination.

9. The Open Economy with Flexible Exchange Rates
Recall: The exchange rate is the ratio at which two currencies are traded, or the price of one currency in terms of another.
Floating, or market-determined, exchange rates are exchange rates determined by the unregulated forces of supply and demand.
Haven’t always been flexible in the U.S.
Not all countries have flexible exchange rates now.
See Case, Fair & Oster appendix for history.

10. The Market for Foreign Exchange
Consider only 2 countries: the US and the UK
Consider the market for pounds from the US perspective.
What does a pound cost in dollars?
1 Pound sterling costs $1.29 (on 11/19/2018)
Then what does 1 US Dollar cost in pounds?
$1 costs £0.77
Good time to vacation in the UK!
The demand for pounds is comprised of holders of dollars wishing to acquire pounds.
The supply of pounds is comprised of holders of pounds seeking to acquire dollars.

11. The Demand for Foreign Exchange: E.g., British Pounds
THE DEMAND FOR POUNDS: derived from the need to obtain pounds to buy UK goods and services
Firms, households, or governments that import British goods into the United States or wish to buy British-made goods and services.
US citizens traveling in Great Britain.
Holders of dollars who want to buy British stocks, bonds, or other financial instruments.
US companies that want to invest in Great Britain – build factories there.
Speculators who anticipate a decline in the value of the dollar relative to the pound.
US wanting to send foreign aid to the UK.

12. The Demand Curve for Pounds
The demand for pounds is downward sloping.
When the $price of pounds falls, British made goods and services appear less expensive to US buyers.
If British prices are constant, US buyers will buy more British goods and services, and the quantity demanded of pounds will rise.

13. i>clicker question
If the exchange rate goes from EROld to ERNew in this diagram, the dollar has
appreciated relative to the pound.
depreciated relative to the pound.
EROld O
ERNew N

14. The Supply of Foreign Exchange: E.g., British Pounds
THE SUPPLY OF POUNDS: derived from the need to obtain dollars to buy US goods and services
Firms, households, or governments that import US goods into Great Britain or wish to buy US-made goods and services.
British citizens traveling in the United States.
Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United States.
British companies that want to invest in the United States.
Speculators who anticipate a rise in the value of the dollar relative to the pound.
The UK sending foreign aid to the US.

15. The Supply Curve for Pounds
The supply of pounds is upward sloping.
When the $price of pounds rises, the British can obtain more dollars for each pound.
This means that US made goods and services appear less expensive to British buyers.
Thus, the quantity of pounds supplied is likely to rise with the exchange rate.

16. The Equilibrium Exchange Rate
An excess supply of pounds will cause the $price of pounds to fall, the dollar will appreciate against the pound, the pound will depreciate with respect to the dollar.
An excess demand for pounds will cause the $price of pounds to rise, the dollar will depreciate against the pound, the pound will appreciate with respect to the dollar.

17. Purchasing Power Parity - The Law of One Price
If the costs of transportation are small, and markets are free, the price of the same good in different countries should be roughly the same.
If the law of one price held for all goods, and if each country consumed the same market basket of goods, the exchange rate between the two currencies would be determined simply by the relative price levels in the two countries.
The theory that exchange rates are set so that the price of similar goods in different countries is the same is known as the purchasing-power parity.
Do we always see that....?

18. ER Comparative Statics: Tastes
i>clicker question If people in the US suddenly want more stuff from the UK then
the dollar appreciates.
the dollar depreciates.
the pound appreciates.
the pound depreciates.
two answers above are correct.

19. ER Comparative Statics:  Relative Price Levels
A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries
there is a general tendency for the currency of relatively higher-inflation country to depreciate.
E.g.: Suddenly more inflation in the US relative to the UK… increases the demand for pounds and decreases the supply of pounds.
The result is an appreciation of the pound against the dollar.
Or depreciation of the dollar against the pound.

20. ER Comparative Statics:  Relative Interest Rates
The level of a country’s interest rates relative to interest rates in another country is another determinant of the exchange rate.
For Example: If US interest rates fall relative to British interest rates then…, 1) US citizens may be relatively more attracted to British bonds & securities and 2) Brits are no longer so fond of US bonds & securities.
So  we see an increase in the demand for pounds and a decrease in the supply of pounds.
The result is a depreciation of the dollar against the pound.
Or the dollar weakens against the pound.

21. ER Comparative Statics:  Relative Rates of Growth-Case A
Suppose the US and the UK start to experience growth, and the US is growing faster than the UK.
Expect that the US would import more stuff from the UK  demand for pounds increases.
Expect that the UK would import more stuff from the US  supply of pounds increases.
But if the US is growing faster than the UK, then the demand increase for pounds is larger than the supply increase of pounds.
The result is a depreciation of the dollar against the pound.
Or the dollar weakens! Sn Dn
But…. If this is the case, then why does it seem that not so long ago many argued that the Chinese yuan should be getting stronger against the dollar when it was the case that China was growing faster than the US? According to this analysis, shouldn’t the yuan get weaker? Not stronger??