1. Economic Modelling Lecture 18 Exchange Rate: Purchasing Power Parity
Uncovered Interest Parity
Fixed or Flexible ER?
@Keshab R. Bhattarai, Business School, University of Hull, UK

2. Why is not appreciation of domestic currency
not good for Foreign Investment?
Net capital outflow
S-I
2004
Real
Exchange
Rate
Appreciation of Pound λ
Current A/C bal +capital A/C bal =0
Net capital inflow
NX(λ)
2001
Net export
When £ appreciate you get more $ per £.

3. Exchange Rate and the Demand and Supply of Foreign Currency
2001:
Exports: X(E,Y*)
Excess supply of FC E1
Depreciation E e
0.66 A NX
Appreciation E2
2004:
Excess Demand for FC
Imports: M(E,Y) F
Demand and supply of Foreign Currency [($) in UK]
Dollar depreciated 23 percent between 2002 and 2004

4. Exchange Rate and the Demand and Supply of Foreign Currency
2003:
Exports: X(E,Y*)
Excess supply of FC E1
Depreciation E e
0.66 A NX
Appreciation E2
2004:
Excess Demand for FC
Imports: M(E,Y) F
Demand and supply of Foreign Currency [($) in UK]
Dollar depreciated 23 percent between 2002 and 2004

5. Musa (1979) ’s seven stylised facts on exchange rates ( from p
Musa (1979) ’s seven stylised facts on exchange rates ( from p.486 of the Burda and Wyplosz)
On daily basis changes in foreign are largely unpredictable.
On month to month basis over 90% are unpredictable, only 10% predictable.
Countries with high inflation have depreciating currencies. And the rate of deprecation approximately is equals the differences in the national inflation rates
Countries with rapidly expanding money supply have depreciation exchange rates and countries with expanding money demand have appreciating currencies
In the long run, excess of domestic interest rate over foreign interest rate equals the expected appreciation of the foreign currency.
Spot exchange rate tends to overshoot any smoothly adjusting measure of equilibrium exchange rate
Countries with persistent trade deficits have depreciating currencies and countries with trade surplus have appreciating currencies in the long run. This relation is not obvious in the short run.

6. Purchasing Power Parity Theory of the Exchange Rate: Long Run
Real Exchange Rate:
Change in the real exchange rate:
Stable real exchange rate implies:
PPP-hypothesis:

7. Purchasing Power Parity Theory : Notations

8. Fundamentals of A Stable Exchange Rate according to the PPP Theory

9. Covered and Uncovered interest parity

10. Impact of Fiscal Policy on the Exchange Rate,
Interest Rate and Output: ISLM Model
IS2
UIP LM i i i2 i1 i IS Y2 E1 E2 Y1
Appreciation
Depreciation
Fiscal expansion raises output and
Interest rate and an appreciation

12. Depreciation of Dollar or Appreciation of Pounds Between December 2001 and February 2004

13. Triangular Exchange Rates and Appreciation
and Depreciation with respect to the Third Currency

14. The Problems of Flexible Exchange Rates

15. Which countries should have fixed exchange rates?

16. Disadvantages of Fixed Exchange Rate System

17. Benefits and cost of a Monetary Union and Optimal Liberalisation?
Impossible trilogy:
fixed exchange rate
free capital mobility
monetary independence
Optimal Order of Liberalization
1st goods market (subsidies)
2nd Trade (Tariffs)
Financial market (no control on r)
Full convertibility

18. References
Britain in Euro
Blanchard (19,20) Mankiw (2) M&S (20)
Dornbusch R. (1976) Expectations and Exchange Rate Dynamics, Journal of Political
Economy, vol. 84, no.6.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
exchange rates, IMF staff paper 9, November ,
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money
Credit and Banking, 11, Aug.
Mundell Robert (1961) A Theory of Optimal Currency Areas, American Economic
Review, September.
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and
flexible exchange rates, Canadian Journal of Economic and Political Science, 29,
Mussa Micheal Empirical Regularities in the Behaviour of Exchange Rates and
Rogoff, K (1999) "International institutions for reducing global financial instability", Journal of Economic Perspectives, 1999 or NBER WP 7265.
Rogoff K and M Obstfeld (1996) Foundation of International Macroeconomics, MIT
Press.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic Literature, March, vol 33, No. 1, pp