1. KYIV SCHOOL OF ECONOMICS MACROECONOMICS II November-December 2013 Instructor: Maksym Obrizan Lecture notes V # 2. CHAPTER 10. Money, Exchange Rates, and Prices The gold standard prevailed from 1870 to 1914 and fully collapsed during the Great Depression Currencies were tied to gold at a fixed rate. Thus, one currency could be exchanged to another at a fixed rate # 3. Bretton Woods agreement after WWII established a fixed-exchange rate system among IMF members Currencies were pegged to the US dollar which could be converted into gold at 35$ per ounce Certain limits – US citizens could not exchange Collapsed in 1971 - managed floating xrates # 4. Some definitions Let E be the price of foreign xchange measured as units of dom currency per unit of foreign curr A rise in E is called devaluation under fixed regime and depreciation under floating A rise in E means a fall in purchasing power of the domestic currency

2. # 5. We need a model determining equilibrium price level (P), exchange rate (E) and quantity of money (M) Strong assumptions: output and income are exogenous, at full-employment level etc Let's introduce 2 building blocks of GenEqbMod: PPP and interest parity Link domestic prices and interest rates to world prices and interest rates # 6. Purchasing Power Parity is an old concept from XVI-XVII popularized by Gustav Cassel in beginning of XX century PPP is based on the law of one price - two prices are the same if expressed in common currency P = EP* The law of one price holds because of arbitrage # 7. PPP is the law of one price aggregated to the basket of commodities PPP requires a number of unrealistic assumptions: (1) No trade barriers (no transport and insurance costs etc) (2) No tariffs or quotas (3) All goods are tradable (4) Price indexes contain the same baskets of goods with same weights # 8. A less restrictive version of PPP: barriers exist but are constant over time Thus, percentage changes in P should approx equal percentage changes in EP* 10.2 10.3

3. # 9. Even this version is unlikely to hold because many goods are not tradable Haircut example: variation in prices is almost 500 % Poorer countries have lower-priced haircuts and average price levels Real exchange rate e = EP*/P is the price of the country's good relative to foreign goods # 10. Real-exchange rate depreciation When e rises foreign goods become more expensive than domestic goods - we speak of real-exchange rate depreciation PPP assumes that e is constant over time PPP may work well but only over long periods of time # 11. Let M be domestic money and B bonds The nominal value of households' financial wealth W = M + B + EB* Real wealth 10-4 and using PPP from 10.1 10-4* # 12. In the financial markets the law of one price can be expressed as 10-5 or as approximation 10-6

4. # 13. The expression above is interest arbitrage: domestic interest rates must equal the foreign interest rate plus the rate of exchange-rate depreciation # 14. The general equilibrium of price, the exchange rate, and money Recall the equilibrium condition in the money market: 10.7 Where velocity of money V(i) is assumed to be an increasing function of the interest rate # 15. Consider a special case when prices, exchange rate and other variables being constant Then E = E+1 and domestic and foreign interest rates must be equal 10.8 # 16. Combining all pieces together 10.9 Whether we want to think of equation 10-9 as M being function of E or E being function of M depends on the exchange-rate system by of the central bank

5. # 17. Fixed exchange rate regime If the exchange rate fixed by the central bank the equation should be re-written as # 18. Flexible exchange rate regime # 19. Monetary policy# 20. Fixed exchange rate

6. # 21. Paradoxical result In a fixed exchange-rate regime, with free capital mobility the central bank cannot affect the quantity of money # 22. The offset coefficient (OC) Defined as the ratio of the loss of foreign reserves to the increase in central bank’s bond holdings # 23. Monetary policy under flexible exchange rate regime # 24. Global fixed exchange rate arrangements Fixed exchange rate regime can be achieved in two countries by

7. # 25. Gold standard Under the gold standard the money supply and the price level depend on the global supply of gold # 26. Quantity of paper money under the gold standard When output increases but there are no gold discoveries the price level will fall! # 27. Unilateral peg From 1944 to 1971 all countries pegged currencies to the US dollar # 28. A cooperative peg Fixed exchange rates could be maintained as a shared responsibility for a group of countries

8. # 29. The exchange-rate mechanism (ERM)# 30. ERM Central rates in this arrangement were fixed but were subject to sporadic adjustments # 31. Monetary policy Under cooperative peg system none of the countries can carry out a completely independent monetary policy # 32. Devaluation Suppose that the central bank unexpectedly increases E

9. # 33. Capital controls How will an open market purchase of bonds work when international capital flows are restricted? # 34. Fixed exchange rates and capital mobility # 35. Flexible exchange rates under capital mobility # 36. Notes

10. # 37. # 38. # 39.# 40.