Chapter 13 - National Income Accounting and the Balance of Payments

I. The National Income Accounts

A. National Income Accounts - classifying each transaction that contributes to

national income

1. Consumption

2. Investment

3. Government purchases

4. Current account Balance

B. National Product and National Income

1. The GNP a country generates must equal its National Income

C. Capital Depreciation and International Transfers

1. GNP = NI is more than just an equality, it is an identity

2. Two adjustments to the definition of GNP must be made before this

identity is entirely correct in practice

a) To calculate NI over a given period we must subtract capital

depreciation from GNP (also known as net national product NNP)

(1) NI = NNP

b) Net unilateral transfers must be added to NNP to equal NI

3. NI = NNP + Net unilateral transfers

D. GDP

1. GNP = GDP + Net receipts of factor income from the rest of the world
 a) Net receipts = income domestic residents earn on wealth they hold

in other countries - the payments domestic resident make to foreign

owners of wealth that is located in the domestic country

II. National Income Accounting for an Open Economy

A. National Income Accounts

1. Consumption

a) Portion of GNP purchased by private households to fulfill current

wants

2. Investment

a) Part of output used by private firms to produce future output; the

portion of GNP used to increase the nation’s stock of capital

3. Government Purchases

a) Any goods and services purchased by any level of government

B. National Income Identity for an Open Economy

1. Y = C + I + G + CA

C. The Current Account and Foreign Indebtedness

1. A country’s CA balance = the change in its net foreign wealth

a) Y - (C + I + G) = CA

b) Surplus = net foreign investment

c) Deficit = net foreign debt

D. Saving and the Current Account

1. National Saving (S) - portion of output (Y) that is not devoted to C or G

 a) S = Y - C - G

b) S = I + CA in open economy

c) Closed economy GNP identity, Y = C + I + G or I = Y - C - G

(1) S = I in closed Economy

E. Private and Government Saving

1. Private Saving - part of disposable income that is saved rather consumed

a) S​p​ = Y - T - C

(1) T = net taxes collected from households and firms by gov.

2. Government Saving: government income - purchases

a) S​g​ = T - G

3. S = Y - C - G = (Y - T - C) + (T - G) = S​p​ + S​g

4. S = S​p​ + S​g​ = I + CA

a) S​p​ = I + CA - S​g

III. Case Study: Government Deficit Reduction May Not Increase CA Surplus

A. CA = S​p​ - I - (G - T)

1. G - T = government deficit

2. If deficit rises and private saving and investment do not change, the CA

surplus must fall by roughly the same amount as the increase in the deficit

B. When European countries attempted to cut their government budget deficits prior

to the launch of the Euro, we would have expected their CA surplus to rise

sharply; however it remained about the same

 1. What happened? A sharp fall in the private saving rate (about as large as

the drop in deficit spending)

a) Ricardian equivalence - when the government cuts taxes and raises

the deficit, consumers anticipate that they will face higher taxes

later on and raise their own private saving to offset the resulting

government debt; governments that lower their deficits through

higher taxes will induce the private sector to lower its own saving.

(1) This doesn’t exactly hold in practice; most likely what also

helped was the rise in household wealth which was a

second factor lowering private savings rates

IV. The Balance of Payments Accounts

A. BOP Accounts - detailed record of the composition of the CA balance and the

many transactions that finance it

1. Keeps track of both a country’s payments to and its receipts from

foreigners. Any transaction resulting a receipt from foreigners is entered in

the BOP accounts as a credit; any transaction resulting in a payment to

foreigners is entered as a debit

B. Three types of international transactions are recorded in the BOP:

1. Current Account - all transactions that arise from the export or import of

goods or services

2. Financial Account - records all international purchases or sales of financial

assets (money, stocks, factories, government debt)

 a) Net Financial Flows - Differences between a country’s purchases

and sales of foreign assets

3. Capital Account - activities resulting in transfers of wealth between

countries; result from non-market activities or represent the acquisition or

disposal of nonproduced, nonfinancial, and possibly intangible assets

(such as copyrights and trademarks)

C. The Fundamental BOP Identity

1. CA + KA = FA

a) Change in Net Foreign Wealth = FA + VA (valuation adjustment)

(1) Change in Net Foreign Wealth = CA + KA + VA

D. Official Reserve Transactions

1. Important aspect of FA transactions - the purchase or sale of official

reserve assets by CBs, also known as Official Foreign Exchange

Intervention

2. Official international reserves - foreign assets held by CBs as a cushion

against national economic misfortune

V. Case Study: The Assets and Liabilities of the World’s Biggest Debtor

A. Bureau of Economic Analysis uses two different methods to place current values

on foreign direct investments:

1. Current Cost Method - values direct investments at the cost of buying

them today
 2. Market Value Method - measures the price at which the investments could

be sold

Chapter 14 - Exchange Rates and the Foreign Exchange Market: An Asset Approach

I. The Foreign Exchange Market

A. Foreign Exchange Market - In which international currency trades take place

B. Actors in Market

1. Commercial Banks

a) Almost every sizable international transaction involves the

debiting and crediting of accounts at commercial banks in various

financial centers

b) Interbank Trading - foreign currency trading among banks; a bank

will also quote to other banks exchange rates at which it is willing

to buy and sell currencies to and from them (Interbank Rates -

wholesale rates)

c) Retail rates - rates available to corporate customers

2. Corporations (that engage in international trade)

a) Those with operations in several countries frequently make or

receive payments in currencies other than that of the country in

which they are headquartered

3. Nonbank Financial Institutions (asset-management firms and insurance

companies)

4. Central Banks
C. Characteristics of the Market

1. Arbitrage - the process of buying a currency cheap and selling it expensive

2. Most transactions are exchanges of foreign currencies for U.S. dollars for

convenience and costs sake

a) US dollar is known as a vehicle currency - one that is widely used

to denominate international contracts made by parties who do not

reside in the country that issues the vehicle currency

D. Spot Rates and Forward Rates

1. Spot Exchange Rates and Transactions - to parties agree to an exchange of

bank deposits and execute the deal immediately

2. Forward Exchange Rates - rates dealt in contracts specifying a future

transaction rate

3. Both rates, while not equal, are typically quite close

E. Foreign Exchange Swap - Spot sale of a currency combined with a forward

repurchase of that currency; a three month swap may result in lower brokers’ fees

than two separate transactions of selling dollars for spot euros and selling euros

for dollars on the forward market

F. Futures and Options

1. When you buy a Futures Contract - you buy a promise that a specified

amount of foreign currency will be delivered on a specific date in the

future
 2. Foreign Exchange Option - gives its owner the right to buy or sell a

specified amount of foreign currency at a specified price at any time up to

a specified expiration date

II. The Demand for Foreign Currency Assets

A. A foreign currency deposits’ future value depends in turn on two factors: the

interest rate it offers and the expected change in the currency’s exchange rate

against other currencies

B. Assets and Asset Returns

1. Defining Asset Returns

a) Rate of Return - the percentage increase in value an asset offers

over some time period

(1) Expected Rate of Return

(a) (E​e​ - E) / E

2. The Real Rate of Return - the rate of return computed by measuring asset

values in terms of some broad representative basket of products that savers

regularly purchase

a) The difference between the returns of two assets must equal the

difference between their real returns

C. Risk and Liquidity

1. All else equal, individuals prefer to hold those assets offering the highest

expected real rate of return; all else however is not always equal. Savers

care about two main characteristics of an asset other than its return:
 a) Risk - the variability it contributes to savers’ wealth

b) Liquidity - the ease with which the asset can be sold or exchanged

for goods

D. Interest Rates

1. To compare returns on different deposits, market participants need two

pieces of information:

a) How money values of the deposits will change; this is the

currency’s interest rate - the amount of that currency an individual

can earn by lending a unit of the currency for a year; this is the rate

of return on the currency in questions’ deposits

b) How exchange rates will change so that they can translate rates of

return measured in different currencies into comparable terms;

what is the dollar rate of return on a euro deposit?

(1) Use today’s dollar/euro exchange rate to figure out the

dollar deposit of €1

(2) Use the euro interest rate to find the amount of euros you

will have a year from now if you purchase a €1 deposit

today

(3) Use the exchange rate you expect a year from today to

calculate the expected dollar value of the euro amount

determined in Step 2
 (4) Now that you know the dollar price of a €1 deposit today

and can forecast its value in a year, you can calculate the

expected dollar rate of return on a €1 deposit

(a) R​$​ = R​€​ + (E​e​$/€ -​ E​$/€​) / E​$/€

(i) The dollar rate of return on euro deposits is

the euro interest rate plus the rate of

depreciation of the dollar against the euro

III. Box: Non Deliverable Forward Exchange Trading in Asia

A. Non (fully) convertible currencies - many developing countries’ currencies cannot

be freely traded on international foreign exchange markets; China’s government

does not allow nonresidents unrestricted ownership of renminbi deposits in China;

currencies in this category cannot use the customary way of trading forward

exchange.

B. Non Deliverable Forward Exchange - facilitates hedging in inconvertible Asian

currencies; traders can hedge currency risks without ever having to trade

inconvertible currencies

1. Essentially the idea of luck is ruled out; parties must pay the difference

that would otherwise be considered loss. If the exchange rate turns out to

be more appreciated than expected, the receiving party must return the

difference to the other contracting party. If the exchange rate turns out to

be more depreciated than expected, the receiving party must receive the

difference from the other contracting party

IV. Equilibrium in the Foreign Exchange Market

A. Interest Parity: The Basic Equilibrium Condition - the condition that the expected

returns on deposits of any two currencies are equal when measure in the same

currency is called the interest parity condition

1. R​$​ = R​€​ + (E​e​$/€ -​ E​$/€​) / E​$/€

B.

V. Case Study: What Explains the Carry Trade?

A. Over much of the 2000s, Japanese yen interest rates were close to zero while

Australia’s interest rates were in the positive (close to 7 percent per year by 2008)

1. Interest parity implies that borrowing yen and investing in Australian

dollar bonds should not be systematically profitable: the interest advantage

of Australian dollars should be wiped out by relative appreciation of the

yen
 2. Nonetheless, market actors pursued this strategy

a) Carry Trade - international investors frequently borrow

low-interest currencies (called funding currencies) and buy

high-interest currencies (called “investment currencies)

3. Eventually the australian dollar crashed against the yen; those who

invested early and pulled out early made out well, those who got into the

game late were screwed

4. That carry trade dynamics will drive investment currencies higher as

investors pile in only makes the crash bigger when it occurs

Chapter 15 - Money, Interest Rates, and Exchange Rates

I. Money Defined: A Brief Review

A. Money as: a medium of exchange, unit of account (measure of value), a store of

value (used to transfer purchasing power over time)

B. Money supply in the context of this course refers to M1 (total amount of currency

and checking deposits held by households and firms

II. The Demand for Money by Individuals

A. Individuals base their demand for an asset on three characteristics:

1. The expected return of the asset compared with the returns offered by

other assets

2. The risk level of the asset’s expected returns

3. The asset’s liquidity

B. Expected Return
 1. All else equal, a rise in the interest rate causes the demand for money to

fall; interest rate measured the opportunity cost of holding money rather

than interest-bearing bonds

C. Risk

1. Not an important factor in money demand; because any change in the

riskiness of money causes an equal change in the riskiness of bonds,

change in the risk of holding money doesn’t reduce the demand for money

by individuals

D. Liquidity

1. An individual’s need for liquidity rises when the average daily value of his

transactions rises. A rise in the average value of transactions carried out by

a firm or household causes its demand for money to rise

III. Aggregate Money Demand

A. Aggregate Money Demand - the total demand for money by all households and

firms in the economy; the sum of all the economy’s individual money demands

B. Determined by three main factors:

1. The interest rate

a) A rise in the interest rate causes each individual in the economy to

reduce their demand for money; all else equal, aggregate money

demand therefore falls when the interest rate rises

2. The price level - price of a broad reference basket of goods and services in

terms of a currency
 a) If the price level rises, individual households and firms must spend

more money than before to purchase their usual weekly basket of

goods and services

b) To maintain the same level of liquidity as before the price level

increase, they therefore have to hold more money

3. Real national income

a) When real national income (GNP) rises, more goods and services

are being sold in the economy, which increases the demand for

money

C. The aggregate demand for money can be expressed as:

1. M​d​ = P * L(R,Y)

2. M​d​/P = L(R,Y)

a) Where L(R,Y) falls when R rises and rises when Y rises

(1) Y being real GNP

(2) L(R,Y) - aggregate real money demand, or aggregate

demand for liquidity

(a) Not a demand for a certain number of currency

units, but instead a demand to hold a certain amount

of real purchasing power in liquid form

b) M​d​/P = the amount of real purchasing power people would like to

hold in liquid form

IV. The Equilibrium Interest Rate: The Interaction of Money Supply and Demand
 A. Equilibrium in the Money Market

1. M​s​ = M​d

2. M​s​/P = L(R,Y)

a) Y - level of output

B. Interest Rates and the Money Supply

1. Have an inverse relationship

C. Output and the Interest Rate

1. Have a positive relationship

V. The Money Supply and the Exchange Rate in the Short Run

A. Increase in M​s​ in the short run cases E to depreciate and vice versa

B. In the Short Run - take price level, output, and money supply as fixed

1. The condition of money market equilibrium: M​s​/P = L(R,Y), determines

the domestic interest rate R, the foreign interest rate R​F​, and the exchange

rate E
C.

D.

1. Actions by the Federal Reserve are found in the domestic money market
 2. Actions by the ECB are found in the foreign money market

VI. Money, the Price Level, and the Exchange Rate in the Long Run

A. Long Run Equilibrium - position an economy would eventually reach if no new

economic shocks occurred during the adjustment to full employment; the

equilibrium that would occur if prices were perfectly flexible and always adjusted

immediately to preserve full employment

B. In the Long Run - allow price to float, and assume full employment of all factors

of production; M​s​US​, M​s​EU​, R​$​, R​€​ all fixed; P​US​, P​EU​ are determined

C. Money Market Equilibrium: P = M​s​/L(R,Y)

1. The price level depends on the interest rate, real output, and the domestic

money supply

D. Money and Money Prices

1. All else equal, an increase in a country’s money supply causes a

proportional increase in its price level

E. The Long-Run Effects of Money Supply Changes

1. A change in the level of the nominal supply of money has no effect on the

long-run values of the interest rate or real output

2. A permanent increase in the money supply causes a proportional increase

in the price level’s long run value; in particular if the economy is initially

in full employment

F. Money and the Exchange Rate in the Long Run

 1. All else equal, a permanent increase in a country’s money supply causes a

proportional long run depreciation of its currency against foreign

currencies, and vice versa

VII. Inflation and Exchange Rate Dynamics

A. Short Run price rigidity versus long run price flexibility

1. Not wholly accurate, however many prices in the economy are written into

long-term contracts and cannot be changed immediately when changes in

the money supply occur; ex: wages

2. To be certain, it is not reasonably applicable to all countries at all times;

those in extremely inflationary conditions would see long-term contracts

go out of use and may have automatic price level indexation of wage

payments

B. Although price levels appear to display short-run fixedness in many countries, a

change in the money supply creates immediate demand and cost pressures that

eventually lead to future increases in the price level stemming from three main

sources:

1. Excess demand for output and labor - an increase in the money supply has

an expansionary effect on the economy. The additional demand for labor

allows workers to ask for higher wages in the next period of wage

negotiations
 2. Inflationary expectations - if everyone expects the price level to rise in the

future, they will act accordingly today; workers may demand higher

money wages to counteract said inflation

3. Raw materials prices - an increase in money supply raises production costs

in materials using industries by causing the prices of raw materials to jump

upwards. Eventually, producers in those industries will rase product prices

to cover their costs

C. Permanent Money Supply Changes and the Exchange Rate

1. Permanent change affects exchange rate expectations; because the US

money supply change is permanent, people expect a long-run increase in

all dollar prices, including the exchange rate

D. Exchange Rate Overshooting - when the immediate response to a disturbance is

greater than its long run response; direct consequence of the short-run rigidity of

the price level

VIII. Box: Money Supply Growth and Hyperinflation in Bolivia

A. During hyperinflations the magnitudes of monetary changes are so enormous that

the “long run” effects of money on the price level can occur very quickly

B. Data on Bolivia’s hyperinflation shows a clear tendency for the money supply,

price level, and exchange rate to move in step and in the same order of magnitude

IX. Case Study: Can Higher Inflation Lead to Currency Appreciation? The Implications of

Inflation Targeting
 A. If central banks act to raise interest rates when inflation rises, then because higher

interest rates cause currency appreciation, it might be possible to resolve the

apparent contradiction to our model

1. The interest rate, not the money supply, is the prime instrument of

monetary policy

2. Most central banks adjust their policy interest rates expressly so as to keep

inflation in check

B. With higher interest rates, interest parity requires an expected future depreciation,

which is consistent with an unchanged future exchange rate only if the currency

appreciates immediately

Chapter 16 - Price Levels and the Exchange Rates in the Long Run

I. The Law of One Price

A. Law of One Price - In competitive markets free of transportation costs and official

barriers to trade, identical goods sold in different countries must sell for the same

price when their prices are expressed in terms of the same currency

1. P​US​ = E​$/€​ * P​EU

2. E​$/€​ = P​i​US​/P​i​EU​ ; i = any one good

II. Purchasing Power Parity

A. PPP - states that the exchange rate between two countries’ currencies equals the

ratio of the countries’ price levels; a fall in a currency’s domestic purchasing

power (as indicated by a rise in the domestic price level) will be associate with a
 proportional currency depreciation in the foreign exchange market, and vice

versa.

1. E​$/€​ = P​US​/P​EU

B. The Relationship Between PPP and the Law of One Price

1. If the law of one price holds true for every commodity, PPP must hold as

long as the reference baskets used to estimate different countries’ price

levels are the same

C. Absolute PPP and Relative PPP

1. Absolute PPP - exchange rates equal relative price levels; invalid if

commodity baskets used are different

2. Relative PPP - states that the percentage change in the exchange rate

between two currencies over any period equals the difference between the

percentage changes in national price levels; may hold even if absolute PPP

doesn’t

a) (E​$/€,t​ - E​$/€, t-1​)/E​$/€, t-1​ = π​US, t​ - π​EU, t

III. A Long Run Exchange Rate Model Based on PPP

A. Monetary Approach to the Exchange Rate

1. Assumes that in the long run, the foreign exchange market sets the rate so

that PPP holds

2. Makes the general prediction that the exchange rate, which is the relative

price of American and European money, is fully determined in the long

 run by the relative supplies of those currencies and the relative real

demands for them

3. Makes the following specific predictions about long run effects:

a) Money supplies - other things equal, a permanent rise in the US

money supply causes a proportional increase in the long run US

price level; the dollar exchange rate also depreciates against the

euro in the long run proportional to the increase in the US money

supply

(1) A permanent increase in the European money supply

causes a proportional increase in the long run European

price level; the dollar exchange rate appreciates against the

euro in the long run proportional to the increase in US

money supply

b) Interest Rates - A rise in the interest rate on dollar denominated

assets lowers real US money demand; the long-run US price level

rises and the dollar depreciates against the Euro

c) Output Levels

(1) A rise in the U.S. output raises real US money demand,

leading to a fall in the long run US price level and an

appreciation of the dollar against the Euro

B. Ongoing Inflation, Interest Parity, and PPP

 1. Other things equal, money supply growth at a constant rate eventually

results in ongoing price level inflation at the same rate, but changes in this

long-run inflation rate do not affect the full-employment output level or

the long-run relative prices of goods and services

2. Interest parity in this context tells us

a) If people expect relative PPP to hold, the difference between the

interest rates offered by the dollar and euro deposits will equal the

difference between the inflation rates expected, over the relevant

horizon, in the US and Europe

(1) π​e​ = (P​e​ - P)/P

(2) (E​$/€​ - E​$/€​)/E​$/€​ = π​e​US​ - π​e​EU

(3) R​$ ​= R​€​ + (E​$/€​ - E​$/€​)/E​$/€

(4) R​$​ - R​€​ = π​e​US​ - π​e​EU

C. The Fisher Effect - all else equal, a rise in a country’s expected inflation rate will

eventually cause an equal rise in the interest rate that deposits of its currency

offer. Similarly, a fall in the expected inflation rate will eventually cause a fall in

the interest rate

1. R​$​ - R​€​ = π​e​US​ - π​e​EU

IV. Empirical Evidence on PPP and the Law of One Price

A. All versions of the PPP theory do badly in explaining the facts, it tells us

relatively little about exchange rate movements

V. Explaining the Problems with PPP

 A. Contrary to the assumption of the law of one price, transport costs and restrictions

on trade do exist

B. Monopolistic or oligopolistic practices in goods markets may interact with

transport costs and other trade barriers to further weaken the link between prices

of similar goods sold in different countries; pricing to market, reflecting different

demand conditions in different countries, is a thing

C. The inflation data reported in different countries are based on different

commodity baskets, therefore there is no real reason for exchange rate changes to

offset official measures of inflation differences; people living in different

countries spend their incomes in different ways

VI. Box: Some Meaty Evidence on the Law of One Price

A. Economist ran a study on the prices of Big Macs around the world

B. The dollar prices of Big Macs turned out to be wildly different in different

countries

1. Transport costs and government regulations, along with product

differentiation are part of the explanation

VII. Case Study: Why Price Levels Are Lower in Poorer Countries

A. When expressed in terms of a single currency, countries’ price levels are

positively related to the level of real income per capita; in other words, a dollar,

when converted to local currency at the market exchange rate, generally goes

much further in a poor country than in rich one

 1. Balassa-Samuelson Theory - assumes that the labor forces of poor

countries are less productive than those of rich countries in the tradables

sector but that the international productivity differences in nontradables

negligible

a) Lower productivity implies lower wages than abroad, lower

production costs in nontradables, and therefore a lower price of

nontradables

2. Bhagwati-Kravis-Lipsey View - relies on differences in endowments of

capital and labor rather than productivity differences, but it also predicts

that the relative price of nontradables increases as real per capita income

increases

a) Rich countries have higher capital-labor ratios, their marginal

productivity of labor is higher, therefore wages are higher

b) Nontradables are naturally labor intensive relative to tradables;

because labor is cheaper in poor countries and is used intensively

in this sector, nontradables will be cheaper there

VIII. Beyond Purchasing Power Parity: A General Model of Long Run Exchange Rates

A. The Real Exchange Rate

1. The Real Exchange Rate - a broad summary measure of the prices of one

country’s goods and services relative to another country’s; relative price of

two output baskets as opposed to the Nominal Exchange Rate - relative

price of two currencies

 a) q​$/€​ = (E​$/€​ * P​EU​) / P​US

(1) Real exchange rate = dollar value of EU’s price level

divided by the US price level

b) Real Appreciation and Real depreciation are in terms of the

increase and decrease of the price of products purchased in the US

or Europe relative to the other

B. Demand, Supply, and the Long-Run Real Exchange Rate

1. Two specific cases in which the long run values of real exchange rates can

change:

a) A change in world relative demand for American products

(1) An increase causes a long-run real appreciation of the

dollar against the euro, and vice versa

b) A change in the relative output supply

(1) A relative expansion of US output causes a long run real

depreciation of the dollar against the euro, and vice versa

 2.

C. Nominal and Real Exchange Rates in Long-Run Equilibrium

1. E​$/€​ = q​$/€​ * (P​US​ / P​EU​)

a) For a given real dollar/euro exchange rate, changes in money

demand or supply in Europe or the United States affect the

long-run nominal dollar/euro exchange rates as in the monetary

approach; changes in the long-run real exchange rate, however,

also affect the long run nominal exchange rate

b) When all disturbances are monetary in nature, exchange rates obey

relative PPP in the long run. In the long run, a monetary

disturbance affects only the general purchasing power of a

currency, and this change in purchasing power changes equally the

currency’s value in terms of domestic and foreign goods.

 (1) When disturbances occur in output markets, the exchange

rate is unlikely to obey relative PPP, even in the long run

IX. Box: Sticky Prices and the Law of One Price: Evidence from Scandinavian Duty-Free

Shops

A. Why might it be difficult for money prices to change from day to day as market

conditions change?

1. Menu costs - can arise from several factors, such as the the actual costs of

printing new price lists and catalogs

a) In addition, when a firm raises its price, some customers will shop

around elsewhere and find it convenient to remain with a

competing seller, even if all sellers have raised their prices.

2. Sellers will often hold prices constant until they are certain the change is

permanent enough to make incurring the costs of price changes

worthwhile

X. International Interest Rate Differences and the Real Exchange Rate

A.

Change Effect on Long Run E​US/EU

Money Market

Increase in US money supply level Proportional increase (nominal

depreciation​US​)

Increase in EU money supply level Proportional decrease (nominal

depreciation​EU​)

Increase in US money supply growth rate Increase (nominal depreciation​US​)

Increase in EU money supply growth rate Decrease (nominal depreciation​EU​)

Output Market

Increase in demand for US output Decrease (nominal appreciation​US​)

Increase in demand for EU output Decrease (nominal appreciation​EU​)

Output supply increase in the US ambiguous

Output supply increase in EU ambiguous

B. Expansion of Fisher Effect to include Real Exchange Rate Movements

1. (q​e​$/€​ - q​$/€​) / q​$/€​ = [(E​e​$/€​ - E​$/€​) / E​$/€​] - (π​e​US​ - π​e​EU​)

2. R​$​ - R​€​ = (E​e​$/€​ - E​$/€​) / E​$/€

3. R​$​ - R​€​ = [(q​e​$/€​ - q​$/€​) / q​$/€​] + (π​e​US​ - π​e​EU​)

XI. Real Interest Parity

A. Nominal Interest rates are rates of return measured in monetary terms, and Real

Interest rates are rates of return measured in terms of a country’s output

1. r​e​ = R - π​e

2. r​e​US​ - r​e​EU​ = (R​$​ - π​e​US​) - (R​€​ - π​e​EU​)

3. r​e​US​ - r​e​EU​ = q​e​$/€​ - q​$/€​) / q​$/€

Chapter 17 - Output and the Exchange Rate in the Short Run

I. Determination of Aggregate Demand in an Open Economy

A. For now assume G and I are given; the following are the determinants of

Consumption Demand and the CA:

1. Consumption Demand

a) C = C(Y​d​)
 (1) A country’s desired consumption level is a function of

disposable income; they are positively related, however

when disposable income rises, consumption demand

generally rises by less because part of the income is saved

2. Determinants of the Current Account

a) CA = CA(EP​*​/P, Y​d​)

(1) A country’s current account balance is a function of its

currency’s real exchange rate and its domestic disposable

income

(2) When EP​*​ rises, foreign products have become more

expensive relative to domestic products; foreign consumers

will therefore demand more of our exports, which will

positively affect the domestic CA

(a) Domestic consumers respond to the price shift by

purchasing fewer foreign products; this does not

mean IM must fall because IM denotes the value of

imports in terms of domestic output, not the volume

of foreign products produced; overall the effect of a

real exchange rate change on the CA is ambiguous

(i) For now assume volume effect is larger, thus

causing an increase in the CA with real

 depreciation and decrease in CA with real

appreciation

(3) A rise in disposable income worsens the CA, other things

equal

II. The Equation of Aggregate Demand

A. D = C(Y-T) + I + G + CA(CA(EP​*​/P, Y-T)

1. Disposable income (Y​d​) is written as output - taxes (Y - T)

2. D = D(EP​*​/P, Y - T, I, G)

a) A rise in EP​*​/P makes domestic goods and services cheaper

relative to foreign goods and services, shifting both foreign and

domestic spending from foreign goods to domestic goods

(1) As a result CA rises and D rises; a real depreciation of the

home currency raises aggregate demand for home output,

other things equal, and vice versa

b) A rise in domestic real income raises aggregate demand for home

output, other things equal, and vice versa

III. How Output is Determined in the Short Run

A. Y = D(EP​*​/P, Y - T, I, G)

1. Output market is in equilibrium when real domestic output, Y, equals the

aggregate demand for domestic output

2. Here we assume that money prices of goods and services are temporarily

fixed
IV. Output Market Equilibrium in the Short Run: The DD Schedule

A. DD schedule - relationship between output and the exchange rate

B. Any rise in the real exchange rate (whether due to a rise in E, a rise in P​*​, or a fall

in P) will cause an upward shift in the aggregate demand function and an

expansion of output, all else equal, and vice versa

C. If we assume that P and P​*​ are fixed in the short run, a depreciation of the

domestic currency (a rise in E) is associated with a rise in domestic output (Y)

and vice versa

D. Factors that shift the DD schedule:

1. A change in G; an increase in G causes the DD to shift to the right, and

vice versa

2. A change in T; an increase in taxes causes the aggregate demand function

to shift to the left, and vice versa

3. A change in I; same as G

4. A change in P; same as T

5. A change in P​*​; same as G and I

6. A change in the consumption function; if an increase in consumption

spending is not wholly devoted to imports, then it causes DD to shift right,

and vice versa

7. A demand shift between foreign and domestic goods

 E. Any disturbance that raises aggregate demand for domestic output shifts the DD

to the right; any disturbance that lowers aggregate demand for domestic output

shifts the DD to the left

V. Asset Market Equilibrium in the Short Run: The AA Schedule

A. AA Schedule - exchange rate and output combinations that are consistent with

equilibrium in the domestic money market and foreign exchange market

B. For asset markets to remain in equilibrium, a rise in domestic output must be

accompanied by an appreciation of the domestic currency, all else equal, and vice

versa

C. Factors that Shift the AA Schedule:

1. A change in M​s​ - for a fixed level of output, an increase in M​s​ causes the

domestic currency to depreciate in the foreign exchange market, and AA

shifts right; a fall in M​s​ causes the AA to shift left

2. A change in P - an increase in P reduces the real money supply and drives

the interest rate upward causing the exchange rate to fall, and resulting in

the AA shifting left; a fall in P causes the AA to shift right

3. A change in E​e​ - A rise in E​e​ causes the domestic currency to depreciate

and results in AA shifting right; a fall in E​e​ causes AA to shift left

4. A change in R​*​ - A rise in R​*​ causes AA to shift right; a fall in R* causes

AA to shift left
 5. A change in real money demand - A reduction in money demand results in

a lower interest rate and a rise in E, thus shifting the AA right; an increase

in money demand would shift AA left

VI. Short-Run Equilibrium for an Open Economy: Putting the DD and AA Schedules

Together

A. Short Run - assume that domestic output prices are temporarily fixed, along with

foreign interest rate, foreign price level, and expected future exchange rate

B.

VII. Temporary Changes in Monetary and Fiscal Policy

A. Assume that expected future exchange rates e qual the long-run rate (full

employment and domestic price equilibrium); a temporary policy change does not

affect E​e

B. Also assume that R​*​, P​*​, and P are fixed or uninfluenced by the effects we are

studying
 C. Monetary Policy

1. The short run effect of a temporary increase in M​s​ shifts AA right but does

not affect the position of DD; depreciation of domestic currency,

expansion of output, and increase in employment

D. Fiscal Policy

1. A temporary fiscal expansion (increase in G, a cut in T, or a combination)

causes DD to shift right, but does not move AA; appreciation of currency,

expansion of output, increase in employment

VIII. Inflation Bias and Other Problems of Policy Formulation

A. Fixed nominal prices not only give a government the power to raise output when

it is abnormally low, but may encourage it to create a politically useful economic

boom just before an election

1. This temptation causes problems when workers and firms expect this and

raise wage demands and prices, which then forces the government to use

expansionary tools to prevent the recession that would occur from the rise

in domestic prices

a) Inflation Bias - high inflation, but no average gain in output

B. In practice, it is sometimes hard to be sure of whether a disturbance to the

economy originates in the output or the asset markets

C. Real world policy choices are frequently determined by bureaucratic necessities

rather than detailed consideration; to avoid procedural delays (dealing with

 congress) governments are likely to respond to disturbances with monetary policy

even when fiscal policy would be more appropriate

D. Fiscal policy may lead to a larger government budget deficit which must at some

point be closed by a fiscal reversal

E. Policies take time to have effect in the real world; not to mention the size and

persistence of a given shock may exacerbate the situation

IX. Permanent Shifts in Monetary and Fiscal Policy

A. A permanent policy shift affects not only the current value of the government’s

policy instrument but also the long run exchange rate, which in turn affects

expectations about future exchange rates

1. Assume economy starts out at full employment with the exchange rate at

its long run level with no change in the exchange rate expected; also that

the domestic interest rate must initially equal the foreign rate

B. A permanent increase in the Money Supply

1. A permanent rise in M​s​ causes E​e​ to rise proportionally, this causes a

rightward shift of AA that is greater than that otherwise caused by a

temporary rise, E and Y are both higher than they would have been

otherwise; this is true vice versa

a) Over time, the inflationary pressure that follows a permanent

money supply expansion pushes the price level to its new long run

value and returns the economy to full employment

 (1) Eventually the rising P causes the DD to shift left and the

AA to shift slightly left again as well, they will only stop

when they reach Y​f

C. A permanent Fiscal Expansion

1. Has not only an a immediate impact in the output market, but also affects

the asset market through its impact on long-run exchange rate expectations

2. An increase in G causes DD to shift right, but also causes a long run

appreciation of the currency; the resulting fall in E​e​ causes the AA to shift

left; the currency will have appreciated to E​2​ but output will remain at Y​f

X. Macroeconomic Policies and the Current Account

A. XX Schedule - Combinations of the exchange rate and output at which the current

account balance would be equal to some desired level: CA(EP​*​/P, Y-T) = X

1. Upward sloping, flatter than DD

B. Monetary expansion causes the current account balance to increase in the short

run; expansionary fiscal policy reduces the current account balance

XI. Gradual Trade Flow Adjustment and Current Account Dynamics

A. J-curve - If the current account initially worsens after a depreciation, its time path

has an initial segment reminiscent of a J; the whole thing looks like an S

1. The current account can deteriorate sharply right after a real currency

depreciation; there is some lag time before it begins to increase beyond its

initial point

B. Exchange Rate Pass-Through and Inflation

 1. The percentage by which import prices rise when the home currency

depreciates by 1% is known as the degree of pass-through from the

exchange rate to import prices

a) In the DD-AA model the degree of pass through is 1; any exchange

rate change is passed through completely to import prices

XII. Box: Exchange Rates and the Current Account

A. The net foreign wealth of an economy with a CA deficit is falling over time;

because a country with a CA deficit is transferring wealth to foreigners, domestic

consumption is falling over time and foreign consumption is rising

1. Relative world demand for home goods will fall and the home currency

will depreciate in real terms

XIII. The Liquidity Trap

A. Liquidity Trap - once an economy’s nominal interest rate falls to zero, the central

bank cannot reduce it further by increasing the money supply because at negative

interest rates, people would find money strictly preferable to bonds and bonds

would be in excess supply

Chapter 18 - Fixed Exchange Rates and Foreign Exchange Intervention

I. Central Bank Intervention and the Money Supply

A. Central Bank Balance Sheet and the Money Supply

1. Central Bank Balance Sheet - records the assets held by the central bank

and its liabilities; organized according to the principles of double-entry

bookkeeping
 a) Assets (domestic and foreign) listed on left, liabilities (deposits

held by private banks, currency in circulation) listed on right

(1) Foreign assets - foreign currency bonds; international

reserves

(2) Domestic assets - CB holdings of claims to future payments

by its own citizens and domestic institutions; domestic

government bonds and loans to domestic private banks

b) CBs total assets = total liabilities + net worth (which is assumed to

be zero at present)

(1) This means that changes in bank assets automatically cause

equal changes in bank liabilities

2. When a CB buys assets, the accompanying increase in the money supply

is generally larger than the initial asset purchase because of multiple

deposit creation within the private banking system

a) The money multiplier effect - magnifies the impact of transactions

on the money supply

(1) Any central bank purchase of assets automatically results in

an increase in the money supply and vice versa

B. Sterilization

1. Sterilized foreign exchange intervention - when the CB carries out equal

foreign and domestic asset transactions in opposite directions to nullify the

impact of their foreign exchange operations on the domestic money supply

 a) Ex: it can cancel out the sale of foreign assets with the purchase of

domestic assets

2. If central banks are not sterilizing and the home country has a balance of

payments surplus, for example, any associated increase in the home CBs

foreign assets implies an increased home money supply, and vice versa

II. Stabilization Policies with a Fixed Exchange Rate

A. Monetary Policy - useless

B. Fiscal Policy - shocks and adjustments are magnified

1. Expansionary or contractionary policies are tied with the buying and

selling of foreign assets to keep fixed E

C. Changes in the exchange rate - devaluation or revaluation

III. Balance of Payments Crises and Capital Flight

A. Balance of Payments Crisis - A sharp change in official foreign reserves sparked

by a change in expectations about the future exchange rate; expectation of a future

devaluation is marked by a sharp fall in reserves and a rise in the home interest

rate above the world interest rate, and vice versa

B. Capital Flight - the reserve loss accompanying a devaluation scare; residents flee

the domestic currency by selling it to the central bank for foreign exchange then

invest the foreign currency abroad; foreigners do the same with their holdings of

home country assets

IV. Managed Floating and Sterilized Intervention

A. Perfect Asset Substitutability and the Ineffectiveness of Sterilized Intervention

 1. Perfect Asset Substitutability - when investors don’t care how their

portfolios are divided between two assets, provided both yield the same

expected rate of return

2. Imperfect Asset Substitutability - risk premium differentiation between

assets

a) p = p(B-A)

(1) B = stock of government debt

(2) A = domestic assets of the central bank

Chapter 19 - International Monetary Systems: A Historical Overview

I. Box: Hume versus the Mercantilists

A. Price-specie flow mechanism - Hume

B. Mercantilists - without severe restrictions on international trade and payments,

britain might find itself impoverished and without an adequate supply of

circulating monetary gold as a result of balance of payments deficits

II. Analyzing Policy Options For Reaching Internal and External Balance

A. Maintaining Internal Balance

1. Total Domestic Spending (Domestic Absorption) is denoted by:

a) A = C + I + G

2. The condition of internal balance (full employment equals aggregate

demand) is therefore:

a) Y​f​ = C + I + G + CA(EP​*​/P, A) = A + CA(EP​*​/P, A)

 3. II schedule - shows combinations of exchange rates and domestic

spending that hold output constant at Y​f​ and thus maintain internal balance

4.

B. Maintaining External Balance

1. Assume the government has a target value, X, for the current account

surplus; the goal of external balance requires the government to manage

domestic spending (perhaps through fiscal policy) and the exchange rate:

a) CA(EP​*​/P, A) = X

2. XX schedule - shows the amount of additional spending that will hold the

current account surplus at X as the currency is devalued by a given

amount

Chapter 20 - Optimum Currency Areas and the European Experience

I. The Theory of Optimum Currency Areas

A. GG schedule - the potential gain from joining a currency area

1. Monetary efficiency gain from joining the fixed exchange rate system

equals the joiner’s savings from avoiding the uncertainty, confusion, and

calculation and transaction costs that arise when exchange rates float

2. A high degree of economic integration between a country and a fixed

exchange rate area magnifies the monetary efficiency gain the country

reaps when it fixes its exchange rate against the area’s currencies

B. LL schedule - the potential loss from joining a currency area

1. Economic stability loss - the costs that arise from joining an exchange rate

area, such as the loss of the ability to use exchange rate and monetary

policy for the purpose of stabilizing output and employment

2. A high degree of economic integration between a country and the fixed

exchange rate area that it joins reduces the resulting economic stability

loss due to output market disturbances

 C.

Chapter 21 - Financial Globalization: Opportunity and Crisis

I. The International Capital Market and the Gains from Trade

A. Three types of trade

1. Trades of goods or services for goods or services

2. Trades of goods or services for assets

3. Trades of assets for assets

B. Three types of gains from trade

1. Comparative advantage - exchange of goods and services for goods and

services

2. Intertemporal trade - exchange of goods and services for claims to future

goods and services, i.e. assets

3. International transactions - trades of assets for assets

 C. Risk aversion - all things equal, people dislike risk

D. Portfolio diversification - when an economy is opened to the international capital

market, it can reduce the riskiness of its wealth by placing some of its “eggs” in

additional foreign “baskets;” this reduction in risk is the basic motive for asset

trade

E. Debt instruments - bonds and bank deposits; they specify that the issuer of the

instrument must repay a fixed value regardless of economic circumstances

F. Equity instruments - a share of stock; a claim to a firm’s profits, rather than a

fixed payment, and its payoff will vary according to circumstances

II. International Banking and the International Capital Market

A. The Structure of the International Capital Market

1. Commercial banks - at the center of the international capital market, not

only because they run the international payments mechanism but also

because of the broad range of financial activities they undertake; banks are

often free to pursue activities abroad that they would not be allowed to

pursue in their home countries

2. Corporations - particularly those with multinational operations - routinely

finance their investments by drawing on foreign sources of fund; to obtain

these funds, they may sell shares of stock, which give owners an equity

claim to the corporations assets, or they may use debt finance

3. Nonbank financial institutions - such as insurance companies, pension

funds, mutual funds, hedge funds

 4. Central banks and other government agencies - foreign exchange

intervention

B. Offshore Banking and Offshore Currency Trading

1. Offshore Banking - used to describe the business that banks’ foreign

offices conduct outside of their home countries through three types of

institutions:

a) An agency office - located abroad, which arranges loans and

transfers funds but does not accept deposits

b) A subsidiary bank - located abroad, subject to the same regulations

as local banks but not subject to the regulations of the parent

bank’s country

c) A foreign branch - an office of the home bank in another country,

subject to local and home banking regulations but can take

advantage of cross border regulatory differences

2. Offshore currency trading - bank deposits denominated in a currency other

than that of the country in which the bank resides, usually referred to as

eurocurrencies; dollar deposits located outside the united states are called

eurodollars and banks that accept deposits denominated in eurocurrencies

are called eurobanks

C. Shadow Banking System - nowadays, numerous financial institutions provide

payment and credit services similar to those that banks provide; they have usually

been minimally regulated compared to banks

III. Regulating International Banking

A. Safety Net set-up to reduce the risk of bank failure:

1. Deposit insurance

2. Reserve requirements

3. Capital requirements and asset restrictions

4. Bank examination

5. Lender of last resort facilities

6. Government organized bailouts

B. International Regulatory Cooperation

1. Basel Committee - central bank heads from 11 industrialized countries in

1974

a) Basel 1 - 1988, minimally prudent level of bank capital (8 percent

of assets)

b) Basel 2 - 2004, revised Basel 1

c) Basel 3 - 2010

2. The international activities of nonbank financial institutions are a trouble

spot

a) Increasing securitization and trade in options and other derivative

securities have made it harder for regulators to get an accurate

picture of global financial flows by examining bank balance sheets

alone

IV. Case Study: Moral Hazard

 A. Facilities for emergency financial support to banks or their customers, and curbs

on unwise risk taking by banks are complements, not substitutes

1. The later is very necessary to avoid moral hazard

B. Some institutions are too interconnected to the system, and their failure may cause

a chain reaction to the point that the government will have no choice but to

support it in case it gets into trouble

1. The resulting moral hazard is a vicious cycle: the institution is perceived

to be under the umbrella of government support, it can borrow cheaply

and engage in risky strategy that yield high returns, which allows it to

become even bigger and more interconnected, etc…

V. How Well Have International Finance Markets Allocated Capital and Risk?

A. The Efficiency of Foreign Exchange Market

1. Three types of tests on whether the international capital market is sending

the right signals to markets

a) Tests based on interest parity

b) Tests based on modeling risk premiums

c) Tests for excessive exchange rate volatility