Macroeconomics Chapter 18 1 Exchange Rates C h a p t e r 1 8
Macroeconomics Chapter 18 1
Exchange Rates
C h a p t e r 1 8
Macroeconomics Chapter 18 2
Different Currencies and Exchange Rates
Each country issues and uses its own currency, instead of using a common currency.
To keep things simple, pretend that there are only two countries.
Think of the home country as the United States and the foreign country as China.
The China nominal quantity of money, Mf, is measured in RMB. The U.S. nominal quantity of money, M, is in Dollars.
Macroeconomics Chapter 18 3
Different Currencies and Exchange Rates
Exchange market, on which participants trade the currency of one country for that of another.
the nominal exchange rate is the number of RMBs received for each dollar.
Let ε denote the nominal exchange rate between RMBs and dollars.
Macroeconomics Chapter 18 4
Example: Chinese Yuan
100美元
0. 00
200. 00
400. 00
600. 00
800. 00
1000. 00
Macroeconomics Chapter 18 5
Macroeconomics Chapter 18 6
Different Currencies and Exchange Rates
Macroeconomics Chapter 18 7
Different Currencies and Exchange Rates
Macroeconomics Chapter 18 8
Purchasing-Power Parity
Sometimes countries allow their nominal exchange rates to move freely in response to market forces. These systems are called flexible exchange rates.
In other circumstances, countries try to maintain a constant nominal exchange rate with respect to another currency, often the U.S. dollar. These systems are called fixed exchange rates.
Macroeconomics Chapter 18 9
Purchasing-Power Parity
Macroeconomics Chapter 18 10
Purchasing-Power Parity
Macroeconomics Chapter 18 11
Purchasing-Power Parity
Macroeconomics Chapter 18 12
Purchasing-Power Parity
The PPP Condition and the Real Exchange Rate The U.S. price level, P, is measured in dollars
per unit of goods. We denote the Chinese price level (or foreign price level) by Pf , measured in RMB per unit of goods.
Assume that the goods produced and used in both countries are physically identical.
We also ignore any transportation or other transaction costs for buying and selling goods in the two countries.
Macroeconomics Chapter 18 13
Purchasing-Power Parity The PPP Condition and the Real
Exchange Rate
1/P = ε·(1/Pf)
quantity of goods that can be bought in U.S. = quantity of goods that can be bought in China
Macroeconomics Chapter 18 14
Purchasing-Power Parity
purchasing-power parity
ε = Pf/P
nominal exchange rate = ratio of foreign price to home
price
Macroeconomics Chapter 18 15
Purchasing-Power Parity
The PPP Condition and the Real Exchange Rate purchasing-power parity (PPP). This condition means that the
purchasing power in terms of goods for dollars (or RMB) is the same regardless of whether households buy goods in the United States or China.
Macroeconomics Chapter 18 16
Purchasing-Power Parity
什么时候 PPP Condition 不一定成立?
各国产品不一样。(想一想,上海的麦当劳和波恩的麦当劳产品真的是一样的吗?)
非贸易商品的存在。(例如,住房)
Macroeconomics Chapter 18 17
Purchasing-Power Parity
The PPP Condition and the Real Exchange Rate real exchange rate= (ε/Pf) / (1/P)
real exchange rate is the ratio of goods that can be bought in China (say, with $1) to goods that can be bought in the United States (also with $1).
Macroeconomics Chapter 18 18
Macroeconomics Chapter 18 19
Purchasing-Power Parity
GDP的国际比较
中国 2004年的名义人均 GDP是 12336元按照 1 : 8 计算,折合 1542美元这样的计算有什么问题?
如果考虑 PPP呢?这样的计算又有什么问题?
Macroeconomics Chapter 18 20
Purchasing-Power Parity
The PPP Condition in long run ε = Pf/ P
real exchange rate= ε/(Pf/P) 1
预测一下人民币汇率的走势: 4.3 1 ε 下降 Pf/P 上升
Macroeconomics Chapter 18 21
Purchasing-Power Parity
growth rate of Pf/P = ∆Pf/Pf − ∆P/P
growth rate of Pf/P = πf − π
growth rate of real exchange rate = ∆ε/ε − (πf − π ) E.g. 30years from 4.3 to 1 implies -4.8%
Macroeconomics Chapter 18 22
Purchasing-Power Parity
The Relative PPP Condition purchasing-power parity, relative form:
∆ε/ε = πf − π
growth rate of nominal exchange rate = foreign inflation rate− home
inflation rate
Macroeconomics Chapter 18 23
Purchasing-Power Parity
Macroeconomics Chapter 18 24
Purchasing-Power Parity
Macroeconomics Chapter 18 25
Interest-Rate Parity
Option 1: Hold U.S. bond dollars received in year t+ 1 = 1 + i
Option 2: Use exchange market and hold Chinese bond dollars received in year t+ 1 =
εt·(1+if)/εt+1
Macroeconomics Chapter 18 26
Interest-Rate Parity
1+i =εt·(1+if)/εt+1
return on holding U.S. bond = return on using exchange market
and holding Chinese bond
Macroeconomics Chapter 18 27
Interest-Rate Parity
1+if = (1+ i) · (εt+1/εt )
The growth rate of the nominal exchange rate is ∆εt/εt = (ε t+1− ε t)/εt
∆εt/εt = (ε t+1/εt )− 1
1 + i f = (1 + i)·(1 + ∆εt/ε t)
Macroeconomics Chapter 18 28
Interest-Rate Parity
i f − i = ∆εt/εt
interest-rate differential= growth rate of nominal exchange rate
i f − i = ∆(εt/εt)e
Macroeconomics Chapter 18 29
Interest-Rate Parity
Real interest-rate
∆ε/ε = πf− π
In terms as expected rates of change:
∆(εt/εt)e= (πf)e−πe
Macroeconomics Chapter 18 30
Interest-Rate Parity
if − i = (πf)e−πe
interest-rate differential = difference in expected inflation rates
if − (πf)e= i− πe
foreign expected real interest rate = home expected real interest rate
Macroeconomics Chapter 18 31
Interest-Rate Parity
real exchange rate= ε/(Pf/P) If it is smaller than 1: The expected growth rate of the
nominal exchange rate, (∆εt/εt) e , must be greater than the expected growth of Pf/P, which equals the difference between the expected inflation rates, (πf)e − πe
Macroeconomics Chapter 18 32
Interest-Rate Parity
Instead of the equality in equation we have the inequality:∆(εt/εt)e> (πf)e− πe
If we substitute this inequality into the interest-rate parity condition in equation
if − i > (πf)e− πe
Macroeconomics Chapter 18 33
Interest-Rate Parity
if − (πf)e> i− πforeign expected real interest rate > home expected real interest rate
i.e., we expect that the price level in those countries whose real exchange rate smaller than 1 will decreases.
Macroeconomics Chapter 18 34
Fixed Exchange Rates
The fixed-exchange-rate regime that applied to most advanced countries from World War II until the early 1970s was called the Bretton Woods
Under this system, the participating countries established narrow bands within which they pegged the nominal exchange rate, ε, between their currency and the U.S. dollar.
Each country’s central bank stood ready to buy or sell its currency at the rate of ε units per U.S. dollar.
Macroeconomics Chapter 18 35
Fixed Exchange Rates
Purchasing Power Parity Under Fixed Exchange Rates ε = Pf/P Pf = εP if the nominal exchange rate, ε, is
fixed, πf = π
Macroeconomics Chapter 18 36
Fixed Exchange Rates
Purchasing Power Parity Under Fixed Exchange Rates i f − i = ∆εt/εt
Under fixed exchange rates: if = i
Macroeconomics Chapter 18 37
Fixed Exchange Rates
The Nominal Quantity of Money Under Fixed Exchange Rates
Mf = Pf· L(Yf,if)
Pf = εP.
Mf = ε P · L(Yf, i)
Macroeconomics Chapter 18 38
Fixed Exchange Rates
Macroeconomics Chapter 18 39
Fixed Exchange Rates
Two possible results of increasing M under
fixed exchange rate regime:
1. The decline of the international reserves, even devaluation.
2. Trade barriers to limit free trade.
Macroeconomics Chapter 18 40
Fixed Exchange Rates
a devaluation, which is a reduction in the value of RMB compared to the dollar.
Macroeconomics Chapter 18 41
Fixed Exchange Rates
Devaluation and Revaluation An appreciation of the Chinese
currency—an increase in 1/ε, the number of dollars that exchange for each yuan— is called a revaluation.
Macroeconomics Chapter 18 42
Flexible Exchange Rates
Since the early 1970s, most advanced countries have allowed their currencies to vary more or less freely to clear the markets for foreign exchange.
The difference from the fixed-exchange-rate setup is that the nominal exchange rate, ε, is not a fixed number. Because of adjustments of ε in a flexible-rate regime, Pf need not move in lockstep with P even if the absolute PPP condition always holds.
Macroeconomics Chapter 18 43
Fixed and Flexible Exchange Rates: A Comparison
An extreme form of fixed nominal exchange rate is a common currency.
a fixed-exchange rate system precludes an independent monetary policy, at least in the long run.
Macroeconomics Chapter 18 44
Fixed and Flexible Exchange Rates: A Comparison
One advantage of a flexible nominal exchange rate is that it introduces an additional way to satisfy the PPP condition, Pf = εP
The independence of monetary policy under flexible exchange rates is not always desirable.
Macroeconomics Chapter 18 45
Extra: Mundell-Fleming Model
Open economy NX(e) is net export
e is the exchange rate
Small country r=rf
Fixed price
Macroeconomics Chapter 18 46
Extra: Mundell-Fleming Model
IS : r=rf Y=C(Y)+I(rf)+NX(e)
e
Y
Macroeconomics Chapter 18 47
Extra: Mundell-Fleming Model
LM: M/P=L(Y,rf)
e
Y
r
Y
r=rf
Macroeconomics Chapter 18 48
Extra: Mundell-Fleming Model
IS : r=rf Y=C(Y)+I(rf)+NX(e) LM: M/P=L(Y,rf) e
Y
Macroeconomics Chapter 18 49
Extra: Mundell-Fleming Model with floating exchange rate
LM: M/P=L(Y,rf) M increases
e
Y
Macroeconomics Chapter 18 50
Extra: Mundell-Fleming Model with floating exchange rate
M increases
Closed economy: r decreases and Investment rises. Y increases.
Open economy: r is fixed, hence, capital flows out. e decreases and net export rises. Y increases.
Macroeconomics Chapter 18 51
Extra: Mundell-Fleming Model with fixed exchange rate
e=e*
e
Y
Macroeconomics Chapter 18 52
Extra: Mundell-Fleming Model with fixed exchange rate
e=e* M increases ?? e
Y
Macroeconomics Chapter 18 53
Extra: Mundell-Fleming Model with fixed exchange rate
Summary
Floating Fixed
Y e NX Y e NX
Monetary policy M