Macroeconomics Chapter 181 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


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.



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.


Example: Chinese Yuan

100美元

0. 00

200. 00

400. 00

600. 00

800. 00

1000. 00







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.









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.


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



purchasing-power parity

ε = Pf/P

nominal exchange rate = ratio of foreign price to home

price



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.



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）



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).




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？



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



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%



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






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



1+i =εt·(1+if)/εt+1

return on holding U.S. bond = return on using exchange market

and holding Chinese bond



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)



i f − i = ∆εt/εt

interest-rate differential= growth rate of nominal exchange rate

i f − i = ∆(εt/εt)e



Real interest-rate

∆ε/ε = πf− π

In terms as expected rates of change:

∆(εt/εt)e= (πf)e−πe



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



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



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



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.


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.



Purchasing Power Parity Under Fixed Exchange Rates ε = Pf/P Pf = εP if the nominal exchange rate, ε, is

fixed, πf = π



Purchasing Power Parity Under Fixed Exchange Rates i f − i = ∆εt/εt

Under fixed exchange rates: if = i



The Nominal Quantity of Money Under Fixed Exchange Rates

Mf = Pf· L(Yf,if)

Pf = εP.

Mf = ε P · L(Yf, i)





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.



a devaluation, which is a reduction in the value of RMB compared to the dollar.



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.


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.


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.


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.


Extra: Mundell-Fleming Model

Open economy NX(e) is net export

e is the exchange rate

Small country r=rf

Fixed price



IS : r=rf Y=C(Y)+I(rf)+NX(e)

e

Y



LM: M/P=L(Y,rf)

e

Y

r

Y

r=rf



IS : r=rf Y=C(Y)+I(rf)+NX(e) LM: M/P=L(Y,rf) e

Y


Extra: Mundell-Fleming Model with floating exchange rate

LM: M/P=L(Y,rf) M increases

e

Y


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.


Extra: Mundell-Fleming Model with fixed exchange rate

e=e*

e

Y



e=e* M increases ?? e

Y



Summary

Floating Fixed

Y e NX Y e NX

Monetary policy M

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Macroeconomics Chapter 181 Exchange Rates C h a p t e r 1 8