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Midterm 2 topics 1. 2. 3. 4. 5. 6. GDP Cost of living, CPI, Inflation Unemployment Production and growth The financial system: saving and investment The open economy Copyright © 2011 Cengage Learning MIDTERM 2 FRIDAY May 16 TIME & FORMAT •The exam will start at 18:30 •50 multiple choice questions, 60 minutes •Closed book exam •For each question/answer: Correct: 2 pts, Wrong: 0 pts, Unmarked: ½ point •Bring your pocket calculator REVIEW OF PAST MIDTERM •Cihan will do a review sessions at 18.30 in room SOS 103 •He will solve the midterm exam 2013 Copyright © 2011 Cengage Learning Studying for the second midterm o Do the midterms for 2013 and then 2012 (These are already posted on course webpage with answers) o (re)Do the exercise sets o Come to office hours o Go to KOLT o Read the slides o Read the book (last resort if nothing else works) Copyright © 2011 Cengage Learning Make up exam policy • Same format, same topics, same level of difficulty as the regular midterm exam #2 • Must have valid excuse • Will be scheduled either before or during the first days of the final exam period, which is May 22 to June 1 • Email Murat Usman ([email protected]) immediately! • No make up for the make up! Copyright © 2011 Cengage Learning Open-Economy Macroeconomics: Basic Concepts An Open Economy An open economy interacts with other countries in two ways: i. It buys and sells goods & services in world product markets. ii. It buys and sells capital assets in world financial markets. Copyright © 2011 Cengage Learning Exchange Rates Exchange rates are the most important “prices” that determine international trade (exports - imports). There are “two” exchange rates! the nominal exchange rate and the real exchange rate. TL / USD rates, 2012 Jan - April Copyright © 2011 Cengage Learning Exchange Rates What is reported daily in the news media is the nominal exchange rate But, the exchange rate that plays the crucial role in determining net exports is the real exchange rate. Nominal Exchange Rates • The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. e = nominal exchange rate, e is the relative price of domestic currency (say, TL) in terms of a foreign currency (say, US$). Copyright © 2011 Cengage Learning The nominal exchange rate EXAMPLE with TL as the domestic currency against US$: e = 0,55 This means that 1 TL can be exchanged for 0,55 US$ But the current “kur” is 1.80! So what goes on here? The nominal exchange rate can be expressed in two ways: Domestic currency: TL; Foreign currency: US$ 1. In units of foreign currency per 1 unit of domestic currency. We can say e = 0,55 We mean that 1TL = 0,55 US$ 2. In units of domestic currency per 1 unit of the foreign currency. We can say e = 1,80 We mean that 1 US$ = 1,80TL Real Exchange Rates • The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. Copyright © 2011 Cengage Learning The real exchange rate ε = real exchange rate, the lowercase Greek letter epsilon the relative price of domestic goods in terms of foreign goods Real Exchange Rates The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy. If a kilo of Swiss cheese beer is twice as expensive as a kilo of English cheese, the real exchange rate is 1/2 a kilo of Swiss cheese per kilo of English cheese. The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies. Nominal exchange rate Domestic price Real exchange rate = Foreign price Copyright © 2011 Cengage Learning The formula exP Real exchange rate ε = e P P* = nominal exchange rate = domestic price of the good in domestic currency P* = foreign price of the good in foreign currency Home country: Turkey Foreign country: US EXAMPLE WITH ONE GOOD: BIG MAC Example with one good, Le BIG MAC The real exchange rate with the bigmac e x P ε= e = 0,55 (means 1TL = 0,55$) P* P = Price of the Big Mac in domestic country (Turkey) in TL P = 8,45TL P* = Price of the Big Mac in foreign country (US) in US$ P* = $4.37 e x P = 0.55 x 8.45= $ 4,65 (US) The real exchange rate with the bigmac e x P ε= e = 0,55 (means 1TL = 0,55$) P* P = Price of the Big Mac in domestic country (Turkey) in TL P = 8,45TL P* = Price of the Big Mac in foreign country (US) in US$ P* = $4.37 e x P = 0.55 x 8.45= 4,65 price of the Turkish BigMac in US$ Finally ε = (e x P)/ P* = 4,65 / 4,37 = 1,06 Interpreting the Real Exchange Rate The real exchange rate ε = 1,06 means what exactly? 1 Turkish Big Mac = 1.06 U.S. Big Macs This means that … To buy one Big Mac in Turkey a US citizen must pay an amount that could purchase 1.06 Big Macs in the US. Question: Which country has the cheaper Big Mac? One more time: Interpreting the Real Exchange Rate The real exchange rate ε = 1,06 means what exactly? 1 Turkish Big Mac = 1.06 U.S. Big Macs We can say that the “amount of money” that buys one Big Mac in Turkey buys 1.06 Big Macs in the US. THE BIG MAC INDEX AROUND THE WORLD The Big Mac Index Compute the real exchange rate with Norway as the domestic country and US as the foreign country. ε = 1,70 Compute a real exchange rate using a cup of Latte Home country US, foreign country Mexico The price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico Which country has the cheaper latte? What is the nominal exchange rate? e = 10 pesos per $ Calculate the real exchange rate, as the number of Mexican lattes per 1 units of US latte. Please determine which country has the more expensive latte. Answers e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico The price of a US latte in pesos is e x P = (10 pesos per $) x (3 $ per US latte) = 30 pesos per US latte The real exchange rate is… exP 30 pesos per U.S. latte = P* 24 pesos per Mexican latte = 1.25 Mexican lattes per US latte A FIRST THEORY OF EXCHANGE RATE DETERMINATION: PURCHASING POWER PARITY • The purchasing power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates: A unit of any given currency should be able to buy the same quantity of goods in all countries. • The theory of purchasing power parity is based on a principle called the law of one price. According to the law of one price, a good must sell for the same price in all locations. Copyright © 2011 Cengage Learning Basic Logic of Purchasing Power Parity • If the law of one price were not true, unexploited profit opportunities (arbitrage) would exist. • The process of taking advantage of differences in prices in different markets is called arbitrage. Copyright © 2011 Cengage Learning Basic Logic of Purchasing Power Parity • If arbitrage occurs, eventually prices that differed in two markets would necessarily converge. • According to the theory of purchasing power parity, a currency must have the same purchasing power in all countries and exchange rates move to ensure that. ex P=P * ® Purchasing power should be the same exP = 1 ® Modify above (assuming PPP) * P e = 1 ® If PPP holds, real exchange rate should be equal to one Copyright © 2011 Cengage Learning Implications of Purchasing Power Parity • If the purchasing power of the YTL is always the same at home and abroad, then the exchange rate cannot change. • The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries. Copyright © 2011 Cengage Learning Implications of Purchasing Power Parity • When the central bank prints large quantities of money, the money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy. Copyright © 2011 Cengage Learning Limitations of Purchasing Power Parity • Many goods are not easily traded or shipped from one country to another. • Tradable goods are not always perfect substitutes when they are produced in different countries. Copyright © 2011 Cengage Learning