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Summary of Impacts of Changes in Various Variables on FOREX Rates Grand Summary of Short-Run, Medium-Term and Long-Run Impact of Various Shocks on FOREX Rates[Document title] Causes Time Horizon (Second Round) E↑ MediumTerm (transition to the new Long-run eq.) Trade Trade FOREX FOREX rate Note Balance 1) External Real Shocks to Domestic Economy: International Demand for X falls (due to Yf↓) Internation Short-Run X↓ X-M↓ Supply E↑ al Economy Trade Down Down (a) X ↑, X-M ↑ Supply Up E starts ↓ M↓ (if MarshallLerner Conditio n holds) Note that at (b) may partially offset (a) with “Cushioning Effect”. 2) Domestic Money Market Shocks: Expansionary Monetary Policy (MS ↑) MS ↑ and S-R M↑ X-M ↓ or Excess E↑ thus Y ↑ Trade Trade Demand Account↓(c) (b) *A secondary Rebounding/ Cushioning Effect i ↓due to S-R Capital Financial Excess E↑ Liquidity International Outflows Account↓(d) Demand Effect Investment Above-the- S-R Sum of (c ) E↑ ↑ line BP Combined and (d) (c ) +(d) (c ) + (d) = Above-the-line Balance of Payment; Note that both (c ) and (d) deteriorate. (Second M-T to new X ↑, M↓ X-M ↑ Supply Up E starts↓ Round) LR eq. iff A secondary/ E↑ MarshallCushioning Lerner Effect Conditio n holds Note that at the beginning, (b) <(a); and then in the Long-run, (b) may partially offset (a) with “Cushioning Effect”. P↑ LR Unchang Unchanged E↑ due to In MV = P y (PPP) ed X or X-M E = P/Pf : for M(S) ↑ M Absolute Version of ,or Purchasing π↑ in π=%M-% y + %V for continuous Money Creation In L-R, i ↑ due to Inflation Expectations Effect; i>if but No Capital Inflows; Interest Parity Theorem saying i-if merely reflects %Ee (+ve or ↑) Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the same reasoning. 3) Domestic Goods Market Shocks: Expansionary Fiscal Policy G ↑ and S-R M↑ X-M ↓ Demand thus Y ↑ Trade Trade ↑ E↑ Account(e) ↓ i ↑due to S-R Capital Domestic CrowingInternational Inflows Financial Supply ↑ E↓ Investment ↓ Out Effect Investment ↑ Account (f) due to ↑ Crowding Out BP ( e+ f) Sum of (e ) E? and (f) = ? S↑-D ↑ uncertain uncertain =? uncertain Note that in the Above-the-Line BP, (e ) and (f) work against each other on E; Net impact of G on E is ambiguous. Secondary MT to new LR uncertain uncertain uncertain uncertain adjustment eq. E ↑ or ↓ P↑ LR E↑ due to iff G is E = P/Pf ‘monetized’: Absolute when Bonds Version of are sold to Purchasing Central Bank: Power iff G = M or Parity π↑ LR %E ↑ = iff G = M ↑– f Relative Version of Purchasing LR (PPP) Unchangi ng X or M Unchanging X-M Power Parity %E ↑ due to relative version of Purchasing Power Parity Purchasing Power Parity Power Parity Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the same reasoning. Causes Time Horizon Trade Trade FOREX FOREX rate Note Balance 4) International Money Market Shocks: U.S. Expansionary Monetary Policy (MSf↑) MSf ↑ and S-R X↑ X-M ↑ or Excess E↓ thus Yf ↑ Trade Trade Supply Account↑(c) If due to Liquidity Effect S-R International Investment Capital Inflows Above-theline BP (c ) +(d) (Second Round) E↓↓ S-R Combined M-T to new LR eq. X↓ , M↑ Financial Account↑ (d) Excess Supply E↓ (c ) + (d) ↑↑ Excess Supply E↓↓ Supply down E starts ↑ X-M ↓ A secondary/ Cushioning Effect Note that at the beginning, (b) <(a); and then in the Long-run, (b) may partially offset (a) with “Cushioning Effect”. Pf ↑ LR Unchang Unchanged E↓ due to In Mf Vf = Pf Trade ed X or X-M E = P/Pf : yf for M(S)f PPP M Absolute ↑ Version of Purchasing Power or Parity πf ↑ Unchangi Unchanging %E ↓due In L-R, if ↑ in LR ng X-M due to to relative X or M Inflation πf=%Mf-% Trade version of PPP Expectations Purchasing yf + %Vf Effect; LR Power for I<if but No Parity continuous Capital Purchasing Money Outflows; Power Creation Interest Parity Parity Theorem saying i-if merely reflects %Ee (-ve, or ↓) Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the same reasoning. 5) Inrternational Money Market Shocks: U.S. Expansionary Fiscal Policy Gf ↑ and S-R X↑ X-M ↑ Supply↑ thus Yf ↑ Trade Trade E↓ Account(e) ↑ If ↑due to S-R Capital U.S. International Outflows Financial Demand E↑ CrowingInvestment Account (f) ↑ Out Effect ↓ BP ( e+ f) E? uncertain Note that in the Above-the-Line BP, (e ) and (f) work against each other on E; Net impact of Gf on E is ambiguous. Secondary MT to new LR uncertain uncertain uncertain uncertain adjustment eq. E ↑ or ↓ Pf ↑ LR E ↓due to iff Gf is Trade E = P/Pf ‘monetized’: PPP Absolute when Bonds VersPurchas are sold to ing Power Central Bank: or Parity iff Gf = Mf πf ↑ LR %E ↓ due iff Gf is Trade to relative ‘monetized’: PPP version of when Bonds Purchasing are sold to Power Central Bank: Parity iff Gf = Mf Note: Use only one of the two above versions of Purchasing Power Parity for LR; both lead to the same reasoning. 6) Real Factor Theory: Technical Innovations in Tradable Sector Only Price of Tradable goods↓ (PT↓) PPP X↑ FOREX Supply↑ E↓ holds → Technical Innovation only in Tradable Sector EPfT/PT=1 Price of Non-Tradable goods↑ PPP does not hold (PNT↑) No change in Overall Price Level Ratio, or small fall (P = PT + PNT) Pf/P more or less constant, or small fall Partial PPP q=E*Pf/P ↓