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Economic Modelling
Lecture 18
Exchange Rate:
Purchasing Power Parity
Uncovered Interest Parity
Fixed or Flexible ER?
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Appreciation of Pound
Why is not appreciation of domestic currency
not good for Foreign Investment?
$
 1.85
£ Real 2004
Exchange
Rate
Net capital
outflow
S-I
S  I   T  G  X  M   Net Cap Flow
 X  M   Cap Flow  0
λ
Current A/C bal +capital A/C bal =0
$
 1.45
£ 2001
Net capital inflow NX(λ)
Net export
When £ appreciate you get more $ per £.
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Exchange Rate and the Demand and Supply of Foreign Currency
£
2001:  0.69
$
E1
Exports: X(E,Y*)
Excess supply of FC
Depreciation
E
0.66
A
e
NX
Appreciation
E2
£
2004:  0.53
$
0
Excess Demand for FC Imports: M(E,Y)
F
Demand and supply of Foreign Currency [($) in UK]
Dollar depreciated 23 percent between 2002 and 2004
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Exchange Rate and the Demand and Supply of Foreign Currency
£
2003:  0.63
$
E1
Exports: X(E,Y*)
Excess supply of FC
Depreciation
E
0.66
A
e
NX
Appreciation
E2
£
2004:  0.53
$
0
Excess Demand for FC Imports: M(E,Y)
F
Demand and supply of Foreign Currency [($) in UK]
Dollar depreciated 23 percent between 2002 and 2004
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Musa (1979) ’s seven stylised facts on exchange rates
( from p.486 of the Burda and Wyplosz)
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On daily basis changes in foreign are largely unpredictable.
On month to month basis over 90% are unpredictable, only 10%
predictable.
Countries with high inflation have depreciating currencies. And
the rate of deprecation approximately is equals the differences
in the national inflation rates
Countries with rapidly expanding money supply have
depreciation exchange rates and countries with expanding
money demand have appreciating currencies
In the long run, excess of domestic interest rate over foreign
interest rate equals the expected appreciation of the foreign
currency.
Spot exchange rate tends to overshoot any smoothly adjusting
measure of equilibrium exchange rate
Countries with persistent trade deficits have depreciating
currencies and countries with trade surplus have appreciating
currencies in the long run. This relation is not obvious in the
short run.
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Purchasing Power Parity Theory of the Exchange Rate:
Long Run
*
EP

P
Real Exchange Rate:
Change in the real exchange rate:
Stable real exchange rate implies:
PPP-hypothesis:
t et Pt* Pt
e  
t t P* Pt
t
t
0
t
et
 *

*
*
*












g




g


et


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Purchasing Power Parity Theory : Notations
P* is foreign price level,
P is the domestic price level,
et
et
is the change in the nominal exchange rate
is the nominal exchange rate
 * = foreign inflation,
* = growth rate of money supply abroad,
g*= growth rate of economy abroad;
 = domestic inflation,
 = growth rate of money supply at home,
g = growth rate of income at home
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Fundamentals of A Stable Exchange Rate according to
the PPP Theory
 Change in the exchange rate must equal the
inflation deferential between home and foreign
et

 *
*
*
*

countries. e      g     g 


t
 Inflation both at home and abroad equals
differences in the growth rate of money supply and
growth in money demand due to income growth.
 Liberal economies have free capital mobility: there
is no control in inflow and outflow of capital;
exchange rate is determined endogenously
 weaker economies cannot commit to free capital
mobility and have controls in the mobility of
capital. They fix the exchange rate arbitrarily to
ration the foreign exchange.
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Covered and Uncovered interest parity
Covered Interest Parity (no risk)
i  i*  F  E
E
where F is forward exchange rate, i = domestic interest
rate i* = foreign interest rate, E = actual exchange rate.
Uncovered interest parity condition (interest differences
are due to expected appreciation or depreciation):
E e  Et 
E e  Et
  i  i*  t 1
1 i  1 i* 1 t 1

Et
Et


Compare CIP and UIP Ft  E e is the forward Exchange
t 1
rate










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Impact of Fiscal Policy on the Exchange Rate,
Interest Rate and Output: ISLM Model
IS2
UIP
LM
i
i
i2
i1
IS
i
Y1 Y2 Appreciation E2
Fiscal expansion raises output and
Interest rate and an appreciation
E1
Depreciation
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t
e
*




Purchasing Power Parity: e
t
t
t
Uncovered Interest Parity:
et
it  i 
et
*
t
(1)
(2)
Using the Fisher equation (2) becomes
et
 t  rt    r 
et
*
t
*
t
(3)
Slight rearrangement:
et
 t     rt   rt*
et
*
t
et
0
t  
From PPP
et t
*
t
(4)
r

r
t
t

*
When both PPP and UIP hold exactly the domestic and foreign real
interest rates are equal.
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Depreciation of Dollar or Appreciation of Pounds Between
December 2001 and February 2004
Sterling Pound Appreciated
Et 1  Et
0.53  0.69
AR£ 
 100 = AR£ 
100  23%
Et
0.69
Euro also appreciated
Et 1  Et
0.78  1.11
AR 
 100 = AR 
100  29.7%
Et
1.11
Yen also appreciated
105  128
Et 1  Et
100  18%
ARY 
 100 = ARY 
Et
128
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Triangular Exchange Rates and Appreciation
and Depreciation with respect to the Third Currency
Initial exchange rates
1.11
£0.69
2001
$1
End of 2002
0.98
0.78
£0.63
$1
2002
£0.53
$1
2004
0.53
In 2004 one dollar in terms of pound and Euro is 0.78  0.68
0.63
In 2002 one dollar in terms of pound and Euro is 0.98  0.64
0.69
In 2001 one dollar in terms of pound and Euro is 1.11  0.621
0.68  0.62
 0.0968  9.7%
Appreciation of  against £ (2001-04) =
0.62
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The Problems of Flexible Exchange Rates
The exchange rate can move for many other reasons
than changes in the domestic interest rate.
Expectations play a large role in the determination of
the exchange rate.
Flexible exchange rate may be subject to large
fluctuations which, in turn, require large movements
in the interest rate which can make the economy
unstable.
Exchange rate may overshoot for a long time
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Which countries should have
fixed exchange rates?
 Countries with poor reputation for controlling inflation
 It is better to fix exchange rate with a country with a
heavy trade link
 Country which has relatively little involvement in the
global capital market
 Coutries with high level of foreign reserves.
 Countries with flexible labour market.
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Disadvantages of Fixed Exchange Rate System
Giving up the powerful exchange rate tool for external
stabilisation.
Sacrifice of domestic stability for external balance.
Gives up control of its interest rate, no independent monetary
policy
Widespread speculation of a devaluation or shift to a flexible
exchange rate system particularly when
Economy is with higher inflation
Or the currency is overvalued
Fear of Speculative attacks require an increase in the interest rate.
Frequent devaluation creates uncertainty and overvalued
currency causes BOP problem.
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Benefits and cost of a Monetary Union
and Optimal Liberalisation?
Which countries benefit from a monetary union?
Criteria for an optimal currency area
 Higher Degree of Trade Link
 Common shocks
 Degree of labour mobility
 Degree of fiscal transfers.
Impossible trilogy:
fixed exchange rate
free capital mobility
monetary independence
Optimal Order of Liberalization
1st goods market (subsidies)
2nd Trade (Tariffs)
Financial market (no control on r)
Full convertibility
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References
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Britain in Euro http://www.britainineurope.org.uk/home.phtml
Blanchard (19,20) Mankiw (2) M&S (20)
Dornbusch R. (1976) Expectations and Exchange Rate Dynamics, Journal of Political
Economy, vol. 84, no.6.
Fleming J. Marcus (1962) Domestic financial policies under fixed and under floating
exchange rates, IMF staff paper 9, November , 369-379.
Krugman Paul (1979) A Model of Balance of Payment Crisis, Journal of Money
Credit and Banking, 11, Aug.
Mundell Robert (1961) A Theory of Optimal Currency Areas, American Economic
Review, September.
Mundell R. A (1962) Capital mobility and stabilisation policy under fixed and
flexible exchange rates, Canadian Journal of Economic and Political Science, 29, 47585.
Mussa Micheal Empirical Regularities in the Behaviour of Exchange Rates and
Rogoff, K (1999) "International institutions for reducing global financial instability",
Journal of Economic Perspectives, 1999 or NBER WP 7265.
Rogoff K and M Obstfeld (1996) Foundation of International Macroeconomics, MIT
Press.
Taylor Mark (1995) The Economics of Exchange Rates, Journal of Economic
Literature, March, vol 33, No. 1, pp. 13-47.
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