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Chapter18 Exchange Rates Macroeconomics Chapter 18 1 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 2 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 3 Example: Chinese Yuan 100美元 1000.00 800.00 600.00 400.00 200.00 Macroeconomics Chapter 18 20 09 20 07 20 05 20 03 20 01 19 99 19 97 19 95 19 93 19 91 19 89 19 87 0.00 4 Macroeconomics Chapter 18 5 Different Currencies and Exchange Rates Macroeconomics Chapter 18 6 Different Currencies and Exchange Rates Macroeconomics Chapter 18 7 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 8 Purchasing-Power Parity Macroeconomics Chapter 18 9 Purchasing-Power Parity Macroeconomics Chapter 18 10 Purchasing-Power Parity Macroeconomics Chapter 18 11 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 12 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 13 Purchasing-Power Parity purchasing-power parity ε = Pf/P nominal exchange rate = ratio of foreign price to home price Macroeconomics Chapter 18 14 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 15 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 16 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 17 Macroeconomics Chapter 18 18 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 19 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 20 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 21 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 22 Purchasing-Power Parity Macroeconomics Chapter 18 23 Purchasing-Power Parity Macroeconomics Chapter 18 24 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 25 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 26 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 27 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 28 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 29 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 30 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 31 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 32 Interest-Rate Parity if − (πf)e> i− π foreign 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 33 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 34 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 35 Fixed Exchange Rates Purchasing Power Parity Under Fixed Exchange Rates i f − i = ∆εt/εt Under fixed exchange rates: if = i Macroeconomics Chapter 18 36 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 37 Fixed Exchange Rates Macroeconomics Chapter 18 38 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 39 Fixed Exchange Rates a devaluation, which is a reduction in the value of RMB compared to the dollar. Macroeconomics Chapter 18 40 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 41 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-exchangerate 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 42 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 43 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 44 Extra: Mundell-Fleming Model Open economy NX(e) is net export e is the exchange rate Small country Fixed price Macroeconomics r=rf Chapter 18 45 Extra: Mundell-Fleming Model IS : r=rf Y=C(Y)+I(rf )+NX(e) e Y Macroeconomics Chapter 18 46 Extra: Mundell-Fleming Model r LM: M/P=L(Y,rf ) r=rf e Y Y Macroeconomics Chapter 18 47 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 48 Extra: Mundell-Fleming Model with floating exchange rate LM: M/P=L(Y,rf ) M increases e Y Macroeconomics Chapter 18 49 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 50 Extra: Mundell-Fleming Model with fixed exchange rate e=e* e Y Macroeconomics Chapter 18 51 Extra: Mundell-Fleming Model with fixed exchange rate e=e* M increases ?? e Y Macroeconomics Chapter 18 52 Extra: Mundell-Fleming Model with fixed exchange rate Summary Floating Y e NX Fixed Y e NX Monetary policy M Macroeconomics Chapter 18 53