Download Discussion section 3

160B Discussion 3 (08/23/2007)
1. Exchange rate determination
 How exchange rate is determined in the short run – asset approach.
Money Mkt Equlim
i$
UIP
E$/ euro
PUS , M US , YUS
Money Mkt Equlim
ieuro
PE , M US , YUS
E$e/ euro

Monetary approach
How exchange rate is determined in the long run – monetary approach.
PUS
Money Mkt Equlim
PE
Money Mkt Equlim
i$ , M US , YUS
PPP
E$/ euro
ieuro , M US , YUS
2. Policy analysis in money market and foreign exchange market
(1) A temporary increase in the home money supply
i$
Expected returns
MS1
MS2
i$1
i$1
i$2
i$2
DR1
DR2
FR1
MD
1
M US
1
PUS
2
M US
1
PUS
M US
PUS
E$1/ euro E$2/ euro
E$ / euro
(2) A permanent increase in the home money supply: overshooting model
 Short-run impact
i$
Expected returns
MS1
MS2
i$1
i$1
i$2
i$2
DR1
DR2
MD
1
M US
1
PUS
2
M US
1
PUS
FR1
M US
PUS
E$1/ euro
FR2
E$2/ euro
E$ / euro
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160B Discussion 3 (08/23/2007)

Adjustment to the long-run equilibrium:
i$
Expected returns
MS1
MS2
i$1
i$1
i$2
i$2
DR1
MD
1
M US
M2
 US
1
PUS
PUS2
2
M US
1
PUS
DR2
FR1
M US
PUS
FR2
E$1/ euro E$4/ euro E$2/ euro
E$ / euro
Time path:
M
P
M/P
E
Over Shooting
i
3. Exchange rate regime
(1) Two broad classifications: flexible exchange rate regime vs. fixed exchange rate regime
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160B Discussion 3 (08/23/2007)

Flexible exchange rate case: i exogenous, E endogenous
Interest rate
Expected returns
MS
i
DR
FR
MD
Real balance

E
Exchange rate
Fixed exchange rate case: i endogenous, E exogenous  lose monetary policy autonomy
Interest rate
Expected returns
MS
i
DR
FR
MD
Real balance
E
Exchange rate
Trilemma: among the three objectives exchange rate stability, monetary policy autonomy and
capital mobility, only two are possible at one time.
(2) Exchange rate peg and central bank balance sheet
 When there is excess supply of domestic currency: central bank buys domestic currency in
exchange for foreign currency, losing foreign reserves and reducing money supply – a
simultaneous decrease in the central bank’s assets and liabilities.
 When there is excess demand of domestic currency: central bank sells domestic currency in
exchange for foreign currency, acquiring foreign reserves and increasing money supply – a
simultaneous increase in the central bank’s assets and liabilities.
Central Bank Balance Sheet
Assets: Foreign assets; Domestic assets
Liabilities: Deposits held by private banks; Currency in circulation
(3) An example: how central bank pegs exchange rate when foreign interest rate rises?
i$
Expected returns
MS1
FR2
MD
DR1
FR1
M US
PUS
E$ / euro
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160B Discussion 3 (08/23/2007)
i$
Expected returns
MS2 MS1
DR2
FR2
MD
DR1
FR1
M US
PUS
E$ / euro
4. National income accounting
(1) Y = C + I + G + CA (National Income Identity)
 Y: Gross National Disposable Income (GNDI)
 C: Consumption
 I: Investment
 G: Government Consumption
 CA: Current Account
(2) CA = TB + NFIA + NUT
 TB: Trade Balance
(= total value of export of goods and services – total value of import of goods and services)
 NFIA: Net Factor Income Abroad
(= foreign income payment to domestic factors – domestic income payment to foreign factors)
 NUT: Net Unilateral Transfer
(= gifts received from ROW – gifts granted to ROW)
(3) GDP = C + I + G + TB; GNI = GDP + NFIA; Y = GNI + NUT
GDP: Gross Domestic Product
GNI: Gross National Income
(4) S = Y – C – G = I + CA (Current Account Identity)
S: National Saving
 S is greater than I if and only if CA is positive, or in surplus
 S is less than I if and only if CA is negative, or in deficit
Implication: A current account deficit measures how much a country spends in excess of income
or – equivalently – how it saves too little relative to its investment needs. If we are running a CA
deficit, we are “spending more than we earn”, or we are “saving too little”.
(5) Twin Deficit Hypothesis: tendency for government budget deficit to cause CA deficit.
S = Sp + Sg = (Y – T – C) + (T – G)
Sp: Private Saving
Sg: Government Saving
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160B Discussion 3 (08/23/2007)
By Current Account Identity, CA = S – I = Sp + Sg – I = Sp – Government Deficit – I. All else
equal, an increase in government deficit causes an increase in CA deficit.
5. Balance of payments accounting
(1) BOP = CA + KA + FA = 0 (Balance of Payment Identity)
CA: Current Account
(recording the flow of goods and services, the flow of factor services, and the flow of non-market real resource transfers, i.e. NUT)
KA: Capital Account
(recording the flow of non-market capital transfers)
FA: Financial Account
(recording the flow of financial assets)
(2) BOP Rules
Rule 1: Debit entry vs. Credit entry
 A transaction resulting in a payment to foreigners is recorded as a debit.
 A transaction resulting in a receipt from foreigners is recorded as a credit.
Rule 2: Twelve types of transaction into three accounts (TEXT, Ch 16, P 34)
Rule 3: Double-Entry Principle (implying the BOP Identity)
(3) Decomposition of FA
Way 1:
FA = EXA – IMA (net export of assets)
FA = (EXAH – IMAH) + (EXAF – IMAF) (net export of home assets + net export of foreign assets)
FA > 0 (< 0) means the country is exporting (importing) assets on net, which is referred to as a
financial inflow (financial outflow) or a capital inflow (capital outflow). From BOP Identity we
see that a current account deficit (i.e. CA < 0) can be financed by a financial inflow (i.e. FA > 0).
Way 2:
FA = OSB + NRFA
OSB: Official Settlements Balance
(balance on reserve transaction)
NRFA: Non-Reserve Financial Account
(balance on all other asset transaction)
(4) External Wealth (W)
W = External Assets – External Liabilities
W = ROW Assets Owned by Home – Home Assets Owned by ROW
ΔW = Capital Gains – FA
ΔW = Capital Gains + CA + KA
Implication: a country can increase external wealth in one of three ways:
 through its own thrift (running a CA surplus)
 by the charity of others (running a KA surplus)
 with the help of windfall (positive capital gains)
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