1. Lecture 18 1
Macroeconomic Analysis 2003
Exchange Rate:PPP, UIP and CIP
Theories of exchange rate
Advantages and disadvantages of fixed and
flexible exchange rate system
Impacts of Fiscal and Monetary Policy in fixed
and Flexible Exchange rate system
(Readings: (Miles & Scott 9,18) or Blanchard (18-21) or
Mankiw(12))

2. Lecture 18 2
Fundamental Macroeconomic Identity for an open economy
Main Features of an open economy
a. exports and imports with the rest
of the world
b. Capital inflow and outflow
c. Exchange rate system
Fixed -pegged
Flexible –floating
d. External shocks affect income
and employment at home – risks
e. Exchange rate stability
arrangements –(monetary union,
dollarisation)
f. Policy coordination
Aggregate demand in an open economy
Income = demand
Economy wide saving = Trade balance
Balance of payment condition
Current account +capital account =0

3. Lecture 18 3
Three GAPs: Investment-Saving, Budget and Trade Gaps
i
Saving and Investment
I(r)
S(Y)
TrwLrKXGICMTSCYcall ++=+++=+++=:Re
( ) ( )
FlowCapNX
MXGTIS
==
−=−+−
IS >
Private saving +public saving
= net export
IS <
0>NX
Trade Surplus
Trade deficit
0<NX
0
i
0=−GT
K-outflow
K-inflow

4. Lecture 18 4
NX(λ)
λ
Real
Exchange
Rate
Net export
45.1
£
$
=
60.1
£
$
= S-I
Net capital
outflow
( ) ( ) FlowCapMXIS =−−−
Net capital inflow
Why is not appreciation of domestic currency
not good for Foreign Investment?
( ) 0=+− FlowCapMX

5. Lecture 18 5
Exchange Rate and the Demand and Supply of Foreign Currency
E
F
Demand and supply of Foreign Currency
Exports: X(E,Y*)
Imports: M(E,Y)
0
E1
E2
Depreciation
Appreciation
Excess Demand for FC
Excess supply of FC
A
69.0
$
£
=
63.0
$
£
=
2002:
2003:
0.66
NX
e

6. Lecture 18 6
Sterling Pound
=
Euro also appreciated
=
Euro also appreciated
=
Depreciation of Dollar against Pound
or Appreciation of Pounds against dollar in 2002

7. Lecture 18 7
Initial exchange rates End of 2002
∈1.11 ∈0.98
£0.69 $1 £0.63 $1
2001 2002
In 2002 one dollar in terms of pound and Euro is
In 2001 one dollar in terms of pound and Euro is
This implies that Euro has become stronger by 0.021
percent (0.64 - 0.621) against the pound.
Triangular Exchange Rates and Appreciation
and Depreciation with respect to the Third Currency

8. Lecture 18 8
0
+
-
Y
Y
0
AD
Trade
balance
Keynesian Open Economy Model
How an Expansion in Income causes Trade Deficit?
)
*
,,(),()(
P
ePf
YYNXG
e
iYITYCY ++−+−= π
X=X0
M=M(Y)
Surplus
Deficit

9. Lecture 18 9
Derivation of Net Exports and Investment Saving in an Open Economy
ΔNX
AD
Y
e
Y1 Y2
e2
e1 IS*(e)
y1 Y2
AD
NX (e)
NX2 NX1
(a)
(b)
(c)
Note:
Shows reduction in AD
ollowing an increase in ER
b) Shows investment saving
Balance in an open economy
c) Shows net export as
a function of the exchange
ate

10. Lecture 18 10
IS-LM Model in an Open Economy
IS*
e*
LM (y, i)
Output
Exchange
Rate
o y

11. Lecture 18 11
Impact of Fiscal Policy under Fixed and Flexible Exchange Rate Systems
IS*
IS*’
e1
e2
Y
No Impact of Fiscal Policy under
Flexible Exchange Rate System
LM LM1
LM2
Effectiveness of Fiscal Policy
Under the Fixed Exchange Rate System
Y1 Y2
e
IS*
IS*’

12. Lecture 18 12
Impact of Monetary Policy under Fixed and Flexible Exchange Rate Syste
IS*
IS*’
e1
e2
Effectiveness of Monetary Policy
under Flexible Exchange Rate
System
LM LM1
LM2
Ineffectiveness of monetary Policy
Under the Fixed Exchange Rate System
Y1 Y2
e
IS*
Y1 Y2

13. Lecture 18 13
Macro Indicators and Trade Balances December 2002
Macro Economic Indicators UK EURO-
Area
USA Japan
Budget deficit as % of GDP -1.4 -2.2 -3.1 -7.9
Inflation rate (% change in CPI) 2.1 2.2 2.6 -0.9
Interest rate (% per year on
3-month money market)
3.97 2.94 1.34 0.02
Trade balance (in billion US $) -49.0 95.6 -456.6 89.3
Current Account balance
(in billion US $)
25.8 38.0 -462.2 113.9
Exchange rate (per US $) 0.63 0.98 1 121
Growth rate of GDP (annual %) 1.8 0.8 3.2 1.3
Growth rate of money supply
(%)
5.8 7.0 6.6 3.2

14. Lecture 18 14
Macro Economic Indicators UK EURO-
Area
USA Japan
Budget deficit as % of GDP 1.1 -1.2 0.6 -6.0
Inflation rate (% change in
CPI)
1.6 2.1 2.2 -0.8
Unemployment rate (%) 5.2 8.1 5.6 5.3
Interest rate (% per year on
3-month money market)
3.97 3.35 1.84 0.02
Trade balance (in billion US
$)
-47.2 24.9 -438.9 74.9
Current Account balance
(in billion US $)
17.7 -31.2 -430.7 3.2
Exchange rate (per US $) 0.69 1.11 1 128
Growth rate of GDP (annual
%)
2.2 1.3 0.6 -0.5
Growth rate of money supply
(%)
8.2 8.0 14.0 3.2
MacroIndicators2001
Macro Indicators and Trade Balances
2003

15. Lecture 18 15
Exchange Rate of Sterling Pound with Dollar, Euro and Yen
$/£
Y/£
1975 1985 1995 2000 2002 2003
US$ 2.22 1.298 1.578 1.515 1.44 1.6
Eff. Rate 129.6 111.3 84.8 107.5 107.3
Euro-area 1.697 1.71 1.191 1.642 1.63 1.46
Yen 658.1 307.1 148.4 163.3 191 188
Value of one US Dollar in Terms of Local Currency
Ghana India Italy Brazil Turkey UK
1955 0.7146 4.764 625 4.3E-11 2.831 0.3571
1965 0.7146 4.763 625.1 2E-09 9.102 0.3571
1975 1.15 8.653 652.8 8.1E-09 14.44 0.452
1985 54.37 12.24 1909 6.2E-06 522 0.7792
1990 326.3 17.95 1198 0.0683 2609 0.5632
2000 5231 45.7 2101 1.8 625,208 0.7
Source: http:/www.worldbank.org/data/countrydata/countrydata.htm,
And Penn World Table.

16. Lecture 18 16
Competitive Open Economy Need Right Exchange Rate
• Overvalued exchange rate reduces volume of exports
and raises volume of imports
• Overvalued exchange rate raises the production cost
• A stable exchange rate is helpful for investors
• Macro fundamentals for right exchange rates
– Balanced government budget over time
– balanced trade over time
– Reasonable domestic and external debt ratios
– Controlled money supply
– Positive real interest rate

17. Lecture 18 17
Real exchange rate :
PPP-hypothesis:
Where P* is foreign price level, P is the domestic price
level, is the change in the nominal exchange rate is
the nominal exchange rate = foreign inflation, =
growth rate of money supply abroad, = growth rate of
economy abroad; = domestic inflation, = growth rate
of money supply at home, = growth rate of income at
home
Purchasing Power Parity Theory of the Exchange Rate: Long Run

18. Lecture 18 18
Since
Similarly for Euro
PPP is Valid in the Long run
PPP is not valid in the short run 2001- 2002
Ghana India Italy Brazil Turkey UK
1955 0.7146 4.764 625 4.3E-11 2.831 0.3571
1965 0.7146 4.763 625.1 2E-09 9.102 0.3571
1975 1.15 8.653 652.8 8.1E-09 14.44 0.452
1985 54.37 12.24 1909 6.2E-06 522 0.7792
1990 326.3 17.95 1198 0.0683 2609 0.5632
2000 5231 45.7 2101 1.8 625,208 0.7

19. Lecture 18 19
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
countries.
• 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.

20. Lecture 18 20
Covered and Uncovered interest parity
Covered Interest Parity (no risk)
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):

Compare CIP and UIP is the forward Exchange
rate

21. Lecture 18 21
i
Y1
i
E1
LM
IS
i1
IS2
i2
E2
Appreciation
Depreciatio
n
UIP
Impact of Fiscal Policy on the Exchange
Rate,
Interest Rate and Output: ISLM Model
Y2
i

22. Lecture 18 22
Uncovered Interest Parity Theory of the
Exchange Rate
Rates of returns (interest rates) across countries are
equalised once expected exchange rate changes are
taken into account.
Exchange rate expected in the next period.
Applying rule of log for small numbers it can be
written as
;
• Adjustment in interest parity condition: domestic
interest rate must be equal to foreign interest plus
the expected change in the value of the currency.

23. Lecture 18 23
Appreciation or Depreciation of Currency According to the
Differences in the Domestic and Foreign Interest Rates
 
Higher domestic interest rate => higher demand for
domestic currency => currency appreciates to make
up the difference
Higher foreign interest rate => more demand for
foreign currency and less demand for domestic
currency => currency will depreciates.
If currency is expected to depreciate in the next
period, exchange rate will be higher today.

24. Lecture 18 24
Purchasing Power Parity: (1)
Uncovered Interest Parity: (2)
Using the Fisher equation (2) becomes
(3)
Slight rearrangement:
(4)
From PPP 
When both PPP and UIP hold exactly the domestic and foreign real
interest rates are equal.

25. Lecture 18 25
Like the PPP, UIP is also valid only in the long run
Compare the interest rates and Exchange Rates between 2001 and 2002

26. Lecture 18 26
Exchange Rate Systems: Capital Mobility
• Flexible exchange rates: The UK, U.S. and
Japan, EURO: Free Mobility of Capital
• Fixed exchange rates: Controlled Mobility
- Gold standard (19 th and early 20th
century)
-Pegs: Setting the exchange rate to the dollar
or some other currencies. Adjust by ( revaluation
and devaluation. Franco-phone countries in
Africa now peg to Euro
-Crawling Peg: Setting an exchange rate target
(allowed change in narrow bands)
• Monetary union (Single Currency, Free Mobility
of Capital): EURO

27. Lecture 18 27
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

28. Lecture 18 28
• 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.
Which countries should have
fixed exchange rates?

29. Lecture 18 29
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.

30. Lecture 18 30
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.
Benefits and cost of a Monetary Union and
Optimal Liberalisation?
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

31. Lecture 18 31
Given these theories of Exchange Rate
Should UK join the European
Monetary Union?
Five Economic Tests: Issues for Referendum
1. Cyclical Convergence
2. Flexibility
3. Investment
4. Financial Services
5. Employment and Growth
What Do YOU Think?

32. Lecture 18 32
Exercises
Triangular exchange rate
Real and nominal exchange rates
Trade weighted exchange rate
Exchange rate changes according to the PPP
Exchange rate according to the UIP
Relation between fiscal and monetary policy and the
exchange rate
Advantages and disadvantages of joining the
monetary union.