Welcome to EC 382: International Economics By: Dr. Jacqueline Khorassani

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Welcome to EC 382 International EconomicsBy
Dr. Jacqueline Khorassani

• Week Eleven

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Week Eleven Class 1

• Tuesday, November 13
• 1410-1500AC 202

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I received a question

• Can you please explain again with some examples
  the open market operations? thank you

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Answer

• Bank of Ireland has some government bonds.
• If the central bank wants to increase the supply
  of money
  
• Offer higher than normal prices for bonds
• Bank of Ireland sell their 1000 bond to the
  central bank
  
• Central bank makes a 1000 deposit into their
  Bank of Ireland Reserve Account at the central
  bank.
  
• Bank of Irelands reserves goes up? Bank of
  Ireland make more loans? that means the people
  (borrowers) will have more money in their
  checking accounts (borrowed) ? M1 goes up ?MS
  goes up

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The central bank supplies money. Who demands
money?

• Firms
• individuals

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Why do we demand money (M1)?

• To buy goods and services.
• Transactions demand for money
• Varies directly with nominal GDP
• In case of emergencies that require purchases
  above normal spending levels
  
• Precautionary demand for money
• 3) As an asset

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Three motivations for holding money combine to
create the aggregate demand for money

• If interest rates go up, do we demand more or
  less money?
  
• Less
• interest rate is the opportunity cost of holding
  money
  
• If the price level goes up, do we demand more or
  less money?
  
• More
• need more money to cover our purchases

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• If our income goes up, will we demand more or
  less money?
  
• More
• Can afford to buy more goods and services
• Money demand related to interest rate, price
  level and real income as
  
• MD f(-i, P, Y)
• i Interest rate
• P Price level
• Y Real GDP

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Money Demand Curve
Shows the relationship between interest rate and
the quantity of money demanded holding everything
else constant
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What shifts the Money Demand Curve?
D1
Increase to D1 if P? or Y?
D2
Decrease to D2 if P? or Y?
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The Equilibrium Interest Rate The Interaction
of Money Supply and Money Demand
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How does an increase in the price level affect
the interest rates?
G
E
MD ? i?
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How does a economic recession affect the interest
rate?
MD? i?
E
F
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How does an open market sale by the central bank
affect the interest rate?
MS ? i? This is a contractionary monetary policy
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Another Question

• I'm trying to understand the example in page 329
  about appreciation and depreciation but I think
  there's something wrong in it. Can you do it in
  class?

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My answer

• Let go over it together

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How does the interest rate relate to the
exchange rate?

• Interest Arbitrage
• Relationship between interest rates and the
  exchange rate in the short run

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International Economics

• Week Eleven Class 2
• Wednesday, November 14
• 1110-1200
• Tyndall

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Final Exam

• Is a 2 hour exam
• Covers everything
• Chapters 1 through 8
• Chapters 11, 13, 14, and 15
• Notes/Slides/Assignments
• Has 3 parts
• 15 MCQ (3 points for correct answers and -0.5
  point for incorrect answers.)? total 45 points
  
• Choose 2 of 4 essay questions for 20 points each
  ? total 40 points
  
• Three problems? total 65 points

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Remember yesterdays question

• I'm trying to understand the example in page 329
  about appreciation and depreciation but I think
  there's something wrong in it. Can you do it in
  class?

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The Interest Rate And the Exchange Rate in the
Short Run

• Example
• You own a company in U.S. looking to invest
  10,000 cash.
  
• Assume U.K. has the best rate of 12.
• You must first buy pounds in the foreign exchange
  market, then invest pounds in U.K. market.
  
• If spot exchange rate is 2/pound, which gives
  you 5000 to invest
  

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The Interest Rate And the Exchange Rate in the
Short Run

• Example (continued)
• In 3 months the money will be worth
• 5000 (10.12/4) 5,150
• If the exchange rate is the same, you will get
• 5,150 2 10,300

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The Interest Rate And the Exchange Rate in the
Short Run

• 2. If pound drops to 1.975/pound
• By how much has pound depreciated?
• (2-1.975) / 2 100 1.25 in 3 months
• the books says 5 (that is the annual rate)? 1.25
  4 5 depreciation
  
• You end up with 5,150 1.975 10,171.25
• So what is your rate of return?
• (10,171.25-10,000)/10,000 4 7

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So your total rate of return is the

• difference between annual interest rate in U.K.
  (12) and depreciation of the pound (5)
  approx. 7.
  

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Similarly

• If the pound appreciates by 5
• Total return is sum of annual interest rate in
  U.K. (12) and appreciation of the pound (5)
  approx. 17

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To eliminate exchange-rate risk

• Buy foreign currency in spot exchange market
• At same time sell pound in forward exchange
  market delivering on date of investments
  maturity
  
• If forward rate current spot rate (pound is
  selling at a forward premium)
  
• more profitable to invest in U.K.
• If forward rate selling at forward discount)
  
• must compare the gain in favorable interest rate
  to loss suffered by exchange rate

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But really the story is more complicated than
that. Here is a rough numerical example to show
the interest rate parity

• Annual yield (interest rate) on US bond 10
• Annual yield (interest rate) on Irish bond 6
• Spot exchange rate ? 1 1
• Forward exchange rate ? 1 1

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So Irish will want to invest in the US

• Spot demand for dollar goes up ? dollar
  appreciates by 1
  
• Demand for US bonds goes up ? price of bonds goes
  up ? interest rate goes down by 1 point.
  
• Demand for Irish bonds goes down? price of bond
  goes down ? interest rate goes up by 1 point.
  
• Forwards supply of dollar goes up ? dollar
  depreciates by 1
  
• Now
• Dollar sells at 2 forward discount Interest
  rate in US is 2 point higher than in Ireland
  

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Interest rate parity

• Funds continue moving between the two countries
  until
  
• forward premium or discount equals the interest
  rate differential
  

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International Economics

• Week Eleven - Class 3
• Wednesday, November 14
• 1510-1600
• AC 201
• Online grades were updated today.
• ICA5 is graded and ready to be picked up

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The Interest Rate And the Exchange Rate in the
Short Run

• What does tightening of money in Ireland do to
  interest rates?
  
• MS declines? interest rates go up
• What does this do in the market for euro?
• Demand goes up? euro appreciates
• Supply goes down? euro appreciates
• This process continues until interest parity is
  achieved.

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Interest Rates, the Exchange Rate, and the
Balance of Payments

• Changes in Interest Rates
• Increasing a countrys interest rate
• Causes capital inflow
• Appreciation of a countrys currency
• Decreasing a countrys interest rate
• Causes capital outflow
• Depreciates a countrys currency
• Movement of capital causes change exchange rates
• Interest rate volatility ? exchange rate
  volatility

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Suppose there is no capital inflow or outflow
At E, quantity demanded for euros quantity
supplied ? current account balance
D S are due current account activities
E
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What happens if there are now capital flows
between countries?

• Assume U.S. interest rates increase
• Capital moves into US.
• Supply of euro increases
• Does demand for euro decrease?
• No there was no capital inflow before.

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Supply shift right euro depreciates imports of g
oods and services go down to less than 200
exports of goods and services go up to more than
400
current account surplus net capital outflow
E1
S2 S1 capital outflow
E2
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Price Levels and ExchangeRates in the Long Run
CHAPTER 15
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The Law of One Price

• Law of One Price
• Identical goods sold in competitive markets
  should cost the same in all countries when prices
  are expressed in terms of the same currency
  
• Example
• If exchange is 2/Pound and a pair of shoes costs
  200, then the same pair of shoes should cost
  400 in U.S. (same price).
  

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What if The Law of One Price does not hold?

• It leaves room for arbitrage between the
  countries.
  
• Example
• Using the pair of shoes from U.K.
• Exchange is 2/Pound, PU.K. 200, and PU.S
  400
  
• If the price in U.S. rose to 500 and the
  exchange rate did not change, what would happen?

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what would happen?

• Demand for Pounds would increase U.S. importers
  need Pounds to buy shoes.
  
• The /Pound exchange rate would rise.
• Demand for UK shoes rise
• increasing price of shoes in UK
• Supply of shoes in the US will go up
• decreasing price of shoes in US
• Continues until prices are the same again.

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But prices in most countries are not usually
equal. Why?

• Transportation costs
• Some goods are not tradable
• Barriers to trade
• Differences in tax rates and regulations
• But over time ? market forces tend to push prices
  toward equality