ECONOMICS 3150C Lecture 3 September 30 - PowerPoint PPT Presentation

1 / 31
About This Presentation
Title:

ECONOMICS 3150C Lecture 3 September 30

Description:

ECONOMICS 3150C Lecture 3 September 30 * – PowerPoint PPT presentation

Number of Views:120
Avg rating:3.0/5.0
Slides: 32
Provided by: laz59
Category:

less

Transcript and Presenter's Notes

Title: ECONOMICS 3150C Lecture 3 September 30


1
ECONOMICS 3150CLecture 3September 30
2
Purchasing Power Parity Big Mac or Tall Latte
Theory of Exchange Rates
  • Law of one price arbitrage, no transactions
    costs
  • Exchange rate between two countries currencies
    ratio of currencies purchasing power as measured
    by national price levels
  • Money prices of typical basket of consumption
    goods
  • E(t) PUS,t/PC,t
  • E ? (?) PUS ? (?) and/or PC ? (?)
  • Relative purchasing power parity
  • ?E ?PUS - ?PC
  • Since ?E - ?E ? ?E ?PC - ?PUS

3
PPP Exchange Rates
PPP Actual
2001 2008 2001 2008
A 1.33 1.48 1.93 1.19
Real 1.02 1.46 2.35 1.83
C 1.22 1.23 1.55 1.07
Yuan 3.29 3.79 8.28 6.95
Rupee 13.8 15.9 47.2 43.5
Yen 149 116 122 103
Won 757 762 1291 1102
Peso 6.31 7.82 9.34 11.13
Rouble 8.32 18.42 29.17 24.85
Rand 3.32 4.63 8.61 8.26
Pound 0.63 0.66 0.69 0.54
4
Limitations of PPP
  • Trade barriers and non-tradables
  • Distortions in prices of traded goods and
    services
  • Non-traded goods and services
  • Imperfect competition
  • Distortions in prices
  • Composition of consumption baskets
  • Differ between/among countries
  • Ignore capital flows

5
Central Banks
  • Monetary policy conducted by central banks
  • U.S. Federal Reserve
  • Most important
  • Created in 1913
  • Bank of Canada created in 1935
  • Riksbank (Sweden) 1668
  • Bank of England 1694
  • Bank of France 1800
  • Bundesbank (Germany) re-established in 1946
  • European Central Bank 1998

6
Classical Monetary Theory
  • M(t)V(t) P(t)Y(t)
  • M supply of money
  • V income velocity of money
  • P price deflator for GDP
  • Y GDP
  • V L(R)
  • Real interest rates matter
  • ?M ?V ?P ?Y

7
Classical Monetary Theory
  • Short run
  • Changes in V depend on changes in R
  • Price rigidity
  • Changes in M can affect Y and R

8
Classical Monetary Theory
  • Long run
  • Flexible prices
  • Assume ?V k ? n (determined by rate of
    growth in factors of production and multi-factor
    productivity growth rate)
  • ?P ?M k - n
  • Assume further that k 0 and cause-effect runs
    from the supply of money to the rate of inflation
  • ? inflation a monetary phenomenon
  • ?P ?M - n

9
Canadian Experience
M1 M2 Core CPI
2001 10.3 6.6 2.1
2002 10.9 7.2 2.4
2003 5.0 4.8 2.2
2004 8.9 4.9 1.5
2005 6.9 4.7 1.6
2006 8.2 6.3 1.9
2007 8.9 8.1 2.1
2008 8.9 10.2 1.7
2009 13.4 11.6 1.8
10
Traditional Balance Sheet
  • US Federal Reserve _at_ 08/13/08
  • Assets
  • U.S Treasury securities 479 B
  • Gold, SDRs, other 52 B
  • Repos, term auction credits 255.8B
  • Total 935 B
  • Liabilities
  • Currency in circulation 831 B
  • Bank deposits 12 B

11
Monetary Policy
  • In U.S., Federal Reserve must balance rate of
    inflation and growth inflation not sole
    objective as in Canada
  • Innovations by U.S. Federal Reserve Chair Ben
    Bernanke in response to financial market crisis
    starting in summer 2008 quantitative easing
  • Provision of short-term liquidity to banks and
    other financial institutions
  • Provision of liquidity directly to borrowers and
    investors in key credit markets
  • Expanded traditional tool of open market
    operations to support the functioning of credit
    markets through the purchase of longer-term
    securities
  • Interest on reserve balances with Fed

12
New Monetary Policy
  • Innovations
  • Term Auction Facility expanded size and term to
    84 days
  • Primary Dealer Credit Facility expanded
    collateral
  • Asset-Backed Commercial Paper Facility
  • Money Market Mutual Fund Liquidity Facility
  • Term Asset-Backed Securities Loan Facility
  • Commercial Paper Funding Facility (CPFF)
  • Central bank liquidity swaps
  • Interest on reserve balances

13
Changes in Fed Balance SheetAugust 1, 2007 to
December 17, 2008
  • Assets
  • Treasury securities 340B
  • Mortgage-backed securities 18B
  • Lending to banks 538B
  • Credit extended to AIG 82 B
  • Lending to primary dealers 47B
  • Lending for purchase of Commercial Paper 346B
  • Assets purchased from Bear Stearns 27B
  • Swaps with central banks 572B
  • Total 1.4 T
  • Liabilities
  • Currency in circulation 64B
  • Bank deposits 785B
  • Treasury cash deposits 475B

14
Current Balance Sheet
  • Assets _at_ 08/11/10
  • US Treasury securities 777 B
  • Mortgage-backed securities 1,120 B
  • Federal agency debt securities 159 B
  • Credit extended to AIG 26 B
  • Total 2.3 T
  • Liabilities _at_ 08/11/10
  • Currency in circulation 907 B
  • Bank deposits 1,058 B

15
Nominal and Real Interest Rates
  • R(t) r(t) ?P(e,t) r(t) ?M(e,t) n
  • assume n 0 for both C and US
  • R(t) r(t) ?M(e,t)
  • Covered interest rate parity condition
  • R(C,t) R(US,t) E(e,t)-E(t)/E(t) ?(t)
  • ? R(C) R(US) ?M(e,C) - ?M(e,US) ?
  • ? r(C,t) r(US,t) ?(t)
  • With unimpeded capital mobility, real interest
    rates in Canada are determined by real interest
    rates in US and the liquidity premium
  • B. of C. can only affect real interest rates in
    Canada if actions have some effect on liquidity
    premium, otherwise, monetary policy in Canada
    ineffective in impacting Y in short run

16
Real Interest Rates
  • Clientele effects provide scope for central banks
    to have some effect
  • Clientele effects
  • Preference by investors for financial instruments
    supplied locally
  • Better informed
  • Tax policies
  • Regulations RRSPs, pension funds and foreign
    investments
  • Currency risks

17
Real Exchange Rates
  • Real Exchange rate Q
  • Q P(US)E/P(C)
  • Real depreciation (appreciation) Q ? (?)
  • When relative PPP holds, real exchange rate
    cannot change in value
  • ?E ?PC - ?PUS
  • ?Q ?PUS ?E - ?PC
  • Real exchange rate can only change when relative
    PPP does not hold

18
Long-run Real Exchange Rate
  • Real exchange rate determined by relative demand
    for and relative supply of Canadian goods and
    services current account only matters in long
    run for real exchange rate
  • 1/Q relative price of Canadian
  • ? in relative D ? ? relative price of C
    (appreciation of real exchange rate ? ? Q
  • ? in relative S ? ? relative price of C
    (depreciation of real exchange rate ? ? Q

19
1/Q
Relative S of Canadian g s
2
Q2 lt Q1
1/Q2
1/Q1
1
Relative D for Canadian g s
C
20
Long-run Real Exchange Rate
  • E(t)Q(t)/P(C, t)/(US,t) ? from definition of
    real exchange rate
  • Changes in real exchange rate also result in
    changes in nominal exchange rate in long run
  • Effects of change in relative S consider the
    case of an increase
  • ? Q (depreciation of real exchange rate)
  • ? P(C) because MV PY, so if M and V constant as
    result of change in relative supply, ? as Y ?, P
    ?
  • Ambiguous effect on E (nominal exchange rate)

21
Exchange Rate Regimes
  • Bank of Canada intervention in currency market
  • Direct intervention buying or selling C
    selling or buying US ? official reserve
    transactions in B. of P.
  • Indirect intervention increase or decrease R(C)
    ? capital account transactions
  • Increase in R(C) ? increase demand for C
    financial assets increase in exports of
    financial assets, decrease in imports of
    financial assets
  • Two models
  • Covered interest rate parity model indirect
    intervention only
  • Traditional D/S model incorporating B. of P.
    both direct and indirect intervention

22
Bank of Canada Balance Sheet
  • Assets
  • Domestic assets Government of Canada bonds
  • Foreign assets Foreign currencies, gold, foreign
    Government Treasury Bills (T-bills)
  • Liabilities
  • Deposits held by private banks
  • Currency in circulation

23
Canadas International Reserves ( billions)
2001 34.2
2002 37.2
2003 36.3
2004 34.5
2005 33.0
2006 35.1
2007 41.1
2008 43.9
2009 54.4
24
B. of C. Intervention
  • Indirect Buy (sell) domestic assets
  • ? (?) R(C) in short run, assuming no perfect
    capital flows ? B. of C. has some control over
    real interest rates
  • ? (?) M(C) ? consider impact on expected
    inflation rate and hence on nominal interest
    rates resulting from change in expected inflation
    rate
  • Direct Buy (sell) foreign assets
  • No short-run impact on R
  • ? (?) M(C) ? consider impact on expected
    inflation rate and hence on nominal interest
    rates resulting from change in expected inflation
    rate
  • Sterilized direct intervention buy foreign
    assets, sell domestic assets ? no change in M, ?
    R ? results in indirect intervention as well

25
Indirect Intervention Covered Interest Rate
Parity Model
26
Indirect Intervention ? R(C)
E
1
E0
2
E1
R(1,US)0, ?0, E(e)0
R(1,C)
R0
R1
27
Indirect Intervention Traditional D/S Model
28
Indirect Intervention ? R(C)
E
S of C imports
E1
2
E0
1
D for C exports
Q(C)
29
Spot Rate
  • Spot rate determined by interaction between D for
    and S of C
  • D Exports
  • S Imports
  • Bank of Canada intervention
  • In short run, capital flows dominate trade flows
    in affecting exchange rates
  • Role of expectations
  • Momentum trading

30
Spot Rate
  • D for C
  • exchange rate (relative price of Canadian
    dollar),
  • real income levels in US (exchange rate is
    between Canadian dollar and US dollar),
  • price levels in Canada,
  • price levels in US,
  • trade barriers,
  • competitiveness of Canadian and US companies,
  • interest rates in Canada and US,
  • profit expectations in Canada and US,
  • expectations regarding movements in equity prices
    in Canada and US,
  • transactions by Bank of Canada in currency market
  • perceptions of risk and attitudes toward risk

31
Spot Rate
  • S of C
  • exchange rate (relative price of Canadian
    dollar),
  • real income levels in Canada,
  • price levels in Canada,
  • price levels in US,
  • trade barriers,
  • competitiveness of Canadian and US companies,
  • interest rates in Canada and US,
  • profit expectations in Canada and US,
  • expectations regarding movements in equity prices
    in Canada and US,
  • transactions by Bank of Canada in currency market
  • perceptions of risk and attitudes toward risk
Write a Comment
User Comments (0)
About PowerShow.com