Transcript class11

Welcome to
EC 382: International
Economics
By: Dr. Jacqueline Khorassani
Week Eleven
1
Week Eleven: Class 1


Tuesday, November 13
14:10-15:00
AC 202
2
I received a question

Can you please explain again with
some examples the open market
operations? thank you
3
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 Ireland’s 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
5
Why do we demand
money (M1)?
1) To buy goods and services.

Transactions demand for money
Varies directly with nominal GDP
2) In case of emergencies that require
purchases above normal spending levels


Precautionary demand for money
3) As an asset
6
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
7

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
8
Money Demand Curve
Interest Rate
(i)
Shows the relationship between
interest rate and the quantity of
money demanded holding
everything else constant
Demand for Money
(MD)
Money (M)
9
What shifts the Money Demand
Curve?
D1
Interest Rate
(i)
Increase to
D1 if P↑ or
Y↑
D2
Decrease
to D2 if
P↓ or Y↓
Demand for Money
(MD)
Money (M)
10
The Equilibrium Interest Rate:
The Interaction of Money Supply
and Money Demand
Interest Rate
(i)
Supply for
Money (MS)
i
Demand for
Money (MD)
Money (M)
11
How does an increase in the
price level affect the
interest rates?
Interest Rate
(i)
i2
i
MD ↑
i↑
Supply for
Money (MS)
G
E
MD
2
Demand for
Money (MD)
Money (M)
12
How does a economic
recession affect the interest
rate?
Supply for
Money (MS)
Interest Rate
(i)
MD↓
i↓
i
E
i1
F
MD1
Demand for
Money (MD)
Money (M)
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How does an open market
sale by the central bank
affect the interest rate?
Interest Rate
(i)
i2
i
MS2
Supply for
Money
(MS)
MS ↓
i↑
This is a
contractionary
monetary
policy
Demand for
Money (MD)
Money (M)
14
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?
15
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
– 11:10-12:00
– 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:
1. 15 MCQ (3 points for correct answers and -0.5
point for incorrect answers.) total = 45 points
2. Choose 2 of 4 essay questions for 20 points
each  total = 40 points
3. Three problems total = 65 points
19
Remember yesterday’s
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?
20
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 (1+0.12/4) = £5,150
1. 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 exchangerate risk
Buy foreign currency in spot
exchange market
At same time sell pound in forward
exchange market delivering on
date of investment’s maturity


1.
–
2.
–
If forward rate > current spot rate
(pound is selling at a forward premium)
more profitable to invest in U.K.
If forward rate < current spot rate
(pound is 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
– 15:10-16:00
– 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?

–
What does this do in the market
for euro?

–
–

MS declines interest rates go up
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 country’s interest rate:


–
Decreasing a country’s interest rate:


–
–
Causes capital inflow
Appreciation of a country’s currency
Causes capital outflow
Depreciates a country’s 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
$/Euro
D & S are due current
account activities
S1 (imports
of G & S)
2.5
2.0
E
1.5
At E,
quantity
demanded
for euros =
quantity
supplied 
current
account
balance
D1 (exports
of G $ S)
100
200 300 400 500
Euros
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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 goods and services go down to less than 200
exports of goods and services go up to more than 400
$/Euro
current
S1
(imports
of G & S)
2.5
2.0
E1
1.5
E2
100
200 300 400 500
account
surplus
= net
capital
outflow
S2 =S1
+ capital
outflow
D1 (exports
of G $ S)
Euros
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CHAPTER 15
Price Levels and Exchange
Rates in the Long Run
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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?
38
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?
1.
2.
3.
4.

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
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