Transcript Fixed Rate System: Preview of Results

Purchasing power parity (PPP):
The Law of One Price … in long run
A good should cost the same in all countries
(aside from tariffs or transportation costs)
Exchange rates should make prices equal across
countries … law of one price
P = ER x P*
Recall: RER = ER x P*/P.
If we’re considering the same good, RER=1 and P=ER xP*.
($/bourbon) = ($/£) x (£ /scotch) = ($/scotch)
If two countries have different inflation rates, exchange
rates will move to keep prices the same
The currency of the high inflation country depreciates
(P/P*)   ER   ($/£) 
… real exchange rate (bourbon/scotch) is steady
Parities you have known
Uncovered interest rate parity:
Ee = E (1+i)/(1+i*)  Δ Ee/E = i – i*
– A higher interest rate compensates for expected
depreciation
– If exchange rate truly fixed, i
= i*
Monetary Discipline
Purchasing Power Parity:
E = (RER) P/P*  Δ Ee/E = π – π*
– High inflation  Currency depreciation
– If exchange rate fixed, π
– π*
 Price Discipline  Wage Discipline
Something’s gotta give: Suppose demand for
your country’s exports falls
Floating rate system
– Excess supply of your
currency on foreign
exchange market
– Your currency
depreciates
– Your exports become
more attractive
– Your export industries
aren’t hurt as badly as
they would otherwise
be
– Your country’s terms
of trade worsen
Fixed rate system
– Excess supply of your
currency on foreign
exchange market
– Your currency can’t
depreciate
Your prices fall
Your wages fall
Your interest rate rises
Your income falls
– Demand for your currency
increases
– Your payments balance
Gold Standard:
The Mother of Fixed Rate Systems
Money was either gold coin, currency backed
by gold issued by central bank, or bank
deposits backed by currency
Each currency’s value was fixed in terms of gold,
e.g., 1 oz. of gold = $22 = £4.27 $4.86/ £
Gold could flow freely internationally
– You could redeem your $ for gold, ship the gold to
England (or France or wherever), and buy the local
currency with the gold
Gold Standard:
Automatic Adjustment Mechanisms
Humian Mechanism
P  … D$  … BoP Deficit
… Gold Outflow … M  … P 
Interest Rate Mechanism
P  … D$  … BoP Deficit Threatens
… “Bank Rate”  … Capital In
Income Mechanism
P  … D$  … BoP Deficit Threatens
… “Bank Rate”  … I  GDP  Im 
Stabilizing Speculation: “Gold Points”
Fixed Rate System:
How it works
Central bank (CB) buys and sells its currency (¥) on
foreign exchange markets to keep the exchange
rate fixed
– It dips into its reserves of “gold” and foreign
currencies to buy ¥ … keep ¥ from falling
– It buys reserves with ¥ … keep ¥ from rising
When CB buys ¥ (sells reserves)
M
When CB buys reserves with “new” ¥
M
Fixed Exchange Rate System:
Automatic Adjustment of BoP
Recall:
MV = PQ
When S¥ > D¥ and the Central Bank buys excess ¥
M…P…X…D¥
M  … i  … Capital Inflows  … D ¥ 
M  … i  … GDP  … Im  … S ¥ 
The balance of payments balances
Fixed Rate System:
Discipline
Wage and price discipline
If W  and P  … D ¥ 
CB buys ¥ to keep ¥ from falling
… M  … P  Q  … unemployment 
Monetary discipline
If M  … P  and i 
… X  and Capital Inflows 
…D¥
CB buys ¥ … M 