Macroeconomics plus MyEconLab plus eBook 1-semester Student Access Kit (6th Edition)

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Econ 304 Sonoma State University Spring 2003 Dr. Robert Eyler Lecture #11: Chapters 20 and 21 External and Internal Balance: Policy Choices and Exchange Rate Regimes I. Three types of variability since 1973 1. Long-Run trends : DM, Swiss FR, ¥ all up over time. a. Canadian $, pound, lira, FR down over time against US$. 2. Medium-Term trends : DM, Swiss FR, ¥ down from 1980-85. a. Lira, pound up from 1985-1988. 3. Short-term : depends on financial events. II. The Macroeconomic Consequences of LR Movements A. Purchasing Power Parity Theory (The theory of LR movements) 1. need a predictable relationship between prices and exchange rates. 2. PPP hypothesis: P US = r S · P UK which implies that r S = (P US /P UK ). a. a change in one ratio leads to a change in the other. b. purchasing power, the relative prices, are at a parity. 3. Mixed empirical support, sometimes extremely poor. a. depends on fixity of r. 4. PPP predicts will at level of one, heavily traded good. a. gold, ag, metals, primary resources. b. integrated economies more difficult. 5. Ratio of CPIs only moderate success. a. PPP best for LR predictions, were price movements are dominated by policy changes. b. tendency to hold in LR. B. Money, Inflation and Prices: Deriving PPP from macroeconomic theory. 1. the more currency, the valuable it is. a. hyperinflations occur because of monetary explosions. 2. Money is a medium of exchange, need a certain stock to cover international transactions. 3. The Quantity Theory of Money: M S = kPy, where k = 1/v, where v equals velocity. 4. Two countries have same, basic macroeconomic set up: M = k S US US P US y US ; = k M S UK UK P UK y UK 5. Take a ratio: P P M M k k y y US UK S US S UK UK US UK US = a. assume that two ratios are constant, such that movements in the monetary ratio lead to movements in price ratios. b. inflations change the exchange rates.
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6. Monetary policy and r: a. If M S increases by 10%, y increases by 10%, P increases by 10%. thus r increases by 10%, assuming other country unchanged. C. Real income (y) and r: r increases in LR if ratio of incomes increases: 1. If y US increases, P US falls, r S falls 2. If domestic y increase matched by foreign y increase, no change to r. 3. movements in y demand dominated in SR, supply dominated in LR. III. What Determines r in the SR?: Interest Rate Parity Theory in our mind. A. Asset Market Approach : r S increases in SR if: 1. (i for - i dom ) increases, or expected spot rate increases. 2. New policies, especially monetary, may cause an “overshoot”.
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