Fixed, float or flaky
why should we care?
Does it matter?
Denmark has a peg
Sweden has changed several times, now floating
Finland changed several times, joined euro in 2002
Hill of beans?
Much more
ECON 401: Matrices
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Matrice
n equations of m variable
a11 x1 C a12 x2 C . C a1m xm D b1
(1)
a21 x1 C
Deriving the
DD Schedule
1
Shifting
exogenous DD
parameters:
G, T, I
2
ShortRun Equilibrium in Asset Markets
We consider the same two sets of asset markets:
1. Foreign exchange markets
interest parit
Modeling Y
D = C + I + G + CA
C = C(YD,r)
1
2
Modeling Y
D = C + I + G + CA
C = C(YD,r)
I = I(r) = investment, with a negative coefficient on
r
G = government spending will be assumed
exogenous
Monetary Approach to FX
Real Exchange Rate
Approach to FX
1
Real Exchange Rate
The real exchange rate is the rate of exchange for goods and services
across countries.
As opposed to the nominal exchang
Monetary Approach to FX
Real Exchange Rate
Approach to FX
1
Exchange Rate Models: SR vs.
LR
Models predict how exchange rates behave.
SR model: Keynesian story about
money
money > interest rates > exc
Testing PPP with Big Macs
The Law of One Price and PPP say a Big
Mac should cost the same anywhere,
once converted to a common currency
Why doesnt this work in practice?
Testing PPP with Big Macs
T
Permanent increase in
US money supply
A permanent shift in the US money supply
changes exchange rate expectations, so
there are 2 changes in the short run to
consider.
With longrun money neutrality
Money supply and money
demand
Determination of the Equilibrium Interest Rate
Ms/P = L(R,Y)
2
Model for the FX market equilibrium:
Uncovered interest parity
R$ = R + (Ee$/ E$/)/E$/
Linking the money ma
Covered Interest Parity
Same as UIP, but with forward rates instead of expected
exchange rates
R$ = R + (F$/ E$/)/E$/
where F$/ is the forward exchange rate.
(F$/ E$/)/E$/ is the forward premium: In
Huge growth in FX market turnover
Only 13% of the market are nonfinancial entities (corporate, govt
and retail)
80% of trading within about 10
banks.
USD dominance, AUD
ascendence, CNY and HKD stories
Labor Mobility in Action
MA share of US
employment
MA
unemployment
rate
US
unemployment
rate
1986
2.7
4
7
1991
2.48
8.8
6.8
1996
2.43
4.6
5.4
Source: Krugman blog, June 24, 2012
Divergent Real Interes
Econ 421 Lecture 20, Nov 13, 2012
Is Europe an OCA?
What are the key features you want to consider to determine an OCA from the
theory we learned last class?
o Integration of goods and services trade
Inflation Convergence for Six Original EMS
Members, 19782009
Source:CPIinflationratesfromInternationalMonetaryFund, InternationalFinancialStatistics.
Members of the Euro Zone
ECON 401: Determinant and Inverse of a Matrice
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Matrice
n equations of n variable
a11 x1 C a12 x2 C
ECON 401: Utility function
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A classic optimization problem in Economics
There are n goods;
income: I
ECON 401 Optimization problems
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Maxima, Minima, Suprema, Inma
Given a nonempty A
R,
max A D fa 2 A :
1
2
3
Adding r back in
+


+  +
Y = C(YD,r) + I(r) + G + CA(q, YD,r)
The impact of r on C and CA is small relative to I
Now R* and Ee shift DD
With sticky prices, R = r
Because of UIP, R = R* + (
PREFERENCE AND REVEALED PREFERENCE
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consumer preferences
Suppose we are given a choice set X .
PREFERENCES
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consumer preferences
Suppose we are given a choice set X .
Let x ; y ; z denote e
ECON 401: Theorem of Khun and Tucker
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Another example
A consumer with a utility function given
ECON 401: Theorem of Khun and Tucker
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An example
a rm uses one iput x . 0/ to produce two outp
ECON 401: Theorem of Khun and Tucker
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Constrained optimization
max f .x / s.t. g .x / D 0 and/
ECON 401: The Envelope Theorem
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Sensitivity analysis: the Envelope Theorem
Consider an unconstrai
ECON 401: Theorem of Lagrange: examples
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examples: consumption Vs leisure
agents get utility f
ECON 401: Theorem of Lagrange
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Constrained optimization
max f .x /
s.t. g .x / D 0,
and/or h .
ECON 401: Quadratic forms and semidenite
matrices
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identify semidenite matrices
a bijection
f1
ECON 401: Quadratic forms and semidenite
matrices
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unconstrained maximization
Throughout the lec
ECON 401: Optimization
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examples of optimization continued: consumption Vs
leisure
agents get utilit