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ECN 160B Lecture 4 International Macroeconomics

ECN 160B Lecture 4 International Macroeconomics Galina A. Schwartz Department of Economics University of CA, Davis Brief on Money (next lecture) Currencies = Monies Money as a store of value, KO, p. 334 this is one of the functions of money Demand for Currency ~ Demand for Money

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ECN 160B Lecture 4 International Macroeconomics

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  1. ECN 160B Lecture 4International Macroeconomics Galina A. Schwartz Department of Economics University of CA, Davis Lecture 4 ECN160B

  2. Brief on Money (next lecture) • Currencies = Monies • Money as a store of value, KO, p. 334 this is one of the functions of money • Demand for Currency ~ Demand for Money • Demand for Currency – two components • Demand by domestic residents • Demand by foreign residents • Supply of Currency (next lecture & next chapter) Lecture 4 ECN160B

  3. Value of Currency • Currency is an asset • How to determine asset returns? (Or in which asset should one invest?) All else equal, one should invest into the asset with the highest real rate of return • Also, (lecture 3-10) asset value depends on ● Liquidity & ● Risk Lecture 4 ECN160B

  4. ForEX Market Characteristics • Rate of Return (+ we will relate this to arguments about Interest Rate Parity(IRP)) • Expected ??? • Real ? What does this mean? • All else equal, in equilibrium, real returns on all assets should be equal, but • Risk (variability of returns) • Liquidity (cost (ease) & speed of selling the asset) • What affects liquidity? Ex. Market volume Lecture 4 ECN160B

  5. Interest Rates & Asset Returns ●Rate of Return & ● Liquidity & ● Risk Rate of Return depends on two factors: • I. Interest rate that the currency offers (examples: R€ and R$) • Interest rate is ? • II. Expected currency exchange rate against other currencies (ex. Ee$/€) Lecture 4 ECN160B

  6. Interest Rate Parity (IRP) • IRP: return on $ deposits in terms of €: R€ +[(Ee$/ € - E$/€ )/E$/€ ] = R$ has to be equal to R$ (otherwise profits can be made via arbitrage) KO, 13-2 • Therate of depreciationof thedollar against the euro is (E1$/ € - E$/€ )/E$/€ E1$/ € dollar/euro rate in one year Ee$/ € expected dollar/euro rate in one year Lecture 4 ECN160B

  7. FOREX Market Equilibrium • Equilibrium is ? • Assumptions R€ , R$ and Ee$/€ are given (i.e., fixed) • Main conclusion: FOREX markets adjust to make deposits of all currencies offer the same expected rate of return • I.e., in equilibrium, IRP holds (KO, 13-2) Lecture 4 ECN160B

  8. FOREX Market Equilibrium • KO, p. 346, Figure 13-4 • use equation 13-2 to deduce Figure 13-4 • Also see handout Lecture 4 ECN160B

  9. Exchange Rate Changes I • KO, p. 348, Figure 13-5 • Effect of a rise in R$ on E$/€ • + see handout Lecture 4 ECN160B

  10. Exchange Rate Changes II • KO, p. 348, Figure 13-6 • Effect of a rise in R€ on E$/€ is the same as a rise in Ee$/€ + see handout Lecture 4 ECN160B

  11. Next Lecture • Money • Long run • Short run • Equilibrium • Connection with interest rates • Exchange Rates Overshooting (time permitting) • covered • uncovered • Your preparation: KO Ch. 14 Lecture 4 ECN160B

  12. Summary of Today • Rate of return • Rate of depreciation / appreciation • Interest parity condition aka Interest Rate Parity (IRP) • FOREX market equilibrium • How equilibrium changes with R or E • Have a Nice Weekend Lecture 4 ECN160B

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