Classical Economics & Relative Prices

1. Classical Economics & Relative Prices

2. Classical Economics • Classical economics relies on three main assumptions:

3. Classical Economics • Classical economics relies on three main assumptions: • Markets are perfectly competitive • All prices are flexible • Markets clear (equilibrium)

4. Classical Economics • Classical economics relies on three main assumptions: • Markets are perfectly competitive • All prices are flexible • Markets clear (equilibrium) • One key result is that all real variables are independent of monetary policy (money neutrality)

5. Savings, Investment, and the Trade Balance • Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities)

6. Savings, Investment, and the Trade Balance • Recall that in a closed economy, demand for loanable funds (supply of marketable securities) must equal the supply of loanable funds (demand for marketable securities) S = I + (G-T) S = Private Savings I = Private Investment (G-T) = Government Deficit/Surplus

7. Savings/Investment in a Closed Economy • Without access to world capital markets, a country’s private saving is the sole source of funds. Therefore, the domestic interest rate must adjust to insure that S = I + (G-T) • In this example, the domestic interest rate is equal to 10% and S = I +(G-T) = 300 • What will happen if we expose this country to trade?

8. Savings in the Open Economy • In an open economy, the rest of the world becomes an added source of demand/supply of marketable securities S = I + (G-T) + NX Further, perfect capital mobility insures that all countries have the same (risk adjusted) real interest rate.

9. Savings in the Open Economy • Again, a trade deficit implies NX<0 • Therefore, S – (I – (G-T)) = NX < 0

10. Savings in the Open Economy • Again, a trade deficit implies NX<0 • Therefore, S – (I – (G-T)) = NX < 0 • A country with a trade deficit is borrowing from the rest of the world • That is, domestic supply of marketable securities is greater than domestic demand

11. Adding Net Exports to Capital Markets • Suppose that the prevailing world (real) interest rate is 6%

12. Adding Net Exports to Capital Markets • Suppose that the prevailing world (real) interest rate is 6% • At 6%, • S = $100 • I + (G-T) = $500 • NX = $100 - $500 = -$400

13. Adding Net Exports to Capital Markets • Suppose that the prevailing world (real) interest rate is 14%

14. Adding Net Exports to Capital Markets • Suppose that the prevailing world (real) interest rate is 14% • S = $500 • I + (G-T) = $100 • NX = $500 - $100 = $400

15. Where does the world interest rate come from? • Aggregate world savings is the sum of private savings across countries • Aggregate Private Investment and Government Deficits are also summed over all countries • By definition, NX summed over all countries must equal zero. Therefore, at the real world equilibrium interest rate, S = I + (G-T) • In this example, r = 11%

16. Example: An increase in productivity • Suppose that trade is initially balanced. A rise in productivity increases investment demand

17. Example: An increase in productivity • Suppose that trade is initially balanced. A rise in productivity increases investment demand • In a closed economy, interest rates would rise

18. Example: An increase in productivity • Suppose that trade is initially balanced. A rise in productivity increases investment demand • In a closed economy, interest rates would rise • In an open economy, the trade deficit would increase. In the case, the deficit increases from zero to -$15,000 • Do interest rates rise at all?

19. World Capital Markets • A country’s ability to influence world interest rates depends on its size relative to the world economy (recall, global interest rates are determined such that global capital markets clear) • The US makes up roughly 35% of the global economy. Therefore, the US can significantly influence global interest rates (as can Japan, EU, and China) • The rest of the world has little influence unless it acts as a unified group (Latin American Financial Crisis, Asian Crisis)

20. The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E Exchange Rates and Price Levels

21. The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E P* = E190 (E Price in Europe) Exchange Rates and Price Levels

22. The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E What should happen here? P* = E190 (E Price in Europe) eP* = ($1.17/E)(E190) = $222.30 Exchange Rates and Price Levels

23. The Law of One Price (LOOP) states that the same product should cost the same in every location For example, suppose that the price of a television is $200 in the US and E190 in Europe. The current exchange rate is $1.17/E What should happen here? A profit can be made by buying TVs in the US and selling them in Europe. P* = E190 (E Price in Europe) eP* = ($1.17/E)(E190) = $222.30 Exchange Rates and Price Levels

24. The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* Exchange Rates and Price Levels

25. The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E Exchange Rates and Price Levels

26. The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E P = $200 P* = E190 P = eP* Exchange Rates and Price Levels

27. The Law of One Price (LOOP) states that the same product should cost the same in every location LOOP states that in equilibrium, no such profits can occur. Therefore, P = eP* If the price of a TV is $200 in the US and E190 in Europe, the implied exchange rate is $1.05/E P = $200 P* = E190 P = eP* e = P/P* = $200/E190 = $1.05/E Exchange Rates and Price Levels

28. Purchasing Power Parity • Purchasing power parity (PPP) is simply LOOP applied to general price indices P = eP*

29. Purchasing Power Parity • Purchasing power parity (PPP) is simply LOOP applied to general price indices P = eP* • A more useful form of PPP is %Change in e = Inflation – Inflation*

30. Purchasing Power Parity • Purchasing power parity (PPP) is simply LOOP applied to general price indices P = eP* • A more useful form of PPP is %Change in e = Inflation – Inflation* • For example, if the US inflation rate (annual) is 4% while the annual European inflation rate is 2%, the the dollar should depreciate by 2% over the year.

31. PPP and the “Fundamentals” • Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P*

32. PPP and the “Fundamentals” • Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P* • Further, the quantity theory give the price level as a function of money and output P = MV/Y

33. PPP and the “Fundamentals” • Again, recall that PPP gives the following formula for the nominal exchange rate: e = P/P* • Further, the quantity theory give the price level as a function of money and output P = MV/Y • Combining the two, e = (V/V*)(M/M*)(Y*/Y) • V,M,and Y are exchange rate “fundamentals”

34. PPP and the Real Exchange Rate • While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods q = eP*/P

35. PPP and the Real Exchange Rate • While the nominal exchange rate is defined as the dollar price of foreign currency, the real exchange rate is defined as the price of foreign goods in terms of domestic goods q = eP*/P • PPP implies that the real exchange is always constant (actually, its equal to 1)

36. Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Interest Rate Parity

37. Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Each $1 invested in the US will be worth $1.05 in a year. How about each $ invested in Europe? Interest Rate Parity

38. Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Each $1 invested in the US will be worth $1.05 in a year. How about each $1 invested in Europe? $1 = (1/1.15) = .87E .87E(1.07) = .93E .93E ($1.10/E) = $1.02 Interest Rate Parity

39. Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E Each $1 invested in the US will be worth $1.05 in a year. How about each $1 invested in Europe? $1 = (1/1.15) = .87E .87E(1.07) = .93E .93E ($1.10/E) = $1.02 Even with the higher return in Europe, the 5% appreciation of the dollar makes the US asset a better investment. Therefore, funds will flow to the US. Interest Rate Parity

40. Interest Rate Parity • Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e)

41. Interest Rate Parity • Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e) • A more useful form is i – i* = % change in e • For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen

42. Interest Rate Parity • Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+i) = (1+i*)(e’/e) • A more useful form is i – i* = % change in e • For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen • Interest rate parity fails just as badly as PPP.

43. Interest Rate Parity & PPP • Recall that PPP gives the following: % change in e = Inflation – Inflation*

44. Interest Rate Parity & PPP • Recall that PPP gives the following: % change in e = Inflation – Inflation* • Interest Parity gives the following: i – i* = % change in e

45. Interest Rate Parity & PPP • Recall that PPP gives the following: % change in e = Inflation – Inflation* • Interest Parity gives the following: i – i* = % change in e • Combining them gives us i – i* = Inflation – Inflation*

46. Interest Rate Parity & PPP • Recall that PPP gives the following: % change in e = Inflation – Inflation* • Interest Parity gives the following: i – i* = % change in e • Combining them gives us i – i* = Inflation – Inflation* i – Inflation = i* - Inflation*

47. Interest Rate Parity & PPP • Recall that PPP gives the following: % change in e = Inflation – Inflation* • Interest Parity gives the following: i – i* = % change in e • Combining them gives us i – i* = Inflation – Inflation* i – Inflation = i* - Inflation* r = r*

48. Summary of Classical Exchange Rate Theory • Real interest differentials across countries are zero. • The trade balance is equal to S – (I + (G-T)) at the world interest rate • Real exchange rates are constant • Nominal Exchange rates are related to the “fundamentals” e = (V/V*)(M/M*)(Y*/Y) • There is no obvious correlation between trade balances, interest rates and exchange rates

49. Exchange Rates & the Fundamentals (JPY/USD)

50. Exchange Rates & the Fundamentals (GBP/USD)