Welcome to Econ 414 International Economics

1. Welcome to Econ 414 International Economics Study Guide Week Fourteen

2. S2 $/pound S1 D pounds Asst 7: # 9, Page 316Key a. Supply of pound goes down because, due to decrease in their income, British can’t afford to buy as many US goods as before. Pound appreciates

3. S $/pound D2 D1 pounds Part b • US residents have more income. They will demand more British goods. Demand increases Pound appreciates.

4. S2 $/pound S1 D2 D1 pounds Part c • Due to inflation in the US, both Americans & British would want to buy more British goods. Therefore, Supply decreases and demand increases. Pound will appreciate

5. S $/pound D1 D2 pounds Part d • American’s purchasing poser goes down. So, they will demand fewer British goods. Demand for pound goes down Pound will depreciate.

6. CHAPTER 14 Money, Interest Rates, and the Exchange Rate

7. What is money? • Anything that can be used for final discharge a debt. • Credit card is not money • Balance in checking account is money • Coins and currency are money

8. What can money be used for? • Medium of Exchange • What is the main problem with barter economy? • It requires double coincidence of wants. • Unit of Account • Measure and compare values • Makes economic transactions easier to compare

9. What can money be used for? • Store of Value • Save now spend later • Smoothes inconsistencies between money earned and money spent • Note: Individuals in high inflation countries my keep other currencies or goods as a store of value.

10. What is the Supply of Money? • Coins and paper currency act as primary mediums of exchange – money. • Demand deposits held at banks and depository institutions provide the same function as currency – money.

11. The Supply of Money • M1: • Is total quantity of currency plus demand deposits (narrow money, internationally). • There are broader measures of money such as M2, M3,…etc. They include other (less liquid) assets. • M1<M2<M3

12. What is Monetary Base (B)? • Cash held by the public (C) and the total quantity of bank reserves (R) on deposit at central bank

13. What is Reserve Requirement? • The percentage of deposits (r) banks are legally required to keep on deposit with the central bank

14. What is Money Multiplier (MM)? • The reciprocal of the reserve requirement MM = 1/r • Money supply (M1) is equal to the monetary base multiplied by the money multiplier. • MS = M1 = 1/r * B

15. Example • €80 = Cash in hands of the public • €230 = Bank Reserve • Required reserve = 0.1 • What is MS? • MS = 1/0.1 * (310) • MS = 3100

16. Monetary policy • Refers to central bank changing money supply by changing the monetary base and/or the money multiplier. • MS = M1 = 1/r * B • MS↑ if • B↑ or if • r↓

17. How can the central bank change B or r? • Change the interest rate banks pay on borrowed money from the central bank • Discount Rate (US), Marginal Lending rate (Europe): • Lower interest rate  increase in borrowed reserves  B↑  MS↑

18. How can the central bank change B or r? 2. Changing reserve requirement (r): • Lower reserve requirement means banks could make more loans. • If r↓  MM↑ MS↑ • Rarely used b/c effect too powerful

19. How can the central bank change B or r? 3. Open Market Operations, refinancing : • Buying and selling bonds by central bank • If the central bank buys bonds, money is given to bond seller (public or bank) and more money is in the economy  B↑ MS↑

20. Interest Rate (i) Money Supply (MS) MS2 MS1 Money (M1) Money Supply Curve Controlled by the central bank Contractionary monetary policy Expansionary monetary policy

21. I received a question • Can you please explain again with some examples the open market operations? thank you

22. Answer • Bank of Ireland has some government bonds. • If the central bank wants to increase the supply of money • Offer higher than normal prices for bonds • Bank of Ireland sell their €1000 bond to the central bank • Central bank makes a €1000 deposit into their Bank of Ireland Reserve Account at the central bank. • Bank of Ireland’s reserves goes up Bank of Ireland make more loans that means the people (borrowers) will have more money in their checking accounts (borrowed)  M1 goes up MS goes up

23. The central bank supplies money. Who demands money? • Firms • individuals

24. Why do we demand money (M1)? • To buy goods and services. • Transactions demand for money • Varies directly with nominal GDP • In case of emergencies that require purchases above normal spending levels • Precautionary demand for money 3) As an asset

25. Three motivations for holding money combine to create the aggregate demand for money • If interest rates go up, do we demand more or less money? • Less • interest rate is the opportunity cost of holding money • If the price level goes up, do we demand more or less money? • More • need more money to cover our purchases

26. If our income goes up, will we demand more or less money? • More • Can afford to buy more goods and services • Money demand related to interest rate, price level and real income as: MD = f(-i, +P, +Y) i = Interest rate P = Price level Y = Real GDP

27. Interest Rate (i) Demand for Money (MD) Money (M) Money Demand Curve Shows the relationship between interest rate and the quantity of money demanded holding everything else constant

28. Interest Rate (i) Demand for Money (MD) Money (M) What shifts the Money Demand Curve? D1 Increase to D1 if P↑ or Y↑ D2 Decrease to D2 if P↓ or Y↓

29. Supply for Money (MS) Interest Rate (i) i Demand for Money (MD) Money (M) The Equilibrium Interest Rate: The Interaction of Money Supply and Money Demand

30. Supply for Money (MS) Interest Rate (i) i2 i MD2 Demand for Money (MD) Money (M) How does an increase in the price level affect the interest rates? G E MD ↑ i↑

31. Supply for Money (MS) Interest Rate (i) i i1 Demand for Money (MD) MD1 Money (M) How does a economic recession affect the interest rate? MD↓ i↓ E F

32. MS2 Supply for Money (MS) Interest Rate (i) i2 i Demand for Money (MD) Money (M) How does an open market sale by the central bank affect the interest rate? MS ↓ i↑ This is a contractionary monetary policy

33. Another Question • I'm trying to understand the example in page 329 about appreciation and depreciation but I think there's something wrong in it. Can you do it in class?

34. My answer • Let go over it together

35. How does the interest rate relate to the exchange rate? • Interest Arbitrage: • Relationship between interest rates and the exchange rate in the short run

36. The Interest Rate And the Exchange Rate in the Short Run • Example: • You own a company in U.S. looking to invest $10,000 cash. • Assume U.K. has the best rate of 12%. • You must first buy pounds in the foreign exchange market, then invest pounds in U.K. market. • If spot exchange rate is $2/pound, which gives you £5000 to invest

37. The Interest Rate And the Exchange Rate in the Short Run • Example (continued): • In 3 months the money will be worth • 5000 (1+0.12/4) = £5,150 • If the exchange rate is the same, you will get • 5,150 * 2 = $10,300

38. The Interest Rate And the Exchange Rate in the Short Run 2. If pound drops to $1.975/pound • By how much has pound depreciated? [(2-1.975) / 2] * 100 = %1.25 in 3 months • the books says 5% (that is the annual rate) 1.25 * 4 = 5% depreciation • You end up with £5,150 * 1.975 = $10,171.25 • So what is your rate of return? [(10,171.25-10,000)/10,000] * 4 = 7%

39. So your total rate of return is the • difference between annual interest rate in U.K. (12%) and depreciation of the pound (5%) = approx. 7%.

40. Similarly • If the pound appreciates by 5% • Total return is sum of annual interest rate in U.K. (12%) and appreciation of the pound (5%) = approx. 17%

41. To eliminate exchange-rate risk • Buy foreign currency in spot exchange market • At same time sell pound in forward exchange market delivering on date of investment’s maturity • If forward rate > current spot rate (pound is selling at a forward premium) • more profitable to invest in U.K. • If forward rate < current spot rate (pound is selling at forward discount) • must compare the gain in favorable interest rate to loss suffered by exchange rate

42. But really the story is more complicated than that. Here is a rough numerical example to show the interest rate parity • Annual yield (interest rate) on US bond = 10% • Annual yield (interest rate) on Irish bond = 6% • Spot exchange rate  $1 = €1 • Forward exchange rate  $1 = €1

43. So Irish will want to invest in the US • Spot demand for dollar goes up  dollar appreciates by 1 % • Demand for US bonds goes up  price of bonds goes up  interest rate goes down by 1% point. • Demand for Irish bonds goes down price of bond goes down  interest rate goes up by 1% point. • Forwards supply of dollar goes up  dollar depreciates by 1% • Now • Dollar sells at 2% forward discount = Interest rate in US is 2% point higher than in Ireland

44. Interest rate parity • Funds continue moving between the two countries until • forward premium or discount equals the interest rate differential

45. The Interest Rate And the Exchange Rate in the Short Run • What does tightening of money in Ireland do to interest rates? • MS declines interest rates go up • What does this do in the market for euro? • Demand goes up euro appreciates • Supply goes down euro appreciates • This process continues until interest parity is achieved.

46. Interest Rates, the Exchange Rate, and the Balance of Payments • Changes in Interest Rates: • Increasing a country’s interest rate: • Causes capital inflow • Appreciation of a country’s currency • Decreasing a country’s interest rate: • Causes capital outflow • Depreciates a country’s currency • Movement of capital causes change exchange rates • Interest rate volatility  exchange rate volatility

47. Suppose there is no capital inflow or outflow $/Euro S1 (imports of G & S) 2.5 2.0 1.5 D1 (exports of G $ S) 100 200 300 400 500 Euros At E, quantity demanded for euros = quantity supplied  current account balance D & S are due current account activities E

48. What happens if there are now capital flows between countries? • Assume U.S. interest rates increase • Capital moves into US. • Supply of euro increases • Does demand for euro decrease? • No there was no capital inflow before.

49. $/Euro S1 (imports of G & S) 2.5 2.0 1.5 D1 (exports of G $ S) 100 200 300 400 500 Euros Supply shift right euro depreciates imports of goods and services go down to less than 200 exports of goods and services go up to more than 400 current account surplus = net capital outflow E1 S2 =S1 + capital outflow E2

50. Asst 8 • Questions 9, 10, and 13, Page 338 • It is an individual assignment • Has 20 points • Is due before 10PM on Friday, November 30 • Do not attach the graphs in a separate document form the texts. Attach only one document to your email please.