International Macro Revision PDF

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International Macro Revision Notes

Chapter 13  

National Income Accounting Balance of Payments Accounting

National income represents the total amount of money that factors of production earn during the course of a year. This mainly includes payments of wages, rents, profits, and interest to workers and owners of capital and property. The national product refers to the value of output produced by an economy during the course of a year. The national product represents the market value of all goods and services produced by firms in a country. The national product is commonly referred to as GDP. GDP is defined as the value of all final goods and services produced within borders of a country during some period of time, usually a year. A few things are worth emphasizing about this definition. - First, GDP is measured in terms of the monetary value at which the items exchange in the market. - Second, it measures only final goods and services as opposed to intermediate goods. Thus, wheat sold by a farmer to a flour mill will not be directly included as part of GDP since the value of the wheat will be included in the value of the flour that the mill sells to the bakery. - GDP must be distinguished from another common measure of national output, gross national product (GNP). GDP measures all production within the borders of the country regardless of who owns the factors used in the production process. GNP measures all production achieved by domestic factors of production regardless of where the production takes place. The product identity describes the way in which the gross domestic product (GDP) is measured – GDP = C + I + G + EX – IM C = Consumption – The portion of GNP purchased by private households to fulfil current wants. I = Investment – The part of output used by private firms to produce future output. Steel and bricks used to build a factory are part of investment spending, as are services provided by a technician who helps build business computers. G = Government Purchases – Any goods and services purchased by federal, state, or local governments. Included in government purchases are federal military spending, highway construction, education. Transfer payments are not included in government purchases. Balance of Payments The balance of payments accounts is a record of all international transactions that are undertaken between residents of one country and residents of other countries during the year. The accounts are divided into several subaccounts, the most important being the current account and the financial account. Current account + Capital account = Financial account 1. Transactions that arise from the export or import of goods and services enter directly into the current account. When a French consumer imports American blue jeans, for example, the transaction enters the U.S. balance of payments accounts as a credit on the current account. If CA > 0, then exports exceeds imports, and the country has a CA surplus.

International Macro Revision Notes 2. Transactions that arise from the purchase or sale of financial assets. The financial account records all international purchases or sales of financial assets. When an American company buys a French factory, the transaction enters the U.S. BoP as a debit in the financial account. Saving and the Current Account In a closed economy, national saving always equals investment. This tells us that the closed economy as a whole can increase its wealth only by accumulating new capital. Let S stand for national saving. S = Y – C – G, which can then lead to S = I However, in an open economy, national savings S equals Y – C – G and that CA = EX – IM, we can rewrite the GNP identity as: S = I + CA This shows an open economy can save either by building up its capital stock or by acquiring foreign wealth, but a closed economy can save only by building up its capital stock. Private and Government Saving Private saving is defined as the part of disposable income that is saved rather than consumed. Disposable income is national income, Y, less the net taxes collected from households and firms by the government, T. Private saving, denoted S P can be expressed as:

SP

=Y–T–C

Government saving is defined similarly to private saving. The governments income is its net tax revenue, T, while its ‘consumption’ is government purchases, G.

S g =T −G

International Macro Revision Notes

Chapter 14 -

Basics of exchange rates How exchange rates are determined in FX market equilibrium Interest parity condition

The exchange rate (ER) represents the number of units of one currency that exchanges for a unit of another. There are two ways to express an exchange rate between two currencies (e.g., between the $ and the £). For example, on January 6,2010, the following exchange rates prevailed: $/£ = 1.59 which implies £/$ = 0.63 Currency appreciation – A currency appreciated with respect to another when its value rises in terms of the other. Currency depreciation – A currency depreciates with respect to another when its value falls in terms of the other. A depreciated currency means that imports are more expensive, and exports are less expensive.

The Demand for Foreign Currency Assets To understand how exchange rates are determined by the foreign exchange market. We first must ask how the major actors’ demands for different types of foreign currency deposits are determined. The demand for a foreign currency bank deposit is influenced by the same considerations that influence the demand for any other asset. Chief among these considerations is our view of what the deposit will be worth in the future. Asset Returns: Because the object of saving is to provide for future consumption, we judge the desirability of an asset largely on the basis of its rate of return, that is, the percentage increase in value it offers over some time period. You often cannot know with certainty the return that an asset will actually pay after you buy it. Both the dividend and the share’s resale price may be hard to predict. Your decision therefore must be based on an expected rate of return. The percentage difference between the expected future value and the price you pay for the asset today equals the asset’s expected rate of return over the time period. Real Rate of Return: The rate of return computed by measuring asset values in terms of some broad representative basket of products that savers regularly purchase.

International Macro Revision Notes Interest Rates As in other asset markets, participants in the foreign exchange market base their demands for deposits of different currencies on a comparison of these assets’ expected rate of return. The first piece of information needed to compute the rate of return on a deposit of a particular currency is the currency’s interest rate, the amount of that currency an individual can earn by lending a unit of the currency for a year. When you buy a U.S. treasury bill, you earn the interest rate on dollars because you are lending dollars to the U.S. government. Exchange Rates and Asset Returns The interest rates offered by a dollar and a euro deposit tell us how their dollar and euro values will change over a year. The other piece of information we need in order to compare the rates of return offered by dollar and euro deposits is the expected change in the dollar/euro exchange rate over the year. To see which deposit, euro, or dollar, offers a higher expected rate of return, you must ask the question: If I use dollars to buy a euro deposit, how many dollars will I get back after a year? This is calculating the dollar rate of return on a euro deposit. Notation:

R€

= today’s interest rate on one-year euro deposits

E$ / €

= today’s dollar/euro exchange rate

E$e / €

= dollar/euro exchange rate expected to prevail next year

Therefore, the expected rate of return on a euro deposit, measured in terms of dollars is:

E e$ /€ R€ +¿

-

E$ / € )/ E$ / €

or

E $e / € ( 1+i€) −1 E$/€

The expected rate of return difference between dollar and euro deposits is therefore equal to

R$

-[

E $e /€ R€ +¿

-

E$ / € )/ E$ / € ]

When the difference above is positive, dollar deposits yield the higher expected rate of return.

We are therefore assuming for now that participants in the foreign exchange market base their demands for foreign currency assets exclusively on a comparison of those assets’ expected rates of return. The main reason for making this assumption is that it simplifies our analysis of how exchange rates are determined in the foreign exchange market.

International Macro Revision Notes

Equilibrium in the foreign exchange market

The foreign exchange market is in equilibrium when deposits of all currencies offer the same expected rate of return. The condition that the expected returns on deposits of any 2 currencies are equal when measured in the same currency is called the interest parity condition.

E $e /€ R$ = R€ +¿

-

E$ / € )/ E$ / €

Why must it hold? If the rate of return on dollar deposits was greater than the rate of return on pound deposits, investors would want to switch from pound deposits to dollar deposits. This would drive down the demand and price of pounds. The dollar would appreciate, and the pound would depreciate, increasing the rate of return on the pound until equality is achieved. Depreciation of the domestic currency today lowers the expected rate of return on foreign currency deposits. When the domestic currency depreciates, the initial cost of investing in foreign currency deposits increases, thereby lowering the expected rate of return of foreign currency deposits. Example Suppose today’s dollar/euro rate is $1.00 per euro and the exchange rate you expect for this day next year is $1.05 per euro. Then the expected rate of dollar depreciation against the euro is (1.05-1.00)/1.00 = 0.05, or 5 percent per year. This means that when you buy a euro deposit, you not only earn the interest R€ but also get a 5% ‘bonus’ in terms of dollars. Now suppose today’s exchange rate suddenly jumps to $1.03 per euro (depreciation of the dollar), but the expected future rate is still $1.05 per euro. What happens to the ‘bonus’ you expected to get from the euro’s increase in value in terms of dollars? The expected rate of dollar depreciation is now only (1.05-1.03)/1.03 = 0.019, or 1.9% instead of 5%. Equilibrium Exchange Rate Our main conclusion will be that exchange rates always adjust to maintain interest parity. Exchange rate will tend to settle at point 1 here. Suppose we are at point 2, the downward sloping schedule measuring the expected dollar return on euro deposits tells us the rate of return on euro deposits is less than the rate of return on dollar deposits. Anyone holding euro deposits wishes to sell them for the more lucrative dollar deposits. The FX market is out of equilibrium as participants are unwilling to hold euro deposits. The euro deposit holders will try to sell them for $ deposits and by

International Macro Revision Notes offering them a better price for dollars, the $/ € falls towards point 1, terms of $. Returns are the same now – Equilibrium.

€

become cheaper in

The Effect of Changing Interest Rates on the Current Exchange Rate 1. Effect of a Rise in the Dollar Interest Rate

The increase in the U.S. interest rates will shift the U.S rates of return to the right. The higher rates will make the U.S. dollar investments more attractive to investors, leading to an increase in demand for dollars on the FX market resulting in an appreciation of the dollar, a depreciation of the Euro thus a decrease in E$ / €

2. Effect of a Rise in the Euro Interest Rate The increase in Euro interest rate will cause the downward sloping schedule (expected $ return on euro deposits) to shift rightward. An increase in R€ raises the value of expected rate of return on euro deposits for any fixed values of E$ / € . The expected return on euro deposits now exceeds that on dollar deposits. This will cause the $/euro exchange to rise to eliminate the excess supply of $ assets at point 1.

The Effect of an Expected Appreciation of the Euro The increase in the expected exchange rate will raise the rate of return on euro assets, which at the original exchange rate will cause the rate of return on euro assets to exceed the rate of return on U.S. assets. This will raise the demand for the Euro on the FX market as U.S. investors seek the higher

International Macro Revision Notes average return on euro assets. This will lower supply of euros by European investors who decide to invest at home than abroad, causing a euro appreciation and dollar depreciation.

Chapter 15     

Unified equilibrium in the asset markets Interest parity condition and money market equilibrium condition Unified money-FX market graph Effect of monetary factors on exchange rates in the SR and LR Overshooting

What is Money? Money is an asset that is widely used as a means of payment. Different groups of assets may be classified as money, but the standard definition is M1 = currency in circulation + checking deposits + debit card accounts. Money’s main functions: -

Medium of exchange – facilitates trade Unit of account – widely recognised measure of value Store of Value – because money can be used to transfer purchasing power from the present into the future, it is also a store of value.

How is Money Supply determined? An economy’s money supply is controlled by the central bank. The central bank directly regulates the amount of currency in existence. If the central bank wants to increase the amount of $ in the country, it will buy financial assets such as bonds. Money Demand Money demand represents the amount of monetary assets that people are willing to hold instead of illiquid assets. Individual Money Demand Determinants - Interest rates/ expected rates of return – Money pays 0 nominal return and checking deposits often do pay interest but offer a RoR that is lower than less liquid forms of wealth. So, all else equal, a rise in the interest rate paid by $ denominated non-monetary assets such as bonds, decreases the demand for the dollar. The main theory is that people prefer assets offering higher expected returns. - Risk – It is risky to hold money because an unexpected increase in the prices of goods and services could reduce the value of your money in terms of the goods you consume. However, other assets such as government bonds also face the same risk, so this is not an important factor. - Liquidity – The main benefit of holding money comes from liquidity, households hold money because it is the easiest way of financing everyday purchases. A need for greater liquidity occurs when the price of transactions increases, or the quantity of goods bought increases. Aggregate Demand of Money Determinants The total demand for money by all households and firms in the economy is the sum of all the economy’s individual money demands.

International Macro Revision Notes - Interest rate –A rise in interest rates causes each individual in the economy to reduce the demand for money. All else equal, aggregate money demand therefore falls when the interest rate rises. - The price level - If the price level rises, individual households and firms must spend more money than before to purchase their usual weekly baskets of goods and services therefore they will demand more money. - Real national income - Greater income implies more goods and services can be bought, so that more money is needed to conduct transactions. Model of Aggregate Money Demand If P is the price level, R is the interest rate, and Y is real GNP, the aggregate demand for money, M d , can be expressed as:

M d=P X L(R , Y ) Where the value of L(R, Y) falls when R rises and rises when Y rises. Alternatively,

Md =L(R ,Y ) where L(R ,Y ) is the aggregate real money demand. P

The downward sloping real money demand schedule shows that for a given real income level Y, real money demand rises as the interest rate falls.

Effect on Aggregate Real Money Demand Schedule of a Rise in Real Income

An increase in real income from Y^1 to Y^2 raises the demand for real money balances at every level of interest rate and causes the demand schedule to shift upward. Changes in interest rate cause movements along the L(R,Y) schedule.

International Macro Revision Notes

Money Market Model / Equilibrium Interest rate The money market is in equilibrium when the money supply set by the central bank equals aggregate money demand. s

M =M

d

After dividing both sides of this equality by the price level, we can express the money market equilibrium condition in terms of aggregate real money demand as: s

M =L(R ,Y ) P Given the price level, P, and the level of output, Y, the equilibrium interest rate is the one at which aggregate real money demand = real money supply.

When the interest rate is too high, such as at point R2 , there is an excess supply of monetary assets as people are holding more money than they desire. Thus, people will want to give up money for interest bearing assets such as bonds. People will begin lending their extra money but since there are more people lending than people borrowing, there is a downward pressure on I.R pushing it down to R1 .

Effect of an increase in the Money Supply on the Interest rate

Since we are holding P constant, a rise in the money supply to M 2 increases the real money supply to 2 2 M /P . Point 2 is the new equilibrium and R is the new, lower interest rate that induces people to hold the increased available real money supply. I.R falls because when M s increased, there is an excess supply of money at the old equilibrium I.R, R1 . People will want to give up money for interest bearing assets.

International Macro Revision Notes Likewise, a fall in M s causes an excess demand for money at the interest rate that previously balanced supply and demand. People attempt to sell interest bearing assets, that is, to borrow – to rebuild their depleted money holdings. Since they cannot all be successful, the interest rate is pushed upward until everyone is content to hold a smaller real money stock.

Effect on the Interest Rate of a rise in Real income When output increases, the aggregate real money demand schedule shifts to the right moving the equilibrium to point 2. At the old interest rate, there is an excess demand for money equal to Q 2 −Q 1 . Since real money supply is given, people will be switching their bonds to money causing their prices to fall and thus increasing interest rates.

Unified equilibrium in money and FX markets We say that money and FX markets are in equilibrium when each market is separately in equilibrium. That is when the following conditions hold: - Interest parity condition: - Money market equilibrium condition:

Ms =L(R ,Y ) P

A strengthening of the $ today (fall in E$ / € ) relative to its given expected future level makes euro deposits more attractive by leading people to anticipate a sharper $ depreciation in the future. At the intersection of the 2 schedules (1’), the expected RoR on $ and euro deposits are equal and thus interest parity holds. Money market equilibrium is at point 1, where the $ interest rate R$1 induces people to demand real balances = to the U.S. real money s supply M US /P US .

International Macro Revision Notes

The U.S. money market (bottom) determines the dollar interest rate, which in turn affects the exchange rate that maintains interest parity.

Money Supply and Exchange Rate in The Short Run In the sho...