Chapter One

1. Exchange Rate and the Foreign Exchange Market

•Each country has a currency in which the prices of Gs & Ss are quoted.
• E.g. dollar -United States, euro -Germany, pound sterling-Britain, yen -
Japan, Birr - Ethiopia, shelling - Kenya, and the peso-Mexico,
•International trade takes place via exchange rates, because it allow us to
compare the prices of goods and services produced in different countries.
•E.g. Price Yaris brand automobile in Ethiopia @ CM price is Br. 350,000
whereas it costs shi.200,000 in Kenya.
•In which country price is dearer?
Comparison is possible if we know the relative price of Birr and Shelling.
exchange rate : -The price of one currency in terms of another
the amount of domestic/ foreign currency that is needed to obtain a unit of
foreign/domestic currency.
It can be expressed as a ratio of price of dollar to foreign currency OR price of
foreign currency to price of dollar.

Direct (American) terms Indirect (American) terms

1
 The foreign exchange market
– Is the market where one buys or sells the currency of country A with
the currency of country B
 A currency exchange rate
– Is simply the ratio of a unit of currency of country A to a unit of the
currency of country B at the time of the buy or sell transaction
• The demand for foreign currencies arises if:
– Tourists visit another country
– A domestic firm wants to import from other nations
– An individual wants to invest abroad
• The supply of a nation’s foreign currency arises from if:
– Foreign tourist expenditures in the nation
– Export earning
– Foreign investment
• Exchange rates: are determined by the interaction of the households,
firms, and financial institutions that buy and sell foreign currencies
to make international payments.
2
Four levels of transactors or participants

1. traditional users -Immediate users and suppliers of foreign currencies

 importers/exporters/ tourists/investors.

2. commercial bank- act as clearing house b/n users and earners of foreign
exchange. (central collection place)

3. Foreign exchange brokers -interbank / wholesale market, through whom

the nation's commercial banks even out their forex inflows and outflows
among themselves.

4. nation’s central bank – act as the seller or buyer of last resort when nation's
total forex earning and expenditure is unequal. (Have a right to recourse)

3
• Characteristics of foreign exchange market:
√ Volume is enormous:
√ Highly integrated globally:
√ Vehicle currency:

• Functions of the Foreign Exchange Market

– Transfer of Purchasing Power/funds: transfer one nation’s fund
and currency to other.
– Provision of Credit: when goods are at transit, it enables buyers
to resell & made pay’t.
– Minimizing Forex Risk: esp. role of commercial banks as clearing
house
– It provides facilities for hedging (forex risk avoidance) and
speculation (forex risk taking)

4
• Different concepts of the exchange rate and Exchange rate regimes
– Arbitrage: purchase of a currency where it is cheaper, resale in the monetary
center where it is more expensive, in order to make a profit.
– It is the practice of taking advantage of a state of imbalance between two/more
markets.
– A person who engages in arbitrage is called an arbitrageur.
• Triangular arbitrage is the act of exploiting an arbitrage opportunity
resulting from a pricing discrepancy among three different currencies
in the foreign exchange market. (cross exchange rate)
• Suppose the current exchange rates of currency pairs are as follows:
 EUR/$: 1.1837 EUR/￡: 0.7231 ￡/$: 1.6388
• In such a scenario, a foreign exchange trader could perform a triangular
arbitrage by adopting the following steps:
– Buy 10,000 Euros for $11,837 USD.
– Sell the 10,000 Euros, for 7,231 British pounds (GBP).
– The 7,231 GBP in turn could then be sold for $11,850 USD.
• A profit of $11,850 - $11,837 = $13 per trade earned trader.
• Adv. Increase demand for currency in the country where the currency is
cheaper, increase supply of currency where the currency is more expensive
– Rapidly equalizes exchange rate among countries=> tendency to unify monetary centers
to single market.
5
 TYPES OF FOREIGN EXCHANGE TRANSACTIONS:
• 1. Spot exchange rates/ spot transaction
– the day’s rate offered by a dealer/bank=> immediate delivery
– The most common type of foreign exchange transaction
– involves the payment and receipt of the foreign exchange within two
business days after the day the transaction is agreed upon.
– The two-day period gives adequate time for the parties to send
instructions to debit and credit the appropriate bank accounts at home
and abroad.
• Participants in spot transaction: Commercial banks, Brokers, Customers of
commercial and central banks.
• 2. Forward exchange rates:
– Agreed in advance rates to buy/sell a currency on a future date at a rate
agreed upon today.
– Usually quoted 30, 90, 120 days in advance
– Forward contracts can be renegotiated for one or more periods when they
become due.

6
• FD (forward discount)
 If the forward rate is below the present spot rate, the
foreign currency is said to be at a forward discount with
respect to the domestic currency.
• FP (forward premium)
 If the forward rate is above the present spot rate, the
foreign currency is said to be at a forward premium with
respect to the domestic currency.
• Participants: Arbitrageurs, Traders, Hedgers and
Speculators.

• Where, F = the forward rate of exchange

S = the spot rate of exchange
n = the number of months in the forward contract

7
• 3. Option rate: A foreign exchange option gives its owner the right to
buy or sell a specified amount of foreign currency at a specified
price at any time up to a specified expiration date.
• 4. Swap rate: is the conversion of one currency to another currency at
one point in time, with an agreement to reconvert it back to the
original currency at a specified time in the future.
– involves the simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates.
– The rates of both exchanges are agreed to in advance
• Since this agreement is executed as a single transaction, the dealer
incurs no unexpected foreign exchange risk.

8
• Foreign exchange rate determination
– Under the flexible exchange rate system, the equilibrium exchange rate is
determined by the market forces of Supply and Demand.
– The demand for foreign exchange corresponds to the debit
items on a nation’s BoPs statement;
• Ethiopia demand for dollars may stream from its desire to import US goods and
services, to make investments in US, /to make transfer payments to residents in US.
• Ethiopia demand for dollars varies inversely with its price; that is, fewer dollars are
demanded at higher prices than at lower prices.
• As the birr depreciates against the dollar (the birr price of the dollar rises), US
goods and services become more expensive to Ethiopian importers.
• This is because more birrs are required to purchase each dollar needed to
finance the import purchases.
– The supply of foreign exchange refers to the amount of foreign
exchange that will be offered to the market at various exchange
rates.
• For example, the supply of dollars is generated by the desire of US residents and businesses to
import Ethiopian goods and services, to lend funds and make investments in the Ethiopia, and
to extend transfer payments to Ethiopian residents.

9
 R= Br/$

Millions of $/day
The higher the exchange rate (R), the greater the quantity of dollars earned by or
supplied to the Ethiopia. Dollar appreciation
It refers to Depreciation (increase) in the domestic currency price of foreign currency.

Is a strong (appreciating) birr always good and a weak (depreciating)

birr always bad?
10
• Foreign exchange risk, Hedging and speculation
• Foreign exchange risk
– Nation’s DD and SS curves for forex shift causing spot and forward rates to
fluctuate frequently.
• Change in tastes for domestic and foreign products.
• Growth and inflation rates in d/t nations
• Change in relative interest
• Change in the expectations.
• Arises out of three types of exposures
– Transaction exposure: transaction involving future pay’ts and receipts in
forex.
– Translation/ Accounting exposure: a need to value inventories held abroad in
terms of domestic currency
– Economic exposure: estimating domestic currency value of future profitability
of the firm

11
• Hedging
– Refers to avoidance of forex risk / covering of an open position .
– But cost of avoiding forex risk depends on the positive difference between the
borrowing and deposit rates of interest.
– Usually takes place in forward market.
• Speculation
– Is opposite of hedging, in the hope of making profit
• In spot market: believing the spot rate of particular currency will rise, they can
purchase currency now and hold it in deposit.
• In forward markets: believing the spot rate of particular currency will rise in
the next three months than present three months.
• Effect of speculation
– Stabilizing effect : purchase of foreign currency when domestic price of
foreign currency falls in the expectation it will rise soon.
– Destabilizing effect: sale of foreign currency when exchange rate falls with an
expectation that it will fall further.
12
• Interest arbitrage and efficiency of forex market
• Interest arbitrage refers to the international flow of short-term liquid
capital to earn higher returns abroad.
• Uncovered interest arbitrage: the transfer of funds to abroad to take an
advantage of higher interest rates in foreign monetary centers involves the
conversion of the Dc to the Fc to make investment.
• At maturity date, Fc reconverted to Dc plus interest earned abroad.
• covered interest arbitrage: refers to the spot purchase of the foreign
currency to make the investment and the balancing with simultaneous forward
sale (swap) of the foreign currency to cover the foreign exchange risk.

13
• The interaction between foreign exchange rate and financial market
• Demand for foreign currency assets:

• What influences the demand of (willingness to buy)

deposits denominated in domestic or foreign currency?

• Factors that influence the return on assets determine the

demand of those assets.
– Interest rate

– Risk involved

– Liquidity of asset

14
 The Demand of Currency Deposits (cont.)

• Rate of return: the percentage change in value that an asset

offers during a time period.
– The annual return for $100 savings deposit with an interest rate of 2%
is $100 x 1.02 = $102, so that the rate of return = ($102 - $100)/$100 =
2%
• Real rate of return: inflation-adjusted rate of return,
– which represents the additional amount of goods & services that can
be purchased with earnings from the asset.
– The real rate of return for the above savings deposit when inflation is
1.5% is: 2% – 1.5% = 0.5%. After accounting for the rise in the prices
of goods and services, the asset can purchase 0.5% more goods and
services after 1 year.

15
 The Demand of Currency Deposits (cont.)

• If prices are fixed, the inflation rate is 0% and

Nominal rates of return = real rates of return.
• Because trading of deposits in different currencies
occurs on a daily basis, we often assume that prices
do not change from day to day.
– A good assumption to make for the short run.

16
 The Demand of Currency Deposits (cont.)

• Risk of holding assets also influences decisions about whether to

buy them.
• Liquidity of an asset, or ease of using the asset to buy goods and
services, also influences the willingness to buy assets.
• But we assume that risk and liquidity of currency deposits in
foreign exchange markets are essentially the same, regardless of
their currency denomination.
– Risk and liquidity are only of secondary importance when deciding to buy or
sell currency deposits.
– Importers and exporters may be concerned about risk and liquidity, but they
make up a small fraction of the market.

17
 The Demand of Currency Deposits (cont.)

• We, therefore, say that investors are primarily concerned

about the rates of return on currency deposits.
• Rates of return that investors expect to earn are
determined by
– interest rates that the assets will earn.
– expectations about appreciation or depreciation

18
 The Demand of Currency Deposits (cont.)

• A currency deposit’s interest rate is the amount of a currency that

an individual or institution can earn by lending a unit of the
currency for a year.
• The rate of return for a deposit in domestic currency is the interest
rate that the deposit earns.
• To compare the rate of return on a deposit in domestic currency
with one in foreign currency, consider
– the interest rate for the foreign currency deposit
– the expected rate of appreciation or depreciation of the foreign currency
relative to the domestic currency.

19
 The Demand of Currency Deposits (cont.)
• Suppose the interest rate on a dollar deposit is 2%.
• Suppose the interest rate on a euro deposit is 4%.
Q Does a euro deposit yield a higher expected rate
of return?
– Suppose today the exchange rate is $1/€1, and the expected rate one year in
the future is $0.97/€1.
– $100 can be exchanged today for €100.
– These €100 will yield €104 after one year.
– These €104 are expected to be worth $0.97/€1 x €104 = $100.88 in one year.
• The rate of return in terms of dollars from investing in euro deposits
is ($100.88-$100)/$100 = 0.88%.

20
 The Demand of Currency Deposits (cont.)

• Let’s compare this rate of return with the rate of return from a
dollar deposit.
– The rate of return is simply the interest rate.
– After 1 year the $100 is expected to yield $102:
($102-$100)/$100 = 2%

• The euro deposit has a lower expected rate of return: thus, all
investors should be willing to dollar deposits and none should
be willing to hold euro deposits.

21
 The Demand of Currency Deposits (cont.)

• Note that the expected rate of appreciation of

the dollar was ($0.97- $1)/$1 = -0.03 = -3%.
• We simplify the analysis by saying that the dollar rate of
return on euro deposits approximately equals
– the interest rate on euro deposits plus the expected rate of
appreciation of euro deposits
– 4% + -3% = 1% ≈ 0.88%

(𝑬𝒆$ € − 𝑬$ €)
– 𝑹€ + / /
𝑬$ €
/

22
 The Demand of Currency Deposits (cont.)

• The difference in the rate of return on dollar deposits

and euro deposits is
• R$ - (R€ + (Ee$/€ - E$/€)/E$/€ ) =
R$ - R€ - (Ee$/€ - E$/€)/E$/€

expected current
expected rate interest rate exchange rate exchange rate
of return = on euro
interest rate deposits expected rate of
on dollar appreciation of the euro
deposits

Expected rate of return on euro deposits

23
E.g. Comparing Dollar Rates of Return on Dollar and Euro Deposits

 Expected annual real rate of return on dollar deposits is 4 % higher than

that on euro.
 Interest difference is the same (4 percent), the two assets have the same
expected rate of return.
 A 4 % interest difference in favor of dollar deposits is offsetted by an 8%
expected depreciation of the dollar, so euro deposits are preferred.
 Dollar is expected to appreciate by 4%, dollar deposits are preferred
24
 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.
• Two currencies are equal when measured in the same currency is
called the interest parity condition.
• A market said to efficient if price reflects all available information.
• similarly, Forex market said to efficient if forward exchange rate
accurately predicts future spot exchange rate.
– Available information, Investors cannot earn consistent and unusual profit.
• Note: even if Forex market were efficient we cannot expect forward
rate same with spot rate b/se of unforeseen events=> volatility of ‘e’

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• Intentionally Left As
Page Breaker

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Test _1 Friday May 10,

2019@11;00 local time
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 Chapter 2
Money, Interest Rates, and Exchange Rates
 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.
• Money can be defined narrowly or broadly.
• Currency in circulation, checking deposits, and debit card accounts form
a narrow definition of money.
• Deposits of currency are excluded from this narrow definition, although
they may act as a substitute for money in a broader definition.
 Money Supply
• The central bank substantially controls the quantity of
money that circulates in an economy, the money supply.
– In the US, the central banking system is the Federal
Reserve and Ethiopia, NB.
• Money demand: represents the amount of monetary
assets that people are willing to hold (instead of illiquid
assets).
 What influences willingness to hold monetary assets?
 We consider individual demand of money and aggregate demand
of money
 What Influences Demand of Money for
Individuals and Institutions?
1. Interest rates/expected rates of return
2. Price level: … unexpected inflation
3. Income
 What Influences Aggregate
Demand of Money?
1. Interest rates/expected rates of return
– A higher interest rate means a higher opportunity cost of
holding monetary assets  lower demand of money.
2. Prices
– A higher level of average prices means a greater need for
liquidity to buy the same amount of goods and services
 higher demand of money.
 What Influences Aggregate
Demand of Money? (cont.)
3. Income
– A higher real national income (GNP) means more goods
and services are being produced and bought in
transactions, increasing the need for liquidity  higher
demand of money.
 A Model of Aggregate Money Demand

The aggregate demand of money can be expressed as:

Md = P x L(R,Y)
where:
P_ is the price level
Y _is real national income
R_ is a measure of interest rates
L(R,Y) is the aggregate demand of real monetary assets
Alternatively:
Md/P = L(R,Y)
Aggregate demand of real monetary assets is a function of national
income and interest rates.
Fig. 2-1: Aggregate Real Money
Demand and the Interest Rate

For a given level of

income, real money
demand decreases
as the interest rate
increases.
Fig. 2-2: Effect on the Aggregate Real Money Demand
Schedule of a Rise in Real Income

When income
increases, real money
demand increases at
every interest rate.
 A Model of the Money Market
• The money market is where monetary or liquid
assets, which are loosely called “money,” are lent and
borrowed.
– Monetary assets in the money market generally have low
interest rates compared to interest rates on bonds, loans,
and deposits of currency in the foreign exchange markets.
– Domestic interest rates directly affect rates of return on
domestic currency deposits in the foreign exchange
markets.
 A Model of the Money Market
• In equilibrium:
Ms = Md
• Alternatively, in real terms:
Ms/P = L(R,Y)
Fig 2-3: Determination of the Equilibrium
Interest Rate
Fig 2-4: Effect of an Increase in the
Money Supply on the Interest Rate
An increase in the
money supply lowers
the interest rate for a
given price level.

A decrease in the
money supply raises
the interest rate for a
given price level.
Fig 2-5: Effect of Rise in Real Income on the Interest
Rate
An increase in national
income increases
equilibrium interest rates for
a given price level.
Fig 2-6: Simultaneous Equilibrium in the U.S. Money Market and
the Foreign Exchange Market
Fig 2-7: Money Market/Exchange Rate Linkages
Fig 2-8: Effect of Increase in the U.S. Money Supply on the
Dollar/Euro Exchange Rate and Dollar Interest Rate
 Changes in the Domestic Money Supply
• M R E (depreciates)
• What happens if there is a decrease in a country’s money
supply?
• An increase in the supply of euros causes a depreciation of the
euro (appreciation of
the dollar).
• The increase in the supply of Euros reduces interest rates in the
EU, reducing the expected rate of return on euro deposits.
• This reduction in the expected rate of return on euro deposits
causes the euro to depreciate.
• We predict no change in the U.S. money market due to the
change in the supply of Euros.
 Long Run and Short Run
• In the short run, prices do not have sufficient time to adjust to
market conditions.
– the analysis heretofore has been a short run analysis.

• In the long run, prices of factors of production and of output have

sufficient time to adjust to market conditions.
– Wages adjust to the demand and supply of labor.
– Real output and income are determined by the amount of workers and
other factors of production—by the economy’s productive capacity—not by
the quantity of money supplied.
– (Real) interest rates depend on the supply of saved funds and the demand
of saved funds.
 Long Run and Short Run (cont.)

• In the long run, the quantity of money supplied is

predicted not to influence the amount of output, (real)
interest rates, and the aggregate demand of real
monetary assets L(R,Y).
• However, the quantity of money supplied is predicted to
make level of average prices adjust proportionally in the
long run.
– The equilibrium condition Ms/P = L(R,Y) shows that P is predicted
to adjust proportionally when Ms adjusts because L(R,Y) does not
change.
 Long Run and Short Run (cont.)

• In the long run, there is a direct relationship between

the inflation rate and changes in the money supply.
– Ms = P x L(R,Y)
– P = Ms/L(R,Y)

𝑃 𝑀𝑠 𝐿
– 𝑝= = −
𝑃 𝑀𝑠 𝐿

– The inflation rate is predicted to equal the growth rate in

money supply minus the growth rate in money demand.
 Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its long
run response.
• Overshooting is predicted to occur when monetary policy
has an immediate effect on interest rates, but not on
prices and (expected) inflation.
• Overshooting helps to explain why exchange rates are so
volatile.
 Purchasing-Power Parity Theory
 Absolute Purchasing-Power Parity Theory
 It postulates that the equilibrium exchange rate is equal to the ratio of
the price levels in the two nations. Specifically:
𝑃
 𝑅=
𝑃∗
 Where, R is the exchange rate, P and P﹡ are respectively the general
price level in the home nation and in the foreign nation
 Law of One Price
 If the price of wheat is $0.50 per kg in US and $1.50 in Ethiopia,
firms would purchase wheat in US and resell it in Ethiopia, at a
profit.
 This commodity arbitrage would cause the price of wheat to fall in
Ethiopia and rise in US until the price is equal, say $1 per kg in both
economies.
• Shortcoming of the Theory
• This version of the PPP theory can be very misleading. There are several
reasons as following:
 It appears to give the exchange rate that equilibrates trade in goods and services
while completely disregarding the capital account( capital outflows would have
a deficit in its balance of payment, capital inflows would have a surplus if the
exchange rate were the one that equilibrated international trade in goods and
services).
 The PPP theory will not even give the exchange rate that equilibrates trade in
goods and services because of the existence of many non-traded goods (e.g.
cement, bricks except the border areas) and services (e.g. hair stylists, family
doctors).
 The absolute PPP theory fails to take into account transportation costs or other
obstructions to the free flow of international trade.
 Relative Purchasing-Power Parity Theory

• The relative PPP theory postulates that the change in the exchange rate over a
period of time should be proportional to the relative change in the price levels
in the two nations. This version of the PPP theory has some value.
• Formula
• Subscribing 0 refers to the base period and 1 to a subsequent period, the
relative PPP theory postulates that :
P1 P0
R1   
R0
P1 P0
• Where R1 and R0 are respectively, the exchange rates in period 1 and in the
base period.
 Example
• If the general price level does not change in the foreign nation from the
base period to current period (i.e. P1*/P0*=1), while the general price
level in the home nation increases by 50 percent, the relative PPP theory
postulates that the exchange rate should be 50 percent higher in current
period as compared with the base period.
 Relation between Relative PPP and Absolute PPP
 while the very existence of capital flows, transportation costs, other
obstructions to the free flow of international trade, and government
intervention policies leads to the rejection of the absolute PPP, only a
change in these would lead the relative PPP theory off target.
Problems of Relative PPPP Theory
 The ratio of the price of non-traded to the price of traded goods
and services is systematically higher in developed nations than
in developing nations
 Reason: Techniques in the production of many non-traded goods and
services (haircutting, for example) are often quite similar in developed and
developing nations.
 However, the labors in these occupations in developed nations must
receive much higher wages comparable to the high wages in the
production of traded goods and services.
 This makes the price of non-traded goods and services systematically
much higher in developed nations than in developing nations.
 Problems of Relative PPPP Theory
 The relative PPP theory will tend to predict overvalued exchange rates for
developed nations and undervalued exchange rates for developing nations,
with distortions being larger the greater the differences in the levels of
development
 Reason: The general price index includes the prices of both traded and non-traded
goods and services, and prices of the latter are not equalized by international trade
but are relatively higher in developed nations.
 Significant structural changes also lead to problems with the relative PPP
theory
• Reason: UK had liquidated many of its foreign investments during the war, so
that the equilibrium exchange rate predicted by the relative PPP theory
would have left a large deficit in the U.K. balance of payments after the war.
The end!!!
 Chapter 2
Money, Interest Rates, and Exchange Rates
 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.
• Money can be defined narrowly or broadly.
• Currency in circulation, checking deposits, and debit card accounts form
a narrow definition of money.
• Deposits of currency are excluded from this narrow definition, although
they may act as a substitute for money in a broader definition.
 Money Supply
• The central bank substantially controls the quantity of
money that circulates in an economy, the money supply.
– In the US, the central banking system is the Federal
Reserve and Ethiopia, NB.
• Money demand: represents the amount of monetary
assets that people are willing to hold (instead of illiquid
assets).
 What influences willingness to hold monetary assets?
 We consider individual demand of money and aggregate demand
of money
 What Influences Demand of Money for
Individuals and Institutions?
1. Interest rates/expected rates of return
2. Price level: … unexpected inflation
3. Income
 What Influences Aggregate
Demand of Money?
1. Interest rates/expected rates of return
– A higher interest rate means a higher opportunity cost of
holding monetary assets  lower demand of money.
2. Prices
– A higher level of average prices means a greater need for
liquidity to buy the same amount of goods and services
 higher demand of money.
 What Influences Aggregate
Demand of Money? (cont.)
3. Income
– A higher real national income (GNP) means more goods
and services are being produced and bought in
transactions, increasing the need for liquidity  higher
demand of money.
 A Model of Aggregate Money Demand

The aggregate demand of money can be expressed as:

Md = P x L(R,Y)
where:
P is the price level
Y is real national income
R is a measure of interest rates
L(R,Y) is the aggregate demand of real monetary assets
Alternatively:
Md/P = L(R,Y)
Aggregate demand of real monetary assets is a function of national
income and interest rates.
Fig. 2-1: Aggregate Real Money
Demand and the Interest Rate

For a given level of

income, real money
demand decreases
as the interest rate
increases.
Fig. 2-2: Effect on the Aggregate Real Money Demand
Schedule of a Rise in Real Income

When income
increases, real money
demand increases at
every interest rate.
 A Model of the Money Market
• The money market is where monetary or liquid
assets, which are loosely called “money,” are lent and
borrowed.
– Monetary assets in the money market generally have low
interest rates compared to interest rates on bonds, loans,
and deposits of currency in the foreign exchange markets.
– Domestic interest rates directly affect rates of return on
domestic currency deposits in the foreign exchange
markets.
 A Model of the Money Market
• In equilibrium:
Ms = Md
• Alternatively, in real terms:
Ms/P = L(R,Y)
Fig 2-3: Determination of the Equilibrium
Interest Rate
Fig 2-4: Effect of an Increase in the
Money Supply on the Interest Rate
An increase in the
money supply lowers
the interest rate for a
given price level.

A decrease in the
money supply raises
the interest rate for a
given price level.
Fig 2-5: Effect of Rise in Real Income on the Interest
Rate
An increase in national
income increases
equilibrium interest rates for
a given price level.
Fig 2-6: Simultaneous Equilibrium in the U.S. Money Market and
the Foreign Exchange Market
Fig 2-7: Money Market/Exchange Rate Linkages
Fig 2-8: Effect of Increase in the U.S. Money Supply on the
Dollar/Euro Exchange Rate and Dollar Interest Rate
 Changes in the Domestic Money Supply
• M R E (depreciates)
• What happens if there is a decrease in a country’s money
supply?
• An increase in the supply of euros causes a depreciation of the
euro (appreciation of
the dollar).
• The increase in the supply of Euros reduces interest rates in the
EU, reducing the expected rate of return on euro deposits.
• This reduction in the expected rate of return on euro deposits
causes the euro to depreciate.
• We predict no change in the U.S. money market due to the
change in the supply of Euros.
 Long Run and Short Run
• In the short run, prices do not have sufficient time to adjust to
market conditions.
– the analysis heretofore has been a short run analysis.

• In the long run, prices of factors of production and of output have

sufficient time to adjust to market conditions.
– Wages adjust to the demand and supply of labor.
– Real output and income are determined by the amount of workers and
other factors of production—by the economy’s productive capacity—not by
the quantity of money supplied.
– (Real) interest rates depend on the supply of saved funds and the demand
of saved funds.
 Long Run and Short Run (cont.)

• In the long run, the quantity of money supplied is

predicted not to influence the amount of output, (real)
interest rates, and the aggregate demand of real
monetary assets L(R,Y).
• However, the quantity of money supplied is predicted to
make level of average prices adjust proportionally in the
long run.
– The equilibrium condition Ms/P = L(R,Y) shows that P is predicted
to adjust proportionally when Ms adjusts because L(R,Y) does not
change.
 Long Run and Short Run (cont.)

• In the long run, there is a direct relationship between

the inflation rate and changes in the money supply.
– Ms = P x L(R,Y)
– P = Ms/L(R,Y)

𝑃 𝑀𝑠 𝐿
– 𝑝= = −
𝑃 𝑀𝑠 𝐿

– The inflation rate is predicted to equal the growth rate in

money supply minus the growth rate in money demand.
 Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its long
run response.
• Overshooting is predicted to occur when monetary policy
has an immediate effect on interest rates, but not on
prices and (expected) inflation.
• Overshooting helps to explain why exchange rates are so
volatile.
 Purchasing-Power Parity Theory
 Absolute Purchasing-Power Parity Theory
 It postulates that the equilibrium exchange rate is equal to the ratio of
the price levels in the two nations. Specifically:
𝑃
 𝑅=
𝑃∗
 Where, R is the exchange rate, P and P﹡ are respectively the general
price level in the home nation and in the foreign nation
 Law of One Price
 If the price of wheat is $0.50 per kg in US and $1.50 in Ethiopia,
firms would purchase wheat in US and resell it in Ethiopia, at a
profit.
 This commodity arbitrage would cause the price of wheat to fall in
Ethiopia and rise in US until the price is equal, say $1 per kg in both
economies.
• Shortcoming of the Theory
• This version of the PPP theory can be very misleading. There are several
reasons as following:
 It appears to give the exchange rate that equilibrates trade in goods and services
while completely disregarding the capital account( capital outflows would have
a deficit in its balance of payment, capital inflows would have a surplus if the
exchange rate were the one that equilibrated international trade in goods and
services).
 The PPP theory will not even give the exchange rate that equilibrates trade in
goods and services because of the existence of many non-traded goods (e.g.
cement, bricks except the border areas) and services (e.g. hair stylists, family
doctors).
 The absolute PPP theory fails to take into account transportation costs or other
obstructions to the free flow of international trade.
 Relative Purchasing-Power Parity Theory

• The relative PPP theory postulates that the change in the exchange rate over a
period of time should be proportional to the relative change in the price levels
in the two nations. This version of the PPP theory has some value.
• Formula
• Subscribing 0 refers to the base period and 1 to a subsequent period, the
relative PPP theory postulates that :
P1 P0
R1   
R0
P1 P0
• Where R1 and R0 are respectively, the exchange rates in period 1 and in the
base period.
 Example
• If the general price level does not change in the foreign nation from the
base period to current period (i.e. P1*/P0*=1), while the general price
level in the home nation increases by 50 percent, the relative PPP theory
postulates that the exchange rate should be 50 percent higher in current
period as compared with the base period.
 Relation between Relative PPP and Absolute PPP
 while the very existence of capital flows, transportation costs, other
obstructions to the free flow of international trade, and government
intervention policies leads to the rejection of the absolute PPP, only a
change in these would lead the relative PPP theory off target.
Problems of Relative PPPP Theory
 The ratio of the price of non-traded to the price of traded goods
and services is systematically higher in developed nations than
in developing nations
 Reason: Techniques in the production of many non-traded goods and
services (haircutting, for example) are often quite similar in developed and
developing nations.
 However, the labors in these occupations in developed nations must
receive much higher wages comparable to the high wages in the
production of traded goods and services.
 This makes the price of non-traded goods and services systematically
much higher in developed nations than in developing nations.
 Problems of Relative PPPP Theory
 The relative PPP theory will tend to predict overvalued exchange rates for
developed nations and undervalued exchange rates for developing nations,
with distortions being larger the greater the differences in the levels of
development
 Reason: The general price index includes the prices of both traded and non-traded
goods and services, and prices of the latter are not equalized by international trade
but are relatively higher in developed nations.
 Significant structural changes also lead to problems with the relative PPP
theory
• Reason: UK had liquidated many of its foreign investments during the war, so
that the equilibrium exchange rate predicted by the relative PPP theory
would have left a large deficit in the U.K. balance of payments after the war.
The end!!!
 Chapter Three

3.Balance of Payments and National

Income Accounting

85
 Objectives
• To review national income accounting
– The national income accounts record all the income
and expenditures of a country.
• To review balance of payments accounting
– The balance of payments accounts record all
international transactions of a country.

86
 The National Income Accounts

• Gross National Product (GNP)

– The value of all final goods and services produced by a
country’s factors of production and sold on the market
in a given time period.
– The Output of a country in a given time period.
• Gross Domestic Product (GDP)
– The value of all final goods and services produced by
the factors of production within a country’s borders.
– GDP = GNP - Net receipts of factor income from the
rest of the world.
87
 The National Income Accounts
• The National Income Identity
Y = C + I + G + EX – IM
where:
• Y is GNP
• C is consumption (Cd + Cf),
• I is investment, (Id + If )
• G is government purchases, (Gd + Gf )
• EX is exports
• IM is imports, (Cf + If + Gf).

88
 The National Income Accounts

Consumption (C)
 The share of GNP consumed by the private sector.
Investment (I)
 The share of GNP used by private firms to produce future
output.
Government Purchases (G)
 The share of GNP used by federal, state, or local governments
 Exports (EX)
 The share of GNP exported to the rest of the world.
 Imports (IM)
 The share of GNP imported from the rest of the world.

89
 The Balance Of Payments
Accounts
• The balance of payments accounts use Double-entry
Bookkeeping Principles: each transaction generates a debit
(value inflow) and a credit (value outflow).
• It has three accounts:
– Current account (CA)
– Capital Account, (KA) and
– financial account, (FA)

CA-The difference between exports and imports of goods and

services including net unilateral transfers
FA: accounts for flows of financial assets.
KA: flows of special categories of assets (capital): typically non-
market, non-produced, or intangible assets like debt forgiveness,
copyrights and trademarks. 90
CURRENT ACCOUNT
1. Merchandise Trade (Goods account)
2. Services
• tourism
• transportation
• business, professional and other services
3. Income (Factor Services)
• Investment Income
• Employee Compensation
4. Unilateral Current Transfers
(incl. workers remittances)
• government grants gov’t transfers
• government pensions
• private remittances and other transfers (including taxes)

91
• The Current Account (CA)
– CA = EX – IM
– A country has a CA surplus when its CA> 0.
– A country has a CA deficit when its CA < 0.
– CA measures the size and direction of international borrowing.
– A country’s current account balance equals the change in its net
foreign wealth.
– It’s also equal to the difference between national income and
domestic residents' spending
𝐶 + 𝐼 + 𝐺, 𝑖. 𝑒. 𝑌 − 𝐶 + 𝐼 + 𝐺 = 𝐶𝐴.
– 𝐒 − 𝐈 = 𝐂𝐀, there may be a condition when S>I or S<I such that
CA<0 or CA>0.
– The current account is a measure of foreign savings at home.
– Q. Are current account deficits good or bad?
92
 Interpreting a current account deficit
• Two views
– A deficit is a sign that a country is spending more
than it earns, a weakness which must be corrected
by either/both reducing expenditure or switching
expenditure from imports in favour of exports
– A deficit is a sign of strength because it means the
country is sufficiently profitable to attract
continued flows of foreign capital (focus on the
basic balance)

93
CAPITAL AND FINANCIAL ACCOUNT
2. Capital Account
• Unilateral Capital Transfers (debt forgiveness, investment grants)
– The capital account records the exports and imports of assets.
– Capital inflow: An export of assets.
– Capital outflow: An import of assets.

® Example. An Ethiopian citizen buys a $1000 typewriter

from an Italian company, and the Italian company
deposits the $1000 in its account at NB in Ethiopia.
Entries in the Ethiopian balance of payments:
– Purchases (imports) typewriter: Debit CA of $1000.
– Sells (exports) asset: Credit to KA of $1000.
 CA (-$1000) + KA (+$1000) = 0

94
3. Financial Account: has at least 3 subcategories:
 Official (international) reserve assets
 All other assets:
 Statistical discrepancy
Financial Account (Private)
• Direct Foreign Investment
• Portfolio Investment (long term and short term)

Financial inflow
 Foreigners loan to domestic citizens by buying domestic assets
 Domestic assets sold to foreigners are a credit (+) because the domestic
economy acquires money during the transaction
Financial outflow
 Domestic citizens loan to foreigners by buying foreign assets
 Foreign assets purchased by domestic citizens are a debit (-) because the
domestic economy gives up money during the transaction

95
 • Official Reserve Transactions (ΔRFX)
– Official international reserves
• foreign assets held by central banks to cushion against
financial instability.
– Official foreign exchange intervention
• Exchange rate intervention often requires to alter the
amount of official reserves.

 Official Reserve Transactions (gold, IMF credits and SDRs, foreign

exchange reserves)
• Changes in domestic assets held by foreign monetary authority
• Changes in foreign assets held by domestic monetary authority

96
 The BOP Accounts…………
• The key relation: CA + KA = ΔRFX
• This is an accounting identity
• Accounting:
– Exports are recorded as credits (+) in CA, KA, FA
– Imports are recorded as debits (-) in CA, KA, FA
• Official Settlements Balance (B )= CA + KA+ FA = 0, Due to the
double entry of each transaction
• If B>0, then BoP said to be surplus Data from a transaction may
• If B<0, then Bop said to be deficit come from different sources that
differ in coverage, accuracy, and
timing

☻any imbalance in the official settlements balance

must be financed (paid for) by official reserves flows
97
 Types of disequilibrium in the BoPs

• Cyclical disequilibrium: due to cyclical factors like trade cycle.

• Secular Disequilibrium: long-term phenomenon like capital
improvement, population growth, territorial expansion,
technological advancement, innovation…etc.
• Structural disequilibrium: structural changes like production of
substitutes goods
• Causes for:
– Cyclical fluctuation
– Huge development and investment program
– rapid economic development
– Shift in production
– Huge population and its high rate of growth
– Demonstration effect

98
 Correcting a balance of payments
imbalance

• Recall (S - I) + (T–G) = (X–M), problem is to reduce

excessive (X–M)
• Expenditure reduction policies
– Increase S
– Reduce I
– Reduce G – T through restrictive fiscal policies
• Expenditure switching policies
– Commercial policy (tariffs, etc)
– Improved cost competitiveness
– Exchange rate changes

99
I. Monetary measures include
a) Deflation
b) Exchange rate depreciation and
c) Exchange control
II. Non monetary measures include
a) Import quota
b) Tariff
c) Export promotion ,policies and programs

100
 Recap
The Balance of Payments Account
Current Account
1. Exports
2. Imports
3. Trade balance (1) – (2)
4. Net investment income
5. Official transfers
6. Current account balance (3) + (4) + (5)
Private Capital Account
7. Foreign purchases of domestic assets (capital inflow)
8. Domestic purchases of foreign assets (capital out flow)
9.Capital account balance (7) – (8)
Official Reserves Transactions Account
10. Official transactions
11. Statistical discrepancy
12. Private balance of payments (6) + (9) + (11)
13. Balance of payments (12) + (10) must be zero
 Cont’d…
® What does the balance of payments account measure?
=>measures flows of currencies b/n a country and the rest of the world
® Balance of Payments Forces: Price Levels and Exchange Rates
 When inflation differs among countries with flexible exchange rates,
we would expect the value of the country’s currency with the greater
inflation to fall relative other currencies.
 When inflation differs among countries with fixed exchange rates, the
country with the higher inflation rate will tend to lose official reserves.
 when a country runs out of reserves, it must devalue its currency.
𝑷𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄
 i.e. 𝑬𝑹 = 𝑬𝑿 ( )
𝑷𝒇𝒐𝒓𝒆𝒊𝒈𝒏
The end!!!
CHAPTER 4
BASIC THEORIES OF THE
BALANCE OF PAYMENTS

THREE APPROACHES

104
 Three Approaches
The Absorption Approach to the Balance of trade
The Elasticities Approach to the Balance of trade
The Monetary Approach to the BoP (MABoP)

105
 1. Absorption Approach to BOT
• Recall the national income identity:
Y = C + I + G + (X – M)
So
Y–A=X–M
where A = C + I + G is the total domestic
spending or absorption.

106
Absorption approach to BOP (cont’d)
• If Y > A, then X – M > 0 or BOT > 0.
If Y < A, then X – M < 0 or BOT < 0.
• Does devaluation always improve BOT?
• Recall: If Y = Y*  Full employment level of output,
then all resources are already employed and hence,
(X – M)  needs A .
• If Y < Y*, then (X – M)  obtains through increasing Y
with A unchanged, i.e. by producing more to sell to
foreigners.

107
 Absorption approach
• So, when Y < Y*, devaluation would improve BOT.
• But when Y > Y*, devaluation would increase (X–M)
but create inflation.

108
2. The Elasticities Approach to BOT

109
 Elasticities
• | d | > 1  the demand is elastic
• | d | < 1  the demand is inelastic
• If the demand is elastic, the 1% rise in price
leads to more than 1% decline in quantity
demanded.

110
 Devaluation and BOT
• Does the devaluation of a currency improve
the country’s balance of trade?

• Consider EBr/$ = the Ethiopian Birr price of the

dollar

111
 Devaluation and BOT (cont’d)
• (1) If the demand curve for the dollar slopes
downward and the supply curve of the dollar
slopes upward, then the devaluation of the
Birr leads to an excess supply of the dollar,
which causes the Ethiopian trade deficit to
decrease.

112
 Devaluation and BOT (cont’d)
• (1): stable FX market equilibrium
• (2): unstable FX market equilibrium
• The case (2) could occur when Ethiopian demand for
US imports and US demand for Ethiopian exports are
both very inelastic.
• The greater the elasticities of both country’s demand
for the other country’s goods, the greater the
improvement in Ethiopia trade balance after a Birr
devaluation.

113
 Devaluation and BOT
• The condition that guarantees the case (1) is called
Marshall-Lerner Condition.
• It states the condition that assures the improvement.

– The sum of price elasticity of export and import greater

than unity

114
 J Curve Effect
• After the devaluation, it is often observed that
the trade balance initially deteriorates for a
while before getting improved.
 It states that the real net export could
improve or deteriorate in the medium
term due to a depreciation of the
CA currency

Surplus
A
0 Time
Deficit

115
 Elasticities and J-Curves
• Why do we have a J-Curve?
• The initial demands tend to be inelastic.
• Suppose Ethiopia imports good X from the US
and exports good Y to the US.
• Devaluation  EBr/$ 
 PXBr  & PY$ 
 QXd  & QYd 
 The current account could immediately decrease after a currency depreciation, then
increase gradually as the volume effect begins to dominate the value effect.

116
 Elasticities and J-Curves
• But if Ethiopian demand for X is inelastic, the % decrease
in QXd would be smaller than the % increase in PXBr so
that Imports = PXBr QXd would increase.
• Further, if US demand for Y is inelastic, the % increase in
QYd would be smaller than the % decline in PY$ so that
Exports = PY$ QYd would fall.

Causes of the J Curve Effect

The Currency Contract Period
The Pass-Through Effect

117
 Pass Through
• Devaluation  Import prices  in the home
country and export prices  in foreign
countries.
But prices do not adjust instantaneously.
• Persistent BOP deficit  devaluation
 Home demand for imports  and foreign
demand for exports 
 an improvement in BOP in the L-R

118
 Pass-through Analysis
• How do prices adjust to exchange rate changes in the
S-R?
• Differences in the pass-through effect across
countries  Producers adjust profit margins
• Example: When the yen appreciated against the
dollar substantially during late 1980s, Japanese auto-
makers limited the pass-through of higher prices by
reducing the profit margins on their products.

119
 Pass-though analysis (cont’d)
• In general,
• Depreciation of the Birr  Foreign sellers cut
their profit margins
• Appreciation of the Birr  Foreign sellers
increase their profit margins

120
 3. Monetary Approach to BOP
o External balance problems are monetary in nature
and that balance of payment deficits are a reflection
of excessive money supply.
 Simple version: Money contraction => rise in interest
rates => reduces pending => reduces incomes =>
reduces imports.
 Sophisticated version: A sale of foreign exchange =>
reduces the stock of high powered money => reduces the
money stock.

121
 Money supply and Money demand
• Considering money supply, we obtain
MS = m (DC + IR) =m(Cu+R) (1)
Dc-domestic credit, IR-International Reserve, CU- Currency and R-Bank
reserve
• Consider Money demand function:
Md = k•P•L (2)
where P = price level at home and L is the
liquidity preference function, which depends on
income and the interest rate. k is a constant.

122
 PPP again
• Now assume PPP
P = E•P* (3)
where E = home currency price of the
foreign currency
P* = price level in the foreign country
• Substituting (3) into (2), we have
Md = k•E•P*•L (4)

123
 Monetary equilibrium
• In equilibrium, Md = MS.
• So, from (1) and (4), we have
k•E•P*•L = m (DC + IR)
• Under fixed exchange rates, if the central bank
is supplying more money than what domestic
residents demand, the excess supply will be
eliminated through capital outflows.
• International capital flows adjust monetary
disequilibria.
124
• Under flexible exchange rates, the adjustment
mechanism is different.
• The KA is assumed to depend on the interest
rate differential.
– KA = f(id-if, St).
• changes in the level of exchange rates adjust
monetary disequilibria.

125
 Nice time
with reading 126
 Performance survey
1. How would you understand the link between balance
of payment disequilibrium and the domestic money
market disequilibrium.
2. Examine how devaluation affects the balance of
payment within the context of monetary model.
3. Compare and contrast the effects of money supply, rise
in domestic income and foreign price shocks on balance
of payment under fixed and floating rates

127
 CHAPTER FIVE
5. Economic Policy in an Open
Economy
Muldel-fleming model to shows how a nation can use FP and MP to
achieve both internal and external balance without any change in the
exchange rate.

128
 Goods Market & the IS Curve
• Keynesian Cross assumes:
• Real interest rate is constant (hence I=I(r0) =I0).
• Exchange rate, e, is constant (hence X=X(e)=X0.)
• Goods Market Equilibrium
Y (Actual Exp)= C (Y-T) + I(i) + G + NX(e, Y, YROW)[Planned Exp]
– IS Curve summarizes relation between interest rate (i) and
output (Y), in domestic goods market equilibrium.
– IS Curve is downward-sloping in representing effect of interest
rate on level of investment, and so i-Y diagram GDP.
– IS Curve shifts with changes in G, T, e, YROW.

129
 E Keynesian Y=E
Deriving the IS Curve Cross E(i1)
1. Increase in interest rate to i2. 2.  I E(i2)
2. Result is fall in Planned Investment, I.
3. Planned Expenditure line shifts down.
Output falls by Multiplier effect, Y.
4. Relationship between i and Y summarized 3.
by the IS Curve.
Y2 Y1 Y
Investment Demand
i i
IS Curve

4.
i2
1.
i1
I(i) IS(G0, e0)
I

I(i2) I(i1) I Y2 Y1 Y
130
Change in Exchange Rate E Keynesian Y=E
Cross E2

• Anything shifting E1
Expenditure Curve with X
1.
interest rate fixed, will
also shift the IS Curve. 2. Y
• At right show effect of
depreciation in nation’s Y
exchange rate (e rises) on i IS2
E and IS Curves. IS1
IS Curve
• Exports rise, shifts up E1
to E2 which raises Y at any
i. i
𝟏 3.
∆𝒀 = [ ]∆𝑿
(𝟏−𝒄(𝟏−𝒕)+𝒎

• IS Curve shifts out to IS2. Y1 Y2 Y

131
 Open Economy IS Curve
• Shape of IS Curve:
• Shows the relationship between the interest rate and
level of income that arises in goods market
equilibrium.
• Slope of IS Curve reflects effect of interest rate on
planned expenditures through I and C.
• Shifts in IS Curve:
• IS Curve is drawn for given level of exchange rate.
• Rise in e, increases NX which shifts IS out.
• IS Curve is drawn for given fiscal policy, G and T.
• Changes in fiscal policy that increase demand (G up or T
down) shift the IS Curve to the right (out).
132
 Money Market & the LM Curve
Domestic Money Market
• Money Demand
Md/P = f(Y, i, E(p))
• Money Supply
Ms/P = a(DR + IR)/P
– a = Money Multiplier
– DR = Domestic Reserves, IR = International Reserves
• Money Market Equilibrium
Ms/P= a(DR + IR)/P= f(Y, i, E(p))
– LM Curve summarizes relation between interest rate, i, and
output, Y, in domestic money market equilibrium.
– LM Curve is upward-sloping in i-Y diagram.
– LM shifts with changes in Ms or P or Y, E(p).

133
 Liquidity Preference & Money

Interest Real Money Supply, Ms/P

Ms/P
Rate - set by DR + IR
Real Money Demand, f(i,Y)
- opportunity cost, i
- transaction demand
depends on level of Y
i0

f(i, Y0)

Real Money Balances M/P

134
 Deriving the LM Curve
1. Begin in equilibrium at (i1, Y1). Now increase Real GDP to Y2.
2. Transaction Demand for money increases, shifts out to L(i, Y2).
3. New Money market equilibrium at Y2 with higher interest rate, i2.
4. LM Curve summarizes relationship between i and Y in Money market.

M/P
i LM

i2
L(i,Y2) 4.
3. 3.
2.
i1

L(i,Y1) 1.

Real Money Balances M/P Y1 Y2 Y

135
 Shifts in the LM Curve

1. Central Bank reduces DR or IR. Result is a fall in M/P.

2. Reduction in M/P, with L(i,Y1) given results in higher interest rate, i2.
3. Y1 now associated with higher i2, LM Curve has shifted up and back.
LM2
M2/P M1/P LM1
r

1. M
i2 3.
2. 2.
i1

L(i,Y1)

Real Money Balances M/P Y1 Y

136
 Open Economy LM Curve
• Shape of LM Curve:
• Shows the relationship between the interest rate
and level of income that arises in money market
equilibrium.
• Slope of LM Curve reflects relative strength of
interest rate and transactions on Money Demand.
• Shifts in LM Curve:
• LM Curve does not depend on exchange rate.
• BUT changes in Int’l Reserves will affect MS and LM.
• LM Curve reflects given monetary policy, DR + IR.
• Changes in monetary policy that increase Ms (DR or IR
up) shift the LM Curve to the right (out).
137
 External Balance & the BP Curve
Balance of Payments
• Current Account +- +
CAB = NX(e, Y, YROW, )
• Capital Account + -
CAP = j(i, i*+ xa)
• Balance of Payments
BOP = NX(e, Y, YROW) + j(i, i*+ xa) = 0
– BP Curve summarizes relation between interest rate, i,
exchange rate, e, and output, Y, for BOP=0.
– BP Curve is upward-sloping in i-Y diagram. BP shifts with
changes in e or i* or Y, YROW.
138
 Deriving the BP Curve
1. Begin with BOP=0 at (i1, Y1) and given level of e.
Now increase Real GDP to Y2.
2. Demand for imports increases, result is fall in CAB.
At original i will have BOP < 0.
i
BP(e0, BOP=0)

i2 3. Require Capital inflows to return BOP = 0.

4. Domestic i rises to new equilibrium at i2.
3. 4. BP Curve summarizes relationship
i1 between i and Y when BOP=0 and e fixed.
1.

Y1 Y2 Y
139
 Shifts in the BP Curve

1. Begin in overall BOP equilibrium at i1, Y1, e1.

2. Depreciation in home currency, e rises.
3. EXR Depreciation raises NX and BOP >0 at Y1.
Need to lower NX to get back to BOP=0.
i
BP(e1) BP(e2)
e2 > e 1 4. For given i, lower NX by rise in
Y which increases imports.

De 5. Depreciation in home currency

i1 shifts BP curve out.

Y1 Y2 Y

140
Capital Mobility & the BP Curve
i Capital Immobile/zero-capital i Capital Relatively Immobile/
flow BP Restricted K flow BP

R independent R*

Y0 Y Y

i Capital Relatively Mobile/ i Capital Perfectly Mobile/

Restricted K flow BP Unrestricted K Flows i.e. R=R*
BP
i*

Y Y

141
 Open Economy BP Curve
• Shape of BP Curve:
• Shows relationship between interest rate and
income level for Balance of Payments equilibrium .
• Slope of BP Curve reflects relative mobility of
capital between nations from interest differentials.
• Shifts in BP Curve:
• BP Curve reflects given exchange rate.
• Rise in e, raises NX at any i, Y rises to keep BOP=0.
• BP Curve shifts out at any i.
• BP Curve reflects given ROW variables, i* and Y*.
• Changes in ROW variables that increase NX or Capital
inflows shift the BP Curve to the right (out).
142
 Open Economy SR Equilibrium:
IS-LM-BP Model
• IS-LM-BP Model described by 3 equations
(IS) Y = C (Y-T, W) + I(i) + G + NX(e, Y, YROW)
(LM) Ms/P= a(DR + IR)/P= f(Y, i, E(p))
(BP) BOP0 = NX(e, Y, YROW) + j(i, i*+ xa)
• IS-LM-BP with Fixed Exchange Rate Regime:
• Endogenous Variables: Y, i, M (BOP=IR)
• Exogenous Variables: G, T, DR, P, e
• IS-LM-BP with Flexible Exchange Rate Regime:
• Endogenous Variables: Y, i, e
• Exogenous Variables: G, T, M (BOP=0), P
143
 IS-LM-BP Model

LM Curve Reach equilibrium by

Interest - shifts with M or P changes in all 3 endog.
Rate variables: i, Y, e or M

LM([DR+IR]/P) BP Curve
- shifts with e or
ROW variables
BP(e0, i*, Y*)

i1
IS Curve
- shifts with e, DG or T

IS(e0, G0, T0)

Y1 Income, Output

144
 CHAPTER 6:
6. Prices and Output in an Open Economy:
6.1. Aggregate Demand and Aggregate Supply
 Organization
• Aggregate Demand, Aggregate Supply, and Equilibrium in a Closed
Economy
• Aggregate Demand in an Open Economy Under Fixed and Flexible
Exchange Rates
• Effect of Economic Shocks and Macroeconomic Policies on
Aggregate Demand in Open Economies with Flexible Prices
• Effect of Fiscal and Monetary Policies in Open Economies with
Flexible Prices
• Macroeconomic Policies to Stimulate Growth and to Adjust to Supply
Shocks
  Aggregate Demand in a Closed Economy
• Aggregate Demand (AD) curve
 It shows the relationship between the total quantity
demanded of goods an services in an economy and the
general price level, while holding constant the nation’s
supply of money, government expenditures , and taxes
 The aggregate demand curve is downward sloping,
indicating that the total quantity of domestic goods and
services demanded in the nation is greater the lower the
price level
 Figure 6.1 shows how the aggregate demand curve is
derived from the IS-LM model of the previous chapter
FIGURE 6-1 Derivation of the AD Curve from the IS-LM Curves.
  Explanation of Figure 6.1

 The intersection of the IS and LM curves at a given

price level determines the equilibrium interest rate
(iE) and national income (YE) at point E in the left
panel.
 This defines point E at price PE and income YE on
aggregate demand curve AD in the right panel.
 An increase in price from PE to P′ reduces the real
value of the nation’s given money supply and causes
the LM curve to shift to the left to LM′ , thus
resulting in the lower income level of Y′ at point E′
in the left panel and on the AD curve in the right
panel
  Aggregate Supply in the Long Run and in the Short
Run
• Aggregate Supply (AS) curve
 It shows the relationship between the total quantity supplied
of goods and services in an economy and the general price
level
 This relationship depends crucially on the time horizon
under consideration
 The long-run aggregate supply (LRAS) curve does not
depend on prices but only on the quantity of labor, capital,
natural resources, and technology available to the economy.
The quantity of inputs available to an economy determines
the natural level of output (YN) for the nation in the long run.
 The short-run aggregate supply (SRAS) curve, slopes
upward, indicating that higher prices lead to larger outputs in
the short run ( See Figure 6.2)
FIGURE 6-2 The Long-Run and Short-Run Aggregate
Supply Curves.
  Explanation of Figure 6.2
• The long-run aggregate supply curve (LRAS) is independent
of prices and is vertical at the nation’s natural level of output
(YN), which depends on the availability of labor, capital,
natural resources, and technology in the nation.
• The nation’s short-run aggregate supply curve (SRAS) slopes
upward, indicating that the nation’s output can temporarily
exceed (point A) or fall short (point B) of its natural level
(point E) because of imperfect information or market
imperfections.
  Short-Run and Long-Run Equilibrium in a Closed Economy
• Figure 6.3 At the intersection of the AD, LRAS, and SRAS curves at
point E, the nation is simultaneously in long-run and short-run
equilibrium.
• An unexpected increase in AD to AD′ defines the new short-run
equilibrium point A at the intersection of AD′ and SRAS curves at PA
and YA. YA exceeds the natural level of output of YN.
• In the long run, as expected prices increase and match actual prices,
the SRAS curve shifts up to SRAS′ and defines the new long-run
equilibrium point C at the intersection of AD′, LRAS, and SRAS′
curves at PC and PN.
FIGURE 6-3 Equilibrium in a Closed Economy.
 6.3 Aggregate Demand in an Open Economy Under Fixed
and Flexible Exchange Rates
 Aggregate Demand in an Open Economy Under
Fixed Exchange Rates
• Figure 6.5
 It shows the derivation of an open economy’s
aggregate demand curve under fixed exchange rates
and compares it to the aggregate demand curve
derived in Figure 6.1 for the closed economy
 The left panel of Figure 19.5 shows original
equilibrium point E in the goods and money
markets and in the balance of payments at iE and YE,
as in Figure 6.2. This gives point E in the right panel
of Figure 6.5
FIGURE 6-5 Derivation of a Nation’s Aggregate Demand Curve
Under Fixed Exchange Rates.
• Explanation of Figure 6.5
• From equilibrium point E at the intersection of the
LM, IS, and BP curves at price level PE and income
YE in the left panel, we get point E in the right panel.
• An increase in the price level to P′ causes the LM, BP,
and IS curves to shift to the left to LM′, BP′, and IS′,
thus defining new equilibrium point E〞, where these
curves intersect.
• By joining points E and E〞 in the right panel, we
derive open-economy aggregate demand curve AD′,
which is flatter or more elastic than closed-economy
aggregate demand curve AD
 Aggregate Demand in an Open Economy Under
Flexible Exchange Rates
• Figure 6.6
 It shows the derivation of an open economy’s
aggregate demand curve under flexible exchange
rates and compares it to the aggregate demand
curve that we derived in Figure 6.1 for the closed
economy and in Figure 6.6 shows original
equilibrium point E in the goods and money
markets and in the balance of payments at iE and YE,
as in Figure 6.5. This gives point E in the right
panel of Figure 6.6
FIGURE 6-6 Derivation of the Nation’s Aggregate Demand Curve
Under Flexible Exchange Rates.
• Explanation of Figure 6.6
• Starting from equilibrium point E in the left and
right panels, an increase in the price level to P′
causes the LM, BP, and IS curves to shift to the
left to LM′, BP′, and IS′. Since the LM′ and IS′
curves intersect above the BP′ curve, the nation
has a surplus in its balance of payments.
• The nation’s currency then appreciates.
• This causes the IS′ curve at point E﹡.
• This gives point E﹡ in the right panel. Joining
points E and E﹡ in the right panel gives aggregate
demand curve AD﹡, which is more elastic than AD
and AD′
6.4 Effect of Economic Shocks and Macroeconomic Policies
on Aggregate Demand in Open Economies with Flexible
Prices

 Introduction
• This section examines the effect of real
and monetary shocks as well as fiscal and
monetary policies on aggregate demand
in open economies with flexible prices
under fixed and flexible exchange rates
 Real-Sector Shocks and Aggregate Demand
• Figure 6.7
 Starting from point E in both panels, an increase in the
nation’s exports and/ or reduction in the nation’s imports
with unchanged domestic prices causes the IS and BP
curves to shift rightward to IS′ and BP′.
 Under fixed exchange rates, this leads to a surplus in the
nation’s balance of payments and a rightward shift of the
LM curve to LM′, which defines new equilibrium point E
〞.
 Thus, the AD curve shifts rightward to AD〞.
 With flexible exchange rates, the nation’s currency
appreciates so that the BP′ and IS′ curves shift back to BP
and IS at original equilibrium point E in both panels
FIGURE 6-7 Changes in the Nation’s Trade Balance and Aggregate
Demand.
 Monetary Shocks and Aggregate Demand
• Figure 6.8
 Starting from equilibrium point E in both panels, an
autonomous short-term capital inflow with unchanged
domestic prices and fixed exchange rates causes the
nation’s BP and LM curves to shift rightward to BP′ and
LM′, thus defining new equilibrium point E〞 with higher
national income Y〞in the left panel.
 Thus, the nation’s aggregate demand curve shifts to the
right. With flexible exchange rates, the nation’s currency
appreciates, so that the BP′ and IS curves shift to the left to
BP〞 and IS′, and they define new equilibrium point E〞
along the original LM curve, so that the nation’s aggregate
demand curve shifts to the left
FIGURE 6-8 Short-Term Capital Flows and Aggregate Demand.
 Fiscal and Monetary Policies and Aggregate Demand in
Open Economies
• In chapter 5, that under highly elastic short-term international
capital flows fiscal policy is effective while monetary policy is not,
whereas the opposite is the case under flexible rates
• Specifically, under fixed exchange rates and highly elastic short-
term international capital flows, expansionary fiscal policy will
lead to capital inflows and is very effective in shifting the nation’s
aggregate demand curve to the right. Similarly, contractionary
fiscal policy will lead to capital outflows and is very effective in
shifting the nation’s aggregate demand curve to the left
• Under flexible exchange rates and high international short-term
capital flows, the opposite is the case. That is, easy monetary
policy will be very effective in shifting the nation’s aggregate
demand curve to the right, and tight monetary policy will be
effective in shifting the nation’s demand curve to the left
6.5 Effect of Fiscal and Monetary Policies in Open Economies
with
Flexible Prices

 Introduction
• Under fixed exchange rates and highly elastic
short-term international capital flows, fiscal
policy is effective whereas monetary policy is
ineffective
• On the other hand, with flexible exchange
rates, monetary policy is effective and fiscal
policy is not
• This section examines fiscal policy under
fixed exchange rates and monetary policy
under flexible rates
  Figure 6.9
 Starting from long-run equilibrium point E in the left panel,
expansionary fiscal policy shifts the AD curve up to AD′ and
defines short-run equilibrium point A at PA and YA >YN
In the long-run , the SRAS curve shifts up to SRAS′ defining
equilibrium point C at PC and YN .
 Starting from recession point R in the right panel with PR and
YR < YN, the nation could use expansionary fiscal policy to shift
the AD curve up to AD′ so as to reach equilibrium point C at PC
and YN at the intersection of the AD′, SRAS, and LRAS curves.
The nation, however, could in time have reached equilibrium
point E and PE and YN automatically as a result of falling
domestic prices because of recession and the SRAS curve
shifting down to SRAS′
FIGURE 6-9 Expansionary Fiscal Policy from the Natural Level of
Output and Recession Under Fixed Exchange Rates.
• Case Study 6.10

There is some evidence that nations with

more independent central banks suffer
less inflation than nations with central
banks that are less independent and more
responsive to political pressures
FIGURE 6-10 Index of Central Bank Independence
and Average Inflation.
 6.6 Macroeconomic Policies to Stimulate Growth and to
Adjust to Supply Shocks

 Introduction
• This section examines fiscal and monetary
policies to stimulate long-run growth and
adjust to supply shocks in open economies
with flexible prices
  Macroeconomic Policies for Growth
Figure 6.11
•Governments can stimulate long-run growth by increasing
expenditures on education, infrastructures, basic research, and
to improve the functioning of markets, also by tax incentives
and low long-term interest rates to encourage private investment
to the extent that efforts to stimulate long-run growth in the
economy are successful, however, they will shift the nation’s
LRAS curve to the right, leading to more employment, higher
incomes, lower prices, and possibly an appreciated currency in
the long run
•The use of expansionary macroeconomic policies to stimulate
growth can be examined with Figure 6.11
FIGURE 6-11 Macroeconomic Policies for Long-Run Growth.
• Explanation of Figure 6.11

Starting at original long-run equilibrium

point E, expansionary macroeconomic
policies for growth shift the AD curve to the
right to AD′ and define new short-run
equilibrium point A and PA > PE and YA >YN.
With long-run growth, the LRAS and SRAS
curves shift to the right to LRAS′ and SRAS
〞 and define equilibrium point G at PG=PE
and YN′> YN
  Macroeconomic Policies to Adjust to Supply Shocks
 Figure 6.12
From original long-run equilibrium point E, the increase in
petroleum prices causes the SRAS curve to shift up SRAS′,
thus defining short-run equilibrium point E′ at P′> PE and
YN′< YN . Over time, prices fall because of recession, and the
nation reaches new long-run equilibrium point E〞 at the
intersection of the LRAS′, SRAS〞, and AD curves at P〞< P′
and Y〞N > Y′N. An expansionary monetary policy that shifts
the AD curve to the right to AD′ would lead to alternative long-
run equilibrium point E﹡ with P﹡P′ and Y〞N
 Case Study ( Figure 6.13)
Monetary policy and booms and busts in the US economy
FIGURE 6-12 Macroeconomics Policies to Adjust to
Supply Shocks.
FIGURE 6-13 Stagflation in the United States, 1970-2001.
 Chapter Summary

• Open-economy macroeconomics
• Aggregate Demand and Aggregate Supply
• Relationship between Prices and Output
• Model of IS, LM and BP
• Expansionary fiscal policy under fixed
exchange rates or monetary policy under
flexible rates
• Macroeconomic policies can be used to
achieve long-run growth