conomics 302 (Sc. 001) Inrmdia Macroconomic Thory and Policy (Spring 2011) 4/25/2011 Insrucor: Prof. Mnzi Chinn Insrucor: Prof. Mnzi Chinn UW Madison
21 1 Th Mdium Run ε = P * P Thr ar wo ways in which h ral xchang ra can adjus:, or P & P* Th aggrga dmand rlaion in an opn conomy wih fixd xchang ra is P Y = Y, G, T * P (, +, ) M/P dosn appar, bu ral ra dos. 2of 32
21 1 Th Mdium Run Aggrga Dmand dundr Fixd xchang R Ras P Y = Y, G, T * P (, +, ) In a closd conomy, h aggrga dmand rlaion ook h sam form as abov, xcp for h prsnc of h ral mony sock M/P insad of h ral xchang ra ĒP/P*. Undr fixd xchang ras, h cnral bank givs up monary policy as a policy insrumn. This is why h mony sock no longr appars in h aggrga dmand rlaion. A h sam im, h fac ha h conomy is opn implis ha w mus includ a variabl ha w did no includ whn looking a h closd conomy arlir, namly, h ral xchang ra, ĒP/P*. 3of 32
21 1 Th Mdium Run quilibrium in h Shor Run and in h Mdium Run Figur 21 1 Aggrga Dmand and Aggrga Supply in an Opn conomy Undr Fixd xchang Ras An incras in h pric lvl lads o a ral apprciaion and a dcras in oupu: Th aggrga dmand curv is downward sloping. An incras in oupu lads o an incras in h pric lvl: Th aggrga supply curv is upward sloping. 4of 32
21 1 Th Mdium Run quilibrium i in h Shor Run and in h Mdium Run Th aggrga supply rlaion is: Y P= P (1 + μ) F 1, z L Th pric lvl P dpnds on h xpcd pric lvl P, and on h lvl of oupu Y. Thr ar wo mchanisms a work: Th xpcd pric lvl affcs nominal wags which affc pric lvls. Highr oupu lads o highr mploymn, which lads o lowr unmploymn, highrwags wags, andhighrpric lvls. 5of 32
21 1 Th Mdium Run quilibrium i in h Shor Run and in h Mdium Run Figur 21 2 Adjusmn undr Fixd xchang Ras Th aggrga g supply curv shifs down ovr im, lading o a dcras in h pric lvl, o a ral dprciaion, and o an incras in oupu. Th procss nds whn oupu has rurnd o is naural lvl. 6of 32
21 1 Th Mdium Run Th Cas for and agains a Dvaluaion Figur 21 3 Adjusmn wih a Dvaluaion A dvaluaion of h righ siz can shif aggrga dmand o h righ, moving h conomy o poin C. A poin C, oupu is back o h naural lvl of oupu. 7of 32
Th Rurn of Briain o h Gold Sandard: Kyns vrsus Churchill Th gold sandard was a sysm in which ach counry fixd h pric of is currncy in rms of gold and sood rady o xchang gold for currncy a h sad pariy. 8of 32
21 2 xchang Ra Criss undr Fixd xchang Ras Suppos a counry is opraing undr a fixd xchang ra, and ha financial i invsors sar bliving bli i hr may soon b an xchang ra adjusmn: Th ral xchang ra may b oo high, h domsic currncy may b ovrvalud. Inrnal condiions may call for a dcras in h domsic inrs ra, a dcras in h domsic inrs ra canno b achivd undr fixd xchang ras. If crdibl, hn wha is ru is: 9of 32 i = i * +1 ( )
21 2 xchang Ra Criss undr Fixd xchang Ras xpcaions ha a dvaluaion may b coming can riggr an xchang ra crisis. Th govrnmn and cnral bank hav a fw opions: Thy can ry o convinc marks hy hav no innion of dvaluing. Th cnral bank can incras h inrs ra. vnually, h choic for h cnral bank bcoms ihr o incras h inrs ra or o valida h mark s xpcaions and dvalu. 10 of 32
Th 1992 MS Crisis 11 of 32 Figur 1 xchang Ras of Slcd uropan Counris Rlaiv o h Dusch Mark, January 1992 o Dcmbr 1993
21 3 xchang Ra Movmns undr Flxibl xchang Ras Tak h inrs pariy condiion: * (1 + i) = (1 i ) + 1 Muliply boh sids by + 1 = 1 + i 1 + i Thn wri h quaion for yar +1 rahr han for yar : * + 1 12 of 32 1+ i + 1 = 1 + i + 1 * + 2 + 1
21 3 xchang Ra Movmns undr Flxibl xchang Ras Th xpcaion of h xchang ra in yar +1, hld as of yar, is givn by + 1 1+ i = 1 + i Rplacing wih h xprssion abov givs + 1 + 1 * + 2 + 1 (1 + i)(1 + i ) + 1 = + (1 + i )(1 + i * * 2 Coninuing o solv forward in im in h sam way w g + 1 = 1+ i 1 + i... 1+ i ( )( ) ( ) + 1 + n 1+ i 1 + i... 1+ i ( )( ) ( ) * * * + 1 + n + n+ 1 13 of 32
21 3 xchang Ra Movmns undr Flxibl xchang Ras xchang Ras and Currn and Fuur Inrs Ras Anyfacor ha movs h currn orxpcd fuur domsic or forign inrs ras bwn yar and +n movs h currn xchang ra. xchang Ra Volailiy Th rlaion bwn h inrs ra i and h xchang ra is all bu mchanical. A counry ha dcids o opra undr flxibl xchang ras mus accp ha i will b xposd o flucuaions ovr im. 14 of 32
21 4 Choosing bw. xchang Ra Rgims Should counris choos flxibl xchang ras or fixd xchang ras? In h shor run, undr fixd xchang ras, a counry givs up is conrol of h inrs ra and h xchang ra. Also, anicipaion i ha a counry may b abou o dvalu is currncy may lad invsors o ask for vry high inrs ras. Anargumn agains flxibl xchang ras is hahymay hy mov a lo and may b difficul o conrol hm hrough monary policy. 15 of 32
21 4 Choosing bw. xchang Ra Rgims In gnral, flxibl xchang ras ar prfrabl. Thr ar, howvr, wo xcpions: Firs, whn a group of counris is alrady ighly ingrad, a common currncy may b h righ soluion. Scond, whn h cnral bank canno b rusd o follow a rsponsibl monary policy undr flxibl xchang ras, a srong form of fixd xchang ras, such as a currncy board or dollarizaion, may provid a soluion. Opimal Common Currncy Aras Two condiions mus b saisfid: Th counris xprinc similar shocks; hus, can choos roughly h sam monary policy. Counris hav high facor mobiliy, which allow counris o adjus o shocks. 16 of 32
Th uro: A Shor Hisory Th uropan Monary Union (MU) was consolidad undr h Maasrich Tray. In January 1999, pariis bwn h currncis of 11 counris and h uro wr irrvocably fixd. Th nw uropan Cnral Bank (CB), basd in Frankfur, bcam rsponsibl for monary policy for h uro ara. 17 of 32
21 4 Choosing bw. xchang Ra Rgims Hard Pgs, Currncy Boards, and Dollarizaion On way of convincing financial marks ha a counry is srious abou rducing mony growh is a pldg o fix is xchang ra, now and in h fuur. A hard pg is h symbolic or chnical mchanism by which a counry plans o mainain xchang ra pariy. Dollarizaion is an xrm form of a hard pg. A lss xrm way is h us of a currncy board involving h cnral bank. 18 of 32