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National Income Identity
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gross domestic product is given by consumption expenditures, plus investment expenditures, plus government expenditures, plus exports, minus imports
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Y=C+I+G+CA
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National Savings
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the amount of output that is not devoted to private consumption and government spending
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S= Y-C(Y-T)-G or S= Sp+Sg or S=I+CA
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Balance of Payments
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records a country's international transactions with the rest of the world in a given time period- records its payments and recepits from foreigners and shows demand and supply of a country's currency in FEM
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*every international transaction enters the BOP accounts twice, once as a credit and once as debit
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Credit Entry
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any transaction resulting in receiving payments from foreigners
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exports of goods, services, assets
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Debit Entry
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any transaction resulting in making payments
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imports of goods services, assets
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Components of BOP Accounts
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Current Account, Financial Account, Capital Account
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CA+KAnon+CapitalAcc= -ORT
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Current Account
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shows the difference b/w exports and imports of goods and services plus net unilateral transfer
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CA= EX-IM+ Net Unilateral Transfer
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Financial Account
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difference b/w sales & purchases of assets to foreigners
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KA= KAnonres+ORT
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Non-reserve Portion
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the purchases & sales of assets by the private sector
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Reserve Portion
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the purchases & sales of foreign assets by the country's monetary authority
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foreign-currency denominated assets held by central banks
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Purchasing Power Parity
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explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels
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Absolute PPP
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identical basket of goods should be sold for same amount of money in diff countries when expressed in same currency
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E= P/P*
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Relative PPP
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% Δ in exchange rate between 2 currencies over many period equals to the inflation rate differentials between 2 countries
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Ee-E/E= π-π*
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Monetary Approach to Exchange Rate
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shows factors that affect MS and MD will play a role in determining exchange rate
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PPP holds, LR Model, shocks are permanent
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Equilibrium exchange rate
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E= (MS/MS)(L(Y,R)/(L(R,Y)
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Domestic MS Increases
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Exchange rate increases
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DC depreciates
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Foreign MS Increases
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Exchange rate decreases
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DC appreciates
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Domestic Interest Rate increases
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Exchange rate increases
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DC depreciates
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Foreign Interest Rate increases
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Exchange rate decreases
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DC appreciates
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Domestic Output increases
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Exchange rate decreases
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DC appreciates
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Foreign Output Increases
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Exchange rate increases
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DC depreciates
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Exchange Rate
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the price of one currency in terms of another(DC/FC)
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EDC/FC=1/EDC/FC
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Forward exchange rates
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the exchange rate that is contracted today for the exchange of currencies at a specified date in the future
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R= R*+Ee-E/E
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Interest Parity Condition
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the condition that the expected returns on deposits of any two currencies are equal when measured in the same currency
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Covered interest Rate Parity
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agents can lock in the future exchange rate by getting a forward contract & eliminating uncertainty
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R= R*+ F-E/E
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Real Rate of Return
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the rate at which its value expressed in terms of a representative output basket is expected to rise
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Expected ate of return
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the rate at which the value of an investment in the asset is expected to rise over time
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Arbitrage
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the process of buying a currency cheap and selling it dear
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Asset Approach
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IPR holds & deals with financial capitals
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Focused on money mkt shocks and impacts on exchange rate (SR & LR)
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R, domestic interest rate
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return on DC deposits
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Ee-E/E
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annualized percentage change in the DC/FC exchange rate
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R*+Ee-E/E
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expecting DC return on FC deposits
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Increase in Domestic Interest
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R curve shifts right, invest in DC Deposit
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Capital inflows & DC appreciates
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Increase in Foreign Interest
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R* curve shifts right, invest in FC deposit
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Capital outflows & DC depreciates
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Expected Depreciation of DC
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R* curve shifts right, invest in FC deposit
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Capital outflows & DC depreciates
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Forward Trading
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parties agree to exchange currencies on some future date at a pre-negotiated exchange rate
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Spot Trading
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trades are settled immediately
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Real exchange rate, q
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measures the purchasing power of a country's currency relative to another country's currency
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shows how many baskets of domestic goods are needed to exchange one basket of foreign goods q= E(P/P*)
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If q increases
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real depreciation of DC
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If q decreases
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real appreciation of DC
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q=1
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Absolute PPP
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q= E(P/P*)
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q=0
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Relative PPP
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qe-q/q=0
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If AD increases-domestic
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domestic goods are more valuable
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PPP of DC increases and real appreciation of DC
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If AD* increases-foreign
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domestic goods are less valuable
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PPP of DC decreases and real depreciation of DC
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Generalized Approach
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considers how changes in both monetary and real sides of the economy affect LR exchange rate
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in the LR changes in q, changes in P and P* lead to a change in E
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Money Supply
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the total amount of currency and checking deposits held by households and firms
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Currency in circulation+Demand Deposit
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Aggregate Money Demand
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the toal demand for money by all households and firms in the economy
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Md= L(R,Y)
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L(R,Y)
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liquidity function
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R
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nominal interest rate
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opportunity cost of holding money
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Y
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real income= real GDP
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when income increases, consumption increases, volume of transaction increases
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Interest rate- fisher
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R= r+Π
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Money market equilibrium
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MS/P= L(R,Y)
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R adjusts to ensure the money market is in equilibrium in SR
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If MS increases
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Pressure for R to fall to initial level
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If real income Y increases
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Consumption increases and we hold more money
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L(R,Y) increases and R increases
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In the long run
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P= MS/L(R,Y)
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P= MS/L(R,Y*)
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Quantity Theory of Money
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%Δ MS+%ΔV= %ΔP+%ΔY
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Level change in MS doesn't impact %Δ in MS
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no change in MS means no change in Π
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Exchange Rate Overshooting
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immediate response to a disturbance is greater than its long-run response
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Exchange Rate Undershooting
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the immediate depreciation of a currency to a shock is greater than its long run response
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