Intermediate Macroeconomics Notes 2020-2021
WEEK 1:
Chapter 4: Exchange rates and the Balance of Payments
Exchange rates
E = nominal exchange rate
E = tells how much foreign currency can be exchanged for a unit of domestic currency
Depreciation occurs when there is an increase in E
Appreciation occurs when there is a decrease in E
R = real exchange rate
R = tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign
country.
e.g. ↑ prices US → you can buy less with your Euros from US
IS curve
,Balance of Payments
Balance of payments: detailed record of international transactions (i.e. Mirror image of foreign exchange market!)
Three main components
All three involve buying and selling of currency
1. Current account (CA) = represents a country's cross-border transactions of goods and services, payments made to
foreign investors, and transfers such as foreign aid.
2. Capital account (CP) =keeps track of the net change in a nation's assets and liabilities during a year. Capital
account's balance will inform economists whether the country is a net importer or net exporter of capital. – records
private financial transactions.
3. Official Reserves Account (OR) = Central Bank actions on FE market. Part of the capital account, are the foreign
currency and securities held by the central bank of a country and used to balance the payments from year-to-year.
The reserves increase in case of a trade surplus and decrease when there is a trade deficit.
(+) sign for all transactions that involve purchase of domestic currency
(-) sign for all transactions that involve sale of domestic currency
Double bookkeeping: Demand and supply of domestic currency always in balance
= FE market always clears
BoP = CA + CP + OR = 0
BoP surplus = CA-CP = OR
• Degree to which Central Bank intervenes in Foreign Exchange (FE) market
• Indicates degree to which exchange rate reflects market forces
• Fully flexible exchange rate → OR = 0 (when central bank refrains/stops from foreign exchange market
involvement)
• CA + CP = 0
• CA = -CP
• Shows how surplus or deficit on CA is financed!
IS-LM Model
• How to incorporate FE market into IS-LM model?
• BoP reflects demand and supply for currency
• Flexible exchange rate → OR=0
• CA = -CP or CA + CP = 0
• So we need to find a way to get CA and CP into IS-LM
• Include a curve that captures equilibrium on FE market in Y-i space
,Current Account
Note: An Exchange Rate Depreciation or a rise in World Income moves the CA up,
shifting the CA=0 line to the right
Capital Account
• Capital flows across borders in search for highest return
• Return on capital = i
When E depreciates Exports>Imports budget surplus
When E appreciates Exports<Imports budget deficit
, Equilibrium on FE market
FE curve = all combinations of Y and i where FE market is in equilibrium
FE curve positive slope
Start in point A. Assume ↑ in Y → increase imports → Deficit on CA
Need for capital import → surplus on CP
How to get more capital import → ↑ i → point B
Simplifying assumption for FE curve
CP = k ( i - iworld )
BoP = CA + CP = 0
i = iworld
WEEK 1:
Chapter 4: Exchange rates and the Balance of Payments
Exchange rates
E = nominal exchange rate
E = tells how much foreign currency can be exchanged for a unit of domestic currency
Depreciation occurs when there is an increase in E
Appreciation occurs when there is a decrease in E
R = real exchange rate
R = tells how much the goods and services in the domestic country can be exchanged for the goods and services in a foreign
country.
e.g. ↑ prices US → you can buy less with your Euros from US
IS curve
,Balance of Payments
Balance of payments: detailed record of international transactions (i.e. Mirror image of foreign exchange market!)
Three main components
All three involve buying and selling of currency
1. Current account (CA) = represents a country's cross-border transactions of goods and services, payments made to
foreign investors, and transfers such as foreign aid.
2. Capital account (CP) =keeps track of the net change in a nation's assets and liabilities during a year. Capital
account's balance will inform economists whether the country is a net importer or net exporter of capital. – records
private financial transactions.
3. Official Reserves Account (OR) = Central Bank actions on FE market. Part of the capital account, are the foreign
currency and securities held by the central bank of a country and used to balance the payments from year-to-year.
The reserves increase in case of a trade surplus and decrease when there is a trade deficit.
(+) sign for all transactions that involve purchase of domestic currency
(-) sign for all transactions that involve sale of domestic currency
Double bookkeeping: Demand and supply of domestic currency always in balance
= FE market always clears
BoP = CA + CP + OR = 0
BoP surplus = CA-CP = OR
• Degree to which Central Bank intervenes in Foreign Exchange (FE) market
• Indicates degree to which exchange rate reflects market forces
• Fully flexible exchange rate → OR = 0 (when central bank refrains/stops from foreign exchange market
involvement)
• CA + CP = 0
• CA = -CP
• Shows how surplus or deficit on CA is financed!
IS-LM Model
• How to incorporate FE market into IS-LM model?
• BoP reflects demand and supply for currency
• Flexible exchange rate → OR=0
• CA = -CP or CA + CP = 0
• So we need to find a way to get CA and CP into IS-LM
• Include a curve that captures equilibrium on FE market in Y-i space
,Current Account
Note: An Exchange Rate Depreciation or a rise in World Income moves the CA up,
shifting the CA=0 line to the right
Capital Account
• Capital flows across borders in search for highest return
• Return on capital = i
When E depreciates Exports>Imports budget surplus
When E appreciates Exports<Imports budget deficit
, Equilibrium on FE market
FE curve = all combinations of Y and i where FE market is in equilibrium
FE curve positive slope
Start in point A. Assume ↑ in Y → increase imports → Deficit on CA
Need for capital import → surplus on CP
How to get more capital import → ↑ i → point B
Simplifying assumption for FE curve
CP = k ( i - iworld )
BoP = CA + CP = 0
i = iworld
