Topic 1- National Income Accounting & BOP
National Income Identity |
gross domestic product is given by consumption expenditures, plus investment expenditures, plus government expenditures, plus exports, minus imports |
Y=C+I+G+CA |
National Savings |
the amount of output that is not devoted to private consumption and government spending |
S= Y-C(Y-T)-G or S= Sp+Sg or S=I+CA |
Balance of Payments |
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 |
*every international transaction enters the BOP accounts twice, once as a credit and once as debit |
Credit Entry |
any transaction resulting in receiving payments from foreigners |
exports of goods, services, assets |
Debit Entry |
any transaction resulting in making payments |
imports of goods services, assets |
Components of BOP Accounts |
Current Account, Financial Account, Capital Account |
CA+KAnon+CapitalAcc= -ORT |
Current Account |
shows the difference b/w exports and imports of goods and services plus net unilateral transfer |
CA= EX-IM+ Net Unilateral Transfer |
Financial Account |
difference b/w sales & purchases of assets to foreigners |
KA= KAnonres+ORT |
Non-reserve Portion |
the purchases & sales of assets by the private sector |
Reserve Portion |
the purchases & sales of foreign assets by the country's monetary authority |
foreign-currency denominated assets held by central banks |
Topic 4- Price Levels & Exchange Rate in LR
Purchasing Power Parity |
explains movements in the exchange rate between two countries’ currencies by changes in the countries’ price levels |
Absolute PPP |
identical basket of goods should be sold for same amount of money in diff countries when expressed in same currency |
E= P/P* |
Relative PPP |
% Δ in exchange rate between 2 currencies over many period equals to the inflation rate differentials between 2 countries |
Ee-E/E= π-π* |
Monetary Approach to Exchange Rate |
shows factors that affect MS and MD will play a role in determining exchange rate |
PPP holds, LR Model, shocks are permanent |
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Equilibrium exchange rate |
E= (MS/MS)(L(Y,R)/(L(R,Y) |
Domestic MS Increases |
Exchange rate increases |
DC depreciates |
Foreign MS Increases |
Exchange rate decreases |
DC appreciates |
Domestic Interest Rate increases |
Exchange rate increases |
DC depreciates |
Foreign Interest Rate increases |
Exchange rate decreases |
DC appreciates |
Domestic Output increases |
Exchange rate decreases |
DC appreciates |
Foreign Output Increases |
Exchange rate increases |
DC depreciates |
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Topic 2- Asset Approach to Exchange Rate
Exchange Rate |
the price of one currency in terms of another(DC/FC) |
EDC/FC=1/EDC/FC |
Forward exchange rates |
the exchange rate that is contracted today for the exchange of currencies at a specified date in the future |
R= R*+Ee-E/E |
Interest Parity Condition |
the condition that the expected returns on deposits of any two currencies are equal when measured in the same currency |
Covered interest Rate Parity |
agents can lock in the future exchange rate by getting a forward contract & eliminating uncertainty |
R= R*+ F-E/E |
Real Rate of Return |
the rate at which its value expressed in terms of a representative output basket is expected to rise |
Expected ate of return |
the rate at which the value of an investment in the asset is expected to rise over time |
Arbitrage |
the process of buying a currency cheap and selling it dear |
Asset Approach |
IPR holds & deals with financial capitals |
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Focused on money mkt shocks and impacts on exchange rate (SR & LR) |
R, domestic interest rate |
return on DC deposits |
Ee-E/E |
annualized percentage change in the DC/FC exchange rate |
R*+Ee-E/E |
expecting DC return on FC deposits |
Increase in Domestic Interest |
R curve shifts right, invest in DC Deposit |
Capital inflows & DC appreciates |
Increase in Foreign Interest |
R* curve shifts right, invest in FC deposit |
Capital outflows & DC depreciates |
Expected Depreciation of DC |
R* curve shifts right, invest in FC deposit |
Capital outflows & DC depreciates |
Forward Trading |
parties agree to exchange currencies on some future date at a pre-negotiated exchange rate |
Spot Trading |
trades are settled immediately |
Generalized Approach (real exchange rate, q)
Real exchange rate, q |
measures the purchasing power of a country's currency relative to another country's currency |
shows how many baskets of domestic goods are needed to exchange one basket of foreign goods q= E(P/P*) |
If q increases |
real depreciation of DC |
If q decreases |
real appreciation of DC |
q=1 |
Absolute PPP |
q= E(P/P*) |
q=0 |
Relative PPP |
qe-q/q=0 |
If AD increases-domestic |
domestic goods are more valuable |
PPP of DC increases and real appreciation of DC |
If AD* increases-foreign |
domestic goods are less valuable |
PPP of DC decreases and real depreciation of DC |
Generalized Approach |
considers how changes in both monetary and real sides of the economy affect LR exchange rate |
in the LR changes in q, changes in P and P* lead to a change in E |
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Topic 3- Money, Interest Rate & Exchange Rate
Money Supply |
the total amount of currency and checking deposits held by households and firms |
Currency in circulation+Demand Deposit |
Aggregate Money Demand |
the toal demand for money by all households and firms in the economy |
Md= L(R,Y) |
L(R,Y) |
liquidity function |
R |
nominal interest rate |
opportunity cost of holding money |
Y |
real income= real GDP |
when income increases, consumption increases, volume of transaction increases |
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Interest rate- fisher |
R= r+Π |
Money market equilibrium |
MS/P= L(R,Y) |
R adjusts to ensure the money market is in equilibrium in SR |
If MS increases |
Pressure for R to fall to initial level |
If real income Y increases |
Consumption increases and we hold more money |
L(R,Y) increases and R increases |
In the long run |
P= MS/L(R,Y) |
P= MS/L(R,Y*) |
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Quantity Theory of Money |
%Δ MS+%ΔV= %ΔP+%ΔY |
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Level change in MS doesn't impact %Δ in MS |
no change in MS means no change in Π |
Exchange Rate Overshooting |
immediate response to a disturbance is greater than its long-run response |
Exchange Rate Undershooting |
the immediate depreciation of a currency to a shock is greater than its long run response |
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