Review Schedule (check web page for room numbers)

• Tomorrow 8 or 10am: meet with your TAs• Tomorrow 7-8pm: usual weekly review• Saturday: 12-2 Macro review, 2-4 Micro review• Sunday: 12-2 Macro review, 2-4 Micro review• Monday, 9am-5pm: office hours

– Taylor: “Open house” style in Econ building

• Tuesday: Exam for Gates lecture people• Wednesday: Exam for Kresge lecture people • Everyday: JohnTayl@leland on “email alert”

Exchange rate determination• Exchange rate is the price of one currency in terms of

another– example: the price of a dollar is 120 yen, or 1.6 DM, or 1.05

euros

• Like any price, the exchange rate is determined in markets by the forces of supply and demand

• But foreign exchange markets are quick moving, like bond or stock markets

• Hence, to determine the price we use “arbitrage type” reasoning

Purchasing power parity (PPP)

• Based on Law of One Price– Basic idea: the price of the same commodity should

be about the same in different countries

• Example:• Golf ball $1.50 in U.S. (PUS = 1.50 dollars)

• Golf ball 200 yen in Japan (PF = 200 yen)

– Implies that purchasing power parity exchange rate is 133 yen per dollar (133x 1.50 = 200)

• In general, E x PUS = PF

How well does PPP work?

• Very well for large differences in inflation in different countries (large differences in PUS versus PF)

– German mark depreciated sharply during hyperinflation of 1920s

– Russian ruble depreciates sharply today during current inflation in Russia

• Very well for long periods of time – (see chart)

31_04

PERCENT

Japan France Italy U.K.Germany

8

6

4

2

0

2

4

6

Inflation rate in each country minus U.S. inflation rate

Appreciation (+) or depreciation (–) of the dollarcompared with each currency (percent per year)

But PPP does not explain exchange rates very well over

shorter periods of time• Short-run deviations of exchange rates from

PPP are due to interest rate differentials.

• If U.S. interest rate rises (falls) relative to interest rate in Japan or Europe, then the dollar will tend to appreciate (depreciate)

• Reason: Financial capital is highly mobile– People move their funds around quickly to get

the highest rate of return: “hot money”

Some evidence that interest rate differentials help explain exchange rate movements

31A

INTEREST RATE

19941974 1982 19901978 1986

6

4

2

0

-2

-4

160

140

120

100

80

60

Interest rate (left scale)

Exchange rate (right scale)

EXCHANGE RATE

Major policy question:Fixed versus flexible exchange rates• Examples of fixed exchange rate systems

– Bretton Woods, Argentina today, European monetary system from mid 1980s till Jan ‘99

– common feature: country fixes (pegs) exchange rate to another currency

• Key Idea: Keeping exchange rates fixed requires that interest rates move together in different countries (car with 2 steering wheels)– loss of international monetary independence

• Example: U.K. dropping out of peg with Germany

– but advantages of certainty and credibility

Marks and franks per dollar before and after Bretton Woods

31_05

19951955 19801970 19851965 1975 19901960

8

7

6

5

4

3

2

1

12.5

10.0

7.5

5.0

2.5

Francs per dollar(right scale)

Marks per dollar(left scale)

MARKS PER

DOLLAR

FRANCS PER

DOLLAR

End of BrettonWoods system

Marks per frank before and after Bretton Woods

31_06

FRANCS PER

MARK

19951955 19801970 19851965 1975 19901960

5

4

3

2

1

0

France and Germany exchangerates fixed

End of BrettonWoods system

WELCOME TO

A school for central bankers.Dedicated to teaching the science

and art of monetary policy.

Listen again to how Kelly McGillis explains monetary policy to Tom Cruise

Monetary policy rule 27_05

Monetary policy rule

7

6

5

4

3

2

1

0 1 2 3 4 5 6

INFLATION RATE (PERCENT)

INTEREST RATE (PERCENT)

Interest rate when inflation is on target

Inflation target

Trying to affect the exchange rate without changing the interest rate• Exchange market intervention

– Example, U.S. government buys yen to keep the yen from depreciating

– But capital flows are so quick and large these interventions are not very effective

• Resorting to capital controls– China, and now Malaysia

European Monetary Union• Goal is to permanently fix exchange rates within

Europe by moving to a single currency: the Euro• Eleven countries participating: Germany, France,

Italy, Spain, Netherlands, Ireland,...– U.K., Sweden not in

• Euroland will have one central bank: – the ECB will set interest rates just like the Fed– Starts operation in January 1999

• Biggest challenge for ECB will be political

Stages: Euro deposits will exist in January 1999, but paper money does not come until 2002

Five parts of macro

END OF COURSE

GOOD LUCK and

LOVE ECON