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Welcome to Welcome to EC 382: International EC 382: International EconomicsEconomicsBy:By: Dr. Jacqueline KhorassaniDr. Jacqueline Khorassani

Week ElevenWeek Eleven

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Week Eleven: Class 1Week Eleven: Class 1

Tuesday, November 13Tuesday, November 13 14:10-15:0014:10-15:00

AC 202AC 202

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I received a questionI received a question

Can you please explain again with Can you please explain again with some examples the open market some examples the open market operations? thank you operations? thank you

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AnswerAnswer

Bank of Ireland has some government bonds.Bank of Ireland has some government bonds. If the central bank wants to increase the If the central bank wants to increase the

supply of moneysupply of money– Offer higher than normal prices for bondsOffer higher than normal prices for bonds– Bank of Ireland sell their Bank of Ireland sell their €€1000 bond to the central 1000 bond to the central

bankbank– Central bank makes a Central bank makes a €€1000 deposit into their 1000 deposit into their

Bank of Ireland Reserve Account at the central Bank of Ireland Reserve Account at the central bank. bank.

– Bank of Ireland’s reserves goes upBank of Ireland’s reserves goes up Bank of Bank of Ireland make more loansIreland make more loans that means the people that means the people (borrowers) will have more money in their checking (borrowers) will have more money in their checking accounts (borrowed) accounts (borrowed) M1 goes up M1 goes up MS goes upMS goes up

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FirmsFirms individualsindividuals

The central bank supplies The central bank supplies money. Who demands money. Who demands money?money?

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1)1) To buy goods and services.To buy goods and services. Transactions demand for moneyTransactions demand for money Varies directly with nominal GDPVaries directly with nominal GDP

2)2) In case of emergencies that require In case of emergencies that require purchases above normal spending purchases above normal spending levelslevels

Precautionary demand for moneyPrecautionary demand for money

3) As an asset3) As an asset

Why do we demand Why do we demand money (M1)?money (M1)?

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If interest rates go up, do we If interest rates go up, do we demand more or less money?demand more or less money?

– LessLess interest rate is the opportunity cost of interest rate is the opportunity cost of

holding moneyholding money

If the price level goes up, do we If the price level goes up, do we demand more or less money?demand more or less money?

– MoreMore need more money to cover our need more money to cover our

purchasespurchases

Three motivations for holding Three motivations for holding money combine to create the money combine to create the aggregate demand for moneyaggregate demand for money

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If our income goes up, will we If our income goes up, will we demand more or less money?demand more or less money?– MoreMore

Can afford to buy more goods and servicesCan afford to buy more goods and services

Money demand related to interest Money demand related to interest rate, price level and real income as: rate, price level and real income as:

MD = f(-i, +P, +Y)MD = f(-i, +P, +Y)i = Interest ratei = Interest rateP = Price levelP = Price levelY = Real GDPY = Real GDP

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Money Demand CurveMoney Demand Curve

Interest Rate(i)

Money (M)

Demand for Money (MD)

Shows the relationship between interest rate and the quantity of money demanded holding everything else constant

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What shifts the Money What shifts the Money Demand Curve?Demand Curve?

Interest Rate(i)

Money (M)

Demand for Money (MD)

D1

D2

Increase to D1 if P↑ or

Y↑

Decrease to D2 if P↓ or

Y↓

1111

i

The Equilibrium Interest The Equilibrium Interest Rate: Rate: The Interaction of Money The Interaction of Money Supply Supply and Money Demandand Money Demand

Interest Rate(i)

Money (M)

Demand for Money (MD)

Supply for Money (MS)

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i

How does an increase in How does an increase in the price level affect the the price level affect the interest rates?interest rates?

Interest Rate(i)

Money (M)

Supply for Money (MS)

Demand for Money (MD)

MD2

i2

G

EMD ↑

i↑

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i

How does a economic How does a economic recession affect the recession affect the interest rate? interest rate?

Interest Rate(i)

Money (M)

Supply for Money (MS)

Demand for Money (MD)MD1

i1

E

F

MD↓

i↓

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i

How does an open How does an open market sale by the market sale by the central bank affect the central bank affect the interest rate?interest rate?

Interest Rate(i)

Money (M)

Supply for Money

(MS)

Demand for Money (MD)

i2

MS2

MS ↓

i↑

This is a contractionary

monetary policy

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Another QuestionAnother Question

I'm trying to understand the I'm trying to understand the example in page 329 about example in page 329 about appreciation and depreciation but appreciation and depreciation but I think there's something wrong in I think there's something wrong in it. Can you do it in class? it. Can you do it in class?

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My answer My answer

Let go over it togetherLet go over it together

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How does the How does the interest rate relate interest rate relate to the exchange to the exchange rate? rate? Interest ArbitrageInterest Arbitrage::

– Relationship between interest rates Relationship between interest rates and the exchange rate in the short and the exchange rate in the short runrun

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International International EconomicsEconomics Week Eleven –Class 2Week Eleven –Class 2

– Wednesday, November 14Wednesday, November 14– 11:10-12:0011:10-12:00– TyndallTyndall

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Final Exam Final Exam Is a 2 hour examIs a 2 hour exam Covers everythingCovers everything

– Chapters 1 through 8Chapters 1 through 8– Chapters 11, 13, 14, and 15Chapters 11, 13, 14, and 15– Notes/Slides/AssignmentsNotes/Slides/Assignments

Has 3 parts:Has 3 parts:1.1. 15 MCQ (3 points for correct answers and -15 MCQ (3 points for correct answers and -

0.5 point for incorrect answers.)0.5 point for incorrect answers.) total = total = 45 points45 points

2.2. Choose 2 of 4 essay questions for 20 Choose 2 of 4 essay questions for 20 points each points each total = 40 points total = 40 points

3.3. Three problemsThree problems total = 65 points total = 65 points

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Remember yesterday’s Remember yesterday’s question:question: I'm trying to understand the I'm trying to understand the

example in page 329 about example in page 329 about appreciation and depreciation but appreciation and depreciation but I think there's something wrong in I think there's something wrong in it. Can you do it in class? it. Can you do it in class?

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ExampleExample::– You own a company in U.S. looking You own a company in U.S. looking

to invest $10,000 cash.to invest $10,000 cash.– Assume U.K. has the best rate of Assume U.K. has the best rate of

12%.12%.– You must first buy pounds in the You must first buy pounds in the

foreign exchange market, then foreign exchange market, then invest pounds in U.K. market.invest pounds in U.K. market.

– If spot exchange rate is $2/pound, If spot exchange rate is $2/pound, which gives you which gives you ££5000 to invest 5000 to invest

The Interest Rate The Interest Rate And the Exchange And the Exchange Rate in the Short RunRate in the Short Run

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Example (continued)Example (continued)::– In 3 months the money will be In 3 months the money will be

worth worth 5000 (1+0.12/4) = 5000 (1+0.12/4) = ££5,150 5,150

1.1. If the exchange rate is the same, If the exchange rate is the same, you will getyou will get

5,150 * 2 = 5,150 * 2 = $10,300$10,300

The Interest Rate The Interest Rate And the Exchange And the Exchange Rate in the Short RunRate in the Short Run

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The Interest Rate And The Interest Rate And the Exchange Rate in the the Exchange Rate in the Short RunShort Run2. If pound drops to $1.975/pound 2. If pound drops to $1.975/pound

– By how much has pound By how much has pound depreciated? depreciated?

[(2-1.975) / 2] * 100 = %1.25 in 3 [(2-1.975) / 2] * 100 = %1.25 in 3 months months

the books says 5% (that is the annual the books says 5% (that is the annual rate)rate) 1.25 * 4 = 5% depreciation 1.25 * 4 = 5% depreciation

– You end up with You end up with ££5,150 * 1.975 = 5,150 * 1.975 = $10,171.25$10,171.25

– So what is your rate of return?So what is your rate of return?[(10,171.25-10,000)/10,000] * 4 = 7%[(10,171.25-10,000)/10,000] * 4 = 7%

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So your total rate of So your total rate of return is thereturn is the difference between annual difference between annual

interest rate in U.K. (12%) and interest rate in U.K. (12%) and depreciation of the pound (5%) = depreciation of the pound (5%) = approx. 7%.approx. 7%.

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If the pound appreciates by 5% If the pound appreciates by 5% – Total return is sum of annual Total return is sum of annual

interest rate in U.K. (12%) and interest rate in U.K. (12%) and appreciation of the pound (5%) = appreciation of the pound (5%) = approx. 17%approx. 17%

SimilarlySimilarly

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Buy foreign currency in spot Buy foreign currency in spot exchange marketexchange market

At same time sell pound in At same time sell pound in forward exchange market forward exchange market delivering on date of delivering on date of investment’s maturityinvestment’s maturity

1.1. If forward rate > current spot rate If forward rate > current spot rate (pound is selling at a forward (pound is selling at a forward premium)premium)

– more profitable to invest in U.K.more profitable to invest in U.K.2.2. If forward rate < current spot rate If forward rate < current spot rate

(pound is selling at forward discount)(pound is selling at forward discount)– must compare the gain in favorable must compare the gain in favorable

interest rate to loss suffered by exchange interest rate to loss suffered by exchange raterate

To eliminate To eliminate exchange-rate riskexchange-rate risk

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Annual yield (interest rate) on US bond = Annual yield (interest rate) on US bond = 10%10%

Annual yield (interest rate) on Irish bond = Annual yield (interest rate) on Irish bond = 6%6%

Spot exchange rate Spot exchange rate $1 = $1 = €€11 Forward exchange rate Forward exchange rate $1 = $1 = €€1 1

But really the story is more But really the story is more complicated than that. Here is a complicated than that. Here is a rough numerical example to show rough numerical example to show

the interest rate paritythe interest rate parity

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So Irish will want to So Irish will want to invest in the USinvest in the US

Spot demand for dollar goes up Spot demand for dollar goes up dollar dollar appreciates by 1 %appreciates by 1 %

Demand for US bonds goes up Demand for US bonds goes up price of price of bonds goes up bonds goes up interest rate goes down interest rate goes down by 1% point.by 1% point.

Demand for Irish bonds goes downDemand for Irish bonds goes down price price of bond goes down of bond goes down interest rate goes up interest rate goes up by 1% point.by 1% point.

Forwards supply of dollar goes up Forwards supply of dollar goes up dollar dollar depreciates by 1%depreciates by 1%

NowNow– Dollar sells at 2% forward discount = Interest Dollar sells at 2% forward discount = Interest

rate in US is 2% point higher than in Irelandrate in US is 2% point higher than in Ireland

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Interest rate parityInterest rate parity

Funds continue moving between Funds continue moving between the two countries untilthe two countries until– forward premium or discount forward premium or discount

equals the interest rate equals the interest rate differentialdifferential

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International International EconomicsEconomics Week Eleven - Class 3Week Eleven - Class 3

– Wednesday, November 14Wednesday, November 14– 15:10-16:0015:10-16:00– AC 201AC 201

Online grades were updated Online grades were updated today.today.

ICA5 is graded and ready to be ICA5 is graded and ready to be picked uppicked up

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What does tightening of money What does tightening of money in Ireland do to interest rates?in Ireland do to interest rates?

– MS declinesMS declines interest rates go up interest rates go up What does this do in the market What does this do in the market

for euro?for euro?– Demand goes upDemand goes up euro appreciates euro appreciates– Supply goes downSupply goes down euro euro

appreciatesappreciates This process continues until This process continues until

interest parity is achieved.interest parity is achieved.

The Interest Rate And the The Interest Rate And the Exchange Rate in the Short Exchange Rate in the Short RunRun

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Changes in Interest Rates:Changes in Interest Rates:

– Increasing a country’s interest rate:Increasing a country’s interest rate: Causes capital inflowCauses capital inflow Appreciation of a country’s currencyAppreciation of a country’s currency

– Decreasing a country’s interest rate:Decreasing a country’s interest rate: Causes capital outflowCauses capital outflow Depreciates a country’s currencyDepreciates a country’s currency

– Movement of capital causes change Movement of capital causes change exchange ratesexchange rates

– Interest rate volatility Interest rate volatility exchange rate exchange rate volatilityvolatility

Interest Rates, the Interest Rates, the Exchange Rate, and the Exchange Rate, and the Balance of PaymentsBalance of Payments

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Suppose there is no Suppose there is no capital inflow or outflowcapital inflow or outflow

S1 (imports of G & S)

$/Euro

1.5

2.0

2.5

100 200 400 Euros

D1 (exports of G $ S)

300 500

E

At E, quantity demanded for euros = quantity supplied current account balance

D & S are due current account activities

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Assume U.S. interest rates increaseAssume U.S. interest rates increase

– Capital moves into US.Capital moves into US.– Supply of euro increases Supply of euro increases – Does demand for euro decrease?Does demand for euro decrease?

No there was no capital inflow before. No there was no capital inflow before.

What happens if there are What happens if there are now capital flows between now capital flows between countries?countries?

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S1 (imports of G & S)

$/Euro

1.5

2.0

2.5

100 200 400 Euros

D1 (exports of G $ S)

300 500

E1

S2 =S1 +

capital outflow

Supply shift right

euro depreciates

imports of goods and services go down to less than 200

exports of goods and services go up to more than 400

current account surplus = net capital outflow

E2

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Price Levels and Price Levels and ExchangeExchangeRates in the Long RunRates in the Long Run

CHAPTER 15CHAPTER 15

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Law of One PriceLaw of One Price::– Identical goods sold in competitive Identical goods sold in competitive

markets should cost the same in all markets should cost the same in all countries when prices are expressed countries when prices are expressed in terms of the same currencyin terms of the same currency ExampleExample: :

– If exchange is 2$/Pound and a pair If exchange is 2$/Pound and a pair of shoes costs £200, then the same of shoes costs £200, then the same pair of shoes should cost $400 in pair of shoes should cost $400 in U.S. (same price).U.S. (same price).

The Law of One PriceThe Law of One Price

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It leaves room for arbitrage It leaves room for arbitrage between the countries.between the countries.

ExampleExample:: Using the pair of shoes from U.K.Using the pair of shoes from U.K.

– Exchange is $2/Pound, PExchange is $2/Pound, PU.K.U.K.= £200, = £200, and Pand PU.SU.S = $400 = $400

– If the price in U.S. rose to $500 and If the price in U.S. rose to $500 and the exchange rate did not change, the exchange rate did not change, what would happen?what would happen?

What if The Law of One What if The Law of One Price does not hold? Price does not hold?

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what would happen?what would happen?

Demand for Pounds would increase Demand for Pounds would increase – U.S. importers need Pounds to – U.S. importers need Pounds to buy shoes.buy shoes.– The $/Pound exchange rate would rise.The $/Pound exchange rate would rise.

Demand for UK shoes riseDemand for UK shoes rise– increasing price of shoes in UKincreasing price of shoes in UK

Supply of shoes in the US will go up Supply of shoes in the US will go up – decreasing price of shoes in USdecreasing price of shoes in US

Continues until prices are the same Continues until prices are the same again.again.

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1.1. Transportation costsTransportation costs2.2. Some goods are not tradableSome goods are not tradable3.3. Barriers to tradeBarriers to trade4.4. Differences in tax rates and Differences in tax rates and

regulationsregulations But over time But over time market market

forces tend to push prices forces tend to push prices toward equalitytoward equality

But prices in most But prices in most countries are not usually countries are not usually equal. Why?equal. Why?