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Summary Intermediate Macro Economics IFR (International Financial Relations)
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Summary of the whole course, Graphs, Book Summary, Lectures included. Chapter 13-22
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Macro IFR Summary
Depreciation: Ex, IM
Appreciation: Ex, IM
E$/€, € appreciates, $ depreciates, Re$/€
E$/€, € depreciates, $ appreciates, Re$/€
Ee, Current E , depreciation
Ee, Current E , appreciation
R Md
Y Md
2xP 2xMd, more transactions
Ms R
Ms R
𝑀𝑠
LR: Ms P because 𝑃 =
𝐿(𝑅,𝑌)
Real exchange rate CA
Real exchange rate CA
Disposable income CA
Disposable income CA
• Increase in M shifts AA-curve to the right
• Increase in P shifts AA-curve to the left
• Increase in R* shifts AA-curve to the right
• Increase in Ee shifts AA-curve to the right
• Increase in money supply
• Temporary increase? Shift of the AA-curve to the right
• Permanent increase? Shift of the AA-curve even further to the right (why?)
• Long run
• Y = Yf
• Permanent increase? Relative to short-run situation AA-curve shifts to the
left (why?) and DD-curve shifts to the left (why?)
1
,Alterations:
Balance of payments transactions
o Payments to foreigners are reported as debit, and receipts for foreigners are
reported as credit.
Changing interest rates
o A rise in the interest rate on deposits of a certain currency lead to an
appreciation of that currency against other currencies. Because the return is
higher.
Changing expected exchange rates
o An increase in the expected exchange rate leads to an increase in the current
exchange rate and a decrease in the expected exchange rate lead to a
decrease in the current exchange rate. An increase in the expected exchange
rate leads to an increase in the expected rate of depreciation of the dollar.
This increased rate of depreciation results in a higher return on euro deposits
in dollars.
Money demand, via price, interest and GNP
o An increase in the interest rate decreases the aggregate money demand
o When the price level increases people have to pay more for the reference
basket, so the demand for money will increase to continue with the same
level of liquidity
o An increase in real national income increases the value of transactions and
thus increases the money demand, given the price level
Increase in money supply
o An increase in the money supply, keeping P constant, leads to a proportional
increase in the real money supply (Ms/P), and the Ms curve shifts to the right.
So there is a new equilibrium at a lower interest rate. So, an increase in the
money supply leads to a decrease in the interest rate and a decrease in the
money supply leads to an increase in the interest rate, for given levels of
prices and output.
An increase in real income (Y), holding prices and money supply
constant, shifts the aggregate real money demand curve to the right.
Changes in US money supply
o A rise in the money supply of a country leads to a depreciation of the
currency of that country and a fall in the money supply leads to an
appreciation of the currency of that country.
o An increase in the US Ms leads to a shift of the Ms curve to the right, and the
interest rates will go down. The lower interest rates shifts the curve of the
dollar return to the left in the foreign exchange market.
Changes in European money supply
o For example, an increase in the European Money Supply means a reduction
in the return on euro deposits, R€. The curve R€ shifts to the left. The new
equilibrium in the foreign exchange market is found at a lower exchange rate
(E$/€). The euro has depreciated and the dollar has appreciated. The US
money market is unaffected by the increase of the European money supply
and remains at its old equilibrium.
2
, Changes in money supply in the long run
o The long run equilibrium is reached when all prices and wages are at their
market clearing levels. So long run equilibrium is met when both output and
interest are at their long run levels and thus fully employed. An increase in
the money supply of a country leads to a proportional rise in the price level of
that country. The increase in the Ms leaves the interest rate and output
unaffected, so the real demand for money doesn’t change.
Money and exchange rate on the long run
o What does change in the long run, after a change in the money supply, is the
exchange rate. A permanent rise in the money supply of a country leads to a
proportional depreciation in the long run of its currency of that country. A
permanent fall of the Ms leads to a proportional appreciation in the long run
of the currency of that country.
3 pressures on the price in the long run
o Excess demand for labour and output:
When the Ms goes up, the economy expands, this leads to an increase
in demand for goods and services, and thus to an increased demand
for labour. Employees will negotiate higher wages, which the
producers will accept and with higher prices they cover the higher
wages.
o Inflationary expectations:
If people expect inflation in the future, they will also adjust their
expectations of the current level of inflation. Employees will again
negotiate higher wages to compensate for the higher prices and the
reduction in their real wage, producers will give in because they also
expect the prices to rise, in which they can cover the increased wages.
o Raw materials prices:
Many markets for raw materials have highly variable prices even in
the short run. A rise in the Ms leads to higher prices for these raw
materials and thus leads to higher production costs. To cover these
higher production costs producers in raw-materials using industries
will increase their price.
A permanent increase in the Money Supply
o Since the increase is permanent, people expect all dollar prices to rise in the
long run, including the dollar prices for euros. This rise in the expected
exchange rate increases the expected depreciation rate and thus the
expected return on euro deposits. The downward sloping curve representing
the expected euro return shifts to the right and the exchange rate increases.
The euro appreciates, the dollar depreciates.
o In the long run the price levels increases in proportion with the money supply
and the long run real money supply will be the same as the real money
supply before the increase. Together with a given level of output, the interest
rate must also return to its old level. The rise in the interest rate also shifts
the curve of the dollar back to the right and the exchange rate falls. The euro
depreciates and the dollar appreciates. This long run equilibrium exchange
rate is lower than the short run equilibrium exchange rate, but higher than
the initial exchange rate.
3
, Monetary approach to the exchange rate
o Money supplies: A rise in the money supply of the US, leads to a proportional
depreciation of the dollar in the long run. A rise in the money supply of
Europe leads to a proportional rise in the European price level.
o Interest rates: An increase in the interest rate has a negative effect on the
demand for money, the the price level increases, so does the exchange rate,
and the dollar depreciates.
o Output level: an increase in the level of output has a positive effect on the
demand for money, so the price level decreases. The exchange rate
decreases (dollar appreciates) proportional to the rise in the price level.
4
,Theory:
Income accounting and balance of payments
Macro economics:
o Level of unemployment
o Level of savings
o Trade imbalances
o Money
o Price level
National income accounting:
o Keep track of all the expenditures that come with the level of income and
output.
Balance of payments accounting:
o Record both changes in the level of debt a country has to foreigners and the
profits from (net) export.
GNP:
o Value of all final goods & services produced by the country’s factors of
production and sold on the market in a given period.
Consumption, investment, government purchases and CA balance
GNP equals national income when:
GNP-Depreciation=NNP (net national product)
GNP + net unilateral transfers
GDP:
o Level of production produced within the borders of a country
So GNP= GDP + net receipts of factor of income from the rest of the
world.
In a closed economy savings equal investment.
Stocks & bonds are not included in GNP
A country with a CA surplus is exporting present consumption and importing future
consumption
Balance of payments (BoP):
o Payments to foreigners, as debit
o Receipts form foreigners, as credit
3 types:
Current Account, exports and imports
Financial Account, international trade in financial assets
Capital Account, transfer of wealth between countries,
intangible assets
Financial derivatives:
o Assets with a fluctuating value, such as bonds and stocks.
Official settlements balance:
o Level of net central bank financial flows
Errors in BoP come up because different sources are used to come up with the debit
and credit accounts, so a ‘net errors & ommissions’ is added.
5
, Official international reserves:
o Foreign assets held by central banks to protect against economic disasters,
treasury bills.
Official Foreign exchange intervention:
o CB’s purchase or sell reserves in private asset markets to have influence on
the economy, so they can add of withdraw money from circulation.
Exchange rates
Depreciation: a decrease in the price of the domestic currency in terms of a foreign
currency
Appreciation: an increase in the price of the domestic currency in terms of a foreign
currency.
Foreign exchange market participants:
o Commercial banks
o Corporations
o Non financial institutions
o Central banks
Profits from arbitrage involve no risk or cost
Vehicle currency, many international transactions involve this currency, even with
two other currencies.
Real rate of return is measured in the return of a basket.
Risk and liquidity are important for savers.
The dollar rate of return on euro deposits is roughly equal to the interest rate on
euros plus the depreciation rate:
o Positive difference: R$>R€
o Negative difference: R$<R€
Interest parity condition:
o The return on deposits of different currencies is equal, in equilibrium when
there is no excess demand of excess supply of a currency. So it doesn’t
matter in what currency you invest, the return will all be the same.
The expected return on euro deposits is negatively sloping because it depends
negatively on the current E
A rise in the interest rates on deposits of a certain currency leads to an appreciation
of that currency against others.
An increase in the expected exchange rate of Ee$/€ leads to an increase in the
expected rate of depreciation of the dollar.
An increase in Ee leads to an increase in current E
6
,Money:
Money:
o Medium of exchange, a mean of payment
o Unit of account, measure of value
o Store of value, asset
Money supply:
o Total amount of bank deposits and currency of households and firms, it
doesn’t include the deposits bought and sold at the foreign exchange market,
because they are not liquid enough.
Money demand: Md=P * L(R, Y)
o Expected return compared to other assets
o Riskiness of the return on money
o Level of liquidity
Aggregate money demand:
o Sum of all the money demands by individuals:
Depends on:
Interest rate
Price level
Real national income
o Moves in proportion with the price level.
People are interested in real money demand, people don’t want to hold a certain
amount of money but a certain amount of purchasing power.
A change in interest, move along the curve
A change in GNP, move of the curve
Real money supply is a vertical line, determined by CB
A decrease in the money supply leads to an excess demand, people will try to sell
assets that pay interest.
An increase in the money supply leads to a decrease in the interest rate and a
decrease in the money supply leads to an increase in the interest rate.
Looking at the short run, we take the price level and real income as given.
Difference in SR equilibrium and LR equilibrium, see formulas.
A change in Ms has no effect on the long run values of the interest rate or real
output.
A permanent increase in the Ms causes a proportional increase in P on the long run.
In the short run prices stay constant, except agricultural prices.
3 pressures on the future price of P:
o excess demand on the labour & output
o inflationary expectations
o raw materials prices
Exchange rate overshooting:
o When the exchange rate initially rises above the long run equilibrium level in
the short run after an increase in the money supply.
Or, the dollar depreciates more in the short run than in the long run.
This happens because of the IPC
7
, The exchange rate needs to overshoot, so people will expect an
appreciation of the dollar in the future. If prices were rigid,
overshooting would not be necessary.
Price levels:
Law of one price:
o Prices of identical goods from different countries must be equal in terms of
the same currency if they are traded in competitive markets where trade is
free without trade barriers and transportation costs.
o The exchange rate is equal to the price ratio
Absolute PPP:
o The same as the law of one price, except that it applies to general price levels
instead of the prices of individual commodities.
If the law of one price holds for every commodity, PPP also holds
when measured with the same reference baskets.
o The exchange rate between two countries is equal to the ratio of the price
levels of those countries.
o When the domestic price level of a currency increases, the domestic PP of
that currency decreases. This will lead to a proportional depreciation of that
currency. Contrary, a decrease in the domestic price level means an increase
the purchasing power which leads to a proportional appreciation.
o The parity also says that the purchasing power of every currency must be the
same.
Relative PPP:
o The percentage change in the exchange rate between two currencies over
any period equals the difference between the percentage changes in national
price levels.
Absolute PPP uses price and exchange rate levels, reference baskets need to be the
same
Relative PPP uses changes in prices and exchange rates, needs a time interval, price
level may be based on different reference baskets.
Relative PPP may hold even when Absolute PPP doesn’t
8
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