1 ECON 100 Lecture 24 Wednesday, May 8

2 Midterm 2 topics GDP Cost of living, CPI, Inflation UnemploymentProduction and growth The financial system: saving and investment The open economy Lecture note slides for Midterm 2: LN 17 – 24. You are responsible only for material in the slides. Extra office hours for Midterm 2: Monday (2 – 4PM) and Tuesday (10AM – 12, and 2 – 4PM)

3 Next week, MONDAY lecture, May 13REVIEW for Midterm 2 and COURSE EVALUATIONS Please come to the Monday lecture

4 Open-Economy Macroeconomics

5 Exchange rates (kur: dolar avro,yen)a few words on the Exchange rates (kur: dolar avro,yen)

6 Exchange rates as of July 12, 2004 Domestic currency is the US dollarcountry exchange rate 7 May 2013 Euro 0.81 Euro/$ 0.76 Euro/$ Japan 108.2 Yen/$ 99.1 Yen/$ Mexico 11.5 Pesos/$ 12.0 Pesos/$ Russia 29.1 Rubles/$ 31.1 Rubles/$ South Africa 6.0 Rand/$ 9.0 Rand/$ Turkey 1,437,120 Liras/$ 1,80 Liras/$ U.K. 0.54 Pounds/$ 0.64 Pounds/$ If you’d like to update these figures before your lecture, you can find good exchange rate data at:

7 Exchange Rates Exchange rates are the most important “prices” that determine international trade (exports - imports). There are “two” exchange rates! the nominal exchange rate and the real exchange rate.

8 TL / USD rates, 2012 Jan - April

9 Exchange Rates What is reported daily in the news media isthe nominal exchange rate But, the exchange rate that plays the crucial role in determining net exports is the real exchange rate.

10 The nominal exchange ratee = nominal exchange rate, e is the relative price of domestic currency (say, TL) in terms of a foreign currency (say, US$). Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.

11 The nominal exchange ratee is a positive real number, that tells us how many units of the foreign currency we can buy with 1 unit of the domestic currency. e = 99 means that 1 unit of the domestic currency can buy … Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.

12 The nominal exchange ratee is a positive real number, that tells us how many units of the foreign currency we can buy with 1 unit of the domestic currency. e = 99 means that 1 unit of the domestic currency can buy 99 units of the foreign currency! Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.

13 The nominal exchange rateEXAMPLE with TL as the domestic currency against US$: e = 0,55 This means that 1 TL can be exchanged for 0,55 US$ But the current “kur” is 1.80! So what goes on here? Warning to students: Some textbooks and newspapers define the exchange rate as the reciprocal of the one here (e.g., dollars per yen instead of yen per dollar). The one here is easier to use, because a rise in “e” corresponds to an “appreciation” of the country’s currency. Using the reciprocal would mean that a rise in “e” is a depreciation, which seems counter-intuitive. So it would be worthwhile to point out to students that a country’s “e” is simply the price (measured in foreign currency) of a unit of that country’s currency.

14 The nominal exchange rate can be expressed in two ways:Domestic currency: TL; Foreign currency: US$ In units of foreign currency per 1 unit of domestic currency. We can say e = 0,55 We mean that 1TL = 0,55 US$ In units of domestic currency per 1 unit of the foreign currency. We can say e = 1,80 We mean that 1 US$ = 1,80TL ECON 100 will ALWAYS use the first method.

15 The foreign exchange market is unique

16 This are “daily” trading volumes!

17 The ten most active traders account for more than 75% of the volumeName % of Volume Deutsche Bank 17 UBS 12.5 Citigroup 7.5 HSBC 6.4 Barclays 5.9 Merrill Lynch 5.7 JP Morgan Chase 5.3 Goldman Sachs 4.4 ABN Amro 4.2 Morgan Stanley 3.9

18 Not all currencies are equal!US currency was involved in 89% of transactions, followed by the Euro (37%), the yen (20%) and sterling (17%).

19 Now, something more complicated!the “real” exchange rate

20 The real exchange rate ε= real exchange rate, the relative price of domestic goods in terms of foreign goods ε the lowercase Greek letter epsilon

21 The formula e x P P* Real exchange rate ε = e = nominal exchange rate P = domestic price of the good in domestic currency P* = foreign price of the good in foreign currency

22 Example with one good: le big macHome country: Turkey Foreign country: US

23 Example with one good, Le BIG MACExample with one good, Le BIG MAC 23

24 Karamelize, yumuşak susamlı ekmeğinin içerisinde iki adet %100 dana eti, tadı damağınızda kalan Big Mac® sosu, taze gevrek salatası, iki adet salatalık turşusu ve leziz peyniri ile doğru süslenmiş iştah açıcı, bir o kadar da doyurucu bir seçim. Enerji (kcal) 480 Protein (g.) 28 Karbonhidrat (g.) 43 Yağ (g.) 22 Sodyum (mg.) 840

25 The real exchange rate with the bigmacThe real exchange rate with the bigmac e x P P* e = 0,55 (means 1TL = 0,55$) P = Price of the Big Mac in domestic country (Turkey) in TL P = 8,45TL P* = Price of the Big Mac in foreign country (US) in US$ P* = $4.37 e x P = 0.55 x 8.45= 4,65 ε = 25

26 The real exchange rate with the bigmacThe real exchange rate with the bigmac e x P P* e = 0,55 (means 1TL = 0,55$) P = Price of the Big Mac in domestic country (Turkey) in TL P = 8,45TL P* = Price of the Big Mac in foreign country (US) in US$ P* = $4.37 e x P = 0.55 x 8.45= 4,65  price of the Turkish BigMac in US$ Finally (e x P)/ P* = 4,65 / 4,37 = 1,06 ε = ε = 26

27 Interpreting the Real Exchange RateInterpreting the Real Exchange Rate The real exchange rate ε = 1,06 means what exactly? 1 Turkish Big Mac = 1.06 U.S. Big Macs This means that … To buy one Big Mac in Turkey a US citizen must pay an amount that could purchase 1.06 Big Macs in the US. Question: Which country has the cheaper Big Mac? 27

28 One more time: Interpreting the Real Exchange RateOne more time: Interpreting the Real Exchange Rate The real exchange rate ε = 1,06 means what exactly? 1 Turkish Big Mac = 1.06 U.S. Big Macs We can say that the “amount of money” that buys one Big Mac in Turkey buys Big Macs in the US. 28

29 The Big Mac index around the world

30 The Big Mac Index Compute the real exchange rate with Norway as thedomestic country and US as the foreign country. ε = 1,70

31 the Maharaja Mac Give me a Big Mac - but hold the beefIn India, where the cow is venerated, most people do not eat beef, but McDonald's still has plans to conquer the subcontinent. 2000, Luke Harding, the Guardian, report on the rise of the Maharaja Mac

32 Now it is your turn

33 Compute a real exchange rate using a cup of Latte Home country US, foreign country MexicoThe price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico Which country has the cheaper latte? What is the nominal exchange rate? e = 10 pesos per $ Calculate the real exchange rate, as the number of Mexican lattes per 1 units of US latte. Please determine which country has the more expensive latte.

34 24 pesos per Mexican latteAnswers e = 10 pesos per $ price of a tall Starbucks Latte P = $3 in U.S., P* = 24 pesos in Mexico The price of a US latte in pesos is e x P = (10 pesos per $) x (3 $ per US latte) = 30 pesos per US latte The real exchange rate is… 30 pesos per U.S. latte 24 pesos per Mexican latte = e x P P* = Mexican lattes per US latte

35 Now a little bit of theory

36 Net exports, NX, (exports minus imports) depend on ε!ε  domestic goods become more expensive relative to foreign goods ε = 2 means that the amount of money that buys 1 unit at home buys 2 units of the good abroad. So, ε   X, M  NX

37 The net exports functionThe net exports function shows this inverse relationship between NX and ε: NX = NX (ε) As ε,  NX

38 The NX function ε ε1 NX(ε) NX NX(ε1)NX ε NX(ε) NX(ε1) so net exports will be positive (high) ε1 When ε is low, domestic goods are relatively cheap

39 The NX function ε ε2 NX(ε) NX NX(ε2)At high enough values of ε, domestically produced goods become so expensive that … NX ε NX(ε) NX(ε2) so net exports will be negative (low)

40 How ε is determined NX(ε) = S – I(r*)We know that NX = S – I must hold. We saw earlier how S – I is determined: S is fixed as Y – C – G I is determined by the world interest rate r * So, ε must adjust to ensure NX(ε) = S – I(r*) In the equation, ε is the only endogenous variable, hence this equation determines its value.

41 How ε is determined ε 1 NX(ε ) NX 1Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε NX NX(ε ) ε 1 ε adjusts to equate NX with net capital outflow, S - I. *** Note *** At the lower left corner of this graph, NX does NOT NECESSARILY EQUAL ZERO!!! NX 1

42 Again, your turn

43 A numerical exercise Y = 5000 C = 250 + 0.75(Y – T) I = 1000 – 50 rG = T = 1000 NX(ε) = 500 – 500 ε Compute the closed economy equilibrium. Compute the open economy equilibrium when the world interest rate is 10%.

44 End of the lecture

45 Closed economy Y = 5000 C = (Y – T) C = (5000 – 1000) C = 3,250 S = Y – C – G S = 5000 – 3,250 – 1000 S = 750 The loanable funds market equilibrium in the closed economy: S = I 750 = 1000 – 50r r = 5% We have S = I = 750

46 Open economy with the world interest rate is 10%C = 3,250 I = 1000 – 50r; At r = 10, we have I = 500 S = 750, I = 500, so NCO = 250. The real exchange rate ε must ensure that NCO = NX. 250 = 500 – 500ε 250 = 500ε The equilibrium ε is 0.5. NX = 250. NCO = S – I = 250

47 Four experiments 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports

48 1. Fiscal policy at home NX 2 ε 2 NX(ε ) ε 1 NX 1A fiscal expansion reduces national saving, net capital outflows, A fiscal expansion reduces… ε NX NX(ε ) ε 1 NX 1 …causing the real exchange rate to rise and NX to fall.

49 End of the lecture