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Colin F. Bullock
• PPP and long run exchange rate determination. • The market for domestic assets and exchange rate determination in the short run. • The Mundell-Fleming Model and monetary, fiscal and trade policy under fixed and floating exchange rates. • Fixed vs floating exchange rates in small open economies.
• Exchange rates are the rate at which one country’s currency trades for another country’s currency. • The exchange rate may either be expressed as units of foreign currency per unit of local currency (US$/J$) or units of local currency per unit of foreign currency. • An increase in US$/J$ is an appreciation of the Jamaica dollar and an increase in J$/US$ is a depreciation of the Jamaica dollar. • The spot market is for settlement in two days while the forward market may be for settlement for longer periods, usually over thirty days. • Depreciation makes exports cheaper abroad and imports more expensive at home. Appreciation does the opposite.
the exchange rate ensures that price is the same in both countries. .Exchange Rates in the Long Run • The Law of one price: for two countries producing an identical commodity with no trade restrictions and transport costs. • Purchasing Power Parity (PPP): An application of the law of one price to the general price level (the cost of an identical basket of goods) in two countries.
goods not identical. .Limitations of PPP • Product differentiation. • Transport costs are not likely to be minimal • Countries use tariffs and quotas to restrict trade. • The general price level includes many nontraded goods that do not influence the exchange rate.
• A rise in the country’s price level relative to other countries depreciates the currency. . • Increased preference for a country’s products appreciates the currency. • Increased restrictions on trade cause an appreciation of the currency. • Increased productivity appreciates the country’s currency.Exchange Determinants in the Long Run • A factor that increases the demand for domestic goods relative to foreign goods will appreciate the exchange rate (and vice versa).
Summary of Long Range Influences on the Exchange Rate .
Short Run Influence of the Market for Domestic assets .
Impact of Increased Domestic Interest Rate .
Impact of Increased Foreign Interest Rate .
Impact of Expected Increase in Exchange Rate .
Mishkin Summary of Influences I .
Mishkin Summary II .
it depreciates the domestic currency. • If it is due to an increase in the expected rate of inflation. . it appreciates the domestic currency.Domestic vs Real Interest rates • Recall the Fisher equation: in = ir + ∏e • If the increase in the nominal interest rate is due to an increase in the real interest rate.
Money Supply and Expected Inflation .
The Mundell-Fleming Model of the Small Open Economy • r = r* (Domestic interest rate = world interest rate) • IS Curve: Y = C(Y-T) + I(r*) + G + NX(e) • LM Curve: M/P = L (r*.Y) .
Derivation of the IS Curve .
Derivation of the LM Curve .
Mundell-Fleming Equilibrium .
Fiscal Policy Under Floating Exchange Rates .
Monetary Policy Under Floating Exchange Rates .
Trade Policy Under Floating Exchange Rates .
Fixed Exchange Rate Governs the Money Supply .
Fiscal Expansion Under Fixed Exchange Rates .
Monetary Expansion Under Fixed Exchange Rates .
Trade Restrictions Under Fixed Exchange rates .
Mundell-Fleming Policy Effects Summary .
There is a loss of independent exchange rate policy. May require costly exchange control to defend exchange rate . A disincentive for political irresponsibility. There is a loss of independent monetary policy.Fixed Exchange Rates for Developing Countries? FOR Facilitates price stability Against Prices stability depends on the true market exchange rate and not merely the official exchange rate. Structural inflationary impulses may cause a loss of competitiveness. Discourages irresponsible fiscal and monetary policy that is inconsistent with exchange rate stability. Stability reduces uncertainty and encourages investment. Policy is entirely dependent on fiscal policy which may be driven into deficits by shocks. Encourages hard work and productivity in the absence of inflationary gains. Avoids independent monetary policy that a small country may not be able to manage.
Policy is more flexible in the face of shocks. The budget may be balanced over time rather than constantly. Against Facilitates exchange rate instability and price uncertainty. Flexibility allows for postponement of difficult decisions in the face of shocks. Independent monetary policy is likely to be irresponsible and inflationary. .Floating Exchange Rates for Developing Countries? For Allows independent exchange rate policy Allows independent monetary policy. On-going exchange rate depreciation may encourage dollarization and loss of monetary policy. Policy can more easily retain price competitiveness. The facilitation of fiscal deficits may become endemic through the build-up of external debt. Exchange rate policy cannot sustain enhanced competitiveness in face of high import price dependence. There is greater capacity to avoid the development of parallel fx markets.
Jamaica liberalized its fx.7 = $US$1). • In the late 1960s. system between Sept 1990 and Sept 1991.From Peg to Float in Jamaica • Jamaica entered independence with an exchange rate fixed to the British pound (1:1). • With very negative NIR. . the “peg” was switched to the United States Dollar at (J$0. minimal gross reserves and an active // market. • Foreign exchange pressures in the 1970s and 1980s elicited a variety of foreign exchange systems with devaluation to J$6 = US$1.
triple digit inflation and loose financial institution management culminating in crisis. • Beneficial results in NIR moving from negative to positive and the elimination of the parallel market in foreign exchange. • This facilitated exchange rate slippage.Performance Under Managed Float • Liberalization in less than ideal circumstances re tightness of macroeconomic policy and financial sector regulation. .
• These factors will create problems in peg or float. . • Floating has benefitted NIR and fx. • Negative comparisons with Barbados and other fixed exchange rate economies.Should Jamaica Return to a Peg? • Concern about slippage in exchange rate over time and impact on inflation and uncertainty. • Perspectives on the ineffectiveness of depreciation in fostering competitiveness. Jamaica lost capacity to fix due to inappropriate fiscal policy and low productivity which is what drives depreciation. • Barbados retained peg because of more effective fiscal policy and even now has competitiveness issues. • In reality. market and success of fix or float depends on effective fiscal policy.
. #1. Edward Seaga and Colin Bullock in Mona School of Business Review Vol. 12 Ghatak and Sanchez-Fung Ch.). Macroeconomics Ch. 10 Articles by Hon. I. 17 Mankiw (7th ed.Readings • • • • Mishkin Ch.