Part 1 Ozan Hatipoglu Spring 2011 - boun.edu.tr · Open Economy Macroeconomics Lecture Notes ... (FX) Markets De–nition, Functions and Features ... Aid : Humanitarian, Goods and

Open Economy Macroeconomics Lecture NotesPart 1

Ozan Hatipoglu

Department of Economics, Bogazici University

Spring 2011

Ozan Hatipoglu (CEE) Open Economy Macroeconomics Spring 2011 1 / 92

Foreign Exchange (FX) MarketsDe�nition, Functions and Features

De�nition: A market where national currencies are bought and sold

Transfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



De�nition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.

Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



De�nition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign trade

Facilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



De�nition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocks

Largest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



De�nition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)

24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers



De�nition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)24 hours trading and no trading limit

No commissions by brokers but bid-ask spread required by dealers



De�nition: A market where national currencies are bought and soldTransfers purchasing power from one currency to another and allowsfor international transactions.Provides credit for foreign tradeFacilitates hedging against currency shocksLargest market in the world in terms of trade volume (over $5 trilliondaily in spot, forward and swaps)24 hours trading and no trading limitNo commissions by brokers but bid-ask spread required by dealers


International Transactions

Occur between individuals, �rms, governments, international agencies.

Trade : Turkish �rm sells a good to a US �rm. Either the US �rm paysin TL by converting $ into TL or pays in $ and the Turkish �rmconverts it to TL. Trade practice of exporting Turkish �rms: get paid inforeign currency if it is Euro or $ otherwise TL.Foreign Direct Investment(FDI). Example : US de�nition: ForeignDirect Investment is de�ned as whenever a US citizen, organization, ora¢ liated group takes an interest of 10 percent or more in a foreignbusiness entity. It includes setting up a business, buying an o¢ ce blocketc.



Occur between individuals, �rms, governments, international agencies.Trade : Turkish �rm sells a good to a US �rm. Either the US �rm paysin TL by converting $ into TL or pays in $ and the Turkish �rmconverts it to TL. Trade practice of exporting Turkish �rms: get paid inforeign currency if it is Euro or $ otherwise TL.

Foreign Direct Investment(FDI). Example : US de�nition: ForeignDirect Investment is de�ned as whenever a US citizen, organization, ora¢ liated group takes an interest of 10 percent or more in a foreignbusiness entity. It includes setting up a business, buying an o¢ ce blocketc.



Occur between individuals, �rms, governments, international agencies.Trade : Turkish �rm sells a good to a US �rm. Either the US �rm paysin TL by converting $ into TL or pays in $ and the Turkish �rmconverts it to TL. Trade practice of exporting Turkish �rms: get paid inforeign currency if it is Euro or $ otherwise TL.Foreign Direct Investment(FDI). Example : US de�nition: ForeignDirect Investment is de�ned as whenever a US citizen, organization, ora¢ liated group takes an interest of 10 percent or more in a foreignbusiness entity. It includes setting up a business, buying an o¢ ce blocketc.



Portfolio Investments:This is an investment by individuals, �rms orpublic bodies (ex. national and local governments) in foreign �nancialinstruments. Foreign �nancial instruments include government bondsand foreign stock.

The biggest di¤erence between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a signi�cantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances"Foreign" in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign �rm.



Portfolio Investments:This is an investment by individuals, �rms orpublic bodies (ex. national and local governments) in foreign �nancialinstruments. Foreign �nancial instruments include government bondsand foreign stock.The biggest di¤erence between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a signi�cantequity stake or in other words management privileges.

Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances"Foreign" in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign �rm.



Portfolio Investments:This is an investment by individuals, �rms orpublic bodies (ex. national and local governments) in foreign �nancialinstruments. Foreign �nancial instruments include government bondsand foreign stock.The biggest di¤erence between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a signi�cantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education Aid

Remittances : Ex: Workers Remittances"Foreign" in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign �rm.



Portfolio Investments:This is an investment by individuals, �rms orpublic bodies (ex. national and local governments) in foreign �nancialinstruments. Foreign �nancial instruments include government bondsand foreign stock.The biggest di¤erence between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a signi�cantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances

"Foreign" in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign �rm.



Portfolio Investments:This is an investment by individuals, �rms orpublic bodies (ex. national and local governments) in foreign �nancialinstruments. Foreign �nancial instruments include government bondsand foreign stock.The biggest di¤erence between FDI and Foreign Portfolio Investment isthat Foreign Portfolio Investment is not associated with a signi�cantequity stake or in other words management privileges.Aid : Humanitarian, Goods and Services, Infrastructure Aid , DebtRelief, Education AidRemittances : Ex: Workers Remittances"Foreign" in this context means foreign national or entity established inanother country. Ex: Garanti Bank International is a foreign �rm.


Types of FX Rate

Bilateral: Between two countries

E¤ective or trade-weighted (Multilateral): Weighted by the proportionof each country�s trade volume in total trade volume.TCMB reports two types of Real E¤ective FX rate ( vs. Developedand vs. Developing Countries)

Nominal FX Rates: Actual Rates

Real FX rates: Adjusted by price di¤erentials in two countries

Real E¤ective FX rates: Adjusted by price di¤erentials in the set oftrade partners


Types of FX Rate







Types of FX Rate







Types of FX Rate







Types of FX Rate







Types of FX Rate

Real FX Rate is a sign of the degree of competitiveness.

Spot vs. forward

Buying vs. Selling ( Bid vs. Ask). Spread=Bid-Ask>0 Spreadincreases during weekends, holidays, turbulent times.


Types of FX Rate


Spot vs. forward



Types of FX Rate


Spot vs. forward



De�nitions:

A bilateral spot exchange rate, St , is domestic currency price of unitof foreign currency FX, so a rise in S (S "), is a fall in value ofdomestic currency. (Except for US and UK other than pound vs.dollar)

Cross exchange rate, Scrosst is bilateral exchange rate between twocurrencies other than Turkish Lira. e.g.

Cross exchange rate = ratio of two bilateral exchange rates againstthe TL, Scrosst = Set / S$tLet SBt = Bid Rate and SAt = Ask Rate.

Suppose the buyer wants to buy $. Dealer asks SAt for 1 $ and Buyerasks 1/SAt for 1TL.Suppose the buyer wants to buy TL. Dealer asks 1/SBt for 1 TL andBuyer asks SBt for 1$.


De�nitions:






De�nitions:



Cross exchange rate = ratio of two bilateral exchange rates againstthe TL, Scrosst = Set / S$t

Let SBt = Bid Rate and SAt = Ask Rate.



De�nitions:






De�nitions:




Suppose the buyer wants to buy $. Dealer asks SAt for 1 $ and Buyerasks 1/SAt for 1TL.

Suppose the buyer wants to buy TL. Dealer asks 1/SBt for 1 TL andBuyer asks SBt for 1$.


De�nitions:






Demand for FX

Turkish establishments demand $ in exchange for TL in order toimport from or invest in USA (and all other international transactionsmentioned above)

US establishments demand TL in exchange for $ in order to importfrom or invest in Turkey(and all other international transactionsmentioned above)

Speculators buy or sell TL (sell or buy $)

Total excess demand/supply eliminated instantaneously by exchange ratemovement


Demand for FX






Demand for FX






Equilibrium in FX Market: UK Example

Copeland Ch 1.


Appreciation and Depreciation

S ": means depreciation

S #: means appreciationException: Real E¤ective Exchange Rates reported by TCMB

Suppose S$ #, there are two possibilities:

1 International Value of TL has gone up or TL has appreciated.2 US$ vs. TL has gone down.(or Lira gained value against $)

Theorem

If S$ # while all other currencies in terms of TL remain the same ! 2If S$ # while all other currencies in terms of TL # ! 1



S ": means depreciationS #: means appreciation

Exception: Real E¤ective Exchange Rates reported by TCMB



Theorem




S ": means depreciationS #: means appreciationException: Real E¤ective Exchange Rates reported by TCMB



Theorem







Theorem





Suppose S$ #, there are two possibilities:1 International Value of TL has gone up or TL has appreciated.

2 US$ vs. TL has gone down.(or Lira gained value against $)

Theorem





Suppose S$ #, there are two possibilities:1 International Value of TL has gone up or TL has appreciated.2 US$ vs. TL has gone down.(or Lira gained value against $)

Theorem






Theorem






TheoremIf S$ # while all other currencies in terms of TL remain the same ! 2

If S$ # while all other currencies in terms of TL # ! 1





TheoremIf S$ # while all other currencies in terms of TL remain the same ! 2If S$ # while all other currencies in terms of TL # ! 1


Some Exchange Rate Regimes

1 Pure �oat(Flexible Float): exchange rate at any moment determinedby net demand for currency.

2 Fixed exchange rate: central bank(CB) intervenes by

buying up excess supply of $ with TL (when TL strong, $ weak). Thisoperation adds $ to FX reserves, adds to TL in circulation orsatisfying excess demand for $ by selling $ for TL (when TL weak, $strong), so as to prevent excess demand /supply a¤ecting the rate.This operation takes $ out of FX reserves, reduces TL in circulation.Sometimes �xed rate regimes are associated with restrictions on FXtransactions such as a ban on FX holdings.

3 Managed Float(Dirty Float): CB intervenes at its discretion.











buying up excess supply of $ with TL (when TL strong, $ weak). Thisoperation adds $ to FX reserves, adds to TL in circulation or

satisfying excess demand for $ by selling $ for TL (when TL weak, $strong), so as to prevent excess demand /supply a¤ecting the rate.This operation takes $ out of FX reserves, reduces TL in circulation.Sometimes �xed rate regimes are associated with restrictions on FXtransactions such as a ban on FX holdings.















Exchange Rate Regimes

Pure �oat (∆CB reserves=0)

Managed Float (∆CB reserves 6=0)Target Zone

Fixed

Currency Board (Domestic currency backed 100% by foreign currency)

Full Dollarization



Pure �oat (∆CB reserves=0)Managed Float (∆CB reserves 6=0)

Target Zone

Fixed


Full Dollarization



Pure �oat (∆CB reserves=0)Managed Float (∆CB reserves 6=0)Target Zone

Fixed


Full Dollarization




Fixed


Full Dollarization




Fixed


Full Dollarization




Fixed


Full Dollarization


Pure Float

Copeland Ch 1.


Balance of Payments(BOP)

De�nitionAll transactions between Turkey and the rest of the world(ROW) in agiven year. It serves as �ow of demand and supply for TL.

It consists of

1 Current Account,

2 Capital and/or Financial Account3 Balancing Item.




It consists of

1 Current Account,2 Capital and/or Financial Account

3 Balancing Item.




It consists of

1 Current Account,2 Capital and/or Financial Account3 Balancing Item.


BOP Items

Current account (CRA): Here and now. Export receipts (X) ascredits, import payments (M) as debits, net = current accountbalance (goods, services including �nancial services, interest anddividends, rent, tourism)

1 Visibles (merchandise account): traded goods, processed goods,repairs on goods, gold, purchase of capital goods such as machinery,aircrafts

2 Invisibles (service account): rights, licenses, insurance, tourism andother intangibles

3 Interests, Pro�ts and Dividends: rents from capital services, e.g.rental income, interest on deposit accounts, dividend payments onstocks, other pro�ts transfers.

4 Transfers: worker�s remittances, aid.


BOP Items







BOP Items







BOP Items







BOP Items







BOP Items (cont�d)

Capital/�nancial account(CPA): net capital in�ows = net purchasesof TL by foreigners in order to acquire claims on Turkey residents lessnet sales of TL by Turkey residents in order to acquire claims onforeigners (Long term including securities �equities, bonds, realestate etc + short term including bank deposits, short term securities)

1 FDI : real estate, buying a Turkish company by foreigners or foreigncompany by Turkish residents, setting up a factory, purchase ofmachinery and factory in order to produce within that country.

2 Portfolio Investment: equities, bonds, securities.3 Other investment: commercial credit lending by banks, nonbankinstitutions, individuals, IMF loans.

4 Change in O¢ cial Reserves: ∆CB FX reserves

Balancing Item: Current Account+Capital Account=-Balancing Item

visit http://tcmb.gov.tr/odemedenge/odmain.html for Turkishpractice.













2 Portfolio Investment: equities, bonds, securities.

3 Other investment: commercial credit lending by banks, nonbankinstitutions, individuals, IMF loans.





































Relationship Between BOP and FX rate regime

Under pure �oat:Total net underlying demand for TL = CRA surplus+CPA surplus=Basic balance is equated to zero by exchange rate movement, unless

Under �xed rates:Government intervenes to �x exchange rate, in which case. Item for 4in CPA :∆CB FX reserves= CRA+CPA to prevent basic balancecausing exchange rate to move


Relationship Between BOP and FX rate regime

Under pure �oat:Total net underlying demand for TL = CRA surplus+CPA surplus=Basic balance is equated to zero by exchange rate movement, unless

Under �xed rates:Government intervenes to �x exchange rate, in which case. Item for 4in CPA :∆CB FX reserves= CRA+CPA to prevent basic balancecausing exchange rate to move


Exchange Rates in 20th Century

Prior to 1939: Gold Standard. Change in money supply=Change ingold reserves. Huge increases in gold reserves after 1890.Perioddescribed by high in�ation, protectionism and competitivedevaluation.

1944: Bretton Woods: Fixed FX rate system.Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US$ �xed at 1 oz gold = $35, all other currencies �xed to $ with 1%�uctuation bands, devaluations to correct persistent de�cits.(GoldWindow) Other currencies �xed to dollar. Foundation of IMF topolice FX rate system to assure convertibility.Breakdown of Bretton Woods: 1968-73 Parities set at war levels.Rapid expansion of Europe and Japan caused huge pressures onexchange rate. US printed excess $ (Vietnam, Public Spending), $became overvalued and gold became undervalued causing worldwidein�ation and �ight into gold, other currencies (DM, Yen). Francehoarded gold. In 1971 Nixon closed the Gold Window.



Prior to 1939: Gold Standard. Change in money supply=Change ingold reserves. Huge increases in gold reserves after 1890.Perioddescribed by high in�ation, protectionism and competitivedevaluation.1944: Bretton Woods: Fixed FX rate system.

Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US$ �xed at 1 oz gold = $35, all other currencies �xed to $ with 1%�uctuation bands, devaluations to correct persistent de�cits.(GoldWindow) Other currencies �xed to dollar. Foundation of IMF topolice FX rate system to assure convertibility.Breakdown of Bretton Woods: 1968-73 Parities set at war levels.Rapid expansion of Europe and Japan caused huge pressures onexchange rate. US printed excess $ (Vietnam, Public Spending), $became overvalued and gold became undervalued causing worldwidein�ation and �ight into gold, other currencies (DM, Yen). Francehoarded gold. In 1971 Nixon closed the Gold Window.



Prior to 1939: Gold Standard. Change in money supply=Change ingold reserves. Huge increases in gold reserves after 1890.Perioddescribed by high in�ation, protectionism and competitivedevaluation.1944: Bretton Woods: Fixed FX rate system.Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US$ �xed at 1 oz gold = $35, all other currencies �xed to $ with 1%�uctuation bands, devaluations to correct persistent de�cits.(GoldWindow) Other currencies �xed to dollar. Foundation of IMF topolice FX rate system to assure convertibility.

Breakdown of Bretton Woods: 1968-73 Parities set at war levels.Rapid expansion of Europe and Japan caused huge pressures onexchange rate. US printed excess $ (Vietnam, Public Spending), $became overvalued and gold became undervalued causing worldwidein�ation and �ight into gold, other currencies (DM, Yen). Francehoarded gold. In 1971 Nixon closed the Gold Window.



Prior to 1939: Gold Standard. Change in money supply=Change ingold reserves. Huge increases in gold reserves after 1890.Perioddescribed by high in�ation, protectionism and competitivedevaluation.1944: Bretton Woods: Fixed FX rate system.Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US$ �xed at 1 oz gold = $35, all other currencies �xed to $ with 1%�uctuation bands, devaluations to correct persistent de�cits.(GoldWindow) Other currencies �xed to dollar. Foundation of IMF topolice FX rate system to assure convertibility.Breakdown of Bretton Woods: 1968-73 Parities set at war levels.Rapid expansion of Europe and Japan caused huge pressures onexchange rate. US printed excess $ (Vietnam, Public Spending), $became overvalued and gold became undervalued causing worldwidein�ation and �ight into gold, other currencies (DM, Yen). Francehoarded gold. In 1971 Nixon closed the Gold Window.


Exchange Rates in 20th Century (cont�d)

Floating Era 1973 onward managed �oats for most convertiblecurrencies at �rst, but later experiments with limited �xed systemse.g. EMS in Europe, currency boards in Hong Kong, Argentina,

EMS tied to a basket of currency.(DM, Fr) EMU 1998 onwardresponse to failure of �xed exchange rates

Increasing importance of Asian exchange rates 2000 onward especiallyRMB, Won, Rupee (varying degrees of �exibility/convertibility,increasingly linked to $/e/Yen currency basket)












Exchange Rates in Turkey

1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.

1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.1988 Switch to full convertibility and CB starts managed �oating5 April 1994. Switch to managed �oating with in�ation expectationsas an anchorStarting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.Free �oat with CB intervention compatible with in�ation target.



1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.

24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.1988 Switch to full convertibility and CB starts managed �oating5 April 1994. Switch to managed �oating with in�ation expectationsas an anchorStarting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.Free �oat with CB intervention compatible with in�ation target.



1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.

1988 Switch to full convertibility and CB starts managed �oating5 April 1994. Switch to managed �oating with in�ation expectationsas an anchorStarting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.Free �oat with CB intervention compatible with in�ation target.



1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.1988 Switch to full convertibility and CB starts managed �oating

5 April 1994. Switch to managed �oating with in�ation expectationsas an anchorStarting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.Free �oat with CB intervention compatible with in�ation target.



1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.1988 Switch to full convertibility and CB starts managed �oating5 April 1994. Switch to managed �oating with in�ation expectationsas an anchor

Starting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.Free �oat with CB intervention compatible with in�ation target.



1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.1988 Switch to full convertibility and CB starts managed �oating5 April 1994. Switch to managed �oating with in�ation expectationsas an anchorStarting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.

Free �oat with CB intervention compatible with in�ation target.



1923-1929 Floating Rates: Reference Currency is £ . March 1929:0.88TL/£ . December 1929: 1.25TL/£ . 1929-1946 Fixed Rates.1946 onwards �xed rates: Reference Currency is $ . 1946 :TL isdevaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Startingfrom 1974 IMF rules: 2% adjustments cap for each currency. apprx.3 adjustments a year.24 December 1980: from 26TL/$ to 70TL/$. More frequentadjustments 246 times in 1983. 1983 commercial banks allowed to settheir own rates.Ban on private FX holdings lifted.1988 Switch to full convertibility and CB starts managed �oating5 April 1994. Switch to managed �oating with in�ation expectationsas an anchorStarting from 2000.Target zone with up to 22.% bandwidth within�ation target as an anchor.Free �oat with CB intervention compatible with in�ation target.


Before and After EMU

40

60

80

100

120

140

160

1990 1992 1994 1996 1998 2000 2002 2004

AUS DOLLARCAN DOLLAREUROPOUND

SWISS FRSWED KRYEN


Theories about Exchange Rate Determination

Purchasing Power Parity (PPP)

1 Law of One Price2 PPP Extensions

1 Harrod-Balassa-Samuelson2 Trade Costs(Iceberg) Model3 Incomplete Pass-Through

Uncovered Interest Rate Parity

Covered Interest Rate Parity



Purchasing Power Parity (PPP)1 Law of One Price

2 PPP Extensions






Purchasing Power Parity (PPP)1 Law of One Price2 PPP Extensions







1 Harrod-Balassa-Samuelson

2 Trade Costs(Iceberg) Model3 Incomplete Pass-Through






1 Harrod-Balassa-Samuelson2 Trade Costs(Iceberg) Model

3 Incomplete Pass-Through






















Law of One Price

De�nitionThe law of one price: Two goods, if they are identical, must sell for thesame price.

Domestic Economy

The law of one price in the context of domestic economy �therelationship holds if transaction costs are allowed: e.g.,PI = PA + C where PI ,PA is the price of the same good in Istanbuland Ankara respectively and C is the transaction cost (transportation,local taxes, etc.).

Open EconomyPI = SPP + C where PI ,PP is the price of the same good in Istanbuland Paris respectively and S is the TL/Euro exchange rate.


Law of One Price


Domestic Economy

The law of one price in the context of domestic economy �therelationship holds if transaction costs are allowed: e.g.,

PI = PA + C where PI ,PA is the price of the same good in Istanbuland Ankara respectively and C is the transaction cost (transportation,local taxes, etc.).



Law of One Price


Domestic Economy




Law of One Price


Domestic Economy




PPP and Real Exchange Rate

De�nitionThe PPP relation is given by Pi = SP�i for i = 1, ...,N where Pi is thedomestic price of good i and P�i is the foreign price of good i and S is theexchange rate or P = SP� where P is domestic price index and P� is theforeign price index

De�nition

The real exchange rate, Q, between two countries is given by Q = SP �P .

CorollaryIf PPP holds then Q = 1.


PPP and In�ation

TheoremIf PPP holds then the rate of home currency depreciation rate is equal todi¤erence between home and foreign in�ation rates.

Proof.Taking logarithms and derivatives of both sides of P = SP�

log(P) = log(S) + log(P�)

dP/P = dS/S + dP�/P�

dS/S| {z } = dP/P| {z } � dP�/P�| {z }depreciation = in�ation� in�ation�

In reality PPP fails most of the time.


PPP and Transaction Costs

Let K be a constant that represents the total costs of conductinginternational trade including tari¤s, etc.

P = KSP�

log(P) = log(K ) + log(S) + log(P�)

TheoremIf trade costs are constant, then they do not a¤ect the currencydepreciation rate

Proof.Taking the derivative above yields

dS/S| {z } = dP/P| {z } � dP�/P�| {z }� dK/K| {z }depreciation = in�ation� in�ation� � change in trade costs

but dK = 0


Harrod, Balassa and Samuelson E¤ect

De�nitionThe observation that consumer price levels in wealthier countries aresystematically higher than in poorer ones (the "Penn e¤ect").

De�nitionAn economic model predicting the above, based on the assumption thatproductivity or productivity growth-rates vary more by country in thetraded goods�sectors than in other sectors (the Balassa�Samuelsonhypothesis)

Workers in some countries have higher productivity than in others.

Certain labour-intensive jobs such as those in services are lessresponsive to productivity innovations than others.Some of the �xed-productivity sectors are also the ones producingnon-transportable goods (for instance haircuts) - this must be thecase or the labour intensive work would have been o¤-shored.





Workers in some countries have higher productivity than in others.Certain labour-intensive jobs such as those in services are lessresponsive to productivity innovations than others.

Some of the �xed-productivity sectors are also the ones producingnon-transportable goods (for instance haircuts) - this must be thecase or the labour intensive work would have been o¤-shored.





Workers in some countries have higher productivity than in others.Certain labour-intensive jobs such as those in services are lessresponsive to productivity innovations than others.Some of the �xed-productivity sectors are also the ones producingnon-transportable goods (for instance haircuts) - this must be thecase or the labour intensive work would have been o¤-shored.


Harrod, Balassa and Samuelson E¤ect(cont�d)

To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.

The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn e¤ect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:

local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn e¤ect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)

Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn e¤ect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhere

The (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn e¤ect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.



To equalize local wage levels with the (highly productive) Zurichengineers, McDonalds Zurich employees must be paid more thanMcDonalds Moscow employees, even though the burger productionrate per employee is an international constant.The CPI is made up of:local goods/services (which are expensive relative to tradables in richcountries)Tradables, which have the same price everywhereThe (real) exchange rate is pegged (by the law of one price) so thattradable goods follow PPP (purchasing power parity) but not localgoods.. PPP holds only for tradable goods. Entirely tradable goodscannot vary greatly in price by location (because buyers can sourcefrom the lowest cost location). But most services must be deliveredlocally (e.g. hairdressing) which makes PPP-deviations sustainable.The Penn e¤ect is that PPP-deviations usually occur in the samedirection: where incomes are high, average price levels are typicallyhigh.


PPP Extensions- Arbitrage in goods.

Goods arbitrage only pro�table when price deviation exceedstransactions costs, C , so:

If price deviation P � P� < C , no trade

If price deviation P � P� > C , trade.

But C di¤erent for each trader and each type of good

When price deviation large (small), arbitrage (not) pro�table for mosttraders/goods

In general, larger the price deviation, greater volume of arbitrage andmore rapid is real exchange rate adjustment










































Iceberg Model

Does the importer or the exporter pay the shipping cost?

PC =SP�C1� τ

where

P�C : price of Brie cheese (produced in France) in France

PC : price of Brie cheese (produced in France) in Turkey

τ: proportion of every unit of goods lost due to shipping cost(�melting iceberg�)

similarly

PH = (1� τ) SP�H

P�H :price of hazelnut(produced in Turkey)in FrancePH : price of hazelnut(produced in Turkey) in Turkey.


Iceberg Model


PC =SP�C1� τ

where




similarly

PH = (1� τ) SP�H



Iceberg Model


PC =SP�C1� τ

where




similarly

PH = (1� τ) SP�H



Iceberg Model


PC =SP�C1� τ

where




similarly

PH = (1� τ) SP�H



Iceberg Model


PC =SP�C1� τ

where




similarly

PH = (1� τ) SP�H



Iceberg Model


PC =SP�C1� τ

where




similarly

PH = (1� τ) SP�H

P�H :price of hazelnut(produced in Turkey)in France

PH : price of hazelnut(produced in Turkey) in Turkey.


Iceberg Model


PC =SP�C1� τ

where




similarly

PH = (1� τ) SP�H



Trade Costs and Iceberg Model(cont�d) and IncompletePass-Through

Combining the above

PHPC

= (1� τ)2P�HP�C

Result: Hazelnuts (Brie) are (1� τ)2% expensive relative toBrie(Hazelnuts) in Turkey(France). Price distortions multiply

Incomplete Pass Through: Exporters and/or importers do not re�ectchanging costs to prices.



Combining the above

PHPC

= (1� τ)2P�HP�C





Combining the above

PHPC

= (1� τ)2P�HP�C




Uncovered Interest Rate Parity(UIRP)

Assume investors are risk neutral, i.e. they are indi¤erent between asafe bet and a lottery that o¤er the same expected return.

Let r be the domestic interest rate of a �nancial instrument with Nperiods to maturity.

Let r � be the foreign interest rate of the same �nancial instrumentwith N periods to maturity.

De�nitionIn the absence of hedging opportunities, the relationship between domesticand foreign interest rates are given by

(1+ r) =Et (St+N )

St(1+ r �)

where Et (St+N ) is the expected spot exchange rate at t +N as of time t.







(1+ r) =Et (St+N )

St(1+ r �)








(1+ r) =Et (St+N )

St(1+ r �)








(1+ r) =Et (St+N )

St(1+ r �)



UIRP Example

Ayse has 10TL. Let St = 1.6(TL/$), r = 8%, r � = 5%(US),Et (St+1) = 1.8. Should Ayse invest in Turkey or US?

If Ayse is risk neutral than she will pick the bet with higher return.

10� (1+ 0.08) = 10. 8TL Return from investing in Turkey

10� 11.6 (1+ 0.05)� 1.8 = 11. 813TL Expected Return from

investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP Example





investing in US.

Should invest in US


UIRP example(cont�d)

Et (St+N )St

= (1+r )(1+r �) , subtract 1 from both sides

Et (St+N )�StSt

= (1+r )(1+r �) � 1 = expected depreciation rate

= ∆Se ....Given r � = 5%

0.4 0.2 0.2 0.4 0.6 0.8 1.0

0.4

0.2

0.2

0.4

0.6

0.8

r

E(dep.rate)

An increase in r results in either Et (St+N ) " or St # or both. Iflong-run equilibrium is �xed Et (St+N ), then only St # .



Et (St+N )St


Et (St+N )�StSt


= ∆Se ....Given r � = 5%

0.4 0.2 0.2 0.4 0.6 0.8 1.0

0.4

0.2

0.2

0.4

0.6

0.8

r

E(dep.rate)




Et (St+N )St


Et (St+N )�StSt


= ∆Se ....Given r � = 5%

0.4 0.2 0.2 0.4 0.6 0.8 1.0

0.4

0.2

0.2

0.4

0.6

0.8

r

E(dep.rate)




Et (St+N )St


Et (St+N )�StSt


= ∆Se ....Given r � = 5%

0.4 0.2 0.2 0.4 0.6 0.8 1.0

0.4

0.2

0.2

0.4

0.6

0.8

r

E(dep.rate)




Find the expected spot rate that leaves Ayse indi¤erent betweeninvesting in US and Turkey.

Et (St+N ) =(1+r )(1+r �)St =

1.081.05 � 1.60 = 1. 645 7

An alternative formulation of the UIRP:

Let Et (St+N )�StSt= ∆Se

(1+ r) = (1+ r�)(1+ ∆Se ) or (1+ r) = 1+ r� + ∆Se + r�∆Se

but r�∆Se � 0 therefore r = r� + ∆Se (UIRP approximate version)




Et (St+N ) =(1+r )(1+r �)St =

1.081.05 � 1.60 = 1. 645 7



(1+ r) = (1+ r�)(1+ ∆Se ) or (1+ r) = 1+ r� + ∆Se + r�∆Se





Et (St+N ) =(1+r )(1+r �)St =

1.081.05 � 1.60 = 1. 645 7



(1+ r) = (1+ r�)(1+ ∆Se ) or (1+ r) = 1+ r� + ∆Se + r�∆Se





Et (St+N ) =(1+r )(1+r �)St =

1.081.05 � 1.60 = 1. 645 7



(1+ r) = (1+ r�)(1+ ∆Se ) or (1+ r) = 1+ r� + ∆Se + r�∆Se





Et (St+N ) =(1+r )(1+r �)St =

1.081.05 � 1.60 = 1. 645 7



(1+ r) = (1+ r�)(1+ ∆Se ) or (1+ r) = 1+ r� + ∆Se + r�∆Se





Et (St+N ) =(1+r )(1+r �)St =

1.081.05 � 1.60 = 1. 645 7



(1+ r) = (1+ r�)(1+ ∆Se ) or (1+ r) = 1+ r� + ∆Se + r�∆Se



Risk Premium

In general, agents demand a reward (risk premium) for the risks theytake.

De�nitionRisk premium is the anticipated excess return.agents demand in return fortaking the risk. A risk averter requires positive risk premium. A riskneutral is willing to undertake the risk for zero risk premium. A risk loveris willing to pay a premium in order to take the risk.

For a risk lover U(100) < 12U(150) +

12U(50) : convex U

For a risk neutral U(100) = 12U(150) +

12U(50) :linearU

For a risk averse U(100) > 12U(150) +

12U(50) :concaveU


Risk Premium




12U(50) : convex U


12U(50) :linearU


12U(50) :concaveU


Risk Premium




12U(50) : convex U


12U(50) :linearU


12U(50) :concaveU


Risk Premium




12U(50) : convex U


12U(50) :linearU


12U(50) :concaveU


Risk Premium




12U(50) : convex U


12U(50) :linearU


12U(50) :concaveU


Forward and Futures Contracts

De�nitionA forward contract (or a forward) is a non-standardized contract betweentwo parties to buy or sell an asset at a speci�ed future time at a priceagreed today. The party agreeing to buy the underlying asset in the futureassumes a long position, and the party agreeing to sell the asset in thefuture assumes a short position. The price agreed upon is called thedelivery price, which is equal to the forward price at the time thecontract is entered into.

De�nitionA futures contract is a standardized �nancial contract, in which twoparties agree to transact a set of standardized �nancial instruments orphysical commodities for future delivery at a particular price. In futurescontracts parties can exchange additional property securing the party atgain (margin call) and the entire unrealized gain or loss builds up while thecontract is open.


Forward and Futures Contracts

De�nitionA forward contract (or a forward) is a non-standardized contract betweentwo parties to buy or sell an asset at a speci�ed future time at a priceagreed today. The party agreeing to buy the underlying asset in the futureassumes a long position, and the party agreeing to sell the asset in thefuture assumes a short position. The price agreed upon is called thedelivery price, which is equal to the forward price at the time thecontract is entered into.

De�nitionA futures contract is a standardized �nancial contract, in which twoparties agree to transact a set of standardized �nancial instruments orphysical commodities for future delivery at a particular price. In futurescontracts parties can exchange additional property securing the party atgain (margin call) and the entire unrealized gain or loss builds up while thecontract is open.


Futures Example

Market ForwardRate andTransactionsTimeline

Ali agrees to sell Ayse$10000 at 1.6TL/$ atT+12

T T+1 T+2 T+8 T+12

TL/$ SpotT T+1 T+2 T+8 T+12

1.58

Profit TimelineT T+1 T+2 T+8 T+12

Both Ali and Aysedeposit $1000 (1/10thof the total exchange)with the broker.

1.60


Futures Example



T T+1 T+2 T+8 T+12


1.61


Ali’s deposit= $1000(1.651.60)X$10000=$500Ayse’s deposit=$1000+(1.651.60)X$10000=$1500

1.65


Futures Example



T T+1 T+2 T+8 T+12


1.58


Ali’s deposit= $500+(1.651.57)x$10000= $1300Ayse’s deposit=$1500(1.651.57)X$10000=$700

1.57


Futures Example



T T+1 T+2 T+8 T+12



Ali’s deposit= $1300(1.671.57)x$10000= $300Ayse’s deposit=$700+(1.671.57)X$10000=$1700

1.67

1.66

Ali gets the margin call and is required toincrease his deposits by $500 to continue


Futures Example



T T+1 T+2 T+8 T+12



Ali’s deposit= $800+(1.671.64)x$10000= $1100Ayse’s deposit=$1700(1.671.64)X$10000=$1400Ali’s profit= $1100 $1000 $500= $400Ayse’s profit=$1500$1000= $400

1.64

1.64

Transaction Closed. Ayse made $400 . Shecan buy at the spot market if she reallyneeds $



With hedging opportunities, the relationship between domestic and foreigninterest rates are given by

(1+ r) =FtSt(1+ r �)

where Ft is the forward rate at t + 1 as of time t. Note that Ft = St atthe maturity date.

FtSt= (1+r )

(1+r �) , subtract 1 from both sides

Ft�StSt

= (1+r )(1+r �) � 1 = f =forward premium

A forward premium is the proportion by which a country�s forwardexchange rate exceeds its spot rate.

Rewriting (1+ r) = (1+ r �)(1+ f ), r �f � 0r = r � + f (CIRP approximate version)




(1+ r) =FtSt(1+ r �)


FtSt= (1+r )


Ft�StSt







(1+ r) =FtSt(1+ r �)


FtSt= (1+r )


Ft�StSt







(1+ r) =FtSt(1+ r �)


FtSt= (1+r )


Ft�StSt



Rewriting (1+ r) = (1+ r �)(1+ f ), r �f � 0

r = r � + f (CIRP approximate version)




(1+ r) =FtSt(1+ r �)


FtSt= (1+r )


Ft�StSt





Borrowing and Lending

An investor who has a liability(an asset) denominated is said to havea short (long) position in that currency. The net position is given bythe di¤erence between long and short positions. There are two typesof arbitrages

Uncovered

example: investing in US or Turkey for interest arbitrage withoutforward contracts

1 January1: Investing in Turkey: Borrow 1.60TL(short TL) at 8% andplace on one year deposit(long TL) with 8% interest. Investing in US:Borrow 1.60TL(short TL) at 8%, buy $ at 1.60, deposit(long $) in USfor a year with 5% interest.

2 Net position in Turkey=long(1.60x1.08)-short(1.60x1.08)=0. Net

position in US= Et (St+1)St

� 1.60� 1.05� (1.60� 1.08) 6= 03 December 31. Investing in Turkey: Liquidatedeposit(1.60TL� 1.08 = 1. 728TL) pay back loan (1.60� 1.08 = 1.728TL) Net pro�t=0TL Investing in US: Liquidatedeposit($1� 1.05 = $1. 05), convert it to TL at the spot price(e.g.1.70),$1.05� 1.70 = 1. 785TL , pay back loan (1.60� 1.08 = 1.728TL) Net pro�t=1.785� 1.728 = 0.057TL



An investor who has a liability(an asset) denominated is said to havea short (long) position in that currency. The net position is given bythe di¤erence between long and short positions. There are two typesof arbitragesUncovered





























� 1.60� 1.05� (1.60� 1.08) 6= 0

3 December 31. Investing in Turkey: Liquidatedeposit(1.60TL� 1.08 = 1. 728TL) pay back loan (1.60� 1.08 = 1.728TL) Net pro�t=0TL Investing in US: Liquidatedeposit($1� 1.05 = $1. 05), convert it to TL at the spot price(e.g.1.70),$1.05� 1.70 = 1. 785TL , pay back loan (1.60� 1.08 = 1.728TL) Net pro�t=1.785� 1.728 = 0.057TL










Borrowing and Lending(cont�d)

Covered.

example: investing in US or Turkey for interest arbitrage with forwardcontracts

1 January1: Investing in Turkey: Borrow 1.60TL(short TL) at 8% andplace on one year deposit(long TL) with 8% interest. Investing in US:Short 1.60TL at 8%, buy 1$ at 1.60, deposit(long $) in US for a yearwith 5% interest and enter a short forward contract in $

2 Net position in Turkey=long(1.60� 1.08)-short(1.60� 1.08)=0. Netposition in US= Ft

St� 1.60� 1.05� 1.60� 1.08 If CIRP holds then

Ft =(1+r )(1+r �)St =

1.081.05 � St and the net position in US=0.

3 December 31. Investing in Turkey: Liquidatedeposit(1.60TL� 1.08 = 1. 728TL) pay back loan (1.60� 1.08 = 1.728TL) Net pro�t=0TL Investing in US: Liquidatedeposit($1� 1.08 = $1. 05), convert it to TL at the forwardprice( 1.081.05 � 1.60 = 1.645 7) ,$1.05� 1.645 7 = 1.728 , pay back loan(1.60� 1.08 = 1. 728TL) Net pro�t=1.728� 1.728 = 0TL



Covered.





Ft =(1+r )(1+r �)St =





Covered.





Ft =(1+r )(1+r �)St =





Covered.





Ft =(1+r )(1+r �)St =





Covered.





Ft =(1+r )(1+r �)St =





In the UIRP example the currency risk associated with investing inTurkey is 0, and in US it isAt � (1+ r)� At � (1+ r �)� Et (St+1)/St where At is the initialasset.

In the CIRP example the currency risk associated with investing inTurkey and US is 0. In the above example the currency risk is 0because of the assumption that CIRP holds. In reality,

the forward rates re�ect the risk premium associated with investing inthat particular country.While the currency risk is zero, the pro�ts are still uncertain. IfSt+1 > Ft then investing in US without hedging would have resulted ingreater pro�ts










the forward rates re�ect the risk premium associated with investing inthat particular country.

While the currency risk is zero, the pro�ts are still uncertain. IfSt+1 > Ft then investing in US without hedging would have resulted ingreater pro�ts







Real Interest Rate

Future sacri�ce required per unit of extra consumption today

De�nitionThe relationship between real, r , and nominal interest rate, R, is given by(1+ R) = (1+ r)(1+ ∆pe ) or in approximate form by r = R + ∆pe

(Fisher equation) where ∆pe is the expected in�ation rate.

Corollary

Take two countries R � R� = (r � r �) + (∆pe � ∆pe�) by UIRPR � R� = ∆Se therefore ∆Se = (r � r �) + (∆pe � ∆pe�).If there is fullcapital mobility, r = r � therefore ∆Se = (∆pe � ∆pe�) (PPP inexpectations).

Note that ∆pe is unobservable therefore at any given time R is alsounobservable.Methods of estimating ∆pe : Use surveys, or econometric forecastmethods.


Real Interest Rate




Corollary




Real Interest Rate




Corollary




Real Interest Rate




Corollary


Note that ∆pe is unobservable therefore at any given time R is alsounobservable.

Methods of estimating ∆pe : Use surveys, or econometric forecastmethods.


Real Interest Rate




Corollary




E¢ cient Market Hypothesis

If all investors are fully informed about market conditions all the time, thenprices fully re�ect all available information and there are no arbitrageopportunities. For example, if the markets are e¢ cient, f = ∆Se .


National Income Accounting in Open Economy

C : Consumption Expenditure on Domestic and Foreign Goods andServices

G : Government Expenditure of Domestic and Foreign Goods andServicesI : Investment Expenditure on Domestic and Foreign Goods andServices.

1 Business �xed investment spending on plant and equipment that �rmswill use to produce other goods and services

2 Residential �xed investment spending on housing units by consumersand landlords

3 Inventory investment: the change in the value of all �rms�inventories

X :ExportsM:Imports (Consumption, Government and Investment Expenditureon Foreign Goods and Services)S : SavingsT : Taxes and TR : transfers



C : Consumption Expenditure on Domestic and Foreign Goods andServicesG : Government Expenditure of Domestic and Foreign Goods andServices

I : Investment Expenditure on Domestic and Foreign Goods andServices.







C : Consumption Expenditure on Domestic and Foreign Goods andServicesG : Government Expenditure of Domestic and Foreign Goods andServicesI : Investment Expenditure on Domestic and Foreign Goods andServices.
































X :Exports

M:Imports (Consumption, Government and Investment Expenditureon Foreign Goods and Services)S : SavingsT : Taxes and TR : transfers







X :ExportsM:Imports (Consumption, Government and Investment Expenditureon Foreign Goods and Services)

S : SavingsT : Taxes and TR : transfers







X :ExportsM:Imports (Consumption, Government and Investment Expenditureon Foreign Goods and Services)S : Savings

T : Taxes and TR : transfers










Three Approaches To Calculate National Income

1 Expenditure2 Income3 Production



Three Approaches To Calculate National Income1 Expenditure

2 Income3 Production



Three Approaches To Calculate National Income1 Expenditure2 Income

3 Production



Three Approaches To Calculate National Income1 Expenditure2 Income3 Production


Expenditure Approach

Households, Business, Government and Foreign Sector Expenditures.

National Income Identity in an open economy is given by:Y = C + I + G + X �M where Y is gross domestic product.(GDP). Imports, M, are subtracted to prevent double counting.

Spri = Yd � C is private savings where Yd is the disposable income.Yd = Y � T + TR. T is taxes collected by the government, TRtransfers made by the government to private sector.

Spri � I| {z } = G � T + TR| {z } + X �M| {z }Private Surplus = Gov. De�cit + CA Balance

Note GDP is a �ow variable and not a stock variable.

GDP is product produced within a country�s borders; GNP (GrossNational Product) is product produced by enterprises owned by acountry�s citizens.






















Spri � I| {z } = G � T + TR| {z } + X �M| {z }

Private Surplus = Gov. De�cit + CA Balance




























Income Approach

The income approach divides GDP according to types of incomegenerated. GDP consists of:

Wages and salaries, Corporate pro�ts (dividens, corporate incometaxes, undistributed pro�ts), Proprietors income (the pro�ts ofpartnerships and soley owned businesses, like a family restaurant),Farm income, Rent, Interest (interest payments by businesses only),Sales taxes (it is an income but later get paid to the gov�t),Depreciation (the amount of capital that has worn out during theyear)

GDP = compensation of employees + gross operating surplus + grossmixed income + taxes less subsidies on production and imports


Income Approach





Income Approach





Production Approach

The production approach looks at GDP from the standpoint of valueadded by each input in the production process

Example

1 Farmer buys seeds and produces wheat. Value added#1= Sale ofWheat = Value of producing and collecting wheat

2 Whole retailer packages wheat and transports the wheat to factoryValue added#2=Sale of Wheat-Cost of Wheat= Value of packagingand shipping wheat

3 Baker cooks bread. Value added#3=Sale of Bread-Cost of Wheat=Value of baking a bread.

4 GDP= ∑iValue addedi


Production Approach


Example

1 Farmer buys seeds and produces wheat. Value added#1= Sale ofWheat = Value of producing and collecting wheat





Production Approach


Example1 Farmer buys seeds and produces wheat. Value added#1= Sale ofWheat = Value of producing and collecting wheat





Production Approach







Production Approach







Production Approach







Expenditure Approach revisited

Examples of GDP component variables

C, I, G, and NX(net exports): If a person spends money to renovate ahotel to increase occupancy, the spending represents privateinvestment, but if he buys shares in a consortium to execute therenovation, it is saving. The former is included when measuring GDP(in I), the latter is not. However, when the consortium conducted itsown expenditure on renovation, that expenditure would be included inGDP.

If a hotel is a private home, spending for renovation would bemeasured as consumption, but if a government agency converts thehotel into an o¢ ce for civil servants, the spending would be includedin the public sector spending, or G.













If the renovation involves the purchase of a chandelier from abroad,that spending would be counted as C, G, or I (depending on whethera private individual, the government, or a business is doing therenovation), but then counted again as an import and subtracted fromthe GDP so that GDP counts only goods produced within the country.

If a domestic producer is paid to make the chandelier for a foreignhotel, the payment would not be counted as C, G, or I, but would becounted as an export.



If the renovation involves the purchase of a chandelier from abroad,that spending would be counted as C, G, or I (depending on whethera private individual, the government, or a business is doing therenovation), but then counted again as an import and subtracted fromthe GDP so that GDP counts only goods produced within the country.

If a domestic producer is paid to make the chandelier for a foreignhotel, the payment would not be counted as C, G, or I, but would becounted as an export.



Snational = Spri + Sgov = (Y � T )� C + (T � G ) = Y � C � G

therefore Snational � I = CASnational � I =net foreign investment.Is CA < 0 necessarily a bad thing?

Comparison between ability to consume more today and paying morelater.

Spri vs. Sgov

Decisions on Sgov makes taxpayers part of the deal!



Snational = Spri + Sgov = (Y � T )� C + (T � G ) = Y � C � Gtherefore Snational � I = CA

Snational � I =net foreign investment.Is CA < 0 necessarily a bad thing?


Spri vs. Sgov




Snational = Spri + Sgov = (Y � T )� C + (T � G ) = Y � C � Gtherefore Snational � I = CASnational � I =net foreign investment.

Is CA < 0 necessarily a bad thing?


Spri vs. Sgov




Snational = Spri + Sgov = (Y � T )� C + (T � G ) = Y � C � Gtherefore Snational � I = CASnational � I =net foreign investment.Is CA < 0 necessarily a bad thing?


Spri vs. Sgov






Spri vs. Sgov






Spri vs. Sgov






Spri vs. Sgov



De�ning Variables of Interest

Assumptions

De�ne B = X (Q)�M(Q, y)B � B(Q, y)where Q = SP �

P and ∂B∂Q > 0,

∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0

G + TR � T is exogenously given



Assumptions

De�ne B = X (Q)�M(Q, y)

B � B(Q, y)where Q = SP �

P and ∂B∂Q > 0,

∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0




Assumptions

De�ne B = X (Q)�M(Q, y)B � B(Q, y)

where Q = SP �P and ∂B

∂Q > 0,∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0




Assumptions


P and ∂B∂Q > 0,

∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0




Assumptions


P and ∂B∂Q > 0,

∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0




Assumptions


P and ∂B∂Q > 0,

∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0




Assumptions


P and ∂B∂Q > 0,

∂B∂y < 0

S � S(y , r), ∂S∂y > 0,

∂S∂r > 0

I � I (r), ∂I∂r < 0



IS Curve

S(y , r)� I (r) = G + TR � T + B(Q, y) (IS curve).

De�nitionIS curve is the combination of income and interest rate pairs such that thenet private savings cover the �nancing requirements of government andthe foreign sector.LEAKAGES (T + S + M) out of the system must equalINJECTIONS (G + TR+ I + X) for the circular �ow to balance (be inEQUILIBRIUM)


IS Curve

S(y , r)� I (r) = G + TR � T + B(Q, y) (IS curve).

De�nitionIS curve is the combination of income and interest rate pairs such that thenet private savings cover the �nancing requirements of government andthe foreign sector.LEAKAGES (T + S + M) out of the system must equalINJECTIONS (G + TR+ I + X) for the circular �ow to balance (be inEQUILIBRIUM)


IS Curve

r

y

S(y,r)I(r)=G+B(Q,y)

y*


IS Curve

r

y

y*

S(y,r)I(r)<G+B(Q,y)


IS Curve

r

y

y*

S(y,r)I(r)=G+B(Q,y)

r*


IS Curve

r

y

y*

S(y,r)I(r)=G+B(Q,y)

r*

IS(G,Q)


An increase in Government Expenditure

r

y

y*

r*

IS(G0,Q0)

IS(G1>G0, Q0)


An increase in Real Exchange Rate.

r

y

y*

r*

IS(G0,Q0)

IS(G0, Q1>Q0)


LM Curve

Relationship between the demand for money and national income

(ignoring the opportunity cost)

Md = kY

where Md is the demand for money and Y national income, bothmeasured in nominal terms.

k positive constant.


LM Curve



Md = kY




LM Curve



Md = kY




LM Curve



Md = kY




LM Curve

De�ne nominal national income Y as follows:

Y = Py where y is real income and P is the price level.

We can also introduce opportunity costsMdP = ky � lr

orMdP � Md

P (y , r) Note that∂MdP (y ,r )

∂y > 0, ∂MdP (y ,r )

∂r < 0


LM Curve




orMdP � Md


∂y > 0, ∂MdP (y ,r )

∂r < 0


LM Curve



We can also introduce opportunity costs

MdP = ky � lr

orMdP � Md


∂y > 0, ∂MdP (y ,r )

∂r < 0


LM Curve




orMdP � Md


∂y > 0, ∂MdP (y ,r )

∂r < 0


LM Curve




orMdP � Md


∂y > 0, ∂MdP (y ,r )

∂r < 0


LM Curve

Let Ms be the nominal money supply and ms = MsP be the real money

supply.

De�nitionThe Equilibrium condition in the money market is given by ms = ky � lror ms = m(y , r)


LM Curve

Let Ms be the nominal money supply and ms = MsP be the real money

supply.

De�nitionThe Equilibrium condition in the money market is given by ms = ky � lror ms = m(y , r)


LM Curve

r

y

Ms/P=kylr

y*


LM Curve

r

y

Ms/P>kylr

y*


LM Curve

r

y

y*

r*

Ms/P=kylr


LM Curve

r

y

y*

r*

Ms/P=kylr

LM(Ms/P)


An increase in Money Supply.

.

r

y

y*

r*

Ms/P=kylr

LM(M0s/P)Ms/P>kylrExcess Supply Ms/P<kylr

Excess Demand

LM(M1s/P)


Monetary System and the Banking Sector



For the Central Bank: FX + LG = MB

For Commercial Banks MBb + L = D, Given D, L is determined byMBb .

The reserve requirement, RR, is the percentage of Commercial Banksdeposits to be held with Central Bank as a precaution or the thepercent of deposits banks are not allowed to lend

Combining both balance sheets FX + LG +MBb + L = MB +D

or FX +DC = MBp +D where DC = L+ LG is total domesticcredit and MBp = MB �MBb is currency circulation.






























Control of Money Supply

FX +DC = MBp +D = Money Supply = Ms

∆FX + ∆DC = ∆Ms

Money supply can be controlled by Central Bank via changes in

1 Reserve/Borrowing Requirements (through reserve requirement ratio(DC and MBp) or discount interest rate (MBp))

2 Open Market Operations (selling and buying Reserves (FX ), or viabuying and selling Treasury Bills (MBp))

3 Public Cash Holding (not really a policy tool but CB may pursuepolicies to increase con�dence in the banking system)





















Money supply can be controlled by Central Bank via changes in1 Reserve/Borrowing Requirements (through reserve requirement ratio(DC and MBp) or discount interest rate (MBp))


















Central Bank Roles

monetary policy (control in�ation, economic growth, employment,�nancial stability)

There might be con�icts among roles such as controlling infation andcreating employment or growth.

control money supply

managing FX and gold reserves

setting o¢ cial interest rates

lender of last resort

issue currency

regulator and supervisor of commercial banks (now BDDK settingcapital requirements for banks)


Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Central Bank Roles







issue currency



Exchange Rate Regimes and The Central Bank

Under pure �oat: ∆FX = 0 only DC a¤ects Ms , therefore ∆DC= ∆Ms .Ms is exogenous and St is endogenous.

Under �xed rates: ∆FX 6= 0, CA balance-CAP balance determine∆FX therefore Ms is endogenous and St is exogenous and ∆St = 0.Under �xed rates independent (independent of exchange ratemovements) monetary policy is impossible.


Exchange Rate Regimes and The Central Bank

Under pure �oat: ∆FX = 0 only DC a¤ects Ms , therefore ∆DC= ∆Ms .Ms is exogenous and St is endogenous.

Under �xed rates: ∆FX 6= 0, CA balance-CAP balance determine∆FX therefore Ms is endogenous and St is exogenous and ∆St = 0.Under �xed rates independent (independent of exchange ratemovements) monetary policy is impossible.


Deriving Aggregate Demand

The equilibrium on the demand side is given by (y ,P) pairs such that

1 S(y , r)� I (r) = (G � T + TR) + B(Q, y) (IS)2 M s

P = m(y , r) (LM)3 M s

P = (G � T + TR) + B(Q, y) where Q = SP �P

We want to express the equilibrium in (y ,P) plane because prices willfrom the link between aggregae demand and aggregate supply.



The equilibrium on the demand side is given by (y ,P) pairs such that1 S(y , r)� I (r) = (G � T + TR) + B(Q, y) (IS)

2 M s

P = m(y , r) (LM)3 M s





The equilibrium on the demand side is given by (y ,P) pairs such that1 S(y , r)� I (r) = (G � T + TR) + B(Q, y) (IS)2 M s

P = m(y , r) (LM)

3 M s






P = m(y , r) (LM)3 M s






P = m(y , r) (LM)3 M s




Deriving Aggregate Demand (Ex: A reduction in prices)

r

y0

r*

P

y

yy0

P0

IS(G,Q0)

LM(Ms/P0)



r

y0

r*

P

y

yy0

P0

IS(G,Q1)

IS(G,Q0)

LM(Ms/P0)



r

y0

r*

P

y

yy0

P0

IS(G,Q1)

IS(G,Q0)

LM(Ms/P0)

LM(Ms/P1)



r

y0

r*

IS(G,Q1)

P

y

y

IS(G,Q0)

LM(Ms/P0)

y0

y1

y1

P0

P1AD

LM(Ms/P1)


Policy Analysis: Relaxation of Monetary Policy

Suppose M0s ", M0

s ! M1s where M

1s > M

0s

M 1sP > ky � lr , : Excess money supply, So quantity of moneydemanded has to increase, money demanded increases when r # ory " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 < r0where r0 is the original interest rate and

M 1sP = ky0 � lr1

But y0, r1 can not be an equilibrium in goods market because:

S(y0, r1)� I (r1) < G � T + TR + B(Q, y0)Therefore y0 ! y1 where y1 > y0 and r1 ! r2 where r2 > r1

This is a movement on LM. M1sP = ky1 � lr2 = ky0 � lr1

No shift in IS curve becauseS(y , r)� I (r) = G �T +TR +B(Q, y). No exogenous change here.The exact change in r and y is determined by the slopes of IS andLM curves.



Suppose M0s ", M0

s ! M1s where M

1s > M

0s

M 1sP > ky � lr , : Excess money supply, So quantity of moneydemanded has to increase, money demanded increases when r # ory " or both.

Assumption : r moves faster than y. If y = y0 is constant than r1 < r0where r0 is the original interest rate and

M 1sP = ky0 � lr1







Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1







Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1







Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1


S(y0, r1)� I (r1) < G � T + TR + B(Q, y0)

Therefore y0 ! y1 where y1 > y0 and r1 ! r2 where r2 > r1





Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1







Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1







Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1




No shift in IS curve becauseS(y , r)� I (r) = G �T +TR +B(Q, y). No exogenous change here.

The exact change in r and y is determined by the slopes of IS andLM curves.



Suppose M0s ", M0

s ! M1s where M

1s > M

0s


M 1sP = ky0 � lr1






Relaxation of Monetary Policy

r

y0

P

y

yy0

P0

AD

IS(G,Q)

LM(Ms0/P)

LM(Ms1/P)

r0

r1


Relaxation of Monetary Policy

r

y0

P

y

yy0

P0

AD0

IS(G,Q)

LM(Ms0/P)

y1

y1

LM(Ms1/P)

r0

r1r2

AD1


Increase in G

Suppose G ", G 0 ! G 1 where G 1 > G 0

S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).

IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.

Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1

This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on IS

S(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) =

= S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)

No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.

The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G


S(y0, r0)� I (r0) < G 1 � T + TR + B(Q, y0).IS curve shifts right. To retain eq., r " or y " or both.Assumption : r moves faster than y. If y = y0 is constant than r1 > r0where r0 is the original interest rate andS(y0, r1)� I (r1) = G 1 � T +TR + B(Q, y0). I (r1) ky0 � lr1 therefore y0 ! y1 where y1 > y0 and r1 ! r2 wherer2 < r1This is a movement on ISS(y0, r1)� I (r1) = G 1 � T + TR + B(Q, y0) == S(y1, r2)� I (r2) = G 1 � T + TR + B(Q, y1)No shift in LM curve there is no exogenous change.The exact change in r and y is determined by the slopes of IS andLM curves.


Increase in G

r

y0

P

y

yy0

P0

AD

IS(G0,Q)

LM(Ms/P0)

r0

IS(G1,Q)

r1


Increase in G

r

y0

P

y

yy0

P0

LM(Ms/P0)

y1

y1

r0

r2

IS(G0,Q)

IS(G1,Q)

AD0

AD1

r1


Firms

Assumptions:

CRS Production Function Yt = f (Kt ,Nt ) where Kt is capital and Ntis labor

∂f (Kt ,Nt )∂Nt

� 0, ∂f (Kt ,Nt )∂Kt

� 0, ∂2f (Kt ,Nt )∂N 2t

� 0, ∂2f (Kt ,Nt )∂K 2t

� 0Firms operate in a perfectly competitive environment and solve thefollowing problem.

maxfKt ,Ntg

ptYt � wtNt � rtKt subject to Yt � f (Kt ,Nt )

First order conditions

1 pt∂f (Kt ,Nt )

∂Nt= wt or MPL = wt

pt (Labor Demand Condition)

2 pt∂f (Kt ,Nt )

∂Kt= rt or MPK = rt

pt

As N ", MPL # because of diminishing marginal productivity therefore�rms are willing to pay less for an additional worker.

De�ne Labor Demand as w � Pf (N)


Firms

Assumptions:

CRS Production Function Yt = f (Kt ,Nt ) where Kt is capital and Ntis labor∂f (Kt ,Nt )

∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0

Firms operate in a perfectly competitive environment and solve thefollowing problem.

maxfKt ,Ntg



1 pt∂f (Kt ,Nt )



2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg



1 pt∂f (Kt ,Nt )



2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg



1 pt∂f (Kt ,Nt )



2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg



1 pt∂f (Kt ,Nt )



2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg


First order conditions1 pt

∂f (Kt ,Nt )∂Nt

= wt or MPL = wtpt (Labor Demand Condition)

2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg



∂f (Kt ,Nt )∂Nt


2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg



∂f (Kt ,Nt )∂Nt


2 pt∂f (Kt ,Nt )


pt




Firms

Assumptions:


∂Nt� 0, ∂f (Kt ,Nt )

∂Kt� 0, ∂2f (Kt ,Nt )

∂N 2t� 0, ∂2f (Kt ,Nt )

∂K 2t� 0


maxfKt ,Ntg



∂f (Kt ,Nt )∂Nt


2 pt∂f (Kt ,Nt )


pt




P

t

n

N

N*

w

N0d

N1d


Workers

Assumptions:

Concave Utility function U(ct , lt ) where ct is consumption and lt isleisure

∂U (ct ,lt )∂ct

� 0, ∂U (ct ,lt )∂lt

� 0, ∂2U (ct ,lt )∂c2t

� 0, ∂2f (ct ,lt )∂l2t

� 0maxfct ,ltg

U(ct , lt ) subject to Pet ct � wt (1� lt ) and 0 � lt � 1

Pet = P(P) 0 � P0 � 1

P0= 0 no adjustment (extreme Keynesian)

P0= 1 full adjustment (perfect fullsight, neoclassical)

Lagrangian:L = U(ct , lt ) + λ(wt (1� lt )� Pet ct )

1 Uc (ct , lt ) = λPet2 Ul (ct , lt ) = λwcombining

3Uc (ct ,lt )Ul (ct ,lt )

= P etw

De�ne Labor Supply as w = PetUc (ct ,lt )Ul (ct ,lt )

� Pet g(Nt ) where Nt = 1� lt


Workers

Assumptions:

Concave Utility function U(ct , lt ) where ct is consumption and lt isleisure∂U (ct ,lt )

∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1



Lagrangian:

L = U(ct , lt ) + λ(wt (1� lt )� Pet ct )



= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1




1 Uc (ct , lt ) = λPet

2 Ul (ct , lt ) = λwcombining


= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw




Workers

Assumptions:


∂ct� 0, ∂U (ct ,lt )

∂lt� 0, ∂2U (ct ,lt )

∂c2t� 0, ∂2f (ct ,lt )

∂l2t� 0

maxfct ,ltg


Pet = P(P) 0 � P0 � 1






= P etw


� Pet g(Nt ) where Nt = 1� ltOzan Hatipoglu (CEE) Open Economy Macroeconomics Spring 2011 91 / 92

Labor Supply: An increase in prices

n

N

N*

w

N0s

N1s

Documents

Part 1 Ozan Hatipoglu Spring 2011 - boun.edu.tr · Open Economy Macroeconomics Lecture Notes ... (FX) Markets De–nition, Functions and Features ... Aid : Humanitarian, Goods and