Macroeconomics Textbook PDF

9-How are all these exchange rates determined? In most cases, they are determined by the familiar forces of supply and demand. As in other markets, each foreign exchange market reaches an equilibrium at which the quantity of foreign exchange demanded is equal to the quantity supplied. -To understand...

9-How are all these exchange rates determined? In most cases, they are determined by the familiar forces of supply and demand. As in other markets, each foreign exchange market reaches an equilibrium at which the quantity of foreign exchange demanded is equal to the quantity supplied. -To understand that we take the market in perspective of dollars exchanged for pounds, we show the model of the supply and demand for a representing the foreign exchange market. Why do Americans want to buy pounds? To buy goods and services from British Firms. -To buy British assets like stocks, corporate/government bonds, and real estate in Britain. Explaining the demand curve for Foreign Currency -The demand curve tells you at different exchange rates, the quantity of pounds American’s will want to buy in any given period. “THE DEMAND FOR POUNDS’’ -Curve slopes downward because the lower the exchange rate, the greater the quantity of pounds demanded. -Shifts along the demand curve are affected by exchange rate Shifts in Demand Curve are affected by-> 1. U.S. real GDP because it indicates continuing economic growth or recovery from a recession or bad time. As a result, Americans will buy and purchase more British goods. ->This would indicate a rightward shift in the supply curve 2. Relative price levels, which are U.S. price levels in comparison to British price levels for a good. For example, if U.S. prices rose by 8 percent compared to 5 percent in Britain, the demand for British goods would rise and it would shift the demand curve to the right. 3. “Increased interest and taste for British goods would also shift it right(Ex:Films, Motor vehicles, etc.)  4. Relative Interest Rates:Rates of return are different for different financial assets like stocks and bonds. So when one country's interest rate is high relative to another, the first country’s assets will have high rates of return. ->suppose you’re an American trying to decide whether to hold some of your wealth in British financial assets or in American financial assets. You will look very carefully at the rate of return you expect to earn in each country. All else being equal, a lower U.S. interest rate, relative to the British rate, will make British assets more attractive to you. Accordingly, as you and other Americans demand more British assets, you will need more pounds to buy them. The demand for pounds curve will shift rightward. 5. Expected Changes in Exchange Rate:An expectation that the price of the pound will fall will make British assets less appealing to Americans, because they will expect a foreign currency loss. In this case, the demand for pounds curve will shift leftward. The opposite holds as well. If Americans expect the price of the pound to rise, they will expect a foreign currency gain from buying British assets. This will cause the demand for pounds curve to shift rightward. - The Supply of British Pounds “The supply of pounds, who is supplying them? ->British Sellers, who are British households and firms who have pounds and need to purchase American goods and services -Why would they want to supply->They want dollars 1.They want to buy goods an dservices from American firms 2.They want to buy American assets like stocks, corporate or government bonds, and real estate. Supply Curve for Foreign Currency -The curve tells you the quantity the British want to sell at any given period, at any given exchange rate. ->It slopes upward because the higher the exchange rate, the greater the british want to supply -Higher exchange rate, a higher price for the pound makes the British want to sell more of them because the higher the price for the pound, the more dollars someone gets for each pound sold. Variables such as … can affect the supply of British pounds -> Supply Curve shift 1.Read GDP in Britain:If the real and income rises in Britain, the people will buy more goods and services. They need more dollars to buy U.S. goods, so they will supply more British pounds regardless of the exchange rate. RIGHTWARD SHIFT 2.Relative Price levels: The rise in the price level in the U.S. makes British goods more attractive to Americans, but the American goods less attractive to British. In turn, the British will supply less pounds to convert into dollars, which would shift the supply curve to the left. 3.British Taste for U.S. goods. If American things got popular Britain wants that shit. As a result it would shift right. If they don’t like that shit it shifts left on god on my momma. 4.Relative Interest Rates:As U.S. interest rate rises, the British will buy more U.S. assets and need more dollars. They supply pounds and it shifts rightward. 5.Expected Change in Exchange rate:In deciding where to hold their assets, the British have the same concerns as Americans. They will look, in part, at rates of return; but they will also think about possible gains or losses on foreign currency transactions. Suppose the British expect the price of the pound to fall. Then, by holding U.S. assets, they can anticipate a foreign currency gain—selling pounds at a relatively high price and buying them back again when their price is relatively low. The prospect of foreign currency gain will make U.S. assets more attractive, and the British will buy more of them. The supply of pounds curve will shift rightward. Floating Exchange Rate:Rate that is freely determined by forces of supply and demand without government intervention to change it or keep it from changing. -The price settles where exchange rate, or the supply of the foreign currency for dollar exchange and the supply of the quantity demanded for the dollar in exchange for foreign currency are equal. - -It is appreciation if the price of any floating foreign currency rises because of a shift in the demand curve, the supply curve, or both. Appreciation Against the dollar It is depreciation of the dollar: A decrease in the price of a currency in a floating-rate system. Exchange Rates changing over time A->B appreciation of foreign currency B->C-Depreciation Very Short Run:Fluctuations of ER over weeks and days Short Run:Fluctuations over months or years A->B B->C Long Run In the very short run, traders can move large volumes of funds and have immediate effect on exchange rates. - -Expectations about future exchange rates can also trigger huge shifts of hot money, and Figure 5 also illustrates what would happen if American and British residents suddenly expect the pound to depreciate against the dollar. In this case, it would be the anticipation of foreign currency gains from holding U.S. assets, rather than a higher U.S. interest rate, that would cause the supply and demand curves to shift. As you can see in Figure 5, the expectation that the pound will depreciate actually causes the pound to depreciate—a self-fulfilling prophecy. Relative interest rates and expectations of future exchange rates are the dominant forces moving exchange rates in the very short run. -In the short run,over months and years there are economic fluctuations. A countries GDP rising will experience a depreciation of tis currency and a country whose GDP falls will experience an appreciation -In the long run, changes in exchange rates are determined by relative price level in two countries PPP-Purchasing power parity:The exchange rate between two countries will adjust in the long run until the average price of goods is roughly the same in both countries -The PPP theory has an important implication: -In the long run, the currency of a country with a higher inflation rate will depreciate against the currency of a country whose inflation rate is lower. Why? Because in the country with the higher inflation rate, the relative price level will be rising. As that country’s basket of goods becomes relatively more expensive, only a depreciation of its currency can restore purchasing power parity. And traders—taking advantage of opportunities like those just described—would cause the currency to depreciate. Important exceptions where PPP does not predict long run trends in exchane rate ->Goods difficult to trade(Haircuts, non tradable things) ->High transportation costs(friegh and insurance costs ->Artificial barriers to trade(Special taxes or quotas on imports) Managed Float:A country’s central bank actively manages its exchange rate and buys its own currency to present depreciations and selling its own currency to prevent appreciations -Used in very short run ->When they want to affect the appreciation or depreciation, they have to use money in reserves of dollars:Dollars its central bank keeps to intervene with the dollar/foreign money market -Fixed exchange rate:A government declares a particular value for its exchange rate with another currency ->The government, through its central bank, then commits itself to intervene in the foreign exchange market any time the equilibrium exchange rate differs from the fixed rate. Panel (b) shows another possibility, where the equilibrium exchange rate is $0.02, so that the same fixed exchange rate of $0.04 per baht is now above the equilibrium rate. There is an excess supply of 300 million baht. In this case, to prevent the excess supply from driving the exchange rate down, the Central Bank of Thailand must buy the excess baht. When a country fixes its exchange rate above the equilibrium value, the result is an excess supply of the country’s currency. To maintain the fixed rate, the country’s central bank must buy enough of its own currency to eliminate the excess supply. ->There are usually no problems until the exchange rate moves far away from the fixed rate. There is a problem when the exchange rate is fixed above the equilibrium rate. -A foreign currency crisis arises when people no longer believe that a country can maintain a fixed exchange rate above the equilibrium rate. As a consequence, the supply of the currency increases, demand for it decreases, and the country must use up its reserves of dollars and other key currencies even faster in order to maintain the fixed rate. -Devaluation:A change in the value of a currency from a higher fixed value to a lower fixed value. Chapter 13:Money, Banks, and the Federal Reserve  Different Forms of Money -Checkable DepositsAccounts are held by households and business firms at commercial banks -Demand Deposits are immediate -Other type of demand deposits specifically automatic transfers from savings accounts: - Travelers checks:A change in the value of a currency from a higher fixed value to a lower fixed value.A change in the value of a currency from a higher fixed value to a lower fixed value. -Money Supply:Cash in the public+Checking account deposits+Traveler’s checks->M1 M2 includes saving deposits, Money market deposits, Money must be in the hands of the public. Until cash is “released” it is not a part of the money supply. -Money functions as a store of value->People view money as a way to hold wealth. -Money serves as a unit of account:Measurement of worth -The Federal Reserve -Charged with creating and regulating the nations supply of money -Fiat money:serves as earning value as means of payment by government Ex of intermediary:Depository institution, which accepts deposits from public and lends the deposits to borrowers -A commercial bank (or just “bank” for short) is a private corporation, owned by its stockholders, that provides services to the public.->checking accounts How does a bank work How does a bank work -Balance Sheet:List that shows the financial condition of a bank at a time -Assets are listed:Everything of value it owns -Liabilities are listed:Amount the bank owes Bond:A promise to pay funds to the holder of the bond, issued by a corporation or government when it borrows money->Future gradually or right now -Loans:Promises signed by households or non corporate businesses to pay back funds Bonds and loans are interest to a bank  - Reserves: A Key to what Banks Assets checking deposits do and how much -Reserves:The sum of cash in the vault and ATMs and in account they keep with the FED -Required Reserves:The amount of reserves a bank must hold. -Required Reserve Ratio:Set by Fed and tells banks the fraction of their checking accounts they must hold as required reserves->Desired reserve ratio:How much fraction of checking Why? deposits the banks want to hold Excess Reserves:Reserves beyond the minimum requirement enlisted by the FED ->There is a desire to do this because they want flexibility to increase loans in the future-> if there are higher interest rate -excess reserve holdings are influenced by a change in the interest rate the Fed pays on reserves. Liabilities Bank borrowing:Borrowing loans from other banks as a bank Shareholders’ Equity -You pay off liabilities(deposits or loans) and sell assets for their value. -Left over money in liabilities is shareholder’s equity->Goes to stockholders ->EQUATION: SE=Total Assets-Total Liabilities How does a nation control money supply m Through a central bankA nation’s principal monetary authority  responsible for controlling the money supply Structure of FED FOMC(Federal Open Market -Consists of 7 governors and 5 reserve bank presidents.->They talk Committee) about employment, inflation, GDP, interest rates, and more. -Changes the nation's money supply to adjust for the changes. Functions of Fed -Supervise and regulate banks->They set required reserve ratio, determines types of loans and investments banks are allowed to make. -Acting as a bank for banks->Banks hold reserves, fed pays interest on these funds, banks borrow from fed and are charged with a discount rate which is the same thing as interest rate -Issues paper currency:Printed money is sent to fed and puts this currency into circulation -Clears checks:The FED provides it by transferring funds from one bank’s reserves to anothers -Guides the macroeconomy -Deals with financial crisis->Uses macroeconomic tools and acts as a “lender of last resort” to make sure banks have enough reserves -Ways Fed changes money -Open Market Operation:The fed buys or sells government bonds in supply->Open Market Operation the bond market, If they buy it is an open market purchase-> Selling gov bonds are open market sales. Assumptions: Open Market Purchases -Banks don't hold excess reserves, and households/businesses do not withdraw or deposit cash.  -Fed injected 100,000 dollars in reserves into a banking system. As a Money Multiplier in relation result checking deposits and the money supply rose by $1 million. This increase is 10 times the injection in reserves EQUATION: What is the Money multiplier m, what -Depends on value of the required reserve ratio-> does it depend on? Equation: 1/RRR Equation: Open Market Sale Open market sale: Gov increases money supply by purchasing gov bonds, and decreases by selling bonds. Different from treasury:Treasury borrows and issues new gov bonds -Fed bond sales are not borroiwng from the government, they change the money supply and have no direct effect on the government budget. -They have deficient reserves in selling bonds->Calling a loan Other ways Fed can change money 1.Changes in the RRR supply 2.Changes in the discount rate 3.Changes in the interest rate on reserves Fractional Reserve System A system in which banks hold only a fraction of their deposit liabilities as reserves Insolvent:Total assets are less than total liabilities -To calculate how much a bank needs to reserve, multiply the amount of its deposits by the required reserve ratio. For example, if a bank has $20,000 in deposits and a 10% reserve ratio, it needs to reserve $2,000 Banking System:Savings and loan associations, credit unions Bank run:Many depositors try to withdraw funds at the same time Banking panic:There is a system wide run on many banks at the same time->Solved by providing deposit insurance Characteristics:Short term liabilities, long term assets, liabilities include gov insured deposits, close regulation by gov. - Chapter 10, The Business Cycle/Economic Fluctuations Economes experience business fluctuations GDP(Y) Fluctuates around trend/Potential GDP Unemployment rate fluctuates around the natural rate