exchange rate volatility and keynesian economics

Exchange Rate Volatility Exchange Rate Volatility and Keynesian Economicsand Keynesian Economics

Classical vs. Keynesian Classical vs. Keynesian EconomicsEconomics

Classical economics Classical economics assumes that prices are assumes that prices are flexible and that money flexible and that money is neutral (money doesn’t is neutral (money doesn’t affect output). This is affect output). This is equivalent to a vertical equivalent to a vertical supply curve.supply curve.


Classical economics Classical economics assumes that prices are assumes that prices are flexible and that money flexible and that money is neutral (money doesn’t is neutral (money doesn’t affect output). This is affect output). This is equivalent to a vertical equivalent to a vertical supply curve.supply curve.

Therefore, changes in Therefore, changes in demand leave output demand leave output unchanged, but raise unchanged, but raise prices.prices.


Keynesians agree that Keynesians agree that the classical solution is the classical solution is correct in the long runcorrect in the long run

Keynesians, however, Keynesians, however, argue that prices are argue that prices are fixed in the short run. fixed in the short run. This suggests a This suggests a horizontal supply curve. horizontal supply curve.


Keynesians, however, Keynesians, however, argue that prices are argue that prices are fixed in the short run. fixed in the short run. This suggests a This suggests a horizontal supply curve. horizontal supply curve.

Therefore increases in Therefore increases in demand increase output demand increase output without raising prices. without raising prices.

Fixed Prices and the Real Fixed Prices and the Real Exchange RateExchange Rate

Recall, that the real exchange rate is Recall, that the real exchange rate is equal toequal to

q = eP*/Pq = eP*/P


Recall, that the real exchange rate is Recall, that the real exchange rate is equal toequal to

q = eP*/Pq = eP*/P With flexible prices and PPP, the real With flexible prices and PPP, the real

exchange rate is constant (and equal to exchange rate is constant (and equal to one).one).


Recall, that the real exchange rate is equal Recall, that the real exchange rate is equal toto

q = eP*/Pq = eP*/P With flexible prices and PPP, the real With flexible prices and PPP, the real

exchange rate is constant (and equal to exchange rate is constant (and equal to one).one).

However, with prices fixed in the short run, However, with prices fixed in the short run, changes in the nominal exchange rate are changes in the nominal exchange rate are reflected in the real exchange ratereflected in the real exchange rate

Fixed Prices and the LM Fixed Prices and the LM CurveCurve

As with classical theory, we start with the As with classical theory, we start with the quantity theory of moneyquantity theory of money

MV = PYMV = PY However, rather than solving for price, we now However, rather than solving for price, we now

solve for outputsolve for output

Fixed Prices and the LM Fixed Prices and the LM CurveCurve

As with classical theory, we start with the As with classical theory, we start with the quantity theory of moneyquantity theory of money

MV = PYMV = PY However, rather than solving for price, we now However, rather than solving for price, we now

solve for outputsolve for output

Y = MV/PY = MV/P Velocity is an increasing function of the Velocity is an increasing function of the

interest rate. Therefore, higher interest rates interest rate. Therefore, higher interest rates are associated with higher output. This is the are associated with higher output. This is the LM curveLM curve

The LM CurveThe LM Curve

The LM curve The LM curve describes a money describes a money market equilibrium market equilibrium with fixed prices (Y = with fixed prices (Y = MV/P)MV/P)

The LM CurveThe LM Curve The LM curve describes The LM curve describes

a money market a money market equilibrium with fixed equilibrium with fixed prices (Y = MV/P)prices (Y = MV/P)

Increasing the money Increasing the money supply shifts LM to the supply shifts LM to the right, raising output right, raising output and lowering interest and lowering interest rates. rates.

Where does this extra Where does this extra output go? output go?

The IS Curve The IS Curve

The IS curve describes an The IS curve describes an equilibrium in the goods marketequilibrium in the goods market

Y = C + I + G + NXY = C + I + G + NX

Or, Equivalently,Or, Equivalently, S = I + (G-T) + NXS = I + (G-T) + NX

The IS CurveThe IS Curve

Typical assumptions include:Typical assumptions include: Savings (S) is increasing in income and Savings (S) is increasing in income and

the interest ratethe interest rate Investment (I) is decreasing in the Investment (I) is decreasing in the

interest rateinterest rate The Government deficit (G-T) is The Government deficit (G-T) is

independent of output and the interest independent of output and the interest raterate

Net Exports (NX) is decreasing in incomeNet Exports (NX) is decreasing in income


Given the previous assumptions Given the previous assumptions and the equilibrium conditionand the equilibrium condition

S = I + (G-T) + NXS = I + (G-T) + NX


Given the previous assumptions Given the previous assumptions and the equilibrium conditionand the equilibrium condition

S = I + (G-T) + NXS = I + (G-T) + NX A rise in income increases savings A rise in income increases savings

and lowers the trade balance.and lowers the trade balance. To maintain equilibrium, interest To maintain equilibrium, interest

rates must fall to stimulate rates must fall to stimulate domestic investmentdomestic investment

The IS CurveThe IS Curve The IS curve reflects the The IS curve reflects the

negative relationship negative relationship between output and between output and interest rates in goods interest rates in goods marketsmarkets

The IS CurveThe IS Curve The IS curve reflects the The IS curve reflects the

negative relationship negative relationship between output and interest between output and interest rates in goods marketsrates in goods markets

An increase in the An increase in the government deficit government deficit increases interest rates (to increases interest rates (to increase private savings increase private savings and discourage private and discourage private investment) and raises investment) and raises income (to further stimulate income (to further stimulate domestic savings) – IS curve domestic savings) – IS curve shifts rightshifts right

The Balance of PaymentsThe Balance of Payments

Recall, that the balance of payments Recall, that the balance of payments equilibrium is given by equilibrium is given by

CA = KFACA = KFA That is, a trade deficit (surplus) must be That is, a trade deficit (surplus) must be

matched by an equal capital inflow matched by an equal capital inflow (outflow)(outflow)

CA is increasing in income and CA is increasing in income and decreasing in the interest rate while KFA decreasing in the interest rate while KFA is increasing in the interest rateis increasing in the interest rate


Rising income Rising income worsens the trade worsens the trade deficit. To attract deficit. To attract foreign capital, foreign capital, interest rates must interest rates must increase – an upward increase – an upward sloping balance of sloping balance of payments curvepayments curve


A currency A currency depreciation depreciation improves the trade improves the trade deficit and, hence, deficit and, hence, shifts the BOP curve shifts the BOP curve to the rightto the right

Capital Mobility & BOPCapital Mobility & BOP

Low mobility of Low mobility of capital creates a capital creates a very steep BOP very steep BOP curve (large interest curve (large interest rate increases are rate increases are required to attract required to attract foreign capital)foreign capital)

Capital Mobility & BOPCapital Mobility & BOP

High mobility of High mobility of capital creates a capital creates a very flat BOP curve very flat BOP curve (small interest rate (small interest rate increases attract increases attract foreign capital)foreign capital)

Putting it all togetherPutting it all together

An equilibrium is An equilibrium is a combination of a combination of (e,r,and y) that (e,r,and y) that clears all three clears all three markets.markets.

Exchange Rates & Money Exchange Rates & Money ShocksShocks

Suppose the Federal Suppose the Federal Reserve increases Reserve increases the Money Supply by the Money Supply by 10%10%

In the long run, the In the long run, the dollar will depreciate dollar will depreciate by 10% (the classical by 10% (the classical solution), but what solution), but what about the short run?about the short run?


The increase in The increase in money shifts LM to money shifts LM to the right. This lowers the right. This lowers interest rates and interest rates and raises outputraises output


The increase in The increase in money shifts LM to money shifts LM to the right. This lowers the right. This lowers interest rates and interest rates and raises outputraises output

Further, the Further, the combination of lower combination of lower interest rates (deters interest rates (deters capital inflow) and capital inflow) and increased income increased income (induces more (induces more imports) creates a imports) creates a BOP DeficitBOP Deficit


Therefore, the dollar Therefore, the dollar must depreciate to must depreciate to correct the correct the imbalance – shifting imbalance – shifting the BOP curve to the the BOP curve to the rightright

Interest ParityInterest Parity

Recall that assets must always pay Recall that assets must always pay equal same currency returns. How equal same currency returns. How should the exchange rate respond to a should the exchange rate respond to a falling interest rate?falling interest rate?



(r – r*) = % change in e($/L)(r – r*) = % change in e($/L)



(r – r*) = % change in e($/L)(r – r*) = % change in e($/L) A falling interest rate should cause a A falling interest rate should cause a

dollar appreciationdollar appreciation

Summing UpSumming Up

The 10% increase in the money supply The 10% increase in the money supply creates a long run 10% depreciation of creates a long run 10% depreciation of the dollarthe dollar

In the short run, low interest rates and In the short run, low interest rates and rising output create a BOP deficit which rising output create a BOP deficit which depreciates the currencydepreciates the currency

However, at some point, the dollar must However, at some point, the dollar must appreciate. appreciate.

How do we reconcile these facts?How do we reconcile these facts?

Exchange Rate DynamicsExchange Rate Dynamics

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Nominal

How about the real How about the real exchange rate?exchange rate?

Recall that in the short run, the Recall that in the short run, the real exchange rate exactly mimics real exchange rate exactly mimics the nominal exchange rate.the nominal exchange rate.

In the long run, however, as prices In the long run, however, as prices adjust, the real exchange rate adjust, the real exchange rate returns to its long run value of one.returns to its long run value of one.


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Keynesian Economics and Keynesian Economics and Exchange RatesExchange Rates

The strong correlation between The strong correlation between real and nominal exchange rates is real and nominal exchange rates is due to short run price rigidities. due to short run price rigidities.

Exchange rate volatility is due to Exchange rate volatility is due to short run BOP changes and short run BOP changes and interest rate parity.interest rate parity.

Government DeficitsGovernment Deficits

Suppose that the Suppose that the government deficit government deficit increases. increases.

The long run impact The long run impact should be zero.should be zero.

Government DeficitsGovernment Deficits However, in the short However, in the short

run, the IS curve shifts run, the IS curve shifts right – output increases right – output increases and interest rates rise.and interest rates rise.

In this example, the In this example, the worsening of the trade worsening of the trade deficit is more than deficit is more than offset by higher offset by higher interest rates attracting interest rates attracting foreign capital. A foreign capital. A balance of payments balance of payments surplus is created.surplus is created.

Summing upSumming up

The long run effect is zeroThe long run effect is zero In the short run, a BOP surplus is In the short run, a BOP surplus is

created causing a currency created causing a currency appreciationappreciation

However, interest parity suggests However, interest parity suggests that higher domestic interest rates that higher domestic interest rates imply a currency depreciationimply a currency depreciation


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Deficits and Low Capital Deficits and Low Capital MobilityMobility

Consider the Consider the previous example, previous example, but with a lower but with a lower capital mobility.capital mobility.

Now, due to lower Now, due to lower capital inflows, a capital inflows, a short run BOP is short run BOP is created causing a created causing a currency currency depreciation.depreciation.


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Keynesian Economics and Keynesian Economics and Exchange RatesExchange Rates

The strong correlation between The strong correlation between real and nominal exchange rates is real and nominal exchange rates is due to short run price rigidities. due to short run price rigidities.

Exchange rate volatility is due to Exchange rate volatility is due to short run BOP changes and short run BOP changes and interest rate parity.interest rate parity.

Capital mobility is responsible for Capital mobility is responsible for much of the exchange rate much of the exchange rate volatilityvolatility

exchange rate volatility and keynesian economics

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