EXCHANGE RATE

 the price of the foreign currency in terms of the domestic currency (direct notation) or
the price of the domestic currency in terms of the foreign currency (indirect notatiton)
 MIDDLE EXCHANGE RATE FORMED BY CNB
o The Croatian National Bank every working day on the basis of the agreed
services and foreign exchange rates in the market of foreign currency
determines the value of kuna against other currencies
o middle exchange rate for the euro (1 EUR/HRK) published on the exchange
rate of the Croatian National Bank is the arithmetic mean of the weighted
buying rate and the weighted selling exchange rates of the commercial banks
o the value of the kuna against the currencies that are not the basic currency (the
basic currency for the determination of the kuna is euro), and are included in
the exchange rate list of the Croatian National Bank, are determined by
dividing the middle exchange rate of the euro currency and all other currencies
in the global foreign exchange market worth at day exchange rate formation at
12.00

DEPRECIATION & APPRECIATION

 Depreciation is a decrease in the value of a currency relative to another currency
o A depreciated currency is less valuable (less expensive) and therefore can be
exchanged for (can buy) a smaller amount of foreign currency
 Appreciation is an increase in the value of a currency relative to another currency
o An appreciated currency is more valuable (more expensive) and therefore can
be exchanged for (can buy) a larger amount of foreign currency
 A depreciated currency means that imports are more expensive and domestically
produced goods and exports are less expensive
o A depreciated currency lowers the price of exports relative to the price of
imports
 An appreciated currency means that imports are less expensive and domestically
produced goods and exports are more expensive
o An appreciated currency raises the price of exports relative to the price of
imports

DEVALUATION
 while the depreciation the common term used to describe movement (weakening)
floating or partially floating exchange rate, term devaluation is used for fixed
exchange rate regimes
 an official act which reduces the current value of the fixed rate in relation to another
currency (often the currency to which the domestic currency is pegged or fixed) to a
new, lower level
 REVALUATION is contrary to the concept of notion of devaluation

FOREIGN EXCHANGE MARKET

 The set of markets where foreign currencies and other assets are exchanged for
domestic ones
 THE PARTICIPANTS:
o Commercial banks and other depository institutions: transactions involve
buying/selling of deposits in different currencies for investment purposes
 o Non-bank financial institutions (mutual funds, hedge funds, securities firms,
insurance companies, pension funds) may buy/sell foreign assets for
investment
o Non-financial businesses conduct foreign currency transactions to buy/sell
goods, services and assets
o Central banks: conduct official international reserves transactions
 The integration of financial markets implies that there can be no significant
differences in exchange rates across locations
o Arbitrage: buying simultaneously at low price at one market and selling at
higher price in another market for a profit

SPOT RATES & FORWARD RATES

 Spot rates are exchange rates for currency exchanges “on the spot,” or when trading is
executed in the present or in three work days
 Forward rates are exchange rates for currency exchanges that will occur at a future
(“forward”) date (30, 90, 180, or 360 days in the future)
o Rates are negotiated between two parties in the present (for a fee), but the
forward rate applies in the future

EFFECTIVE VS. BILATERAL EXCHANGE RATES

 bilateral exchange rates - the price of one currency in relation to the price of some
other individual currencies (EUR/HRK, EUR/USD, USD/JPY, EUR/CHF)
 effective exchange rates - rates that put one currency in a simultaneous relationship
with a basket of currencies where the currencies included in the basket are the
currencies of (the most important) trading partners
o indicate the movement of the price competitiveness of the country: the
appreciation of the effective exchange rate shows that the country's exports
become more expensive in foreign markets, and the country is becoming less
cost-competitive in foreign markets

THE DEMAND OF CURRENCY DEPOSITS

 Factors that influence the return on assets determine the demand of those assets:
o Real rate of return
o Risk of holding assets
o Liquidity of an asset
 Rate of return- the percentage change in value that an asset offers during a time
period (mostly of one year)
o The annual return for $100 savings deposit with an interest rate of 2% is:
 $100 x 1.02 = $102
o so that the rate of return is:
 ($102 – $100)/$100 = 2%
 Real rate of return- inflation-adjusted rate of return, which represents the additional
amount of goods and services that can be purchased with earnings from the asset
o The real rate of return for the above savings deposit when inflation is 1.5% is:
 2% – 1.5% = 0.5%
o After accounting for the rise in the prices of goods and services, the asset can
purchase 0.5% more goods and services after 1 year
 the risk of holding the assets is related to the possibility that a company or
government does not fulfill its obligations in part or in whole (a unilateral declaration
of a moratorium on the payment of outstanding debts, bankruptcy)
 asset liquidity, or ease of conversion of assets into cash in order to acquire, for
example, goods and services, also influences the willingness to buy certain assets
 Let’s assume that inflation is equal to zero and that the risk of holding an asset and the
risk related with the liquidity of an asset are minimal
 in that case investors are primarily concerned about the (nominal) rates of return on
currency deposits
 Rates of return that investors expect to earn are determined by:
o interest rates that the assets will earn
o expectations about appreciation or depreciation
 A currency deposit’s interest rate is the amount of a currency that an individual or
institution can earn by lending a unit of the currency for a year
 The rate of return for a deposit in domestic currency is the interest rate that the
deposit earns
 To compare the rate of return on a deposit in domestic currency with one in
foreign currency, consider:
o the interest rate for the foreign currency deposit
o the expected rate of appreciation or depreciation of the foreign currency (euro)
relative to the domestic currency (dollar)
 Suppose the interest rate on a dollar deposit is 2% ; Suppose the interest rate on a
euro deposit is 4% ; Suppose today the exchange rate is $1/€1,(for one euro is needed
to give one dollar) and the expected rate one year in the future is (1EUR/USD)e=0,97
(for one euro is needed to give one dollar, in other words, is expected to the exchange
rate to fall, dollar appreciate thus euro depreciate)
 Does a euro deposit yield a higher expected rate of return?
o $100 can be exchanged today for €100.
o These €100 will yield €104 after one year; 100*1,04=104
o These €104 are expected to be worth $0.97/€1 x €104 = $100.88 in one year
 The rate of return in terms of dollars from investing in euro deposits is
o ($100.88 – $100)/$100 = 0.88%
 Let’s compare this rate of return with the rate of return from a dollar deposit
o After 1 year the $100 is expected to yield $102:
($102 – $100)/$100 = 2%
 The euro deposit has a lower expected rate of return: thus, all investors should be
willing to hold dollar deposits and none should be willing to hold euro deposits
 Note that the expected rate of appreciation of the dollar was ($0.97 – $1)/$1 = –0.03
= –3%
 We simplify the analysis by saying that the dollar rate of return on euro deposits
approximately equals
 the interest rate on euro deposits
 plus the expected rate of appreciation of euro deposits
 4% + –3% = 1% ≈ 0.88%
 R€ + (Ee$/€ – E$/€)/E$/€
 The difference in the rate of return on dollar deposits and euro deposits is
 R$ - (R€ + (Ee$/1€ - E$/1€)/E$/1€) =
 

MODEL OF FOREIGN EXCHANGE

 to construct a model of foreign exchange markets we use the
o demand of (rate of return on) dollar denominated deposits
o demand of (rate of return on) foreign currency denominated deposits
 This model is in equilibrium when deposits of all currencies offer the same expected
rate of return: (uncovered) interest parity
o Interest parity implies that deposits in all currencies are equally desirable assets
o Interest parity implies that arbitrage in the foreign exchange market is not
possible.
o Interest parity implies that an exchange market is in equilibrium
o R$ = R€ + (Ee$/€ – E$/€)/E$/€
o Suppose R$ > R€ + (Ee$/€ – E$/€)/E$/€
o Then no investor would want to hold euro deposits, driving down the demand
and price of euros
o Then all investors would want to hold dollar deposits, driving up the demand
and price of dollars
o The dollar would appreciate and the euro would depreciate, increasing the right
side until equality was achieved:
 R$ > R€ + (Ee$/€ – E$/€)/E$/€
o CHANGES IN THE CURRENT EXCHANGE RATE AFFECT THE
EXPECTED RATE OF RETURN OF FOREIGN CURRENCY DEPOSITS
 R$ = R€ + (Ee$/€ - E$/€)/E$/€
o Depreciation of the domestic currency today lowers the expected rate of return
on foreign currency deposits
 When the domestic currency depreciates, the initial cost of investing in
foreign currency deposits increases, thereby lowering the expected rate
of return of foreign currency deposits (before 100 USD = 100 EUR,
now, 107 USD = 100 EUR) and vice versa with appreciation

THE RELATION BETWEEN THE CURRENT DOLLAR/EURO EXCHANGE

RATE AND THE EXPECTED DOLLAR RETURN ON EURO DEPOSITS
 

CURRENT EXCHANGE RATE AND THE EXPECTED RATE OF RETURN

ON DOLLAR DEPOSITS WITH R $ = 5 %

EQUILIBRIUM DOLLAR/EURO EXCHANGE RATE

No one wants to hold
euro deposits

No one wants
to hold dollar
deposits

MODEL OF FOREIGN EXCHANGE

 The effects of changing interest rates: R$ = R€ + (Ee$/€ - E$/€)/E$/€
o an increase in the interest rate paid on deposits denominated in a particular
currency will increase the rate of return on those deposits. This leads to an
appreciation of the currency
o Higher interest rates on dollar-denominated (R$) assets cause the dollar to
appreciate in relation to euro
  (Effect of a Rise in the Dollar Interest Rate)
o Higher interest rates on euro-denominated (R€) assets cause the dollar to
depreciate in relation to euro

 (Effect of a Rise in the Euro Interest Rate)

THE EFFECT OF AN EXPECTED APPRECIATION OF THE EURO

 R$ = R€ + (Ee$/€ - E$/€)/E$/€
 If people expect the euro to appreciate in the future (dollar depreciate), then expected
rate of returns on euro deposits denominated in dollar is increasing
 An expected depreciation of a currency leads to an actual depreciation (self-fullfilling
expectations)
 in general, expectations of exchange rate changes lead to real changes in exchange
rates

COVERED INTEREST PARITY

 relates interest rates across countries and the rate of change between forward exchange
rates and the spot exchange rate: R$ = R€ + (F$/€ - E$/€)/E$/€ (F$/€ - Forward exchange
rate)
 rates of return on dollar deposits and “covered” foreign currency deposits are the same
MONEY AND ITS FUNCTION
 a special kind of asset that is characterized by the following functions:
o money as a medium of exchange
 Money is a generally accepted mean of payment, and that property
eliminates the enormous costs of search that are associated with the
system of barter. Complex contemporary economy would cease to
function without a standardized and convenient means of payment
o money as a unit of calculation (measure of value)
 agreement that the prices are determined in monetary terms simplifies
economic calculations by making price comparison of various goods
easier
o money as a mean of storing (saving)
 since the money can be used as a transfer of purchasing power from the
present to the future, it is also a store of value. This characteristic is
essential for any medium of exchange because no one would want to
accept it if its purchasing value in terms of goods and services is
narrowly limit in time
 DIFFERENT GROUPS OF ASSETS MAY BE CLASSIFIED AS MONEY:
o Currency in circulation, checking deposits, and debit card accounts form a
narrow definition of money. This, narrower definition of money can be
associated with monetary aggregate M1 (money supply)  
o Deposits of currency are excluded from this narrow definition, although they
may act as a substitute for money in a broader definition. This expanded
definition of money approximately corresponds to the monetary aggregate M4
(total liquid assets)
 THE DEGREE OF ASSET LIQUIDITY AND THE CORRESPONDING RATES OF
RETURN
o Money is a liquid asset: (we say that an asset is liquid if it can be easily
converted in goods and services and without substantial transaction costs).
Since the money is a generally accepted mean of payment, money determines
the standard on which is evaluated the liquidity of other assets  
 monetary or liquid assets earn little or no interest
o Illiquid assets require substantial transaction costs in terms of time, effort, or
fees to convert them to funds for payment
 Illiquid assets earn a higher interest rate or rate of return than
monetary assets
 MONEY SUPPLY
o The central bank substantially controls the quantity of money that circulates in
an economy, the money supply (MS)
 In the U.S., the central banking system is the Federal Reserve System
(Fed)
 In the euro zone the role of the central bank is performed by the
European Central Bank (ECB) and the Eurosystem (consists of national
central banks of the eurozone and the ECB)
 these institutions directly regulate the amount of currency in
circulation , and indirectly affect the size of demand deposits
and other forms of monetary assets
 MONEY DEMAND
o represents the amount of monetary assets that households and firms are willing
to hold (instead of illiquid assets)
o DETERMINANTS OF INDIVIDUAL DEMAND FOR MONEY
 Interest rates/expected rates of return on monetary assets relative to
the expected rates of returns on non-monetary assets
 A higher interest rate on term deposits or government bonds the
lower is the demand of money
 Risk: the risk of holding monetary assets principally comes from
unexpected inflation, which reduces the purchasing power of money
 But many other assets have this risk too, so this risk is not very
important in defining the demand of monetary assets versus
nonmonetary assets
 Liquidity: A need for greater liquidity occurs when the price of
transactions increases (or the price or quantity of goods bought
increases, the money demand increases)
o DETERMINANTS OF AGGREGATE DEMAND FOR MONEY
 Interest rates/expected rates of return: monetary assets pay little or
no interest, so the interest rate on non-monetary assets like bonds,
loans, and deposits is the opportunity cost of holding monetary assets
 A higher interest rate means a higher opportunity cost of
holding monetary assets which results in lower demand of
money
 General price level: the prices of goods and services bought in
transactions will influence the willingness to hold money to conduct
those transactions
 A higher level of average prices means a greater need for
liquidity to buy the same amount of goods and services and so
the higher demand of money
 Real National Income a higher real national income (GNP) means
more goods and services are being produced and bought in transactions,
increasing the need for liquidity leading to a higher demand of money
o A MODEL OF AGGREGATE MONEY DEMAND
 Md = P x L(R,Y)
 P is the price level
 Y is real national income
 R is a measure of interest rates on nonmonetary assets
 L(R,Y) is the aggregate demand of real monetary assets
 Aggregate demand of real monetary assets is a function of national
income and interest rates: Md/P = L(R,Y)

Given the level of real income,

real money demand decreases
as interest rate increases.


 EFFECT ON THE AGGREGATE REAL MONEY DEMAND
SCHEDULE OF A RISE IN REAL INCOME
 The increase in real national income
increases the demand for real money at
each level of interest rates


 A MODEL OF THE MONEY MARKET
o When no shortages (excess demand) or surpluses (excess supply) of monetary
assets exist, the model achieves an equilibrium: Ms = Md
o Alternatively, when the quantity of real monetary assets supplied matches the
quantity of real monetary assets demanded, the model achieves an equilibrium:
Ms/P = L(R,Y) ; (point 1)


 When there is an excess supply of monetary assets,(point 2)
there is an excess demand for interest- bearing assets like bonds,
loans, and deposits
o People with an excess supply of monetary assets are
willing to offer or accept interest-bearing assets (by
giving up their money) at lower interest rates, but there
are more people who are willing to lend money to
decrease their liquidity than those who are willing to
borrow the money and to increase their liquidity
o Those who can not get rid of their excess money are
trying to attract potential borrowers by lowering the
interest rates charged by the loan. The pressure on
continuous lower of the interest rate is continued until
the interest rate (R2) reaches equilibrium level (R1)
 When there is an excess demand of monetary assets, (point 3)
there is an excess supply for interest-bearing assets like bonds,
loans, and deposits
o People want more liquid monetary assets (money), even
though they are willing to sell the non monetary to get
the monetary assets the wishes of all can’t be satisfied in
the point 3
 o Ultimately, people compete for money by offering
higher interest rate and shift interest rate from R3 up to
R1
 CONCLUSION: the market is always moving towards an
interest rate at which the real money supply equals
aggregate real money demand. If in the beginning there is
excess money supply over demand, interest rates fall, and if
in the beginning there is an excess of demand over supply,
the interest rate rises
 THE EFFECT OF THE INCREASE IN MONEY SUPPLY ON THE INTEREST
RATE

The increase in the money

supply lowers the interest rate
at a given price level

The decline in the money supply

increases the interest rate at a
given price level

o
 Money market is initially in equilibrium at point 1, with the M1 money
supply and interest rate R1. Since P is maintained constant, an increase
in the money supply M2 increases the real money supply from M1/P to
M2/P. With real money supply M2/P, in point 2 is the new equilibrium,
and R2 is a new, lower interest rate, which encourages people to keep
increasing the available real money supply
 after the central bank raised the Ms, there is an initial excess supply of
money in the old equilibrium interest rate, R1, previously balancing the
market
 the process of falling of the interest rate, we have already explained:
how people keep more money than they want to, they use their excess
resources to compete for assets that carries an interest rate. The
economy as a whole can reduce its funds, and the interest rates go
down as the reluctant owners of money are competing to lend their
excess cash  
 CONCLUSION: an increase in the money supply decreases the
interest rate, while the decrease in money supply increases the
interest rate with a given price level and the domestic product  
 THE EFFECT OF THE INCREASE IN REAL INCOME ON INTEREST RATE

The increase in real national

income increases equilibrium
interest rate with a given price
level

o

growth domestic product causes the shift of entire curve of real
aggregate demand for money to the right , shifting the balance from the
point 1
 with the old equilibrium interest rate, R1 , there is an excess demand for
money equal to Q2–Q1 (point 1')
 since the real money supply is given, the interest rate increases until it
reaches a new higher equilibrium level R2 (point 2)  
 CONCLUSION: an increase in real income (real GDP) increases the
interest rate, while the decrease in real income, decreases the
interest rate, with a given price level and the money supply
 SIMULTANEOUS EQUILIBRIUM IN THE U.S. MONEY MARKET AND THE
FOREIGN EXCHANGE MARKET

o
 EFFECT ON THE DOLLAR/EURO EXCHANGE RATE AND DOLLAR
INTEREST RATE OF AN INCREASE IN THE U.S. MONEY SUPPLY

o
 CHANGES IN THE DOMESTIC MONEY SUPPLY
o An increase in a country’s money supply causes interest rates to fall, rates
of return on domestic currency deposits to fall, and the domestic currency
to depreciate
o A decrease in a country’s money supply causes interest rates to rise, rates
of return on domestic currency deposits to rise, and the domestic currency
to appreciate
 CHANGES IN THE FOREIGN MONEY SUPPLY
o An increase in the supply of euros decreases the interest rates in eurozone,
which leads to a decrease of an expected rate of return on euro deposits
o That decrease of an expected rate of returns on euro deposits causes a
depreciation of the euro (an appreciation of the dollar)
o no change is predcited in the US market due to the changes in the money
supply of euro
 EFFECT OF AN INCREASE IN THE EUROPEAN MONEY SUPPLY ON THE
DOLLAR/EURO EXCHANGE RATE
 o
 PRICES IN THE LONG AND SHORT RUN
o in the short run prices do not have enough time to adapt to market conditions.
So we're talking about inflexible, rigid or sticky prices in the short run
 The most common reason of inflexible prices in the short run are
relatively long contractual agreements (agreements on wages), and the
costs entailed by frequent price changes (menu costs)
 So far considered balance was related to the short run because the price
level and expectations about the exchange rate were given (fixed)  
o in the long run prices of factors of production and the final product have
sufficient time to adapt to market conditions
 wages are adjusting to the supply and demand for labour
 real domestic product and national income are determined by the
amount of workers and other production factors, not the amount of
money supply
 (real) interest rates are dependent on the supply of savings and demand
for savings  
 MONEY AND PRICES IN THE LONG RUN
o since in the short run the price level and the production are fixed , equilibrium
condition for the money market is defined as: MS/P= L(R,Y)
o money market moves to equilibrium in the long run during which the P and Y
and R, can be changed. Therefore, the equilibrium condition in the short run
can be converted in the long run as: P = MS/ L(R,Y)
 which shows that the price level depends on the interest rate, the real
domestic product and domestic (nominal) money supply
o long-term equilibrium price level is exactly the value of P which satisfies the
condition when the interest rate and the domestic product are on their long-
term equilibrium levels, ie. at levels that are consistent with full employment
o CONCLUSION: in the long run, if the R and Y are unchanged (constant, the
increase in the money supply MS causes a proportional increase in general
price level
 If, for example, money supply doubles (at 2MS), and the interest rate
and the domestic product does not change, in order to maintain balance
in the money market, the price level has also to be doubled (to 2P)
 Economic explanation of this very precise prediction follows from the
fact that the demand for money, the demand for real cash (real
purchasing power), and the real demand for money, with R and Y
 constant, does not change with the increase of Ms. If the real aggregate
demand for money does not change, the money market will remain in
balance only if real money supply also remains the same. To real
money supply Ms / P held constant, P must grow proportionately with
Ms
 LONG-TERM EFFECTS OF CHANGES IN THE MONEY SUPPLY
o level of domestic product at full employment is determined by the economy
supply of labor and capital so in the long run real domestic product does not
depend on money supply. Similarly, the interest rate is independent of the
supply of money in the long run. If the money supply and all prices
permanently double, there is no reason why people who had previously been
willing to invest $ 1 with an annual return of $ 1.10 would not be willing to
invest $ 2 later with an annual return of $ 2.20 (in both case the annual interest
rate is unchanged and it is equal to 10 %). Thus, changes in the money supply
does not change the long-term resource allocation. Only the absolute level of
cash prices is changing
o changes in the money supply has no effect on long-term real interest rates
or the value of the real domestic product
o claim that a single change in the level of money supply has no effect on long-
term value of real economic variables is commonly referred to as long-term
neutrality of money
o CONCLUSION: holding everything else unchanged, a permanent increase in
the money supply of a country causes a proportional long-term
depreciation of its currency against the foreign currencies. Similarly, a
permanent reduction in the money supply of a country causes a
proportional long-term appreciation of its currency against the foreign
currencies
 EXCHANGE RATE OVERSHOOTING
o immediate response (deprecation) of an exchange rate on an increasing money
supply is greater than its long-run response (depreciation)
o a direct consequence of sluggish short-term adjustments in the price level
(which the central bank cannot influence) and, on the other hand, the
conditions of interest rate parity  
o helps explain why exchange rates are so volatile

THE BEHAVIOR OF EXCHANGE RATES

 models used to predict how exchange rates behave/change:
o (a) monetary approach on exchange rate which includes purchasing power
parity and (b) model that is based on the real exchange rate (both models are
long-run models, there are also short-run models)
o Long run means a sufficient amount of time for prices of all goods and services
to adjust to market conditions so that their markets and the money market are
in equilibrium
o Because prices are allowed to change, they will influence interest rates and
exchange rates in the long-run models
 LAW OF ONE PRICE
o the same good in different competitive markets must sell for the same price,
with an assumption that transportation costs and barriers between those
markets are not important
 o Due to the price difference, entrepreneurs would have an incentive to buy
raspberry at the cheap location and sell it at the expensive location for an easy
profit
o Due to strong demand and limited supply, the price of raspberry 20 USD/kg
would tend to increase
o Due to weak demand and relatively increased supply, the price of raspberry 40
USD/kg would tend to decrease
o People would have an incentive to adjust their behavior and prices would tend
to adjust until one price is achieved across markets (the same price of
raspberry)
o PraspberryUS = (EUS$/C$) x (PraspberryCanada)
o PraspberryUS = price of 1 kg of raspberry in Seattle
o PraspberryCanada = price of 1 kg of raspberry in Vancouver
o EUS$/C$ = U.S. dollar/Canadian dollar exchange rate
 PURCHASING POWER PARITY (PPP)
o the application of the law of one price across countries for all goods and
services, or for representative groups (“baskets”) of goods and services
o PUS = (EUS$/C$) x (PCanada)
o PUS = level of average prices in the U.S.
o PCanada = level of average prices in Canada
o EUS$/C$ = U.S. dollar/Canadian dollar exchange rate
o EUS$/C$ = PUS/PCanada
 exchange rate is determined by levels of average prices (PUS/PCanada) 
o predicts that people in all countries have the same purchasing power with their
currencies: 2 Canadian dollars buy the same amount of goods as 1 U.S. dollar,
since prices in Canada are twice as high (as an example)
o 2 FORMS:
 Absolute PPP: has already been discussed. Exchange rates equal the
level of relative average prices across countries:
 E$/€ = PUS/PEU
 Relative PPP: changes in exchange rates equal changes in prices
(inflation) between two periods:
 (E$/€,t – E$/€, t –1)/E$/€, t –1 = US, t – EU, t
o where t = inflation rate in USA from period t –1 to t,
respectively: US,t = (PUS,t - PUS,t –1)/ PUS,t –1
 MONETARY APPROACH
o uses monetary factors to predict how exchange rates adjust in the long run,
based on the absolute version of PPP
 It predicts that levels of average prices across countries adjust so that
the quantity of real monetary assets supplied will equal the quantity of
real monetary assets demanded:
 PUS = MsUS/L (R$, YUS)
 PEU = MsEU/L (R€, YEU)
 E$/€= (MsUS/L (R$, YUS)) / (MsEU/L (R€, YEU))
o PREDICTIONS ABOUT CHANGES
 The exchange rate is determined in the long run by prices (PUS i PEU),
which are determined by the relative supply (MUS i MEU) and demand of
 real monetary assets in money markets across countries (L(R$, YUS) and
L(R€, YEU))
 1) Money supply-a permanent rise in the domestic money supply
 causes a proportional increase in the domestic price level
 thus causing a proportional depreciation in the domestic
currency (through PPP)
 This is same prediction as long-run model without PPP
 2) Interest rates- a rise in domestic interest rates
 lowers the demand of real monetary assets
 associated with a rise in domestic prices
 thus causing a proportional depreciation of the domestic
currency (through PPP)
 3) Output level- a rise in the domestic level of production and income
(output)
 raises domestic demand of real monetary assets
 associated with a decreasing level of average domestic prices
(for a fixed quantity of money supplied)
 thus causing a proportional appreciation of the domestic
currency (through PPP)
 All 3 changes affect money supply or money demand, and cause prices
to adjust so that the quantity of real monetary assets supplied matches
the quantity of real monetary assets demanded, and cause exchange
rates to adjust according to PPP
o CHANGES IN THE MONEY SUPPLY
 results in a change in the level of average prices
 A change in the growth rate of the money supply results in a change in
the growth rate of prices (inflation)
 A constant growth rate in the money supply results in a persistent
growth rate in prices (persistent inflation) at the same constant rate,
when other factors are constant
 Inflation does not affect the productive capacity of the economy and
real income from production in the long run
 Inflation, however, does affect nominal interest rates (Fisher effect)
 THE FISHER EFFECT
 relationship between nominal interest rates and inflation
 after derivation: R$ – R€ = eUS – eEU
 a rise in the domestic inflation rate causes an equal rise in
the interest rate on deposits of domestic currency in the long
run, when other factors remain constant
 Suppose that the U.S. central bank unexpectedly increases the growth
rate of the money supply at time t0
 Suppose also that the inflation rate is  in the US before t0 and  + 
after this time, but that the European inflation rate remains at 0%
 According to the Fisher effect, the interest rate in the U.S. will adjust to
the higher inflation rate
 LONG-RUN TIME PATHS OF U.S. ECONOMIC VARIABLES
AFTER A PERMANENT INCREASE IN THE GROWTH RATE OF
THE U.S. MONEY SUPPLY
 


 SHORTCOMINGS OF PPP
o little evidence argues in favor of absolute purchasing power parity
 prices of identical basket of goods, when converted into a common
currency, vary considerably among countries
o relative PPP is more consistent with the data, but also poorly predicts
exchange rates  
o The reasons explaining the shortcomings of PPP in explaining exchange rates
largely relate to the emergence that lead to violations of the law of one price
and include:
 trade barriers and the existence of non-traded goods
 imperfect competition (monopolies , oligopolies, cartels)
 Differences in the measurement of the average price of the basket of
goods and services
o Trade barriers and nontradable products
 Transport costs and governmental trade restrictions make trade
expensive and in some cases create nontradable goods or services
 Services are often not tradable: services are generally offered within a
limited geographic region (for example, haircuts)
 The greater the transport costs, the greater the range over which the
exchange rate can deviate from its PPP value
 One price for the same product (law of one price) doesn’t need to hold
in two markets
 o Imperfect competition may result in price discrimination:
 A firm sells the same product for different prices in different markets
(market segments) to maximize profits, based on expectations about
what consumers are willing to pay
 In countries in which demand is more price inelastic a higher margin is
tried to be charged above the production costs
 One price doesn’t need to hold in two markets, even on this basis
o Differences in the measure of average prices for goods and services
 Levels of average prices differ across countries because of differences
in how representative groups (“baskets”) of goods and services are
measured
 One reason for those differences is that people that live in difference
countries spend their incomes on different ways. Generally, people
spend relatively more domestic products , or products of their country
 Because measures of groups of goods and services are different, the
measure of their average prices need not be the same
 THE REAL EXCHANGE RATE APPROACH
o rate of exchange for goods and services across countries
o In other words, it is the relative value/price/cost of goods and services across
countries
o Real exchange rate (q) can be rewritten as: qUS/EU = (E$/€ x PEU)/PUS
 A real depreciation of the value of U.S. products means a fall in a
dollar’s purchasing power of EU products relative to a dollar’s
purchasing power of U.S. products
 This implies that U.S. goods become less expensive and less
valuable relative to EU goods
 This implies that the value of U.S. goods relative to value of EU
goods falls
 A real appreciation of the value of U.S. products means a rise in a
dollar’s purchasing power of EU products relative to a dollar’s
purchasing power of U.S. products
 This implies that U.S. goods become more expensive and more
valuable relative to EU goods
 This implies that the value of U.S. goods relative to value of EU
goods rises
o FACTORS THAT INFLUENCE REAL EXCHANGE RATE
 A change in relative demand of U.S. products
 An increase in relative demand of U.S. products causes the
value (price) of U.S. goods relative to the value (price) of
foreign goods to rise
 A real appreciation of the value of U.S. goods: PUS rises relative
to E$/€ x PEU
 The real appreciation of the value of U.S. goods makes U.S.
exports more expensive and imports into the U.S. less expensive
(thereby reducing the relative quantity demanded of U.S.
products)
 A change in relative supply of U.S. products
 
An increase in relative supply of U.S. products (caused by an
increase in U.S. productivity) causes the price/cost of U.S.
goods relative to the price/cost of foreign goods to fall
 A real depreciation of the value of U.S. goods: PUS falls relative
to E$/€ x PEU
 The real depreciation of the value of U.S. goods makes U.S.
exports less expensive and imports into the U.S. more expensive
(thereby increasing relative quantity demanded to match
increased relative quantity supplied)
o DETERMINATION OF THE LONG-RUN REAL EXCHANGE RATE

In the long term supply of goods The demand for American

and services ( RS ) in each products in relation to demand for
country depends on factors of European products (RD) depends
production such as labor, capital on the relative prices of these
and technology, not on prices or products or the real exchange
exchange rates . Because of that rate . For this reason, the direction
, RS is vertical . of RD is growing


o a more general approach to explain exchange rates

o both monetary factors and real factors influence nominal exchange rates:
 Increases in monetary levels lead to temporary inflation and changes
in expectations about inflation.
 Increases in monetary growth rates lead to persistent inflation and
changes in expectations about inflation.
 Increases in relative demand of domestic products lead to a real
appreciation.
 Increases in relative supply of domestic products lead to a real
depreciation

DETERMINANTS OF AGGREGATE DEMAND

 the aggregate amount of goods and services that individuals and institutions are
willing to buy:
o consumption expenditure (C)
o investment expenditure (I)
o government purchases (G)
o net expenditure by foreigners: the current account (CA)
 DETERMINANTS OF CONSUMPTION EXPENDITURE (C)
o Disposable income (Yd): income from production (Y) minus taxes (T): C = C(Yd)
o More disposable income means more consumption expenditure, but
consumption typically increases less than the amount that disposable income
increases. Why? Because a part of disposable income goes to savings (real
interest rate and wealth also influence but simplicity wise, we assume they
are unimportant)
 DETERMINANTS OF THE CURRENT ACCOUNT(CA)
o the real exchange rate and the disposable income: CA = CA(EP*/P, Yd)
 Disposable income (Yd): more disposable income means increase both
for domestic and foreign goods, consequently more expenditure on
foreign products (imports) ; (The assumption on which the model is
build is that the foreign disposable income (Yd*) remains unchanged all
the time and it doesn't affect the export)
 Real exchange rate (q): prices of foreign products relative to the prices
of domestic products, both measured in domestic currency: EP*/P
 qUS/EU = (E$/€ x PEU)/PUS or, shortly: qUS/EU = EP*/P
 HOW REAL EXCHANGE RATE CHANGES AFFECT THE CURRENT ACCOUNT
o The current account measures the value of exports relative to the value of
imports (ignoring sub factor income and current transfers sub-account):
CA ≈ EX – IM
o The change of the real exchange rate affects also the quantities and the value
of the export and import. If we assume that the impact on qualities is higher
than the impact on the values (which is mostly the case in practice) we can
highlight that:
 Increase of the real exchange rate (real depreciation) is improving the
current account ( because export increases and import decreases)
 Decrease of the real exchange rate (real appreciation) is worsening
the current account (because export is decreasing and import is
increasing)
 Aggregate demand is therefore expressed as: D = C(Y – T) + I + G + CA(EP*/P, Y – T)
o Real exchange rate: an increase in the real exchange rate increases the
current account, and therefore increases aggregate demand of domestic
products. Decrease of the real exchange rate (real appreciation) leads to the
decrease of the current account which leads to a decreases of the aggregate
demand for domestic goods
o Disposable income: an increase in the disposable income increases
consumption expenditure, but decreases the current account
 Since consumption expenditure is usually greater than expenditure on
foreign products, the first effect dominates the second effect
 aggregate consumption expenditure and aggregate demand increase
by less than disposable income (because of the increase of Yd on
savings)

 SHORT-RUN EQUILIBRIUM FOR AGGREGATE DEMAND AND OUTPUT

o Equilibrium is achieved when the value of income from production (output) Y
equals the value of aggregate demand D: Y = D(EP*/P, Y – T, I, G)
 THE DETERMINATION OF OUTPUT IN THE SHORT RUN
 o
 EQUILIBRIUM
o simultaneously defined nominal exchange rate and domestic output in the
short run, in order to understand that process we need to define two more
elements:
 the relation between domestic output and the exchange rate which
needs to hold when the goods market is in equilibrium
 the relation between domestic output and the exchange rate which
needs to hold when the asset market is in equilibrium
 Both elements are necessary because economy as a hole is in
equilibrium when both the goods and asset market are in equilibrium
 SHORT-RUN EQUILIBRIUM AND THE NOMINAL EXCHANGE RATE
o E↑, P P* fixed , q↑ , EX↑, IM↓ , CA↑ , D↑ , D=Y , Y↑
o OUTPUT EFFECT OF A CURRENCY DEPRECIATION WITH FIXED OUTPUT PRICES

o
o DD CURVE
 DEFINITION: shows combinations of output and the exchange rate at
which the output market is in short-run equilibrium (such that
aggregate demand = aggregate output or D=Y) ; slopes upward
because a rise in the exchange rate causes aggregate demand and
aggregate output to rise
 DERIVATION:
 
 SHIFTS:
 E change ; move along the DD curve
 Any other variable change that results in the ↑ of Y ; DD shifts
right
 Any other variable change that results in the ↓ of Y ; DD shifts
left
 G↑ , D↑ , D=Y , Y↑ (DD shifts right)

o
 T↓ , Yd ↑ , C↑ , CA↓ , delta C > delta CA , D↑ , D=Y , Y↑(DD
shifts right)
 I↑ , D↑ , D=Y , Y↑(DD shifts right)
 P P*↑ , D↑ , D=Y , Y↑(DD shifts right)
 C↑ , D↑ , D=Y , Y↑(DD shifts right)
 ↑ in demand of domestic goods relative to foreign goods ; D=Y
, Y↑(DD shifts right)
 SHORT-RUN EQUILIBRIUM IN ASSET MARKETS
o 1)Foreign exchange markets
 interest parity represents equilibrium: R = R* + (Ee – E)/E
o 2)Money market
  Equilibrium when the quantity of real monetary assets supplied
matches the quantity of real monetary assets demanded: Ms/P = L(R,Y)
o Y↑ , L(R,Y) ↑ , Ms unchanged, R↑ , E↓

o
o AA CURVE
 DEFINITION: Inverse relation between domestic output and nominal
exchange rate is necessary so that money and foreign exchange
market can be in equilibrium
 DERIVATION:


 SHIFTS:
 Y changes ; move along AA curve
 Any other variable change that results in deprecition of E ; AA
shifts right
 Any other variable change that results in apprecition of E ; AA
shifts left
 Ms↑ , Md unchanged , R↓ , E↑ (AA shifts right)
 o
 q↑ , EX↑ , IM↓ , CA↑ , D↑ , D=Y, Y↑ (AA shifts right)
 P↑ , Ms↓ , R↑ , E↓ (AA shifts left)
 Md↓ , R↓ , E↑ (AA shifts right)
 R*↑ , E↑ (AA shifts right)
 Ee↑ (dep.) , E↑ (dep.) (AA shifts right)
 DD & AA curves together
o A short-run equilibrium means a nominal exchange rate and level of output
such that:
 D=Y
 R = R* + (Ee – E)/E
 Ms/P = L(R,Y)
o A short-run equilibrium occurs at the intersection of the DD and AA curves:
 output markets are in equilibrium on the DD curve
 asset markets are in equilibrium on the AA curve


 TEMPORARY CHANGES IN MONETARY AND FISCAL POLICY
o Monetary policy: policy in which the central bank influences the supply of
monetary assets
 Affects directly asset markets, indirectly (with time lag) output market
 If there is a problem on asset market, if possible fix it with MP
(optimal), if not possible fix it with FP (suboptimal)
 Expansionary (Ms↑)
 Contractionary (Ms↓)
o Fiscal policy: policy in which governments (fiscal authorities) influence the
amount of government purchases and taxes
 Affects directly output (goods and services) market, indirectly (with
time lag) asset market (foreign exchange & money market)
 If there is a problem on output market, if possible fix it with FP
(optimal), if not possible fix it with MP (suboptimal)
 Expansionary (G↑ AND/OR T↓)
 Contractionary (G↓ AND/OR T↑)
o Temporary policy changes are expected to be reversed in the near future and
thus do not affect expectations about exchange rates in the long run
o TEMPORARY CHANGES IN MONETARY POLICY
 Ms↑ , R↓ , E , (AA shifts right)
 
o TEMPORARY CHANGES IN FISCAL POLICY
 G↑ OR T↓ , D↑ , D=Y , Y↑ (DD shifts right) , Md↑ , R↑ , E↓ (app.)


 ECONOMIC POLICIES AND MAINTAINANCE OF FULL EMPLOYMENT
o 1) EX↓ (temporary fall in world demand for domestic products) , CA↓ , D↓ ,
D=Y , Y↓ (DD shifts left) ; (Y2 < Y1)
o Policy makers want to ↑ Y and they have at disposal fiscal and monetary
policy. Since the problem/shock happened on ouput (good) market, fiscal
policy is optimal (first best) and should be used. If not possible, monetary
policy , which is suboptimal (second best) should be used
 FISCAL POLICY (first best)
 Expansionary (G↑ AND/OR T↓) , (DD curve shifts right)
o Y1 –> Y2 –> Y1
o E1 –> E2 –> E1
 MONETARY POLICY (second best)
 Expansionary (Ms↑) , (AA curve shifts right)
o Y1 –> Y2 –> Y1
o E1 –> E2 –> E3
 Huge cost in terms of nominal ex. Rate dep.
 MAINTAINING FULL EMPLOYMENT AFTER A TEMPORARY FALL IN
WORLD DEMAND FOR DOMESTIC PRODUCTS
 
o 2) M ↑ (increase in money demand for domestic products) , Ms unchanged ,
d

R↑ , E↓ (AA shifts left) ; (Y2 < Y1)

o Policy makers want to ↑ Y and they have at disposal fiscal and monetary
policy. Since the problem/shock happened on asset (money) market,
monetary policy is optimal (first best) and should be used. If not possible,
fiscal policy, which is suboptimal (second best) should be used
 MONETARY POLICY (first best)
 Expansionary (Ms↑) , (AA curve shifts right)
o Y1 –> Y2 –> Y1
o E1 –> E2 –> E1
 FISCAL POLICY (second best)
 Expansionary (G↑ AND/OR T↓) , (DD curve shifts right)
o Y1 –> Y2 –> Y1
o E1 –> E2 –> E3
 price to pay for using the suboptimal policy is
huge app. of the exchange rate
 POLICIES TO MAINTAIN FULL EMPLOYMENT AFTER A TEMPORARY
MONEY DEMAND INCREASE


o Policies to maintain full employment may seem easy in theory, but are hard in
practice
 1)At the shown graphs we have assumed that prices and expectations
do not change, but economic subjects in reality may anticipate the
effects of policy changes and modify their behavior
 Workers may require higher wages if they expect overtime and
easy employment, and producers may raise prices if they
expect high wages and strong demand due to monetary and
fiscal policies
 Fiscal and monetary policies may therefore create price
changes and inflation, thereby preventing high output and
employment: inflationary bias
 2)Economic data are difficult to measure and to understand
 Policy makers cannot interpret data about asset markets and
aggregate demand with certainty, and sometimes they make
mistakes
 3)Changes in policies take time to be implemented and to affect the
economy
 Because they are slow, policies may affect the economy after
the effects of an economic change have dissipated
 4)Policies are sometimes influenced by political or bureaucratic
interests, lobbies
o PERMANENT CHANGES IN MONETARY AND FISCAL POLICY
 ”Permanent” policy changes are those that are assumed to modify
people’s expectations about exchange rates in the long run
o ECONOMIC POLICIES AND THE CURRENT ACCOUNT
 Economic policies affect the current account through their impact on
the domestic currency value
 Increase of the money supply leads to a depreciation of the
domestic currency in the short run that results mostly in the
improvement of the current account balance in the short run
 Increase in the government spending or in tax reduction leads
to an appreciation of the domestic currency and mostly results
in deterioration of the current account balance in the short run
Exercises: 8. EXCHANGE RATES AND THE FOREIGN EXCHANGE MARKET
1. Assume that the interest rate on euro deposits is 15%, while the interest rate on
dollar deposits is 10%. The nominal spot EUR/USD exchange rate is 0,75.

a) Considering all the above information, how much is the forward USD/EUR
exchange rate with maturity in 12 months, if the covered interest rate parity is
valid?
R $ = 10% (interest rate on dollar deposits)
R € = 15% (interest rate on euro deposits)
E € / $ = 0,75 (nominal spot EUR/USD exchange rate)
E$/ € = 1/0,75 = 1,33
F $ / € = ? (forward USD/EUR exchange rate?)

F $ /€ −E $ / €
R $=R € +
E $ /€

10% = 15% + (F – 1,33)/1,33

F -1,33 = 1,33 *( 10%-15%)
F = 1,2635

Change between forward and nominal spot exchange rate is negative (1,2635-1,33) This leads
to a strengtening of the domestic currency

b) Assume that the current forward exchange rate isn't the one that you calculated
under (a), but that it is 1.4 dollars per euro. What would the participant on the
foreign exchange market do?

F$/€ = 1,4
E$/€ = 1/0,75= 1,33

Difference between forward and nomianl exchange rate is positive (1,4-1,33) – Domestic
currency will decrease in value
Weak domestic currency = stronger foreign currency

If the forward exchange rate was F$/€ =1.4 , the return on euro deposits denominated in dollars
would be higher than the return on dollar deposits and everyone would start to sell dollars and
buy euros which would lead to the depreciation of the dollar and appreciation of the euro and
would finally re-establish the covered interest rate parity.
2. Assume that kuna and euro-denominated financial assets (deposits, bonds) are equally
liquid and equally risky. If economic subjects expect that in one year the kuna will be
worth 10% less than today, and the interest rate on euro deposits is 3%, what is the current
interest rate on deposits in kunas?
R € = 3% (interest rate on euro deposits)

EeHRK / € −E HRK /€
= 10%
E HRK / €

R HRK = ?

EeHRK /€ −E HRK / €
R HRK =R € +
EHRK / €

RHRK =0,03 + 0,10 = 13%

deprecijacija (rast tečaja, +)

aprecijacija (pad tečaja, -)
3. The ratio between prices in Croatia and the Eurozone is 0.87, and the real kuna/euro
exchange rate is q HRK/€ =8.5. If the expected HRK/EUR exchange rate is 7.5, and the
interest rate on kuna deposits is 5%, how much is the current interest rate on euro
deposits?

p HR
= 0,87 (ratio between prices in Croatia and Eurozone)
PEU

q HRK / € = 8,5 (real kuna/euro exchange rate)

EeHRK /€ = 7,5 (expected HRK/EUR exchange rate)

R HRK = 5% (interest rate on kuna deposits)

R € = ? (interest rate on euro deposits?)

EeHRK /€ −E HRK / €
R HRK =R € +
EHRK / €

E HRK / €∗p EU
q HRK / € =
p HR

8,5 = EHRK/€ * (1/0,87)

EHRK/€ = 7,395

R€ = 0,05 – (7,5-7,395) / 7,395

R€ = 3,58%
 9. MONEY, INTEREST RATES AND EXCHANGE RATES

1. Show graphically the American money market and the foreign exchange market and
explain the effects of a temporary increase in US money supply on the USD/EUR
exchange rate.

Exchange rate
dollar/euro, E $ /€

dolla
rreturn

expected
euro return

Rates of return
(in dollars)

increase of US real
money
supply -

real US monetary
funds -

An increase of the US money supply will decrease dollar interest rates. The dollar return
(interest rates on dollars) moves to the left, along the curve of the expected return on euro
deposits expressed in dollars. The final result is an increase of the exchange rate, in other
words the depreciation of the dollar (appreciation of the euro).
 2. Show graphically the American money market and the foreign exchange market and
explain the effects of a temporary increase in European money supply on the
USD/EUR exchange rate.

An increase of the European money supply will decrease the interest rate on euros and will
move the curve of the expected dollar return on euro deposits to left. That will cause the
decrease of the USD/EUR exchange rate, or in other words the dollar will appreciate (the euro
will depreciate). There is no effect on the US supply or demand for money, so the interest rate
in the US does not change.
 10. PRICE LEVEL AND EXCHANGE RATES IN THE LONG RUN

1. Assuming that the relative purchasing power parity (PPP) is true, then fill in the table
below:
E$/E,t E$/E,t-1 ΠUS,t ΠE,t
2,0 A 0,03 -0,08111
2,1 2,0 0,04 -0,01
2,2 2,1 B 0,002381
C 2,2 0,06 0,014545
2,4 D 0,07 0,026522

E$ / € ,t −E$ / € ,t −1
=❑US , t−❑E , t
E$ / € ,t −1

A:
2−x
= 0,03 – (-0,08111)
x

x = 1,8

B:
2,2−2,1
= x– (-0,002381)
2,1

x = 0,05

C:
x−2,2
= 0,06 – 0,014545
2,2

x = 2,3

D:
2,4−x
= 0,07 – 0,026522
x

x=2,3
 11. DOMESTIC PRODUCT AND THE EXCHANGE RATE IN THE SHORT RUN

1. Assume that the economy is on a level of production with full employment. Explain
and show graphically on the AA-DD diagram how will a decrease of world demand
for domestic products affect the equilibrium level of production and exchange rates.
How could monetary and fiscal policy in the short run return the economy on the level
of full employment?

Exchange rate
E

Production, Y

AA krivulja prikazuje financijska tržišta (tržište novca i devizno tržište)

DD krivulja prikazuje ravnotežu na tržištu roba i usluga
D = C(Y-T) + I + G + CA (q, Y-T)

(1) a temporary decrease of world demand for domestic products shifts the DD curve up and
to the left and decreases domestic production below the normal level. This causes the
exchange rate to increase and the domestic currency to depreciate (shift from point 1 to point
2);
(2) temporary fiscal policy could cancel out the effects of a fall in aggregate demand and
domestic product by either increasing government spending or decreasing taxes which returns
the DD curve on the starting level (shift from point 2 to point 1). The exchange rate falls, and
the domestic currency appreciates.
(3) temporary monetary expansion moves the AA curve up and to the right, which leads to a
depreciation of the domestic currency even further and returns the economy to the level of
production with full employment (shift from point 2 to point 3).
 2. Assume that the economy is on a level of production with full employment. Explain
and show graphically on the AA-DD diagram how will an increase in the demand for
money affect the equilibrium level of production and exchange rate. How could
monetary and fiscal policy in the short run return the economy on the level of full
employment?

Exchange rate,
E

Production, Y

1) an increase of demand for money moves the AA curve down and to the left, increases
interest rates, leads to an appreciation of domestic currency and decreases domestic product
below the normal level (shift from point 1 to point 2)
(2) temporary fiscal policy could either increase government spending or decrease taxes to
increase aggregate demand, which will move the DD curve down and to the right and return
the economy on the level of full employment (shift from point 2 to point 3)
(3) temporary monetary policy could increase money supply in order to balance the demand
and directly return the AA curve on its starting level (shift from point 2 to point1)
 HOMEWORK QUESTIONS

Exchange rates and the foreign exchange market

1. Define bilateral exchange rate.

Bilateral exchange rate is the price of the foreign currency in terms of the
domestic currency (direct notation 1EUR = 7,61HRK) or the price of the
domestic currency in terms of the foreign currency (indirect notation 1HRK =
0.131EUR)

2. What is meant by the term depreciation and what under the term appreciation?
Depreciation is a decrease in the value of a currency relative to another
currency. A depreciated currency is less valuable (less expensive) and therefore
can be exchanged for a smaller amount of foreign currency. Appreciation is an
increase in the value of a currency relative to another currency. An appreciated
currency is more valuable and therefore can be exchanged for a larger amount
of foreign currency.

3. Are the concepts of depreciation and devaluation synonyms? Explain.

Depreciation is the common term used to describe movement for floating or
partially floating exchange rate. Term devaluation is used for fixed exchange
rate regimes. Devaluation is an official act which reduces the current value of
the fixed rate in relation to another currency to a new, lower level.

4. Define what is the spot and what is the forward exchange rate?
Spot rates are exchange rates for currency exchanges “on the spot”, or when
trading is executed in the present or in three work days. Forward rates are
exchange rates for currency exchanges that will occur at a future (forward) date.

5. What is the difference between bilateral and effective exchange rate?

Bilateral exchange rate — the price of one currency in relation to the price of
some other individual currency. Effective exchange rates are rates that put one
currency in a simultaneous relationship with a basket of currencies where the
currencies included in the basket are currencies of the most important trading
 partners. Effective exchange rates indicate the movement of the price
competitiveness of the country.

6. What is indicated by the appreciation of the effective exchange rate or

strengthening of a country?
The appreciation of the effective exchange rate shows that the country’s
exports become more expensive in foreign markets and the country is becoming
less cost-competitive in foreign markets.

7. Highlight basic and two additional factors that influence the demand for foreign
currency deposits.
Factors that influence the return on assets determine the demand for those
assets: real rate of return, risk of holding assets, liquidity of an asset.

8. What determines the rate of return on deposits in domestic and what the rate of
return on deposits in foreign currency?
The rate of return for a deposit in domestic currency is the interest rate that the
deposit earns. To compare the rate of return on a deposit in domestic currency
with one in foreign currency consider the interest rate for the foreign currency
deposit and the expected rate of appreciation or depreciation of the foreign
currency relative to the domestic currency.

9. Define what is the interest rate parity. What implies in terms of the
desirability/interest in assets denominated in domestic and foreign currency,
and what when it comes to the possibilities of arbitration?
To construct a model of FX markets we use the demand of dollar denominated
deposits and the demand of foreign currency denominated deposits. The model
is in equilibrium when deposits of all currencies offer the same expected rate of
return — INTEREST PARITY. Interest parity implies that deposits in all
currencies are equally desirable assets, that arbitrage in the foreign exchange
market is not possible and that an exchange market is in equilibrium. R$
e
= R€ + (E $/€ – E$/€)/E$/€
10. What connects the covered interest rate parity? Explain.
Covered interest parity relates interest rates across countries and the rate of
change between forward exchange rate and the spot exchange rate:R $ = R€ +
(F$/€ - E$/€)/E$/€ Covered interest parity says that rates of return on dollar
deposits and “covered” foreign currency deposits are the same.Money, Interest
Rates and Exchange Rates

1. Define what money is. Define and explain the three basic functions of money.
Money is a special kind of asset that is characterized by the following
functions: money as a medium of exchange — money is a generally accepted
means of payment and that property eliminates the enormous costs of search
that are associated with the system of barter. Complex contemporary economy
would cease to function without a standardized and convenient means of
payment. Money as a unit of calculation (measure of value) — agreement that
the prices are determined in monetary terms simplifies economic calculations
by making the price comparison of various goods easier. Money as a means of
storing (saving) — since the money can be used as a transfer of purchasing
power from the present to the future, it is also a store of value. This
characteristic is essential for any medium of exchange because no one would
want to accept it if its purchasing value in terms of goods and services is
narrowly limited in time.

2. Why is it said that money is the most liquid asset? What is the main difference
between liquid and illiquid financial assets? Explain.
Money is a liquid asset. Since money is a generally accepted means of
payment, money determines the standard on which the liquidity of other assets
is evaluated. Monetary or liquid assets earn little or no interest. Illiquid assets
require substantial transaction costs in terms of time, effort, or fees to convert
them to funds for payments. Illiquid assets earn a higher interest rate than
monetary assets.

3. Who determines/affects money supply?

The central bank substantially controls the quantity of money that circulates in
an economy i.e. the money supply.
4. What are the determinants of individual money demand? What are determinants
of aggregate money demand? Explain.
Determinants of individual money demand are interest rates/expected rates of
return, risk and liquidity. Determinants of aggregate money demand are interest
rates/expected rates of return, general price level and real national income GNP.

5. What is aggregate demand for money equal to? How is it changing considering
the changes of the function liquidity L components?
Md = P x L(R,Y) where P is the price level, Y is real national income, R is a
measure of interest rates on non-monetary assets and L(R,Y) is the aggregate
demand of real monetary assets.

6. Why, if there is an excess of supply over the demand in the beginning, the
interest rate is decreasing until the equilibrium interest rate is reached? Explain.
When there is an excess supply of monetary assets there is an excess demand
for interest bearing assets like bonds, loans and deposits. People with an excess
supply of monetary assets are willing to offer or accept interest-bearing assets
(by giving up their money) at lower interest rates, but there are more people
who are willing to lend money to decrease their liquidity than those who are
willing to borrow the money and to increase their liquidityThose who can not
get rid of their excess money are trying to attract potential borrowers by
lowering the interest rates charged by the loan .The pressure on continuous
lower of the interest rate is continued until the interest rate (R2) reaches
equilibrium level (R1).

7. Why, if there is a shortage of supply over the demand in the beginning, the
interest rate is increasing until the equilibrium interest rate is reached? Explain.

When there is an excess demand of monetary assets (point 3 on slide 14-15)

there is an excess supply for interest- bearing assets like bonds, loans, and
deposits. People want more liquid monetary assets (money), even though they
are willing to sell the non monetary to get the monetary assets the wishes of all
can’t be satisfied in point 3 Ultimately , people compete for money by offering
higher interest rate and shift interest rate from R3 up to R1.

8. How does, with given price level and production, the change of money supply
affect the interest rate? Explain.
 The increase in the money supply lowers the interest rate at a given price level.
The decline in the money supply increases the interest rate at a given price
level.

9. How does, with given price level and money supply, the change of real
production affect the interest rate? Explain.
An increase in real income ( real GDP ) increases the interest rate, while the
decrease in real income decreases the interest rate, with a given price level and
the money supply.

10. How do the changes of domestic money supply affect the rate of return on
deposit in domestic currency and domestic exchange rate? Explain.
An increase in a country’s money supply causes interest rates to fall, rates of
return on domestic currency deposits to fall, and the domestic currency to
depreciate. A decrease in a country’s money supply causes interest rates to rise,
rates of return on domestic currency deposits to rise, and the domestic currency
to appreciate.

11. Why do we say that prices are sticky or non-flexible in the short run? Explain.
In the short run prices do not have enough time to adapt to market conditions.
So we’re talking about inflexible, rigid or sticky prices in the short run. The
most common reason for inflexible prices in the short run are relatively long
contractual agreements and the costs entailed by frequent price changes.

12. Are the price levels also sticky in the long run? What determines the price level
in the long run?
In the long run prices of factors of production and the final product have
sufficient time to adapt to market conditions. Wages are adjusting to supply and
demand of labor, real domestic product and national income are determined by
the amount of workers and other production factors, not the amount of money
supply, real interest rates are dependent on the supply of savings and demand
for savings.
13. What is the inflation rate equal to in the long run?
14. Does the change in money supply impact long term value of interest rate and
the real production?
Changes in the money supply have no effect on long-term real interest rates or
the value of the real domestic product. Claiming that a single change in the
level of money supply has no effect on long-term value of real economic
variables is commonly referred to as long-term neutrality of money.

15. How does a permanent change in money supply affect the exchange rate?
A permanent increase in the money supply of a country causes a proportional
long-term depreciation of its currency against the foreign currencies . Similarly,
a permanent reduction in the money supply of a country causes a proportional
long-term appreciation of its currency against the foreign currencies.

16. What is the exchange rate overshoot? Explain why it usually happens and what
it largely refers to?
The exchange rate is said to overshoot when its immediate response
(depreciation) of an exchange rate on an increasing money supply is greater
than its long run response. Overshooting of an exchange rate is a direct
consequence of sluggish short term adjustments in the price level and
conditions of the interest rate parity. Overshooting helps explain why exchange
rates are so volatile.Price levels and the Exchange Rate in the Long Run

1. What is the law of one price? Under which assumption is it valid? Explain the
law by example.

The law of one price simply says that the same good in different competitive
markets must sell for the same price with an assumption that transportation
costs and barriers between those markets are not important. Suppose the price
of 1 kg of raspberries at one seller is $20, while the price of 1 kg of raspberries
(same quality) at seller B across the street is $40. Many people will buy the
raspberries for $20/kg, while few will buy the $40/kg.

2. What is purchasing power parity? It rests on which basis? Explain the parity
with an example.

Purchasing power parity (PPP) is the application of the law of one price across
countries for all goods and services or for representative groups (baskets) of
 goods and services.
which implies that the exchange rate is determined by levels of average prices.

3. What is the main difference between absolute and relative purchasing power
parity? Differentiate it with formulas and explain them with words.

Absolute PPP: purchasing power parity that has already been discussed. Exchange
rates equal the level of relative average prices across countries.

Relative PPP: changes in exchange rates equal changes in prices (inflation) between
two periods.

4. Explain the monetary approach to exchange rates. It rests on which basis? What
does the monetary approach predict of exchange rates in the long run?
Monetary approach to the exchange rate uses monetary factors to predict how
exchange rates adjust in the long run, based on the absolute version of PPP. It
predicts that levels of average prices across countries adjust so that the quantity
of real monetary assets supplied will equal the quantity of real monetary assets
demanded.

5. In accordance with the monetary approach to the exchange rate, how do the
changes in money supply affect the exchange rate?
A permanent rise in the domestic money supply causes a proportional increase
in the domestic price level, thus causing a proportional depreciation in domestic
currency (through PPP). This is the same prediction as the long run model
without PPP.

6. In accordance with the monetary approach to the exchange rate,how the

changes in the interest rates affect the exchange rate?
A rise in domestic interest rates lowers the demand for real monetary assets
and is associated with a rise in domestic prices thus causing a proportional
depreciation of the domestic currency (through PPP).
7. In accordance with the monetary approach to the exchange rate, how do the
changes in the increase of the domestic level production affect the exchange
rate?
A rise in the domestic level of production raises domestic demand of real
monetary assets and is associated with a decreasing level of average domestic
prices (for a fixed quantity of money supplied) thus causing a proportional
appreciation of the domestic currency (through PPP).

8. Define, explain and derive the Fisher effect.

The Fisher effect describes the relationship between nominal interest rates and
inflation. A rise in the domestic inflation rate causes an equal rise in the interest
rate on deposits of domestic currency in the long run, when other factors remain
constant.

9. Does the practice confirm (absolute) and/or relative purchasing power parity as
a good predictor of changes/behavior of exchange rates?
Little evidence argues in favor of absolute PPP. Prices of identical basket of
goods, when converted into common currency, vary considerably among
countries. Relative PPP is more consistent with the data, but also poorly
predicts exchange rates.

10. What mostly explains shortages of PPP in predicting the changes in exchange
rates? Explain every reason.
The reasons explaining shortcomings of PPP in explaining exchange rates
largely relate to the emergence that lead to violations of the law of one price
and include: trade barriers and the existence of non-traded goods; imperfect
competition (monopolies, oligopolies, cartels); differences in the measurement
of the average price of the basket of goods and services.
11. The other model that tries to predict the exchange rate behavior is based on the
concept of real exchange rate. Define and explain the term of real exchange
rate. Show it with the formula.

Because of the shortcomings of PPP economists have tried to generalize the

monetary approach to PPP to make a better theory. One of such efforts
developed a model based on the real exchange rate. The real exchange rate is
the rate of exchange for goods and services across countries. In other words, it
 is the relative value/price/cost of goods and services across countries. Real
exchange rate (q) can be rewritten as: qUS/EU = (E$/€ x PEU)/PUS.

12. What results in real depreciation of the value of American products compared
to the value of European products in terms of the movement of exchange rates?
A real depreciation of the value of US products means a fall in a dollar’s
purchasing power of EU products relative to a dollar’s purchasing power of US
products. This implies that US goods become less expensive and less valuable
relative to EU goods. This implies that the value of US goods relative to the
value of EU goods falls.

13. What results in real appreciation of the value of American products compared
to the value of European products in terms of the movement of exchange rates?
A real appreciation of the value of US products means a rise in a dollar’s
purchasing power of EU products relative to a dollar’s purchasing power of US
products. This implies that US goods become more expensive and more
valuable relative to EU goods. This implies that the value of US goods relative
to the value of EU goods rises.

14. What and in which way affects the changes in real exchange rates?
A change in relative demand of US products — an increase in relative demand
of US products causes the value of US goods relative to the value of foreign
goods to rise.
A change in relative supply of US products — an increase in relative supply of
US products causes the price/cost of US goods relative to the price/cost of
foreign goods to fall.

1. Economic subjects who are involved in foreign exchange transactions with maturity
at some future date are exposed to what?

When it comes to forward transactions economic subjects are exposed to currency risk.
In the case of floating exchange rates, subjects who need to pay or charge a certain
amount in national currency may, depending on exchange rate fluctuations, get more
or less than they have expected. They either want to cover the risk or not. If they don't
cover the risk, they can make either a profit or a loss, depending on exchange rate
changes. Speculators don't cover the risk hoping to gain due to exchange rate changes.

2. How do we call the process of covering the exchange rate risk? Specify by which
instruments we can protect ourselves against exchange rate risk.
Hedging. Exchange rate risk can be covered by a whole range of instruments; some of
them having very complex structures. These instruments are usually derived from the
basic financial instruments and then adapted for specific roles. This is why we call
them derivative securities or derivatives. Businesses can secure themselves from
foreign exchange risk with forward contracts, swaps, future contracts and options.

3. What is an arbitrage? Explain why they shouldn't exist on the foreign exchange
market?

Arbitrage is simultaneous or nearly simultaneous purchase of foreign currency at a

lower price on one market and sale at a higher price in another market for profit. Due
to a very large number of participants on the foreign exchange market it is a rare and
very short phenomenon (deviation).

4. Define and explain the difference between covered and uncovered interest rate
parity.

Uncovered interest rate parity implies that deposits are equally desirable assets in all
currencies, i.e. they bring the same expected rate of return, expressed in a single
currency. Uncovered interest rate parity implies that arbitrage on the foreign exchange
market isn't possible and that the foreign exchange market is always in balance.

R$ = R€ + (Ee$/€ - E$/€)/E$/€

Covered interest rate parity says that the rates of return on domestic deposits and
"covered" foreign deposits are equal. It connects interest rates between countries with
rate of change between forward and spot rates.

R$ = R€ + (F$/€ - E$/€)/E$/€

1. Explain the law of one price and give an example.

The law of one price claims that, in markets with perfect competition where there are
no transport costs and trade barriers, identical goods will be sold at the same price
when they are expressed in the same currency:

PiUS = (E$/E) x (PiE) for goods i.

E$/E = PiUS/PiUK

If, for instance, the price of CDs in London is lower than the price in NY, US
importers and UK exporters will have an incentive to buy CDs in London and sell
them in New York, thus increasing the price in London and reducing it in NY until
prices are equated in both markets.
3. Explain why it is often argued that a real appreciation of the domestic currency hurts
exporters, while the real depreciation of the domestic currency benefits them.

A real appreciation of the domestic currency may be the result of an increase in

demand for goods that aren‘t tradable (non-tradables) compared to the goods that are
tradable (tradables) which would initiate exchange rate appreciation. An increase in
demand for non-tradable goods increases their price, putting pressure on the general
level of prices and currency appreciation. In this case, the exporters really do suffer.
However, the real appreciation can occur for different reasons and with different
consequences for exporters. The shift in foreign demand in favor of domestic goods
will appreciate the domestic currency in real terms and benefit exporters. Similarly, the
growth of productivity in exports is likely to benefit the exporters although it will
cause real appreciation. To sum up, ceteris paribus, domestic currency appreciation is
usually bad for exporters because their goods become more expensive for foreigners
and this may reduce foreign demand for our goods. In principle, however, we need to
know why the real exchange rate changes in order to comment on whether the change
is good or bad.

4. Explain the Fisher effect and give an example?

An increase in expected inflation, ceteris paribus, in a country will eventually lead to

an equal rise in interest rates on deposits in domestic currency. Similarly, the decline
in expected inflation will lead to a drop in interest rate. If, for example, the expected
US inflation increases from peUS to peUS + ∆peUS, current dollar interest
rate will eventually catch up with higher inflation rising to
∆R$ = ∆peUS. This is in accordance with the monetary approach: in the long run pure
monetary movements shouldn't have an impact on relative prices in the economy
considering that real rate of return on dollar assets remained unchanged.

1.What personal consumption and current account depend on? Show with formula and
explain.
· DETERMINANTS OF CONSUMPTION EXPENDITURE (C)
o Disposable income (Yd): income from production (Y) minus taxes
(T): C = C(Yd)
o More disposable income means more consumption expenditure, but
consumption typically increases less than the amount that disposable
income increases. Why? Because a part of disposable income goes to
savings (real interest rate and wealth also influence but simplicity
wise, we assume they are unimportant)
· DETERMINANTS OF THE CURRENT ACCOUNT(CA)
o the real exchange rate and the disposable income: CA = CA(EP*/P,
Yd )
§ Disposable income (Yd): more disposable income means
increase both for domestic and foreign goods, consequently
more expenditure on foreign products (imports) ; (The
 assumption on which the model is build is that the foreign
disposable income (Yd*) remains unchanged all the time and it
doesn't affect the export)
§ Real exchange rate (q): prices of foreign products relative to
the prices of domestic products, both measured in domestic
currency: EP*/P
· qUS/EU = (E$/€ x PEU)/PUS or, shortly: qUS/EU = EP*/P

2.What does current account measure? How does real appreciation and how real
depreciation of the domestic currency affect the current account balance ? Explain.
o The current account measures the value of exports relative to the value of
imports (ignoring sub factor income and current transfers sub-account):
CA ≈ EX – IM
o The change of the real exchange rate affects also the quantities and the
value of the export and import. If we assume that the impact on qualities is
higher than the impact on the values (which is mostly the case in practice)
we can highlight that:
§ Increase of the real exchange rate (real depreciation) is improving
the current account ( because export increases and import
decreases)
§ Decrease of the real exchange rate (real appreciation) is worsening
the current account (because export is decreasing and import is
increasing)
· Aggregate demand is therefore expressed as: D = C(Y – T) + I + G + CA(EP*/P, Y
– T)
o Real exchange rate: an increase in the real exchange rate increases the
current account, and therefore increases aggregate demand of domestic
products. Decrease of the real exchange rate (real appreciation) leads to the
decrease of the current account which leads to a decreases of the aggregate
demand for domestic goods
o Disposable income: an increase in the disposable income increases
consumption expenditure, but decreases the current account
§ Since consumption expenditure is usually greater than expenditure
on foreign products, the first effect dominates the second effect
aggregate consumption expenditure and aggregate demand increase
by less than disposable income (because of the increase of Yd on
savings)

3.If investments and government spending are fixed, what does aggregate demand of residents
depends on? Show it with formula. Explain shortly every aggregate demand determinant and
show how the aggregate demand is changing if each of the variable is changing
o Real exchange rate: an increase in the real exchange rate increases the
current account, and therefore increases aggregate demand of domestic
products. Decrease of the real exchange rate (real appreciation) leads to the
decrease of the current account which leads to a decreases of the aggregate
demand for domestic goods
o Disposable income: an increase in the disposable income increases
consumption expenditure, but decreases the current account
 § Since consumption expenditure is usually greater than expenditure
on foreign products, the first effect dominates the second effect
§ aggregate consumption expenditure and aggregate demand increase
by less than disposable income (because of the increase of Yd on
savings)

4. What does the DD curve show? What is the slope? Explain why.

shows combinations of output and the exchange rate at which the output market
is in short-run equilibrium (such that aggregate demand = aggregate output or
D=Y).

slopes upward because a rise in the exchange rate causes aggregate demand and
aggregate output to rise.

5. How the increase of the government spending (G) or decrease of tax (T)
affects the DD curve? Explain why.

Changes in G: more government purchases cause higher aggregate demand and

output in equilibrium. Output increases for every exchange rate: the DD curve
shifts right.

Changes in T: lower taxes generally increase consumption expenditure,

increasing aggregate demand and output in equilibrium for every exchange rate:
the DD curve shifts right.

6.What can cause the shift of DD curve to right from the (origin)?

Changes in T, I , P, C and changes in demand of domestic goods relative to

foreign goods

7.What shows the AA curve? What is the slope? Explain why.

● Inverse relation between domestic output and nominal exchange rate is

necessary so that money and foreign exchange market can be in equilibrium
○ On the previous example we could see that if the level of domestic
output increases, exchange rate of the domestic currency needs to
decrease (appreciate) so that the money and foreign exchange market can
stay in equilibrium
○ Because of the increase of output from Y1 to Y2, ceteris paribus, cause an
increase of the domestic interest rate and the appreciation of the
domestic currency (decrease of the exchange rate from E1 to E2) the AA
curve has a negative (decreasing) slope
 8. How the increase of the domestic money supply (MS) affects AA curve?
Explain why.

1. Changes in Ms: an increase in the money supply, ceteris paribus, reduces

interest rates in the short run, causing the domestic currency to depreciate (a
rise in E) for every Y: the AA curve shifts up (right).

9. What can cause the shift of AA curve to right from the (origin)?

1. Changes in the demand of real monetary assets: if domestic residents are

willing to hold a lower amount of real money assets and more non-monetary
assets, interest rates on nonmonetary assets would fall, leading to a depreciation
of the domestic currency (a rise in E): the AA curve shifts
up (right).
2. Changes in R*: An increase in the foreign interest rates makes foreign currency
deposits more attractive, leading to a depreciation of the domestic currency (a
rise in E): the AA curve shifts up (right).
3. Changes in Ee: if market participants expect the domestic currency to
depreciate in the future, foreign currency deposits become more attractive,
causing the domestic currency to depreciate (a rise in E): the AA curve shifts up
(right).

10.Economic policy, also refers to monetary and fiscal policy. Explain shortly what
monetary and fiscal policy mean.

o Monetary policy: policy in which the central bank influences the

supply of monetary assets
§ Affects directly asset markets, indirectly (with time lag) output
market
§ If there is a problem on asset market, if possible fix it with MP
(optimal), if not possible fix it with FP (suboptimal)
 § Expansionary (Ms↑)
§ Contractionary (Ms↓)
o Fiscal policy: policy in which governments (fiscal authorities)
influence the amount of government purchases and taxes
§ Affects directly output (goods and services) market, indirectly
(with time lag) asset market (foreign exchange & money
market)
§ If there is a problem on output market, if possible fix it with FP
(optimal), if not possible fix it with MP (suboptimal)
§ Expansionary (G↑ AND/OR T↓)
§ Contractionary (G↓ AND/OR T↑)
11.How temporary changes in monetary policy (increase of money supply) affect the
equilibrium in the short run (intersection of AA an DD curves)? Show it on graph and
explain.
§ Ms↑ , R↓ , E , (AA shifts right)

12. How temporary changes in fiscal policy (increase of government spending) affect
the equilibrium in the short run (intersection of AA an DD curves)? Show it on graph
and explain.
● § G↑ OR T↓ , D↑ , D=Y , Y↑ (DD shifts right) , Md↑ , R↑ , E↓ (app.)
 ●

13.If temporary decrease of world demand for domestic goods occurs what can be the
answer and whit which impacts of fiscal and monetary policy? Show the answer on the
graph and explain.
o 1) EX↓ (temporary fall in world demand for domestic products) ,
CA↓ , D↓ , D=Y , Y↓ (DD shifts left) ; (Y2 < Y1)
o Policy makers want to ↑ Y and they have at disposal fiscal and
monetary policy. Since the problem/shock happened on ouput (good)
market, fiscal policy is optimal (first best) and should be used. If not
possible, monetary policy , which is suboptimal (second best) should
be used
§ FISCAL POLICY (first best)
· Expansionary (G↑ AND/OR T↓) , (DD curve shifts
right)
o Y1 –> Y2 –> Y1
o E1 –> E2 –> E1
§ MONETARY POLICY (second best)
· Expansionary (Ms↑) , (AA curve shifts right)
o Y1 –> Y2 –> Y1
o E1 –> E2 –> E3
§ Huge cost in terms of nominal ex. Rate
dep.
14.Why are the economic policies which wants to obtain the full employment mostly
inefficient in practice? Explain.
o Policies to maintain full employment may seem easy in theory, but
are hard in practice
§ 1)At the shown graphs we have assumed that prices and
expectations do not change, but economic subjects in reality
may anticipate the effects of policy changes and modify their
behavior
· Workers may require higher wages if they expect
overtime and easy employment, and producers may
raise prices if they expect high wages and strong
demand due to monetary and fiscal policies
· Fiscal and monetary policies may therefore create price
changes and inflation, thereby preventing high output
and employment: inflationary bias
§ 2)Economic data are difficult to measure and to understand
· Policy makers cannot interpret data about asset markets
and aggregate demand with certainty, and sometimes
they make mistakes
§ 3)Changes in policies take time to be implemented and to affect
the economy
· Because they are slow, policies may affect the economy
after the effects of an economic change have dissipated
§ 4)Policies are sometimes influenced by political or bureaucratic
interests, lobbies

15.What is the main difference between temporary and permanent changes in

economic policies? Explain.
● ”Permanent” policy changes are those that are assumed to modify people’s
expectations about exchange rates in the long run
 ● Temporary policy changes are expected to be reversed in the near future and
thus do not affect expectations about exchange rates in the long run

16.How can economic policies influence the current account balance? Explain
separately the possible effects of fiscal and monetary policy on the current account.
§ Economic policies affect the current account through their
impact on the domestic currency value:
· Increase of the money supply leads to a depreciation of
the domestic currency in the short run that results
mostly in the improvement of the current account
balance in the short run
· Increase in the government spending or in tax reduction
leads to an appreciation of the domestic currency and
mostly results in deterioration of the current account
balance in the short run