Notes: ECON 182 / International Monetary Economics

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I My friend Lauren took these notes for ECON 182: International Monetary Economics taught by Maurice Obstfeld. I PNP’d this class, so I’m not sure if the content below is accurate. I gave up after the midterm. Cool content though.


National Income Accounting

National income is the income earned by national factors of production. Gross national product (GNP) refers to all final goods and services produce by those factors of production:

\[GNP = C + I + G + CA\]

GNP must be adjsuted for depreciation and unilateral transfers (foreign aid, reparations, pensions, etc). In contrast, gross domestic product refers to final goods/services produced in a country.

\[GDP = GNP - \text{Foreign payments for production} + \text{Payments to foreign} - \text{Unilateral transfer payments}\]

Exports increase net foreign wealth, while imports decrease it.

Savings is gross national product minus consumption and government spending:

\[S = Y - C - G = I + CA\]

Savings can be subdivded into private savings (saved disposable income) and government savings (net tax revenue):

\[S = S^p + S^p = (Y - T - C) + (T - G)\]

Balance of Payments

A credit increases a liability/equity account or decreases an asset/expense account, while a debit increases an asset/expense account or decreases a liability/equity account. Debits are inflows, credits are outflows.

  1. Current account: Flows of goods and services in imports and exports.
  2. Financial account: Flows of financial assets in financial transactions.
  3. Capital account: Non-market intangibles, e.g. debt forgiveness, copyrights, trademarks.
Examples of Accounting
1. Suppose you import a fax machine from Olivetti and Olivetti deposits the check in a U.S. bank. The current account decreases by $1,000 and the financial account increases by $1,000. 2. You buy lunch in France and pay by credit card, which is recieved from a U.S. bank. The current account decreases by $200 and the financial account increases by $200. 3. You buy a share of BP, which deposits the money in a bank. The cfinancial account decreases by $95 from the stock purchase but increases by $95 from the deposit.

Foreign Exchange

Depreciation and appreciation refer to decreases and increases int he value of a currency, respectively. The terms of trade are the price of imports in terms of exports. A higher relative import price denotes worse terms of trades.

Foreign exchange (forex) markets are comprised of commercial banks, non=-bank financial institutions (hedge funds, mutual funds, insurance, pension funds), non-financial businessses, and central banks.

Spot rates refer to exchange rates on the spot. Forward rates apply for some future exchange, often a month to a year in the future. Other derivatives include foreign exchange swaps, future contracts, and options contracts.

Demand for currency deposits depends on four factors:

  1. Rate of return: is the change in value that an asset return.
  2. Real rate of return: Adjusted for inflation, which is in turn influenced by interest rates and expectations.
  3. Risk: E.g. if uncorrelated with economy.
  4. Liquidity: Ease of usage.

The uncovered interest parity (UIP) condition states that interest rates in country c ($R_c$) and country b ($R_b$) are identical after adjusting for the exchange rate $E$ and the expect exchange rate $E^e$.

\[R_c = R_b + \frac{E^e - E}{E}\]

An increase in interest rates increases the value of returns and appreciates the currency.

The covered interest parity condition relates the forward ($F$) and spot ($E$) exchange rate. It always holds because otherwise, investors could exploit the arbitrage opportunity.

\[R_c = R_b + \frac{F - E}{E}\]


Money is a store of value, means of payment, and unit of account. Monetary demand ($M^d) is the amount of monetary assets people are willing to hold, affected by interest rates, inflation risk, and liquidity. Usually, monetary demand rises with interest rates, prices ($P$), and income ($Y$).

\[M_d = P \times L(R, Y)\]

The monetary supply ($M^s$) reaches an equilibrium at $\frac{M^s}{P} = L(R, Y)$. In the long run, wages adjust to prices, in turn impacting labor and real output. Monetary supply rises with excess demand na dinflationary expectations. Permanent changes in monetary supply cause proportional changes in appreciation/depreciation$.

Exchange rate overshoot refers to the overreaction of exchange rates to monetary supply changes.

Price Levels

The Law of One Price (LOOP) dictates that the same good must sell for the same price in competitive markets when barriers are absent.

$P_c = E * P_b$

Purchasing power parity (PPP) applies LOOP for all goods and services. Absolute PPP states taht exchange rates equal the level of average prices across countries:

\[E = \frac{P_c}{P_b}\]

Relative PPP states that changes in exchange rates mirrors inflation; it’s weaker than absolute PPP.

\[\frac{E_t - E_{t-1}}{E_{t-1}} = \pi_c - \pi_b\]

The monetary approach to exchange rates begins with the assumption that $M^S = M^D$. Predictions:

  • A permanent increase in money supply depreciates the currency without affecting foreign price level.
  • Greater interest rates lower money demand and increase price level, depreciating the currency.
  • Increases in output decrease the price level and appreciate the currency.

The Fisher effect states that a rise in domestic inflation causes an equal rise in home interest rate in the long run:

$R_c - R_b = \pi_c - \pi_b$

The effect of interest rates on exchange rates depends on why $R$ rises:

  • If nominal interest rates rise due to inflation, the currency depreciates.
  • If nominal interest rates rise due to increased real interest rates, the currency appreciates.

After a one-shot rise in $M^s$, the price level $P$ is sticky and pushes the interest rate down.

LOOP might not hold in the presence of trade barriers, imperfect cmopetition, and different baskets. Balassa-Samuelson theory speculates that non-tradables and price levels are higher in richer countries. Bragwan-Krans-Lipsey theory hypothesizes taht non-tradables are labor-intensive and thereby cheaper in poor countries.

Real interest rate is the relative price of goods and services across countries.

\[q = \frac{E \times P_b}{P_c}\]

Increase in relative demand for U.S. products decreases foreign demand. Increase in the relative supply of U.S. goods increases foreign demand.

Short-Run Output and Exchange Rate

Aggregate demand is determined by consumption $C$, investment $I$, governemnt purchases $G$, and capital balance $CA$.

Consumption is determined by disposable income $Y^d$. The current account is determined by the real exchange rate $\frac{EP^*}{P}$ and disposable income. Usually, a higher exchange rate improves the current account by increase trade volume. Although the relative value of imports will be higher, the volume effect usually dominates the value effect.

Put together, aggregate demand is expressed as:

\[D(\frac{EP^*}{P}, Y-T, I, G) = C(Y - T) + I + G + CA(\frac{EP^*}{P}, Y-T)\]

The DD schedule is upward sloping and shows output and exchange rates at short-run equilibriums. The curve shifts right when $\frac{EP^*}{P}$ rises, $Y-T$ falls, $I$ rises, or $G$ rises.

The asset market is determined by the forex and domestic money markets. The AA schedule is downward sloping. The curve shifts right when $M^s$ rises, $P_c$ falls, $i_b$ rises, or $E$ rises.

The AA-DD diagram displays the superequilibrium between the AA and DD schedules.

Monetary policy involves the central bank influencing $M^s$, affecting AA. Fiscal policy involves changing $G$ or $T$, which affects DD.

Fiscal policy can cause crowd out, as a stronger domestic currency can hurt net exports.

Pass through is the proportion by which imports change when the value of domestic currency changes. The DD-AA model assumes 100% passthrough, but in reality, firms can decide not to match exchange rate changes, dampening the effect of appreciation/depreciation on the current account.