IV. Stabilization policy
B. Foreign exchange markets
3. Exchange rate determination
b. The asset market approach to ER changes

Results of interest arbitrage:

    Implication for basic monetary theory: 
    Closed economy: Fed, by regulating bank reserves, controls quantity of credit available to the economy, and therefore i-rates. 
    Open economy with mobile financial assets: Eurocurrency market has largely taken control of i-rates away from Fed.
    Monetary policy now mainly affects ERs

    Perfect interest parity is not met in practice because of:
    --Transaction costs
    --Controls on asset mobility
    Systematically the case that foreign asset transactions are more profitable than domestic ones. Unclear if traders simply can't learn to predict well, or if traders insist on a risk premium.

For our purposes, reasonable to assume perfectly mobile financial assets

c. Combining PPP and IPC

    PPP => %DEPPP = %DPfor - %DPdom
        ER changes offset differences in inflation to equalize goods and services prices across countries
    IPC => %DEIPC = ifor - idom
        ER changes offset differences in interest rates to equalize rates of returns across countries

    It turns out we can fit the PPP model into the IPC model:

    Recall from macroeconomics:
    What does the real interest rate (r) mean? inflation-adjusted
    r = i - %DP =>
    i = r + %DP

    1: PPP: stabilizes the real exchange rate when inflation rates differ
    2: real IPC: destabilizes the real exchange rate when real interest rates differ

    What makes currencies get undervalued or overvalued?
    Lowering your real i-rate --> K-outflows --> real depreciation, making the currency undervalued
    Raising your real i-rate --> K-inflows --> real appreciation, making the currency overvalued

    See Combining PPP and the IPC handout

Resulting time path for R     This offers economists' best explanation of the cyclical behavior of ERs:     PPP accounts for why ER changes tend to be neutral in the long run.     IPC accounts for why ERs tend to deviate from their PPP levels in the short run.

C. Foreign sector geometry

    We've now set the table for analysis of international investment
    1. international transactions: CA and foreign financial assets
    2. ERs and the key role of the real ER (R) vs. the nominal rate (E)

    Goal now: turn to how international investment actually plays out in an open economy

    Key assumptions:
    --Financial assets are freely mobile internationally
    --The economy is too small to affect global interest rates
    --Many traded products are imperfect substitutes for each other
    --Floating exchange rates

1. Basic setup

    Notation:
        NX = net exports (approximately = CAB)
        NFI = net foreign investment

    Recall from international transactions--these are always the same size.

        NX º NFI --gives us 2 curves to draw

    Horizontal axis: NX and NFI values
    Vertical axis: R
    Simplified notation: NX and CAB assumed to mean the same thing

Curve (1) NX     ? What direction will it slope?     NX tends to slope down because of international competitiveness considerations.     real depreciation (-R) => domestic products more competitive => +NX     real appreciation (+R) => domestic products less competitive => -NX

Note: With floating ERs, if foreign investments don't occur, NX always = 0.
    countries would use exports to pay for imports, just as we assumed back in the trade part of the course

    Curve (2) NFI

Slope:     ? All else equal, suppose R suddenly rises, making the currency overvalued--how would you expect savers to respond?     NFI slopes up because of  reactions by savers to unexpected ER fluctuations. (based on the IPC)     Unexpected +R => Overvalued ER--> capital outflows     Unexpected -R => Undervalued ER --> capital inflows