International Economy Lecture Notes

Open Economy Macroeconomics Lecture Notes
Open Economy Macroeconomics
Ozan Hatipoglu
Department of Economics, Bogazici University
Spring 2014
Ozan Hatipoglu (Department of Economics)
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Foreign Exchange (FX) Markets -Definition, Functions and

Features
Definition: A market where national currencies are bought and sold
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Features

Transfers purchasing power from one currency to another and allows
for international transactions.
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Features

Provides credit for foreign trade
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Features

Facilitates hedging against currency shocks
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Features

Largest market in the world in terms of trade volume (over $6 trillion
daily in spot, forward and swaps)
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Features

24 hours trading and no trading limit
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Features

24 hours trading and no trading limit
No commissions by brokers but bid-ask spread required by dealers
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International Transactions
Occur between individuals, firms, governments, international agencies.
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Trade : Turkish firm sells a good to a US firm. Either the US firm pays
in TL by converting $ into TL or pays in $ and the Turkish firm
converts it to TL. Trade practice of exporting Turkish firms: get paid in
foreign currency if it is Euro or $ otherwise TL.
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Trade : Turkish firm sells a good to a US firm. Either the US firm pays
in TL by converting $ into TL or pays in $ and the Turkish firm
converts it to TL. Trade practice of exporting Turkish firms: get paid in
foreign currency if it is Euro or $ otherwise TL.
Foreign Direct Investment(FDI). Example : US definition: Foreign
Direct Investment is defined as whenever a US citizen, organization, or
affiliated group takes an interest of 10 percent or more in a foreign
business entity. It includes setting up a business, buying an office block
etc.
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Portfolio Investments:This is an investment by individuals, firms or

public bodies (ex. national and local governments) in foreign financial
instruments. Foreign financial instruments include government bonds
and foreign stock.
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and foreign stock.
The biggest difference between FDI and Foreign Portfolio Investment is
that Foreign Portfolio Investment is not associated with a significant
equity stake or in other words management privileges.
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and foreign stock.
Aid : Humanitarian, Goods and Services, Infrastructure Aid , Debt
Relief, Education Aid
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and foreign stock.
Remittances : Ex: Workers Remittances
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and foreign stock.
Remittances : Ex: Workers Remittances
Foreign in this context means foreign national or entity established in
another country. Ex: Garanti Bank International is a foreign firm.
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Types of FX Rate
Bilateral: Between two countries
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Types of FX Rate

Effective or trade-weighted (Multilateral): Weighted by the proportion
of each countrys trade volume in total trade volume.
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Types of FX Rate

Nominal FX Rates: Actual Rates
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Types of FX Rate

Real FX rates: Adjusted by price differentials in two countries
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Types of FX Rate

Real FX rates: Adjusted by price differentials in two countries
Real Effective FX rates: Adjusted by price differentials in the set of
trade partners. TCMB reports two types of Real Effective FX rate (
vs. Developed and vs. Developing Countries)
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Types of FX Rate
Real FX Rate is a sign of the degree of competitiveness.
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Types of FX Rate

Spot vs. forward rates.
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Types of FX Rate

Spot vs. forward rates.
Buying vs. Selling ( Bid vs. Ask). Spread=Bid-Ask0 Spread
increases during weekends, holidays, turbulent times.
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Definitions:
A bilateral spot exchange rate, St , is domestic currency price of unit
of foreign currency FX, so a rise in S (S ), is a fall in value of
domestic currency. (Except for US and UK other than pound vs.
dollar)
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Definitions:
dollar)
Cross exchange rate, Stcross is bilateral exchange rate between two
currencies other than Turkish Lira. e.g.
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Definitions:
dollar)
Cross exchange rate = ratio of two bilateral exchange rates against
the TL, Stcross = Ste / St$
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Definitions:
dollar)
Let StB = Bid Rate and StA = Ask Rate.
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Definitions:
dollar)
Suppose the buyer wants to buy $. Dealer asks StA for 1 $ and Buyer
asks 1/StA for 1TL.
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Definitions:
dollar)
Suppose the buyer wants to buy $. Dealer asks StA for 1 $ and Buyer
asks 1/StA for 1TL.
Suppose the buyer wants to buy TL. Dealer asks 1/StB for 1 TL and
Buyer asks StB for 1$.
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Demand for FX
Turkish establishments demand $ in exchange for TL in order to

import from or invest in USA (and all other international transactions
mentioned above)
Total excess demand/supply eliminated instantaneously by exchange rate

movement
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Demand for FX

mentioned above)
US establishments demand TL in exchange for $ in order to import
from or invest in Turkey(and all other international transactions
mentioned above)
movement
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Demand for FX

mentioned above)
US establishments demand TL in exchange for $ in order to import
from or invest in Turkey(and all other international transactions
mentioned above)
Speculators buy or sell TL (sell or buy $)
movement
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Equilibrium in FX Market: UK Example
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Appreciation and Depreciation
S : means depreciation
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S : means appreciation
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Exception: Real Effective Exchange Rates reported by TCMB
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Suppose S $ , there are two possibilities:
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1
International Value of TL has gone up or TL has appreciated.
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1
2

US$ vs. TL has gone down.(or Lira gained value against $)
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1
2

Theorem
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1
2

Theorem
If S $ while all other currencies in terms of TL remain the same 2
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1
2

Theorem
If S $ while all other currencies in terms of TL remain the same 2
If S $ while all other currencies in terms of TL 1
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Balance of Payments (BOP)
Definition
All transactions between Turkey and the rest of the world(ROW) in a
given year. It serves as flow of demand and supply for TL.
It consists of
1
Current Account,
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Definition
It consists of
1
Current Account,
Capital and/or Financial Account
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Definition
It consists of
1
Current Account,
Capital and/or Financial Account
Balancing Item.
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BOP Items: Current Account

Current account (CRA): Here and now. Export receipts (X) as
credits, import payments (M) as debits, net = current account
balance (goods, services including financial services, interest and
dividends, rent, tourism)
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1
Visibles (merchandise account): traded goods, processed goods,

repairs on goods, gold, purchase of capital goods such as machinery,
aircrafts
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1

aircrafts
Invisibles (service account): rights, licenses, insurance, tourism and

other intangibles
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1

aircrafts

other intangibles
Interests, Profits and Dividends: rents from capital services, e.g.

rental income, interest on deposit accounts, dividend payments on
stocks, other profits transfers.
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1

aircrafts

other intangibles
Interests, Profits and Dividends: rents from capital services, e.g.

rental income, interest on deposit accounts, dividend payments on
stocks, other profits transfers.
Transfers: workers remittances, aid.
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BOP Items: Capital Account

Capital/financial account(CPA): net capital inflows = net purchases
of TL by foreigners in order to acquire claims on Turkey residents less
net sales of TL by Turkey residents in order to acquire claims on
foreigners (Long term including securities equities, bonds, real estate
etc + short term including bank deposits, short term securities)
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1
FDI : real estate, buying a Turkish company by foreigners or foreign

company by Turkish residents, setting up a factory, purchase of
machinery and factory in order to produce within that country.
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1

Portfolio Investment: equities, bonds, securities.
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1
2
3

Other investment: commercial credit lending by banks, nonbank
institutions, individuals, IMF loans.
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1
2
3

Change in Official Reserves: CB FX reserves
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1
2
3

Balancing Item: Current Account+Capital Account=-Balancing Item
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1
2
3

Balancing Item: Current Account+Capital Account=-Balancing Item

visit http://tcmb.gov.tr/odemedenge/odmain.html for Turkish
practice.
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While the overall BOP accounts will always balance when all types of
payments are included, imbalances are possible on individual elements
of the BOP, such as the current account, the capital account
excluding the central banks reserve account.
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BOP deficit refers to a situation when current account plus the
capital account (except the reserves) is negative. In other words
sources of funds ( all exports, bonds sold) is less than uses of funds
(imports, bonds purchases)
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BOP Deficit 6= Current Account Deficit 6= Capital Account Deficit
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BOP imbalances are due to: the exchange rate, the governments
fiscal deficit, business competitiveness, and private behaviour such as
the willingness of consumers to go into debt to finance extra
consumption. Ben Bernanke argues that the primary driver is the
capital account, where a global savings glut caused by savers in
surplus countries, runs ahead of the available investment
opportunities, and is pushed into the US resulting in excess
consumption and asset price inflation
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BOP imbalances are due to: the exchange rate, the governments
fiscal deficit, business competitiveness, and private behaviour such as
the willingness of consumers to go into debt to finance extra
consumption. Ben Bernanke argues that the primary driver is the
capital account, where a global savings glut caused by savers in
surplus countries, runs ahead of the available investment
opportunities, and is pushed into the US resulting in excess
consumption and asset price inflation
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Relationship Between BOP and FX rate regime
Under pure float: Total net underlying demand for TL = CRA

surplus+CPA surplus =Basic balance is equated to zero by exchange
rate movement, unless
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Relationship Between BOP and FX rate regime
Under pure float: Total net underlying demand for TL = CRA

surplus+CPA surplus =Basic balance is equated to zero by exchange
rate movement, unless
Under fixed rates: Government intervenes to fix exchange rate, in
which case. Item for 4 in CPA :CB FX reserves= CRA+CPA to
prevent basic balance causing exchange rate to move
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Balance of Payments: Crisis and Balancing Mechanisms

A BOP crisis (currency crisis) occurs when a nation is unable to
service its debt repayments and/or to pay for essential imports. It
generally is coupled with a fast depreciation of home currency.
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Balance of Payments: Crisis and Balancing Mechanisms

A BOP crisis (currency crisis) occurs when a nation is unable to
service its debt repayments and/or to pay for essential imports. It
generally is coupled with a fast depreciation of home currency.
General Mechanism: Large Capital Inflows over Time (either due to
finance high economic growth, in this case to finance investment / or
due to excessive consumption, in this case to finance consumption (
and lower savings)) unsustainable levels of debt creates a chain of
events: investors pull out their funds by selling domestic currency
denominated assets causing rapid depreciation of home currency
Local banks and firms run in to sudden debt problems because their
revenues are in local currency but their existing debt is in foreign
currency the central bank can support the currency as long as it
has enough FXreserves, but once reserves fall below a certain level
chooses to increase interest rates to prevent outflows prevents
currency depreciation and reduces the value of debt in domestic
currency however, the domestic economy is depressed recession
follows.
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Theories about Exchange Rate Determination
Purchasing Power Parity (PPP)
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1
Law of One Price
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1
2
Law of One Price

PPP Extensions
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1
2
Law of One Price

PPP Extensions
1
Harrod-Balassa-Samuelson
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1
2
Law of One Price

PPP Extensions
1
2
Trade Costs(Iceberg) Model
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1
2
Law of One Price

PPP Extensions
1
2
3
Incomplete Pass-Through
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1
2
Law of One Price

PPP Extensions
1
2
3
Uncovered Interest Rate Parity
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1
2
Law of One Price

PPP Extensions
1
2
3
Uncovered Interest Rate Parity

Covered Interest Rate Parity
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Law of One Price

Definition
The law of one price: Two goods, if they are identical, must sell for the
same price.
Domestic Economy
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Law of One Price

Definition
same price.
Domestic Economy
The law of one price in the context of domestic economy the
relationship holds if transaction costs are allowed: e.g.,
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Law of One Price

Definition
same price.
Domestic Economy
PI = PA + C where PI , PA is the price of the same good in Istanbul
and Ankara respectively and C is the transaction cost (transportation,
local taxes, etc.).
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Law of One Price

Definition
same price.
Domestic Economy
PI = PA + C where PI , PA is the price of the same good in Istanbul
and Ankara respectively and C is the transaction cost (transportation,
local taxes, etc.).
Open Economy PI = SPP + C where PI , PP is the price of the same

good in Istanbul and Paris respectively and S is the TL/Euro
exchange rate.
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PPP and Real Exchange Rate

Definition
The PPP relation is given by Pi = SPi for i = 1, ..., N where Pi is the
domestic price of good i and Pi is the foreign price of good i and S is the
exchange rate or P = SP where P is domestic price index and P is the
foreign price index
Definition
The real exchange rate, Q, between two countries is given by Q =
SP
P .
Corollary
If PPP holds then Q = 1.
Example: When PPP adjusted India s GDP is 3,608 billion dollars as
opposed to 1,704 billion dollars calculated with nominal exchange
rates. Denmark GDP per head: PPP adjusted: $37,500 vs. Nominal
Exch Rate: $62,100
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PPP and Inflation

Theorem
If PPP holds then the rate of home currency depreciation rate is equal to
difference between home and foreign inflation rates.
Proof.
Taking logarithms and derivatives of both sides of P = SP
log(P ) = log(S ) + log(P )
= dS /S + dP /P
dS /S = dP/P dP /P
| {z }
| {z }
| {z }
depreciation = inflation
inflation
dP/P
In reality PPP fails most of the time.
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PPP and Transaction Costs

Let K be a constant that represents the total costs of conducting
international trade including tariffs, etc.
= KSP
log(P ) = log(K ) + log(S ) + log(P )
P
Theorem
If trade costs are constant, then they do not affect the currency
depreciation rate
Proof.
Taking the derivative above yields
dS /S = dP/P
| {z }
| {z }
depreciation = inflation
dP /P dK /K
| {z }
| {z }
inflation change in trade costs
but dK = 0
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Harrod, Balassa and Samuelson Effect

Definition
The observation that consumer price levels in wealthier countries are
systematically higher than in poorer ones (the Penn effect).
Definition
An economic model predicting the above, based on the assumption that
productivity or productivity growth-rates vary more by country in the
traded goods sectors than in other sectors (the BalassaSamuelson
hypothesis)
Workers in some countries have higher productivity than in others.
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Definition
Definition
hypothesis)
Certain labour-intensive jobs such as those in services are less
responsive to productivity innovations than others.
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Definition
Definition
hypothesis)
Certain labour-intensive jobs such as those in services are less
responsive to productivity innovations than others.
Some of the fixed-productivity sectors are also the ones producing
non-transportable goods (for instance haircuts) - this must be the
case or the labour intensive work would have been off-shored.
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Harrod, Balassa and Samuelson Effect(contd)

To equalize local wage levels with the (highly productive) Zurich
engineers, McDonalds Zurich employees must be paid more than
McDonalds Moscow employees, even though the burger production
rate per employee is an international constant.
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The CPI is made up of:
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local goods/services (which are expensive relative to tradables in rich
countries)
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countries)
Tradables, which have the same price everywhere
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countries)
Tradables, which have the same price everywhere
The (real) exchange rate is pegged (by the law of one price) so that
tradable goods follow PPP (purchasing power parity) but not local
goods.. PPP holds only for tradable goods. Entirely tradable goods
cannot vary greatly in price by location (because buyers can source
from the lowest cost location). But most services must be delivered
locally (e.g. hairdressing) which makes PPP-deviations sustainable.
The Penn effect is that PPP-deviations usually occur in the same
direction: where incomes are high, average price levels are typically
high.
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PPP Extensions- Arbitrage in goods.
Goods arbitrage only profitable when price deviation exceeds

transactions costs, C , so:
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If price deviation P P < C , no trade
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If price deviation P P > C , trade.
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But C different for each trader and each type of good
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When price deviation large (small), arbitrage (not) profitable for most
traders/goods
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When price deviation large (small), arbitrage (not) profitable for most
traders/goods
In general, larger the price deviation, greater volume of arbitrage and
more rapid is real exchange rate adjustment
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Iceberg Model
Does the importer or the exporter pay the shipping cost?
PC =
SPC
1
where
PC : price of Brie cheese (produced in France) in France
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Iceberg Model
PC =
SPC
1
where
PC : price of Brie cheese (produced in France) in Turkey
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Iceberg Model
PC =
SPC
1
where
: proportion of every unit of goods lost due to shipping cost
(melting iceberg)
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Iceberg Model
PC =
SPC
1
where
(melting iceberg)
similarly
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Iceberg Model
PC =
SPC
1
where
(melting iceberg)
similarly
PH = (1 ) SPH
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Iceberg Model
PC =
SPC
1
where
(melting iceberg)
similarly
PH = (1 ) SPH
PH :price of hazelnut(produced in Turkey)in France
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Iceberg Model
PC =
SPC
1
where
(melting iceberg)
similarly
PH = (1 ) SPH
PH :price of hazelnut(produced in Turkey)in France
PH : price of hazelnut(produced in Turkey) in Turkey.
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Trade Costs and Iceberg Model(contd) and Incomplete

Pass-Through
Combining the above

P
PH
= (1 )2 H
PC
PC
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Pass-Through
Combining the above

P
PH
= (1 )2 H
PC
PC
Result: Hazelnuts (Brie) are (1 )2 % expensive relative to
Brie(Hazelnuts) in Turkey(France). Price distortions multiply
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Pass-Through
Combining the above

P
PH
= (1 )2 H
PC
PC
Result: Hazelnuts (Brie) are (1 )2 % expensive relative to
Brie(Hazelnuts) in Turkey(France). Price distortions multiply
Incomplete Pass Through: Exporters and/or importers do not reflect
changing costs to prices.
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Uncovered Interest Rate Parity(UIRP)

Assume investors are risk neutral, i.e. they are indifferent between a
safe bet and a lottery that offer the same expected return.
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Let r be the domestic interest rate of a financial instrument with N
periods to maturity.
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Let r be the foreign interest rate of the same financial instrument
with N periods to maturity.
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Let r be the foreign interest rate of the same financial instrument
with N periods to maturity.
Definition
In the absence of hedging opportunities, the relationship between domestic
and foreign interest rates are given by
(1 + r ) =
Et (St +N )
(1 + r )
St
where Et (St +N ) is the expected spot exchange rate at t + N as of time t.

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UIRP Example
Ayse has 10TL. Let St = 1.6(TL/$), r = 8%, r = 5%(US ),

Et (St +1 ) = 1.8. Should Ayse invest in Turkey or US?
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UIRP Example

If Ayse is risk neutral than she will pick the bet with higher return.
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UIRP Example

10 (1 + 0.08) = 10. 8TL Return from investing in Turkey
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UIRP Example

1
10 1.6
(1 + 0.05) 1.8 = 11. 813TL Expected Return from
investing in US.
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UIRP Example

1
10 1.6
(1 + 0.05) 1.8 = 11. 813TL Expected Return from
investing in US.
Should invest in US
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UIRP example(contd)
Et (St +N )
St
(1+r )
(1+r )
, subtract 1 from both sides
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UIRP example(contd)
(1+r )
(1+r )
Et (St +N )St
= ((11++rr)) 1 = expected depreciation
St
= S e ....Given r = 5%
Et (St +N )
St
rate
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UIRP example(contd)
(1+r )
(1+r )
Et (St +N )St
= ((11++rr)) 1 = expected depreciation
St
= S e ....Given r = 5%
Et (St +N )
St
rate
An increase in r results in either Et (St +N ) or St or both. If

long-run equilibrium is fixed Et (St +N ), then only St .
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UIRP example(contd)
Find the expected spot rate that leaves Ayse indifferent between
investing in US and Turkey.
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UIRP example(contd)
Et (St +N ) =
(1+r )
S
(1+r ) t
1.08
1.05
1.60 = 1. 645 7
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UIRP example(contd)
Et (St +N ) =
(1+r )
S
(1+r ) t
1.08
1.05
1.60 = 1. 645 7
An alternative formulation of the UIRP:
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UIRP example(contd)
Et (St +N ) =
(1+r )
S
(1+r ) t
1.08
1.05
1.60 = 1. 645 7

Let
Et (St +N )St
St
= S e
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UIRP example(contd)
Et (St +N ) =
(1+r )
S
(1+r ) t
1.08
1.05
1.60 = 1. 645 7

E (S
)S
t
Let t t +SNt
= S e
(1 + r ) = (1 + r )(1 + S e ) or (1 + r ) = 1 + r + S e + r S e
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UIRP example(contd)
Et (St +N ) =
(1+r )
S
(1+r ) t
1.08
1.05
1.60 = 1. 645 7

E (S
)S
t
Let t t +SNt
= S e
(1 + r ) = (1 + r )(1 + S e ) or (1 + r ) = 1 + r + S e + r S e
but r S e 0 therefore r = r + S e (UIRP approximate version)
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Risk Premium
In general, agents demand a reward (risk premium) for the risks they
take.
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Risk Premium
take.
Definition
Risk premium is the anticipated excess return.agents demand in return for
taking the risk. A risk averter requires positive risk premium. A risk
neutral is willing to undertake the risk for zero risk premium. A risk lover
is willing to pay a premium in order to take the risk.
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Risk Premium
take.
Definition
For a risk lover U (100) < 12 U (150) + 21 U (50) : convex U
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Risk Premium
take.
Definition
For a risk neutral U (100) = 12 U (150) + 21 U (50) :linearU
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Risk Premium
take.
Definition
For a risk neutral U (100) = 12 U (150) + 21 U (50) :linearU
For a risk averse U (100) > 12 U (150) + 21 U (50) :concaveU
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Forward and Futures Contracts

Definition
A forward contract (or a forward) is a non-standardized contract between
two parties to buy or sell an asset at a specified future time at a price
agreed today. The party agreeing to buy the underlying asset in the future
assumes a long position, and the party agreeing to sell the asset in the
future assumes a short position. The price agreed upon is called the
delivery price, which is equal to the forward price at the time the
contract is entered into.
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Forward and Futures Contracts

Definition
A forward contract (or a forward) is a non-standardized contract between
two parties to buy or sell an asset at a specified future time at a price
agreed today. The party agreeing to buy the underlying asset in the future
assumes a long position, and the party agreeing to sell the asset in the
future assumes a short position. The price agreed upon is called the
delivery price, which is equal to the forward price at the time the
contract is entered into.
Definition
A futures contract is a standardized financial contract, in which two
parties agree to transact a set of standardized financial instruments or
physical commodities for future delivery at a particular price. In futures
contracts parties can exchange additional property securing the party at
gain (margin call) and the entire unrealized gain or loss builds up while the
contract is open.
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Futures Example
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Futures Example
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Futures Example
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Futures Example
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Futures Example
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With hedging opportunities, the relationship between domestic and foreign
interest rates are given by
(1 + r ) =
Ft
(1 + r )
St
where Ft is the forward rate at t + 1 as of time t. Note that Ft = St at

the maturity date.
= ((11++rr)) , subtract 1 from both sides to get covered interest rate

parity (CIRP)
Ft
St
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(1 + r ) =
Ft
(1 + r )
St

the maturity date.

parity (CIRP)
Ft
St
F t St
St
(1+r )
(1+r )
1 = f =forward premium (discount) if f > 0 (< 0)
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(1 + r ) =
Ft
(1 + r )
St

the maturity date.

parity (CIRP)
Ft
St
F t St
St
(1+r )
(1+r )
A forward premium is the proportion by which a countrys forward

exchange rate exceeds its spot rate.
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(1 + r ) =
Ft
(1 + r )
St

the maturity date.

parity (CIRP)
Ft
St
F t St
St
(1+r )
(1+r )

Rewriting (1 + r ) = (1 + r )(1+ f ), r f 0
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(1 + r ) =
Ft
(1 + r )
St

the maturity date.

parity (CIRP)
Ft
St
F t St
St
(1+r )
(1+r )

Rewriting (1 + r ) = (1 + r )(1+ f ), r f 0
r = r + f (CIRP approximate version)
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Borrowing and Lending

Consider an importer who has to make a payment of X in foreign currency
at some future date: His options are:
1. pay immediately (i.e. buy foreign exchange spot) and settle his
debt. Costs: If he already has the funds: opportunity cost of not
holding domestic funds : it X . If he does not have any funds: interest
rate payment when he pays back it X . (Assume for now borrowing and
lending costs are the same) Benefits: discount that he will get because
X .
he pays now, which will be related to foreign interested rate: X 1+
i
t
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X .
it
2. buy foreign exchange spot and invest in foreign country : Costs:
Same as above.Benefits: He will earn foreign interest payment it X
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X .
it
2. buy foreign exchange spot and invest in foreign country : Costs:
Same as above.Benefits: He will earn foreign interest payment it X
3. buy foreign exchange forward: The settlement is in the future
therefore there is no payment now. His costs will depend on the
forward premium (or discount) . His total costs are: Ft X
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pay immediately (i.e. buy foreign exchange spot) and settle his debt.
X (1 + i ) Why? S X is the amount he
Total opportunity cost: St 1+
t
t 1+i
it
t
needs to raise now due to discount and (1 + it ) is the cost of not
holding domestic funds.
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t
t 1+i
it
t
buy foreign exchange spot and invest in foreign country : Total
X (1 + i ) Why? because he will only need to
opportunity cost: St 1+
t
i
t
X now in a foreign bank to raise S X = S X (1 + i ) in

invest St 1+
t
t 1+i
t
it
t
the future and (1 + it ) is the cost of not holding domestic funds.
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t
t 1+i
it
t
buy foreign exchange spot and invest in foreign country : Total
X (1 + i ) Why? because he will only need to
opportunity cost: St 1+
t
i
t
X now in a foreign bank to raise S X = S X (1 + i ) in

invest St 1+
t
t 1+i
t
it
t
the future and (1 + it ) is the cost of not holding domestic funds.
Decision : Note 1 and 2 are equivalent so the choice is between (1 or
X (1 + i ) If F <S
2 ) and 3. Ft X QSt 1+
t
t
t 1+i (1+i ) choose 3
i
t
otherwise (1 or 2). Rearranging this condition:
F t St
St
(1+r )
(1+r )
1 =
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An investor who has a liability(an asset) denominated is said to have
a short (long) position in that currency. The net position is given by
the difference between long and short positions. There are two types
of arbitrages
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of arbitrages
Uncovered
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of arbitrages
Uncovered
example: investing in US or Turkey for interest arbitrage without
forward contracts
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of arbitrages
Uncovered
forward contracts
1 January1: Investing in Turkey: Borrow 1.60TL(short TL) at 8% and
place on one year deposit(long TL) with 8% interest. Investing in US:
Borrow 1.60TL(short TL) at 8%, buy $ at 1.60, deposit(long $) in US
for a year with 5% interest.
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of arbitrages
Uncovered
forward contracts
2 Net position in Turkey =long(1.60x1.08)-short(1.60x1.08)=0. Net
E (S )
position in US= t Stt +1 1.60 1.05 (1.60 1.08) 6= 0
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of arbitrages
Uncovered
forward contracts
2 Net position in Turkey =long(1.60x1.08)-short(1.60x1.08)=0. Net
E (S )
position in US= t Stt +1 1.60 1.05 (1.60 1.08) 6= 0
3 December 31. Investing in Turkey: Liquidate
deposit(1.60TL 1.08 = 1. 728TL) pay back loan (1.60 1.08 = 1.
728TL) Net profit=0TL Investing in US: Liquidate
deposit($1 1.05 = $1. 05), convert it to TL at the spot price(e.g.
1.70),$1.05 1.70 = 1. 785TL , pay back loan (1.60 1.08 = 1.
728TL) Net profit=1.785 1.728 = 0.057 TL
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Borrowing and Lending(contd)

Covered.
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Covered.
example: investing in US or Turkey for interest arbitrage with forward
contracts
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Covered.
contracts
1
January1: Investing in Turkey: Borrow 1.60TL(short TL) at 8% and

Short 1.60TL at 8%, buy 1$ at 1.60, deposit(long $) in US for a year
with 5% interest and enter a short forward contract in $
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Covered.
contracts
2 Net position in Turkey =long(1.60 1.08)-short(1.60 1.08)=0. Net
position in US = FStt 1.60 1.05 1.60 1.08 If CIRP holds then
1
(1+r )
F t = ( 1 + r ) St =
1.08
1.05
St and the net position in US=0.
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Covered.
contracts
2 Net position in Turkey =long(1.60 1.08)-short(1.60 1.08)=0. Net
position in US = FStt 1.60 1.05 1.60 1.08 If CIRP holds then
1
(1+r )
Ft = (1+r ) St = 1.08
1.05 St and the net position in US=0.
3 December 31. Investing in Turkey: Liquidate
deposit(1.60TL 1.08 = 1. 728TL) pay back loan (1.60 1.08 = 1.
728TL) Net profit=0TL Investing in US: Liquidate
deposit($1 1.08 = $1. 05), convert it to TL at the forward
1.08
1.60 = 1.645 7) ,$1.05 1.645 7 = 1.728 , pay back loan
price( 1.05
(1.60 1.08 = 1. 728TL) Net profit=1.728 1.728 = 0 TL
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In the UIRP example the currency risk associated with investing in

Turkey is 0, and in US it is
At (1 + r ) At (1 + r ) Et (St +1 )/St where At is the initial
asset.
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asset.
In the CIRP example the currency risk associated with investing in
Turkey and US is 0. In the above example the currency risk is 0
because of the assumption that CIRP holds. In reality,
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asset.
the forward rates reflect the risk premium associated with investing in
that particular country.
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asset.
the forward rates reflect the risk premium associated with investing in
that particular country.
While the currency risk is zero, the profits are still uncertain. If
St +1 > Ft then investing in US without hedging would have resulted in
greater profits
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Real Interest Rate

Future sacrifice required per unit of extra consumption today
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Real Interest Rate

Definition
The relationship between real, r , and nominal interest rate, i, is given by
(1 + i ) = (1 + r )(1 + p e ) or in approximate form by i = r + p e (Fisher
equation) where p e is the expected inflation rate.
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Real Interest Rate

Definition
Corollary
Take two countries i i = (r r ) + (p e p e ) by UIRP
i i = S e therefore S e = (r r ) + (p e p e ).If there is full
capital mobility, r = r therefore S e = (p e p e ) (PPP in
expectations).
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Real Interest Rate

Definition
Corollary
expectations).
Note that p e is unobservable therefore at any given time R is also
unobservable.
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Real Interest Rate

Definition
Corollary
expectations).
Note that p e is unobservable therefore at any given time R is also
unobservable.
Methods of estimating p e : Use surveys, or econometric forecast
methods.
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Efficient Market Hypothesis
If all investors are fully informed about market conditions all the time,
then prices fully reflect all available information and there are no arbitrage
opportunities. For example, if the markets are efficient, f = S e .
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National Income Accounting in Open Economy

C : Consumption Expenditure on Domestic and Foreign Goods and
Services
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Services
G : Government Expenditure of Domestic and Foreign Goods and
Services
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Services
Services
I : Investment Expenditure on Domestic and Foreign Goods and
Services.
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Services
Services
Services.
1
Business fixed investment spending on plant and equipment that firms

will use to produce other goods and services
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Services
Services
Services.
1

Residential fixed investment spending on housing units by consumers
and landlords
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Services
Services
Services.
1

and landlords
Inventory investment: the change in the value of all firms inventories
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Services
Services
Services.
1

and landlords
X :Exports
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Services
Services
Services.
1

and landlords
X :Exports
M:Imports (Consumption, Government and Investment Expenditure
on Foreign Goods and Services)
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Services
Services
Services.
1

and landlords
X :Exports
S: Savings
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Services
Services
Services.
1

and landlords
X :Exports
S: Savings
T : Taxes and TR : transfers
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Three Approaches To Calculate National Income
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1
Expenditure
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1
2
Expenditure
Income
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1
2
3
Expenditure
Income
Production
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Expenditure Approach
Households, Business, Government and Foreign Sector Expenditures.
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National Income Identity in an open economy is given by:
Y = C + I + G + X M where Y is gross domestic product.
(GDP). Imports, M, are subtracted to prevent double counting.
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S pri = Yd C is private savings where Yd is the disposable income.
Yd = Y T + TR. T is taxes collected by the government, TR
transfers made by the government to private sector.
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pri
S
| {z }I =
G
| T{z+ TR}
X
|
{z M}
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pri
S
G
| {z }I =
| T{z+ TR} + X
|
{z M}
Private Surplus = Gov. Deficit + CA Balance
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pri
S
G
| {z }I =
| T{z+ TR} + X
|
{z M}
Note GDP is a flow variable and not a stock variable.
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pri
S
G
| {z }I =
| T{z+ TR} + X
|
{z M}
Note GDP is a flow variable and not a stock variable.

GDP is product produced within a countrys borders; GNP (Gross
National Product) is product produced by enterprises owned by a
countrys citizens.
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Income Approach
The income approach divides GDP according to types of income

generated. GDP consists of:
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Income Approach

Wages and salaries, Corporate profits (dividens, corporate income
taxes, undistributed profits), Proprietors income (the profits of
partnerships and soley owned businesses, like a family restaurant),
Farm income, Rent, Interest (interest payments by businesses only),
Sales taxes (it is an income but later get paid to the govt),
Depreciation (the amount of capital that has worn out during the
year)
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Income Approach

Wages and salaries, Corporate profits (dividens, corporate income
taxes, undistributed profits), Proprietors income (the profits of
partnerships and soley owned businesses, like a family restaurant),
Farm income, Rent, Interest (interest payments by businesses only),
Sales taxes (it is an income but later get paid to the govt),
Depreciation (the amount of capital that has worn out during the
year)
GDP = compensation of employees + gross operating surplus + gross
mixed income + taxes less subsidies on production and imports
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Production Approach
The production approach looks at GDP from the standpoint of value

added by each input in the production process
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Production Approach

Example
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Production Approach

Example
1
Farmer buys seeds and produces wheat. Value added#1= Sale of

Wheat = Value of producing and collecting wheat
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Production Approach

Example
1

Whole retailer packages wheat and transports the wheat to factory
Value added#2=Sale of Wheat-Cost of Wheat= Value of packaging
and shipping wheat
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Production Approach

Example
1

and shipping wheat
Baker cooks bread. Value added#3=Sale of Bread-Cost of Wheat=
Value of baking a bread.
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Production Approach

Example
1

and shipping wheat
Baker cooks bread. Value added#3=Sale of Bread-Cost of Wheat=
Value of baking a bread.
GDP= Value addedi
i
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Expenditure Approach revisited
Examples of GDP component variables
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C, I, G, and NX(net exports): If a person spends money to renovate a
hotel to increase occupancy, the spending represents private
investment, but if he buys shares in a consortium to execute the
renovation, it is saving. The former is included when measuring GDP
(in I), the latter is not. However, when the consortium conducted its
own expenditure on renovation, that expenditure would be included in
GDP.
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C, I, G, and NX(net exports): If a person spends money to renovate a
hotel to increase occupancy, the spending represents private
investment, but if he buys shares in a consortium to execute the
renovation, it is saving. The former is included when measuring GDP
(in I), the latter is not. However, when the consortium conducted its
own expenditure on renovation, that expenditure would be included in
GDP.
If a hotel is a private home, spending for renovation would be
measured as consumption, but if a government agency converts the
hotel into an office for civil servants, the spending would be included
in the public sector spending, or G.
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If the renovation involves the purchase of a chandelier from abroad,

that spending would be counted as C, G, or I (depending on whether
a private individual, the government, or a business is doing the
renovation), but then counted again as an import and subtracted from
the GDP so that GDP counts only goods produced within the country.
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If the renovation involves the purchase of a chandelier from abroad,

that spending would be counted as C, G, or I (depending on whether
a private individual, the government, or a business is doing the
renovation), but then counted again as an import and subtracted from
the GDP so that GDP counts only goods produced within the country.
If a domestic producer is paid to make the chandelier for a foreign
hotel, the payment would not be counted as C, G, or I, but would be
counted as an export.
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S national = S pri + S gov = (Y T + TR ) C + (T G TR ) =

Y C G
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Y C G
therefore S national I = Y C G I = X M = CA
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Y C G
By BOP equilibrium: S national I =net foreign investment.
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Y C G
Is CA < 0 necessarily a bad thing?
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Y C G
Comparison between ability to consume more today and paying more
later.
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Y C G
later.
S pri vs. S gov
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Y C G
later.
S pri vs. S gov
Investment and Growth vs. Consumption
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Y C G
later.
S pri vs. S gov
Investment and Growth vs. Consumption
Decisions on S gov makes taxpayers part of the deal!
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Defining Variables of Interest
Assumptions
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Assumptions
Define B = X (Q ) M (Q, y )
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Assumptions
B B (Q, y )
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Assumptions
B B (Q, y )
where Q =
SP
P
and
B
Q
> 0, B
y < 0
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Assumptions
B B (Q, y )
SP
P
S (y , r ), S
y
where Q =
and
B
Q
0, S
r
> 0, B
y < 0
>
>0
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Assumptions
B B (Q, y )
SP
B
P and Q
S
S S (y , r ), S
y > 0, r
I
I I (r ), r
<0
where Q =
> 0, B
y < 0
>0
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Assumptions
B B (Q, y )
SP
B
P and Q
S
S S (y , r ), S
y > 0, r
I
I I (r ), r
<0
where Q =
> 0, B
y < 0
>0
G + TR T is exogenously given
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IS Curve
S (y , r ) I (r ) = G + TR T + B (Q, y ) (IS curve).
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IS Curve
S (y , r ) I (r ) = G + TR T + B (Q, y ) (IS curve).
Definition
IS curve is the combination of income and interest rate pairs such that the
net private savings cover the financing requirements of government and
the foreign sector.LEAKAGES (T + S + M) out of the system must equal
INJECTIONS (G + TR+ I + X) for the circular flow to balance (be in
EQUILIBRIUM)
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IS Curve
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IS Curve
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IS Curve
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IS Curve
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An increase in Government Expenditure
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An increase in Real Exchange Rate.
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LM Curve
Relationship between the demand for money and national income

(ignoring the opportunity cost)
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LM Curve

Md = kY
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LM Curve

Md = kY
where Md is the demand for money and Y national income, both
measured in nominal terms.
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LM Curve

Md = kY
where Md is the demand for money and Y national income, both
measured in nominal terms.
k positive constant.
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LM Curve
Define nominal national income Y as follows:
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LM Curve

Y = Py where y is real income and P is the price level.
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LM Curve

We can also introduce opportunity costs
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LM Curve

Md
P
= ky lr
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LM Curve

Md
P
= ky lr
or MPd
Md
P (y , r )
Note that
Md
P
(y ,r )
y
> 0,
Md
P
(y ,r )
r
<0
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LM Curve
Let Ms be the nominal money supply and ms =

supply.
Ms
P
be the real money
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LM Curve
Let Ms be the nominal money supply and ms =

supply.
Ms
P
be the real money
Definition
The Equilibrium condition in the money market is given by ms = ky lr
or ms = m (y , r )
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LM Curve
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LM Curve
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LM Curve
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LM Curve
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An increase in Money Supply.
.
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Monetary System and the Banking Sector
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For the Central Bank: FX + LG = MB
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For Commercial Banks MB b + L = D, Given D, L is determined by
MBb .
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MBb .
The reserve requirement, RR, is the percentage of Commercial Banks
deposits to be held with Central Bank as a precaution or the the
percent of deposits banks are not allowed to lend
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MBb .
Combining both balance sheets FX + LG + MB b + L = MB + D
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MBb .
Combining both balance sheets FX + LG + MB b + L = MB + D
or FX + DC = MB p + D where DC = L + LG is total domestic
credit and MB p = MB MB b is currency circulation.
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Assets of Major Central Banks as a Percentage of GDP
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European Central Bank
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Control of Money Supply
FX + DC = MB p + D = Money Supply = M s
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FX + DC = M s
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FX + DC = M s
Money supply can be controlled by Central Bank via changes in
Spring 2014
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FX + DC = M s
1
Reserve/Borrowing Requirements (through reserve requirement ratio

(DC and MB p ) or discount interest rate (MB p ))
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FX + DC = M s
1

Open Market Operations (selling and buying Reserves (FX ), or via
buying and selling Treasury Bills (MB p ))
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FX + DC = M s
1

Open Market Operations (selling and buying Reserves (FX ), or via
buying and selling Treasury Bills (MB p ))
Public Cash Holding (not really a policy tool but CB may pursue
policies to increase confidence in the banking system)
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Central Bank Roles

monetary policy (control inflation, economic growth, employment,
financial stability)
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Central Bank Roles

There might be conflicts among roles such as controlling infation and
creating employment or growth.
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Central Bank Roles

control money supply
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Central Bank Roles


managing FX and gold reserves
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Central Bank Roles


setting official interest rates
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Central Bank Roles


lender of last resort
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Central Bank Roles


issue currency
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Central Bank Roles


issue currency
regulator and supervisor of commercial banks (now BDDK setting
capital requirements for banks)
Spring 2014
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Exchange Rate Regimes and The Central Bank
Under pure float: FX = 0 only DC affects M s , therefore DC

= M s .M s is exogenous and St is endogenous.
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Exchange Rate Regimes and The Central Bank
Under pure float: FX = 0 only DC affects M s , therefore DC

= M s .M s is exogenous and St is endogenous.
Under fixed rates: FX 6= 0, CA balance-CAP balance determine
FX therefore M s is endogenous and St is exogenous and St = 0.
Under fixed rates independent (independent of exchange rate
movements) monetary policy is impossible.
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Deriving Aggregate Demand
The equilibrium on the demand side is given by (y , P) pairs such that
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1
S (y , r ) I (r ) = (G T + TR ) + B (Q, y ) (IS)
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1
2
S (y , r ) I (r ) = (G T + TR ) + B (Q, y ) (IS)
M s = m (y , r ) (LM)
P
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1
2
3
S (y , r ) I (r ) = (G T + TR ) + B (Q, y ) (IS)
M s = m (y , r ) (LM)
P
M s = (G T + TR ) + B (Q, y ) where Q = SP
P
P
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1
2
3
S (y , r ) I (r ) = (G T + TR ) + B (Q, y ) (IS)
M s = m (y , r ) (LM)
P
M s = (G T + TR ) + B (Q, y ) where Q = SP
P
P
We want to express the equilibrium in (y , P ) plane because prices will

from the link between aggregae demand and aggregate supply.
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Deriving Aggregate Demand (Ex: A reduction in prices)
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Policy Analysis: Relaxation of Monetary Policy

Suppose Ms0 , Ms0 Ms1 where Ms1 > Ms0
Spring 2014
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Ms1
P
> ky lr , : Excess money supply, So quantity of money

demanded has to increase, money demanded increases when r or
y or both.
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Ms1
P

y or both.
If y = y0 is constant than r1 < r0 where r0 is the original interest rate
1
and MPs = ky0 lr1
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Ms1
P

y or both.
1
and MPs = ky0 lr1
But y0 , r1 can not be an equilibrium in goods market because:
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Ms1
P

y or both.
1
and MPs = ky0 lr1
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
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Ms1
P

y or both.
1
and MPs = ky0 lr1
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
Therefore y0 y1 where y1 > y0 and r1 r2 where r2 > r1
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Ms1
P

y or both.
1
and MPs = ky0 lr1
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
This is a movement on LM.
Ms1
P
= ky1 lr2 = ky0 lr1
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Ms1
P

y or both.
1
and MPs = ky0 lr1
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
1
This is a movement on LM. MPs = ky1 lr2 = ky0 lr1

No shift in IS curve because
S (y , r ) I (r ) = G T + TR + B (Q, y ). No exogenous change here.
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Ms1
P

y or both.
1
and MPs = ky0 lr1
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
1
This is a movement on LM. MPs = ky1 lr2 = ky0 lr1

No shift in IS curve because
S (y , r ) I (r ) = G T + TR + B (Q, y ). No exogenous change here.
The exact change in r and y is determined by the slopes of IS and
LM curves.
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Spring 2014
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Spring 2014
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Policy Analysis: Increase in G

Suppose G , G 0 G 1 where G 1 > G 0
Spring 2014
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S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Spring 2014
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S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
IS curve shifts right. To retain eq., r or y or both.
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
If r = r0 is constant than y1 > y0 where y0 is the original interest rate
and S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ).
Spring 2014
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S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
But yo , r1 can not be an equilibrium in money market because:
Spring 2014
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S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
P < ky1 lr0 therefore r0 r1 where r1 > r0 and y1 y2 where
y2 < y1
Spring 2014
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S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
This is a movement on IS
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ) =
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ) =
= S (y2 , r1 ) I (r1 ) = G 1 T + TR + B (Q, y2 )
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ) =
= S (y2 , r1 ) I (r1 ) = G 1 T + TR + B (Q, y2 )
As r investment crowds out.I (r1 ) < I (r0 )
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ) =
= S (y2 , r1 ) I (r1 ) = G 1 T + TR + B (Q, y2 )
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ) =
= S (y2 , r1 ) I (r1 ) = G 1 T + TR + B (Q, y2 )
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
No shift in LM curve there is no exogenous change.
Spring 2014
85 / 93

S (y0 , r0 ) I (r0 ) < G 1 T + TR + B (Q, y0 ).
Ms
y2 < y1
S (y1 , r0 ) I (r0 ) = G 1 T + TR + B (Q, y1 ) =
= S (y2 , r1 ) I (r1 ) = G 1 T + TR + B (Q, y2 )
S (y0 , r1 ) I (r1 ) < G T + TR + B (Q, y0 )
No shift in LM curve there is no exogenous change.
The exact change in r and y is determined by the slopes of IS and
LM curves.
Spring 2014
85 / 93
Spring 2014
86 / 93
Exchange Rate Regimes
Pure float
(CB reserves=0)
Spring 2014
87 / 93
Pure float
(CB reserves=0)
Managed Float (CB reserves6=0)
Spring 2014
87 / 93
Pure float
(CB reserves=0)

Target Zone
Spring 2014
87 / 93
Pure float
(CB reserves=0)

Target Zone
Fixed
Spring 2014
87 / 93
Pure float
(CB reserves=0)

Target Zone
Fixed
Currency Board (Domestic currency backed 100% by foreign currency)
Spring 2014
87 / 93
Pure float
(CB reserves=0)

Target Zone
Fixed
Currency Board (Domestic currency backed 100% by foreign currency)
Full Dollarization
Spring 2014
87 / 93
Pure Float
Spring 2014
88 / 93
Some Exchange Rate Regimes
Pure float(Flexible Float): exchange rate at any moment determined

by net demand for currency.
Spring 2014
89 / 93

Fixed exchange rate: central bank(CB) intervenes by
Spring 2014
89 / 93

buying up excess supply of $ with TL (when TL strong, $ weak). This
operation adds $ to FX reserves, adds to TL in circulation or
Spring 2014
89 / 93

satisfying excess demand for $ by selling $ for TL (when TL weak, $
strong), so as to prevent excess demand /supply affecting the rate.
This operation takes $ out of FX reserves, reduces TL in circulation.
Sometimes fixed rate regimes are associated with restrictions on FX
transactions such as a ban on FX holdings.
Spring 2014
89 / 93

satisfying excess demand for $ by selling $ for TL (when TL weak, $
strong), so as to prevent excess demand /supply affecting the rate.
This operation takes $ out of FX reserves, reduces TL in circulation.
Sometimes fixed rate regimes are associated with restrictions on FX
transactions such as a ban on FX holdings.
Managed Float(Dirty Float): CB intervenes at its discretion.
Spring 2014
89 / 93
Exchange Rates in 20th Century

Prior to 1939: Gold Standard. Change in money supply=Change in
gold reserves. Huge increases in gold reserves after 1890.Period
described by high inflation, protectionism and competitive
devaluation.
Spring 2014
90 / 93

devaluation.
1944: Bretton Woods: Fixed FX rate system.
Spring 2014
90 / 93

devaluation.
Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US
$ fixed at 1 oz gold = $35, all other currencies fixed to $ with 1%
fluctuation bands, devaluations to correct persistent deficits.(Gold
Window) Other currencies fixed to dollar. Foundation of IMF to
police FX rate system to assure convertibility.
Spring 2014
90 / 93

devaluation.
Mechanism of Bretton Woods: Gold Exchange Standard. 1944-68 US
$ fixed at 1 oz gold = $35, all other currencies fixed to $ with 1%
fluctuation bands, devaluations to correct persistent deficits.(Gold
Window) Other currencies fixed to dollar. Foundation of IMF to
police FX rate system to assure convertibility.
Breakdown of Bretton Woods: 1968-73 Parities set at war levels.
Rapid expansion of Europe and Japan caused huge pressures on
exchange rate. US printed excess $ (Vietnam, Public Spending), $
became overvalued and gold became undervalued causing worldwide
inflation and flight into gold, other currencies (DM, Yen). France
hoarded gold. In 1971 Nixon closed the Gold Window.
Spring 2014
90 / 93
Exchange Rates in 20th Century (contd)
Floating Era 1973 onward managed floats for most convertible

currencies at first, but later experiments with limited fixed systems
e.g. EMS in Europe, currency boards in Hong Kong, Argentina,
Spring 2014
91 / 93

EMS tied to a basket of currency.(DM, Fr) EMU 1998 onward
response to failure of fixed exchange rates
Spring 2014
91 / 93

EMS tied to a basket of currency.(DM, Fr) EMU 1998 onward
response to failure of fixed exchange rates
Increasing importance of Asian exchange rates 2000 onward especially
RMB, Won, Rupee (varying degrees of flexibility/convertibility,
increasingly linked to $/e/Yen currency basket)
Spring 2014
91 / 93
Before and After EMU
Spring 2014
92 / 93
Exchange Rates in Turkey

1923-1929 Floating Rates: Reference Currency is . March 1929:
0.88TL/. December 1929: 1.25TL/. 1929-1946 Fixed Rates.
Spring 2014
93 / 93

1946 onwards fixed rates: Reference Currency is $ . 1946 :TL is
devaluated from 1.30TL/$ to 2.80.TL/$. 1955 from 2.80.TL/$ to
5.25TL/$. 1958 from 5.25TL/$ to 9TL/$.. 1970 to 15TL/$. Starting
from 1974 IMF rules: 2% adjustments cap for each currency. apprx.
3 adjustments a year.
Spring 2014
93 / 93

24 December 1980: from 26TL/$ to 70TL/$. More frequent
adjustments 246 times in 1983. 1983 commercial banks allowed to set
their own rates.Ban on private FX holdings lifted.
Spring 2014
93 / 93

1988 Switch to full convertibility and CB starts managed floating
Spring 2014
93 / 93

5 April 1994. Switch to managed floating with inflation expectations
as an anchor
Spring 2014
93 / 93

as an anchor
Starting from 2000.Target zone with up to 22.% bandwidth with
inflation target as an anchor.
Spring 2014
93 / 93

as an anchor
Starting from 2000.Target zone with up to 22.% bandwidth with
inflation target as an anchor.
Free float with CB intervention compatible with inflation target.
Spring 2014
93 / 93

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Open Economy Macroeconomics Lecture Notes

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Definition: A market where national currencies are bought and sold

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Foreign Exchange (FX) Markets -Definition, Functions and

Definition: A market where national currencies are bought and sold

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Definition: A market where national currencies are bought and sold

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Definition: A market where national currencies are bought and sold

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