Real World Economic Activity

1

• Real World Economic Activity

Data Collection
Economic Analysis
Economic Theory
Models
2
The Quantity Theory
Equation 1
Equation 2
Equation 3
3

• Quantity Theory of Price Adjustment

2 M0
M
M0
time
t
2P0
P
P0
time
Q0
Q0
Q0
Q
time
4

• Extreme Macro Instability

5
The Purchasing Power Parity
Equation 4
Equation 5
6

• Purchasing Power Parity and Overshooting

2M0
M
M0
time
E
P,E
2P0, 2E0
P0,E0
P
time
7
Unpleasant Monetarist Arithmetic
Equation 6
8

• Unpleasant Monetarist Arithmetic
• Sargent and Wallace P vs P

Deficit
time
Bonds
Money, Bonds
Money
time
t
P
Price Level
P
time
9
The Absorption Model of the Balance of Trade
Equation 7
Equation 8
10

• United States Current Account and Fiscal Balance,
  1968-1992

11
Further Implications
Equation 9
Equation 10
Equation 11
Equation 12
12
Balance of Payments
BOP Current Account Capital Account
Under fixed exchange rates only Change in
Foreign Exchange Reserves BOP
13

• Fiscal and External Balances, USA

14
Organization and Characteristics of FOREX Markets

• Spot and forward markets
• Many buyers and sellers, so no buyer or seller
  dominates
• Transactions are quick, buy/sell decisions have
  to be made very quickly
• Low transactions costs
• Open virtually 24/7.

15
Reasons to Use FOREX Markets

• Export and Import Transactions
• Triangular arbitrage in the Spot Market
• Hedging on foreign investment
• Forward speculation
• Interest arbitrage
• Engage in a speculative attack on a foreign
  currency (aka hedge fund management)

16

• Demand and Supply of
• Foreign Exchange

R(,DM)
German Supply of DM
R
US Demand for DM
DM
17

• Responses to Overvaluation
• Devaluation and Fiscal Contraction

R(,DM)
German Supply of DM
R
New US Demand
R
Trade Deficit
US Demand for DM
DM
18
Conditions for a Devaluation to Work , or not!

• Marshall-Lerner conditions must hold elasticity
  of foreign demand for export good and elasticity
  of domestic demand for import good must sum to
  value greater than unity.
• Example imports are oil, exports are wheat.
  Devaluation may actually make BOT worse! People
  will still buy oil and just need so much wheat.
  Elasticity pessimism.

19
Further conditions why devalution may not work

• Issue of contractionary devaluation imports may
  be inputs in production so devaluation may cause
  a fall in investment, employment, output
• Harberger-Laursen-Metzler effect devaluation
  worsens income, so net saving falls quickly, so
  there is a savings-investment imbalance, and the
  trade balance falls.

20

• Multiple Equilibria in ForEx Market

R
B
Demand
A
Supply
C
DM
21
J-Curve Dynamics
Trade Balance
Devaluation
0
time
22
Triangular Arbitrage
Equation 13
Equation 14
Equation 15
23

• Covered Interest Parity

K dollars
US investment
K(1r)
(K/R)(1r) FR
sell forward
buy spot
UK investment
K/R sterling
(K/R)(1r)
24
Covered Interest Rate Parity
Equation 16
Equation 17
Equation 18
Equation 19
Equation 20
Equation 21
25
Measuring Capital Mobility
Equation 22
Equation 23
Equation 24
Equation 25
26
Real Exchange Rate
Non-tradeables
Real Exchange Rate
NT
Tradeables
T
27
The Real Exchange Rate
Equation 26
Equation 27
Equation 28
28

• U.S. Real Exchange Rate Swings, 79-81

29
Classification of Policy Regimes
Exchange Rate Regime
Fixed
Flexible
Instrument
STRONG
WEAK
Monetary Policy
Fiscal Policy
WEAK
STRONG
30
The Mundell-Fleming Model of Fixed Exchange Rates
Equation 29
31

• Mundell - Fleming Model
• General Equilibrium

IS
r
LM
FF
E

Y
32
Endogeneity of the Money Supply
Equation 30
33

• Mundell - Fleming Model
• Effects of Monetary Expansion

r
LM
LM
FF
E
E
IS
Y
34

• Mundell - Fleming Model
• Effects of Fiscal Expansion

r
LM
LM
FF
E
IS
E
IS
Y
35

• Mundell - Fleming Model
• Effects of Devaluation

r
LM
LM
FF
E
FF
IS
Y
36
Swan Diagram Internal/External Balance
r
II
Bexternal surplus, internal inflation
EE
Aexternal deficit, internal inflation.
G-T
37
The Dornbusch Model of Flexible Exchange Rates
Equation 31
38
Dornbusch Model Basic Setup
e
DD
A
AA
p
39
Dornbusch Model Monetary Expansion with
Overshooting
e
DD
B
C
AA
AA
A
p
40

• Wicksell's Problem

Sweden
timber
Norway
fish
ultimate flows
Denmark
wheat
intermediate flows
41

• Bilateral Exchange Arrangements-Unbalanced Flows

A
B
D
C
42

• Ds Money as Medium of Exchange, Barter between A
  and B

A
B
D
C
43

• As and Bs Money as Media of Exchange

A
B
D
C
44
Borrowing and Lending Strategies
Lending
Borrowing
Period 1
r1
i1
r
i
Period 2
i2
r2
Positive maturity transformation
45
The Phillips Fixed-Coefficient Model of the
Banking System
Equation 32
Equation 33
46
Internal Structure of Eurodollar Market
Borrowers
Lenders
USA
London
Europe
47
Eurodollar Market and OPEC Recycling
Borrowers
Lenders
USA
LDC Borrowers
OPEC Deposits
London
Europe
48

• Manufacturing, Resources, and Service Sector
  Economy

D-m
D-r
D-s
w
w

Manufacturing employment
Resource employment
Services
R
O
O'
M
49

• Manufacturing, Resources, and Service Sector
  Economy-
• Direct Deindustrialization Due to Boom in
  Resource Sector
• M-M' Direct De-industrialization Effect

D-m
D-r
D-s
W
w
R
O
O'
M
M'
50

• Manufacturing, Resources, and Service Sector
  Economy-
• Indirect Deindustrialization Due to Boom in
  Ensuring Service-Sector Boom
• M'-M'' Indirect De-industrialization Effect

D-m
D-r
D-s
w''
w'
w
M
R
M'
M''
O
O'
51
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Secondary Market Value
B
C

• A

Nominal Value of Debt
55
Seignorage and Dollarization Multiple Equilibria
Equation 34
Equation 35
56
Inflation Laffer Curve
?
Deficit
A
B
? (M/P)
57

• Inflationary Dynamis in a Dollarized Indexed
  Economy

Oil Shock
Manufacturing
50 Import Component
50 wages
Devaluation
COLA
Price of Output
Indexed Gov't Debt
Dollarization
Monetary Growth
Fiscal Deficit
58
Figure 1Instruments of Markets

• Structure of Financial Markets

Banks
Acceptances
Time and Saving Deposits
CD's
Mortgages
Parallel loans and currency swaps
Mortgage-backed securities
Bonds
Repurchase Agreements
T'Bills
Long-term bonds
Commercial Paper
Stripped and zero coupon bonds

Heaven and hell bonds
Dual currency bonds
warrants and convertible bonds
Swapsdebt for equity
Prime and score securities
Equity
Optioned and non-optioned equity
Poisoned pills
Preferred stock
Foreign Exchange
call/put option
spot
forward
future
59
Figure 2

• Trading Structure in Financial Markets

Structured/ embedded
Over-the- counter
Exchange-traded
Convertibles
Swaps
Futures
Warrants
Options
60
Figure 3

• Nikkei-linked bond with puts

put
Investor
Issuer
coupon,premium
put
premium
Arranging bank
put
premium
Investor
61
Figure 4

• Equity derivative swap, two-sided

appreciation
Bank A
Bank B
depreciation
premium (upfront or LIBOR flow)
62
Figure 5

• Customized derivative swap

premium for call at 22,000
appreciation
Bank A
Investor
5
T-notes at 5
appreciation in Nikkei over 22,000
63
Figure 6

• Equity Derivative Swap with Embedded Options

LIBOR Prem
Bank Y
Bank X
Index apprec.
Knock-out on Nikkei
Yen/ Quanto
64
Figure 7

• Swap Credit Exposure Regulatory Approach

CEM
OEM
Credit conversion
Mark to market
Swap credit risk
Swap credit risk
Swap credit risk
Swap credit risk
65
Figure 8

• Creation of a Differential Swap

i-US
i-US
Company Y
Bank A
Bank B
US fixed
i-DM less SPR
DM fixed
i-DM
Bank C
i-DM and i-US DM and US LIBOR