Welcome to EC 382 International Economics By Dr Jacqueline Khorassani Week Eleven 1 Week Eleven Class 1 Tuesday November 13 14 10 15 00 AC 202 2 I received a question Can you please explain again with some examples the open market operations thank you 3 Answer Bank of Ireland has some government bonds If the central bank wants to increase the supply of money Offer higher than normal prices for bonds Bank of Ireland sell their 1000 bond to the central bank Central bank makes a 1000 deposit into their Bank of Ireland Reserve Account at the central bank Bank of Ireland s reserves goes up Bank of Ireland make more loans that means the people borrowers will have more money in their checking accounts borrowed M1 goes up MS goes up 4 The central bank supplies money Who demands money Firms individuals 5 Why do we demand money M1 1 To buy goods and services Transactions demand for money Varies directly with nominal GDP 2 In case of emergencies that require purchases above normal spending levels Precautionary demand for money 3 As an asset 6 Three motivations for holding money combine to create the aggregate demand for money If interest rates go up do we demand more or less money Less interest rate is the opportunity cost of holding money If the price level goes up do we demand more or less money More need more money to cover our purchases 7 If our income goes up will we demand more or less money More Can afford to buy more goods and services Money demand related to interest rate price level and real income as MD f i P Y i Interest rate P Price level Y Real GDP 8 Money Demand Curve Interest Rate i Shows the relationship between interest rate and the quantity of money demanded holding everything else constant Demand for Money MD Money M 9 What shifts the Money Demand Curve D1 Interest Rate i Increase to D1 if P or Y D2 Decreas e to D2 if P or Y Demand for Money MD Money M 10 The Equilibrium Interest Rate The Interaction of Money Supply and Money Demand Interest Rate i Supply for Money MS i Demand for Money MD Money M 11 How does an increase in the price level affect the interest rates Interest Rate i i 2 i MD i Supply for Money MS G E MD 2 Demand for Money MD Money M 12 How does a economic recession affect the interest rate Supply for Money MS Interest Rate i MD i i E i 1 F Demand for MD1 Money MD Money M 13 How does an open market sale by the central bank affect the interest rate Interest Rate i i 2 i MS 2 Supply for Money MS MS i This is a contractionary monetary policy Demand for Money MD Money M 14 Another Question I m trying to understand the example in page 329 about appreciation and depreciation but I think there s something wrong in it Can you do it in class 15 My answer Let go over it together 16 How does the interest rate relate to the exchange rate Interest Arbitrage Relationship between interest rates and the exchange rate in the short run 17 International Economics Week Eleven Class 2 Wednesday November 14 11 10 12 00 Tyndall 18 Final Exam Is a 2 hour exam Covers everything Chapters 1 through 8 Chapters 11 13 14 and 15 Notes Slides Assignments Has 3 parts 1 15 MCQ 3 points for correct answers and 0 5 point for incorrect answers total 45 points 2 Choose 2 of 4 essay questions for 20 points each total 40 points 3 Three problems total 65 points 19 Remember yesterday s question I m trying to understand the example in page 329 about appreciation and depreciation but I think there s something wrong in it Can you do it in class 20 The Interest Rate And the Exchange Rate in the Short Run Example You own a company in U S looking to invest 10 000 cash Assume U K has the best rate of 12 You must first buy pounds in the foreign exchange market then invest pounds in U K market If spot exchange rate is 2 pound which gives you 5000 to invest 21 The Interest Rate And the Exchange Rate in the Short Run Example continued In 3 months the money will be worth 5000 1 0 12 4 5 150 1 If the exchange rate is the same you will get 5 150 2 10 300 22 The Interest Rate And the Exchange Rate in the Short Run 2 If pound drops to 1 975 pound By how much has pound depreciated 2 1 975 2 100 1 25 in 3 months the books says 5 that is the annual rate 1 25 4 5 depreciation You end up with 5 150 1 975 10 171 25 So what is your rate of return 10 171 25 10 000 10 000 4 7 23 So your total rate of return is the difference between annual interest rate in U K 12 and depreciation of the pound 5 approx 7 24 Similarly If the pound appreciates by 5 Total return is sum of annual interest rate in U K 12 and appreciation of the pound 5 approx 17 25 To eliminate exchange rate risk Buy foreign currency in spot exchange market At same time sell pound in forward exchange market delivering on date of investment s maturity 1 2 If forward rate current spot rate pound is selling at a forward premium more profitable to invest in U K If forward rate current spot rate pound is selling at forward discount must compare the gain in favorable interest rate to loss suffered by exchange rate 26 But really the story is more complicated than that Here is a rough numerical example to show the interest rate parity Annual yield interest rate on US bond 10 Annual yield interest rate on Irish bond 6 Spot exchange rate 1 1 Forward exchange rate 1 1 27 So Irish will want to invest in the US Spot demand for dollar goes up dollar appreciates by 1 Demand for US bonds goes up price of bonds goes up interest rate goes down by 1 point Demand for Irish bonds goes down price of bond goes down interest rate goes up by 1 point Forwards supply of dollar goes up dollar depreciates by 1 Now Dollar sells at 2 forward discount Interest rate in US is 2 point higher than in Ireland 28 Interest rate parity Funds continue moving between the two countries until forward premium or discount equals the interest rate differential 29 International Economics Week Eleven Class 3 Wednesday November 14 15 10 16 00 AC 201 Online grades were updated today ICA5 is graded and ready to be picked up 30 The Interest Rate And the Exchange Rate in the Short Run What does tightening of money in Ireland do to interest rates What does this do in the market for euro MS declines …