Chapter 13 - Economics policy in and open economy. After studying this chapter you will be able to: Illustrate why it is difficult to keep exchange rates constant; Explain how foreign exchange market intervention works and why it cannot permanently fix exchange rates; introduce purchasing power parity (PPP) and review the evidence on how well it explains long-run exchange rates; introduce the aggregate demand/aggregate supply (AD/AS) macroeconomic model, which determines price levels;. | Economic Policy in an Open Economy How many more fiascos will it take before responsible people are finally convinced that a system of pegged exchange rates is not a satisfactory financial arrangement? (Milton Friedman, 1992) The Goals of This Chapter Illustrate why it is difficult to keep exchange rates constant. Explain how foreign exchange market intervention works and why it cannot permanently fix exchange rates. Introduce purchasing power parity (PPP) and review the evidence on how well it explains long-run exchange rates. Introduce the aggregate demand/aggregate supply (AD/AS) macroeconomic model, which determines price levels. Combine the AD/AS model, purchasing power parity, and the interest parity condition into a general exchange rate model. Explain the trilemma and show how attempts to defy the trilemma has caused recent financial crises. Floating Versus Fixed Exchange Rates Floating Exchange Rate: An exchange rate that permitted to vary in accordance with the changes in the supply and demand for foreign exchange. Fixed Exchange Rate: An exchange rate that is intentionally prevented from changing by means of specific government policies that influence the supply and demand for foreign exchange. Why It Is Hard to Fix the Exchange Rate The interest parity condition, et = Etet+n[(1 + r*)/(1 + r)]n, suggests that the spot exchange rates will remain the unchanged if all variables on the right-hand side of the equation stay the same, that is if: Expectations about future exchange rates, Etet+n, do not change; Rates of return on assets are the same at home and abroad, that is r = r*. Why It Is Hard to Fix the Exchange Rate The spot exchange rate can also remain unchanged, even when one of the right-hand variables changes, provided that: Policy makers immediately adjust domestic policies when expectations change. This latter condition requires a country’s policy makers to stay attuned to exchange rates and adjust their economic policies to satisfy the interest . | Economic Policy in an Open Economy How many more fiascos will it take before responsible people are finally convinced that a system of pegged exchange rates is not a satisfactory financial arrangement? (Milton Friedman, 1992) The Goals of This Chapter Illustrate why it is difficult to keep exchange rates constant. Explain how foreign exchange market intervention works and why it cannot permanently fix exchange rates. Introduce purchasing power parity (PPP) and review the evidence on how well it explains long-run exchange rates. Introduce the aggregate demand/aggregate supply (AD/AS) macroeconomic model, which determines price levels. Combine the AD/AS model, purchasing power parity, and the interest parity condition into a general exchange rate model. Explain the trilemma and show how attempts to defy the trilemma has caused recent financial crises. Floating Versus Fixed Exchange Rates Floating Exchange Rate: An exchange rate that permitted to vary in accordance with the changes in .
