Problem 3c on the first problem set states that the French government

uses dollars held in the US bank to buy French currency from citizens.

Dimitre said that the answer would be 0 net change in the US capital

account and a net change in the official reserves account.

*this sounds right to me. basically, there is an asset in the US that starts out with the name of a French citizen on it. The citizen's name is erased, and replaced with the name of the French *central bank. So, there should be no change in the capital account, only a shift in numbers between the nonreserve and reserve components of the capital account. No element of the *current account is involved.

I understand why his answer is correct, but I think my answer could be

correct also. Can you tell me why my reasoning is wrong?

I said that there would be a debit on the current account b/c since the

French government is withdrawing money from a US bank, it is investment

income paid. It would also be a credit on the capital account b/c there

*investment income paid would be something like interest payments on a treasury bill, or equity payments on stock. There doesn't seem to be anything like that going on in this example.

would ultimately be an increase in foreign holdings of US assets since

French citizens would invest the dollars that they got from their

government in the US.

*over time this might happen. But, in the moment that the french central bank makes the purchase from the french citizen, the only change in the balance of payments is the shift between *reserve and non-reserve components of the capital accounts.

Question 2 I dont understand why the lowering of interest rate in the

US would cause a depreciation of the dollar. You talk about that twice

in lecture #4 notes (in number 2 and 5) and I dont understand it either

time.

*when there is a lower us interest rate, dollar assets become less attractive than foreign assets. so, people try to sell dollars and buy foreign currency, so that they can buy the foreign *assets. the attempt to sell dollars and buy foreign currency causes a fall in the value of the dollar.

It makes sense that if US interest rate was higher (page 3 of notes),

then more people would want to buy dollars and sell the other currency.

But why would this make the US dollar appreciate? Wouldnt the reverse

be true since people would be willing to pay more euros per dollar?

*Consider the following example. People want to buy more apples. They would try to exchange dollars for apples. This would lead to a rise in the price of apples. This corresponds to a *'depreciation' in the value of the currency, because now a given amount of currency will buy fewer apples. There is an appreciation of the value of an apple, because now an apple will *fetch more currency. Now replace the word 'apple' with 'euro'.

(this is line 4 on the third page). Then it says that with appreciation

(which I dont understand), there would be a lower E, and this in turn

implies a higher anticipated depreciation of the currency. Why would

there be a higher anticipate depreciation? I dont understand that

either.

*E is the price of foreign currency ($/foreign currency). So, the domestic currency being more valuable corresponds to the situation in which a given amount of domestic currency *translates into more foreign currency, i.e., E falls. In the notes I hold Ee fixed. So, if E falls, then the anticipated depreciation of the currency goes up. That is, (Ee-E)/E rises.

Question 3 On this week's homework, page 357, for my clarification (bc

I always have problems with this), interest rate would be taken as 0.10

and not 1.1, correct? That relates to question #3 on that page. On the

same type of thing... are real prices always 1+ some rate, while nominal

is just that rate?

We are usually treating the interest rate as a net rate, i.e., the 0.10 number. In contrast with an interest rate, a price does not have the dimension of a rate.

Question 4 p.358 number 13 seems like a two part question.

a) forward premium on euro and b) difference b/w interest rate on one

year dollar deposits and one-year euro deposts

But, when I looked up interest premium in the appendix of the chapter,

the equation was (F-E)/E which is exactly the equation as given in

lecture 4, problem 4 notes for covered interest parity which rearranging

seems to answer part b).

R($) = R(euro) + (F-E)/E --> R($)-R(euro) = (F-E)/E

Is it supposed to be the same exact thing?

*yes, covered interest parity is the same formula as uncovered interest parity with Ee replaced with F. Under the assumptions that underly UIP, the expected echange rate, Ee should *coincide with F. Checking this is not totally straightforward, since Ee is inside people's head it's their expectation of the future exchange rate.

And finally,

Question 5 In today's notes, we ended on the fact that with lower US

rate of return, people prefer to have foreign assets. You said that

means that the US dollar depreciates and E increases. Did I write that

down incorrectly? Since E is dollars/foriegn currency, if it increases,

that would mean more dollars are needed to buy the same amount of

foreign currency which means that it appreciates (value goes down)?

Also, why would the dollar depreciate if people want foreign assets?

Doesnt the foreign stuff become more valuable and more dollars are

needed to buy it, making the dollar appreciate?

*yes, you wrote it down correctly. when they want more foreign assets, they need to first buy more foreign currency that they can then use to buy the foreign assets. The increase in *demand for the foreign currency will produce a rise in its price, E. When E goes up, that corresponds to a depreciation of the domestic currency, since its value is now less. It can buy *less of the foreign currency.

I'm sorry for all these questions. I hope I didnt overwhelm you too

much. If you think it would be better for me to come into office hours,

I can do that as well.

*The three equations of the simple monetary approach to the exchange rate includes money demand. Money demand relates M/P to L(R,Y). If Y goes up, then so does L(R,Y), so that M/P *goes up too. Assuming M does not respond to the rise in Y, this means P must fall. Looking at PPP, we see that E must fall by the same proportion. Since the rise in Y is permanent, E *falls at all dates, so that Ee (the future value of E) falls too, and by the same proportion. As a result, nothing happens to the UIP equation. That's it, so a permanent jump in Y leads to a *permanent drop in P and E, in the long run.

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Can't the Fed move interest rates simply by announcing that they want the interest rate changed, without trading in bonds?

answer:

 The idea in the model is that the interest rate is determined in the money market. It is determined by the intersection of the demand and supply of money. The only way the Fed can control the interest rate is by controlling the supply of stuff - money - in that market. That corresponds well with what happens in reality. The interest rate that the Fed pays most attention to is called the federal funds rate. The federal funds rate is the interest rate that banks pay to each other for loans of money they hold on deposit at the fed (the fed acts as a bank for private banks....they like to hold deposits at the fed because the deposits satisfy reserve requirements and also because that money is useful to banks for the purpose of making payments to each other).

So, the federal funds rate is an interest rate that is determined in a private money market. The fed cannot move that rate merely by announcing a change in that rate. If they want to change that rate they must change the quantity of money available in that market, and they do that by conducting open market operations. Now, the fed may seem to be able to move the federal funds rate by simply announcing that they wish it to change. But, that would be a misunderstanding of the way that market works.

Here is how the fed seems to be able to move the federal funds rate merely by announcing a change, and why this interpretation of what the fed does is misleading. Currently, the fed thinks of monetary policy more in terms of the federal funds rate than in terms of the money supply (actually, this is the way central banks have thought about policy in most countries, most of the time). So, when the fed says it plans to loosen policy, they typically announce that they want a drop in the interest rate (the federal funds rate, to be precise). This is what they have been doing since early 2000. But, the reason why rates fall when the fed says it wants them to fall can be seen when you ponder why it is that rates would not fall if the department of agriculture announced a fall. The thing is that there is a key difference between the two institutions, and that difference is that the fed can back up its wish to change rates with a change in the money supply while the department of agriculture cannot. When the fed announces a fall in the interest rate, they instruct their person who does open market operations (the money manager on the 'open market desk' in New York) to buy and sell bonds in the right amount until the money supply is such that given demand, the market interest rate is what the fed wants. If Fed announcements about the interest rate were not accompanied by such instructions to the open market manager in New York, they would cease to have an impact on the federal funds rate.

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