Part 4: The Exchange Rate: The Mother of all Prices

The Exchange Rate: The price of foreign exchange in domestic currency; say the price of a US dollar in pesos (today about 43.50 pesos per US dollar: we write it as ER = P/$). If we treat the $ as any other good, then there is a market for $ where S meets D. (Show graph) Suppose that the market is allowed free play. Then the price of the dollar will be determined by the intersection of S and D at ER*. At that rate there is no excess demand for dollars. Types of Exchange Rate Regime: Flexible Exchange Rate, Fixed Exchange Rate and Everything in Between 1. Floating Exchange Rate: The exchange rate is determined solely by supply and demand for dollars. No direct intervention by the monetary authorities on the ER. But the Central Bank may buy or sell dollars in the market. Thus the graph. If S shifts outwards, say, due to an increase in the inflow of portfolio capital, then a new lower equilibrium P/$ is established. If there is a shift outwards of D say due to rise in the price of oil (a barrel of imported oil requires more dollars than before) then a new higher P/$ equilibrium is established. Since many factors influence the P/$ rate and volatility is bad for business, many countries that say their ER is a float would many times intervene to keep it steady. 2. Fixed Exchange Rate: The Central bank mandates that the ER be fixed at official rate ER^ = P/$^. There are two possibilities: 3. ER^ < ER*, the official is lower than the equilibrium rate ER*. There is an excess demand for dollars. Foreign goods become cheaper than domestic counterparts. The peso is said to be overvalued at official rate. ER^ has to be supported otherwise it will float upwards to ER*. Types of supports: (a) Since there is excess demand unrequited, who gets the dollars? The government/central bank can ration the available $ to favored users. Those who need dollars but cant get it officially can procure from the black market

where the (black market) un-official rate ER^^ > ER^ , that is, higher than the official rate. The government in response may then pass a law punishing the buying and selling of dollars in the black market. But in many jurisdictions, enforcement is weak and the underground trade goes on anyway because it is very profitable. Enforcers may themselves get involve in the parallel/curb market. So two rates coexist: the official rate, ER^, and the black market rate ER^^. Exporters who cannot escape the official rate at home will tend to keep their earnings abroad in $ accounts. Thus the official flow of dollars say from exports decrease further. . (b) The Central bank may use monetary instruments to reduce the excess demand. It can raise interest rate to reduce loan demand and overall economic activity (reduce imports in general, demand for oil products or imported watches, say) and D will shift back (show in a graph). This is demand side intervention. It can also raise required reserves for banks to reduce lending to the same effect. It can sell central bank bonds fetching very high interest rate which re-channels the pesos chasing dollars towards purchase of central bank bonds. The interest rate on these bonds can be very high (say 45%) so it creates a collapse of economic activity. In our history, in 1984-85, the Central Bank of the Philippines under Gov Jose Jobo Fernandez sold CB bills at just this rate to soak up excess pesos which caused the economy to shrink. This reduced demand for dollars.

[Box: The Matsusakata Deflation: When Meiji Japan adopted the Gold Standard in the 1880s, the yen was heavily overvalued. The Finance Minister Matsusakata shrank the economy and forced the demand for foreign exchange to the shift back. The reason is that it would lose face in the world if it devalued the yen so soon after its adoption of the Gold Standard. This was called the Matsusaka deflation. You force the economy to shrink to conform to

the official exchange rate. This is precisely what is happening today in Greece and Spain! (History repeating itself!). The reason is different: Spain and Greece do not have an independent monetary policy.] (c) The central bank can sell $ from its forex reserves (the gross international reserves of the BSP) to soak up excess demand. This a usual response if the excess demand is viewed as due to a temporary shift in demand (temporary rise in oil price say). If the shift is permanent the CB continually loses $ reserves and may run out altogether. [George Soros: The Man Who broke the Bank of England: If you believe a devaluation will happen then you can buy $1m at P40/$ using your pesos paying P40m and wait for the peso to be devalued. If the peso is devalued to P50/$, you earn P10m no sweat. What Soros did was bet that the Bank of England will devalue the British pound sterling against the German mark. So he borrowed billions of pounds from British banks and bought Deutchmark thus increasing the demand for the German currency. Others soon followed suit and the Bank of England sold DM to counter what is known as a speculative attack. The speculators bet that BOE will soon run out of DM. The BOE ran out and devalued the pound. Soros realized 1 billion pounds! He had broken the Bank of England! Why did not the BOE sell high interest bond to counter the speculative attack? The British economy was just recovering from a recession. A high interest policy would have killed the recovery, very politically costly.] Speculating against an overvalued currency: When the currency (say peso) propped up by the central bank is overvalued (there is excess demand year in and year out), the central bank forex reserves will begin to dwindle. When the GIR of the central bank falls to certain low levels (usually gauged in months of imports), a belief arises that that the ER will be adjusted upwards or the currency devalued. Holders of the currency stand to lose if it happens and may begin converting their pesos into dollars at current exchange rate. If the

devaluation is 50%, peso

holders lose fifty % of the value of their peso

holdings in terms of dollars. Those who do not have pesos will borrow pesos from banks and buy dollars: they are speculating against the peso (shorting the peso). When the devaluation occurs, they then convert their dollars back to pesos. Example: You have P1m. Suppose the current ER is P10/1$ (true circa 1980s). Suppose the GIR of the central bank is discovered to be very low and word gets around that to remedy the imbalance, the ER will move up to P15/1$. At current ER, P1m = $100th. If the peso is devalued 50% to P15/$, P1m = $66.6th, a loss of $34th. If you converted to % at current ER you get $100th. After the devaluation this is worth P1.5m, a profit of P500th! So you convert to dollars at current ER. You speculate against the peso. Example: The central bank strikes back: Suppose the central bank would like to hold on to the P10/$ ER. It sells bonds with interest rate at 51%. Instead of converting to dollars, you buy CB bonds worth P1m. Next year your interest earning is P501m > P500m buying dollars. So you just buy CB bonds. But with interest rate so high nobody borrows money and economic activity stops. The economy shrinks to accommodate the wrong (overvalued) ER. This is what happened in 1985 with Jobo Bills.This is known as the interest rate cure. When this happens, and the economy cannot service its debt and its imports, we have a payments crisis. The overvalued domestic currency is the most common cause of payments crisis which causes the economy to contract. (d) When a payments crisis occurs, the CB if it has monetary independence can devalue the peso, that is raise the official rate to from ER^ to ER^^ and the crisis eases. This happened in the 2001 Argentina crisis and the 1990 crisis of the British pound. Unfortunately for the PIGS (Portugal, Italy, Greece, Spain) they cannot devalue.

(e) Overvaluation EURO style: When the EURO was adopted, it meant that the member countries lost monetary independence (they cannot print money (only the ECB can), they cannot have domestic interest rate, they cannot have their own exchange rate. It is an extreme form of a fixed exchange rate. Greece, Spain, Italy and Portugal (derisively called PIGS) effectively experienced a massive currency overvaluation with the shift to the Euro. The Euro is not overvalued indeed may even be undervalued relative to Germany but it clearly is with respect the PIGS. The result is a sovereign debt crisis: the demise of tradables in the PIGS and an orgy of foreign borrowing that fueled a humungous real estate bubble. The European sovereign debt crisis is the unwanted child of massive overvaluation. It is a re-run wrought large of the Argentine crisis in early 2000 when Argentina pegged by law the value of one Argentine peso to one US dollar. Argentina wallowed on borrowed affluence and for a while was the icon of growth with price stability. Until, that is, the bill came due. Argentina recovered only after it reversed the mistake with a massive devaluation. By contrast, the PIGS cannot devalue its currency to reverse the process as they gave up monetary independence in 2000 with the monetary union. And so they must instead devalue all their assets primarily their labor assets. The imperative spawned a neologism fiscal devaluation! It used to be called simply deflation.The forced retreat of asset prices reaps the harvest of social unrest. The Philippines by contrast has monetary independence but for so long has chosen to deploy it in a sado-masochistic sacrifice on the altar of the strong peso.

4. Undervaluation: The P/$ rate is fixed by the monetary authority at a rate higher than equilibrium, say at P50/$. There scenarios are possible: a. There emerges an excess supply of forex as exports grow and imports fall. The central bank can just print pesos to soak up excess supply of $. The dollars bought becomes part of the Gross International reserves of the Central Bank.

The GIR grows. At present the GIR of the BSP is about $79.3b. We say that the peso is undervalued. The central bank has a weak peso policy. The

central bank will not run out of bullets (pesos) because it can print pesos at will. b. Since the money supply is rising with printed pesos, there arises an inflationary pressure. The central bank might want to stem the inflation by selling high interest bonds, by raising required reserves (RR) or raising the policy rate (rate at which it lends or borrows form the private banks; the SDA rate). In any case, the domestic interest rate rises to slow down the economy. (recall the JOBO Bonds episode in the mid-80s) c. The Peoples Republic of China is by contrast the Asian witness to the wisdom of the East Asian exceptionalism that began in the 1950s. PRC in the last decade is the current embodiment of the East Asian Model before the orgiastic financial and capital account liberalization of the 1990s. It has used currency undervaluation to support its export and employment creation. Consequently it has huge dollar reserves. PRC has staunchly resisted the mounting global pressure to revalue the yuan at a pace dictated by Western countries. The Chinese authorities view the yuan undervaluation (estimated to be about 25%) as the ticket out of poverty of the still hundreds of millions of Chinese below the poverty line. Premature appreciation is viewed correctly as the unconscionable embrace of the Japanese-style Bubble Economy and an invitation to a similar decade-long economic stagnation. This is wielding monetary independence responsibly. d. PRC has an overheated economy in 2009, It was experiencing inflation especially in food. It was slowly raising the interest rate so as to achieve a soft landing, a slowdown without a rude bump. Some say it has a real estate bubble. Still the PRC has reduce the number of people under poverty line by 500m. It has become the second largest economy after the USA. Should not the Philippines be following PRC?

3. Hybrid Exchange Rate Policy: (a) Inflation Targeting. Many countries who profess to having a market-based

exchange rate follow inflation targeting. That is their monetary policy is anchored on hitting an inflation target usually around 2.5%. Thus their goal is
macroeconomic stability gauged by a low and stable inflation (usually core inflation (without fuel and housing). Usually, the Central Bank has an inflation band 2-3%. The exchange rate is allowed to fluctuate also within a band with a floor and a ceiling. The CB intervenes in the exchange market when either the ceiling or the floor is breached. The reason given is to reduce volatility of the exchange rate. The CB will say that it is neutral as regards the level of the exchange rate. (b) Currency Board: The CB maintains a hard fixed ER; ita monetary policy is anchored to the fixed ER and nothing else; the CB raises the money supply equal to the inflow of forex times the ER: M = K x ER^. If the inflow is negative (outflow of forex), the CB reduces money supply by corresponding amount. Currency Board countries have very low inflation rates tracking the inflation rates of the mother currency (say US). They are prohibited from printing pesos to finance government programs. Printing pesos when there is large forex inflows is not inflationary. (AS-AD Diagram) 4. Real Exchange Rate: the real value of a real dollar is defined as:

RERt = ER^t (pWt /pDt ) where ER^t is the official ER at time t, pWt is the

wholesales price index price index in the W at time t, pD t is

the consumers price index in D = (the Philippines) at time t.
Base year: the analyst chooses a year called the base year at which all the variables are rebased to 100. So if the base year W = 1.0 x 100 = 100 for year 2010; chosen is 2010, E^ , P P

, D

thus RER2010 = 100. Note that RER at time t falls if ER^ falls; it also falls if the domestic inflation exceeds the inflation in the US. Suppose everything else being equal, the ER^ is raised in 2012, then ER2012 > ER2010 and the peso is now undervalued relative to 2010.

5. For subsequent years, Plug in the data from the rebased series. If for year 2009 RER2009 < RER2010 , the peso is overvalued for 2009 relative to 2010. This means that the inflation in the Phl is higher than the US and the ER was not adjusted upwards. If RER2012 > RER2011, the peso is undervalued for 2012. Competitiveness of the peso has risen. What this means is that if the inflation in the US is higher than in the PHL and the ER was not adjusted downwards, the peso will be undervalued. Competitiveness of the dollar has fallen. Thus competitiveness of the peso can change simply by differential inflation rates. 6. If your inflation is higher, you can compensate by raising the ER^ to maintain real peso value. In Indonesia for a while they deliberately adjusted the Rupiah by as much as the differential in inflation: say inflation US is 4% and inflation in Indonesia is 9%, they devalued the Rupiah 5% to maintain competitiveness. In this case the economy maintains a fixed RER = RER^ instead of a fixed ER^. 7. Nominal Effective Exchange rate (NEER): say with respect to yen NEERt = (ERb /ERt)phlus/(ERb /ERt)jpnus x ai Where ERb is base year official peso/yen exchange and ERt is official current exchange rate of the peso/yen against the dollar; ai are trade weight of Japan in Phl trade(see below). So if NEERt > NEERb, the peso has become overvalued relative to the yen. If NEERt < NEERb the peso has become undervalued relative to the yen and relative to base year. Say base year exchange rate against the dollar are 42 for the peso and 80 for the yen in 2010. Suppose in 2012, the official ERs are 40 for peso and still 80 for the yen. The NEER2012 = (42/40)/(80/80) = 1.02 > 100, the peso has lost competitiveness against to the yen relative to base assuming the ai constant. If peso ER became 50 in 2012 ceteris paribus, the NEER in 2012 is 0.84 < 1.00, the peso has gained competitiveness against the yen relative to base.

8. Real Effective Exchange Rate: Competitiveness against a basket of currencies (dollar, yen, euro). REERt = (ai x RERti) Where ai = the trade weight for country i [ ai = Mi +Xi)/ (Mi + Xi)]; and RERi = the RER of the peso with country Is currency (say yen). REERt > REERb the peso has become overvalued relative to base year and relative to the countries included in the basket. 9. Capital Mobility: free or controlled. Free capital mobility : no barriers to entry and exit of capital; you can exchange your pesos for $ and vice versa and send them abroad (free convertibility of the peso); controlled means there are barriers to convertibility and sending in or out. The yuan is not freely convertible and there are capital controls; speed bumps (waiting times, differential treatment of foreign deposits, Tobin tax). Two kinds of capital: DFI that go into financing factories and portfolio capital that go into liquid assets (equities, bonds, SDAs). Portfolio investment must be distinguished from DFIs. Since the 1990s, capital controls have been slowly dismantled by most countries in what is known as capital account liberalization. (FDI versus FPI). 10. Theories of ER Determination (when in a float and capital is mobile) (i) Interest Rate Parity: relates the domestic interest rate, the world interest rate and the exchange rate. At equilibrium, the interest rate parity equation must hold: r = r* + (ERe ER)/ER Where r = domestic interest rate; r* is world interest rate (say on US treasuries), ER is the current exchange rate, ERe the expected exchange rate in some future date and (ERe ER)/ER = the expected depreciation of the domestic currency. If r < r* while expected depreciation is zero, domestic holders of capital will buy dollars and bring them out (capital flight). Dollar supply falls and the domestic currency will depreciate. If r > r* with expected depreciation being zero, foreign capital will flow in to take advantage of the differential. The supply of dollars rise and the ER falls. If expected depreciation is positive, dollar holders will hesitate to purchase peso assets because a sizeable depreciation will reduce

the value of their peso assets. Note what G Soros did against the pound sterling. He bet that the pound will devalue since r < r* on German assets. We can solve for ER in terms of r and r* from the interest parity equation: ER = ERe/ (r r* + 1). Note the relationship between ER and r or r*. So ER falls with a rise in r and rises with a rise in r*. (dER/dr) = - ERe(r- r*+1)-2 < 0 and (d2ER/dr2) = ERe2(r- r* - 1)(r- r*+1)-4 > 0. A rise in r ceteris paribus causes the domestic r to exceed world interest rate and capital flows into the economy forcing the domestic currency to rise or ER to fall. The central bank may set the interest rate directly or may use Ms to manage r indirectly. (Graph on the ER-r space). [Current event: Why the ERs of the emerging markets are rising in last week of Aug 2013 : Indian Rupee falls to 64 to $, peso falls to 44.17 to a dollar: Tapering of QE as cause: in anticipation of the tapering of the QE by the FRB, market players are beginning to raise the interest rate; interest rate in the US has risen 100 basis points (1%) or r* rises. Capital is beginning to move back from the emerging markets to the US. The interest rate parity is imbalanced. To restore equality, the current domestic ER rises as the interest rate parity theory predicts!] When r is endogenous, it is determined by supply and demand for money in the Money Market: The money market consists of the supply of money Ms and the demand for money Md = PL(r, Y) where P is the price level, L(r,Y) is the demand for money function, r is the domestic interest rate, and Y is the National Income (GNP). Ms is exogenous, that is, it determined by the central bank. Generally we assume that Md falls when r increases and rises when Y increases (Lr < 0, the higher is the interest rate, the lower is the speculative demand for money and LY > 0, the higher is income the higher is transactions demand for money). At money market equilibrium Ms = Md and this determines the equilibrium interest rate. Example: Let real demand for money be Md/P = h +tY kr and money supply be Ms . Setting to equality and solving for equilibrium r we have r = (h Ms +tY)/k.

If the CB reduces money supply ceteris paribus (same Y), the interest rate r rises above r*, capital flows in as above and the ER falls or the peso appreciates. If the money supply decreases, r rises above r* and capital flows out so ER rises or the peso falls. If National income Y rises ceteris paribus i.e., same Ms , transactions demand for money rises causing r to rise. This causes an inflow of capital and the peso rises or ER falls. If the CB does not want the ER to fall or peso to rise, it can raise money supply enough so the effect on r of increased Y is just compensated (dr = tdY - dMs = 0 or dY/dMs = 1/t). (ii) Macro Fundamentals: BOP = X M + K. X = X(ER), XER > 0 M = M(r, ER, Y); Mr < 0, MER < 0, MY > 0. K = K(r r*, ERe-ER), Kr-r* >0, KERe-ER > 0 Note that subscripts indicate partial derivatives. The equilibrium domestic ER is that which sets BOP = 0. So if BOP < 0, ER will rise to boost X and reduce M; if BOP > 0, ER will fall to reduce X and boost M. Thus, BOP = X(ER) M(r,ER,Y) + K(r-r*, ERe -ER) = 0 for equilibrium ER* given r, r*, Y. (iii) There other more sophisticated theories of ER. They are all rather weak as predictors in the short run (say within a month where the ER seems to exhibit a Brownian motion). The longer run is better.

11. When the currency is fixed, the game of predicting the ER becomes the game of predicting how the CB responds to events: how and when will the CB react to rising BOP deficit; to the depletion of the GIR; when there is a persistent BOP surplus, how will the CB respond to clamor from trading partners for downward adjustment (as in China)? Speculators make bets for or against a devaluation or appreciation.
12. Global Equilibrium and Arbitrage

When there is perfect capital mobility and the exchange rates are flexible, then the different spot exchange rate with respect to each other will settle at equilibrium levels where arbitrage is zero. Suppose Peso/$ = P42 and Yen/$ = Y84, then Peso/Yen = (Peso/$)/(Yen/$) = 0.5 must hold at equilibrium, that is, for there to be zero arbitrage between Peso and Yen. Arbitrage is the gain realized from trading in currencies. Suppose for the moment that Peso/Yen = 1.0. Then a person with $1m will buy Yen (Y84m), convert this into pesos (P84m at ER = 1) and then convert this back to into dollars ($2m)! A cool $1m profit! This buying and selling of currency (currency trade) to realize profit is what is known as arbitrage and the person doing it is an arbitrageur or a currency trader. This will go on until the Peso/Yen returns to O.5. at which arbitrage is zero. The P/Y = 1.0 is known as a (temporary) mis-alignment. Arbitrageurs love misalignments. Mis-alignments can also occur with interest rates as shown in the interest rate parity discussion. 13. Forward Market Dollar users can buy dollars at the spot market when they need it. They pay the spot price (the one quoted in the newspapers). Users like oil companies whose revenues is in pesos may dislike the fluctuation in the local dollar market. If they think the spot price will increase, they may want to purchase dollar forwards today at an agreed price today so they dont have to pay the spot price at the time they need the dollars say 4 months from now. But they have to pay a price for such insurance. The price is called a forward premium or discount depending on the sign. Forward Discount (FD) = [(FER SER)/SER] x 4 x 100 where FER is the future exchange rate (4 months later), SER is the spot ER. If FD < 0 then Discount; if > 0 then premium. Suppose SER = 42 and FER = 40, then FD = [(40 42)/42] x 4 x 100 = -19.04%, a discount . If FER = 44 instead for same SER, FD = +19.04%, a premium. The buyer has to pay more if FD > 0 is the case. If the market is deep, there will always be people who believe the market will go the other way. So for this type of exchangr we need depth of the market: deep means one can always find buyers or seller. Of course

if you pay the forward premium thinking the ER will go to 44 and the ER goes to 40 instead you lose. But you can plan on the forward dollars you bought. The forward market is a way of reducing uncertainty associated with the forward exchange rate. Buying dollars forward is a form of insurance. Many financial instruments are based on the principle of the uncertain future; If an indebted country like Greece is in deep financial straits, there will be people who will bet that Greece will default on its debt and others who dont. The bet is facilitated by an instrument called debt-default swaps. One party sells an instrument which says the holder will be paid $x if the firm or country defaults on its debt; the instrument is s

Econ 141 Midterm Exam August 14, 2013 1. A tariff t is imposed on imports of y by a small country H producing x and y. The domestic price of y increases to _________ and output x _________ due to ________. a. b. c. d. Py, increases, unemployment Py(1+ t), increases, full employment Px(1+ t), decreases, unemployment Py(1+ t), decreases, full employment

2. When both H and W are large, a tariff by H shifts its OC ___and the equilibrium TOT shifts ___. a. b. c. d. inwards, counterclockwise outwards, counterclockwise inwards, clockwise both (a) and (b) above

3. When a tariff by large H generates a welfare _____ for H, then the _______ output effect the tariff is swamped by the ______ TOT effect. a. b. c. d. gain, negative, negative loss, positive, positive gain. negative, positive both (a) and (b)

4. When H imposes _______ on its import and W retaliates with _______, both will ________. a. tariff, subsidy, gain b. tariff, tariff, lose c. tariff, subsidy, lose d. none of the above 5. In the trade war game, both H and W do better with ________; but this is _______ and so both will employ _______. a. b. c. d. free trade, unstable, subsidy free trade, stable, tariff tariff, unstable, free trade free trade, unstable, tariff

6. The equilibrium in the trade war game is _______ equilibrium which is _______ for both. a. b. c. d. a stable, good an unstable, bad a Nash, bad none of the above

old at $y < $x. Depending on your probability of default reading p, the instrument is a good buy ($y < p$x), or a bad one ($y > p$x) If the market is deep, there will be enough people on each side of the bet.

Part 5: The Open Macroeconomy: The Mundell-Fleming Model The Mundell=Fleming model is about the effectiveness of policy instruments under a fixed or floating ER under perfect capital mobility. It integrates the IS-LM model with the BOP to get an IS-LM-BOP model. i) The Local Goods Market: Y = C + I + G. Now Y C G = S and Y C G = I, So at equilibrium S = I or Savings equals Investment. We assume the Investment is a function of r and Y: I (r, Y), and the savings function is S(r, Y),

Ir < 0 and IY > 0.

Sr > 0 and

> 0.

Savings increases with increase in r and investment falls with a rise in r. Both rise with a rise in Y. Example: S = a + bY + cr and I = d + eY fr, where a,b,c, d, e, f > 0 are constants. b=

SY, e = IY .We assume e

< b. At equilibrium S = I. So solving for r in S = I, we

get the IS equation: r = [(d-a) +(e b)Y]/(c+ f). The IS is a combination of r and Y that clears the local goods market. Note dr/dY = 2 2 (e-b)/(c+f) < 0 since (e b) < 0; d r/dY = 0 (straight line). This gives the IS curve in the r-Y space (graph, illustrate when S > I when I > S)). The intercept of the IS curve is (d-a)/(c+f). Now d is identified with government investment or consumption. So an increase in govt spending increases d and raises the intercept of the IS curve. Show equilibrium in all three markets. (intersection of the IS, LM and the BOP curve.

Show comparative statics starting from a situation where domestic equilibrium is above the BOP curve thus a BOP surplus. This is the case of China and the Philippines. China is a huge BOP surplus country. The surplus comes from it trade surplus (X M > 0). The trading partners are complaining that it is taking away jobs from the US and EU. It now has 2 trillion dollars in forex reserves. They want China to revalue the Yuan to move the BOP curve upwards. The ER falls and raises the intercept of the BOP curve So the BOP curve shifts upwards until equilibrium is reached at same o income Y . But China still has 200m poor people and wants income to rise. It prefers to shift the IS curve outwards (by increased govt spending) and/or the LM curve s downwards by increase in M (which lowers the LM intercept)

(ii) The Money Market d Let real demand for money be M = h +tY kr, h,k >0 are constants and money s supply be M , fixed by the Central Bank. Setting to equality and solving for equilibrium r we have s r = (h M +tY)/k. This is the combination of r and Y that clears the money market. We have (dr/dY) = 2 2 s (t/k) > 0, d r/dY = 0 (straight line). The intercept is (h-M )/k, so the intercept s decreases if M rises. (Graph on the r= Y space; illustrate when Ms > Md and when the reverse). (iii) The BOP

The BOP Equation: BOP = X M + K. The Export Function: X = X(ER), XER > 0 The Import Function: M = M(ER, Y); MER < 0, MY > 0. The Net Capital Flow Equation: K = K(r r*). K > 0.

Let M = - iER + n, X = qER, K = p + o(r r*)

where i, q, p o >0 are exogenous constants. i is not interest rate. For example p (not a price) can rise if our rivals in East Asia have problems (PRC dispute with Japan and Japan is looking for other investment destination; nothing to do with (r-r*) at all; or the perception of the Philippines improves say with credit upgrades, so more inflows will happen). Solving for r in terms of Y we get: r = [mY + (-(I + q)ER p + or* - n)]/o Thus the slope of the BOP curve on the r-Y space is (dr/dy) = m/o. As o approaches infinity, the slope approaches zero. The intercept is (-(I + q)ER p + or*) which increases if ER falls.