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Turkish Lira Example British Pound 0 1.0e+06 2.0e+06 3.0e+06 4.0e+06 5.0e+06 01jan195001jan196001jan197001jan198001jan199001jan200001jan201001jan2020 date British Pound British Pound Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 14 / 190

Formal Definition of the Real Exchange Rate Q = SP P where Q is the real exchange rate S is the nominal exchange rate P, domestic price level as indicated by a price index( example: a consumption basket) andp is the foreign price level as indicated by the same price index. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 15 / 190

Balance of Payments (BOP) Definition All transactions between Turkey and the rest of the world(row) in a given year. It serves as flow of demand and supply for TL. It consists of 1 Current Account, Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 16 / 190

Balance of Payments (BOP) Definition All transactions between Turkey and the rest of the world(row) in a given year. It serves as flow of demand and supply for TL. It consists of 1 Current Account, 2 Capital and/or Financial Account Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 16 / 190

Balance of Payments (BOP) Definition All transactions between Turkey and the rest of the world(row) in a given year. It serves as flow of demand and supply for TL. It consists of 1 Current Account, 2 Capital and/or Financial Account 3 Balancing Item. zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 16 / 190

BOP Items: 1. Current Account (CA) Current account (CA): Here and now. Export receipts (X) as credits, import payments (M) as debits, net = current account balance (goods, services including financial services, interest and dividends, rent, tourism) 1 1.1 Visibles (merchandise account): traded goods, processed goods, repairs on goods, gold, purchase of capital goods such as machinery, aircrafts 2 1.2 Invisibles (service account): rights, licenses, insurance, tourism and other intangibles Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 17 / 190

BOP Items: 1. Current Account (CA) Current account (CA): Here and now. Export receipts (X) as credits, import payments (M) as debits, net = current account balance (goods, services including financial services, interest and dividends, rent, tourism) 1 1.1 Visibles (merchandise account): traded goods, processed goods, repairs on goods, gold, purchase of capital goods such as machinery, aircrafts 2 1.2 Invisibles (service account): rights, licenses, insurance, tourism and other intangibles 3 1.3 Interests, Profits and Dividends: rents from capital services, e.g. rental income, interest on deposit accounts, dividend payments on stocks, other profits transfers. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 17 / 190

BOP Items: 1. Current Account (CA) Current account (CA): Here and now. Export receipts (X) as credits, import payments (M) as debits, net = current account balance (goods, services including financial services, interest and dividends, rent, tourism) 1 1.1 Visibles (merchandise account): traded goods, processed goods, repairs on goods, gold, purchase of capital goods such as machinery, aircrafts 2 1.2 Invisibles (service account): rights, licenses, insurance, tourism and other intangibles 3 1.3 Interests, Profits and Dividends: rents from capital services, e.g. rental income, interest on deposit accounts, dividend payments on stocks, other profits transfers. 4 1.4 Transfers: worker s remittances, aid. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 17 / 190

BOP Items: 2. Capital Account (CPA) Capital/financial account(cpa): net capital inflows = net purchases of TL by foreigners in order to acquire claims on Turkey residents less net sales of TL by Turkey residents in order to acquire claims on foreigners (Long term including securities equities, bonds, real estate etc + short term including bank deposits, short term securities) 1 2.1 FDI : real estate, buying a Turkish company by foreigners or foreign company by Turkish residents, setting up a factory, purchase of machinery and factory in order to produce within that country. 2 2.2 Portfolio Investment: equities, bonds, securities. zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 18 / 190

BOP Items: 2. Capital Account (CPA) Capital/financial account(cpa): net capital inflows = net purchases of TL by foreigners in order to acquire claims on Turkey residents less net sales of TL by Turkey residents in order to acquire claims on foreigners (Long term including securities equities, bonds, real estate etc + short term including bank deposits, short term securities) 1 2.1 FDI : real estate, buying a Turkish company by foreigners or foreign company by Turkish residents, setting up a factory, purchase of machinery and factory in order to produce within that country. 2 2.2 Portfolio Investment: equities, bonds, securities. 3 2.3 Other investment: commercial credit lending by banks, nonbank institutions, individuals, IMF loans. zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 18 / 190

BOP Items: 2. Capital Account (CPA) Capital/financial account(cpa): net capital inflows = net purchases of TL by foreigners in order to acquire claims on Turkey residents less net sales of TL by Turkey residents in order to acquire claims on foreigners (Long term including securities equities, bonds, real estate etc + short term including bank deposits, short term securities) 1 2.1 FDI : real estate, buying a Turkish company by foreigners or foreign company by Turkish residents, setting up a factory, purchase of machinery and factory in order to produce within that country. 2 2.2 Portfolio Investment: equities, bonds, securities. 3 2.3 Other investment: commercial credit lending by banks, nonbank institutions, individuals, IMF loans. 4 2.4 Change in Official Reserves: CB FX reserves Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 18 / 190

BOP Items: 2. Capital Account (CPA) Capital/financial account(cpa): net capital inflows = net purchases of TL by foreigners in order to acquire claims on Turkey residents less net sales of TL by Turkey residents in order to acquire claims on foreigners (Long term including securities equities, bonds, real estate etc + short term including bank deposits, short term securities) 1 2.1 FDI : real estate, buying a Turkish company by foreigners or foreign company by Turkish residents, setting up a factory, purchase of machinery and factory in order to produce within that country. 2 2.2 Portfolio Investment: equities, bonds, securities. 3 2.3 Other investment: commercial credit lending by banks, nonbank institutions, individuals, IMF loans. 4 2.4 Change in Official Reserves: CB FX reserves 3. Balancing Item: Current Account+Capital Account=-Balancing Item Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 18 / 190

BOP Items: 2. Capital Account (CPA) Capital/financial account(cpa): net capital inflows = net purchases of TL by foreigners in order to acquire claims on Turkey residents less net sales of TL by Turkey residents in order to acquire claims on foreigners (Long term including securities equities, bonds, real estate etc + short term including bank deposits, short term securities) 1 2.1 FDI : real estate, buying a Turkish company by foreigners or foreign company by Turkish residents, setting up a factory, purchase of machinery and factory in order to produce within that country. 2 2.2 Portfolio Investment: equities, bonds, securities. 3 2.3 Other investment: commercial credit lending by banks, nonbank institutions, individuals, IMF loans. 4 2.4 Change in Official Reserves: CB FX reserves 3. Balancing Item: Current Account+Capital Account=-Balancing Item visit http://tcmb.gov.tr/odemedenge/odmain.html for Turkish practice. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 18 / 190

BOP Items: Capital vs. Current Account Note that income (rent, dividend, etc.) obtained from foreign assets or paid to foreigners are placed under Current Account but actual transfers made in purchasing or selling of these assets are placed under Capital Account. While the overall BOP accounts will always balance when all types of payments are included, imbalances are possible on individual elements of the BOP, such as the current account, the capital account excluding the central bank s reserve account. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 19 / 190

BOP Items: BOP deficit refers to a situation when current account plus the capital account (except the reserves) is negative. In other words sources of funds ( all exports, bonds sold) is less than uses of funds (imports, bonds purchases) Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 20 / 190

BOP Items: BOP deficit refers to a situation when current account plus the capital account (except the reserves) is negative. In other words sources of funds ( all exports, bonds sold) is less than uses of funds (imports, bonds purchases) BOP Deficit = Current Account Deficit = Capital Account Deficit A BOP deficit leads to a decline in CB reserves. BOP imbalances are due to: the exchange rate, the government s fiscal deficit, business competitiveness, and private behaviour such as the willingness of consumers to go into debt to finance extra consumption. Ben Bernanke argues that the primary driver is the capital account, where a global savings glut caused by savers in surplus countries, runs ahead of the available investment opportunities, and is pushed into the US resulting in excess consumption and asset price inflation Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 20 / 190

BOP Items: BOP deficit refers to a situation when current account plus the capital account (except the reserves) is negative. In other words sources of funds ( all exports, bonds sold) is less than uses of funds (imports, bonds purchases) BOP Deficit = Current Account Deficit = Capital Account Deficit A BOP deficit leads to a decline in CB reserves. BOP imbalances are due to: the exchange rate, the government s fiscal deficit, business competitiveness, and private behaviour such as the willingness of consumers to go into debt to finance extra consumption. Ben Bernanke argues that the primary driver is the capital account, where a global savings glut caused by savers in surplus countries, runs ahead of the available investment opportunities, and is pushed into the US resulting in excess consumption and asset price inflation visit http://tcmb.gov.tr/odemedenge/odmain.html for Turkish practice. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 20 / 190

Relationship Between BOP and FX rate regime Under pure float: Total net underlying demand for TL = CRA surplus+cpa surplus =Basic balance is equated to zero by exchange rate movement. Under fixed rates: Government intervenes to fix exchange rate, in which case. Item for 4 in CPA : CB FX reserves= CRA+CPA to prevent basic balance causing exchange rate to move Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 21 / 190

Balance of Payments: Crisis and Balancing Mechanisms A BOP crisis (currency crisis) occurs when a nation is unable to service its debt repayments and/or to pay for essential imports. It generally is coupled with a fast depreciation of home currency. General Mechanism: Large Capital Inflows over Time (either due to finance high economic growth, in this case to finance investment / or due to excessive consumption, in this case to finance consumption ( and lower savings)) unsustainable levels of debt creates a chain of events: investors pull out their funds by selling domestic currency denominated assets causing rapid depreciation of home currency Local banks and firms run in to sudden debt problems because their revenues are in local currency but their existing debt is in foreign currency the central bank can support the currency as long as it has enough FXreserves, but once reserves fall below a certain level chooses to increase interest rates to prevent outflows prevents currency depreciation and reduces the value of debt in domestic currency however, the domestic economy is depressed recession follows. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 22 / 190

BOP Items: The Mystery of the Current Account It is not simply exports-imports. zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 23 / 190

BOP Items: The Mystery of the Current Account It is not simply exports-imports. Indicative of Consumption/Savings Behavior of Nations zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 23 / 190

BOP Items: The Mystery of the Current Account It is not simply exports-imports. Indicative of Consumption/Savings Behavior of Nations Indicative of Growth sources Ex: Inputs and Intermediate Inputs Also affected by asset evaluation effects, i.e. bubbles, stock market performance, real estate through indirect effects of these on consumption zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 23 / 190

BOP Items: The Mystery of the Current Account It is not simply exports-imports. Indicative of Consumption/Savings Behavior of Nations Indicative of Growth sources Ex: Inputs and Intermediate Inputs Also affected by asset evaluation effects, i.e. bubbles, stock market performance, real estate through indirect effects of these on consumption Coupled with Budget Deficit, can be indicative of a country s probability of default Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 23 / 190

Review True or False? Why? Under pure float: CA surplus + CPA surplus + CB reserves = 0 if there are no mismeasurements Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 24 / 190

Review True or False? Why? Under pure float: CA surplus + CPA surplus + CB reserves = 0 if there are no mismeasurements True or False? Why? BOP deficit likely to cause depreciation of the currency Explain how a real estate bubble can affect CA surplus/deficit Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 24 / 190

Review True or False? Why? Under pure float: CA surplus + CPA surplus + CB reserves = 0 if there are no mismeasurements True or False? Why? BOP deficit likely to cause depreciation of the currency Explain how a real estate bubble can affect CA surplus/deficit Explain how growth is financed through Current Account Deficit Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 24 / 190

Review True or False? Why? Under pure float: CA surplus + CPA surplus + CB reserves = 0 if there are no mismeasurements True or False? Why? BOP deficit likely to cause depreciation of the currency Explain how a real estate bubble can affect CA surplus/deficit Explain how growth is financed through Current Account Deficit List and explain the items of CA, CPA and BOP Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 24 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price 2 PPP Extensions zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price 2 PPP Extensions 1 Harrod-Balassa-Samuelson zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price 2 PPP Extensions 1 Harrod-Balassa-Samuelson 2 Trade Costs(Iceberg) Model zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price 2 PPP Extensions 1 Harrod-Balassa-Samuelson 2 Trade Costs(Iceberg) Model 3 Incomplete Pass-Through zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price 2 PPP Extensions 1 Harrod-Balassa-Samuelson 2 Trade Costs(Iceberg) Model 3 Incomplete Pass-Through Uncovered Interest Rate Parity zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Theories about Exchange Rate Determination Purchasing Power Parity (PPP) 1 Law of One Price 2 PPP Extensions 1 Harrod-Balassa-Samuelson 2 Trade Costs(Iceberg) Model 3 Incomplete Pass-Through Uncovered Interest Rate Parity Covered Interest Rate Parity zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 25 / 190

Law of One Price Definition The law of one price: Two goods, if they are identical, must sell for the same price. Domestic Economy zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 26 / 190

Law of One Price Definition The law of one price: Two goods, if they are identical, must sell for the same price. Domestic Economy The law of one price in the context of domestic economy the relationship holds if transaction costs are allowed: e.g., zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 26 / 190

Law of One Price Definition The law of one price: Two goods, if they are identical, must sell for the same price. Domestic Economy The law of one price in the context of domestic economy the relationship holds if transaction costs are allowed: e.g., P I = P A + C where P I, P A is the price of the same good in Istanbul and Ankara respectively and C is the transaction cost (transportation, local taxes, etc.). The idea here is that arbitrage opportunities will be eliminated by trade. zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 26 / 190

Law of One Price Definition The law of one price: Two goods, if they are identical, must sell for the same price. Domestic Economy The law of one price in the context of domestic economy the relationship holds if transaction costs are allowed: e.g., P I = P A + C where P I, P A is the price of the same good in Istanbul and Ankara respectively and C is the transaction cost (transportation, local taxes, etc.). The idea here is that arbitrage opportunities will be eliminated by trade. Open Economy P I = SP P + C where P I, P P is the price of the same good in Istanbul and Paris respectively and S is the TL/Euro exchange rate. zan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 26 / 190

PPP and Real Exchange Rate Definition The PPP relation is given by P i = SPi for i = 1,..., N where P i is the domestic price of good i and Pi is the foreign price of good i and S is the exchange rate or P = SP where P is domestic price index and P is the foreign price index Definition The real exchange rate, Q, between two countries is given by Q = SP P. Corollary If PPP holds then Q = 1. Example: When PPP adjusted India s GDP is 3,608 billion dollars as opposed to 1,704 billion dollars calculated with nominal exchange rates. Denmark GDP per head: PPP adjusted: $37,500 vs. Nominal Exch Rate: $62,100 Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 27 / 190

PPP and Inflation Theorem If PPP holds then the rate of home currency depreciation rate is equal to difference between home and foreign inflation rates. Proof. Taking logarithms and derivatives of both sides of P = SP log(p) = log(s) + log(p ) dp/p = ds/s + dp /P ds/s = dp/p dp }{{}}{{} /P }{{} depreciation = inflation inflation In reality PPP fails most of the time. Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 28 / 190

PPP and Transaction Costs Let K be a constant that represents the total costs of conducting international trade including tariffs, etc. P = KSP log(p) = log(k ) + log(s) + log(p ) Theorem If trade costs are constant, then they do not affect the currency depreciation rate Proof. Taking the derivative above yields ds/s }{{} = dp/p }{{} dp /P }{{} dk /K }{{} depreciation = inflation inflation change in trade costs but dk = 0 Ozan Hatipoglu (Department of Economics) Open Economy Macroeconomics Spring 2017 29 / 190