Evaluate the likely future path of interest rates over the next 2 years for US. You need to consider the following: 1. Monetary policy conducted by central bank “CB”, which tradeoffs inflation and unemployment in the short-run. 2. CBs control the short-term policy rate through open market operations which change the monetary base. 3. The policy rate affects other rates and transmits with lags to the rest of the aggregate economy through various channels. 5. In exceptional time, when interest rate is at zero or near zero, monetary policy can use other tools such as liquidity provision. •Financial account (FA): records flow of financial assets. These are Foreign Direct Investment, Net Portfolio Flows and Net Other (mainly bank loans and trade credits) •Capital account (KA): records flow of non-financial assets between countries – debt forgiveness, purchase of royalty rights Nominal exchange rate Bilateral vs. effective exchange rate Real Exchange Rates Purchasing Power Parity Inflation and Currency Movements What determines the current account? Uncovered Interest Parity : In the short-term, exchange rates are influenced by interest rate movements, expectations, risk premia. However, the majority of exchange rate fluctuations cannot be explained by macro factors in the short run. • In the medium to long-term, the real exchange rate will adjust to a level where the current account surplus/deficit matches longer term capital flows. • In the long run changes in nominal exchange rates reflect differences in inflation.