ECON 442:ECONOMIC THEORY II (MACRO) Lecture 11: 17th April 2017

OPEN ECONOMY MACROECONOMICSThe Goods and Money Markets in an Open Economy

Dr Ebo Turkson

Nominal exchange rates quoted in one of two ways:Quantity or Volume or Indirect Quotation• As the price of a unit of the domestic currency in terms of the

foreign currency. • As in ¢1= £0.25 or ¢1=$0.38

• Here variations in the exchange rate is directly related to changes in the value of the domestic currency

• If yesterday ¢1= £0.25 and today ¢1= £0.30 then E↑ (an appreciation of the cedi)

• If yesterday ¢1= £0.25 and today ¢1= £0.20 then E↓ (a depreciation of the cedi)

• Used in commonwealth countries UK, Australia, New Zealand (Study text makes use of this quotation)

Recap of Nominal Exchange Rates

Nominal exchange rates quoted in one of two ways:Price or Direct Quotation• As the exchange rate of the domestic currency in terms of a unit

of a foreign currency. • As in ¢4.20= £1 or ¢2.67=$1

• Here variations in the exchange rate is indirectly related to changes in the value of the domestic currency

• If yesterday ¢4.10= £1 and today ¢4.00= £1 then E↓ (an appreciation of the cedi)

• If yesterday ¢4.10= £1 and today ¢4.20= £1 then E↑ (a depreciation of the cedi)

• Used in Ghana as in many other SSA countries. Most countries in the World use this quotation.

Recap of Nominal Exchange Rates

Recap of Real Exchange Rates

Recap of Trade Balance and Real Ex. Rate

• The purchase and sale of foreign assets implies buying or selling foreign currency—sometimes called foreign exchange.

• Openness in financial markets allows:

Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate movements.

Allows countries to run trade surpluses and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.

Openness in Financial Markets

This is the relation you must remember: Arbitrage implies that the domestic interest rate must be (approximately) equal to the foreign interest rate plus the expected depreciation rate of the domestic currency.

If , then 1

e

t tEE +

=*

tti i=

Interest Rates and Exchange Rates

* 1

e

t t

t t

t

Ei iE

E +−

≈ −

Openness in Financial Markets (cont.)

The relation between the domestic nominal interest rate, the foreign nominal interest rate and the expected rate of depreciation of the domestic currency is stated approximately as:

Interest Rates and Exchange Rates

* 1 ............Very Importante

t t

t t

t

Ei iE

E +−

≈ −

Openness in Financial Markets

This is the relation you must remember: Arbitrage implies that the domestic interest rate must be (approximately) equal to the foreign interest rate plus(minus) the expected depreciation (appreciation) rate of the foreign currency (domestic currency).

Should you hold domestic bonds or foreign bonds?• It depends whether you expect the domestic currency to

depreciate vis-á-vis the foreign currency over the coming year.

• If you expect the Ghana cedi to depreciate by more than the difference between the domestic and foreign interest rate, then investing in Ghana bonds is less attractive than investing in foreign bonds.

• The reverse is true

Interest Rates and Exchange Rates

Openness in Financial Markets

The Goods Mkt. In An Open Economy( based on Blanchard et al. Ch. 6 and 18

The IS relation in an open economy Assume that P and P* are fixed ⇒ Δε = ΔE The demand for domestic goods in an open

economy is given by, Z = C + I +G − IM /ε + X

The goods mkt. eqm. conduction, Y=Z, implies, Y = C(Y −T) +I(Y, r) +G−IM(Y,ε)/ε+ X(Y*,ε)

Y= C(Y −T) +I(Y, r) +G+ NX(Y,Y*,ε)

Y = C (Y −T )+ I (Y, r) + G+ NX (Y,Y*,ε ) + − + − + − + ?

(i) If G↑ or T↓ or C↑ ⇒ Y↑ howeverHigher domestic output, Y leads to a deterioration of the trade balance (NX)

How?Y↑⇒ IM↑ ⇒ ↓NX

Change in Y is smaller than under a closed economy

Important Remarks to note

(2) If Y*↑⇒ NX↑ ⇒ Y↑higher foreign output, Y*, implies improvements of the trade balance.

How? ↑Y* implies higher exports of domestic goods (↑X) which ↑ both domestic output, Y, and domestic demand, Z, through the multiplier.

Important Remarks to note

(3) The effect of a real depreciation (appreciation) on the trade balance, NX, is ambiguous.

↓ε affects NX = X (Y ,ε ) − IM ( Y, ε )/ ε through three channels

If 1 and 2 larger than 3, a real depreciation leads to an improvement in the trade balance (Marshall-Lerner condition).

Important Remarks to note

(4) A real depreciation leads initially to a deterioration, then to an improvement of the trade balance (J-curve).

Important Remarks to note

Focus• Saving, Investment, and Trade Balance

• IS-LM model in an open economy under perfect capital mobility and a floating and fixed exchange rate

The IS-LM in an Open Economy

• Saving, Investment, and Trade Balance Recall: We can always rewrite eqm. in goods mkt. (Y=Z), as the condition

Y = C + I +G + NX ⇔

Y − C −T = G −T + I + NX ⇔

NX = S + (T − G) − Ii.e. Trade balance = (Private + Public Savings) - Investment

The IS-LM in an Open Economy (cont)

Saving, Investment, and theTrade Balance

An increase in investment must be reflected either an increase in private saving or public saving, or in a deterioration of the current account balance.

A deterioration in the government budget balance must be reflected in an increase in either private saving, or in a decrease in investment, or else in a deterioration of the current account balance.

A country with a high saving rate must have either a high investment rate or a large current account surplus.

Output, the Interest Rate, and the Exchange Rate

In Chapter 18, we treated the exchange rate as one of the policy instruments available to the government.

The exchange rate is not a policy instrument, but instead it is determined in the foreign exchange market.

In this chapter, we examine the implications of equilibrium in both the goods market and financial markets, including the foreign exchange market.

The model is an extension to the open economy of the IS-LM model and it is known as the Mundell-Flemingmodel.

• A trade surplus corresponds to an excess of savings over investment. Implies this country is lending to the rest of the world [e.g. China].

• A trade deficit corresponds to an excess of investment over saving. Implies this country is borrowing from the rest of the world [e.g. US].

• An increase in the budget deficit must be reflected in an increase in private saving, a decrease in investment, or a deterioration of the trade balance.

The IS-LM in an Open Economy (cont)

Derivation of the Marshall-Lerner Condition

The Marshall-Lerner condition is the condition under which a real depreciation (lower Ɛ) leads to an increase in net exports.

Given the definition of net exports: NX = X – IM/ε Multiply both sides by ε to get: εNX = εX – IM, which can be

written as: ε(∆NX )= (∆ε)X + ε (∆X) – (∆IM) Divide both sides by εX to get:

If trade is initially balanced (εX = IM), then:

Assume Marshall-Lerner condition holds, hence:

NX (Y *, Y , ε )− + −

• P is fixed, πe = 0 ⇒ r = i • P and P* fixed, can set P = P* ⇒ ε = E

• The new equilibrium relation (IS), reads as follows

Y = C(Y − T ) + I (Y , i) + G + NX (Y ,Y *, E)+ + − − + −

The IS-LM Under perfect capital mobilityThe Mundell-Fleming Model

19-1 Equilibrium in the Goods Market

Recall the equilibrium condition in Chapter 18:

which can be rewritten as:

If ε = E, then goods market equilibrium implies that output depends negatively on both the nominal interest rate and the nominal exchange rate:

Equilibrium in the Money market

19-2 Equilibrium in Financial Markets

Recall the arbitrage relation or the interest parity condition in Chapter 17:

Assume the expected future exchange rate as given, so

which tells us that: An increase in the domestic interest rate leads to an increase in the

exchange rate. An increase in the foreign interest rate leads to a decrease in the

exchange rate. An increase in the expected future exchange rate leads to an increase in

the current exchange rate.

Equilibrium in the Money market

* (1 + ) (1 + ) tett

Ei iE

=

1

ee

tE E+=

*

1

U.I.P (1 + ) (1 + ) tett

t

Ei iE +

=

Equilibrium in Financial MarketsThe Relation between the Interest Rate and theExchange Rate Implied by Interest Parity

Putting Goods and Financial Markets Together

Putting Goods and Financial Markets TogetherThe IS–LM Model in the Open Economy

19-3 Putting Goods and Financial Markets Together

Figure 19-2 The IS–LM Model in the Open Economy

An increase in the interest rate reduces output both directly and indirectly (through the exchange rate). The IS curve is downward sloping. The LM curve is horizontal, as in Chapter 6.

19-4 The Effects of Policy in an OpenEconomy

Figure 19-3 The Effects of an Increase in the Interest Rate

An increase in the interest rate leads to a decrease in output and an appreciation.

19-4 The Effects of Policy in an OpenEconomy

Figure 19-4 The Effects of an Increase in Government Spending with an Unchanged Interest Rate

An increase in government spending leads to an increase in output. If the central bank keeps the interest rate unchanged, the exchange ratealso remains unchanged.