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OPEN ECONOMY

MACROECONOMICS

Dongpeng Liu

Department of Economics

Nanjing University

EXCHANGE RATE

The determination of exchange rate and how an economy responds

to changes in exchange rates are the key issues of open economy

macroeconomics

We begin the lecture with definitions of

Nominal exchange rate

Direct quotation

Indirect quotation

Real exchange rate

MACROECONOMICS, FALL 2016, DONGPENG LIU, NANJING UNIV 2

NOMINAL EXCHANGE RATE

Nominal exchange rates between two currencies can be quoted in

one of the two ways:

Indirect quotation: the price of the domestic currency in terms of

the foreign currency (amount of foreign currency needed to buy

certain amount of domestic currency)

Direct quotation: the price of the foreign currency in terms of the

domestic currency (amount of domestic currency needed to buy certain

amount of foreign currency)



An appreciation of the domestic currency is an increase in the

price of domestic currency in terms of the foreign currency.

An increase in indirect quotation of nominal exchange rate

A decrease in direct quotation of nominal exchange rate

A depreciation of the domestic currency is a decrease in the

price of the domestic currency in terms of foreign currency.

A decrease in indirect quotation of nominal exchange rate

An increase in direct quotation of nominal exchange rate

For the rest of the lecture, we use the indirect quotation of

nominal exchange rate unless otherwise specified. (An increase

in exchange rate corresponds to higher value of the domestic

currency)



Appreciation and depreciation are terms when the economy

operates under a flexible exchange rate regime.

When the economy operates under fixed exchange rate regime,

that is, the monetary authority aims to keep the exchange rate

between the domestic currency and a foreign currency constant,

two other terms are used

Revaluation: one time upward adjustment of exchange rate.

Devaluation: one time downward adjustment of exchange rate.




• USD appreciated

vs. Pounds in the

long run

• The exchange rate

fluctuates

dramatically over

the period

FROM NOMINAL TO REAL EXCHANGE RATE

Consider the following scenario

The price of a Cadillac in the US is $50,000.

The price of a BMW in Germany is €42,000.

A dollar is worth of 0.95 euro

The euro denominated price of the Cadillac is €47,500

The price of a Cadillac in terms of BMWs would be

47,500/42,000=1.13



To generalize this example to all the goods in the economy, we

use a price index for the economy (often GDP deflator) to

calculate the number of foreign goods needed to buy 1 unit of

domestic goods

𝜀 =𝐸𝑃

𝑃∗

𝜀: Real exchange rate

E: Nominal exchange rate

P: Domestic price level

𝑃∗: Foreign price level



An increase in 𝜀 implies domestic goods become more expensive

relative to foreign goods, which is called real appreciation

A decrease in 𝜀 implies domestic goods become less expensive

relative to foreign goods, which is called real depreciation.


FROM BILATERAL TO MULTILATERAL EXCHANGE RATE

Bilateral exchange rates are exchange rates between two

countries. Multilateral exchange rates are exchange rates

between several countries.

To measure the average price of US goods relative to the

average price of goods of US trading partners, we use the US

share of import and export trade with each country as the

weight for that country and construct the multilateral real US

exchange rate

Equivalent names for the relative price of US goods vs. foreign

goods are

Real multilateral US exchange rate

US trade weighted real exchange rate

US effective real exchange rate


INTEREST RATE PARITY

Let’s consider how the exchange rate is determined in the short-

run

Investors decide which asset or assets to hold based on the

characteristics the financial assets

Return

Risk

Liquidity

For simplicity, we believe government bonds are very liquid and

risk free (not necessarily the case in less stable countries)

Therefore, whether a investor invests in domestic or foreign

government bonds only depends on which bond offers higher

return



Suppose we have $1 in year t and can use the fund to buy domestic

government bond or foreign government bond. Let’s consider how

much money (in terms of dollar) we can receive 1 year later

Invest in domestic market: 1 + 𝑖𝑡

Invest in foreign market: 𝐸𝑡(1 + 𝑖𝑡∗)/𝐸𝑡+1

𝑒

In addition to foreign interest rate, the return of foreign

assets also depends on the exchange rate

Given the coexistence of both domestic and foreign government

bonds, it must be the case that

1 + 𝑖𝑡 = 𝐸𝑡(1 + 𝑖𝑡∗)/𝐸𝑡+1

𝑒



(1 + 𝑖𝑡)𝐸𝑡+1𝑒

𝐸𝑡= 1 + 𝑖𝑡

∗

(1 + 𝑖𝑡)(1 +𝐸𝑡+1𝑒 −𝐸𝑡

𝐸𝑡) = 1 + 𝑖𝑡

∗

𝑖𝑡 +𝐸𝑡+1𝑒 −𝐸𝑡

𝐸𝑡≈ 𝑖𝑡

∗

𝑖𝑡 ≈ 𝑖𝑡∗ −

𝐸𝑡+1𝑒 −𝐸𝑡

𝐸𝑡

Domestic interest rate = foreign interest rate – expected

foreign currency depreciation rate

Given expected exchange rate and the interest rates, interest

rate parity determines the (short-run) equilibrium exchange

rate



Holding other things equal, an increase in domestic interest

rate will be followed with domestic currency appreciation or

foreign currency depreciation

A sudden increase in domestic interest rate

Domestic asset return becomes higher and domestic assets are more

attractive

Domestic and foreign investors want to sell foreign assets and buy

domestic assets

The demand for domestic currency rises and the demand for foreign

currency drops

Domestic currency appreciates and foreign currency depreciates

Expected depreciation rate of foreign currency decreases, the

returns of foreign and domestic assets equate again



Holding other things equal, a decrease in domestic interest

rate will be followed with domestic currency depreciation or

foreign currency appreciation

Holding other things equal, a decrease in foreign interest rate

will be followed with domestic currency appreciation or foreign

currency depreciation

Holding other things equal, an increase in foreign interest

rate will be followed with domestic currency depreciation or

foreign currency appreciation

If a foreign country commits to a fixed exchange rate, the

foreign central bank must respond to an increase in domestic

interest rate with a contractionary monetary policy



Holding other things equal, an increase in expected exchange

rate leads to higher 𝐸𝑡

If a foreign country commits to a fixed exchange rate, the

foreign central bank must respond to an increase in expected

exchange rate with a contractionary monetary policy


THE GOODS MARKET IN AN OPEN ECONOMY

In an open economy, the demand for goods can be distinguished

between the following terms

Demand for domestic goods (total expenditure): C + I + G + NX

Domestic demand for goods: C + I + G

Domestic demand for domestic goods: C + I + G – IM

Foreign demand for domestic goods: X

In an closed economy

demand for domestic goods = domestic demand for goods

Now we need to subtract imports and add imports to calculate

demand for domestic goods


THE DETERMINANTS OF IMPORTS AND EXPORTS

𝐼𝑀 = 𝐼𝑀(𝑌, 𝜀)

Higher real exchange rate leads to higher imports

An increase in domestic income leads to an increase in imports

𝑋 = 𝑋(𝑌∗, 𝜀)

Higher real exchange rate leads to lower exports

An increase in foreign income 𝑌∗ leads to an increase in

exports



Note that the domestic demand

for domestic goods is still an

increasing function of Y

The gap between the two lines

implies the size of the

imports



ZZ: demand for domestic goods

The gap between ZZ and AA

implies the size of exports

ZZ and AA are parallel to each

other as exports is not

affected by domestic income

The gap between DD and ZZ

implies the size of net export

When Y is smaller than 𝑌𝑇𝐵, there is trade surplus. When Y

is larger than 𝑌𝑇𝐵, there is trade deficit


GOODS MARKET EQUILIBRIUM

The goods market is in

equilibrium when total output

equals demand for domestic goods

(total expenditure)

𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 + 𝐺 + 𝑁𝑋(𝑌, 𝑌∗, 𝜀)

At equilibrium level of output,

the trade balance may show a

deficit or a surplus


FISCAL POLICIES

Similar to the closed economy

income-expenditure model, an

increase in G will lead to higher

equilibrium output

An increase in G will also result

in higher trade deficit

This scenario is often called

twin deficits

The multiplier effect of

government spending would be

smaller compared to the case of

an closed economy


EXPORTS

An increase in exports leads to

an increase in output an net

export

The increase of net export is

smaller than the increase in

export

The increase in exports might be

caused by increase in foreign

output, or a change of preference

of foreign countries

The change of exports caused by a

real depreciation will be

discussed in detail later


THE IS RELATION IN AN OPEN ECONOMY

Y = C + I + G + NX

S = Y – T – C

S = C + I + G + NX – T – C

I = S + (T - G) - NX

Positive net exports imply lending to foreign countries

Negative net exports (net import) imply borrowing from foreign

countries

S + (T - G) – NX is the total savings available in the domestic

country


THE IS CURVE IN AN OPEN ECONOMY

Let’s consider what happens if there is a change in interest

rate

According to the interest rate parity, we know that

𝐸𝑡 =1 + 𝑖𝑡1 + 𝑖𝑡

∗ 𝐸𝑡+1𝑒

Given foreign interest rate and expected exchange rate, an

increase in domestic interest rate will lead to an appreciation

of domestic currency

In the short-run, domestic and foreign prices are constant,

therefore, real and nominal exchange rates are proportional to

each other

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


THE IS CURVE IN AN OPEN ECONOMY

If interest rate decreases…

Domestic currency depreciates. For any given Y, AA line shifts

up due to

1. An increase in investment

2. A decrease in imports

ZZ line shifts upward further due to an increase in exports

Equilibrium output increases

Output and interest rate move in opposite directions if the

goods market is in equilibrium

Downward sloping IS curve


THE LM CURVE IN AN OPEN ECONOMY

The money market equilibrium is still governed by the equality of

demand and supply of money𝑀

𝑃= 𝑌𝐿(𝑖)

Output and interest rate move in the same direction if the

money market is in equilibrium

Upward sloping LM curve


THE MUNDELL-FLEMING MODEL

The Mundell-Fleming model is the IS-LM model in an open economy

context


FISCAL POLICY

An increase in government spending shifts the IS curve to the

right

LM curve remains at the same position

Equilibrium output, interest rate and nominal exchange rate

rise

Consumption and government spending both go up

Investment falls

Net exports decrease


FISCAL POLICY


MONETARY POLICY

A contractionary monetary policy shifts LM curve up

IS curve remains at the same position

Equilibrium output decreases

Equilibrium interest rate and nominal exchange rate rise

Consumption and investment increases

The effect on trade balance is ambiguous


MONETARY POLICY


FIXED EXCHANGE RATE REGIME

Some central banks act under implicit and explicit exchange

rate targets and use monetary policies to achieve those targets

Many countries peg their currencies to the US dollar

Two extreme cases of fixed exchange rate regime

1. Dollarization

2. Common currency (Euro)

Let’s consider the implications of fixed exchange rates



Recall interest rate parity

1 + 𝑖𝑡 = 𝐸𝑡(1 + 𝑖𝑡∗)/𝐸𝑡+1

𝑒

For the purpose of this part, let’s take United States as the

foreign country. (In other words, the domestic currency is

pegged to USD)

Given the expected exchange rate and US interest rate (𝑖𝑡∗), a

fixed exchange rate implies a fixed domestic interest rate 𝑖𝑡


FISCAL POLICY UNDER FIXED EXCHANGE RATES


FISCAL POLICY UNDER FIXED EXCHANGE RATE REGIME

An increase in G shifts the IS curve to the right

If domestic central bank does not respond to the change in G,

domestic interest rate will rise and domestic currency will

appreciate

In order to keep interest rate and thereby, exchange rate,

constant, the central bank has to increase money supply, which

shifts LM curve downward

The increase in output will be larger compared to the case in

which the central bank allows the exchange rate to fluctuate



If the Federal Reserve believes the US economy is over-heated

and determines a contractionary monetary policy is appropriate,

US interest rate will increase

If the domestic country would like to maintain the exchange

rate at the target level, it has to adopt a contractionary

monetary policy as well

Domestic interest rate will increase and domestic output will

decrease


PROS AND CONS OF FIXED EXCHANGE RATE REGIME

Pros:

Stable exchange rate expectation

Low volatility of international trade

Low inflation

Cons:

Giving up monetary policy. In other words, money supply is no

longer an exogenous variable.

Domestic currency may under attack when the target rate

significantly deviates from equilibrium exchange rate


THE IMPOSSIBLE TRINITY

Fixed exchange

rate

Free flow of capital

Independence of monetary

policy


• Fixed exchange rate,

independence of monetary

policy and free flow of

capital are all

desirable

• However, only 2 of the

three policy positions

can be adopted by a

country simultaneously

• Which one to give up?

THE IMPOSSIBLE TRINITY

A small open economy is more likely to adopt a fixed exchange

rate regime and give up independence of monetary policy to

stabilize the economy

A economy experienced hyper inflation may adopt a fixed

exchange rate regime to fight inflation (It is desirable to

give up monetary policy under this scenario)

Larger economies tend to keep independence of monetary policy

Fixed exchange rate by regulating capital flow: China before 2005

Or allow exchange rate to float


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