The Open Economy: Macroeconomics IITlf 948 16 84 79 Alba Del Villar (UPNA) Macroeconomics II Curso 2014/2015 1 / 90. Outline 1 Literature Textbooks Interesting published papers

The Open Economy: Macroeconomics II

Exchanges rates and policy choices

Alba Del Villar PhD [email protected]

Office D-2.19- Los Madroños BuildingOffice Hours: Monday: 10-12h , Thrursday 10-12h

Tlf 948 16 84 79

Alba Del Villar (UPNA) Macroeconomics II Curso 2014/2015 1 / 90

Outline

1 LiteratureTextbooksInteresting published papersOpen Economy Questions

2 Openess in goods and financial marketsOpenness in goods marketsOpenness in financial markets

3 The equilibrium in the goods marketsIS curve

4 The Mundell-Fleming Model

5 Exchange rate regimesFixed exchange rates


Outline







Literature

Blanchard Textbook:European Perspective: Chapters:6,18 and 19American Perspective: Chapters 18,19,20 and 21

N.Gregory Mankiw Macroeconomics: Ch.5, Ch 12


Outline







Interesting published papers

Robert E. Lucas, “Why Doesn’t Capital Flow from Rich to PoorCountries?” American Economic Review 1990New Keynesian Open Economy DSGE Model, Galí and MonacelliReview of Economic Studies 2005Melitz , EconometricaMilner et al (2006) ’A Natural Experiment for Identifying the Impactof ’Natural’ Trade Barriers on Exports’, Journal of DevelopmentEconomicsMilner, C., Morrissey, O. and Rudaheranwa, N. (2000) ’Policy andnon-Policy Barriers to Trade and Implicit Taxation of Exports inUganda’, Journal of Development StudiesJ. Marcus Fleming Staff Papers IMF Vol. 9, No. 3 (Nov., 1962), pp.369-380


http://www.jstor.org/discover/10.2307/2006549?sid=21105804677063&uid=4&uid=2&uid=3737952


http://restud.oxfordjournals.org/content/72/3/707.short

http://restud.oxfordjournals.org/content/72/3/707.short

http://www.sciencedirect.com/science/article/pii/S0304387805000982



http://www.tandfonline.com/doi/abs/10.1080/713600069.VN8WRi4mknY



http://www.jstor.org/discover/10.2307/3866091?uid=3737952&uid=2129&uid=2&uid=70&uid=4&sid=21106144575201


Outline







Open Economy Questions

What is the difference between real and nominal exchange rate?What is purchasing power parity and how does it explain nominalexchange rates?What happends after the sounded ECB expansionary monetarypolicy?What if our domestic currency is been depreceated over thelong-run?and over the short-run?What exchange rate system is better to control economy policy?OCDE WebSite


http://data.oecd.org/spain.htm

What do we know so far....

A model is a set of Variables, Equations and ParametersWhat are the main characteristics of the Short-Medium-Long Run?In a closed economy, agents ( people) face one decision: Save orbuy(consume), what happens in an open economy setting?Agents now face two decisions: Save or buy, Domestic or foreign.From Ad-hoc Macro Models to the microfundations of MacroModels.


Outline







The Open Economy

The world is still a closed economy, but its regions and countries arebecoming increasingly open. . . . The international economic climatehas changed in the direction of financial integration, and this hasimportant implications for economic policy.—Robert Mundell, 1963The small open economy and the two country model.The Mundell–Fleming model is the IS–LM model for a small openeconomy. It takes the price level as given and then shows what causesfluctuations in income and the exchange rate.The large open economy is an average of the closed economy and thesmall open economy. To find how any policy will affect any variable, findthe answer in the two extreme cases and take an average.


The framework

Openness in goods markets:Ch denotes domestic-goods and Cf denotes foreign goodsFree trade restrictions include tariffs and quotas

Openness in financial markets:bh denotes domestic-bonds and b∗ denotes foreign assetsCapital controls place restrictions on the ownership of foreignassets

Openness in factor markets:Labour:Domestic L,Foreign L∗ and capital:domestic K and foreignK ∗

European Zone, NAFTA and other treaties


From closed to open economy


Net trade US dollars: The case of Spain

OECD (2015), Trade in g&s (%GDP) (indicator). (Accessed on 18 January 2015): Spain , UK & OCDE

OECD (2015), Trade in goods and services (indicator). doi: (Accessed on 18 January 2015)


Imports as percentage of GDP: The case of Spain




Exports as percentage of GDP: The case of Spain




Trade balance USA and CHINA


OECD (2015), (Accessed on 18 January 2015)


Exports and Imports

Ratio of Exports to GDP for selected OCDE Countries ( 2006)United States 11%, Japan 18% United Kingdom 30 %Germany 48% , Switzerland 54%, Netherlands 80%Austria 55% , Belgium 81%

Can exports exceed GDP? Exports ratio greater than one?(Blanchard book P.402)

NO: A country cannot export more than it producesYES: Exports and Imports may include intermediate goods.

Do those numbers indicate that the US has more trade barriersthan UK?What are the factors behind these differences?


Nominal and real exchange rate

Warning! Nominal exchange rate can be quoted in two ways andthere is no agreed upon rule among economists as to which of thetwo definitions to use.

As the price of the domestic currency in terms of foreign currency.1E = 1.20$As the price of the foreign currency in terms of the domesticcurrency. 0.83E = 1 $

An appreciation of the domestic currency is an increase in the price ofthe domestic currency in terms of the foreign currency, whichcorresponds to a increase in the nominal exchange rate. What if theEuro/dollar rate increases?A depreciation of the domestic currency is a decrease in the price of thedomestic currency in terms of the foreign currency, or a decrease in thenominal exchange rate. What if the euro/dollar rate decreases?Countries under fixed exchange rate: REVALUATION Vs DEVALUATION



What really matters is how much of foreign goods we are able tobuy with domestic goods. An that is the Real Exchange RateExample of the American Cadillac and the British Jaguar.The nominal exchange rate is the rate at which people trade thecurrency of one country for the currency of another country.The real exchange rateis the rate at which people trade the goodsproduced by the two countries.The real exchange rate equals the nominal exchange ratemultiplied by the ratio of the price levels in the two countries.The nominal exchange rate is determined by the real exchangerate and the price levels in the two countries. Other things equal, ahigh rate of inflation leads to a depreciating currency.



Like nominal exchange rates, real ER move over timeAn increase in the relative price of domestic goods in terms offoreign goods is called Real AppreciationA decrease in the relative price of domestic goods in terms offoreign goods is called Real Depreciation

Because the real exchange rate is the price of domestic goodsrelative to foreign goods, an appreciation of the real exchange ratetends to reduce net exports.The equilibrium real exchange rate is the rate at which thequantity of net exports demanded equals the net capital outflow.

ε =Et ∗ Ph

P∗ (1)




Big Mac Prices and the Exchange Rate


CASE STUDY: Factors behind trade balance

Geography: Low ratio in Japan : Gravity modelsSize: The smaller the more specialize:High ratio in BelgiumWhy in some developing countries trade liberalization has not leadto an exports response?

Trade costs: Policy-induced costs Vs Natural CostsMalawi: Transport costs are as twice as high as the effect of tariffs.Mali: It is more expensive ( Double) to trade within African countriesthan with the US

Case of Uganda:Aggressive trade liberalization reforms + No Exports Response.Landlocked country, credit constrained, institutional inefficiencies ,infrastructure...

"The Great Lakes Corridor Study" World Bank 1994


CASE STUDY: Factors behind trade balance

Are the reported exports data reliable?One-third of all export taxes cover natural resource sectors (WTO)Some show that the illegal avoidance of such barriers is rife andleaves traces in official statisticsExports are more likely to be missing from the exporter’s officialstatistics when export barriers are in place, suggesting part ofmissing exports are illegal, having circumvented export barriersThe intensity of exports barriers by country: China, India, SouthAfrca, Argentina..


Reading Check

The ratio of a country‘s exports to its GDP must?be greater than oneEqual to onebe larger than the ratio of imports to GDP?be less than oneNone of the above

Which of the following, all else fixed, will cause the real exchangerate to increase?

a nominal depreciationa reduction in the foreign price levela reduction in the domestic price levelAll of the aboveNone of the above


Reading Check

If the Exchange rate ( dollar / pound) is 1.5 pounds for a dollar,and is expected to be 1.35 in one year, the expected rate of ...

depreciation of the dollar is 10 percentappreciation of the dollar is 10 percentdepreciation of the dollar is 15 percentappreciation of the dollar is 15 percentnone of the above

If the price level in Japan is 1.0, and in the U.S is 2.0. It costs 100Yen to buy 1 dollar, then the real exchange rate b/ U.S and Japanis....

25020010010


Little notes about large numbers

Germany (2014)44 190 US dollars per capita45.7 percent exports to GDP, 1510.7 BUS dollars39.1 percent imports to GDP, 1216 BUS dollars57539 MUS dollars outflows FDI, 1.58 percent of GDP (2013)72617 MUS dollars outflows FDI, 2.0 percent of GDP(2008)26716 MUS dollars inflows FDI, 0.7 percent of GDP (2013)8093 MUS dollars inflows FDI, 0.2 percent of GDP( 2008)

Spain (2014)33 985 US dollars per capita29.2 percent exports to GDP, 324 BUS dollars.32 percent imports to GDP, 355 BUS dollars26030 MUS dollars outflows FDI, 0.7 percent of GDP ( 2013)74573 MUS dollars outflows FDI,4.7 percent of GDP ( 2008)39159 MUS dollars inflows FDI, 2.9 percent of GDP(2013)76843 MUS dollars inflows FDI,4.8 percent of GDP(2008)


Outline







The balance of payments

Summarizes a countrys transactions with the rest of the world.Transactions ABOVE the line : current accountTransactions BELOW the line: capital accountCapital account should be equal to current account:StatisticaldiscrepancyCurrent account: Exports and imports + Investment income + Nettransfers =>0Capital account: Domestic holdings by foreigners - foreignholdings by localsCurrent account>0 Surplus or Current account<0 DeficitCapital account >0 Surplus or Capital account<0 Deficit


Balance of payments U.S 2006


Domestic Vs Foreign Assets

What would you buy: domestic or foreign assets? why?Determinants: Interest rate differencials i - i*BUT also the Expectations on nominal exchange rate.Whats the expected rate of return of foreing holdings?Should they have the same expected rate of return than domesticholdings?

(1 + it ) = (Et )(1 + i∗t )1

Eet+1

(2)

(1 + it ) = (1 + i∗t )Et

Eet+1

(3)


Interest rates and Exchange rates: UIPR

Uncovered interest parity relation or interest parity conditionDomestic interest rate must be ( approx) equal to the foreigninterest rate plus the expected depreciation rate of the domesticcurrencyTherefore, if Ee

t+1 = Et , then it = i∗tThen, the highest expected rate of return the better....BUTWhat about transactions cost? Risk?


Interest rates and Exchange rates: UIPR

Would you buy brazilian bonds if the monthly interest rate is 36.9percent? (Blanchard book P.414)Depends whether you expect the brasilian real to depreciate w.r.t.the euro over the coming year.We assume that the expected exchange rate is similar to that oflast month.Then, the expected rate of return in Euros from holding Brazilianbonds is only ( 1.017-1 ) = 1.7 percentWhat about transactions cost? Risk?


CASE STUDY: International capital flows

Spanish trade deficit represents a flow of capital into Spain fromthe rest of the world.Since the world is a closed economy, the capital must come fromcountries running trade surpluses.In some nations, savings exceed investment in domestic capital sothat they send funds abroad to other countries.Using the clasical Cobb Douglas production function andassuming free capital markets, capital should flow to countrieswith the highest marginal product of capital.MPK tells us how much extra output an extra unit of capital wouldproduce.


CASE STUDY: International capital flows

DIMINISHING MARGINAL PRODUCT: The more capital a nationhas, the less valuable an extra unit of capital is.Then, capital should be more valuable where capital is scarce:Rich Vs Poor countries.Is capital flowing from rich countries to poor countries?Robert E. Lucas, “Why Doesn’t Capital Flow from Rich to Poor

Countries?” American Economic Review 1990Why not?

Technology differencesInstitutional qualityHuman capital




FDI Flows to rich countries


FDI Flows to poor countries


Portfolio equity flows to rich countries


Portfolio equity flows to poor countries


Private flows: The Case of Spain

OECD (2015), Private flows (indicator). (Accessed on 18 January 2015): Span & UK


Net errors and omissions

Under normal conditions in an ideally perfect world, the currentaccount is always found equal to the capital account, by definition.Net errors and omissions constitute a residual category needed toensure that accounts in the balance of payments statement sumto zero. Net errors and omissions are derived as the balance onthe financial account minus the balances on the current andcapital accountsOne of the estimates of capital flight includes the errors andomission of the Balance of Payment which is been used tobalance up the accounts.Errors and Omissions is known as statistical discrepancy and isintended to offset over-statements or under-statements in aBalance of PaymentWorld Bank World Development Indicators


http://data.worldbank.org/indicator/BN.KAC.EOMS.CD/countries/1W?page=1&display=map

Reading Check II

Because the U.S traditionally gives more foreign aid than itreceives, the U.S tradicionally has a negative value for...

The capital account balanceThe trade balanceInvestment incomeNet transfers receivedAll of the above

The difference between net capital flows and the current accountdeficit is called the...

Capital account surplusCapital account deficitInternational errorMissing numberStatistical discrepancy


Reading Check II

Assume that interest parity condition holds...Domestic interest rate is 9 %, foreign interest rate is 5%. Wewould expect that...

Individuals will only hold foreign bondsIndividuals will only hold domestic bondsdomestic currency is expected to appreciate by 4 %domestic currency is expected to depreciate by 4 %None of the above

Also, assume that the US interest rate is greater than the UK rate.Then, investors expect....

the pound to depreciate relative to the dollarthe pound to appreciate relative to the dollarThe dollar-pound exchange rate to remain fixedThe US interest rate to fallNone of the above


Outline







The IS relation in an open economy

KEY : Domestic demand for goods (DD) Vs Demand for domesticgoods ( ZZ)Therefore, DDt = Ct + It + Gt

Therefore, ZZt = Ct + It + Gt + EXt - IMt

ZZ slope is FLATTER than DDs : As income increases,DDincreases more than ZZ because some demand falls into foreigngoods.Note that Ct is now a composite index of domestically producedgoods and foreign produced goods ( Imports)The IS curve will be Yt = Ct + It + Gt + EXt - IMt


Exhange rate and Trade Balance

The Marshall- Lerner Condition refers to the condition under whicha real depreciaion leads to an increase in net exports.To improve the trade balance, real depreciation will make exportsand imports( in value) to increase. Latter on the net exports willaccomodate so that the increase in Exports offsets the increase inImports.It turns out that this condition is satisfied in reality, usually takesfrom 6 to 12 months so see NX increase after a real depreciation.


Savings, Investment and the trade balance.

An alternative way of representing the goods market equilibrium isby looking at the savings-investment relation:Recall that savings equals to disposable income minusconsumption, so we need to do some arrangement to the LHS ofthe equation (IS) to move from total income to savings. Also, notethat Current Account ( CA) is defined as the sum of net exports,net income received and net transfers.If CAt ≡ NXt + NIt+ NTt

Then, CAt = St + (Tt - Gt ) - ItWhich is the same as CAt = St - It , where St contains private andpublic savings Tt - Gt


Open Economy Model: Short Run Analysis

The small open economy and the large economy modelThe Mundell–Fleming model is the IS–LM model for a small openeconomy. It takes the price level as given and then shows whatcauses fluctuations in income and the exchange rate.The large open economy is an average of the closed economyand the small open economy. To find how any policy will affect anyvariable, find the answer in the two extreme cases and take anaverage.This model has been described as the dominant policy paradigmfor studying open-economy monetary and fiscal policy. In 1999,Robert Mundell was awarded the Nobel Prize for his work inopen-economy macroeconomics, including this model.J. Marcus Fleming Staff Papers IMF Vol. 9, No. 3 (Nov., 1962), pp.369-380Robert Mundell, Laureate in Economic Sciences 1999




https://www.youtube.com/watch?v=Qsm1HHmbBSw

Open Economy Model in the Short Run

KEY ASSUMPTION : The small open economy Vs the largeeconomy modelThe Small open economy model ( SOE model ) assumes that theinterest rate in the economy is determined by the world interestrate. rt = r∗tNote that r∗t is assumed to be exogenously fixed because theeconomy is sufficiently small relative to the world economy that itcan borrow or lend as much as it wants in world financial marketswithout affecting the r∗t .Therefore, the Money Market and the LM curve are a bit differentNow the money supply is still controlled by the central bank butmoney demand depends on r∗t , so that it can be representedgraphically with a vertical line. Given the world interest rate the LMequation determines aggregate income, regardless of theexchange rate.


Putting all components together: The SOE Model

Then, the IS curve Yt = Ct ( Yt - Tt ) + It ( r∗t ) + Gt + NXt (et )And, the LM curve Mt / Pt =Lt ( r∗t , Yt )


The SOE model: Short Run Dynamics


The large economy case

In this course we are going to focus on the Short Run Model of theLarge Open Economy, which combines the closed-economy logicof the IS-LM model and the small open economy logic of theMundell-Fleming model.They key difference from the SOE is that its interest rate is nolonger fixed by world financial markets. So that the relationbetween the interest rate and the flow of capital abroad must beconsidered.Now interest rate differencials will have effects on net capitaloutflows: Since the expected future return on each bond might bedifferent, investors will buy the more attractive bond and sell theless atractive bond.Thus, the net capital outflow is negatively related to the interestrate.


Putting all components together

Then, the IS curve Yt = Ct ( Yt - Tt ) + It ( rt ) + Gt + NXt (et )And, the LM curve Mt / Pt =Lt ( rt , Yt )And the NX curve NXt = CFt ( rt ) where CFt is net capital outflowand it depends on rt

To better understand the implications of this model, we cansubstitute the 3rd equation into the 1st, so thatIS: Yt = Ct ( Yt - Tt ) + It ( rt ) + Gt + CFt (et )LM: Mt / Pt =Lt ( rt , Yt )Note that expenditure now depends on the interest rate for tworeasons: As in the closed economy model, a higher interest ratereduces investment. But now, a higher interest rate also reducesnet capital outflows and thus lowers net exports.


The LOE model


The LOE model


Fiscal Policy dynamics SOE Vs LOE

Effects after a Positive Fiscal Policy Shock ( i.e. Increase ingoverment spending)It shifts the IS curve to the right ( due to the increase in ZZt ). AsZZt increases, so does Yt , then there is an increase in Md

tincreasing rt . These two effects are similar to those in a closeeconomy.They key thing here is to notice that in the large open economy,the higher interest rate reduces the net capital outflow sincedomestic bonds are now more attractive.A higher demand for domestic bonds leads to an exchange rateappreciation, which in turn makes domestic goods moreexpensive relative to foreign goods: then, net exports fall.BUT it does not offset the initial increase in output


Fiscal Policy dynamics SOE Vs LOE

The impact on income, however, is smaller in the large openeconomy than in a close economy, besides the offsetting factor ofinvestment, there is a secondary offsetting factor throughexchange rate and net exportsIt should be noticed that a positive fiscal policy shock under asmall open economy has NO effects on domestic income.Note that there are no interest rate differencials that would makedomestic bonds more/less attractive than foreign bonds.Therefore, the effect on net exports will offset completly the initialincrease in income.


The LOE model


Monetary Policy dynamics SOE Vs LOE

Effects after a Contractionary Monetary Policy Shock ( i.e.Increase in interest rate)Recall that in a closed economy a reduction in the money supplydecreases spending because it increases rt and it lowersinvestment.However, in a small open economy this channel of moentarytransmission is not available, because the rt is fixed by the worldinterest rate.As soon as the reduction in money supply starts putting downwardpressure on the rt , capital will flow IN the economy, preventing rtfrom falling above the r∗t .


Monetary Policy dynamics SOE Vs LOE

The same happends in a large open economy: increase in rt .A higher rt leads to a lower net capital outflow, which decreasesthe supply of domestic currency in the market for foreign exchangeThus, domestic appreciation makes domestic goods relativelymore expensive than foreign goods, so that net exports decline.


Little notes about large numbers

Exchange Rates Data Sources :Bloomberg Markets Currency1 Australian Dollar (AUD) is equal to 0.7196 Euro (EUR)1 Chinese Renminbi (CNY) is equal to 0.1485 Euro (EUR)1 South Korean Won (KRW) is equal to 0.0009 Euro (EUR)1 Canadian Dollar (CAD) is equal to 0.7555 Euro (EUR)1 Kenyan Shilling (KES) is equal to 0.0098 Euro (EUR)1 British Pound (GBP) is equal to 1.3969 Euro (EUR)1 Argentine Peso (ARS) is equal to 0.1035 Euro (EUR)1 Czech Koruna (CZK) is equal to 0.0364 Euro (EUR)1 Russian Ruble (RUB) is equal to 0.0181 Euro (EUR)


http://www.bloomberg.com/markets/currencies/

The Euro Dollar Exchange Rate


Reading Check III

In an open economy under flexible exchange rates andrepresented by the IS-LM IP model, a reduction in govermentspending will cause a reduction in ... ...

Net ExportsThe Exchange rate ( i.e. depreciation)ExportsAll of the abovenone of the above

Suppose a country with a fixed exchange rate decides to reducethe price of its currency. This change in policy is called....

An appreciationA depreciationA pegA devaluationA revaluation


Reading Check III

Assume that a country is operating in a fixed exchange rateregime and that perfect capital mobility exists. Then ...

The domestic and foreign interest rates must be equalThe CB cannot use monetary policy to affect domestic outputAn expansionary fiscal policy will require that the CB increases theMoney SupplyAll of the abovenone of the above

Suppose a country is pursuing a fixed exchange rate regime withIMPERFECT capital mobility.The ability of that country to move itsdomestic interest rate while maintaining its exchange rate willdepend on....

The degree of development of its financial marketsThe degree of capital controlsThe amount of foreign exchange it holdsAll of the aboveA and B are correct


Outline







Fixed Exchange Rate System

Under a fixed exchange rate system and perfect capital mobilitythe rt must be equal to r∗t .Recall the interest parity condition

(1 + it ) = (1 + i∗t )−Ee

t+1 − Et

Et(4)

If nominal exchange rate is now fixed, then the termEe

t+1−Et

Et≈ 0

rt = r∗t .Increases in the domestic demand for money must be matched byincreases in the supply of money in order to maintain the rtconstant.To summarize: Central Bank gives up monetary policy as a policyinstrument.


Fixed Exchange Rate System

The essence is the commitment of the CB to allow the Mst to adjust

to whatever level to ensure that the equilibrium Et in the market forforeign currency exchange equal the announced exchange rate.The Central Bank stands ready to buy or sell foreign currency atthe fixed exchange rateIn a sense, when a nation fixes its currency to that of anothernation, its adopting that other nation s monetary policyExchange rate uncertainty makes international trade more difficult: Since the mid 70s, both real and nominal exchange rate becameand have remained much more volatile than anyone hadexpected. Is it irrational and destabilizing specualtion?


Fiscal policy under Fixed Exchange Rate System


Some facts about exchange rate system

The Gold Standard : Late 19th and early 20th centuries.Exchange one unit of a country s currency for a specified amount ofgoldKeynes Vs Churchill

1950s and 1960s : Bretton Woods SystemFixed Exchange Rate Regimes : Currencies peg to US dollar, andUS dollar fixed at 35$ per ounce of gold.

1973 : Flexible Exchange Rate SystemRichard Nixon closing Bretton Woods Meetings


https://www.youtube.com/watch?v=OcVtdViitko

The Impossible Trinity

Is it possible to have it all?A nation must choose one side of this triangle, giving up theinstitutional feature at the opposite corner.1st Option: Allow free flows of capital and to conduct anindependent monetary policy. Thus, is impossible to have a fixedexchange rate: it should float to equilibrate the forex market.2nd Option: Allow free flows of capital and to fix the exchangerate. Thus, the country loses the hability to run an independentmonetary policy since the unique goal would be to maintain the Et .3rd Option: Restrict international capital flows. Then rt is nolonger fixed to world interest rate but is determined by domesticforces. Thus, is possible to both fix the ET and conductindependent monetary policy.


From Short Run to Medium Run I

There is a sharp contrast between the behavior of an economywith flexible ex.rate and an economy with fixed exchange rates.

Flexible: To reduce trade deficit a country would achieve realdepreciation by relying on an expansionary monetary policy toachieve both a lower interest rate and a decrease in the exchangerate.Fixed: The country lost both instruments, since the nominalexchange rate was fixed and thus it could not be adjusted and theIPC implied that the country could not adjust its interest ratesbecause it had to remain equal to the foreign interest rate.

So, is the flexible exchange rate regime much more attractive thana fixed one? Why should a country give up two key tools tostabilize the economy? Do these conclusions remain equal in themedium run?


From Short Run to Medium Run II

Recall the definition of real exchange rate,

ε =Et ∗ Ph

P∗ (5)

see that there are two ways of adjustment:By changing nominal exchange rate: Only possible under flexibleregime.By changing the good s relative prices: Decrease the price ofdomestically produced goods or increase the price of foreignproduced goods: Possible under both regimes, Flexible and fixed.


Aggregate demand in an Open Economy

Start from the condition on the goods market equilibriumYt = Ct ( Yt - Tt ) + It ( Yt , rt ) + Gt + NXt (Yt , Y ∗

t , ε)In equilibrium: Output must be equal to the demand forDOMESTIC goods.Recall Fisher Equation ....

r ≡ i − πe (6)

Then, we should check whether the exchange rate system isFlexible or fixed.


Aggregate demand under Fixed Exchange rates I

Assume that nominal exchange rate is, by definition, fixed, so that

Et = Et (7)

Also, assume that perfect capital mobility exists. Then, domesticinterest rate should be equal to foreign interest rate it = i∗tNow, the IS curve can be rewritten as the following function,

Yt = Ct (Yt − Tt ) + It (Yt , i∗t − πe) + Gt + NXt (Yt ,Y ∗t ,

Et ∗ Ph

P∗ ) (8)


Aggregate demand under Fixed Exchange rates II

This is a rich and complicated equilibrium condition: The level ofoutput implied by the equilibrium in the goods, financial andforeign exchange markets depends on:

Government spending, G, and Taxes, T. : ↑ G→ ↑ YForeign nominal interest rate minus expected inflation. An ↑ in i∗trequires a parallel ↑ in itForeign outputThe real exchange rate


Aggregate demand under Fixed Exchange rates II

For the moment, we only focus on the effects of only three ofthese variables: ε, G, and T. We shall therefore write,

Y = Y (Et ∗ Ph

P∗ ,G,T ) (9)

While the sign of the effect of the price level on output remains thesame, the channel is very different:

In the closed economy, the price level affects output through itseffect on the real money stock, and in turn, its effect on the interestrate.In the open economy under fixed exchange rates, the price levelaffects output through its effect on the REAL EXCHANGE RATE


Aggregate supply under Fixed Exchange rates I

The AS function describes the behavour of price level and wagesand it is obtained from the equilibrium in the labour markets.

P = Pe(1 + η)F ((1− YL

), z) (10)

Current price level depends on the Pe and on the level of YtHigher output leads to higher employment, which leads to lowerunemployment, higher wages and higher price levels.The expected price level affects nominal wages which affect currentprice leve.


Equilibrium in the Short Run and in the Medium Run

The AS curve shifts down over time ( since output is below its naturallevel), leading to a decrease in the price level:steady real depreciation.


The case for and against a Devaluation

Then, is there another way to return output to its natural level?YES, one time devaluation of the "right size". Not easy tocalculate the right size devaluation.A decrease in the nominal exchange rate, in a fixed exchange rateregime, leads to a real depreciation and thus to an increase inoutput.

Higher output leads to higher employment, which leads to lowerunemployment, higher wages and higher price levels.The expected price level affects nominal wages which affect currentprice leve.


Adjustment with a devaluation

A devaluation of the right size can shift AD to the right, moving theeconomy back to its natural level.


Reading Check IV

If the exchange rate between two countries is expected to remainfixed at its current rate....

Output growth rates must be equal in the two countriesPrice levels must be equal in the two countriesInflation must be equal in the two countriesNominal interest rates must be equal in both countries.None of the above

Suppose foreign exchange markets anticipate a devaluation forcountry A. Policy makers in A will continue to fix its nominalexchange rate. In order to peg the currency at its original level.....

Increase in the domestic interest rateIncrease in the domestic price levelConvince trading partners to raise their interest ratesAll of the aboveNone of the above


Reading Check IV

An increase in the foreign one year interest rate expected to occurin, say, 2 years will, all else fixed, have which of the followingeffects in a flexible ex. rate regime....

The ε will decrease with no change in the EtThe Et will decrease with no change in the εBoth Et and ε will decreaseNo change in either Et or εBoth Et and ε will increase

Assume a fixed regime and that the economy is initially operatingat the natural level of output. Then, after a revaluation....

The ε will be permanently higher in the medium runThe ε will be permanently lower in the medium runThe effect will be ambiguous.The ε will be unchangedNone of the above


Exchange rates movements under Flexible ExchangeRates I

We can rearrange the IPC to obtain the following....

(1 + it ) = (1 + i∗t )Et

Eet+1

(11)

Et =(1 + it )(1 + it+1)...(1 + it+n)

(1 + i∗t )...(1 + i∗t+n)Ee

t+n+1 (12)

Any factor that moves the Eet+1 , moves the Et . Indeed, if the it and

the i∗t are expected to be the same in both countries from t to t+n,then the RHS of the equation is equal to one, so it reduces theIPC toEt = Ee

t+1


Exchange rates movements under Flexible ExchangeRates II

Any factor that moves current or expected future domestic orforeign interest rates: moves the Et

The relation between it and Et is all but mechanical.Thus, any news that affects forecasts of the current accountbalance in the future is likely to have an effect on the expectedfuture exchange rate and, in turn, on the exchange rate today.When the central bank cuts the interest rate, financial marketshave to assess whether this action signals a major shift inmonetary policy and the cut in the interest rate is just the first ofmany such cuts, or whether this cut is just a temporary movementin interest rates.Operating under flexible regime means accepting fluctuations overtime


Choosing between exchange rate regimes I

We have seen that the exchange rate regime may not matter inthe medium run. But it does still matter in the short run.In the Short run, under fixed regime and perfect capital mobility, acountry gives up its control of interest rate and exchange rate.Also, expectations of future devaluation may lead investors to askfor very high interest rates. This in turn makes the economicsituation worse and puts more pressure on the country to devalue.However, operating under flexible rates may lead to a very volatileexchange rate and it may be difficult to control them throughmonetary policy.Then, we can say that in general flexible exchange rates arepreferable. Are there any exceptions?


Choosing between exchange rate regimes II

Yes, there are two exceptions:When a group of countries is already tightly integrated, a commoncurrency may be the right solution.When the CB cannot be trusted to follow a responsible monetarypolicy under flexible regime, a strong form of fixed regime, such asa currency board or dollarization, may provide a solution.But, what is an optimal- currency area?

The countries experience similar shocks, so they can choose thesame monetary policy.Countries with high factor mobility, which help countries to adjust toshocks.It is based on the argument that there may be times when a countrymight want to limit its ability to use monetary policy.


Choosing between exchange rate regimes III

What is a hard peg? It refers to the symbolic or technicalmechanism by which a country plans to mantain exchange rateparity.An extreme case of hard peg is simply to replace the domesticcurrency with a foreign currency. Because the foreign currencychosen is typically the dollar, this is known as dollarisation.A less extreme way would be the use of a currency boardinvolving the central bank.Under a currency board, a central bankstands ready to exchange foreign currency for domestic currencyat the official exchange rate set by the government; furthermore,the bank cannot engage in open market operations – that is, buyor sell government bonds.


Summary I

Even under a fixed exchange rate regime, countries can adjusttheir real exchange rate in the medium run. They can do this byrelying on adjustments in the price level.Exchange rate crises typically start when participants in financialmarkets believe a currency may soon be devalued. Defending theparity then requires very high interest rates, with potentially largeadverse macroeconomic effects.These adverse effects may force the country to devalue, even ifthere were no initial plans for such a devaluation.


Summary II

Any factor that increases current or expected future domesticinterest rates leads to an increase in the exchange rate today.Any factor that increases current or expected future foreigninterest rates leads to a decrease in the exchange rate today.Any factor that increases the expected future exchange rate leadsto an increase in the exchange rate today.There is wide agreement among economists that flexibleexchange rate regimes generally dominate fixed exchange rateregimes,


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Documents

The Open Economy: Macroeconomics IITlf 948 16 84 79 Alba Del Villar (UPNA) Macroeconomics II Curso 2014/2015 1 / 90. Outline 1 Literature Textbooks Interesting published papers