Chapter 10 Exchange Rates, Business Cycles, And Macroeconomic Policy In .

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Chapter 10Exchange Rates, BusinessCycles, and MacroeconomicPolicy in the Open EconomyEconomics 282University of AlbertaThe Open Economy Two aspects of the interdependence of theworld economies:– international trade in goods and services;– worldwide integration of financial markets.Nominal Exchange Rates If someone in one country wants to buygoods, services, or assets from someonein another country, normally she will firsthave to exchange her currency for that ofher trading partner’s country.1

Nominal Exchange Rates(continued) The nominal exchange rate, or exchangerate, between two currencies, enom, is thenumber of units of foreign currency whichcan be purchased with a unit of thedomestic currency.Exchange Rate Systems In a flexible-exchange-rate, or floatingexchange-rate, system exchange rates arenot officially fixed, but are determined byconditions of supply and demand in theforeign exchange market. Under this system exchange rates movecontinuously.2

Exchange Rate Systems(continued) In a fixed-exchange-rate system exchangerates are set at officially determined levels. The official rates are maintained by thecommitment of nations’ central banks tobuy and sell their own currencies at thefixed exchange rate.Real Exchange Rate The real exchange rate is the number offoreign goods someone gets in exchangefor one domestic good. Real exchange rates are based on priceindexes of “baskets” of goods. We assumethat each country produces a single good.Real Exchange Rate(continued)e enom PPForEnom is the nominal exchange rate;PFor is the price of foreign goods, measuredin the foreign currency;P is the price of domestic goods, measuredin nominal currency.3

Appreciation and Depreciation Under a nominal depreciation the nominalexchange rate, enom, falls, a dollar buysless units of foreign currency, it becomes“weaker”. Under a nominal appreciation the nominalexchange rate, enom, rises, a dollar buysmore units of foreign currency, it becomes“stronger”.Appreciation and Depreciation(continued) The terms “depreciation” and“appreciation” are associated with flexibleexchange rates. The fixed-exchange rate systemequivalents are devaluation andrevaluation.Appreciation and Depreciation(continued) A real appreciation is an increase in thereal exchange rate. With real appreciation the same quantity ofdomestic goods can be traded for moreforeign goods. A real depreciation is a drop in the realexchange rate.4

Purchasing Power Parity Purchasing Power Parity (PPP) similarforeign and domestic goods, or baskets ofgoods, should have the same price interms of the same currency (e 1).Purchasing Power Parity(continued) The PPP implies that:enom PForP PPP holds in the very long run.Purchasing Power Parity(continued)Δe Δenom ΔP ΔPFor ee nomPPForAfter re-arrangingSo, relative PPP isΔenom Δe πFor πenomeΔenom πFor πenom5

The Real Exchange Rate andNet Exports The real exchange rate:– represents the rate at which domestic goodscan be traded for foreign goods;– affects a country’s net export. The higher the real exchange rate is, thelower a country’s net exports will be.How Exchange Rates areDetermined The nominal exchange rate enom is thevalue of a currency, say the dollar. The value of the dollar is determined bysupply and demand in the foreignexchange market.6

Demand for Dollars Reasons to demand dollars (nationalcurrency):– to be able to buy Canadian goods;– to be able to buy Canadian real and financialassets. The demand curve is downward sloping.Supply of Dollars Reasons to supply dollars (nationalcurrency):– to be able to buy foreign goods;– to be able to buy real and financial assets inforeign countries. The supply curve is upward sloping.Effects of Changes in Output(Income) When domestic output (income) rises thedemand for imports increases and netexports must fall. The domestic currency depreciates, theexchange rate falls.7

Effects of Changes in Output(continued) When foreign output (income) risesexports increase and net exports mustrise. The domestic currency appreciates, theexchange rate rises.Effects of Changes in RealInterest Rate If the domestic country’s real interest raterises, other factors held constant, thecountry’s real and financial assets aremore attractive for investment. The demand for domestic currencyincreases and the exchange rateappreciates (enom rises).Effects of Changes in RealInterest Rate (continued) After the domestic real interest rate risesthe exchange rate appreciation reducesnet exports. If the foreign country’s real interest raterises the supply of domestic currencyincreases, the exchange rate depreciates,and the domestic country net exports rise.8

Returns on Domestic andForeign Assets In an open economy, savers have anopportunity to buy financial assets sold byforeign borrowers as well as those sold bydomestic borrowers.Returns on Domestic andForeign Assets (continued) Investment decisions depend on:– nominal interest rates;– expected changes to the exchange rate.Returns on Domestic andForeign Assets (continued) The gross nominal rate of return on aforeign bondexpected gross nominal rate (1 i For )enomfenom(10.4)efnom is the expected future value of enom.9

Interest Rate Parity The difference in returns cannot persist forlong, the nominal interest rates equalize.Interest Rate Parity (continued) The equilibrium for the international assetmarket or nominal interest rate paritycondition:e nom(1 i For ) 1 i (10.6)fe nomInterest Rate Parity (continued) If the nominal exchange rate is expectedto remain the same as its current value thenominal interest rate parity condition isi iFor10

Interest Rate Parity (continued) The real interest rate parity condition is:e(1 rFor ) 1 ref For e ef the condition is r rFor , which isthe assumption in what follows.The IS-LM Model for an OpenEconomy Assume that the expected (trend) rates ofgrowth in domestic prices and moneysupply are given. Assume that the expected (trend) rate ofgrowth in foreign prices PFor is given. Then changes in e are equal to changes inenom.The Open-Economy IS Curve Net exports have to be incorporated intothe IS curve:– It is still downward sloping.– All factors shifting the IS curve in the closedeconomy shift the IS curve in the openeconomy.– All factors that change net exports also shiftthe IS curve.11

The Open-Economy IS Curve(continued) The goods market equilibrium conditionfor an open economy is:S d I d NX The S-I curve is upward sloping, itincreases when r rises. The NX curve is downward sloping, itdecreases when r rises.The Open-Economy IS Curve(continued) Suppose that output rises:– Sd increases, Sd Id, the S-I curve shifts tothe right;– import rises, NX falls, and the NX curve shiftsto the left;– the equilibrium is restored with lower r;– the IS curve slopes downward.12

The Open-Economy IS CurveShifters Any factor that changes the real interestrate that clears the goods market at aconstant level of output shifts the IS curve. Any factor that changes NX, given Y, willshift the open-economy IS curve.13

The Transmission of BusinessCycles The impact of foreign economic conditionson the real exchange rate and net exportsis one of the principal ways by whichcycles are transmitted internationally. A decline in US output shifts the CanadianIS curve down.Macroeconomic Policy withFlexible Exchange Rates An economy is small. The exchange rate does not change, thatis r rFor. This is known as Mundell-Fleming model.14

A Fiscal Expansion and theFlexible Exchange Rate An increase in G crowds out NX:– shifts the IS curve to the right;– r is above rFor, the demand for Canadianfinancial assets increases;– the e increases and the NX falls;– the IS curve shifts to the left where r rFor;– no change in Y and P.A Monetary Expansion and theFlexible Exchange Rate An increase in M:– shifts the LM curve to the right;– r is below rFor, the demand for Canadianfinancial assets decreases;– the e decreases and the NX rises;– the IS curve shifts to the right where r rFor.15

A Monetary Expansion(continued) The Keynesian model predicts furtheradjustments in the LR:– Y is higher than Y , P increases;– the LM curve shifts to the left;– r is above rFor, the demand for Canadianfinancial assets increases;– the e increases and the NX falls;– the IS curve shifts to the left, where r rFor.A Monetary Expansion(continued) The Keynesian model predicts:– a monetary expansion will result in a higherprice level;– no change in Y, r, NX, e;– thus, monetary neutrality holds. The money neutrality holds immediately inthe classical model.16

Fixing the Exchange Rate In a fixed-exchange-rate system, the valueof the nominal exchange rate is officiallyset. An overvalued exchange rate is a situationwhen an exchange rate (enom) is higherthat its fundamental value (e1nom).Overvalued Exchange Rate In a situation of an overvalued exchangerate a government can:– devalue its nominal fixed exchange rate;– restrict international transactions;– buy back its currency in foreign exchangemarket.17

Overvalued Exchange Rate(continued) To support the domestic currency thecentral bank must use the reserves thatcorrespond to the country’s balance ofpayment deficit. It cannot do that forever because theamount of reserves is limited.A Speculative Run An attempt to support an overvaluedcurrency can be ended by a speculativerun – to avoid losses, financial investorsfrantically sell assets denominated in theovervalued currency.18

How to Support an OvervaluedCurrency To support an overvalued currency acountry could:– impose strong restrictions on internationaltrade and finance;– devalue its currency;– make a policy change to raise thefundamental value of the exchange rate (usemonetary policy).Undervalued Exchange Rate An undervalued exchange rate exists if theofficially fixed value is lower than thefundamental value of the exchange rate. An undervalued exchange rate could bemaintained indefinitely if a country tradingpartners would not lose their reserves.19

A Monetary Policy and theFixed Exchange Rate An increase in M:– shifts the LM curve to the right, r is below rFor;– the exchange rate is overvalued. An decrease in M:– shifts the LM curve to the left, r is above rFor;– the exchange rate is undervalued.20

A Monetary Policy (continued) Under fixed exchange rate the centralbank cannot use monetary policy topursue macroeconomic stabilization goals.A Fiscal Policy and the FixedExchange Rate An increase in G:– shifts the IS curve to the right, r is above rFor;– the exchange rate is undervalued;– the monetary expansion accommodates thefiscal expansion, LM shifts to the right where r rFor.21

A Fiscal Policy (continued) enom, P and PFor are fixed in the short runand under the fixed exchange rate, e isfixed. In the long run P increases, e increases,NX fall. Eventually NX have been crowded out bythe fiscal expansion.A Fiscal Policy (continued) In the classical model P and e increaseimmediately in response to the fiscalexpansion and NX is immediatelycrowded out. Under the fixed exchange rate fiscal policyis an effective tool for adjusting domesticoutput in the Keynesian short run.22

Fixed versus Flexible ExchangeRates Benefits of fixed-exchange-rate systems:– less costly trade in goods between countries,i.e. lower transaction cost;– promoted monetary policy discipline. The downside is inability of a country touse its monetary policy to deal withrecessions.Open-Economy Trilemma In selecting an exchange rate system acountry can choose only two of the threefeatures:– a fixed exchange rate to promote trade;– free international movement of capital;– autonomy for domestic monetary policy.Fixed Exchange Rate System Fixed exchange rates are useful whenused in a group of countries:– large benefits can be gained from increasedtrade and integration;– monetary policies can be coordinated closely.23

Flexible Exchange RatesSystem A flexible exchange rate system is useful ifa country has specific macroeconomicshocks. Then they can be reduced withhelp of monetary policy.Currency Unions A currency union is sharing of a commoncurrency by a group of countries. A currency union reduces the cost oftrading and prevents speculative attackson currencies. However, monetary policies cannot beindependent.The Self-Correcting SmallEconomy A small open economy has more sourcesof unexpected shocks. However, there also exist a correctingmechanism in addition to the price level –an exchange rate adjustment.24

The Self-Correcting SmallEconomy (continued) A fixed-exchange-rate system:– neutralized both fiscal policy and the shocksto the IS curve;– monetary policy and shocks to the LM curvehave a magnified impact.The Self-Correcting SmallEconomy (continued) A flexible-exchange-rate systemneutralizes monetary shocks andmagnifies effects of the fiscal policy.End of Chapter25

Exchange Rate Systems (continued) In a fixed-exchange-rate system exchange rates are set at officially determined levels. The official rates are maintained by the commitment of nations' central banks to buy and sell their own currencies at the fixed exchange rate. Real Exchange Rate The real exchange rate is the number of

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