Exchange Rates, Business Cycles, And Macroeconomic Policy In The Open .
ChChapter100(part 1)Exchange Rates,Business Cycles,and MacroeconomicPolicy in the OpenEconomyCopyright 2009 Pearson Education Canada
This Chapter In this chapter we build an open-economyversion of the IS-LM model Extend our analysis to include the foreign sectorto understand international trade, financialg rates.markets and exchangeCrucial as most economies are nowinternationallyy linked.Important relationship between interestrates, r, and exchange rates, e throughasset markets.Copyright 2009 Pearson Education Canada10-2
The Open Economy Two aspectsTt off theth interdependencei t ddof the world economies:international trade in goods andservices; worldwideld id iintegrationttioff fifinanciali lmarkets. Fiscall andFidMMonetarytpoliciesli i are goingito have different outcomes, becauseoff theth internationali ttil relationships.l tihiCopyright 2009 Pearson Education Canada10-3
Exchange Rates First let’s distinguish between nominaland real exchange rates:Nominal: enom How many units of a foreign currency canI gett withith one unitit off theth domesticdticurrency?Real: e How many units of a foreign good can Iget in exchange for one unit of a domesticgood?Copyright 2009 Pearson Education Canada10-4
Nominal Exchange Rates Some wellll kknown currencies tradedd d in thehforeign exchange market : US , Canadian Japanese Yen, ,Yen British pounds,pounds Euro EuroThe rate at which one currency can betraded for another is enom E.g. the amount of US one can get with 1Canadian , currentlyy about 90 US cents, soenom 90 USSo this rate is like the 'price’ of US currencyCopyright 2009 Pearson Education Canada10-5
Nominal Exchange Rates If someone in one country wants to buygoods, services, or assets from someone inanotherth country,tnormallyll sheh willill firstfi thave to exchange her currency for that ofher trading partner’spartner s countrycountry.Copyright 2009 Pearson Education Canada10-6
Exchange Rate Systems In a flexible-exchange-rate,flexible exchange rate or floatingfloatingexchange-rate system, exchange rates arenot officially fixedfixed, but are determined byconditions of supply and demand in theforeigng exchangeg market. Exchange rates adjust continuously inresponse to market developments.At present: (mostly) floating exchange ratesystemCopyright 2009 Pearson Education Canada10-7
Exchange Rate Systems(continued) In a fixed-exchange-ratefixed exchange rate systemexchange rates are set at officiallydetermined levels.levels The official rates are maintained by thecommitment of nations’ central banks tobuy and sell their own currencies at thefixed exchange rate.EE.g.BBrettonttWoodsW d systemt(1944) Fixed currency in terms of the US dollar Collapsedpamidst highg inflation rates in the USin the 1970s which made it nearly impossible tomaintain the fixed exchange rate.Copyright 2009 Pearson Education Canada10-8
Real vs NominalExchange Rates Suppose nominalSi l exchangehratet forfCanada-Japan is: 1 dollar 78 yengreat:t go tot JapanJandd you're' richi h not really. We need to accoaccountnt forfo cost of living:li ingHamburgers: 312 in Tokyo, 3 inKingston so 312/( 78/ 1) 4 Canadian so Kingston burger is ¾ price of Tokyoburger Copyright 2009 Pearson Education Canada10-9
Real Exchange Rate In our example,example the real exchange rate betweenCanada and Japan is 0.75 Japanese hamburgersper Canadian hamburgerpgMore formally, the real exchange rate is thenumber of foreign goods someone gets inexchange for one domestic good:enom Pe PFo renom is the nominal exchange rate;PFor isi ththe pricei off fforeignigoods,d measuredd ini foreignficurrency;P is the price of domestic goods, measured in nominal currency.Copyright 2009 Pearson Education Canada10-10
Real Exchange Rate(continued)In reality, real exchange rates arebased on price indexes of“baskets” of goods (such as theGDP deflator or the CPI) To simplify the analysis, weassumeauthata eachacountryou yproduces a single good. Copyright 2009 Pearson Education Canada10-11
Appreciation andDepreciationType ofExchange rateExchange ratestAppreciationFixedexchange ratesRevaluationExchange pyright 2009 Pearson Education Canada10-12
Appreciation andDepreciation Changeshin enom are referredfd to as nominallappreciation / nominal depreciation With nominal appreciation the same amount ofdomestic currency can buy more units of foreigncurrency than before.Changes in the real exchange rate, e arereferred to as real appreciation / realdepreciation With real appreciation the same quantity ofdomestic goods can be traded for more foreigngoods than before.Copyright 2009 Pearson Education Canada10-13
Purchasing Power Parity How are nominal and real exchange ratesrelated?Suppose all countries produce the samegoods and these goods are freely tradedThenhin theh absenceboff transportation anddtransactions costs, Purchasing PowerParity (PPP) says similar foreign anddomestic goods (or baskets of goods)should have the same price in terms ofthe same currency (e 1).Copyright 2009 Pearson Education Canada10-14
Purchasing Power Parity(continued) PPP implies that:e nom PFor PThis says that the nominal exchange ratechanges quickly to reflect relative pricemovements.Empirically, PPP holds in the very long-run.To find a relationship that holds moregenerally we can use the definition of thereall exchangehratet andd derived ia relativel tiPPPmeasure.Copyright 2009 Pearson Education Canada10-15
Purchasing Power Parity(continued)Starting with the definition of e:Δe Δenom ΔP ΔPFor eenomPPForAfter re-arrangingΔenom Δe πFor πenomeSo, relative PPP isΔenom πFor πenomCopyright 2009 Pearson Education Canada10-16
Purchasing Power Parity(continued) In growth terms, the percentage changein the nominal exchange rate depends onth growththeth off ththe RER andd ththe diffdifferencein the inflation rates between countriesNominal appreciation occurs if:– the real exchange rate grows– domestic inflation is less than foreign inflation Relative PPP usually works well for highinflation countries, not for low inflationcountries like CanadaCopyright 2009 Pearson Education Canada10-17
The Real Exchange Rateand Net Exports We have not yet discussed the importanceof the real exchange rate.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 raterate, thelower is a country’s net exports whichaffects real economic activity.yCopyright 2009 Pearson Education Canada10-18
The Real Exchange Rateand Net Exports (continued)An increase in e (real appreciation) meansthat domestic goods can buy more foreigngoodsd (domestic(dti goodsd becomebmoreexpensive)Domestically: switch to foreign goods,goods or anincrease in IMForeigners: switch away from domesticgoods, or a decrease in X NX X - IM Copyright 2009 Pearson Education Canada10-19
Copyright 2009 Pearson Education Canada10-20
How Exchange Rates areDetermined It’ byIt’sb supplyl andd demanddd– Supply of currency Canadians offer toexchange dollars for foreign currency– Demand for currency Foreigners’ demand fordollars in the foreign exchange market We focus on enom Recall that: e enom(P/PFor)so for P and PFor that grow at similar rates,ratesfocusing on enom only is okenom: value of a currency,y, determined byysupply and demand in the foreign exchangemarket Copyright 2009 Pearson Education Canada10-21
Copyright 2009 Pearson Education Canada10-22
Why is thereSupply/Demand for Dollars? Whyh dod Canadiansdsupplyl ddollarsll((S):)To be able to buy foreign goods and services (IM)(ii) ToT beb ablebl tot buybforeignfifinancialfii l assetst (capital(it loutflows)(These transactions correspond to the CA and KA)(i) Why do foreigners demand dollars (D):(ii)To be able to buyy Canadian goodsgand services (X)( )To be able to buy Canadian financial assets(capital inflows) So, value of the dollar increases if D or S ((i))Copyright 2009 Pearson Education Canada10-23
MacroeconomicDeterminants of e and NX Recall, the goal is to build an IS-LMmodel for an open economyThe IS-LM model relates Y and rNow we have also e and NXAgain, since price levels are heldconstant the results weconstant,we’llll presentapply to both enom and e.Copyright 2009 Pearson Education Canada10-24
Effects of Changes inOutput (Income)1. Whenhddomestici output (income)(i) risesithehdemand for imports increases and netexportspfall. The domestic currencyydepreciates, the exchange rate falls:When Y increases, there is an increase in Mdemand (NX decreases because of a directeffect) since consumers spend more in allgoods and servicesCCanadiansdisellll CAD tto gett fforeignicurrency, i.e. the Supply of CAD increases.A depreciation of the exchange rate enomfollows.Copyright 2009 Pearson Education Canada10-25
Effects of Changes inOutput (continued)2. On theh otherh hand,h d whenhfforeignoutput(income) rises, Canadian exports increaseand NX rises.risesThe domestic currency appreciates, theexchange rate rises.risesThe example in Figure 1010.33 shows the effectof an improvement in the quality of Canadiangoods.Copyright 2009 Pearson Education Canada10-26
Copyright 2009 Pearson Education Canada10-27
Effects of Changes in RealInterest Rate If the domestic country’s real interest raterises, other factors held constant, thecountry’scountrys real and financial assets are moreattractive for investment.The demand for the domestic currencyincreases and the exchange rateappreciates (enom rises).After the domestic real interest rate rises,the exchange rate appreciation reduces netexports (NX because of an indirect effect)Copyright 2009 Pearson Education Canada10-28
Effects of Changes in RealInterest Rate (continued) Conversely,l iff theh foreignfcountry’s’ reallinterest rate rises (rFor ), foreign assets willbecome more attractive to CanadiansThe supply of domestic currency (Canadiandollars) increasesThe exchange rate depreciates (enom falls),and the CanadaCanada’ss net exports riserise.Copyright 2009 Pearson Education Canada10-29
The International AssetMarket: Interest Rate Parity In an open economy,economy savers have anopportunity to buy financial assets sold byforeign borrowers as well as those sold bydomestic borrowers.Investment decisions depend on: nominal interest ratesexpected changes to the exchange rate.International asset markets give a particularrelationshipp between interest rates andexchange ratesCopyright 2009 Pearson Education Canada10-30
Returns on Domestic andForeign Assets: Example A Canadiandsaver hash 10,000 to investfor one year either in Canadian bonds orGerman bonds.bonds Canadian bonds payinterest i 8% and German bonds payinterest iFor 6%6%Assume both assets have the same risk ofdefault and liquidity.qy Which bond shouldwe buy?It mayy seem that since i 8% iFor 6% ,we should buy Canadian bonds.Copyright 2009 Pearson Education Canada10-31
Returns on Domestic andForeign Assets (continued) but, this answer may not be correct sincewe haven’t accounted for expectedchangeshini theth exchangehrate:t the German bond carries an additional potentialreturn (gain/loss) because we need to purchaseEuros.Assume that the current nominalexchangehratet isi enom 0.70 7 euros per Before the pay-out next year, you expectthe euro to appreciatepp( will depreciate)p)to efnom 0.679.Copyright 2009 Pearson Education Canada10-32
Returns on Domestic andForeign Assets (continued) General steps to calculate the grossnominal rate of return on foreign asset:(b(board)d) Step 1: Convert home currency to foreigncurrency.currencyStep 2: Earn interest on foreign asset.Step 3: Convert foreign currency to homecurrency.Expectedpggross nominal rate of return onenom(1 i)foreign asset ForefnomCopyright 2009 Pearson Education Canada10-33
Interest Rate Parity Why would gross nominal rates of returndiffer in a free and competitive market?The difference in returns cannot persistfor long since arbitragers should makethem equal (investors who move to takeadvantage of the differences in nominalinterest rates)An explicit equilibrium conditionsummarizes this concept: itit’ss callednominal interest rate parityCopyright 2009 Pearson Education Canada10-34
Interest Rate Parity(continued) The equilibrium for the international assetmarket or nominal interest rate paritycondition:ditit kitakingtheth exchangehratest enomand efnom as given the interest rates, i andiFor, will adjust until the expected return fortwo similar investment options are equal((No-Arbitrageg condition):)enom(1 i For ) 1 ifenomCopyright 2009 Pearson Education Canada10-35
Interest Rate Parity(continued) For thish to holdh ld exactlyl a numberb offconditions must be met like similarliquidity default riskliquidity,risk, transactions costs,coststaxes, etc.If the nominal exchange rate isexpected to remain the same as itscurrent value the nominal interest rateparity condition reduces to:i iForCopyright 2009 Pearson Education Canada10-36
Interest Rate Parity(continued) The real interest rate parity condition is:e(1 rFor ) 1 rfe The difference in returns cannot persistfor long, interest rates equalizeFor e ef the condition is r rFor , which isthe assumption we make for now, thoughwe willll return to thish issue llater.Copyright 2009 Pearson Education Canada10-37
The IS-LM Model for anOpen Economy We now look at how trade and exchangerates affect the economy by using theIS LM modelIS LMd lAssume that the expected (trend) rates ofgrowth in P,P Pfor, and M are givengiven. If both Pand Pfor grow at given rates, then we canequate changes in e with changes in enom.Our analysis will not affect thesupply/demand for money so we can usethe same LM curve as in Ch 9.Copyright 2009 Pearson Education Canada10-38
The IS-LM Model for anOpen Economy (continued) The labour market and production functionare not directly affected by internationalfactors so the FE line is also the same.factors,sameThe effect of opening up the economy totrade will come through the IS curve.NX has to be incorporated into the IS curve: IS is still downward sloping.All factors shifting the IS curve in the closedeconomy shift the IS curve in the open economy.All factors that change NX also shift the IS curve.Copyright 2009 Pearson Education Canada10-39
The Open-Economy ISCurve (continued) The goods market equilibrium conditionddfor an open economy is: S I NXThis condition says thatthat, for goods marketequilibrium, desired foreign lending mustequal desired foreign borrowing.The S-I curve is upward sloping; itincreases when r rises: r Æ Sd and IdThe NX curve is downward sloping; itdecreases when r rises throughg the effectof r on the real exchange rate, e.Copyright 2009 Pearson Education Canada10-40
Copyright 2009 Pearson Education Canada10-41
The Open-Economy ISCurve (continued) To derive the open economy version of theIS curve we need to know what happensto real interest rates when output rises.risesSuppose that output rises: Sd increases but not Id so the SS-II curve shifts tothe right;import rises, NX falls and the NX curve shifts tothe left;the equilibrium is restored with lower r;the IS curve slopes downward (see next slide).slide)Copyright 2009 Pearson Education Canada10-42
Copyright 2009 Pearson Education Canada10-43
Factors that Shift TheOpen-Economy IS Curve As in a closedld economy, any ffactor thathchanges the real interest rate that clearsthe goods market at a constant level ofoutput shifts the IS curve.Consider a temporary increase in G: Sd is lower at every level of Y and r so S-I shiftsleftThis raises the r that clears the goods market,so IS shifts rightN ti thNoticethatt an increaseiini G hash theth same effectff tas it did in a closed economy.Copyright 2009 Pearson Education Canada10-44
Copyright 2009 Pearson Education Canada10-45
The Open-Economy ISCurve Shifters (continued) For an open economy, there are additionalfactors that shift the IS curve.Any factor that changes NX, given Y, willshift the open-economy IS curve.Factors thath couldld cause NX to rise include:l d an increase in foreign output;an increaseiini foreignfiinteresti tt ratestan improvement in the quality of domesticgoods aandd seservices.cesCopyright 2009 Pearson Education Canada10-46
Copyright 2009 Pearson Education Canada10-47
The Transmission ofBusiness CyclesThe iimpactt off foreignThfieconomiciconditions on the real exchange rateandd nett exportst isi one off theth principali i lways by which cycles are transmittedi tinternationally.till Example: if US goes into recession, NXfor Canada falls, IS shifts down, Y falls The cycleycan also be transmittedthrough international asset markets. Copyright 2009 Pearson Education Canada10-48
Macroeconomic Policy withFlexible Exchange Rates Analyzelusing theh Mundell-Flemingd ll lmodeld lAssumptions:p A small open economy. Savers expect no change in exchangerates: r rfor (real interest rate parity/noarbitrage) We then look at the implications for fiscaland monetary policy under both flexibleand fixed exchange rates.Copyright 2009 Pearson Education Canada10-49
Fiscal Expansion andFlexible Exchange Rates The Mundell-FlemingMundell Fleming model gives thesurprising implication that fiscal policy isineffective in a small open economy withflexible exchange ratesConsider this: We start off in LR equilibrium,q,and G rises temporarily SR: IS shifts right and Y, r riseIn a closed economy, the increase in r means thatthe fiscal expansion would crowd out privateinvestmentBut, in a small open economy, it doesn’t end thereCopyright 2009 Pearson Education Canada10-50
Fiscal Expansion andFlexible Exchange Rates Since now r rFor, arbitragebkkicksk in:foreigners demand CAD to use theirsavings in Canadaenom rises, so NX falls until r rFor (the IScurve shifts back to the left)Overall: A rise in G leads to a fall in NX– this is the net export crowding out If G rise by 1, NX fall by 1– so Y wonwon'tt riserise, meaning that there is no Long Runchange in P (i.e. no LM curve shift)Copyright 2009 Pearson Education Canada10-51
Copyright 2009 Pearson Education Canada10-52
Fiscal Expansion andFlexible Exchange Rates The IS shifts back to its original position. Ifthe response of the exchange rate is fast,ththereare no reall effects,ff t so therethisi nochange in the price level PFiscal policy is ineffective in a Small OpenEconomy with flexible exchange ratesIt merely shifts the composition ofdomestic spending from NX to GIf fiscal policy cancan’tt work,work can monetarypolicy?Copyright 2009 Pearson Education Canada10-53
Monetary Expansion andFlexible Exchange Rates Consider an increase in M: (board) Classical: There is immediate monetary neutralitydduet rapidtoid pricei changeshKeynesian: There is only LR monetary neutralityReal exchange rates have no LR change howevernominal exchange rates will rise if M rises by 10%, then P rises by 10%, enomrises by 10% given e enom(P/PFor) and both e and PForunchanged enom must fall by the amount Punchanged,rises.Copyright 2009 Pearson Education Canada10-54
Copyright 2009 Pearson Education Canada10-55
Flexible Exchange Rates: ASummary FiFiscall expansion:ino effect, even in short run, as upwardpressure on e offsetsff t expansionaryieffectff tof higher G; in long run,run P doesndoesn’tt change (as M hasnhasn’ttchanged) so enom does the adjusting – itrises and crowds out NX completely the conclusion is that higher G thencrowds out completely NX through theeffect on e. Copyright 2009 Pearson Education Canada10-56
Flexible Exchange Rates: ASummary (continued) Monetary expansion: large short run effect as increased M lowers e(with P constant) and stimulates NX;the higher NX shifts the IS curve to the right;short-runshortrun equilibrium where r is unchanged buthigher real M (with P unchanged) and Y (whichcan be determined from LM curve);Y , P now startswithith Y greatert thantht t tot riseishifting back the LM curve;this causes e to rise and NX to fall, shifting backthe IS curve.Copyright 2009 Pearson Education Canada10-57
What’s next? Q3 from Ch 10 of the textbook Next class:Finish off Ch 10 Review of the course Details of the final exam Copyright 2009 Pearson Education Canada10-58
How Exchange Rates are Determined It' b l d d dIt's by supply and demand - Supply of currency Canadians offer to exchange dollars for foreign currency - Demand for currency Foreigners' demand for dollars in the foreign exchange market We focus on e nom Recall that: e e nom(P/P For) so for P and P
Listing Exchange Exchange Exchange Exchange); Exchange Exchange listing Exchange Exchange listing. Exchange Exchange. Exchange ExchangeExchange Exchange .
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
Studies in Business Cycles 1 Business Cycles: The Problem and Its Setting By Wesley C. Mitchell 2 Measuring Business Cycles By Arthur F. Burns and Wesley C. Mitchell 3 A merican Transportation in Prosperity and Depression By Thor Hultgren 4 Inventories and Business Cycles, with Special Re
e ective exchange rates and (ii) estimates of equilibrium real exchange rates and of currency misalignments can be freely downloaded. The rst sub-database, on e ective exchange rates, provides indices of nominal and real e ective exchange rates for 187 economies over the 1973-2016 period. The ef-
how economists have chosen to frame the concept of exchange rate equilibrium. First, most assessment exercises have been cast in terms of multilateral real exchange rates—i.e., weighted averages of bilateral real exchange rates, where real exchange rates are constructed as nominal exch
CHAPTER 1 INTERPRETATION 1. Definitions CHAPTER 2 RATING 2. Power to levy rates Part 1: Rates policy 3. Adoption and contents of rates policy 4. Community participation 5. Annual review of rates policy 6. By-laws to give effect to rates policy Part 2: Levying of rates 7. Rates to be levied on all rateable property 8. Differential rates 9.
existence of life cycles in various applications, e.g., life cycles of scholars and research topics (academia), life cycles of consumers and merchandises (on-line business) etc. Despite the significance of it, collaborative filtering with life cycles is highly challenging, as summarized below. Life Cycle versus Wall Time: Users and items may .
monitor and report on those outcomes. Relevant Exchange products include performance contracts, land tenure agreements, and financial . CENTRAL VALLEY HABITAT EXCHANGE USER'S MANUAL 1. THE EXCHANGE: AN INTRODUCTION The Central Valley Habitat Exchange The Central Valley Habitat Exchange (Exchange) is a program that facilitates effective and .
