Exchange Rates:

 

Nominal Exchange Rates:

 

·       Tells you how much foreign currency you can buy with one unit of domestic currency.

·       Transactions take place on the foreign exchange market

·       enom  is the foreign currency per unit of domestic currency

 

Under a flexible or floating exchange rate exchange rates are determined by supply and demand. If exchange rates increase the currency is appreciating and if the fall it is depreciating.

 

 

 

Fixed exchange rates government sets the exchange rate, includes currency unions. If the fixed exchange rate is adjusted we call this a devaluation  or a revaluation.

 

Real Exchange Rates:

 

·       Tells you how much of a foreign good you can get in exchange for one unit of domestic good.

·       e = enom (PF/PD) – the real exchange rate is the nominal exchange rate time the price ratio of the foreign to the domestic economy.

·       The real exchange rate determined the relative prices of goods between two economies.

 

 

 

 

Purchasing Power Parity

 

·       Similar goods have the same price in different countries when measured in the same currency (e=1).

·       If e = 1 then PD = PF / enom

 

·       If not then Δe/e = Δenom/enom +  ΔP/P – ΔPF/PF, and nominal appreciation is a result of either real appreciation or a relatively lower rate of inflation.

 

·       If Δe/e = 0 then Δenom/enom = - ΔP/P + ΔPF/PF, and nominal appreciation is a function of changes in inflation rates. (relative purchasing power parity)

 

 

 

Net Exports:

 

·       NX = EXPORTS – IMPORTS = EX – IM

·       Changes in NX are often how business cycles are transmitted internationally.

·       High exchange rates make domestic goods relatively more expensive and reduce NX, as imports increase and exports decrease.

·       Low exchange rates make domestic goods relatively cheaper and increase NX.

 

 

 

 

 

 

 

Exchange Rate Determination:

 

Hold prices fixed so that changes in the real exchange rate are the same as the nominal exchange rate.

 

 People demand domestic currency in order to:

 

a)   Buy domestic exports

b)    Buy domestic financial assets (capital inflows)

 

People sell domestic currency in order to:

 

a)   Buy foreign exports.

b)    Buy foreign financial assets (capital outflows)

 

Anything that increases the demand for either domestic exports or capital inflows will shift the demand for currency to the right.

Open – economy IS-LM

 

Exchange rates influence both the level of Y and real interest rates and therefore influence the equilibrium in the IS-LM economy.

 

Determinants of exchange rates:

If Y increases:

 

a)   Income/out increases for the whole economy.

b)    Increase demand for all goods including imports and NX declines.

c)    The supply of domestic currency increases as people sell their domestic currency for foreign currency.

d)    The exchange rate depreciates.

 

The opposite is true if Y decreases. Then NX increase and the exchange rate appreciates.

If real interest rates increase:

 

a)   Foreigners want to buy domestic financial assets.

b)    Demand for domestic currency increases

c)    The exchange rate appreciates.

 

The opposite is true if the real interest rate decreases, the demand for financial assets decrease and the currency depreciates.

 

*** It is important to note that output has a direct impact on NX while the impact of interest rates is strictly through the exchange rate***

 

 

 

 

 

IS curve in an open economy

 

(LM and FE are unaffected by the open economy)

 

The IS curve remains the same and factors that shift the IS curve in the closed economy have the same affect in the open economy.

 

·       Factors that increase NX shift the IS curve up

·       Factors that decrease NX shift the IS curve down

 

 

The Goods Market Equilibrium condition is now:

 

Sd – Id = NX

 

This means that desired foreign lending must equal desired foreign borrowing.

 

Alternatively,

 

Y = C + I + G + NX = C + I + G + EX – IM

 

So the supply of goods must equal the demand for goods.

 

The S – I curve is upward sloping as interest rates increase savings increases relative to investment.

 

The NX is downward sloping as rise in the real interest rate increase the exchange rate decreasing NX.

 

The equilibrium is at the point where the curve intersect.

 

We can now (re)derive the IS in an open economy by allowing Y to vary.

 

Increase in Y:

 

a)   Increase S so the S – I curve shifts out (down)

b)    Reduces NX so the NX curve shifts down

c)    Higher Y and lower r

 

So the open economy IS curve is downward sloping.

 

Factors that shift the open economy IS curve:

 

1) Anything that reduces desired national savings relative to investment shifts the IS curve up.

2) Anything that raises NX (holding Y and r constant) will shift the IS curve up.

 

 

 

For example:

 

The US, our biggest trading partner has  either a significant increase in income, or a increase in real interest rates (which cause the domestic exchange rate to fall and our NX to increase). Then Americans demand more Canadian goods. The NX curve shifts up and the IS curve shifts up. The real interest rate that clears the goods market is higher for every level of Y.

 

 

Macro Policy in a small open economy

 

We can now use the IS-Lm model to see how policy affects the general equilibrium outcome of either a fiscal or monetary policy on output and interest rates and then determine it’s affect on exchange rates and net exports.

 

Fiscal Policy

Example:

The government temporarily increases expenditure:

 

1.   The IS curve shifts up as desired savings falls relative to investment and interest rates increase.

2.   Real interest rates and output increase.

3.   Higher output decreases net exports as imports increase.

4.   The LM curve shifts up as firms increase prices in response to increases in output

5.   Higher interest rates drive up the exchange rate (as the demand for domestic financial assets increase)

6.   The higher exchange rate reduces net exports as Canadian goods become more expensive relative to foreign goods.

So with an increase in government spending both higher output and higher interest rates reduce net exports.

 

Example:

A monetary contraction.

In the short run:

1.   M is reduced

2.   The LM curve shifts up and to the left, higher interest rates and lower output.

3.   Lower output reduces the demand for imports and net exports increases

4.   The exchange rate appreciates because of the reduction in NX and the increase in r

5.   The appreciation in the exchange rate reduces NX.

 

With a monetary contraction it is ambiguous as to whether or not NX are higher or lower in the short run as the decrease in output and the increase in the exchange rate have opposite effects.

 

In the long-run:

 

1.   Prices decline and the LM curve returns to original level

2.   All real variables return to their original level (Money Neutrality)

3.   No long-run effect on any real variables

4.   Nominal exchange rates increase as P decreases

 

(Consider what is happening in the foreign economy in terms of an IS framework)

 

 

 

 

 

 

 

The Mundell-Fleming Model

 

A small open economy were the interest rate is always equal to the world interest rate.

 

The IS curve is horizontal at the level of the world interest rate.

 

Fiscal policy has no effect.

 

A Monetary Contraction:

 

1.   Full effect reduces output as interest rates do not increase

2.   Prices rise and nominal interest rates rise

3.   No effect on any real variables.

 

Macro Policy in a Large Open Economy

 

Now we can use the foreign IS-LM model to examine the effect of a either fiscal or monetary policy decisions of a large open economy (like the US) on small open economies.

 

Fiscal Expansion:

 

1.   The foreign IS curve shifts up and to the right

2.   Increasing interest rates and output in that economy

3.   Foreign exchange rates appreciate, meaning depreciating domestic exchange rates.

4.   NX increase as domentic goods are relatively cheaper

5.   The domestic IS curve shifts up and to the right

6.   In the long run the LM curve in both economies shift up, higher prices and real exchange rates.

 

 

Monetary Contraction:

 

1.   The foreign LM curve shifts up and to the left.

2.   Foreign imports fall (NX increase) as output falls, the foreign currency appreciates and the domestic currency depreciates.

3.   The domestic IS curve shifts up as NX increase.

4.   Domestic price levels increase and foreign price levels decrease so there is real domestic appreciation

5.   In the long run the adjustment in the exchange rate returns the IS curve to it’s original position

 

This explains why international interest rates often move in tandem. Flexible exchange rates in this instance protect us from foreign monetary contractions.

 

 

 

 

A Numerical Example:

 

Cd = 200 + 0.6 (Y-T) – 200r

Id  = 300 – 300 r

T = 20 +0.2Y

G = 152

NX = 150 – 0.08 Y – 500 r

MD / P = 0.5 Y – 200 r

M = 924

Y = 1000 (full employment output)

 

What are the long run equilibrium levels of:

Y , r , C, I, NX and P?

 

Now let G = 214, what are the short-run levels of these values? What are the long-run levels?

What if instead of G increasing, NX increases instead by the same amount so that NX = 212 – 0.08 – 500r ?

Solution:

 

The equation for the IS curve in an open economy is given by solving:

Sd – Id = NX

Sd - Id = Y – [200 + 0.6 (Y-(20+0.2Y)) – 200r] – G - 300 + 300r

     = 0.52Y – (488 +G) + 500r

so in equilibrium:

 0.52Y – (488 +G) + 500r  = 150 – 0.08 Y – 500 r

or

1000r = (638 + G) – 0.6Y (IS)

 

The LM curve is found where MD/P = M/P so:

 

924/P = 0.5Y – 200r

and

 

P = 924 (0.5Y – 200r)-1

When G = 152 and Y = 1000

r = .19

P = 2

NX = -25

C = 630

I = 243

 

When G = 214 and P = 2 (short run)

IS: 1000r = (638+214) – 0.6Y

LM: 200r = 0.5Y – 462 or 1000r = 0.25 Y – 2310

Setting IS = LM we can solve for Y = 1020

Plug this into LM to get r = .24

 

NX = -51.6

C = 629.6

I = 228

When G = 214 and Y = 1000 (long run)

r = .252

P = 2.055

NX = -56

C = 617.6

I = 224.4

With G = 152 and NX = 212 the IS curve is the same as with an increase in G (above). The only difference is the now G = 152 and NX = 10.4 in the short run and NX = 6 in the long run.