Economics II – Part 2 November-December 2018 Bachelor in Business Administration and Management Instructor: Dr. Andrea Venegoni (course responsible) Mail: avenegoni@liuc.it Office hours: Thursday, 3 p.m. (mail communication required)

The open economy: the basics, the goods’ market functioning and the Marshall-Lerner condition Required readings: Blanchard, O.J., Macroeconomics (ch.20-21) Suggested readings: Risks in the bond market (https://www.ft.com/content/9880b004-de0f-11e8- 9f04-38d397e6661c) Alternative exchange rate regimes (https://piie.com/commentary/testimonies/alternative-exchange-rate-systems- and-reform-international-financial) Fisher on echange rate regimes (http://web.mit.edu/15.018/attach/Fischer,%20S.%20Exchange%20Rate%20Regi mes%20Is%20the%20Bipolar%20View%20Correct.pdf) Argentina’s case (https://core.ac.uk/download/pdf/6784713.pdf) Switzerland exchange rate regime: (https://piie.com/blogs/realtime-economic- issues-watch/two-cheers-swiss-national-bank)

Introducing financial markets in the open economy Recall the equilibrium condition in the goods market: 𝑌= 𝑐 0 + 𝑐 1 𝑌−𝑇 +𝐼 𝑌,𝑟 +𝐺−𝐼𝑀 𝑌,ε +𝑋( 𝑌 ∗ ,ε) Knowing that NX=X-IM we can rewrite the same expression in the following way: 𝑌= 𝑐 0 + 𝑐 1 𝑌−𝑇 +𝐼 𝑌,𝑟 +𝐺+𝑁𝑋 𝑌, 𝑌 ∗ ,ε Given that we are considering the short run in which prices are assumed to be fixed, two simplifications are needed. We, therefore, consider i (nominal interest rate) instead of r (the real one) and E (nominal exchange rate) instead of ε (the real one). 𝑌= 𝑐 0 + 𝑐 1 𝑌−𝑇 +𝐼 𝑌,𝑖 +𝐺+𝑁𝑋 𝑌, 𝑌 ∗ ,𝐸 + - + -

Financial markets in the open economy Investors’ dilemma Closed Economy Money or bonds Open Economy Buy domestic or foreign bonds Hold domestic or foreign money As we said, in an open economy investors can choose between domestic and foreign assets. Lets assume, also, that people can choose between only two different financial assets: money and bonds

Invest in domestic bonds Invest in foreign bonds Investing processes Time t t+1 Invest in domestic bonds 1- Buy the bond. 2- Get back your capital plus the one year interest rate Invest in foreign bonds 1- Convert money into the foreign currency. 2- Buy the bond 3-Get back the redemption (in foreign currency) equal to the capital plus the foreign interest rate 4- Convert the redemption of the investment from foreign to domestic currency

Evaluating bond yields Assumption: Investors do not consider risk, they seek the highest return; There are no transaction costs; Time t+1 Time t 1- 1£ Invest in italian bonds: 2- 1£(1+it) Invest in US bonds: 2- $Et 3- $Et(1+ 𝑖 𝑡 ∗ ) 4- £Et(1+ 𝑖 𝑡 ∗ )(1/ £𝐸 𝑡+1 ) 1 year UK interest rate To invest in US bonds UK citizens have first to buy dollars. 1 year US interest rate In determining the final return on the investment must be taken into account the evolution of the exchange rate To cash back the investment dollars must be converted back into pounds

Functioning of open financial markets: the UIP (Uncovered Interest Parity) For the international financial markets to be in equilibrium the following relation must hold: (1+ 𝑖 𝑡 )=Et(1+ 𝑖 𝑡 ∗ )( 1 𝐸 𝑡+1 𝑒 ) That can be rewritten as: (1+ 𝑖 𝑡 )= (1+ 𝑖 𝑡 ∗ )( Et 𝐸 𝑡+1 𝑒 ) This, notwithstanding the two strong assumption on which is based, still remains a good description of reality: it suffice a news on possible appreciation or depreciation of exchange rates to generate massive financial flows of investments from a country to another.

UIP: meaning and economic implications THE ONE TO BE REMINDED!! The UIP relation (1+ 𝑖 𝑡 )= (1+ 𝑖 𝑡 ∗ )( Et 𝐸 𝑡+1 𝑒 ) can be rewritten as: (1+ 𝑖 𝑡 )= ( 1+ 𝑖 𝑡 ∗ 1+( 𝐸 𝑡+1 𝑒 − 𝐸 𝑡 )/ 𝐸 𝑡 ) that can be approximated as 𝑖 𝑡 ≈ 𝑖 𝑡 ∗ − 𝐸 𝑡+1 𝑒 − 𝐸 𝑡 𝐸 𝑡 The last formulation clearly says that, for the financial markets to be in equilibrium, the domestic interest rate must be equal to the foreign one minus the expected variation of the exchange rate. THE ONE THAT GIVES YOU THE ECONOMIC INTUITION !!

Equilibrium in open financial markets: the UIP (Uncovered Interest Parity) Lets start from UIP expression: (1+ 𝑖 𝑡 )= (1+ 𝑖 𝑡 ∗ )( 𝐸t 𝐸 𝑡+1 𝑒 ) Solving for 𝐸 𝑡 we obtain: 𝐸 𝑡 = 1+ 𝑖 𝑡 1+ 𝑖 𝑡 ∗ 𝐸 𝑡+1 𝑒 Taking the expected future exchange rate as given and exogenous and dropping the time notation we have: 𝐸= 1+ 𝑖 𝑡 1+ 𝑖 𝑡 ∗ 𝐸 𝑒

Equilibrium in financial markets: implications 𝐸= 1+ 𝑖 1+ 𝑖 ∗ 𝐸 𝑒 This is the equilibrium expression for the financial markets in open economy. What does this tell us? The exchange rate depends on the domestic and foreign interest rates and on the future expectations on itself; Exchange rates are positively related to domestic interest rates. If i↑,E↑ Exchange rates are negatively related to foreign interest rates. If i*↓,E↓ Exchange rates are positively related to future expectations. If 𝐸 𝑒 ↑,E↑

The economic equilibrium: joining goods and financial markets Lets recall the expressions that describe equilibrium in both markets: Goods market: 𝑌= 𝑐 0 + 𝑐 1 𝑌−𝑇 +𝐼 𝑌,𝑖 +𝐺+𝑁𝑋 𝑌, 𝑌 ∗ ,𝐸 Financial market: 𝐸= 1+ 𝑖 1+ 𝑖 ∗ 𝐸 𝑒 Lets finally assume that the interest rate is determined by the money supply and demand equality: 𝑀 𝑃 =𝑌𝐿(𝑖) From this 3 relations we are able to derive the expression of the IS and LM curve in an open economy: 𝐼𝑆: 𝑐 0 + 𝑐 1 𝑌−𝑇 +𝐼 𝑌,𝑖 +𝐺+𝑁𝑋 𝑌, 𝑌 ∗ , 1+ 𝑖 1+ 𝑖 ∗ 𝐸 𝑒 LM: 𝑀 𝑃 =𝑌𝐿(𝑖)

The graphic representation Interest rate, i Exchange rate, E UIP, interest rate parity IS Output, Y LM i Y E

Domestic fiscal policies in an open economy Lets again suppose the government increases the public expenditure G (G↑) . What happens to the economic equilibrium?. An increase in G ↑ makes the demand grow (shifting the IS curve upwards) and pushing Y ↑ If Y increases, we have an increase in the money demand, that, in turn, makes interest rates(i) go up. The upward shift in the interest rate pushes the nominal exchange rate that appreciates itself. Interest rate, i Exchange rate, E UIP, interest rate parity IS Output, Y LM i Y E Y’ i’ E’ i’ IS’

Domestic monetary policy in an open economy Assume that the domestic central bank decides to operate a monetary contraction. What happens to the economic equilibrium? A decrease in the real supply of money 𝑀 𝑃 ↓ makes the interest rate go up, contracting investments, the domestic demand and the production (Y ↓). (We have an upward shift of the LM curve, with a new equilibrium in which the interest rate is higher and the production lower than before). For what concerns the exchange rate, a higher domestic interest rate leads to an appreciation. Interest rate, i Exchange rate, E UIP IS Output, Y LM i Y E Y’ i’ E’ LM’

What if exchange rate expectations change? Let’s consider what happens to the economic equilibrium if the expected exchange rate level decrease due to a negative shock. Due to a negative shock on the economy, the expectations on the exchange rate are bound to decrease. What happens if 𝐸 𝑒 ? If 𝐸 𝑒 ↓ 𝐸 ↓ (This makes UIP curve shift to the left, as for an unchanged level of the domestic interest rate now we have a lower exchange rate). If E decreases, NX increases, leading to a higher ZZ and hence Y (IS curve shifts rightwards). This leads to a higher production and domestic interest rate, that makes the exchange rate rise a little, still leaving as final reasult an overall depreciation (𝐸 ↓: E’’<E) REMEMBER:𝐸= 1+ 𝑖 1+ 𝑖 ∗ 𝐸 𝑒 Interest rate, i Exchange rate, E UIP’ IS’ Output, Y i Y E’’ i' Y’ i’ E’ LM UIP i IS E

Exchange rate regimes: «not all exchange rates are the same»! Until now we have assumed that the exchange rate of a country is left free to float according to the changes of the variables that determine it. However, this assumption does not hold for all the countries. Many of them prefer to keep their exchange rate level constant in terms of some foreign currencies. Different interest rate regimes: Flexible exchange rate: (USA; UK; Japan) Pegs (Venezuela, Saudi Arabia, Oman, Denmark, Bulgaria) Crawling pegs (China) Floating bands (former EMS)

Fixed exchange rate regime: how monetary policy works Assume that the domestic central bank decides to operate a monetary contraction. What happens to the economic equilibrium? A decrease in the real supply of money 𝑀 𝑃 ↓ makes the interest rate go up, contracting investments, the domestic demand and the production (Y ↓). (We have an upward shift of the LM curve, with a new equilibrium in which the interest rate is higher and the production lower than before). For what concerns the exchange rate, a higher domestic interest rate leads to an appreciation. But the economy we consider operates under fixed exchnge rates, so the Central bank has to operate an opposite intervention to restore the original equilibrium. THIS DOES NOT MAKE SENSE! Under fixed exchange rate the central bank looses its monetary policy power. Interest rate, i Exchange rate, E UIP IS Output, Y LM i Y E=E’’ Y’ i’ E’

Fixed exchange rate regime: how fiscal policy works Interest rate, i Exchange rate, E UIP, interest rate parity IS Output, Y LM i Y E=E’’ i=i’’ Y’ i’ E’ LM’ i’ IS’ Y’’

A brief recap: flexible vs. fixed exchange rates Policy intervention Expansionary fiscal policy Expansionary monetary policy Contractionary fiscal Contractionary monetary Fixed exchange rates ΔY>>0 ΔE=0 ΔY=0 Is ineffective!! ΔY<<0 Flexible exchange rates ΔY>0 ΔE>0 ΔE<0 ΔY<0