Open Economy Macro: The transmission mechanism through the real exchange rate

2 The Transmission Mechanism in Open Economy Macro We saw that changes in domestic saving and investment, or changes in world interest rates, or domestic risk premiums would affect net exports. How does that happen? Through the adjustment of the real exchange rate. Let see how.

Financial Globalization fig_finglob_2013

4 Summary on Exchange Rates I will only sketch basics in class. Refer to notes and text. Foreign-exchange rates are the relative prices of different national monies or currencies. Convention: exchange rates = amount of foreign currency per unit of domestic currency (e.g., Japanese Yen: 100 yen to $.) Notation: e = nominal exchange rate; R = Real exchange rate Appreciation = rise in e or R; depreciation = fall

5 Exchange rates Foreign-exchange rates are the relative prices of different national monies or currencies. Convention in Econ 122 and Mankiw: Nominal exchange rate exchange rates = amount of foreign currency per unit of domestic currency. Think Japanese Yen: 100 yen to $. Notation: e = nominal exchange rate; R = Real e.r. Appreciation = rise in e or R; depreciation = fall Real exchange rate, R [Mankiw uses ε) R = nominal exchange rate corrected for relative prices R = e × (p d / p f ) = p d / (p f / e) = domestic prices/foreign prices in a common currency

6 Exchange rates Foreign-exchange rates are the relative prices of different national monies or currencies. Convention in Econ 122 and Mankiw: Nominal exchange rate exchange rates = amount of foreign currency per unit of domestic currency. Think Japanese Yen: 100 yen to $.

7 Terminology For market-determined exchange rates: An appreciation of a currency is when the value of the currency rises –e or R rises A depreciation of a currency is when the value of the currency falls –e or R falls For fixed exchange rates: Price set by government is the “parity.” A revaluation is an increase in the official parity. A devaluation is a decrease in the parity.

8 Index of US nominal exchange rate (e) Appreciation Depreciation This is the “broad index” of major countries.

9 Summary on Exchange Rates I will only sketch basics in class. Refer to notes and text. Foreign-exchange rates are the relative prices of different national monies or currencies. Convention: exchange rates = amount of foreign currency per unit of domestic currency (e.g., Japanese Yen: 100 yen to $.) Notation: e = nominal exchange rate; R = Real exchange rate Appreciation = rise in e or R; depreciation = fall Real exchange rate = nominal exchange rate corrected for relative prices R = e × (p d / p f ) = p d / (p f / e) = domestic prices/foreign prices in a common currency

10 Real exchange rates Real exchange rate, R [Mankiw uses ε) R = nominal exchange rate corrected for relative prices R = e × (p d / p f ) = p d / (p f / e) = domestic prices/foreign prices in a common currency Note: If you calculate the rate of growth of R, you get Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y; Ford = $20,000; R = 100 * 20000/ = 1 Toyota/Ford

11 Big Mac Real Exchange Rate R = p d / (p f / e) Example of Big Mac* Price in Beijing: 13 Yuan Price in New York: $3.73 Real exchange rate: $3.73/(Y13/6.7) = $3.73/($1.97) = 1.89 People use this to argue that Yuan is “overvalued.” Anything wrong with this argument? *

Real exchange rate of $ relative to major currencies (R) Appreciation Depreciation Dollar bubble with high interest rates Flight to $ safety Dot.com stock bubble

We saw last time that changes in the domestic S-I balance led to changes in NX (the trade balance). We need next to understand the macroeconomic mechanism by which this occurs. We will see that this operates through changes in the real exchange rate, which leads to changes in the relative prices of foreign and domestic goods. Now to the Macroeconomic Equilibrium

Saving-Investment Balance in Open Economy NX(R) = S priv + S g – I(r w ) Net domestic saving = net foreign investment = lending abroad = ΔNFA Recall S does not depend upon r (but unimportant for our analysis) Small open economy with mobile capital means r d = r w The only new relationship is NX(R): –Real deprecation (R ↓) lowers the price of exports in foreign markets and raises import P in domestic markets. –This raises exports and lowers imports; raising NX. –Hence NX’(R) < 0 Putting this with the S-I curves, we can see how real exchange rate is determined.

15 Net exports and the real exchange rate Real exchange rate (R) NX(R) NX 0 R* NX*

16 Savings-investment and the determination of the real exchange rate: NX(R) = S n -I(r w ) R NX(R) 0 R* NX* S n -I(r w ) E* Have two behavioral relationships: (1) NX and (2) net savings. R and NX are determined as the equilibrium of these two functions. S-I, NX

17 Why does fiscal tightening lead to a lower trade deficit?

18 Fiscal policy: G ↓ → net S ↑ → R ↓ → NX ↑ R NX(R) S-I, NX 0NX* (S-I(r w ))* E** (S-I(r w ))** NX** E* Fiscal tightening

Impact of protectionism

20 Protectionism R NX(R) S-I, NX 0NX*=NX** (S-I(r w )) R* R** NX(R)’ Counterintuitive: Trade measures lead to real appreciation, not to change in trade balance!

21 Now analyze large open economy Large Open Economy: - Country large enough to affect world financial markets - Domestic assets imperfect substitutes for foreign assets. - Because imperfect substitutes, domestic r differs from foreign r (r d ≠ r w ) Analysis Goods markets: (1)NX(R) = S n – I(r d ) Financial market equilibrium: CF = net financial investment abroad = - financial surplus (2) CF = CF(r d, r w ). In analysis, we suppress r w Notes that capital flows in if domestic interest rates rise CF’(r d ) < 0.

Domestic interest rate (r d ) CF 0CF* CF(r d ) rdrd Equation (2)

23 Now analyze large open economy Large Open Economy: - Country large enough to affect world financial markets - Domestic assets imperfect substitutes for foreign assets. - Because imperfect substitutes, domestic r differs from foreign r (r d ≠ r w ) Analysis Goods markets: (1)NX(R) = S n – I(r d ) Financial market equilibrium: CF = net financial investment abroad = - financial surplus (2) CF = CF(r d, r w ). In analysis, we suppress r w Notes that capital flows in if domestic interest rates rise CF’(r d ) < 0. Equilibrium comes when (1) and (2) equilibrate the balance of payments: (3) NX(R) = CF(r d ) = S n – I(r d ) In our diagrams below, we use (3): (4) I(r d ) + CF(r d ) = S n = S priv + S g

Domestic interest rate (r d ) CF CF(r d ) rdrd S, I,CF SnSn I(r d )+CF(r d ) CF Real exchange rate, R 0 NX NX(R) R* NX* r d* 0 CF*

Bernanke’s surprising theory of why the US deficit is so high “I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today.” (Bernanke, 2005)

26 Global savings glut: Global effect S, I Real interest rate (r) I d (r) I* r* S world ** S world * r** I**

Domestic interest rate (r d ) CF CF(r d ) rdrd S, I,CF S I+CF CF R 0 NX NX(R) R* NX* r d* 0 Bernanke’s “world savings glut” -Current situation is one in which rest of world has savings glut (particularly China, Japan, and oil exporting countries accumulating $ reserves). - This increases inflows to US. - This is leading to low world and US real interest rates - and to the large US trade deficit.

Here are the basic data (pre-crisis)

29 That’s it for classical open-economy macro Next session: To business-cycles and the Keynesian model.

Key insight: Financial dog wags trade tail Dog of trade Tail of finance!