LECTURE 10 The open economy Øystein Børsum 21 st March 2006

Overview of forthcoming lectures Lecture 10: Open economy  Features of a small, open economy with perfect capital mobility Lecture 11: Open economy and the market for foreign exchange (Prof. Nymoen)  The AD-AS framework for the open economy  The market for foreign exchange and the domestic money market Lecture 12: Fixed and floating exchange rates (Prof. Nymoen)  Macroeconomic policy under a fixed and floating exchange rate regimes.  Inflation targeting Lecture 13: Choice of exchange rate regime  The source of perturbations to the economy and the optimal exchange rate regime

PART 1 Assumptions and evidence of the open economy

Overview of assumptions and evidence of the open economy Strong growth in exports and international capital flows motivates modeling the open economy. An economy like Norway, and most economies indeed, are small and specialized (engages in trade but cannot influence global macroeconomic conditions) There is a market for foreign currency both spot and forward. Under certain conditions – perfect capital mobility and risk- neutral investors – the expected future spot price equals today’s forward price (uncovered interest rate parity) In the long run, relative purchasing power parity is a reasonable condition. This implies real interest rate parity

Strong growth in international trade and capital flows World exports, portfolio investments and foreign direct investments, Bill dollars

The forward price for foreign currency Spot price of foreign currency What if you need to buy foreign currency one year from now? Currency forward contract: Agreement today to buy a specified amount of foreign currency in one year, where the price is determined today By a no arbitrage condition, the forward price is determined by the spot price of foreign currency and the interest rate differential between the two currencies Instead of buying a forward contract, consider the equivalent strategy of borrowing today in your own currency, buy currency spot today and invest the foreign currency

Determining the forward price by no arbitrage Suppose you need 1$ in one year (in period t + 1) Buy $ in the spot market today for i f = foreign rate of interest E t = Spot exchange rate (price of one unit of foreign currency in terms of the domestic currency) Finance your purchase by a one-year loan in your home currency When the loan is due, you must pay i = domestic rate of interest Notice that this strategy is completely risk-free: You know for sure that you obtain 1 dollar in one year, and how much you must to pay for it now 1 + i f 1 EtEt EtEt (1 + i)

Covered interest rate parity (CIP) Ẽ t = Forward exchange rate (F t ; t+1 is an alternative notation) By log-approximation we can simplify to ẽ t = ln Ẽ t If investors are risk neutral, the forward rate must equal the expected future exchange rate. This gives uncovered interest rate parity e e +1 = expected future exchange rate (log form) Covered and uncovered interest rate parity 1 + i f EtEt F t ; t+1 = Ẽ +1 = = (1 + i)(1 + i) = (1 + i f ) EtEt Ẽ +1  i = i f + ẽ +1 - e i = i f + e e +1 - e

The evidence on nominal interest rate convergence in Europe is very convincing Difference between domestic ten-year government bond yield and the corresponding EU average, Percentage points Source: IMF International Financial Statistics.

International capital mobility and interest rate parity Assume that  Domestic and foreign assets are perfect substitutes  Investors can reallocate their portfolios instantaneously and costlessly  Investors are risk neutral Then both covered interest rate parity and uncovered interest rate parity will hold

The real exchange rate and the international terms of trade The real exchange rate is a measure of international competitiveness  Example: The price of foreign goods measured in kroner relative to the price of Norwegian goods measured in kroner The international terms of trade

The development of the real exchange rate depends on inflation differentials and the nominal exchange rate Use a log-approximation Insert the lagged real exchange rate to obtain an expression for the change in the real exchange rate

Relative purchasing power parity In long-run equilibrium, the real exchange rate must be stable Relative purchasing power parity (RPPP) Reasonable that the purchasing power of a country in the long run is independent from inflation differentials or changes in the nominal exchange rate 

The evidence on relative purchasing power parity between Denmark and Germany is convincing The bilateral exchange rate and the relative price level between Denmark and Germany Source: Chart 4.1 of Monetary Policy in Denmark, Danmarks Nationalbank, 2003.

Relative purchasing power implies real interest rate parity in the long run Uncovered interest rate parity: In long-run equilibrium, exchange rate expectations are correct and we have relative purchasing power parity Real interest rate parity Conclusion: In the long run, the domestic real interest rate is tied to the foreign real interest rate. This holds regardless of the exchange rate regime

Over time, real interest rate differentials tend to disappear Long-term real interest rate differential between various countries, Percentage points Source: Centre for European Policy Studies, Adjusting to Leaner Times, 5th Annual Report of the CEPS Macroeconomic Policy Group, Brussels, July 2003

Key assumptions when modeling the open economy The economy is small  Global macroeconomic conditions can be taken as given The economy is specialized  Domestically produced goods are imperfect substitutes for foreign goods (relative prices may change) International capital mobility is perfect and investors are risk neutral  Uncovered interest rate parity holds Assumptions about the long-run macroeconomic equilibrium: Relative purchasing power parity holds Real interest rate parity holds