OPEN ECONOMY MACRO AND THE EXCHANGE RATE (1) Up to now, we have ignored the exchange rate: i.e. the price of foreign currency in terms of domestic currency. Implicitly we have assumed the exchange rate to be fixed (as well as general price levels, both foreign and domestic). We now allow for flexible exchange rates and contrast the workings of fiscal and monetary policies under different exchange rate regimes For any open economy, there will be: –a demand for foreign currency for imports, investment abroad –a supply of foreign currency from exports and inward investment –also international factor income payments, transfers, etc. Generally the resulting relative price of foreign and domestic currencies can display significant volatility.

OPEN ECONOMY MACRO AND THE EXCHANGE RATE (2) The Nominal Exchange rate is usually the number of Foreign Currency units per unit of Domestic Currency: i.e. number of $ or £ per € (or if you are in the USA, the number of € or £ per $) Some countries operate fixed exchange rate regimes, where the Nominal Exchange rate is fixed: in that case the monetary authorities mop up and excess supply of foreign exchange by adding to reserves, and meet any excess demand by running down reserves In a fixed exchange rate regime: Ms is endogenous: excess Supply adds to Foreign exchange reserves and to reserve assets of banks, and thus to an expansion of Ms. Excess demand similarly leads to a fall in Ms. Therefore in a fixed exchange rate regime, an independent domestic Monetary Policy is impossible (unless there are draconian foreign exchange controls)

NOMINAL AND REAL EXCHANGE RATES (1) The nominal exchange rate is what we observe directly: e.g. €1 = $1.50 or $1= €0.67 However in terms of the effects on Trade (or NX), the real exchange rate is what matters Let e, E, P, Pf = real exch rate, nominal exch rate, Domestic price level and Foreign price levels respectively. Then: e = E(P/Pf) Initially, suppose P = 100 and Pf = 200 Recall E is no. of $ (foreign currency units) per € (domestic) Suppose E = 2.00, then e = 2.00(100/200) = 1 If P increases to 110, and Pf remains the same, and also E is constant, then e = 2.00(110/200) = 220/200 = 1.1: i.e a real appreciation of the €

NOMINAL AND REAL EXCHANGE RATES (2) For levels: e = E(P/Pf) For changes:  e/e =  E/E +  P/P –  Pf/Pf If domestic inflation is 2%, “foreign” inflation is 5% and  E/E=0 Then:  e/e = 0 + 2% – 5% = – 3%, i.e. a real depreciation of 3% If domestic and foreign inflation were both 2% and  E/E = +20% Then:  e/e = +20% + 2% – 2% = + 20%: a 20% real appreciation In recent years, many fairly large changes in E have occurred while inflation rates were roughly equal implying corresponding changes in e This bring us to the concept of Purchasing-Power Parity (PPP) PPP is a hypothesis about the correspondence between Nominal Exchange Rates and relative prices, such as to equalise Purchasing power of a given sum of money in different countries

NOMINAL AND REAL EXCHANGE RATES (3) Formally PPP implies: e = 1 = E(P/Pf);  E = (Pf/P) and  e/e =  E/E +  P/P –  Pf/Pf = 0;   E/E =  Pf/Pf –  P/P Under a fixed Exchange Rate regime as  E/E = 0, then PPP implies that  P/P =  Pf/Pf, and for a small open economy  P/P is clearly the dependent variable. Under a flexible exchange rate regime PPP may imply that E adjusts to compensate for any difference between  P/P and  Pf/Pf A quick examination of the data reveals that PPP does not apply at least in the short or medium term: in the very long-term the evidence is more mixed. For the moment, we can assume that e is not constant, and therefore the relation between NX and e is important. Let NX = NXa + nY – ue

BALANCE OF PAYMENTS EQUILIBRIUM (1) A fundamental BOP condition is: NX + NCF = 0 Where NCF = net capital outflow A higher level of Y reduces NX (via increased import demand) A higher r also reduces NCF  increasing Y and r simultaneously will maintain BOP equilibrium. If capital is perfectly mobile then even very small changes in r will offset large changes in Y If E (and e) increases, then a higher r will be needed to maintain BOP equilibrium (at any given level of Y). B is  FRes Formally: B = f(y, r, e), and dB = f' y dy + f' r dr + f' e de For any given e, BOP equil implies B = 0 = f' y dy + f' r dr So dr/dy = - (f' y /f' r ) We can summarise this in a BOP equilibrium locus: BB

BALANCE OF PAYMENTS EQIULIBRIUM (2) BB is locus of r, Y giving BOP equilibrium (  FRes = 0) Above BB, BOP surplus,  +  Ms, below BB deficit  –  Ms Increase in E (or e)  shifts to B 1 B 1, fall in E  B 2 B 2 Y r 0 B B B1B1 B1B1 B2

FISCAL POLICY IN SOE (FIXED-E) Fiscal expansion  IS 2 ; r increases; BOP > 0; +  Ms;  LM 2 Result: “effective” Fiscal Policy: y  y 2 (NB caveat re multiplier) B B LM 1 IS 1 r Y 0 Y 1Y 1 IS 2 LM 2 Y 2Y 2

MONETARY POLICY IN SOE (FIXED-E) Monetary expansion  LM 2 ; r falls; BOP < 0;   Ms;  LM 1 Result: “ineffective” Monetary Policy: y remains at  y 1 B B LM 1 IS 1 r Y 0 Y1Y1 LM 2

FISCAL POLICY IN SOE (FLEXIBLE-E) IS shift leads to E appreciating: this shifts IS again Result: International “crowding out” r 0Y IS 1 LM B1 IS 2 B2 y1y1 y2y2 B3 IS 3 y3y3

MONETARY POLICY IN SOE (FLEXIBLE-E) LM shift leads to E depreciating Shift in BB leads to outward shift in IS Result: “effective” monetary policy r 0Y IS1 LM1 B1 B2 IS2 Y1 Y2 LM2

SMALL OPEN ECONOMY MACRO: SOME PROVISIONAL CONCLUSIONS We now see how one cannot have (a) an independent exchange rate policy; (b) any effective monetary policy and (c) complete capital mobility In the Euro-zone there is practically perfect capital mobility, but for individual members, no exchange rate policy discretion and no effective monetary policy There is however scope for fiscal policy (but this is blunted by the openness of individual economies) There are also parameters which have been agreed for fiscal policies: the EU Stability and Growth pact, and there are “Excessive Deficit” procedures. Without going into details: note that the revised pact makes allowances for the impact of economic cycles, and recent events have necessitated a general re-think.

Policy In an Open Economy Can look at Monetary, Fiscal and Exchange Rate Policy If we think of the purpose of policy is to control Y then we get The reason is the automatic effects of BP Fixed eFloat e FiscalEffectiveLittle effect MonetaryIneffectiveEffective