1. CHAPTER 10 EXCHANGE RATES, BUSINESS
CYCLES, AND MACROECONOMIC POLICY IN THE OPEN ECONOMY

2. Part I Outline: Exchange Rates How Exchange Rates Are Determined
The International Asset Market

3. Exchange Rates . 1. Nominal Exchange Rates ( )
is the number of units of foreign currency that can be purchased with one unit of the domestic currency.
Flexible-exchange-rate system:
exchange rates are determined by conditions of supply and demand in the foreign exchange market.
Fixed-exchange-rate system:
exchange rates were set by the government. .

4. 2. Real Exchange Rate
is the number of foreign goods that can be obtained in exchange for one domestic good:
= the price of foreign goods, measured in the foreign currency
= the price of domestic goods, measured in the domestic currency

5. 3. Appreciation and Depreciation
Type of Exchange Rate System
Exchange rate
increases
“stronger”
decreases
“weaker”
Flexible exchange rates
Appreciation
Depreciation
Fixed
exchange rates
Revaluation
Devaluation

6. 4. Purchasing Power Parity
“purchasing power parity” (PPP): (in the absence of transportation costs), the similar foreign and domestic goods should have the same price in terms of the same currency. Empirical evidence: PPP holds in the very long run, but not in the short run.

7. 4. Purchasing Power Parity
In the more general case: When is constant, “Relative purchasing power parity”: works well for high-inflation countries, but not low-inflation countries.

8. 5. The Real Exchange Rate and Net Exports
The real exchange rate is the price of domestic goods relative to foreign goods.
It determines the demand for domestic goods both in home and foreign countries.
real exchange rate net export

9. II. How Exchange Rate Are Determined
Supply of dollars: (upward sloping)
Why supply?
(i) buy foreign goods and services
(ii) buy foreign financial assets
Demand for dollars: (downward sloping)
Why demand?
(i) buy Canadian goods and services
(ii) buy Canadian financial assets

10. Macroeconomic Determinants of the Exchange Rate and Net Export
Effects of Changes in Output
Domestic income
net export
exchange rate (depreciation)
Foreign income
exchange rate (appreciation)

11. Macroeconomic Determinants of the Exchange Rate and Net Export
Effects of Changes in Real Interest Rate
Domestic real interest rate
exchange rate (appreciation)
net export (indirectly through )
Foreign real interest rate
exchange rate (depreciation)

12. III. The International Asset Market
1. Returns on Domestic and Foreign Assets
Example: A Canadian saver has $100 to invest either in Canadian bonds or US bonds. Canadian bonds pay interest ; US bonds pay interest . Assume the two assets have the same risk and liquidity. Which bond should she buy? (Assume and )

13. General steps to calculate the gross nominal rate of return on foreign asset:
Step 1: Convert home currency to foreign currency.
Step 2: Earn interest on foreign asset.
Step 3: Convert foreign currency to home currency.
Expected gross nominal rate of return on foreign asset =

14. 2. Interest Rate Parity
The equilibrium condition in the international asset market: “nominal interest rate parity condition” In real term, “real interest rate parity condition”

15. Part II Outline: The IS-LM Model for an Open Economy
Macro Policy in a Small Open Economy with Flexible Exchange Rate
Fixed Exchange Rate

16. IV. The IS-LM Model for an Open Economy
The LM curve and FE line are the same as in the closed economy; the IS curve will be modified.
3 main points about the IS curve in the open economy:
i). downward sloping;
ii). Factors shift IS curve in the closed economy shift IS in the open economy.
iii). Factors that change NX also shift IS.

17. 1. The Open-Economy IS Curve
Goods Market Equilibrium:
Closed economy:
Open economy:
Equivalently:
The curve: slopes upward.
The curve: slopes downward.
Goods market equilibrium is given by the intersection of curve and curve

18. Numerical example:
Given the following, derive the open- economy IS curve:

19. 2. Factors That Shift the IS Curve
Factors that shift closed-economy IS curve up:
shifts curve to the left
shifts open-economy IS curve up
e.g.: expected future output, wealth, , ,
and effective tax rate on capital

21. Factors that shift the curve:
i). Foreign output,
ii). Foreign real interest rate,
iii). Demand for domestic goods
shifts open-economy IS curve up

22. V. Macro Policy under Flexible Exchange Rate
1. A Fiscal Expansion
IS curve first shifts to the right IS curve then shifts to the left Overall effects: i). Fiscal policy is ineffective. ii). exchange rate and “net export crowding out”

24. 2. A Monetary Expansion Short-run effects: Long-run effects:.
LM and IS both shifts right
, , (holding fixed)
Long-run effects:.
LM and IS both shifts left
Overall effects: Money is neutral
i). Real variables are unaffected
ii). Nominal variables change proportionally

25. VI. Fixed Exchange Rates
Fundamental value of the exchange rate
the value that would be determined by the supply and demand in the foreign exchange markets.
Overvalued exchange rate:
fixed value > the fundamental value
Undervalued exchange rate:
fixed value < the fundamental value

28. i). Devaluation: change the official value to the fundamental value
How to deal with a situation with overvalued exchange rate?
i). Devaluation: change the official value to the fundamental value
ii). Restrict international transactions
iii). Use official reserve assets to buy back its own currency
Speculative run: investors expect overvalued currency will soon devalue, so they sell assets in that currency.

30. 2. Monetary Policy and the Fixed Exchange Rate
fundamental value of
an overvalued exchange rate
An overvalued exchange rate is not sustainable, so the monetary expansion eventually must be reversed.
The relationship of the money supply to the fundamental value of : slopes downward.

33. 2. Fiscal Policy and the Fixed Exchange Rate
Short-run effects:
IS and LM both shifts right
, , (holding fixed)
Long-run effects:.
LM and IS both shifts left
a) Fiscal expansion has no effect on .
b) Real exchange rate is increased.
c) Net export is crowding out.

34. VII. Choosing an Exchange Rate System
Advantage of fixed exchange rates:
i). Stable exchange rates promote trade.
ii). Improve monetary policy “discipline”
Disadvantage of fixed exchange rates:
i). Unable to use monetary policy to deal with recession.
ii). Lose monetary policy independence.
iii). Vulnerable to speculative attacks.

35. – an alternative to fixed exchange rate
Currency union
– an alternative to fixed exchange rate
– common monetary policy is controlled by a single institution.
– 2 advantages over fixed exchange rates:
i). With a single currency, trading cost is
even less.
ii). Using the common currency,
speculative attacks can be avoided.

36. 2. Self-Correcting Adjustment
Closed Economy
Self-correcting mechanism: price adjustment.
When the intersection of IS and LM curves lies to the right of the FE line, price increases to shift LM curve up.
When the Intersection lies to the left of the FE line, price decreases to shift LM curve down.

37. Small Open Economy
Self-correcting mechanism: price adjustment & exchange rate adjustment
Under a flexible exchange rate system:
Fiscal policy is ineffective, but many unexpected shocks that shift IS curve requires no stabilization policy response.
Monetary policy is effective for stabilization purpose, but it has a magnified impact on output.

40. Small Open Economy
Under a fixed exchange rate system:
Fiscal policy accompanied by a monetary expansion/contraction is effective for stabilization purpose, but it has larger impact on output.
Monetary policy is ineffective, but factors that shift LM curve has no impact on output.