These notes were prepared based on the lectures and supplemented by information from textbooks and tutorials where parts of the lecture were unclear. Graphs, equations, and bullet-point explanations included. Prepared by a first class Economics and Management student for the FHS Macroeconomics pape...
HT4 Macroecons (Open Economy)
Week's outline
Lecture 9
o Modelling the Foreign Exchange market (3 arbitrage conditions)
o The AD side – 3 equation model in open economy
Lecture 10
o Policy reactions in open economy
o Inflation shocks and AD shocks
o Overshooting of exchange rates
Lecture 11
o The AS side
o Current Account deviations from equilibrium
Lecture 9: FX market in the Open Economy
Introduction: the open economy
What is different in an open economy?
We have a new market (Foreign Exchange, FX) and a new price to clear it (exchange rate: e)
o Mediates buying/selling foreign (domestic) currency (money), goods and financial assets
Dynamics of the real exchange rate q are of great importance
o The real exchange rate varies in the medium-run equilibrium in response to permanent
aggregate demand and supply shocks
o In a closed economy, the real interest rate r plays this key role
The CB chooses the deviation of the interest rate r from the world interest rate r*, in the
dynamic adjustment of the economy to shocks
o (r – r*) as opposed to just r as in a closed economy
Output y responds both to changes in r and to the associated changes in q
o FX market does part of the job of the CB
In practice, these open economy issues are particularly important for smaller economies,
compared to larger economies (eg. US, China)
2 stabilization channels in open economy
2 stabilization channels: the interest rate & exchange rate channels.
o Shock → 𝜋 > 𝜋𝑇→ CB raises 𝑖 → negative 𝑦-gap → 𝜋↓
o Also, FX market expects 𝑖↑ → returns to home bonds↑ (arbitrage opportunity) →
currency appreciates → Exports & AD↓ → 𝜋↓
In addition to the interest rate channel that we studied in the closed economy, we have the
exchange rate channel
o Hence, CB raises 𝑖 by less than the closed economy case (since the exchange rate
channel helps stabilise the economy as well)
Key Assumption: CB and FX market form expectations rationally
o Reality: while forex markets may be generally rational due to sophisticated financial
investors, it is still prone to fads and manias
o If not well-behaved, FX market may not be stabilising
Before the era of high international capital mobility, FX was driven by trade
, o Now, the FX market is dominated by international financial markets
o The key determinant of exchange rate fluctuations is now the buying and selling of
currencies to trade in government bonds of different countries
International Financial Markets- Simplifying Assumptions
Perfect international capital mobility (between countries, currencies)
Small home country
o Any action does not affect the world interest rates (global variables can be treated as a
constant and independent of our actions)
Households can hold 2 assets:
o Bonds (home & foreign) and money.
Perfect substitutability between home and foreign bonds
o Only difference between bonds is expected return, they have the same default risk
o *If the default risk difference between countries' bonds is constant over time, our
analysis would not be affected
Modelling the FX market
Does arbitrage equalize prices for the same good in different countries?
How do traders decide on home and foreign assets?
Answers: Three parity conditions
o 1. Purchasing Power Parity (PPP)
o 2. Covered Interest Parity (CIP)
o 3. Uncovered Interest Parity (UIP)
Dornbusch’s overshooting of exchange rates
o The overshooting model argues that the foreign exchange rate will temporarily
overreact to changes in monetary policy to compensate for sticky prices of goods in the
economy (more later)
Exchange rates and pricing
The Nominal Exchange Rate
Definition: Nominal exchange rate (E)
o
An increase in E corresponds to a depreciation of home currency
o Home currency becomes less valuable- more units of home currency to buy one unit of
foreign currency
o Think of foreign currencies as goods bought domestically
o *Be careful: some textbooks may have a different definition where increase in E is
appreciation
Convention: 𝑒 ≡ ln(𝐸)
The Real Exchange Rate
Nominal exchange rates do not account for differences in prices between two countries
o Eg. USD/GBP = 0.74, €/GBP = 0.89 does not necessarily mean that America is cheaper
than Europe for a Brit
, The real exchange rate is a measure of relative purchasing power
o
o P*: the foreign price level
o P: the domestic price level
o Obtain RHS by taking logarithm (ln) of both sides. Small letters indicate ln(.)
o Therefore, increase in Q or q (the real exchange rate) is a depreciation
It’s also a measure of relative price competitiveness
o
o Terms of trade (TOT) represent the ratio between a country's export prices (P) and its
import prices (P* E)
o A higher TOT means export prices are higher than import prices:
It means that the country can sell its products on the world market, receiving
more import good units for one unit of its export good
Domestic products are thus deemed so attractive – and thus competitive – by
consumers abroad that they are willing to pay an increasing price.
o Therefore, an economy can be considered internationally competitive if it succeeds in
selling its products on the world market without the Terms of Trade deteriorating. And
when the Terms of Trade improve, the competitiveness of the economy increases.
Competitiveness and pricing rules
Home-cost pricing: exporters set prices based on domestic costs (in home currency)
o Eg. BMW setting prices based on costs in Germany (depreciation of GBP relative to EUR
would increase BMW nominal prices in UK and make them less attractive to buyers)
World-pricing: exporters set prices to match competitors’ abroad (in foreign currency)
o Chinese apparel exporters
Implication of a ↑ domestic costs:
o Home-cost: ↑𝑃, ↓𝑄
Higher domestic costs, higher price set, real appreciation of goods prices
(decrease in real exchange rate Q), loss of competitiveness
o World-pricing: price and real exchange rate unaffected
No apparent loss of competitiveness as domestic cost increase is absorbed by
exporters (squeezes their margins) who set prices matching overseas
competitors that are not affected by the domestic cost increase
Better measure: relative unit labour costs (RULC)
o
o If firms adopt world-pricing, looking at relative costs rather than prices could be more
insightful as a definition of real exchange rate
o Loss of competitiveness for most European countries (excluding Germany) as their RULC
decreased (foreign labour cheaper) while that of Germany (red line) stayed high (foreign
labour more expensive)
, The diagram below uses a different definition of RULC (the reciprocal) so
Germany is low and other European countries is high
o
Three Parity Conditions
Purchasing Power Parity (PPP)
Consequence of arbitrage in international market for goods/ services
o Traded Goods: goods with high value-to-transportation costs (eg. Cars, crude oil)
o Non-traded Goods: goods with low value-to-transportation costs (eg. Haircuts, water)
Do not have their prices arbitraged due to high transportation costs to do so
Law of One Price (LOP): Traded Goods should have the same price irrespective of location (so
real exchange rate 𝑄 = 1)
o 𝑃 = 𝑃*𝐸; 𝑄 = 1
o Implies Absolute Purchasing Power Parity if LOP applies to all goods
o Theoretically, the action of arbitrage should work to move prices so that they are
consistent with LOP
o In practice, LOP will only work if we are able to exclude transportation costs, tariffs,
taxes, and other location-specific outlays.
Absolute PPP
o Price of baskets of goods are equal across countries, so the exchange rate between the
two nations will be equal to the ratio of the price levels for those two countries.
o It never applies in practice:
Only traded goods are arbitraged
Different basket of goods in CPI across countries (so even if LOP holds, if we use
CPI as a proxy for price levels, Q ≠ 1)
Exploitation of local market power distort pricing etc.
o Absolute PPP for all goods implies 𝑄 = 1. If there is perfect competition (p = MC), then
all MC in all countries is also equal (unlike the world-pricing hypothesis where costs can
differ across countries and profit margins expand and contract)
Relative PPP
o
Nominal exchange rate percentage changes equal to the difference in inflation
rates
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