**Unformatted text preview: **2/28/2015 Chapter 6 THE OPEN ECONOMY(PART C)
WUKUANG CUN Outline - exchange rate ° nominal and real exchange rates, definition
° net exports function - how is the real exchange rate determined The nominal exchange rate e = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency (e.g. yen per dollar) A few exchange rates, as of 6/24/2013 country
Euro area
Indonesia
Japan
Mexico
Russia
South Africa
U.K. exchange rate
0.76 euro/$
9,930 rupiahsl$
98.2 yen/$
13.4 pesos/$
32.91 rubleS/$
10.16 rand/$
0.65 poundsl$ 2/28/2015 2/28/2015 "’ McZamp/e "’ one good: Big Mac
price in Japan: P* = 200 Yen
price in USA: P = $2.50 nominal exchange rate
e = 120 Yen/$ To buy a U.$. Big Mac,
someone from Japan
would have to pay an
amount that could buy
1.5 Japanese Big Macs. The real exchange rate a = real exchange rate,
the relative price of
the lowercase domestic goods Greek /etter in terms of foreign goods
epsnlon (e.g. Japanese Big Macs
per US. Big Mac) 2/28/2015 Understanding the units of e e x P
P *
_ (Yen per $)x($ per unit U.S. goods)
Yen per unit Japanese goods £2 Yen per unit U.S. goods
Yen per unit Japanese goods Units of Japanese goods
per unit of US. goods 5 in the real world & our model In the real world: We can think of s as the relative price of a basket of domestic goods in terms of a basket of
foreign goods In our macro model: There’s just one good, "output." So a is the relative price of one country’s output in
terms of the other country’s output Outline ° interaction between domestic economy and the
outside: trade and capital - saving and investment (the loanable funds market)
in a small open economy ° exchange rate
° nominal and real exchange rates, definition
° net exports function - how is the real exchange rate determined How NX depends on e Ts => U.S. goods become more expensive relative to
foreign goods => lEX, TIM => lNX 2/28/2015 2/28/2015 U.S. net exports and the real exchange rate, 1973—2012 4% 140
Trade-weighted real
2% _ / exchange rate index 120 100) 100
0% - 80
_2% _
60 _4% _
/ 40 _6% _ Net exports
(left scale) NX (% of GDP)
Index (March 1973 -8% 1970 1975 1980 1985 1990 1995 2000 2005 2010 The net exports function The net exports function reflects this inverse
relationship between NX and E: NX = NX(£) 2/28/2015 The NX curve for the US. 6 so U.S. net When 5 is exports will
relatively low, be hlgh
U.S. goods are relatively inexpensive The NX curve for the US. a At high enough
values of a,
52 US. goods become
so expensive that
we export
lessthan
we import Outline ° interaction between domestic economy and the
outside: trade and capital - saving and investment (the loanable funds market)
in a small open economy ° exchange rate
° nominal and real exchange rates, definition
° net exports function - how is the real exchange rate determined How 5 is determined The accounting identity says NX= 5— I We saw earlier how 5— I is determined: 05 depends on domestic factors (output, fiscal policy
variables, etc.) 0 I is determined by the world interest
rate r* So, 5 must adjust to ensure NX(£) = E — I(r*) 2/28/2015 2/28/2015 How 5 is determined Neither 5 nor I 51_ I(,>i<)
depends on 5', so the net capital outflow curve is vertical. E adjusts to
equate NX
with net capital
outflow, 5— I Interpretation: supply and demand
in the foreign exchange market demand: 51 _ 10*)
Foreigners need dollars to buy U.S.
net exports. supply:
Net capital
outflow (5— I)
is the supply of
dollars to be
invested abroad. Example 6.4 Ex1: IfS=2,I(r*)= 1, NX=2—a Q: what is the real exchange rate in equilibrium?
5— Hr") = 1 NX=2—8=198=1 Next, four experiments: 1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand
(exercise) 4. Trade policy to restrict imports 2/28/2015 10 1. Fiscal policy at home A fiscal expansion
reduces national
saving, net capital
outflow, and the
supply of dollars in the foreign
exchange market... 52 — I(r*) ...causing the real
exchange rate to rise
and NX to fall. 2. Fiscal policy abroad An increase in r*
reduces investment,
increasing net
capital outflow and
the supply of dollars
in the foreign
exchange market... ...causing the real exchange rate to fall
and NX to rise. 2/28/2015 11 NOW YOU TRY Determine the
impact of an
increase in
investment
demand on
net exports,
net capital
outflow, and the real
exchange rate. ANSWERS An increase in
investment
reduces net
capital outflow
and the supply
of dollars in the
foreign
exchange
market... ...causing the real
exchange rate to rise
and NX to fall. 2/28/2015 12 2/28/2015 4. Trade policy to restrict imports At any given 8,
an import quota 2 lIM :> TNX :> demand for
dollars shifts
ﬁght Trade policy doesn’t
affect S or I, so
capital flows and the
supply of dollars
remain fixed. 4. Trade policy to restrict imports Results: A: > 0
(demand
increase) ANX = 0
(supply fixed) AIM < 0
(policy) AEX< 0
(rise in E) 5—] 13 The determinants of the nominal exchange rate Start with the expression for the real exchange rate: e X
P*
' Solve for the nominal exchange rate:
P*
e = 8 X —
p £2 The determinants of the nominal exchange rate So e depends on the real exchange rate and the price
levels at home and abroad... ...and we know how a is determined: P*
X—
p NX(£) = E — I(r*) 2/28/2015 14 The determinants of the nominal exchange rate * p
e:£><—
p Rewrite this equation in growth rates
(see "arithmetic tricks for working with percentage
changes,” Chapter 2 ): AS *
— + 7: — 7r
5
' For a given value of £3 the growth rate of e equals the difference
between foreign and domestic inflation rates. Inflation differentials and nominal exchange rates for a
cross section of countries 0/o change 8% in nominal 0
exchange 6 /0 Pakistan I
rate 4% Mexico
I 2% u_ K_ I S. Africa 00/ Sweden \ IS. Korea
0
Japa“! \ Denmark _ o
2 /° /" Canada
Singapore l -4°/o '- lAustralia _ I
Swn‘zerland New Zea/and -6% -4% -2% 0% 2% 4% 6% 8%
inflation differential 2/28/2015 15 ...

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