06c - Chapter 6 THE OPEN ECONOMY(PART C WUKUANG CUN Outline exchange rate \u00b0 nominal and real exchange rates definition \u00b0 net exports function how is

06c - Chapter 6 THE OPEN ECONOMY(PART C WUKUANG CUN Outline...

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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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