EC404-Lecture 8

The exchange rate The Labour Market in the open economy Aggregate demand in the open economy AD Shocks in the open economy model

Macroeconomic CSI: The open economy in themedium run

Rodolphe Desbordes

http://www.rodolphedesbordes.com/

http://www.rodolphedesbordes.com/


Table of Contents I

1 The exchange rateThe real exchange rateThe evolution of the nominal exchange rate

2 The Labour Market in the open economyWage settingPrice settingEquilibrium output

3 Aggregate demand in the open economyAggregate demand and the RER

4 AD Shocks in the open economy modelThe open economy modelA positive AD shockCase study: the domestic and international impacts ofGerman reunification


The real exchange rateIn an open economy, economic agents can buy domestic or foreign goods.

The choice of buying domestic or foreign goods will largely be based on a comparisonof their prices, expressed in a common currency:

The price of domestic goods is P.The price of foreign goods is their price in foreign currency P∗ multiplied by theexchange rate e: eP∗.

Note that we define e as the price that domestic agents must pay to obtain one unit offoreign currency, e.g. £0.85 for one Euro.

Hence an indicator of international price competitiveness can be the Real ExchangeRate (RER), denoted θ:

θ =eP∗

P

It is called the real exchange rate because it measures the rate at which domestic andforeign goods exchange for each other. The higher the RER the more competitive acountry is.

For instance if RER = 2, it means that foreigners, for the same amount of money, couldget twice as many goods if they bought them abroad. Hence, in an open economy, theywill shift their spending from domestic goods to foreign goods.


The real yuan-dollar exchange rate

Source: http://1.2.3.11/bmi/media.economist.com/sites/default/files/imagecache/

original-size/20101106_WOC930.gif

The nominal exchange rate is a poor indicator of international price competitiveness. Itis also important to take into account relative changes in domestic and foreign prices,i.e. the relative inflation rates:

RER = eP∗

P , hence ∆RERRER = ∆e

e + ∆P∗

P∗ − ∆PP = ∆e

e + π∗ − π.

http://1.2.3.11/bmi/media.economist.com/sites/default/files/imagecache/original-size/20101106_WOC930.gif

http://1.2.3.11/bmi/media.economist.com/sites/default/files/imagecache/original-size/20101106_WOC930.gif


The nominal exchange rate and the uncovered interestparity

We have seen last year that a risk-neutral investor will hold domestic or foreign bondsindifferently if their respective returns are equal:

(1 + i) = (1 + i∗)eE

t+1

et

et =1 + i∗

1 + ieE

t+1

et ' (1 + i∗ − i)× eEt+1

For a given eEt+1, et will depend on the interest rate differential (i∗ − i) and this Uncov-

ered Interest Parity condition (U.I.P.) provides a link between domestic/foreign mone-tary policies and the value of the nominal exchange rate.

Note that if the exchange rate is credibly fixed, i = i∗ since et = eEt+1. In that case, a

country has no independent monetary policy, with the risk that the monetary policy ofthe foreign (anchor) country is inappropriate for the home country.


Wage setting and the consumer price index in theopen economy

We have previously described the consumer price index as the price (PC),which includes the indirect tax on consumption (tv ):

PC = P(1 + tv )

We now need to take into account that

1 a fraction (φ) of consumption is devoted to foreign goods, which cost, indomestic currency and before tax, eP∗.

2 a fraction (1− φ) is devoted to domestic goods, which cost before tax P.

Hence we can rewrite PC as:

PC = (1 + tv )[φeP∗ + (1− φ)P]

And workers care about the real consumption wage WPC

: IWS + βY .


Price setting in the open economy IThe producer price of domestic goods, sold at home or exported is:

P = (1 + td )W

(1− µ)λ

The ratio PCP is:

PC

P= (1 + tv )[φ

eP∗

P+ (1− φ)

PP

]

PC

P= (1 + tv )[φθ + (1− φ)]

PC

P= (1 + tv )[1 + φ(θ − 1)]

Hence to go from the real product wage ( WP ) to the real consumption wage ( W

PC), we

need to multiply WP by the inverse of the ratio PC

P :

WP

PPC

=1

(1 + tv )[1 + φ(θ − 1)]

(1− µ)λ

(1 + td )

WPC

=(1− µ)λ

(1 + td )(1 + tv )[1 + φ(θ − 1)]


Price setting in the open economy II

WPC

= (1− µ)λ×1

(1 + td )(1 + tv )︸︷︷︸×1

[1 + φ(θ − 1)]︸︷︷︸wPS = Taw wedge RER

Assume a world price P∗ of imports. Four possibilities:

1 φ = 0: It is a closed economy and we go back to our previous definition of wPS .

2 θ = 1: It is an open economy but we still go back to our previous definition ofwPS , since foreign and domestic goods have the same price.

3 θ = 1 vs. ↓ e⇒ θ < 1 : It is an open economy and for a given nominal wage andtax wedge, workers can now increase their total consumption of goods becausethe price of imports has decreased thanks to an appreciation of the RER. wPSincreases.

4 θ = 1 vs. ↑ e⇒ θ > 1: It is an open economy and for a given nominal wage andtax wedge, workers have to reduce their total consumption of goods because theprice of imports has increased thanks to a depreciation of the RER. wPSdecreases.

Hence the position of the PS curve depends on the value of θ as wPS is negativelyrelated to the RER.


The equilibrium level of outputThe equilibrium level of output (Ye) is achieved when the real wage chosen inwage-setting is equal to the real wage implied by price-setting:

IWS + βY =(1− µ)λ

(1 + td )(1 + tv )[1 + φ(θ − 1)]

Ye =1β

[(1− µ)λ

[(1 + td )(1 + tv )[1 + φ(θ − 1)]− IWS]

Equ. output =Labour productivity

Sensitivity of wWS to E× 1−Mark-up

Tax wedge× RER− InstitutionsWS

Sensitivity of wWS to E.

= Closed economy factors (CEF)× 1RER

It is important to notice that

1 Equilibrium output is negatively related to the RER.2 AD shocks can influence the RER and therefore Ye.3 In the open economy, there is a range of unemployment rates at which

wWS = wPS .


The ERU curve: Ye = CEFRER

The ERU curve is downward sloping as an appreciation of the RER (↓ θ) leads to ahigher wPS , a higher level of employment and a higher level of output.


The meaning of being on the ERU curve

A or B: On the ERU, wPS = wWS and θ = eP∗

P is constant. If the inflation targetis the world inflation rate, π = π∗ and e is constant.

Below the ERU: A′.1 A′ is below the ERU, hence to go back on the ERU, θ must increase and

therefore π < π∗ for a given e until θH is achieved.2 π < π∗ because at this employment level, given θL, wWS < wPS . Workers

ask for lower wage increases than before, π falls and θ depreciates.However, since π∗ has not fallen, the real wage falls.

3 The negative gap is resorbed through a fall of wPS , which occurs thanks tothe depreciation of θ. Once A is reached, π = π∗.


Impact of the RER on AD

We always express our IS equation in real terms, i.e. all nominal variables aredivided by P.

In the case of imports, domestic agents buy a volume M at price eP∗. Thenominal value of imports is therefore eP∗ ×M and the real value of imports iseP∗M

P = θM. Our open economy IS equation becomes Y = C + I + G + (X −θM), where the trade balance is TB = X − θM.

We have seen that the RER is an indicator of international price competitive-ness in the sense that a real depreciation (↑ θ) makes domestic goods rela-tively cheaper in comparison to foreign goods. Following a real depreciation:

1 The volume of exports (∆X > 0) will increase and the volume ofimports (∆M < 0) will decrease: foreigners buy more domestic goodsand domestic residents buy less foreign goods.

2 The price of imports increases (∆θ > 0).3 Assuming that the Marshall-Lerner condition holds, the positive volume

effects will dominate the negative price effect and ∆TB > 0, following aRER depreciation.

Hence aggregate demand/output is positively related to the RER.


The AD and BT curves

The AD curve is upward sloping as a depreciation of the RER (↑ θ) leads to an improve-ment of the trade balance.

The BT curve shows all the combinations (Y , θ) at which X = M. It is upward sloping asan increase in exports generated by a real depreciation leads to higher exports whichneed to be met by higher imports for trade to remain balanced. Since imports arepositively related to income, income must increase.

Starting at A (trade is balanced) a depreciation of the RER leads to a trade surplus andhigher output (B). Hence, above the BT curve there is trade surplus, and, below the BTcurve a trade deficit.


Characterisation of short-run, medium-run andlong-run

In the short run, wages and prices are fixed and any nominal exchange rateadjustments take place according to the U.I.P condition until i = i∗ again.Changes in output are determined by the demand-side of the economy, hencethe short-run equilibrium is on the AD curve.

In the medium run, prices and wages are free to change. Changes in outputare not only determined by the demand-side of the economy but also by itssupply-side. Hence, we move along the AD curve until it intersects the ERUcurve, since, at that point, the labour market reaches a stable medium-runequilibrium and the RER does not change anymore.

In the long run, any trade deficit or trade surplus must be eliminated for tradeto be balanced. Accumulated debt must be repaid (e.g. through higher taxes)or domestic income needs to be increased (e.g. through higher governmentspending). Hence we move along the ERU curve, while remaining on a shiftingAD curve, until both intersect the BT curve at the same point, associated withthe long-run equilibrium.


Equilibrium

ERU

BT

AD

A

RER

Y

The economy is in equilibrium at A since it on the AD, ERU, BT curves.

If A is a stable equilibrium, θ must be constant. We know that ∆RERRER = ∆e

e + π∗ − π.

We have assumed that i = i∗ in equilibrium. In that case, whatever the exchange rateregime ∆e

e = 0 and if ∆RERRER = 0, π∗ = π at A according to the UIP condition. In that

sense, the nominal interest parity is also a real interest parity i−π = i∗−π∗ =⇒ r = r∗at A.


Short-run: positive AD shock and fixed exchange rates

ERU

BT

AD

A

RER

Y

AD’

C

There is a positive AD shock. Hence the AD curve shifts to the right.

Given that prices and the exchange rate are fixed, the RER does not change and wemove to C.


Short-run: positive AD shock and flexible exchangerates with monetary targeting

ERU

BT

AD

A

RER

Y

AD’

D


Prices are fixed and income has initially increased, leading to higher money demandand therefore to a higher interest rate, given fixed money supply. The higher interestrate generates an appreciation of the nominal/real exchange rate which totally crowdsout the positive AD shock. We move to D.


Short-run: positive AD shock and flexible exchangerates with interest rate targeting

ERU

BT

AD

A

RER

Y

AD’

C


Prices are fixed and the central bank does not change the interest rate. The RER doesnot change and we move to C.


Medium-run: positive AD shock and fixed exchangerates

ERU

BT

AD

A

RER

Y

AD’

C

B

C is above the ERU curve, implying that the workers are not happy with the existingreal wage (wWS < wPS) at the new employment level. Workers ask for higher wageincreases than before, which translate into an acceleration of the domestic inflation rate(π).

Initially, π = π∗ at A. At C, π > π∗, hence θ appreciates, leading to a fall in AD untilpoint B is reached at the intersection of the AD and ERU curves.

At B, π = π∗ again. Ye is higher than initially. The real appreciation has led to higherreal wages as nominal wages have always increased faster than the consumer pricelevel. For a given WS curve, the PS curve has shifted upward.


The trajectories of the real wage and inflation

A

B


Medium-run: positive AD shock and flexible exchangerates with monetary targeting

ERU

BT

AD

A

RER

Y

AD’

D

B

D is below the ERU curve, implying that the workers are more than happy with theexisting real wage (wWS > wPS). The real appreciation has led to a higher real wage.Workers ask for lower wage increases than before, which translate into a reduction ofthe domestic inflation rate (π).

Initially, π = π∗ at A. At D, π < π∗, hence θ depreciates, leading to a rise in AD untilpoint B is reached at the intersection of the AD and ERU curves.

At D, π = π∗ again. Ye is higher than initially, despite the real depreciation, becausethe initial appreciation had led to very high real wages. For a given WS curve, the PScurve had shifted upward enough initially to prevent a full erosion of the real wage gainsby the subsequent real depreciation.


The trajectories of the real wage and inflation


Medium-run: positive AD shock and flexible exchangerates with interest rate targeting

ERU

BT

AD

A

RER

Y

AD’

C

B

D

AD’’

E

Initially, π = π∗ at A. At C, π > π∗. The central bank increases the interest rate toreduce inflationary pressures. AD shifts to the right to point E . π > π∗ and i > i∗,implying exchange rate appreciation. Hence θ appreciates.

The economy will be guided along a new MR curve with the interest rate being slowlybrought back to its stabilising value. AD will increase again but not by much as thepositive effects of lower interest rates are partly offset by the ongoing appreciation of θ.

At B, π = π∗ again. Thanks the intervention of the central bank, there has been noexcessive appreciation of the real exchange rate (A → C → E → B instead of A →D → B) .


Domestic impact of German reunification on WestGermany

C

In 1990, the two parts of Germany reunified. At the same time, other European countrieshad pegged their currencies to the Deutschmark (DM), as part of the EMS.

Before the reunification, West Germany was at A: trade surplus and stable andlow inflation.Reunification led to higher government spending. The AD curve shifted to theright (C).West Germany took path 2. Given rising inflationary pressures, the central bankraised the German interest rate (iGER ) until B was reached.An alternative path would have been to revalue the exchange rate between theDM and other European currencies, i.e. engineer an appreciation of the DMRER: path 1.


International effects of German reunification

C

B

Under fixed exchange rates, the UIP condition dictated that i = i∗ = iGER .

Other European countries had to raise their interest rates, leading to a fall in AD.

Path 1: European countries went from an already bad position A, to an evenworse position.

If path 2 had been taken (revaluation of the DM), this would have led to adevaluation of other currencies, leading to a move along AD towards B.

Under the pressure of the foreign exchange market, some countries decided toabandon the ERM, including the UK in 1992.

The punchline is that a fixed exchange rate arrangement is dangerous when the peggedcountries and the anchor country do not share the same interests.


The costs of having remained pegged to the DMfollowing the German reunification: France vs. UK

Source: Feenestra Robert C. and Alan M. Taylor (2008), International Economics, New York: Worth Publishers.

EC404-Lecture 8

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