Macro Session 7

7/27/2019 Macro Session 7

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Macroeconomics & The globaleconomy

Ace Institute of Management

Session 7: The Open economy

InstructorRijan [email protected]

9851069004
mailto:[email protected]:[email protected]


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2

The exchange rate between two countries isthe price at which residents of those countriestrade with each other.

Nominal and Real exchange rates


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The nominal exchange rate

e = nominal exchange rate,the relative price of domestic currencyin terms of foreign currency(e.g. Nepali Rs. 86 per US Dollar)


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e

Dollar Value of Transactions

D$

Ae 0

S$

$

Demand and Supply for the currency determines theexchange rate.

Important factor: trade and Investment requirements


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D$ shifts rightward andincreases the nominalexchange rate, e. This is knownas appreciation of the dollar.Be 1

e

Dollar Value of Transactions

D$

Ae 0

S$

$

Suppose there is an increase in the demand for U.S. Dollars in Nepal(for importing goods and services or going abroad). How will thisaffect the nominal exchange rate for US dollar in Nepal ?

Events which decrease thedemand for the dollar, and thus

decrease e, would be adepreciation of the dollar.

D$


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Understanding Real Interest Rate

A Japanese businessmanthinks that Japanese carsmade in the US are farbetter than those madein Japan.

The car model he likes in

Japan costs 2400,000Japanese Yen. The existingspot (nominal) exchangerate is 120 Yen/dollar.


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Understanding Real Interest Rate

So, he exchanges 2400,000Japanese Yen for $20,000and Travels to US to buythe same car.

For his surprise, the samecar in US costs only$10,000.

What are his impressionsabout the US and

Japanese currencies?


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Understanding Real Interest RateImpression:

1. Overvaluation of Japanesecurrency:He can buy more cars (2 cars)in US than Japan with same

amount of money. TheJapanese Yen is overvalued

2. Real exchange rate is different from nominal exchange rate:

1 American car = 0.5 JapaneseCar (as US car costs half the price of the car in Japan ).


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The real exchange rate= real exchange rate,

the relative price of domestic goodsin terms of foreign goods(e.g. How many Nepali KFC basketscan you buy with the amount you pay

for 1 U.S. KFC basket? )

the lowercase Greek letter

epsilon


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Relationship between e and e

RealExchangeRate

=Nominal Exchange Rate at Home x Price of Domes. Goods

Price of Foreign Goods

RealExchangeRate

=

Nominal

ExchangeRate

X

Relative

Price of Goods

e = e X (P / P*)

P = Price of DomesticGoods

P* = Price of ForeignGoods


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The real exchange rate with KFCCosts of KFC basket in Nepal = Rs. 900

Costs of same KFC basket in US = $10If the nominal exchange rate is Rs. 73/dollar,1) What is the real exchange rate? 2) Is Nepalese currency overvalued or undervalued

compared to US currency?


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The real exchange rate with KFCCosts of KFC basket in Nepal = Rs. 900

Costs of same KFC basket in US = $10If the nominal exchange rate is Rs. 73/dollar,1) What is the real exchange rate? 1.232) Is Nepalese currency overvalued or undervalued

compared to US currency? - Overvalued


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Relationship between NX and ?

Nepalese goods become more expensiverelative to US goods

EX , IM NX


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The net exports function The net exports function reflects this inverse

relationship between NX and :

NX = NX ( )

NX NX ( )

1


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How is determined

The accounting identity says NX = S I We saw earlier how S I is determined:

S depends on domestic factors (output, fiscalpolicy variables, etc )

I is determined by the world interestrate r *

So,

( ) ( )*NX S I r


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How is determinedNeither S nor I depend on ,so the net capitaloutflow curve is

vertical.

NX

NX (

)

1 ( *)S I r

adjusts toequate NX with net capitaloutflow, S I .

1

NX 1


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Next, four applications:

Impact on Real Exchange Rate due to:

1. Expansionary Fiscal policy at home

2. Expansionary Fiscal policy abroad

3. Domestic increase in investment demand

4. Trade policy to restrict imports


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1. Fiscal policy at home

A fiscal expansionreduces nationalsaving, net capitaloutflow, and the

supply of NPRagainst dollarsin the foreignexchange market

causing the realexchange rate to riseand NX to fall.

NX

NX ( )

1 ( *)S I r

1

NX 1NX 2

2 ( *)S I r

2


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2. Fiscal policy abroadExpansionary Fiscal

Policy abroadincreases worldinterest rate r*, reduces investmentin Nepal, increasingnet capital outflow(S>I) and the supplyof NPR againstdollars in the foreign

exchange market

causing the realexchange rate to falland NX to rise.

NX

NX ( )

1 1( *)S I r

NX 1

1

21 ( )*S I r

2

NX 2


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3. Increase in investment demand at home

An increase ininvestment in Nepalreduces net capitaloutflow (S


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4. Trade policy to restrict imports

NX NX ( )1

S I

NX 1

1NX ( )2

At any given value of ,an import quota

IM NX (Note: Net Export =

Export Import)

Trade policy doesn taffect S or I , socapital flows and thesupply of NPR againstUS Dollar remain fixed.

2


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Purchasing Power Parity (PPP)

Law of One Price: A doctrine which states that goods must sell at the

same (currency-adjusted) price in all countries. The nominal exchange rate adjusts to equalize the

cost of a basket of goods across countries.

Reasoning: arbitrage, the law of one price


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Purchasing Power Parity (PPP)

PPP: e P = P *

Cost of a basket of domestic goods, inforeign currency.

Cost of a basket of domestic goods, indomestic currency.

Cost of a basket of foreign goods, inforeign currency.

Solve for e : e = P */ P

PPP implies that the nominal exchange ratebetween two countries equals the ratio of thecountries price levels.


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Does PPP hold in the real world? No, for two reasons:

1. International arbitrage not possible. nontraded goods

transportation costs2. Different countries goods not perfect substitutes.

Nonetheless, PPP is a useful theory: Its simple & intuitive In the real world, nominal exchange rates

tend toward their PPP values over the long run.


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Thank You

Macro Session 7

Documents

Transcript of Macro Session 7