OPEN ECONOMY MACRO AND THE EXCHANGE RATE (1)

• Up to now, we have ignored the exchange rate: i.e. the price of foreign currency in terms of domestic currency.

• Implicitly we have assumed the exchange rate to be fixed (as well as general price levels, both foreign and domestic).

• We now allow for flexible exchange rates and contrast the workings of fiscal and monetary policies under different exchange rate regimes

• For any open economy, there will be: – a demand for foreign currency for imports, investment abroad

– a supply of foreign currency from exports and inward investment

– also international factor income payments, transfers, etc.

• Generally the resulting relative price of foreign and domestic currencies can display significant volatility.

OPEN ECONOMY MACRO AND THE EXCHANGE RATE (2)

• The Nominal Exchange rate is usually the number of Foreign Currency units per unit of Domestic Currency: i.e. number of $ or £ per € (or if you are in the USA, the number of € or £ per $)

• Some countries operate fixed exchange rate regimes, where the Nominal Exchange rate is fixed: in that case the monetary authorities mop up and excess supply of foreign exchange by adding to reserves, and meet any excess demand by running down reserves

• In a fixed exchange rate regime: Ms is endogenous: excess Supply adds to Foreign exchange reserves and to reserve assets of banks, and thus to an expansion of Ms. Excess demand similarly leads to a fall in Ms.

• Therefore in a fixed exchange rate regime, an independent domestic Monetary Policy is impossible (unless there are draconian foreign exchange controls)

NOMINAL AND REAL EXCHANGE RATES (1)

• The nominal exchange rate is what we observe directly:

• e.g. €1 = $1.50 or $1= €0.67

• However in terms of the effects on Trade (or NX), the real exchange rate is what matters

• Let e, E, P, Pf = real exch rate, nominal exch rate, Domestic price level and Foreign price levels respectively.

• Then: e = E(P/Pf)

• Initially, suppose P = 100 and Pf = 200

• Recall E is no. of $ (foreign currency units) per € (domestic)

• Suppose E = 2.00, then e = 2.00(100/200) = 1

• If P increases to 110, and Pf remains the same, and also E is constant, then

• e = 2.00(110/200) = 220/200 = 1.1: i.e a real appreciation of the €

NOMINAL AND REAL EXCHANGE RATES (2)

• For levels: e = E(P/Pf)

• For changes: e/e = E/E + P/P – Pf/Pf

• If domestic inflation is 2%, “foreign” inflation is 5% and E/E=0

• Then: e/e = 0 + 2% – 5% = – 3%, i.e. a real depreciation of 3%

• If domestic and foreign inflation were both 2% and E/E = +20%

• Then: e/e = +20% + 2% – 2% = + 20%: a 20% real appreciation

• In recent years, many fairly large changes in E have occurred while inflation rates were roughly equal implying corresponding changes in e

• This bring us to the concept of Purchasing-Power Parity (PPP)

• PPP is a hypothesis about the correspondence between Nominal Exchange Rates and relative prices, such as to equalise Purchasing power of a given sum of money in different countries

NOMINAL AND REAL EXCHANGE RATES (3)

• Formally PPP implies: e = 1 = E(P/Pf); E = (Pf/P)

• and e/e = E/E + P/P – Pf/Pf = 0; E/E = Pf/Pf – P/P

• Under a fixed Exchange Rate regime as E/E = 0, then PPP implies that P/P = Pf/Pf , and for a small open economy P/P is clearly the dependent variable.

• Under a flexible exchange rate regime PPP may imply that E adjusts to compensate for any difference between P/P and Pf/Pf

• A quick examination of the data reveals that PPP does not apply at least in the short or medium term: in the very long-term the evidence is more mixed.

• For the moment, we can assume that e is not constant, and therefore the relation between NX and e is important.

• Let NX = NXa + nY – ue

BALANCE OF PAYMENTS EQUILIBRIUM (1)

• A fundamental BOP condition is: NX + NCF = 0

• Where NCF = net capital outflow

• A higher level of Y reduces NX (via increased import demand)

• A higher r also reduces NCF increasing Y and r simultaneously will maintain BOP equilibrium. If

capital is perfectly mobile then even very small changes in r will offset large changes in Y

• If E (and e) increases, then a higher r will be needed to maintain BOP equilibrium (at any given level of Y). B is FRes

• Formally: B = f(y, r, e), and dB = f'ydy + f'rdr + f'ede

• For any given e, BOP equil implies B = 0 = f'ydy + f'rdr

• So dr/dy = - (f'y /f'r)

• We can summarise this in a BOP equilibrium locus: BB

BALANCE OF PAYMENTS EQIULIBRIUM (2)

• BB is locus of r, Y giving BOP equilibrium (FRes = 0)

• Above BB, BOP surplus, + Ms, below BB deficit – Ms

• Increase in E (or e) shifts to B1 B1, fall in E B2B2

Y

r

0

B

B

B1

B1

B2

B2

FISCAL POLICY IN SOE (FIXED-E)

• Fiscal expansion IS2 ; r increases; BOP > 0; + Ms; LM2

• Result: “effective” Fiscal Policy: y y2 (NB caveat re multiplier)

BB

LM1

IS1

r

Y0 Y 1

IS2

LM2

Y 2

MONETARY POLICY IN SOE (FIXED-E)

• Monetary expansion LM2 ; r falls; BOP < 0; Ms; LM1

• Result: “ineffective” Monetary Policy: y remains at y1

BB

LM1

IS1

r

Y0 Y1

LM2

FISCAL POLICY IN SOE (FLEXIBLE-E)

• IS shift leads to E appreciating: this shifts IS again

• Result: International “crowding out”

r

0 Y

IS1

LM

B1B1

IS2

B2B2

y1 y2

B3B3

IS3

y3

MONETARY POLICY IN SOE (FLEXIBLE-E)

• LM shift leads to E depreciating

• Shift in BB leads to outward shift in IS

• Result: “effective” monetary policy

r

0 Y

IS1 LM1

B1B1 B2B2

IS2

Y1 Y2

LM2

SMALL OPEN ECONOMY MACRO: SOME PROVISIONAL CONCLUSIONS

• We now see how one cannot have (a) an independent exchange rate policy; (b) any effective monetary policy and (c) complete capital mobility

• In the Euro-zone there is practically perfect capital mobility, but for individual members, no exchange rate policy discretion and no effective monetary policy

• There is however scope for fiscal policy (but this is blunted by the openness of individual economies)

• There are also parameters which have been agreed for fiscal policies: the EU Stability and Growth pact, and there are “Excessive Deficit” procedures.

• Without going into details: note that the revised pact makes allowances for the impact of economic cycles, and recent events have necessitated a general re-think.

Policy In an Open Economy

• Can look at Monetary, Fiscal and Exchange Rate Policy

• If we think of the purpose of policy is to control Y then we get

• The reason is the automatic effects of BP

Fixed e Float e

Fiscal Effective Little effect

Monetary Ineffective Effective