Download Essential macroeconomic tools for the analysis of open economies

Chapter 13:
Essential macroeconomic tools
for the analysis of open economies
“The point is that you can’t have it all: A country must pick two out of three.”
Paul Krugman (1999)
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Macroeconomic Tools - Chapter Overview
International trade and exchange rates (I)
International trade and the impact of the exchange rate
- From autarky to free trade: Price determination and welfare
- Impact of the exchange rate on the trade equilibrium
Macroeconomic policy in an open economy
- Refresher: Macroeconomic analysis in the closed economy
- Interdependence of goods markets in an open economy
- Integrated financial markets and interest rate parity (IRP)
- The impossible trinity principle and exchange rate regimes
Exchange rate determination in the long run
- Monetary neutrality and inflation
- Nominal exchange rate, relative prices and real exchange rate
- Purchasing Power Parity (PPP) and equilibrium real exchange rate
- Catching up and the Balassa-Samuelson-Effect
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From autarky to free trade: Equilibrium determination
Foreign
p
pFT
DS*
Foreign
Home
p
M
pa *
(iMport)
DD
DD*
q
q
International trade and exchange rates (III)
Exchange rate: Impact on trade volume and trade direction
Foreign (USA)
DS
p
DS*
Home (EU)
p (in$)
pa
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DS*
pa
X
C
D
pFT
B
pa *
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q
q
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DD(1€=1$)
DD(1€=0.5$)
DD*
q
DS(1€=1$)
X
pa
M
DD
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pa
(eXport)
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From autarky to free trade: Impact on welfare
A
DS
p
X
International trade and exchange rates (II)
pFT
pa *
Home
q
The closed economy: a refresher (I)
The closed economy: a refresher (II)
The goods market: Y = C + I + G
The goods market and role of fiscal policy:
The IS curve:
Expansionary fiscal policy shifts the IS curve:
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© The McGraw-Hill Companies, 2015
The closed economy: a refresher (III)
The closed economy: a refresher (IV)
The financial market equilibrium:
The financial market equilibrium and monetary policy
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© The McGraw-Hill Companies, 2015
The closed economy: a refresher (V)
The closed economy: a refresher (VI)
The general equilibrium
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© The McGraw-Hill Companies, 2015
Open economy: Interdependent goods markets (I)
Open economy: Interdependent goods markets (II)
The goods market:
X - Z is called “current account”
Shape of IS-curve is unchanged, however,
increase in interest rate will reduce demand for imports.
This implies that goods markets become interdependent.
Example:
Impact of the 2008 financial crisis on the BRIC countries
(Brasil,Russia, India and China), emerging markets
that were not directly hurt by the crisis
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© The McGraw-Hill Companies, 2015
Open economy: Financial Markets and IRP (I)
Open economy: Financial Markets and IRP (II)
Integrated financial markets imply interest rate parity (IRP)
Does the interest rate parity condition work?
The IRP condition
Interest parity condition interpreted as revealing market expectations:
IRP: A trader deciding on investing anywhere in the world:
- compare interest rates;
- consider exchange rate fluctuations: if foreign currency
appreciates, an investment abroad will also lead to capital gain.
-
Thus, financial markets are in equilibrium when:
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But on top of exchange rate fluctuations there is also risk:
Interest rate of risky asset = Interest rate of safe asset + Risk premium
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Open economy: Financial Markets and IRP (III)
Government bond interest rates:
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Impossible trinity and exchange rate regimes (I)
-
Exchange rate regime only matters because nominal exchange rate
has real effects in the short run. Non-neutrality arises because
prices and wages move slowly (i.e., they are ‘sticky’).
-
Regimes:
- free floating;
- managed floating:
central banks buy their own currency when they consider it too
weak, and sell it when they see it as too strong, but they refrain
from pursuing any particular exchange rate target;
- fixed exchange rates or target zones:
authorities declare an official parity vis-à-vis another currency or
a basket of currencies, with margins of fluctuations around the
central parity (i.e., target zone);
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Impossible trinity and exchange rate regimes (II)
Impossible trinity and exchange rate regimes (III)
IRP does not necessarily go through A (i chosen by central bank):
central bank must either accept being at B (free floating) or
‘do something’ about the exchange rate (fixed or target rate).
Impossible trinity principle means that only two of the three following
features are compatible with each other:
- full capital mobility;
- fixed exchange rates;
- autonomous monetary policy.
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© The McGraw-Hill Companies, 2015
Impossible trinity and exchange rate regimes (IV)
-
The impossible trinity principle is central to European integration:
fixing the exchange rate means adopting the foreign interest rate;
conversely, maintaining the ability to choose the domestic interest
rate requires allowing the exchange rate to float freely.
-
Since the EU adopted in 1992 the principle of open capital markets,
the choice has been circumscribed to the left or bottom sides of the
triangle. One way of escaping the choice between exchange rate
stability and monetary policy autonomy is to restrict capital
movements. This is one reason why many European countries
operated extensive capital controls until the early 1990s when full
capital mobility was made compulsory. Likewise, many of the new
EU members only abandoned capital controls upon accession.
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Impossible trinity and exchange rate regimes (V)
-
Full capital mobility and flexible exchange rate:
high volatility of exchange rates impacts external competitiveness
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Impossible trinity and exchange rate regimes (VI)
-
Full capital mobility and fixed exchange rate:
monetary autonomy is lost – difference to euro membership?
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Monetary Neutrality and Inflation (I)
-
In the short run (1-3 years) monetary policy allows the central bank
to set the interest rate which in turn influences demand (low interest
rates push demand while high interest rates yield reduced demand)
-
In the long run (5 years and more) monetary policy loses its
effectiveness as the price level increases in the same proportion as
the money stock.
-
This is called “monetary neutrality” as monetary policy only affects
nominal variables in the long run (printing more money yields
inflation but has no impact on demand as people understand that
these higher prices do not imply a change in purchasing power)
-
In the AS-AD-schedule the long run AS curve is vertical at trend
GDP while the short run AS curve rises with higher P
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Monetary Neutrality and Inflation (II)
-
Monetary neutrality tends to work well (see graph until 2008), but
may break down under special circumstances (financial crisis)
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Nominal vs. real exchange rate
-
The nominal exchange rate E tells you the amount of the foreign
currency necessary to by one unit of the domestic currency
(e.g. how many dollars for one euro – measured as $/€)
-
The real exchange rate E×P/P* is a measure of competiveness
- P and P* are prices of a basket of goods at home and abroad.
-
When the real exchange rate appreciates, competitiveness declines
as more baskets of foreign goods would need to be traded for one
basket of domestic goods.
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Purchasing Power Parity
-
The purchasing power parity (PPP) principle asserts that:
-
So, if inflation at home is durably lower than abroad, domestic
currency should appreciate (and conversely).
-
Note that purchasing power parity principle only implys that the
nominal exchange rate E appreciates with lower domestic inflation.
The real exchange rate E×P/P* remains constant!
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Purchasing Power Parity at work
Real exchange rate and Purchasing Power Parity
-
Exchange rate and prices are nominal variables.
The money neutrality principle asserts that nominal variables
do not affect real variables in the long run.
 PPP implies that in the long run the real exchange rate is constant.
(this is the “equilibrium
real exchange rate”)
Nominal and real
exchange rates:
Germany vs. UK
(1950–2010)
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The Balassa-Samuelson effect at work
Equilibrium exchange rate of countries that enjoy lasting fast growth
because of catching up from a lower level of development follow an
appreciation trend – e.g. middle and eastern european countries:
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© The McGraw-Hill Companies, 2015