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CHAPTER 10
EXCHANGE RATES, BUSINESS
CYCLES, AND MACROECONOMIC
POLICY IN THE OPEN ECONOMY
Part I Outline:
I.
Exchange Rates
II.
How Exchange Rates Are
Determined
III.
The International Asset Market
I. Exchange Rates
1. Nominal Exchange Rates (enom )


is the number of units of foreign currency
that can be purchased with one unit of the
domestic currency.
Flexible-exchange-rate system:
exchange rates are determined by
conditions of supply and demand in the
foreign exchange market.
Fixed-exchange-rate system:
exchange rates were set by the government.
2. Real Exchange Rate
is the number of foreign goods that can
be obtained in exchange for one
domestic good:
enom P
e
PFor
PFor = the price of foreign goods, measured in
the foreign currency
P = the price of domestic goods, measured in
the domestic currency
3. Appreciation and Depreciation
Type of
Exchange rate
Exchange Rate
increases
System
“stronger”
Flexible
exchange rates Appreciation
Fixed
exchange rates
Revaluation
Exchange rate
decreases
“weaker”
Depreciation
Devaluation
4. Purchasing Power Parity
e 1
PFor
P 
enom
“purchasing power parity” (PPP):
(in the absence of transportation costs),
the similar foreign and domestic goods
should have the same price in terms of
the same currency.
Empirical evidence: PPP holds in the very
long run, but not in the short run.
4. Purchasing Power Parity
In the more general case:
enom
e

  For  
enom
e
When e is constant,
enom
  For  
enom
“Relative purchasing power parity”:
works well for high-inflation countries,
but not low-inflation countries.
5. The Real Exchange Rate
and Net Exports

The real exchange rate is the price of
domestic goods relative to foreign
goods.

It determines the demand for domestic
goods both in home and foreign
countries.
real exchange rate
net export
II. How Exchange Rate Are
Determined
Supply of dollars: (upward sloping)
Why supply?
(i) buy foreign goods and services
(ii) buy foreign financial assets
 Demand for dollars: (downward sloping)
Why demand?
(i) buy Canadian goods and services
(ii) buy Canadian financial assets

Macroeconomic Determinants of the
Exchange Rate and Net Export

Effects of Changes in Output
Domestic income
net export
exchange rate (depreciation)
Foreign income
net export
exchange rate (appreciation)
Macroeconomic Determinants of the
Exchange Rate and Net Export

Effects of Changes in Real Interest Rate
Domestic real interest rate
exchange rate (appreciation)
net export (indirectly throughenom)
Foreign real interest rate
exchange rate (depreciation)
net export (indirectly throughenom)
III. The International Asset Market
1. Returns on Domestic and Foreign Assets
Example:
A Canadian saver has $100 to invest
either in Canadian bonds or US bonds.
Canadian bonds pay interest i  3% ;
US bonds pay interest iFor  6% .
Assume the two assets have the same
risk and liquidity. Which bond should she
f
 1.07 )
buy? (Assume enom  1.02 and enom
General steps to calculate the gross
nominal rate of return on foreign asset:

Step 1: Convert home currency to
foreign currency.

Step 2: Earn interest on foreign asset.

Step 3: Convert foreign currency to
home currency.
Expected gross nominal rate of return
enom
on foreign asset = (1  iFor ) ef
nom
2. Interest Rate Parity
The equilibrium condition in the
international asset market:
enom
(1  iFor )  (1  i )
f
enom
“nominal interest rate parity condition”
In real term, e
nom
f
nom
e
(1  rFor )  (1  r )
“real interest rate parity condition”
Part II Outline:
IV.
The IS-LM Model for an Open
Economy
V.
Macro Policy in a Small Open
Economy with Flexible Exchange
Rate
VI.
Fixed Exchange Rate
IV. The IS-LM Model for an Open
Economy

The LM curve and FE line are the same
as in the closed economy; the IS curve
will be modified.

3 main points about the IS curve in the
open economy:
i). downward sloping;
ii). Factors shift IS curve in the closed
economy shift IS in the open economy.
iii). Factors that change NX also shift IS.
1. The Open-Economy IS Curve

Goods Market Equilibrium:
d
d
Closed economy: S  I  0
Open economy:
S  I  NX
d
d
d
d
Y

C

I
 G  NX
Equivalently:
The S  I curve: slopes upward.
 The NX curve: slopes downward.

Goods market equilibrium is given by the
intersection of S  I curve and NX
Numerical example:
Given the following, derive the openeconomy IS curve:
C  100  0.90Y  300r
d
I  60  150r
d
G  50
NX  40  0.20Y  0.40YFor  50r
2. Factors That Shift the IS Curve

Factors that shift closed-economy IS
curve up:
shifts S  I curve to the left
r
shifts open-economy IS curve up
e.g.: expected future output, wealth, G , T ,
f
MPK and effective tax rate on capital

Factors that shift the NX curve:
i).
Foreign output, YFor
ii).
Foreign real interest rate, rFor
iii).
Demand for domestic goods
NX
shifts open-economy IS curve up
V. Macro Policy under Flexible
Exchange Rate
1. A Fiscal Expansion
G
IS curve first shifts to the right
IS curve then shifts to the left
Overall effects:
i). Fiscal policy is ineffective.
ii).
exchange rate and
NX
“net export crowding out”
2. A Monetary Expansion

Short-run effects:
M

LM and IS both shifts right
Y , enom , NX (holding P fixed)
Long-run effects:.
P
LM and IS both shifts left
Overall effects:
Money is neutral
i). Real variables are unaffected
ii). Nominal variables change proportionally
VI. Fixed Exchange Rates

Fundamental value of the exchange rate
the value that would be determined by the
supply and demand in the foreign
exchange markets.

Overvalued exchange rate:
fixed value > the fundamental value

Undervalued exchange rate:
fixed value < the fundamental value

How to deal with a situation with
overvalued exchange rate?
i). Devaluation: change the official value to
the fundamental value
ii). Restrict international transactions
iii). Use official reserve assets to buy back
its own currency

Speculative run: investors expect
overvalued currency will soon devalue, so
they sell assets in that currency.
2. Monetary Policy and the Fixed
Exchange Rate

M
fundamental value of enom
an overvalued exchange rate
An overvalued exchange rate is not
sustainable, so the monetary expansion
eventually must be reversed.

The relationship of the money supply to
the fundamental value of enom : slopes
downward.
2. Fiscal Policy and the Fixed
Exchange Rate

Short-run effects:
G

IS and LM both shifts right
Y , enom , NX (holding P fixed)
Long-run effects:.
P
LM and IS both shifts left
a) Fiscal expansion has no effect on Y .
b) Real exchange rate is increased.
c) Net export is crowding out.
VII. Choosing an Exchange Rate System

Advantage of fixed exchange rates:
i). Stable exchange rates promote trade.
ii). Improve monetary policy “discipline”

Disadvantage of fixed exchange rates:
i). Unable to use monetary policy to deal
with recession.
ii). Lose monetary policy independence.
iii). Vulnerable to speculative attacks.

Currency union
– an alternative to fixed exchange rate
– common monetary policy is controlled by
a single institution.
– 2 advantages over fixed exchange rates:
i). With a single currency, trading cost is
even less.
ii). Using the common currency,
speculative attacks can be avoided.
2. Self-Correcting Adjustment
Closed Economy
 Self-correcting mechanism: price
adjustment.
 When the intersection of IS and LM
curves lies to the right of the FE line,
price increases to shift LM curve up.
 When the Intersection lies to the left of
the FE line, price decreases to shift LM
curve down.
Small Open Economy

Self-correcting mechanism: price
adjustment & exchange rate adjustment

Under a flexible exchange rate system:
I.
Fiscal policy is ineffective, but many
unexpected shocks that shift IS curve
requires no stabilization policy response.
II.
Monetary policy is effective for
stabilization purpose, but it has a
magnified impact on output.
Small Open Economy

Under a fixed exchange rate system:
I.
Fiscal policy accompanied by a monetary
expansion/contraction is effective for
stabilization purpose, but it has larger
impact on output.
II.
Monetary policy is ineffective, but factors
that shift LM curve has no impact on
output.