TOPIC 8. The Open Economy
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1 TOPIC 8 The Open Economy
2 Goals of Topic 8 The currency market NX is back! What is the link between the exchange rate and net exports? How do different shocks affect the exchange rate and NX? Monetary coordination in the global economy Potential problems of a currency union 2
3 The Nominal Exchange Rate The nominal exchange rate is the rate at which two currencies are exchanged on the foreign exchange market Example: the nominal exchange rate between the US dollars and the euro is now 0.8 euro per dollar It means that 1 dollar can buy 0.8 euro in the foreign exchange market (the market for international currencies) Definition: e nom = nominal exchange rate = units of foreign currency that can be purchased with 1 unit of domestic currency 3
4 Foreign Exchange Market Who trades on the foreign exchange market euro/dollar? European importers demand dollars to buy US goods and services (US exports) European investors demand dollars to buy US assets (US financial inflows) American importers supply dollars (and demand euro) to buy European goods and services (US imports) American investors supply dollars to buy European assets (US financial outflows) 4
5 Dollars Demand and Supply When the value of the dollar is higher, everything else equal, US goods and assets are more expensive European importers and investors demand less dollars to buy US goods and assets Demand for dollars is downward sloping US importers and investors supply more dollars to buy European goods and assets Supply of dollars is upward sloping 5
6 How Is the Exchange Rate Determined? Nominal exchange rate Supply of dollars e nom Demand of dollars Dollars traded for euro Value of the dollar (in euros) = nominal exchange rate 6
7 Increase in Quality of US Exports (iphone 5) Nominal exchange rate Demand of dollars Supply of dollars e nom Dollars traded for euro If Europeans wants to buy more US goods, they have to buy more dollars! Hence, the value of dollar increases = appreciation of the dollar (Movement along demand: substitution effect tend to reduce NX back) 7
8 Increase in US GDP Nominal exchange rate Demand of dollars Supply of dollars e nom Dollars traded for euro Americans want to consume more of all goods, including European ones Hence, they need more euros 8
9 Increase in US Real Interest Rate Nominal exchange rate Demand of dollars Supply of dollars e nom Dollars traded for euro American assets are more attractive and Europeans need more dollars to invest in them Americans supply less dollars, as they need less euro to invest in European assets 9
10 Increase in US GDP: Summing Up Domestic consumers spend more on foreign goods and services supply of dollars shifts to the right dollar depreciates Increase in European GDP: European consumers spend more on US goods and services demand for dollars shifts to the right dollar appreciates Increase in US interest rate Demand for dollar assets increases and for euro assets decreases dollar appreciates Increase in European real interest rate Demand for dollar assets decreases and for euro assets increases dollar depreciates 10
11 The Real Exchange Rate If you know that e nom = 0.8 euro, do you know if it is cheaper to leave in Europe or in the US? NO! You need information about prices The real exchange rate is the price of domestic goods relative to foreign goods e = real exchange rate = units of foreign consumption basket that can be obtained in exchange for 1 unit of the domestic basket: e = (e nom P) / P f An increase in the real exchange rate increases the price of domestic goods relative to foreign goods 11
12 Purchasing Power Parity (PPP) How are nominal and real exchange rates related? Imagine two countries produce and consume the same good If the good is freely traded, then the real exchange rate must be 1! PPP = the price of the domestic good must equal the price of the foreign good, in terms of domestic currency: P = P f / e nom e nom = P f / P e = 1 Empirical evidence: PPP tends to hold in the long run, but not in the short run. Why? Non-traded goods, trade tariffs, monopoly power 12
13 Why Does the Real Exchange Rate Matters? The real exchange rate represents the rate at which domestic goods (and services) can be traded for those produced abroad Why an increase in the real exchange matters? It increases the price of domestic goods relative to foreign goods Substitution effect net export is going to be lower Example: dollar appreciates German cars become cheaper relative to US cars Americans demand more German cars, so import increases, and Germans demand less US cars, so export decreases NX decreases! IMPORTANT: NX is a decreasing function of the exchange rate 13
14 NX are Back! An increase in domestic GDP (Y) increases imports, reduces NX An increase in foreign GDP (Y foreign ) increases exports, increases NX A new channel from the interest rate to spending: r increases e appreciates NX decreases Symmetrically for foreign interest rate (r foreign ) So we write NX = NX (r, Y, r foreign, Y foreign, ) 14
15 The FE not affected Open-Economy IS-LM Model The LM not affected The IS is affected by NX! Still downward sloping: as r increases, e appreciates and NX decreases The goods market equilibrium condition is now Y = C (r, Y-T+Tr, Y df ) + I (r, A f ) + G + NX (r, Y, r foreign, Y foreign ) The excess of savings over investment is the amount US residents want to lend abroad and NX is the amount foreigners want to borrow from US: S I = NX 15
16 What Shifts the IS Curve? The IS curve shifts to the right because of: Any exogenous variable that shifts the closed economy IS curve to the right Any exogenous variable that increases NX, for given Y and r: 1. An increase in foreign GDP (Y foreign ) 2. An increase in foreign interest rate (r foreign ) 3. Other factors such as a reduction in saving rate of foreigners, a shift in the world taste for US goods, 16
17 IS-LM in Open Economy: A User Manual Start from equilibrium in IS-LM and foreign currency market Shock the economy and shift IS and LM curves Find new equilibrium for r, Y using IS-LM diagram Use foreign currency market diagram to see implications for exchange rate Use NX (r, Y, r foreign, Y foreign ) to see implications for net exports (Sometimes you can t tell which way it goes!) 17
18 International Transmission of the Business Cycle The impact of foreign economic conditions on NX and the real exchange rate is the principal reason why cycles are transmitted internationally Imagine Europe is the major importer from US If Europe is in recession, US net exports decrease and this can generate a recession in the US as well Let s see now the effect of fiscal and monetary policies when US is an open economy 18
19 Monetary Policy in Open Economy For simplicity, imagine that prices are fixed (SRAS version 1 in the background) r LM e nom S of Dollars D of Dollars IS Y* Y Dollars 19
20 Monetary Policy in Open Economy If M increases, interest rate falls, output increases On the exchange rate market: 1. Y increases imports increase supply of dollars increases 2. r decreases demand for euro assets increases supply of dollars increases and demand of dollars falls the dollar depreciates! Effect of NX ambiguous: 1. Y increases more imports NX decreases 2. depreciation more exports and less imports NX increases In the long run, money is still neutral! (prices adjust and LM shifts back but also the real exchange rate goes back) 20
21 Fiscal Policy in Open Economy Imagine G increases (assume Ricardian equivalence fails) r LM e nom S of Dollars D of Dollars IS Y* Y Dollars 21
22 International Crowding Out Interest rate increases, output increases Exchange rate effect ambiguous: 1. Increase in Y NX decreases supply of dollars increases dollar depreciates 2. Rise in r supply of dollars falls and demand of dollars increases dollar appreciates Assume interest rate effect dominates Then dollar appreciates and NX will unambiguously decrease International crowding out : in an open economy, the increase in imports crowds out some of the effects of expansionary fiscal policy 22
23 Current Account Current account = net exports + net factor payments CA = NX + NFP Current account identity: CA = change in the net financial position of a country towards the rest of the world Usually net factor payments are relatively small so use CA NX Trade in assets compensates for trade in goods: if we buy more foreign goods then we must sell more domestic assets to foreigners to get the foreign currency needed Always 2 sides of a CA deficit: a portfolio side and a trade side!
24 Global Imbalances 24
25 Are Global Imbalances to Blame for the Crisis? One story: Emerging economies want to accumulate safe assets 1. Demographics/lack of social insurance 2. Protection for capital flights They buy US Treasuries (CA deficit increases) pushing down interest rates Bernanke pointed out this global saving glut in 2005 Interest rates are low private banks search for yield increase in demand for AAA-rated assets with higher returns (MBS, ) This saw the seeds for the current crisis 25
26 Two Views (and My Comments) 1. Sachs: who really made interest rates low is the Fed, not Asian countries, so the Fed is to blame BUT the Fed objective is to keep Y=Y* if there is no inflation keep r low if NX drops (because of dollar appreciation) 2. Krugman: the problem of the story is that bankers are greedy BUT if there is limited supply of safe assets and demand increases the market (the banks) is just responding to this scarcity by creating more safe assets (Caballero) Housing usually is pretty safe... So the underlying forces are going to stay with us even after the crisis 26
27 US Perspective The US perspective: output below potential Monetary expansion: lowers interest rate Expand domestic demand Expand supply of dollars, reduce demand of dollars Dollar depreciates: it helps! r LM e nom S of Dollars D of dollars Y* IS Y Dollars 27
28 Emerging Markets Perspective (1) The emerging markets perspective: output above potential, inflation Option 1: Contract monetary policy High interest rates attracts capital inflows Reduce supply of Yuan, increase demand of Yuan Yuan appreciates more r LM e nom S of Yuan IS D of Yuan Y* Y Yuan 28
29 Emerging Markets Perspective (2) The emerging markets perspective: output above potential, inflation Option 2: Keep interest rate aligned with US Avoid capital inflows Keep exchange rate stable (avoid appreciation) But get overheated economy, inflation r LM e nom S of Yuan IS D of Yuan Y* Y Yuan 29
30 Emerging Markets Perspective (3) The emerging markets perspective: output above potential, inflation Option 3: Keep interest rate aligned with US Contract fiscal policy or capital controls Keep exchange rate stable, avoid inflation But get large current account surplus (back to global imbalances) r LM e nom S of Yuan IS D of Yuan Y* Y Yuan 30
31 Comparing the Options US prefers Option 1: more demand for US goods, output closer to potential, less imbalances (see Bernanke on Rebalancing the Global Recovery ) Emerging economies prefer some combination of 2 and 3 They want to avoid an appreciation But also worried about inflation. So they don t like 2 But 3 is worse for imbalances Overall, they would prefer the US to scale back QE and stimulus 31
32 Why Emerging Economies Dislike Appreciation? They are afraid to move away from successful export-led growth model Resources will have to be reallocated from supplying to foreign consumers to supplying to domestic consumers That reallocation has to happen eventually! The choice is whether to do it through appreciation or through inflation They are also concerned with short-term capital inflows per se, aside with concern with appreciation. Why? Capital inflows (and reversals) have led to boom-bust episodes in the past (see IMF Brazil conference) 32
33 Real and Nominal Appreciation 33
34 Fixed Exchange Rates and Currency Union If the exchange rate is fixed, and there is a depreciation pressure from the private market, there are three possibilities: 1. the country changes the official exchange rate (devaluation) 2. the government restrict international transactions, such as taxes on imports or financial outflows (capital controls, trade restrictions) 3. the central bank becomes a demander and supplier of currency to counteract the private market forces (pegged exchange rate) In a peg, the country loses monetary policy independece For a country in a currency union (e.g., Greece), any shock that would affect the exchange rate is absorbed by automatic changes in the country money supply (euros flow in and out freely) 34
35 A Recession with Flexible Exchange Rate Greece before the Euro: effects of a drop in consumer confidence (assume interest rate effect on forex market) r LM e nom S of Dracma IS D of Dracma Y* Y Dracma 35
36 A Recession with Fixed Rates/Monetary Union If Greek central reduced M to maintain exchange rate parity: bigger recession r LM e nom S of Dracma LM MU IS D of Dracma Y* Y Dracma In a currency union, the same happens automatically: capital perfectly mobile and LM adjust automatically as euros flow freely across countries e nom does not move 36
37 When Should We Have a Currency Union? What is an Optimal Currency Area? There are many benefits from having a common currency but there are macroeconomic costs Mundell s criteria focus on minimizing these costs: Syncronized business cycles Labor mobility and flexible wages A risk-sharing mechanism to use fiscal policy to stabilize local cycles 37
38 Is the Euro area an Optimal Currency Area? Probably not Advantages for Southern Europe: stabilize inflation (a very extreme nominal anchor) Advantages for Germany/France: more power in world economy, more developed and deep capital markets (first to finance eastern German states after unification, later to support export-led growth) When did problems begin? Growth model based on borrowing in the South and export-led growth in Germany (a bit like global imbalances in the small, but with no room for depreciation) 38
39 What Should We Have Learned What are the nominal and the real exchange rates When we think about an open economy we have to think about an extra market: the exchange rate market How to integrate IS-LM framework in an open economy Monetary and fiscal policies now also have effects through the exchange rate Global imbalances and possible solutions Pros and cons of a currency union 39
40 Final Exam When? NEXT WEEK (Tue 11:30-2:30 pm, Wed 6:30-9:30 pm) How long? 3 hours Grading Policy (again!): 30% quizzes, 70% midterm and final I count midterm once and final twice I will drop the lowest observation and average the other two Final counts up to 70% of your grade Study hard! Material: Closed Book. Cheat Sheet: Lecture Notes for Topic all related book chapters listed in the syllabus Calculator recommended. 2 PAGES, 2 SIDED HANDWRITTEN OR TYPED BY YOURSELF (FONT 12 minimum, NO FOTOCOPIES FROM BOOK OR SLIDES) Good luck!!! 40
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