OPEN ECONOMY MACRO AND THE EXCHANGE RATE (1)

1. 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.

2. 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)

3. 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 €

4. 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

5. 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

6. 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

7. 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 r B1 B1 B B B2 B2 0 Y

8. 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) r LM1 LM2 B B IS2 IS1 Y 0 Y2 Y1

9. MONETARY POLICY IN SOE (FIXED-E) • Monetary expansion  LM2 ; r falls; BOP < 0; Ms; LM1 • Result: “ineffective” Monetary Policy: y remains at y1 r LM1 LM2 B B IS1 Y 0 Y1

10. FISCAL POLICY IN SOE (FLEXIBLE-E) • IS shift leads to E appreciating: this shifts IS again • Result: International “crowding out” r LM B2 B2 B3 B3 B1 B1 IS2 IS1 IS3 0 Y y1 y2 y3

11. 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 IS1 IS2 LM1 LM2 B1 B1 B2 B2 0 Y Y2 Y1

12. 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.

13. 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