Open Economy I: Concepts

Transcription

1 Open Economy I: Concepts

2 1. Exchange Rates 2. Full Employment Output 3. Interest Rates

3 1 Exchange Rates Nominal exchange rate E t Cost of domestic currency in terms of foreign currency Foreign-currency price of domestic currency Example: recently dollar hit a low of costs.76 Euros, so E t (Euros/dollar) is.76 Dollars per Euro is just the inverse 1/.76 = 1.32

4 Changes in the nominal exchange rate Dollar appreciates = E t rises, implying dollars become more expensive Dollar depreciates = E t falls, implying dollars become cheaper Price comparison using the exchange rate tourist decides whether to buy a particular Nike running shoe in Paris for e90, when the same shoe in the US costs $100.

5 Law of One Price (LOOP) prices of the same goods are the same when converted to a common currency does LOOP hold? commodities vs. Nike shoes E P corn = P corn prices of similar goods can t get too far apart

6 Purchasing Power Parity (PPP) Price levels in di erent countries, when converted to the same currency, are the same EP = P Since price levels are just indexes, must refer to changes in price levels Does LOOP imply PPP? Price levels in di erent countries contain di erent goods Exchange rate changes equal di erences in in ation de E =

7 Real exchange rate = t = E tp t compared with foreign goods P t = relative price of domestic goods Real exchange rate appreciation t increases, making domestic goods relatively more expensive Real exchange rate depreciation t decreases Since goods are not identical, if the real exchange rate of the dollar for the Euro appreciates, US goods become relatively more expensive, and both domestic and European consumers switch out of US goods into European goods.

8 Net exports and the real exchange rate in dollar terms P X(Y ; ) P E IM(Y; ) in terms of US goods NX = X(Y P ; ) EP IM(Y; ) = X(Y ; ) 1 IM(Y; ) how does an increase in the real exchange rate () a ect the real value of @ + 1 2IM as domestic goods become more expensive, exports fall and imports rise, reducing NX,but the value of imports falls, raising NX

9 Marshall-Lerner condition requires that the sum of the real exchange rate elasticities of the demand for exports and imports exceed unity. In this case a real depreciation will raise net exports.

10 J- Curve - exports and imports take time to react to the exchange rate. immediate response of N X includes only the exchange rate response, such that a real depreciation reduces net exports immediately over, time, quantities react and NX rise Net exports NX = NX (Y; Y ; < 0

11 Long-run real exchange rate relative prices must assure that demands and supplies of domestic and foreign goods are equal change in preferences toward foreign goods would raise their relative price, reducing increase in US government spending on domestic goods would raise their relative price raising technological progress in the US increasing the relative supply of US goods would reduce their relative price reducing

12 2 Full Employment Output (FE) Firm pro t maximization in an open economy Nominal pro t P AK N 1 W N P k K CPI in an open economy contains prices of domestic goods and imported goods CP I = P P! 1 E

13 Note: P CP I = P P P E 1 = EP P 1 = 1 w = p k = W CP I P k CP I Real pro ts 1 AK N 1 wn p k K Firm s labor demand 1 (1 ) AK N = w

14 requires the marginal product of labor, adjusted for the real exchange rate equal the real wage. Labor demand shifts up with an increase in the real exchange rate. Full employment output rises with an increase in the real exchange rate

15 3 Nominal Interest Rates In choosing which international bond to buy, what do you consider? Interest rate parity - arbitrage between domestic and foreign interest rates 1 + i t = E t Et+1 e (1 + i t ) If we assume that E e t+1 is xed at E, then we can draw the domestic interest rate as an upward sloping function of the exchange rate. The relation shifts for a change in either i or E e t+1 :

16 We can express the exchange rate as a function of the interest rate E t = 1 + i t 1 + i Et+1 e t The only way nominal interest rates can di er from each other is if the exchange rate is expected to change! i t i t Ee t+1 E t E t

17 4 Real Interest Rates Relation between real interest rates and nominal interest rates 1 + i t = (1 + r t ) 1 + e t+1 = (1 + rt ) P e t+1 P t Interest rate parity using real rates becomes: (1 + r t ) P e t+1 P t = E t E e t+1 (1 + r t ) P e t+1 P t Solving for the current real exchange rate yields: t = E tp t P t = (1 + r t) 1 + rt E e t+1 P e t+1 P e t+1! = (1 + r t) 1 + rt e t+1

18 Di erences in real interest rates can be expressed as the expected rate of depreciation of the real exchange rate: r t r t e t+1 t t