Opening the Economy. Topic 9

Opening the Economy Topic 9

Goals of Topic 9 What is the exchange rate? NX is back!! What is the link between the exchange rate and net exports? What is the trade deficit? How do different shocks affect the exchange rate and net exports? How do different policies affect the trade deficit? How can the business cycle be transmitted abroad? 2

Nominal exchange rates The nominal exchange rate is the rate at which two currencies are exchanged! Example: the nominal exchange rate between the US dollars and the Japanese Yen is 110 yen per dollar. It means that 1 dollar can buy 110 yen in the foreign exchange market (the market for international currencies). More technically: The nominal exchange rate, e nom, between two currencies is the number of units of foreign currency that can be purchased with 1 unit of domestic currency. 3

Real Exchange Rates If you know that e nom = 110 yen, do you know if it is cheaper to buy Japanese cars or American cars? NO! You need more information about prices The real exchange rate is the price of domestic goods relative to foreign goods. More technically: The real exchange rate, e, is the number of units of foreign goods that can be obtained in exchange for 1 unit of the domestic good: e = (e nom * P) / P f 4

Purchasing Power Parity (PPP) How are nominal and real exchange rates related? Imagine two countries producing the same goods and that goods are freely traded. Then, if trade is possible, real exchange rates must be equal to 1! That is the purchasing power in the two countries is the same (Purchasing Power Parity). PPP = the price of the domestic good must equal the price of the foreign good, both in terms of the domestic currency: P = P f / e nom e nom = P f / P Empirical evidence: PPP tends to hold in the long run, but not in the short run. Why? Different goods, non-traded goods, transportation costs, tariffs, 5

Why does the real exchange rate matter? The Real exchange rate represents the rate at which domestic goods (and services) can be traded for those produced abroad (terms of trade). Why an increase in the real exchange rate is good? People are able to obtain more foreign goods in exchange for a given amount of domestic goods. Why an increase in the real exchange rate is not so good? Net export is going to be lower (substitution effect!). Domestic prices are higher relative to foreign imports so exports will be lower & imports higher. Example: A US car costs twice as much as a Japanese car. Then Americans will demand more Japanese cars, so import will increase. Japanese will demand less US cars, so export decrease. It follows that NX decrease! Real exchange rate is the relative price of a country s good. If it increases, people will switch towards other countries goods. 6

Caveat on Real Exchange Rate Decreases: J curve NX 0 Terms of trade shocks (say, your products become cheaper than the rest of the world: a real depreciation) take a while to kick in. time Japanese cars are more expensive than US ones. Substitution effect can take time to kick in Short run: Americans import the same amount of Japanese cars, but they are more expensive. Then, the nominal value of import increases and NX decreases. Long run: Americans stop importing Japanese cars and NX increases. 7

Appreciation and Depreciation If the nominal exchange rate between US$ and changes from 110 for $1 to 120 for $1 we say that the Dollar has appreciated relative to the Yen in nominal terms (an exchange rate is always a relative concept, as it identifies the value of $1 against some other currency Yen in this instance). Conversely the Yen has depreciated relative to the Dollar. It takes more Yen to buy a Dollar. Depreciation and Appreciation are terms used when currencies are allowed to be freely traded on a market (i.e. allowed to float). We are then in a flexible exchange rate regime. Example, Dollar and Yen. 8

Revaluation and Devaluation Revaluation and Devaluation are terms used when one of the currencies (or both) is not allowed to be traded on a market (i.e. it is pegged). We are in a fixed exchange rate regime. Example, Dollar and Chinese renminbi. Consider this San Francisco Fed report of 09/2005: On July 21, 2005, after more than a decade of strictly pegging the renminbi to the U.S. dollar at an exchange rate of 8.28, the People's Bank of China (PBOC 2005a) announced a revaluation of the currency and a reform of the exchange rate regime. The revaluation puts the renminbi at 8.11 against the dollar, which amounts to an appreciation of 2.1%. Before 7/21/05 $1 bought 8.28 renminbi, after the revaluation $1 bought only 8.11 renminbi. The renminbi has revalued. 9

Different exchange rate systems In summary In a flexible (or floating) exchange rate system, exchange rates are determined by demand and supply in the foreign exchange market. In a fixed (or peg) exchange rate system, exchange rates are set at officially predetermined levels. The central bank commits to buy and sell its own currency at that rate (e.g. gold standard, Bretton Woods). For now focus on flexible exchange rate system and think about two countries: the domestic (US) and the foreign country (Japan). I refer always to the nominal exchange rate, when I do not specify otherwise. 10

How is the exchange rate determined? Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars Nominal exchange rate = value of the dollar (yen/dollars) 11

Currency Demand and Supply Supply of dollars is upward-sloping: when the value of the dollar is higher (you get a lot of yen for 1 dollar), then people supply more dollars. Demand of dollars is downward-sloping: when the value of the dollar is higher (you have to pay a lot of yen to get 1 dollar), then people demand less dollars. The amount of dollars traded in equilibrium and the equilibrium exchange rate are determined by the intersection of demand and supply (as in any market!) Why the Japanese demand dollars? 1. To buy US goods and services (US exports) 2. To buy US real and financial assets (US financial inflows) Why Americans supply dollars (to get yen)? 1. To buy Japanese goods and services (US imports) 2. To buy Japanese real and financial assets (US financial outflows) 12

Caveat on the feedback effect 1) If the exchange rate appreciates exports are more expensive for people abroad and imports are cheaper for domestic consumers. Hence NX goes down. 2) When NX goes down people tend to inject in the currency market domestic currency (that they wish to exchange with foreign currency in order to buy those exports) and demand of the domestic currency by foreigners goes down, this moves the exchange rate towards depreciating. Notice that the feedback effect. The way to think about it: Consider shocks that affect directly either step 1) or step 2). Then let the system adjust back to equilibrium. 13

Increase in Quality of US exports Value of dollars Demand of dollars Supply of dollars e 1 e 0 Dollars traded Number of dollars If Japanese consumers want to buy more US goods, they have to buy more dollars! Hence, the value of dollar increases = appreciation of the dollar 14

(1) Increase in US GDP Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars Americans want to consumer more of all goods, including Japanese ones! Hence, they need more yen 15

(1) Increase in US GDP Value of dollars Demand of dollars Supply of dollars e 0 e 1 Dollars traded Number of dollars The dollar depreciates! 16

(2) Increase in Japanese GDP Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars Japanese want to consumer more of all goods, including US ones! Hence, they need more dollars 17

(2) Increase in Japanese GDP Value of dollars Demand of dollars Supply of dollars e 1 e 0 Dollars traded Number of dollars The dollar appreciates! 18

Changes in GDP Increase in US GDP: 1. Effect on net exports: when domestic income rises, consumers will spend more on all goods, including imports. Hence, NX decreases (everything else equal). 2. Effect on exchange rate: to increase imports they need more yen. Hence, they must supply more dollars! The dollar depreciates. Increase in Japanese GDP: 1. Effect on net exports: when Japanese income rises, Japanese consumers will spend more on all goods, including US goods. Hence, US exports increase and NX increases. 2. Effect on exchange rate: to buy more US goods, Japanese need more dollars. The demand for dollars increases and the dollar appreciates. 19

(1) Increase in US real interest rate Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars American assets are more attractive and Japanese need more dollars to invest in them (Demand increases) American need more dollars to invest in them (Supply decreases) 20

(1) Increase in US real interest rate Value of dollars e 1 Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars The dollar appreciates! 21

(2) Increase in Japanese real interest rate Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars Japanese assets are more attractive and Japanese need more yen to invest in them American need more yen to invest in them 22

(2) Increase in Japanese real interest rate Value of dollars Demand of dollars Supply of dollars e 0 e 1 Dollars traded Number of dollars The dollar depreciates! 23

(1) Increase in US prices Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars Careful here: we have two channels at work! 24

(1) Increase in US prices Value of dollars Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars First channel, US goods are more expensive Americans want to buy more Japanese goods Japanese want to buy less US goods 25

(1) Increase in US prices (effect through NX) Value of dollars Demand of dollars Supply of dollars e 0 e 1 Dollars traded Number of dollars The partial effect on the first channel (trade balance) is that the dollar depreciates! 26

(1) Increase in US prices (effect through Financial Account) Value of dollars e 1 Demand of dollars Supply of dollars e 0 Dollars traded Number of dollars However, US real interest rates are going to increase because M s /P decreases! American assets are more attractive (second channel) and Japanese need more dollars to invest in them (Demand increases) American need more dollars to invest in them (Supply decreases) 27

(1) Increase in US prices (two effects) Two channels operate in opposite direction. Which one dominates? Second channel. Japanese demand dollars: 1. Fewer $ to buy US goods and services (US exports are more expensive) 2. More $ to buy US real and financial assets (US financial inflows) Americans supply dollars (to get yen): 3. More $ to buy Japanese goods and services (US imports are cheaper) 4. Fewer $ to buy Japanese real and financial assets (US financial outflows) We will assume that the real interest rate dominates (channel 2 and 4). So an increase in the price level in the US when money supply is constant produces an appreciation of the dollar. 28

(2) Increase in Japanese prices Value of dollars Demand of dollars Supply of dollars e 0 Japanese prices are higher Japanese want to buy more US goods Number of dollars Americans want to buy less Japanese goods Japanese assets are more attractive and Japanese need more yen to invest in them (Demand of dollars decreases) American need more yen to invest in them (Supply of dollars increases) 29

(2) Increase in Japanese prices Value of dollars Demand of dollars Supply of dollars e 0 e 1 Dollars traded Number of dollars Interest rate (second) channel dominates. The dollar depreciates! 30

Direct Effects Summary GDP: 1. Increase in US GDP decrease NX and the dollar depreciates. 2. Increase in Japanese GDP increases NX and the dollar appreciates. Interest rate 1. Increase in US real interest rate increases demand for dollars and reduces supply: the dollar appreciates. 2. Increase in Japanese real interest rate decreases demand for dollars and increases supply: the dollar depreciates. Prices: 1. Increase in US prices decreases NX but increases US real rates, the dollar may depreciate or appreciate (we assume the second). 2. Increase in Japanese prices increases NX but increases Japanese real rates, the dollar may depreciate or appreciate (we assume the first). 31

Trade Balance Trade balance = exports - imports = NX. If trade balance is positive, we say there is a trade surplus. If trade balance is negative, we say there is a trade deficit. When the real exchange rates appreciates, the value of the dollar is higher. Hence, domestic exports are more expensive (for the Japanese, so they will buy less of them) and imports are cheaper (for Americans, so they will buy more from abroad). Other things constant, an exchange rate appreciation reduces NX. In other words, if the dollar appreciates, we would expect the trade surplus to fall (trade deficit to rise). If the dollar appreciates, imports will increase and exports will fall. 32

Open-Economy IS-LM Model Opening the economy to trade: LM not affected FE not affected IS affected by NX!! Remember: in an open economy, the good market equilibrium is now S d I d = NX Y = C d + I d + G + NX The excess of national savings over investment is the amount US residents want to lend abroad and net export is the amount that foreigners (Japanese) want to borrow from the US. 33

Goods Market Equilibrium r NX S I r* 0 S I, NX 1. S I is upward-sloping because an increase in r increases S and reduces I 2. NX is downward-sloping because an increase in r appreciates the dollar and reduces NX. 3. The area to the left of 0 is a trade deficit, above 0 a trade surplus. 34

Open-Economy IS curve r NX S I (Y=Y 1 ) S I (Y=Y 2 ) r IS r 1 r 1 r 2 r 2 S I, NX Y 1 Y 2 Y An increase in US GDP (Y): 1. Increases S (= Y C G) and does not affect I 2. NX stays constant. (Alternative in the book: when Y increases, decreases NX). 35

Factors that shift the IS curve The open-economy IS curve shifts to the right as a result of: Any factor that shifts the closed-economy IS curve to the right. Anything that rises NX, given Y and r: 1. An increase in foreign GDP; 2. An increase in foreign interest rate; 3. A shift in the world demand towards US goods. 36

Example (1): a decrease in Japanese GDP r NX r S(Y 1 ) I IS r 1 r 1 r 2 r 2 S I, NX Y 1 Y NX decreases and the dollar depreciates. The interest rate decreases and the dollar depreciates further. The blue line stops because the depreciation start reincreasing NX and balances. 37

International Transmission of the Business Cycle The impact of foreign economic conditions on the real exchange rate and NX is one of the principal reasons why cycles are transmitted internationally. Imagine US is the major importer from Japan. If US is in recession, Japan net export decrease and a negative demand shock can generate a recession! Similarly, a change in world taste for Japanese goods, can generate a recession in Japan! Let s see now the effect of fiscal and monetary policies when US is an open economy 38

Fiscal Policy in Open Economy Suppose the US government increases G or decreases T. How will this affect goods market, money market, labor market and exchange rate market? Good market: the demand increases, that is, S I decreases. Money Market: demand increases and firms rise prices and real money supply decreases. Labor Market: Not affected (Assume that agents are not-ricardian and do not predict any change in their PVLR). Exchange Rate Market 39

Fiscal Policy in Open Economy (cont.) Exchange rate market: Ambiguous! 1. Increase in Y tend to decrease NX and depreciates the dollar 2. Rise in r tend to appreciate the dollar Which one dominates? It depends on the size of the changes. But, often the interest rate effect dominates. If the interest rate effects dominate and the dollar appreciates, NX will decrease! As a result, both the AD and the IS will shift some to the left In the end, Y will still increase, but not as much if exchange rates adjust. 40

Fiscal Policy in Open Economy P SRAS(W 0 ) W/P N s P 0 W 0 /P 0 r Y* 0 AD(G 0 ) Y LM(P 0 ) e N* 0 N d S of $ N e 0 Y* 0 IS(G 0 ) Y 41 D of $ Dollars

Fiscal Policy in Open Economy: Short Run P SRAS(W 0 ) W/P N s P 1 P 0 AD W 0 /P 0 r Y* 0 Y 1 LM(P 1 ) Y N* 0 N 1 N d N S of $ e 0 IS(NX 0, G 1 ) D of $ Y* 0 Y 1 Y 42 Dollars

Fiscal Policy in Open Economy: Short Run P SRAS(W 0 ) W/P N s P 2 P 0 W 0 /P 0 r Y* 0 Y 1 AD(NX 1 ) Y LM(P 2 ) N* 0 N 2 N 1 N d N e 1 S of $ r 0 e 0 Y* 0 Y 2 IS(NX 1 ) Y 43 D of $ Dollars

Fiscal Policy in Open Economy: Long Run P SRAS(W 1 ) W/P N s P 2 P 0 W 0 /P 0 Y* 0 AD(NX 2 ) LM(P 2 ) Y r e r 2 1 2 Y 1 N* 0 N 2 N d S of $ N e 0 Y* 0 Y 2 IS(NX 2 ) Y 44 D of $ Dollars

International Crowding out International crowding out : in an open economy, expansionary fiscal policy could lead to the appreciation of the dollar. The increase in imports crowds out some of the effects of expansionary fiscal policy. If international crowding out occurs fiscal policy is less effective. A given increase in G leads to a smaller change in Y when exchange rates are allowed to result. TWIN DEFICITS: budget deficit and trade deficit can occur together: 1. If G increases an T does not change, budget deficit increases. 2. If the interest rate effect dominates exchange rates, the dollar will appreciate. This will cause the trade deficit to increase. 1980s in the U.S.: A budget deficit can lead to a trade deficit. This is what happened in the 1980s (along with an appreciation of the dollar). 45

Monetary Policy in Open Economy Suppose the Fed cuts the federal fund rate. Good market: the monetary policy decreases real interest rate and stimulates investment (AS shifts! Movement along the IS). Money Market: real money supply increases. Labor Market: Not affected. Exchange Rate Market 46

Monetary Policy in Open Economy We have seen how the exchange rate market is affected by Y and r. With an expansionary monetary policy, r decreases and Y increases. All of these increase the supply for dollars and decrease the demand for dollars. The dollar depreciates! Depreciation of the dollar will decrease imports and increase exports (NX increase). In an open economy, AD will shift out further than it does in a closed economy (because of I and NX!). Monetary policy is more effective in an open economy. 47

Monetary Policy in Open Economy P SRAS(W 0 ) W/P N s P 0 W 0 /P 0 r Y* 0 AD(C 0 ) Y LM(P 0 ) e N* 0 N d S of $ N Y* 0 IS(C 0 ) Y 48 D of $ Dollars

Monetary Policy in Open Economy: Short Run P SRAS(W 0 ) W/P N s P 1 P 0 W 0 /P 0 r Y* 0 Y 1 AD(C 0 ) Y LM(P 0 ) N* 0 N 1 N d N S of $ IS(NX 1 ) D of $ Y* 0 Y 1 Y 49 Dollars

Monetary Policy in Open Economy: Long Run P SRAS(W 0 ) W/P N s P 1 P 0 W 0 /P 0 r Y* 0 Y 1 AD(C 0 ) Y LM(P 0 ) N* 0 N 1 N d N S of $ IS(C 0 ) D of $ Y* 0 Y 1 Y 50 Dollars

More thoughts Money neutrality revisited: in the long run a monetary policy does not affect the real exchange rate, but it does affect the nominal exchange rate! A monetary expansion depreciates the nominal exchange rate! Example: Japan. One solution to the Japanese recession was to depreciate the Yen. By making the Yen cheaper, the Japanese Central Bank could spur on economic growth by stimulating net exports. 51

Preparation: Final Exam Time and duration set by university. Determines at least 33 percent of your final grade. Covers Topic 1 to Topic 8. A 2-pages cheat-sheet (it means 1 sheet of paper double-sided) and calculator allowed. Some important issues: Monetary Policy, the Fed, LM curve, deriving the IS-LM equilibrium, AD curve, AS curve (short and long run), labor market. Analysis of the general equilibrium plus examples. Phillips curve, Taylor rule. Material in the Midterm. Try to catch up with readings and textbook. Good luck! 52