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nominal exchange rate is …
the price of the domestic currency in terms of the foreign currency
Yes because exports and imports may include exports and imports of intermediate goods.
A in terms of B equals to
To Convert a good in A currency to B currency
Price of good in A*A/B
If inflation rates were exactly equal,
- P/P* would be constant
- both E and ε would move together exactly
Openness in financial markets allows
Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate movements.
Allows countries to run trade surpluses and deficits.
A country that runs a current account deficit must finance it through…it is because
capital account surplus (positive net capital flows)
sustain its trade deficit; A country that buys more than it sells must pay for the difference by borrowing from the rest of the world.
Arbitrage implies that
domestic interest rate must be (approximately ) equal to the foreign interest rate minus the expected appreciation rate of the domestic currency (or, minus the expected depreciation rate of the foreign currency).
UIP condition ignores
If there is no capital control
Will converge to the UIP condition
Suppose two countries make a credible commitment to fix their bilateral exchange rate and also allow capital to flow freely between two countries. In such a situation, we know that
the interest rate in the two countries must be equal.
Assume that the uncovered interest parity condition holds. Also assume that the U.S. interest rate is less than the U.K. interest rate. Given this information, we know that investors expect
the pound to depreciate
demand for domestic goods
Domestic demand for goods
real exchange rate affects domestic Demand in terms of …but does not affect
- the composition of C&I(between domestic goods and imports)
- the overall level of these aggregates
The Determinants of Exports
- An increase in foreign income, Y*, leads to an increase in exports
- An increase in the real exchange rate, , leads to a decrease in exports
The Determinants of Imports
An increase in domestic income, Y, leads to an increase in imports.
An increase in the real exchange rate, , leads to an increase in imports, IM.
AA has a positive slope means
As long as some of the additional demand falls on domestic goods, an increase in income leads to some increase in the demand for domestic goods.
AA is flatter than DD implies
As income increases, the domestic demand for domestic goods increases less than total domestic demand (total domestic demand=domestic goods+imports)
demand for domestic goods(ZZ)-domestic demand(DD)
The goods market is in equilibrium when… At the equilibrium level of output, the trade balance is…
- domestic output is equal to the demand for domestic goods.
As domestic output increases, the trade balance moves from
Surplus to deficit
difference you should note between open and closed economies
- effect on the trade balance: increase in output leads to a trade deficit
- The effect of government spending on output is smaller than it would be in a closed economy. This means the multiplier is smaller in the open economy.
- * the smaller the slope of the demand relation, the smaller the multiplier; ZZ is flatter than the demand relation in a closed economy, DD.
Contrast the effect of increase in domestic demand & increase in foreign demand
- increase in domestic demand: increase in domestic output + a deterioration of the trade balance.
- increase in foreign demand: increase in domestic output and an improvement in the trade balance.
the domestic demand for goods and the demand for domestic goods are equal if
the trade balance is equal to zero
when there is a real depreciation, what components of ZZ is affected?
- Exports, X, increase.
- Imports, IM, decrease
- The relative price of foreign goods in terms of domestic goods increases.
Summarized Effects of a Depreciation
- shift in demand, both foreign and domestic, toward domestic goods
- increase in domestic output
- an improvement in the trade balance.
Marshall-Lerner condition is
a real depreciation leads to an increase in net exports.
An increase in investment must be reflected in either …
- an increase in private saving or public saving, or
- in a deterioration of the trade balance.
An increase in the budget deficit must be reflected in …
- an increase in either private saving, or
- a decrease in investment, or
- a deterioration of the trade balance.
A country with a high saving rate must have either …
- a high investment rate or
- a large trade surplus
UIP implication: current exchange rate depends on the
- domestic interest rate, +
- foreign interest rate, -
- expected future exchange rate, +
why would increase in US interest rate appreciate the dollar?
- demand for U.S. bonds to rise
- As investors switch from foreign currency to dollars, the dollar appreciates.
Assume that the future expected exchange rate remain unchanged. This implies that the appreciation of dollar today leads to…
an expected depreciation of dollar in future
reduction in foreign income leads to reduction in imports because
NX decreases, domestic income decreases, import decreases
An increase in the interest rate reduces output through
- NX (exchange rate)
The Effects of Expansionary Fiscal Policy in an Open Economy
- C and G increases
- Investment: ambiguous
- net exports: decrease (due to increase in output and appreciation)
- twin deficit: Budget deficit + trade deficit
Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument.
Increases in the domestic demand for money must be matched by increases in the supply of money in order to maintain the interest rate constant so that Ms=Md (because now i=i*)
TRILEMMA IN INTERNATIONAL ECONOMICS: Impossible trinity refers to
- 1. A fixed exchange rate.
- 2. Free capital movement (absence of capital controls).
- 3. An independent monetary policy (monetary autonomy)
Cons of fixing exchange rate
- gives up a monetary policy for correcting trade imbalances or changing the level of economic activity.
- gives up control of its interest rate, and they must match movements in the foreign interest rate risking unwanted effects on its own activity.
- Although the country retains control of fiscal policy, one policy instrument is not enough. A country that wants to decrease its budget deficit cannot, under fixed exchange rates, use monetary policy to offset the contractionary effect of its fiscal policy on output
Fiscal policy has a … effect on output in an economy with fixed exchange rates than in an economy with flexible exchange rates.
the interest parity condition implies that the domestic currency will …in response to an increase in the expected exchange rate.
If financial investors expect the dollar to depreciate against the yen over the coming year, one-year interest rates will be … in the US than in Japan.
If foreign investors are reluctant to lend to the US(buy US bonds), there will be pressure for the dollar to…
Why would deflation limit the ability of expansionary monetary policy to increase output?
- Increasing M shift AD to the right, price increases;
- If there is deflation, price does not increase as much as expected, hence deflation offset part of the increase in output
How can monetary policy correct trade deficit?
Consider ISLM: By decreasing M, output decreases, NX increases
By committing to a particular exchange rate, a country also gives up control of its interest rate, and they must match movements in the foreign interest rate risking unwanted effects on its own activity.” Give example of an unwanted effect.
If foreign interest rate increases, domestic interest rate increases, domestic investment decreases (undesirable when in recession)
What are the advantages of fixing exchange rate?
Reduce fluctuation in exchange rate, thus Reduce fluctuation in NX and output
exchange rate is an automatic stabilizer: exchange rate movement dampens the effects of any shock to IS
suppose investment confidence drops, Y drops; IS shift left and i drops, E drops and NX increases, Y increases
for any policy abroad, consider ....to determine its effect on domestic NX and Y
- i* thus E thus NX thus Y
- Y* thus NX thus Y
The more open an economy is, the smaller the effect of fiscal policy on output and the larger the effect of fiscal policy on trade position
- (i.e. the higher is the ratio of imports and exports to GDP) -flatter ZZ
- the greater the extent to which higher government spending or tax cuts will feed into rising demand for imported goods and services, lowering the impact on domestic GDP.