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OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate

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Macroeconomics ECO 403
VU
LESSON 16
OPEN ECONOMY (Continued...)
How ε is determined
·  The accounting identity says NX = S I
·  We saw earlier how S I is determined:
·  S depends on domestic factors (output, fiscal policy variables, etc)
·  I is determined by the world interest
rate r *
·  So, ε must adjust to ensure
NX (ε ) = S - I (r *)
S1 ­ I(r*)
ε
ε
1
NX (ε)
NX
NX 1
Neither S nor I depend on ε, so the net capital outflow curve is vertical.
ε adjusts to equate NX with net capital outflow, S - I.
Supply and demand in foreign exchange market
Demand: Foreigners need dollars to buy U.S. net exports.
Supply: The net capital outflow (S - I) is the supply of dollars to be invested abroad.
The net exports function
·
The net exports function reflects this inverse relationship between NX and ε:
NX = NX (ε)
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Macroeconomics ECO 403
VU
The NX curve
ε
so net exports for home
country will
be high
When ε is relatively low,
Home goods are relatively
inexpensive
ε1
NX (ε)
NX
0
NX (ε1)
At high enough values of ε, Home
ε
goods become so expensive that
ε2
we export less than
we import
NX (ε)
0
NX
NX (ε2)
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Macroeconomics ECO 403
VU
Four experiments
1.
Fiscal policy at home
2.
Fiscal policy abroad
3.
An increase in investment demand
4.
Trade policy to restrict imports
1. Fiscal policy at home
S2 ­ I(r*)
ε
S1 ­ I(r*)
ε2
ε1
NX (ε )
NX
NX 1
NX 2
A fiscal expansion reduces national saving, net capital outflows, and the supply of dollars in
the foreign exchange market causing the real exchange rate to rise and NX to fall.
2. Fiscal policy abroad
S1 ­ I(r*)
ε
S2 ­ I(r*)
ε1
ε2
NX (ε)
NX
NX 2
NX 1
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Macroeconomics ECO 403
VU
An increase in r* reduces investment increasing net capital outflows and the supply of dollars
in the foreign exchange market causing the real exchange rate to fall and NX to rise.
3.
An increase in investment demand
S1 ­ I2
ε
S1 ­ I1
ε2
ε1
NX(ε )
N
NX 1
NX 2
An increase in investment reduces net capital outflows and the supply of dollars in the foreign
exchange market causing the real exchange rate to rise and NX to fall.
4. Trade policy to restrict imports
S­I
ε
ε2
ε1
NX (ε )2
NX (ε )1
NX
NX1
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Macroeconomics ECO 403
VU
At any given value of ε, an import quota
NX
IM
demand for dollars shifts right. Trade policy doesn't affect S or I , so capital flows and
the supply of dollars remains fixed.
Results:
Δε > 0 (demand increase)
ΔNX = 0 (supply fixed)
ΔIM < 0 (policy)
ΔEX < 0 (rise in ε )
The Determinants of the Nominal Exchange Rate
·
Start with the expression for the real exchange rate:
e ×P
ε =
Pe:
*
Solve it for the nominal exchange rat
·
P*
e = ε×
P
·
So e depends on the real exchange rate and the price levels at home and abroad...
·
...and we know how each of them is determined:
M*
= L  * (r * + š *,Y * )
P*
P*
e = ε×
P
NX (ε ) = S - I (r *)
M
= L (r * + š ,Y )
P
·
We can rewrite this equation in terms of growth rates
Δε
Δe
Δε
ΔP  *
ΔP
+ š* - š
=
=
+
-
e
ε
P*
P
ε
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Macroeconomics ECO 403
VU
Inflation and nominal exchange rates
Percentage 10
change
9
in nominal
exchange  8
South Africa
rate
7
6
Depreciation
relative to
Italy
5
U.S. dollar
4
New Zealand
Australia
Spain
3
Sweden
Ireland
2
Canada
1
UK
France
Belgium
0
-1
Appreciation
Germany
Netherlands
relative to
-2
U.S. dollar
Switzerland
-3
Japan
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
Inflation differential
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand