XI. Open economy in
Keynesian models
Reminder- Lecture III
• Definitions: floating and fixed ExR
• Asset approach to ExR determination
• Monetary approach and purchasing
power parity
• Real ExR and price level
Rationale for this Lecture
• Important component of macroeconomic
policy: aggregate demand management
• Previous semester: model of closed
economy mainly, factors influencing
– Household consumption (C)
– Private investment (I)
– Policy tools: government expenditures (G) or
taxes (T)
• This semester: open economy models, i.e.
what are the factors influencing exports
and imports
– The role of nominal and (especially) real ExR
XI.1 Money and the exchange
rate
• Equilibrium on forex market determined
by:
– Domestic and foreign interest rate
– Expectations about future ExR
• Interest rates determined on money
markets → link between money
markets and forex market
• Expectations: may be considered as
covering all other aspects, namely
short run risk perception
XI.1.1 Short term
• Price is fixed, conceptually imagine, e.g.,
ISLM framework
• Demand for money depends on real income
and interest rate, L(Y,r)
– Keynesian demand for money
• Supply of money determined by central
authorities
• This applies both for domestic and foreign
market
• Graphical explanation – next slide
Return on domestic
currency deposit
E
E0
Expected return
on forex deposit
r0
Expected returns
L(Y,r)
MS
P
M
P
Equilibrium and money
markets
• Graphical exposition: simultaneous forex
and money market equilibrium on
– Domestic money market – obvious from above
– Foreign country’s money market: expected return
on forex deposits depends on “foreign” interest
rate r*, that results from monetary policy in
foreign country
• Comparative statics:
– Change in domestic money supply
– Change in foreign country’s money supply
– Change in ExR expectations, demand functions’
parameters, etc.
E
E2
E1
Increase in domestic
money supply
B’
A’
r2
r1
Expected returns
L(Y,r)
M1S
P
M S2
P
M
P
A
B
Decrease in foreign
country’s money supply
E
B
E2
E1
e
E
-E
r2* 
E
e
E
-E
r1* 
E
A
r
Expected returns
L(Y,r)
MS
P
M
P
Effects of money supply
changes
• Domestic money supply:
– Increase → depreciation, decrease →
appreciation
• Foreign money supply:
– Increase → foreign interest rate r*↓ →
appreciation
– Decrease → r* → depreciation
• Other effects (changes in expectations,
etc.): do it yourself
XI.1.2 Long run
• Prices (wages, interest rates, exchange
rates) allowed to adjust
• Conceptually, imagine the long run
adjustment in the framework of
neoclassical synthesis:
– Output returns to its potential level
– Unemployment at natural rate
– Vertical AS
• Long run money neutrality: change in
money supply leads to proportional
change in price levels
Money and ExR in the long
run
• ExR - just another price, of foreign currency
• If all prices change due to the change in
money supply, so changes the ExR
– Money supply increase, in the long run, i.e.
permanent increase → all prices increase → also
price of forex increase → proportional, long run
depreciation of domestic currency (numerically:
increase in value of ExR)
– Money supply permanent decrease – vice versa,
proportional, long run appreciation of domestic
currency (numerically: decrease in the value of
ExR)
Inflation and ExR dynamics
• Transmission process from
(permanent) money supply change via
adjustment of prices (inflation) and ExR
(appreciation or depreciation)
• Prices much more rigid (sticky) than
ExR
• However, in the long run, the
adjustment to, e.g., money supply
increase, takes place, because
– Excess demand for output and labor
– Inflationary expectations
– Flexible adjustment of prices of material
inputs
Example: money supply increase
• Short run reaction
– As above: r↓ → E↑
– But still in short run: change of expectations, as people
know that change in money supply permanent, Ee↑ → shift
of the curve for expected return from investment abroad →
additional increase of E
• Long run reaction
– Prices and wages adjust to the excess demand on goods
and labor markets: P↑ → (M/P)↓ → output returns to original
(potential) level, but mainly interest returns to original level
as well
– ExR, after initial strong depreciation (numerical increase)
starts to appreciate
– Because of the permanent change in expectations, the final
level of E is larger than initial one, but lower than it was after
short run adjustment
• Final result in the long run
– Permanent increase of money supply leads to depreciation
of currency
– Initial “overshooting”
Money supply increase: long run ExR adjustment
E
E2
B’
EX
X
B’
E2
E3
E e2 - E
r 
E e
r* 
r2
E e2 - E
r 
E
r1
Expected returns
*
E1 - E
E
Expected returns
r2
L(Y,r)
M1S
P1
M
P
r1
C’
*
A’
E1
M S2
P1
E1  E 3  E 2
E
A
L(Y,r)
M S2
P2
M S2
P1
B
Short run
M
P
C≡A
B
Long run
Exchange Rate Overshooting
Different dynamics of different variables
• Money supply: one time jump
• Interest rate: immediate adjustment
(decrease), then gradual return to original
level
• Price: no immediate reaction, then gradual
increase
• ExR: immediate sharp depreciation
(overshooting), then gradual appreciation,
the final outcome – depreciation compared to
original level, but less than immediate
reaction
XI.2 Real Exchange Rate
XI.2.1 Reminder – Lecture III
next 4 slides review relative ExR
Relative prices of goods
• Nominal ExR: relative price of two currencies,
its level on the forex market
• International trade: people make decisions,
comparing relative prices of comparable
goods, that can be purchased either on
domestic market or in a foreign country,
provided that prices are allowed to adjust
• Problem on macroeconomic level, when
comparing two countries: each country has
different basket of commodities that are
purchased
• Back to starting example: suppose that CZ and
D produce only Octavias and Passats
Octavia vs. Passat Again
• Price of foreign goods in terms of domestic
goods, how to construct?
• Example (nom.ex.rate 1 € = 24 CZK):
• CZ
Octavia
552,000 CZK
• D
Passat
25,000 €
• Price of Passat in terms of Octavia?
– Price of Passat in CZK: 25,000x24=600,000
CZK
– In terms of 1 Octavia: 600,000/552,000=1.09
– “Real ex.rate” between Passat and Octavia:
1 P =1.09 O, or, 1 O = 0.917 P
Real ExR - Definition
• Generalization to the economy-wide level
– Problem of “comparable good”: price over standard
(reference, typically purchased) basket of purchases in
both countries in a given period of time (e.g. a week,
months, year, etc.)
– Important: when constructing price indexes, relatively
larger weight on commodities, produced (and
consumed) domestically
• Formally (see example on Octavia and Passat
above):
e=(E.P*)/P
– Direct quotation again: price (expressed in domestic
currency) of a reference basket (considered as one unit)
in a foreign country relative to the reference basket in
domestic country (again considered as one unit)
• Real appreciation, e decreases
• Real depreciation, e increases
Real exchange rate and price level (1)
• Alternative interpretation: e = E.(P*/P) - ratio of foreign
and domestic price levels, when both expressed in
domestic currency
– Real ExR evaluates the purchasing power of domestic
currency over foreign goods
• If e < 1, then foreign price level relatively lower than
domestic one, domestic goods relatively more
expensive, so less competitive
• if e > 1, then foreign price level relatively higher than
domestic one, domestic goods relatively cheaper, so
more competitive
• Real depreciation: fall of purchasing power of domestic
currency over the goods in foreign country
• Real appreciation: increase of purchasing power over
foreign goods
XI.2.2 Long –Run Real ExR,
relative demand and supply
Long-Run Equilibrium (1)
• Real ExR – relative price, i.e. determined by
supply and demand conditions, but both in
domestic and foreign country
• Many factors influence domestic/foreign
demands and supply, two of them decisive:
– Relative demand for domestic output
– Relative output supply
• Long-run: prices clear the markets
• In the same logic: definition of long-run real
ExR
– e is relative price, depends on long-run
settlement of relative (domestic vs. foreign)
demand and supply
Long-run real ExR equilibirum
• Real ExR e – relative price
• Long-run equilibrium: how long term settlement of
relative demands and supplies (i.e. ratio of demand for
domestic output to foreign output, respectively, ratio of
supply of domestic output to foreign output) determines
real ExR
• Useful graphical representation (see Krugman, Obstfeld,
Ch. 15): relation between ratio Y/Y* and e
– If Y/Y* is ratio of demands for domestic and foreign output,
then there is a positive correlation: if e rises, demand for
domestic products rises (it is cheaper), i.e. ratio Y/Y* rises
(and vice versa)
– If Y/Y* is ratio of supplies of domestic and foreign outputs,
there is no correlation between real ExR and supplies (output
supply is determined by respective production functions,
where real ExR does not have any impact)
• See next slide (RD – relation between ratios of relative
demand and e, RS – the same for ratio of relative
supplies)
e
RS
RD
Increase in RD  shift to the
right
 real appreciation
e1
Increase in productivity
 shift of RS to the right
 real appreciation
(Y/Y*)1
Y/Y*
Change in relative demand for
domestic output
• !!! Not only domestic demand for domestic
output, but from abroad as well and not even
only from the foreign country under
consideration
• Demand increase → P↑ relative to P* → e, i.e.
real appreciation
– Vice-versa, demand decrease → e, i.e. real
depreciation
• Increase/fall of domestic and world relative
demand for domestic output → long-run real
appreciation/depreciation of domestic currency
against the foreign one (e numerically
falls/raises)
• Graphically: increase/decrease of overall
demand for domestic output relative to foreign
one → shift of RD to right/left
Change in relative output supply
• Situation, when – due to productivity,
efficiency, etc. more effective using both of
labor and capital – output and income
raises
• Due to rise of output (and income) at given
price and due to fact that part of increased
income spent on imported goods→ excess
supply of domestic output → P↓ relative to
P* → e, real depreciation → excess supply
disappears, return to equilibrium
– Vice-versa, labor and capital productivity
decrease → e, real appreciation → equilibrium
• Graphically: increase/decrease of overall
supply of domestic output relative to foreign
one → shift of RS to right/left
e
RS1
RS3
RD1
RD2
Increase in RD →
shift to the right
→ real appreciation
Increase in
productivity →
shift of RS to the
right → real
depreciation
e3
e1
e2
(Y/Y*)1
(Y/Y*)3
Y/Y*
XI.3 Long run nominal ExR again
• In 1997, after CZK was floated, ExR to USD
was 32 CZK, in 2000 it was above 40 CZK,
today it is around 19 CZK (but few years
ago, attacked 15 CZK)
• The same applies for ExR to EUR, albeit
here the CZK appreciation is not so fast
• Strong daily fluctuations, but the trend is
clear (see LIII)
– Why it is so?
• We will not discuss CZK case in particular
now (but see case studies later), but
determinants of long run nominal ExR
movements in general
Nominal and Real ExR (1)
• Real ExR: e=(E.P*)/P
• Nominal ExR: E=e.(P/P*), i.e. nominal ExR equals
real ExR, multiplied of domestic and foreign
price levels
• Important remark: ratio P/P* - purchasing power
parity, i.e. monetary approach to ExR
determination
– Open economy versions of classical model assumed
that nominal ExR is equal to PPP, i.e. E= P/P*
– In this approach, ExR is only determined by monetary
factors (that – in classical model – affect only prices)
– Even in the very long run, this is not (and never was)
consistent with reality
– However, by definition, nominal ExR implies that it is
equal to PPP, but multiplied by real ExR
Nominal and Real ExR (2)
Conclusions from previous slide on what
determines (nominal) ExR in the long run:
• Monetary disturbances affect only prices, not
real ExR, so
– Shift in relative money supply (relative to money
supply in foreign country), e.g. permanent one
time increase of MS → after adjustment, output
and unemployment back to potential levels, but
P, real ExR does not change → E (depreciation)
– Shift in relative money supply growth rates →
larger long run inflation and increase of interest
rates (relative to interest in foreign country) → P,
no effect on real ExR → E (depreciation again)
Nominal and Real ExR (3)
• Changes in relative output demand or
supply; in the long run, prices (both in
domestic and foreign countries)
determined only by demand and supply
of money, so in this case it is only real
ExR that matters:
– Change in relative output demand (e.g.
increase, see XI.3 above): e (real
appreciation) → E, nominal appreciation
– Change in relative output supply (e.g.
increase due to the productivity increases,
again see above): e (real depreciation) →
E, nominal depreciation
XI.4 Conclusions
• Asset approach to nominal ExR
• In the short run: link between money and
forex markets, in combination with
expectations about future ExR (that contains
also other factors like risk, etc.), determines
equilibrium ExR
– Comparative statics
• Long run adjustment of nominal ExR
– ExR overshooting
• Real ExR and its determinants
– Link to monetary approach and PPPs
• More accurate explanation of long term
nominal ExR
– Separation of monetary and real effects
Literature to Chapter XI
Basic text:
• Krugman, P.R., Obstfeld, M.: International
Economics, Theory and Policy, Pearson, Addison
Wesley, Boston 2006 (7th ed.), Ch. 13-15. In Ch.15,
try to learn a bit more about monetary approach and
PPPs.
Recommended:
• On overshooting: Dornbusch, R. Expectations and
Exchange Rate Dynamics, Journal of Political
Economy 84 (December 1976), pp. 1161-1176.
• On real ExR: Devereaux, M.B. Real Exchange Rates
and Macroeconomics: Evidence and Theory.
Canadian Journal of Economics 30 (November 1977),
pp.773-808