Open Economy Macro:
The transmission mechanism
through the real exchange rate
The Transmission Mechanism in Open Economy Macro
We saw that changes in domestic saving and
investment, or changes in world interest rates, or
domestic risk premiums would affect net exports.
How does that happen?
Through the adjustment of the real exchange rate.
Let see how.
2
Financial Globalization
180
US foreign assets/GDP
Foreigners US assets/GDP
160
Assets as % of US GDP
140
120
100
80
60
40
20
0
1980
fig_finglob_2013
1985
1990
1995
2000
2005
2010
Summary on Exchange Rates
I will only sketch basics in class. Refer to notes and text.
• Foreign-exchange rates are the relative prices of different
national monies or currencies.
• Convention: exchange rates = amount of foreign currency per
unit of domestic currency (e.g., Japanese Yen: 100 yen to $.)
• Notation: e = nominal exchange rate; R = Real exchange rate
• Appreciation = rise in e or R; depreciation = fall
4
Exchange rates
Foreign-exchange rates are the relative prices of different national
monies or currencies.
Convention in Econ 122 and Mankiw: Nominal exchange rate
• exchange rates = amount of foreign currency per unit of
domestic currency.
• Think Japanese Yen: 100 yen to $.
Notation: e = nominal exchange rate; R = Real e.r.
Appreciation = rise in e or R; depreciation = fall
Real exchange rate, R [Mankiw uses ε)
R = nominal exchange rate corrected for relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
5
Exchange rates
Foreign-exchange rates are the relative prices of different
national monies or currencies.
Convention in Econ 122 and Mankiw: Nominal exchange rate
• exchange rates = amount of foreign currency per unit of
domestic currency.
• Think Japanese Yen: 100 yen to $.
6
Terminology
For market-determined exchange rates:
• An appreciation of a currency is when the value of the
currency rises
– e or R rises
• A depreciation of a currency is when the value of the
currency falls
– e or R falls
For fixed exchange rates:
• Price set by government is the “parity.”
• A revaluation is an increase in the official parity.
• A devaluation is a decrease in the parity.
7
Index of US nominal exchange rate (e)
Appreciation
Depreciation
This is the “broad index” of major countries.
8
Summary on Exchange Rates
I will only sketch basics in class. Refer to notes and text.
• Foreign-exchange rates are the relative prices of different
national monies or currencies.
• Convention: exchange rates = amount of foreign currency per
unit of domestic currency (e.g., Japanese Yen: 100 yen to $.)
• Notation: e = nominal exchange rate; R = Real exchange rate
• Appreciation = rise in e or R; depreciation = fall
• Real exchange rate = nominal exchange rate corrected for
relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
9
Real exchange rates
Real exchange rate, R [Mankiw uses ε)
R = nominal exchange rate corrected for relative prices
R = e × (p d / p f )
= p d / (p f / e)
= domestic prices/foreign prices in a common currency
Note: If you calculate the rate of growth of R, you get
 rate of real   rate of nominal   domestic
  foreign




 

appreciation
appreciation
inflation
rate
inflation
rate

 
 
 

Example of car exchange rate: 100 Yen/$; Toyota = 2,000,000Y;
Ford = $20,000; R = 100 * 20000/2000000 = 1 Toyota/Ford
10
Big Mac Real Exchange Rate
R = p d / (p f / e)
Example of Big Mac*
Price in Beijing: 13 Yuan
Price in New York: $3.73
Real exchange rate: $3.73/(Y13/6.7) = $3.73/($1.97) = 1.89
People use this to argue that Yuan is “overvalued.”
Anything wrong with this argument?
* http://www.economist.com/node/16646178?story_id=16646178
11
Real exchange rate of $ relative to major currencies (R)
Appreciation
Dollar bubble with
high interest rates
Dot.com stock
bubble
Flight to $
safety
Depreciation
Now to the Macroeconomic Equilibrium
We saw last time that changes in the domestic S-I balance
led to changes in NX (the trade balance).
We need next to understand the macroeconomic mechanism
by which this occurs.
We will see that this operates through changes in the real
exchange rate, which leads to changes in the relative
prices of foreign and domestic goods.
Saving-Investment Balance in Open Economy
NX(R) = Spriv + Sg – I(rw)
Net domestic saving = net foreign investment
= lending abroad = ΔNFA
Recall S does not depend upon r (but unimportant for our analysis)
Small open economy with mobile capital means rd = rw
The only new relationship is NX(R):
– Real deprecation (R ↓) lowers the price of exports in foreign markets
and raises import P in domestic markets.
– This raises exports and lowers imports; raising NX.
– Hence NX’(R) < 0
Putting this with the S-I curves, we can see how real exchange rate is
determined.
Net exports and the real
exchange rate
Real
exchange
rate (R)
R*
NX(R)
NX*
0
NX
15
Have two behavioral
relationships:
(1) NX and (2) net
savings.
R and NX are determined
as the equilibrium of
these two functions.
Sn-I(rw)
R
Savings-investment
and the determination
of the real exchange
rate:
NX(R) = Sn-I(rw)
R*
E*
NX(R)
NX*
0
S-I, NX
16
Why does fiscal tightening lead to a lower trade deficit?
17
Fiscal tightening
(S-I(rw))*
(S-I(rw))**
R
Fiscal policy:
G↓→
net S ↑ →
R ↓→
NX ↑
E*
E**
NX(R)
NX*
0 NX**
S-I, NX
18
Impact of protectionism
Protectionism
(S-I(rw))
R
Counterintuitive:
Trade measures
lead to real
appreciation, not to
change in trade
balance!
R**
NX(R)’
R*
NX(R)
NX*=NX**
0
S-I, NX
20
Now analyze large open economy
Large Open Economy:
- Country large enough to affect world financial markets
- Domestic assets imperfect substitutes for foreign assets.
- Because imperfect substitutes, domestic r differs from foreign r (rd ≠ rw)
Analysis
Goods markets:
(1) NX(R) = Sn – I(rd)
Financial market equilibrium:
CF = net financial investment abroad = - financial surplus
(2) CF = CF(rd, rw). In analysis, we suppress rw
Notes that capital flows in if domestic interest rates rise
CF’(rd) < 0.
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Equation (2)
Domestic
interest
rate (rd)
rd
CF(rd)
CF*
0
CF
Now analyze large open economy
Large Open Economy:
- Country large enough to affect world financial markets
- Domestic assets imperfect substitutes for foreign assets.
- Because imperfect substitutes, domestic r differs from foreign r (rd ≠ rw)
Analysis
Goods markets:
(1) NX(R) = Sn – I(rd)
Financial market equilibrium:
CF = net financial investment abroad = - financial surplus
(2) CF = CF(rd, rw). In analysis, we suppress rw
Notes that capital flows in if domestic interest rates rise
CF’(rd) < 0.
Equilibrium comes when (1) and (2) equilibrate the balance of payments:
(3) NX(R) = CF(rd) = Sn – I(rd)
In our diagrams below, we use (3):
(4) I(rd) + CF(rd) = Sn = Spriv + Sg
23
rd
Domestic
interest
rate (rd)
Sn
rd*
I(rd)+CF(rd)
CF(rd)
CF*
CF
0
S, I,CF
Real exchange
rate, R
R*
NX(R)
NX*
NX
0
Bernanke’s surprising theory of
why the US deficit is so high
“I will argue that over the past decade a
combination of diverse forces has created a
significant increase in the global supply of saving--a
global saving glut--which helps to explain both the
increase in the U.S. current account deficit and the
relatively low level of long-term real interest rates in
the world today.” (Bernanke, 2005)
Global savings glut: Global effect
Real interest rate (r)
Sworld *
Sworld **
r*
r**
Id (r)
I*
I**
S, I
26
rd
Domestic
interest
rate (rd)
S
rd*
CF(rd)
I+CF
CF
0
S, I,CF
R
Bernanke’s “world savings glut”
-Current situation is one in which rest
of world has savings glut (particularly
China, Japan, and oil exporting
countries accumulating $ reserves).
- This increases inflows to US.
- This is leading to low world and US
real interest rates
- and to the large US trade deficit.
R*
NX(R)
NX*
NX
0
Here are the basic data (pre-crisis)
.01
16
NX/GDP ( <---- )
.00
14
-.01
12
-.02
10
-.03
8
-.04
6
Net exports/GDP
10-year T-bond rate
-.05
-.06
80
82
84
86
88
90
92
4
T-bond rate (----> )
94
96
98
00
02
04
2
That’s it for classical open-economy macro
Next session: To business-cycles and the
Keynesian model.
29
Key insight: Financial dog wags
trade tail
Tail of
finance!
Dog of trade