Basic Exchange Rate Concepts
Nominal Exchange Rate
e Nom 
units of foreign currency
unit of domestic currency
Real Exchange Rate
e
Foreign currency price of domestic good e Nom P units of foreign goods


Foreign currency price of foreign good
PFor
unit of domestic goods
Dollar Appreciation
Nominal Appreciation: Dollar buys more units of foreign currency: e Nom 
Real Appreciation: Sale of domestic goods purchases more foreign goods: e 
Dollar Depreciation
Nominal Depreciation: Dollar buys fewer units of foreign currency: e Nom 
Real Depreciation: Sale of domestic goods purchases less foreign goods: e 
Purchasing Power Parity
Goods have equal values in each country: e 
e Nom P
1
PFor
Short-Run Real Exchange Rate Determination
While Purchasing Power Parity offers a reasonably satisfactory explanation of longrun trends in nominal exchange rates, financial market conditions are more important for
the determination of the equilibrium real exchange rate in the short run. Suppose that
some domestic traders are interested in acquiring foreign assets, like foreign stocks or
bonds. Such purchases (net of foreign traders' purchases of domestic assets) are referred
to as Net Capital Outflow (NCO). Net Capital Outflow is the net amount of payments
made to foreigners for the purchase of assets, so NCO is also identically equal to the
Capital Account Deficit. That is:
NCO  KA  CA
We also find it useful to identify NCO as the supply of dollars in the foreign exchange
market. To engage in a positive amount of NCO, domestic residents must sell (supply)
dollars to buy the foreign currency needed to buy the foreign assets.
2
Currency transactions also result from trade in goods. In particular, when foreigners
want to buy U.S. goods, they need to exchange their own currency for dollars to make
their purchases. We therefore identify net exports (NX) as the demand for dollars in the
foreign exchange market. The other current account items, net factor payments and net
unilateral transfers, also result in a need to demand dollars, but we continue to assume
that these two items are approximately zero.
Equilibrium in the foreign exchange market occurs when the supply of dollars equals
the demand for dollars. How does this equilibration take place? The supply of dollars
due to Net capital outflow is determined primarily by financial conditions (factors like
savings and investment flows, foreign and domestic real interest rates, and expected
future appreciation or depreciation of the dollar) that are unrelated to the current level of
the real exchange rate. Alternatively, the demand for dollars due to net exports is likely
to be predictably related to the real exchange rate. In particular, when the real exchange
rate, e , rises, U.S. goods rise in value (price) relative to foreign goods. Therefore, we
expect that foreigners would want to buy fewer U.S. goods, and U.S. residents would
want to buy more foreign goods. We therefore assume that net exports are negatively
related to the real exchange rate.
The foreign exchange market is in equilibrium when supply and demand are equal as in
the diagram below. This diagram represents short-run equilibrium in the foreign
exchange, and e may be greater or less than one; because Purchasing Power Parity may
not hold in the short run.
e
NCO   KA  Supply of $' s
e
NX  Demand for $' s
0
Figure 1
Short-Run Exchange Rate Determination
NCO   KA  Supply of $' s
S , D for $' s
3
Perfect Asset Substitutability
In chapter 5 of the text, we assumed that the real interest rate was constant throughout
the world. In the small open economy, the real interest rate is fixed. In the large open
economy, the real interest rate is determined by the interaction of domestic and foreign
levels of desired savings and investment. However, the large country open economy
model determines a common real interest rate for both the domestic and the foreign
economies.
To determine the real exchange rate in these models, we first use graphical means to
determine equilibrium Net capital outflow as the horizontal distance between domestic
desired savings and domestic desired investment. This distance is equal to the current
account balance. That is:
NCO  S  I  CA  KA
Graphically, this distance is measured as in Figure 2, below.
r
Sd
rw
NCO
Id
S, I
I
S
Figure 2
Net Foreign Investment with Perfect
Asset Substitutability
We now simply draw the distance, NCO , from Figure 2, as a vertical line in Figure 1.
The resulting level of e gives the equilibrium real exchange rate. Figure 2 could also
refer to the domestic half of the diagram we use to find equilibrium in the large open
economy case. Again we plot the equilibrium level of Net capital outflow in the
domestic economy as a vertical line spaced the distance, NCO , from the origin as in
Figure 1, and read off the resulting equilibrium real exchange rate.
4
Imperfect Asset Substitutability
Our earlier discussions of the small open economy and the large open economy both
share the characteristic that the real interest rate is identical everywhere in the world.
Practical applications are more complicated. Suppose that you could earn a real interest
rate of 5% by depositing your savings in a local domestic bank. Also suppose that you
could earn a real interest rate of 5.1% depositing your savings in a foreign bank, perhaps
a bank in Australia. Are you likely to withdraw all of your funds from your local bank
and deposit them in the Australian bank? Because of the added safety and convenience
of keeping your funds in a domestic bank, you are likely to keep at least some of your
funds in the domestic bank, even though you are receiving a lower real rate of interest on
these funds.
Now consider the net amount of savings allocated to foreign lending (that is, the net
acquisition of foreign assets). This flow of funds is likely to depend on the level of the
foreign real interest rate relative to the level of the domestic real interest rate. Therefore,
for any given level of the foreign real interest rate, r w , the amount of Net capital outflow
is likely to be negatively related to the domestic real interest rate, r , as in Figure 3,
below.
r
NCO d
NCO
0
Figure 3
Desired Net Foreign Investment
We are now ready to explain the determination of the domestic real interest rate in a
world with imperfect asset substitutability. The domestic real interest rate must exactly
balance desired domestic national savings, S d , with the sum of desired domestic
investment, I d , plus the desired amount of foreign net investment, NCOd . For a given
level of the world real interest rate, r w , we first add domestic investment and net capital
outflow as in Figure, 4, below.
Finally, we equate the sum of desired domestic investment and desired net capital
outflow with the level of desired domestic national savings, as in Figure 5, below. This
diagram shows the equilibrium domestic real interest rate, and the equilibrium amount of
net capital outflow. Finally, once we have found the equilibrium amount of net capital
outflow, we may compute the equilibrium real exchange rate by equating the supply and
demand for dollars in the foreign exchange market. This last step is depicted in Figure 5,
below.
r
r

I
r

I d  NCO d
d
I
NCO d
NCO
Figure 4
The Demand for Dollars
I  NCO
r
r
Sd
r
I d  NCO d
NCO d
NCO
S , I  NCO
0
e
NCO
e
NX
Figure 5
Exchange Rate Determination with Imperfect Asset
Substitutability
7
Capital Flight
An important application of the preceding model is the phenomenon of capital flight.
While capital flight does not typically apply directly to the U.S. economy, nevertheless
the U.S. economy is affected when other, primarily developing countries, experience
capital flight. Principle applications would be the Mexican experience in the early 1990's
and the East Asian experience in the late 1990's. Take for example the case of Thailand,
whose domestic currency is called the bhat. Perhaps due to local political instability, or
due to a financial crisis in Thailand, foreign investors suddenly become concerned that
loans, either to the Thai government or private sector, might not be repaid. In this
situation, foreign lenders may try to quickly liquidate their holdings of Thai assets, and
refuse to grant any new loans to Thailand. This disturbance, from the point of view of
Thailand, is a sudden rightward shift in the desired net capital outflow schedule, as
depicted in Figure 6, below.
r
r
Sd
r
I d  NCO d
NCO d
NCO
S , I  NCO
0
e
NCO
e
NX
Figure 6
Capital Flight in a Developing Economy
As a result of this disturbance, domestic interest rates in Thailand suddenly increase,
but not enough to entirely eliminate the increase in net capital outflow. Therefore, the
supply of bhats increases and the value of the bhat declines. Furthermore, as the foreign
exchange market re-equilibrates, net exports in Thailand increase. While this last
development suggests an improvement in Thailand's balance of payments, it comes about
8
because Thailand can no longer afford the imports of energy, natural resources and
capital equipment that is sorely needed for Thai development.
From the standpoint of the developing world, including the U.S., the shifts in the
curves work exactly the same way, but in the opposite direction. The developed world
sees a reduction in real interest rates, a reduction in net capital outflow, a real
appreciation of the currency, and a decline in net exports. Because the developed world
is a lot bigger in economic size than the developing countries under attack, the effects are
much smaller in absolute magnitude. However, during these foreign exchange market
crises, U.S. attention usually focuses on the deterioration of the current account balance,
which primarily shows up as a reduction in exports to the affected countries. Political
pressure in the U.S. to try to quell the crises is often most vocal from special interests in
the affected export industries, primarily from labor unions and from industry business
interests.