Exchange Rate
Content
The nominal exchange rate
e = nominal exchange rate,
the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar)
CHAPTER 5
The Open Economy
slide 22
The real exchange rate
ε = real exchange rate,
the lowercase Greek letter
epsilon
the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac)
CHAPTER 5
The Open Economy
slide 24
Understanding the units of ε
ε =
=
e ×P P *
(Yen per $) × ($ per unit U.S. goods) Yen per unit Japanese goods
Yen per unit U.S. goods Yen per unit Japanese goods
=
=
Units of Japanese goods per unit of U.S. goods
The Open Economy
slide 25
CHAPTER 5
ε in the real world & our model
In the real world: We can think of ε as the relative price of
a basket of domestic goods in terms of a basket of foreign goods
In our macro model:
There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output
CHAPTER 5
The Open Economy
slide 27
How NX depends on ε
↑ε ⇒ U.S. goods become more expensive relative to foreign goods ⇒ ↓EX, ↑IM ⇒ ↓NX
CHAPTER 5
The Open Economy
slide 28
U.S. Net Exports and the Real Exchange Rate, 1975-2002
Percent of GDP 1 0 -1 -2 -3 -4 -5 1975 1980 1985 1990 1995 2000 120 100 80 60 40 20 0 1998:2 = 100
slide 29
2
140
Net exports (left scale) Real exchange rate (right scale)
CHAPTER 5
The Open Economy
The net exports function
The net exports function reflects this inverse relationship between NX and ε:
NX = NX (ε )
CHAPTER 5
The Open Economy
slide 30
The NX curve for the U.S.
ε
so U.S. net exports will be high
relatively low, U.S. goods are relatively inexpensive
When ε is
ε1
NX(ε)
0
NX(ε1)
NX
slide 31
CHAPTER 5
The Open Economy
The NX curve for the U.S.
ε ε2
At high enough values of ε, U.S. goods become so expensive that we export less than we import
NX(ε)
NX(ε2)
CHAPTER 5
0
NX
slide 32
The Open Economy
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 *)
CHAPTER 5
The Open Economy
slide 33
How ε is determined
Neither S nor I depend on ε, so the net capital outflow curve is vertical.
ε
S 1 − I (r *)
ε adjusts to equate NX
with net capital outflow, S − I.
CHAPTER 5
ε1 NX(ε ) NX 1
NX
The Open Economy
slide 34
Interpretation: supply and demand in the foreign exchange market
demand:
Foreigners need dollars to buy U.S. net exports.
ε
S 1 − I (r *)
supply:
The net capital outflow (S − I ) is the supply of dollars to be invested abroad.
CHAPTER 5
ε1 NX(ε ) NX 1
NX
The Open Economy
slide 35
Four experiments
1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports
CHAPTER 5
The Open Economy
slide 36
1. Fiscal policy at home
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.
CHAPTER 5
ε
S 2 − I (r *) S 1 − I (r *)
ε2 ε1 NX(ε ) NX 2 NX 1
NX
The Open Economy
slide 37
2. Fiscal policy abroad
An increase in r* reduces investment, ε increasing net capital outflows and ε 1 the supply of dollars in the foreign exchange market… ε 2 …causing the real exchange rate to fall and NX to rise.
CHAPTER 5
S 1 − I (r1 *) S 1 − I (r 2 * )
NX(ε ) NX 1 NX 2
NX
The Open Economy
slide 38
3. An increase in investment demand
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.
CHAPTER 5
ε
S1 − I 2 S1 − I1
ε2 ε1 NX(ε ) NX 2 NX 1
NX
The Open Economy
slide 39
4. Trade policy to restrict imports
At any given value of ε ε, an import quota ⇒ ↓IM ⇒ ↑NX ⇒ demand for ε2 dollars shifts right ε1 Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed.
CHAPTER 5
S −I
NX (ε )2 NX (ε )1
NX1 NX
The Open Economy
slide 40
4. Trade policy to restrict imports
Results: ∆ε > 0 ε
S −I
(demand increase) ∆NX = 0 (supply fixed) ∆IM < 0 (policy) ∆EX < 0 (rise in ε )
ε2 ε1 NX (ε )2 NX (ε )1
NX1 NX
CHAPTER 5
The Open Economy
slide 41
The Determinants of the Nominal Exchange Rate
Start with the expression for the real exchange rate:
ε =
e ×P P*
Solve it for the nominal exchange rate:
P* e = ε × P
CHAPTER 5
The Open Economy
slide 42
The Determinants of the Nominal Exchange Rate
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 * + π *, Y * ) * P
P* e = ε × P
NX (ε ) = S − I (r *)
CHAPTER 5
M = L (r * + π , Y ) P
slide 43
The Open Economy
The Determinants of the Nominal Exchange Rate
P* e = ε × P We can rewrite this equation in terms of growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ):
∆e
e
=
∆ε
ε
+
∆P *
P
*
−
∆P
P
=
∆ε
ε
+ π* − π
For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.
CHAPTER 5
The Open Economy
slide 44
Inflation and nominal exchange rates
Percentage 10 change 9 in nominal exchange 8 rate 7 6 5 4 3 2 1 0 -1 -2 -3 -4
South Africa
Italy New Zealand Australia Spain Sweden Ireland Canada Belgium Germany France UK
Depreciation relative to U.S. dollar
Netherlands
Switzerland Japan
Appreciation relative to U.S. dollar 1 2 3 4 5 6 7 8 Inflation differential
-3
-2
-1
0
CHAPTER 5
The Open Economy
slide 45
Purchasing Power Parity (PPP)
def1: a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. def2: the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: arbitrage, the law of one price
CHAPTER 5
The Open Economy
slide 46
Purchasing Power Parity (PPP)
PPP:
e ×P = P*
Cost of a basket of foreign goods, in foreign currency.
Cost of a basket of domestic goods, in foreign currency.
Cost of a basket of domestic goods, in domestic currency.
Solve for e :
e = P*/P
PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels.
CHAPTER 5
The Open Economy
slide 47
Purchasing Power Parity (PPP)
If e = P*/P, P P ε =e× * = then
*
P
P
×
P =1 P*
and the NX curve is horizontal:
ε S −I
Under PPP, changes in (S − I ) have no impact on ε or e.
ε =1
NX
NX
CHAPTER 5
The Open Economy
slide 48
Does PPP hold in the real world?
No, for two reasons: 1. International arbitrage not possible. nontraded goods transportation costs 2. Goods of different countries not perfect substitutes. Nonetheless, PPP is a useful theory: • It’s simple & intuitive • In the real world, nominal exchange rates have a tendency toward their PPP values over the long run.
CHAPTER 5
The Open Economy
slide 49
The U.S. as a large open economy
So far, we’ve learned long-run models for two extreme cases: closed economy (chapter 3) small open economy (chapter 5) A large open economy---like the U.S.---is in between these two extremes. The analysis of policies or other exogenous changes in a large open economy is a mixture of the results for the closed & small open economy cases. For example…
CHAPTER 5
The Open Economy
slide 51
A fiscal expansion in three models
A fiscal expansion causes national saving to fall. The effects of this depend on the degree of openness:
closed economy
large open economy
rises, but not as much as in closed economy falls, but not as much as in closed economy falls, but not as much as in small open economy
small open economy
no change no change falls
r I NX
rises falls no change
CHAPTER 5
The Open Economy
slide 52
Chapter summary
1. Net exports - the difference between -
exports and imports a country’s output (Y ) and its spending (C + I + G)
2. Net capital outflow equals
purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment
3. National income accounts identities:
Y = C + I + G + NX trade balance NX = S − I net capital outflow
CHAPTER 5
The Open Economy
slide 53
Chapter summary
4. Impact of policies on NX :
NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy
nominal: the price of a country’s currency in terms of another country’s currency real: the price of a country’s goods in terms of another country’s goods. The real exchange rate equals the nominal rate times the ratio of prices of the two countries.
5. Exchange rates
CHAPTER 5
The Open Economy
slide 54
Chapter summary
6. How the real exchange rate is determined
NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate NX with net capital outflow e equals the real exchange rate times the
7. How the nominal exchange rate is determined
country’s price level relative to the foreign price level. For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates.
CHAPTER 5
The Open Economy
slide 55
e = nominal exchange rate,
the relative price of domestic currency in terms of foreign currency (e.g. Yen per Dollar)
CHAPTER 5
The Open Economy
slide 22
The real exchange rate
ε = real exchange rate,
the lowercase Greek letter
epsilon
the relative price of domestic goods in terms of foreign goods (e.g. Japanese Big Macs per U.S. Big Mac)
CHAPTER 5
The Open Economy
slide 24
Understanding the units of ε
ε =
=
e ×P P *
(Yen per $) × ($ per unit U.S. goods) Yen per unit Japanese goods
Yen per unit U.S. goods Yen per unit Japanese goods
=
=
Units of Japanese goods per unit of U.S. goods
The Open Economy
slide 25
CHAPTER 5
ε in the real world & our model
In the real world: We can think of ε as the relative price of
a basket of domestic goods in terms of a basket of foreign goods
In our macro model:
There’s just one good, “output.” So ε is the relative price of one country’s output in terms of the other country’s output
CHAPTER 5
The Open Economy
slide 27
How NX depends on ε
↑ε ⇒ U.S. goods become more expensive relative to foreign goods ⇒ ↓EX, ↑IM ⇒ ↓NX
CHAPTER 5
The Open Economy
slide 28
U.S. Net Exports and the Real Exchange Rate, 1975-2002
Percent of GDP 1 0 -1 -2 -3 -4 -5 1975 1980 1985 1990 1995 2000 120 100 80 60 40 20 0 1998:2 = 100
slide 29
2
140
Net exports (left scale) Real exchange rate (right scale)
CHAPTER 5
The Open Economy
The net exports function
The net exports function reflects this inverse relationship between NX and ε:
NX = NX (ε )
CHAPTER 5
The Open Economy
slide 30
The NX curve for the U.S.
ε
so U.S. net exports will be high
relatively low, U.S. goods are relatively inexpensive
When ε is
ε1
NX(ε)
0
NX(ε1)
NX
slide 31
CHAPTER 5
The Open Economy
The NX curve for the U.S.
ε ε2
At high enough values of ε, U.S. goods become so expensive that we export less than we import
NX(ε)
NX(ε2)
CHAPTER 5
0
NX
slide 32
The Open Economy
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 *)
CHAPTER 5
The Open Economy
slide 33
How ε is determined
Neither S nor I depend on ε, so the net capital outflow curve is vertical.
ε
S 1 − I (r *)
ε adjusts to equate NX
with net capital outflow, S − I.
CHAPTER 5
ε1 NX(ε ) NX 1
NX
The Open Economy
slide 34
Interpretation: supply and demand in the foreign exchange market
demand:
Foreigners need dollars to buy U.S. net exports.
ε
S 1 − I (r *)
supply:
The net capital outflow (S − I ) is the supply of dollars to be invested abroad.
CHAPTER 5
ε1 NX(ε ) NX 1
NX
The Open Economy
slide 35
Four experiments
1. Fiscal policy at home 2. Fiscal policy abroad 3. An increase in investment demand 4. Trade policy to restrict imports
CHAPTER 5
The Open Economy
slide 36
1. Fiscal policy at home
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.
CHAPTER 5
ε
S 2 − I (r *) S 1 − I (r *)
ε2 ε1 NX(ε ) NX 2 NX 1
NX
The Open Economy
slide 37
2. Fiscal policy abroad
An increase in r* reduces investment, ε increasing net capital outflows and ε 1 the supply of dollars in the foreign exchange market… ε 2 …causing the real exchange rate to fall and NX to rise.
CHAPTER 5
S 1 − I (r1 *) S 1 − I (r 2 * )
NX(ε ) NX 1 NX 2
NX
The Open Economy
slide 38
3. An increase in investment demand
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.
CHAPTER 5
ε
S1 − I 2 S1 − I1
ε2 ε1 NX(ε ) NX 2 NX 1
NX
The Open Economy
slide 39
4. Trade policy to restrict imports
At any given value of ε ε, an import quota ⇒ ↓IM ⇒ ↑NX ⇒ demand for ε2 dollars shifts right ε1 Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remains fixed.
CHAPTER 5
S −I
NX (ε )2 NX (ε )1
NX1 NX
The Open Economy
slide 40
4. Trade policy to restrict imports
Results: ∆ε > 0 ε
S −I
(demand increase) ∆NX = 0 (supply fixed) ∆IM < 0 (policy) ∆EX < 0 (rise in ε )
ε2 ε1 NX (ε )2 NX (ε )1
NX1 NX
CHAPTER 5
The Open Economy
slide 41
The Determinants of the Nominal Exchange Rate
Start with the expression for the real exchange rate:
ε =
e ×P P*
Solve it for the nominal exchange rate:
P* e = ε × P
CHAPTER 5
The Open Economy
slide 42
The Determinants of the Nominal Exchange Rate
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 * + π *, Y * ) * P
P* e = ε × P
NX (ε ) = S − I (r *)
CHAPTER 5
M = L (r * + π , Y ) P
slide 43
The Open Economy
The Determinants of the Nominal Exchange Rate
P* e = ε × P We can rewrite this equation in terms of growth rates (see “arithmetic tricks for working with percentage changes,” Chap 2 ):
∆e
e
=
∆ε
ε
+
∆P *
P
*
−
∆P
P
=
∆ε
ε
+ π* − π
For a given value of ε, the growth rate of e equals the difference between foreign and domestic inflation rates.
CHAPTER 5
The Open Economy
slide 44
Inflation and nominal exchange rates
Percentage 10 change 9 in nominal exchange 8 rate 7 6 5 4 3 2 1 0 -1 -2 -3 -4
South Africa
Italy New Zealand Australia Spain Sweden Ireland Canada Belgium Germany France UK
Depreciation relative to U.S. dollar
Netherlands
Switzerland Japan
Appreciation relative to U.S. dollar 1 2 3 4 5 6 7 8 Inflation differential
-3
-2
-1
0
CHAPTER 5
The Open Economy
slide 45
Purchasing Power Parity (PPP)
def1: a doctrine that states that goods must sell at the same (currency-adjusted) price in all countries. def2: the nominal exchange rate adjusts to equalize the cost of a basket of goods across countries. Reasoning: arbitrage, the law of one price
CHAPTER 5
The Open Economy
slide 46
Purchasing Power Parity (PPP)
PPP:
e ×P = P*
Cost of a basket of foreign goods, in foreign currency.
Cost of a basket of domestic goods, in foreign currency.
Cost of a basket of domestic goods, in domestic currency.
Solve for e :
e = P*/P
PPP implies that the nominal exchange rate between two countries equals the ratio of the countries’ price levels.
CHAPTER 5
The Open Economy
slide 47
Purchasing Power Parity (PPP)
If e = P*/P, P P ε =e× * = then
*
P
P
×
P =1 P*
and the NX curve is horizontal:
ε S −I
Under PPP, changes in (S − I ) have no impact on ε or e.
ε =1
NX
NX
CHAPTER 5
The Open Economy
slide 48
Does PPP hold in the real world?
No, for two reasons: 1. International arbitrage not possible. nontraded goods transportation costs 2. Goods of different countries not perfect substitutes. Nonetheless, PPP is a useful theory: • It’s simple & intuitive • In the real world, nominal exchange rates have a tendency toward their PPP values over the long run.
CHAPTER 5
The Open Economy
slide 49
The U.S. as a large open economy
So far, we’ve learned long-run models for two extreme cases: closed economy (chapter 3) small open economy (chapter 5) A large open economy---like the U.S.---is in between these two extremes. The analysis of policies or other exogenous changes in a large open economy is a mixture of the results for the closed & small open economy cases. For example…
CHAPTER 5
The Open Economy
slide 51
A fiscal expansion in three models
A fiscal expansion causes national saving to fall. The effects of this depend on the degree of openness:
closed economy
large open economy
rises, but not as much as in closed economy falls, but not as much as in closed economy falls, but not as much as in small open economy
small open economy
no change no change falls
r I NX
rises falls no change
CHAPTER 5
The Open Economy
slide 52
Chapter summary
1. Net exports - the difference between -
exports and imports a country’s output (Y ) and its spending (C + I + G)
2. Net capital outflow equals
purchases of foreign assets minus foreign purchases of the country’s assets the difference between saving and investment
3. National income accounts identities:
Y = C + I + G + NX trade balance NX = S − I net capital outflow
CHAPTER 5
The Open Economy
slide 53
Chapter summary
4. Impact of policies on NX :
NX increases if policy causes S to rise or I to fall NX does not change if policy affects neither S nor I. Example: trade policy
nominal: the price of a country’s currency in terms of another country’s currency real: the price of a country’s goods in terms of another country’s goods. The real exchange rate equals the nominal rate times the ratio of prices of the two countries.
5. Exchange rates
CHAPTER 5
The Open Economy
slide 54
Chapter summary
6. How the real exchange rate is determined
NX depends negatively on the real exchange rate, other things equal The real exchange rate adjusts to equate NX with net capital outflow e equals the real exchange rate times the
7. How the nominal exchange rate is determined
country’s price level relative to the foreign price level. For a given value of the real exchange rate, the percentage change in the nominal exchange rate equals the difference between the foreign & domestic inflation rates.
CHAPTER 5
The Open Economy
slide 55
