XI. Open economy in Keynesian models

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XI. Open economy in Keynesian models
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Reminder- Lecture III

• Definitions floating and fixed ExR
• Asset approach to ExR determination
• Monetary approach and purchasing power parity
• Real ExR and price level

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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

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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

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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

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Return on domestic currency deposit
E
Expected return on forex deposit
Expected returns
L(Y,r)
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Equilibrium and money markets

• Graphical exposition simultaneous forex and
  money market equilibrium on
• Domestic money market obvious from above
• Foreign countrys 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 countrys money supply
• Change in ExR expectations, demand functions
  parameters, etc.

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E
Increase in domestic money supply
B
A
Expected returns
L(Y,r)
A
B
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Decrease in foreign countrys money supply
E
B
A
Expected returns
L(Y,r)
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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

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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

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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)

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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

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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

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Money supply increase long run ExR adjustment
E
E
B
B
X
C
A
Expected returns
Expected returns
L(Y,r)
L(Y,r)
A
CA
B
B
Short run
Long run
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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

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XI.2 Real Exchange Rate
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XI.2.1 Reminder Lecture IIInext 4 slides
review relative ExR
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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

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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 25,000x24600,000 CZK
• In terms of 1 Octavia 600,000/552,0001.09
• Real ex.rate between Passat and Octavia 1 P
  1.09 O, or, 1 O 0.917 P

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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

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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 lt 1, then foreign price level relatively
  lower than domestic one, domestic goods
  relatively more expensive, so less competitive
• if e gt 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

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XI.2.2 Long Run Real ExR, relative demand and
supply
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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

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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)

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RD
RS
e

• Increase in RD ? shift to the right
• real appreciation
• Increase in productivity
• ? shift of RS to the right
• ? real appreciation

e1
(Y/Y)1
Y/Y
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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

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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

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RS3
RD1
RS1
e
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
(Y/Y)3
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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

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Nominal and Real ExR (1)

• Real ExR e(E.P)/P
• Nominal ExR Ee.(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

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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)

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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

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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

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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