The open economy

ES20013 – intermediate macro

The open economy

Exchange rates
- The rate at which one currency can be exchanged for another
- How much is a currency
- We denote the nominal exchange rate as E
- We define the nominal exchange rate between country A and country B as the
amount of country A currency that must be paid to purchase one unit of country B’s
currency
- For example, the amount of pounds required to buy 1 dollar
- The domestic currency depreciates if the price of foreign currency increases
- So, an increased amount of domestic currency is needed to purchase a unit of
foreign currency
- A depreciation of the pound against the euro implies that the number of pounds
needed to buy a euro increases
- So, depreciation of the nominal exchange rate means E increases
- Exchange rates are more volatile than for example output, employment and
inflation, with substantial shifts in short periods of time



- We denote the real exchange rate as R
- The real exchange rate of the domestic economy is defined as


o
o Where
o E is the effective nominal exchange rate of the domestic economy, the
average nominal exchange rate between the domestic economy and other
countries
o Pw is the world rice level
o P is the domestic price level
- Converting the foreign price level into domestic currency gives us EPw, so the world
price level relative to the domestic price level, expressed in terms of the domestic
currency is EPw/P
- So, the real exchange rate measures relative prices in terms of domestic currency
- Converting the domestic price level into a foreign currency gives P/E. so the domestic
price level relative to the world price level, expressed in terms of foreign currency is
P/EPw
- So, the real exchange rate also measures (inversely) relative prices of foreign
currency


- A depreciation of the real exchange rate means that R increases
- A depreciation occurs if

, o The nominal exchange rate depreciates, so E increases
o The foreign price level increases, so Pw increases
o The domestic price level decreases, so P decreases
- Consider the rate of depreciation of the real exchange rate; this is the proportional
change of the real exchange rate
- This is △R/R
- Define the rate of depreciation of the nominal exchange rate as △E/E
- And define the domestic and world inflation rates as pi = △P/P and Piw = △Pw/Pw
- Then

o
- For example, if the nominal exchange rate depreciates by 5% (△E/E = 0.05) , the
domestic inflation rate is 2% ( pi = 0.02) and the world inflation rate is 5% (Piw =
0.05) then the real exchange rate depreciates by 8%


Exports imports and the current account
- Imports depend on the price of foreign goods in terms of domestic currency, relative
to the price of domestic goods
o As discussed above, the price of foreign goods in terms of domestic currency
is EPw
o So, the relative price of foreign goods in terms of domestic is EPw/P
o This is the real exchange rate
- We assume that the demand for imports is higher when the relative price of imports
is lower
- So imports are higher when R is lower
- A depreciation in R leads to a reduction in imports
- We write the demand for imports as

o
o not very realistic
o m1 and m2 are parameters = they capture the marginal propensity to import
(M1) and M2 measures the sensitivity of imports to the exchange rate

- exports depend on the price of domestic goods in terms of foreign currency relative
to the price of foreign goods
o the price of domestic goods in terms of foreign currency is P/E
o so the relative price of domestic goods in terms of foreign currency is P/EPw
o this is the inverse of the real exchange rate
- we assume the demand for exports is higher when the relative price of exports is
lower
- so the exports are higher when R is higher
- a depreciation in R leads to an increase in exports
- we write the demand for exports as

o
o Where Yw is the world income