IC

Exchange Rates, Business Cycles & Macroeconomic Policy in an Open Economy

Key Definitions

  • Nominal exchange rate: e_{nom} = foreign currency per 1 unit domestic currency.
  • Real exchange rate: e = \dfrac{e{nom} P}{P{For}} (domestic vs foreign price levels).
  • Appreciation / depreciation: ↑ or ↓ in e_{nom} (flexible); revaluation / devaluation (fixed).

Exchange-Rate Systems

  • Flexible (floating): e_{nom} set by supply & demand; major currencies.
  • Fixed: e_{nom} set by government/CB; maintained via FX intervention (e.g.
    Saudi riyal).

Purchasing Power Parity (PPP)

  • Absolute PPP: identical baskets should yield e = 1 ⇒ e{nom} = \dfrac{P{For}}{P}.
  • Relative PPP: \dfrac{\Delta e{nom}}{e{nom}} = \pi_{For} - \pi (if \Delta e/e = 0).
  • Holds long-run; short-run failures from non-traded goods, costs, barriers.

Determinants of e_{nom} (Flex)

  • Demand for domestic currency: exports, asset inflows.
  • Supply: imports, asset outflows.
  • Shifters:
    • ↑ domestic quality/competitiveness ⇒ e{nom} ↑ (appreciation). • ↑ domestic income Y ⇒ imports ↑ ⇒ e{nom} ↓.
    • ↑ foreign income Y{For} ⇒ exports ↑ ⇒ e{nom} ↑.
    • ↑ domestic real rate r (vs r{For}) ⇒ capital inflow ⇒ e{nom} ↑.

Interest Rate Parity (IRP)

  • Covered/uncovered parity: \dfrac{e{nom}}{e{nom}^f}(1+i_{For}) = 1+i.
  • If e{nom}^f = e{nom}, then i = i_{For}.
  • Real parity: \dfrac{e}{e^f}(1+r{For}) = 1+r ⇒ with e=e^f, r=r{For}.

IS–LM–FE Framework (Small Open Economy)

  • FE line: r = r_{For} (capital mobility).
  • IS curve: goods mkt with NX(e); downward-sloping.
  • LM: money mkt.

Policy with Flexible Rates

• Fiscal expansion (↑G / ↓T)

  • IS → right ⇒ r>r_{For} ⇒ e appreciates, NX ↓, IS ← back.
  • Result: Y,P,r,e,NX unchanged (crowding-out via exchange rate).
    • Monetary expansion (↑M)
  • LM → right ⇒ r<r_{For} ⇒ e depreciates, NX ↑, IS → right.
  • Short-run: Y ↑ ; Long-run (prices rise) ⇒ neutrality: Y,r,e,NX return; P ↑.

Policy with Fixed Rates

• Monetary policy impotent: CB must adjust M to keep e_{nom} fixed.

  • ↑M → overvalued; reserves fall; must reverse.
    • Fiscal expansion
  • IS → right ⇒ r>r_{For} ⇒ undervalued; CB expands M (LM → right) to defend peg.
  • Short-run: Y ↑ effectively; Long-run: P ↑, real appreciation crowds out NX.

Over- & Undervalued Pegs

  • Overvalued: official e_{nom} > fundamental; requires reserve loss; vulnerable to speculative run.
  • Undervalued: official e_{nom} < fundamental; reserves accumulate; sustainable if partners tolerate.

Fixed vs Flexible & Trilemma

  • Fixed benefits: lower trade costs, policy discipline.
  • Flexible benefits: monetary autonomy to absorb shocks.
  • Trilemma: cannot simultaneously have (1) fixed e_{nom}, (2) free capital mobility, (3) independent monetary policy ➔ choose any two.

Currency Unions

  • Single currency eliminates FX risk & speculation; trades off national monetary policy.

Self-Correcting Dynamics (Small Economy)

  • Flexible: IS shocks offset by e adjustment; LM shocks magnified.
  • Fixed: LM shocks auto-correct via M adjustment; IS shocks magnified without policy.