Macro 8 - 2: Open Economy - Exchange Rate and Capital Mobility

1. Nominal Exchange Rate (Price of Foreign Currency)

-

Nominal Exchange Rate is the amount of domestic currency required to pay for 1
unit of foreign currency. It is denoted as EDC/FC.

In 2003, exchange rate for Singapore Dollar to US Dollar is E = 1.67. This means
that it costs S$1.67 to buy US$ 1.

When E increases, more units of domestic currency are required to buy one unit of
foreign currency. We say that domestic currency depreciates and foreign currency
appreciates.

When E decreases, less units of domestic currency are required to buy one unit of
foreign currency. We say that domestic currency appreciates and foreign currency
depreciates.

2. Real Exchange Rate (, Price of Foreign Product in Real Term)

-

Real exchange rate () shows the rate of exchange between domestic and foreign
product. The following example shows its derivation.

Suppose we want to buy a unit of domestic goods, we need S$P to buy one unit of
domestic good. Where P is the domestic price level.

When we import goods from oversea market, we dont pay Singapore dollar,
rather, we use US$ as the means of payment.

How much S$ is required if we need to buy a unit of foreign product? The answer
comes in two parts.

First, we have to convert our local currency into the foreign currency. Then, we
pay for the foreign product according to its price using foreign currency.

If the foreign price level is P*, then we need P* units of foreign currency to buy
one unit of foreign product.

In terms of domestic currency, this will cost us EP* if the nominal exchange rate
is E.

If the domestic price level is P, then this amount of domestic currency would have
bought us:

EP *
units of domestic product.
P

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EP * 1.67 50
=
= 0.835 . This
P
100
means that it costs us 0.835 units of domestic product to buy one unit of foreign
product.

For example: P* = 50, E = 1.67, P = 100 and

EP *
gives us the rate of exchange between domestic and foreign product. It tells
P
us how many units of domestic product we need to exchange for 1 unit of foreign
product. This is called the real exchange rate.

If the real exchange rate is above 1, that means the goods abroad is more
expensive than goods in domestic country. This might encourage foreign citizens
to consume domestic goods, hence, demand for export increases.

EP *
If P increases: More units of domestic goods are required to exchange for one
unit of foreign goods. Domestic goods are more competitve.

EP *
If P decreases: Less units of domestic goods are required to exchange for one
unit of foreign goods. Domestic goods are less competitve.

3. Impact of Real Exchange Rate on Demand for Export and Demand for
Import
-

The demand for exports is a function of the real exchange rate. That is:
X(

EP *
EP *
) = X0(
)
P
P

When real exchange rate increases, it costs more units of domestic products to buy
one unit of foreign product. Compare to domestic products, foreign product is now
more expensive.

Thus, export is increasing when the real exchange rate increases and decreasing
when the real exchange rate decreases.

Demand for imports depends not only on the real exchange rate, but also on
income. Specifically,
EP *
EP *
IM (
, Y ) = IM 0 (
) + mY
P
P
where 0 < m < 1 is the Marginal Propensity to Import

When real exchange rate increases, it costs more units of domestic products to buy
one unit of foreign product. Compared to domestic products, foreign product is

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now more expensive. An increase in the real exchange reduces the quantity which
we wish to import.
Further, whenever income increases, demand for imports will increase.

Exercise:
Assuming that other things being equal, determine the impact of the following
changes on demand for export and demand for import.

Impact on Export

Impact on Import

E increases
P increases
P* increases
Y increases

4. Equilibrium and Multiplier in Open Economy

The aggregate demand, adjusted for the effects of imports and exports, can be
written as follows:

E(Y, r,

EP *
EP *
EP *
) = C(Y, T) + I(r)+ G + X(
) IM(
,Y )
P
P
P

= C0 + c1(Y T0 ) + I0 - I1r + G0 + X 0 (

= C0 + c1(Y T0 )+ I0 - I1r + G0 + X 0 (

EP *
EP *

) + mY
) IM 0 (
P
P

EP *
EP *
) mY
) IM 0 (
P
P

= C0 + c1Y c1T0 + I0 - I1r + G0 + X 0 IM 0 (

= A(r, G0, T0,

C0 - c1T0 + G0 + I0 - I1r+ X 0 IM 0 (

EP *
) mY
P

EP *
)
P

} + ( c1 m)Y

EP *
) + ( c1 m)Y
P

In equilibrium,

E(Y, r0,

E0 P0 *
)= Y0
P0

E(Y, r0,

E0 P0 *
E P*
)= A(r0, G0, T0, 0 0 )+( c1 m)Y = Y
P0
P0

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Y = A(r0, G0, T0,

E0 P0 *
1
)
P0
1 (c1 m)

1
.
1 c1
Note that the multiplier under an open economy is smaller than that of a closed
economy.
Under a closed economy with Lump-sum tax, Y = A(G0 , T0, r0)

Exercises:
1) Derive the multiplier for an open economy with a proportional tax system.

2) Compare the slope of IS curves between a closed economy and an open

economy with a proportional tax system.

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5. Exchange Rate Regimes

-

Nominal exchange rate can be fixed or flexible.

Under a fixed exchange rate regime, countries maintain a constant exchange rate
or, equivalently, central parity between their currencies.

In contrast, under a flexible exchange rate the relative price between two
currencies is free to fluctuate and there is no explicit commitment to maintain a
specific parity.
a) Flexible exchange rate

When exchange rate regime is flexible, the central bank does not intervene in the
exchange rate movements. The nominal exchange rate will adjust to equate the
demand for foreign currency with the supply.

An excess demand for foreign currency will cause the domestic currency to
Depreciate, and E will rise.

Consequently, the real exchange rate (

The adjustments in nominal exchange rate and current account will restore the
economy to a new equilibrium.

EP *
) will increase which will increase the
P
demand for exports and reduce the demand for imports.

E
Sfc

E0

Dfc
Qfc

An excess supply for foreign currency will cause the domestic currency to
Appreciate, and E will Fall.

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EP *
) will decrease which will increase
P
demand for import and reduce demand for exports.

Consequently, the real exchange rate (

The adjustments in nominal exchange rate and current account will restore the
economy to a new equilibrium.

E
Sfc

E0

Dfc

Qfc

b) Fixed exchange rate

-

To fix the exchange rate, the central bank must stand ready to buy or sell domestic
currency/foreign currency at the stipulated exchange rate, E .

Whenever demand for foreign currencies from the domestic economy exceeds
supply available, there will be an excess demand for foreign currency.

If the central bank does not intervene, the exchange rate will increase.

To fix the exchange rate, the central bank will sell foreign currency to eliminate
the excess demand.

When the central bank sells foreign currency, its foreign currency reserves1 will
decrease.

When the central bank sells foreign currency, it buys back domestic currency;
hence, the domestic money supply will decrease.

Governments in an open economy hold foreign currency as foreign currency reserve. The foreign
currency reserve allows the governments to purchase domestic currency which is considered as
liabilities of central banks. The operation helps to stabilize the domestic currency.

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Domestic
Economy

Central
Bank

Whenever demand for foreign currencies is less than supply, there will be an
excess supply of foreign currencies.

If the central bank does not intervene, the exchange rate will fall.

To fix the exchange rate, the central bank will buy back foreign currency to
eliminate the excess supply.

When the central bank buys back foreign currency, its foreign currency reserves
will increase.

When the central bank buys back foreign currency, it pays for it by domestic
currency; hence, money supply will increase.

Domestic
Economy

Central
Bank

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6. Capital Mobility
-

In an open economy, trades with foreign economies include trades in goods and
services.

If capital is mobile between economies, they also include trades in financial

assets, such as stocks and bonds,.

In this course, we study two extreme forms of capital mobility. That is, capital is
either perfectly mobile or there is no capital mobility(zero capital mobility).

a) Zero capital mobility

-

This happens when governments do not allow for any capital movements between
domestic and foreign economies.

That is, domestic(foreign) citizens are not allowed to hold foreign(domestic)

financial assets.

As a result, zero capital mobility excludes the demand and supply of foreign
currency generated by the capital account.

b) Perfect capital mobility

-

It means capital movements between domestic and foreign economies is allowed,

i.e., domestic(foreign) citizens can hold foreign(domestic) financial assets.

With perfect capital mobility, investors must be indifferent in equilibrium between

holding assets denominated in any two currencies. This requirement means that
risk-free interest rates (the interest rates on government bonds) must be equalized
across any pair of countries.

If interest rates were not the same then there would be large capital flows towards
the country with the high interest rate and away from the country with the low
interest rate.

If the rates of return for foreign assets(government bonds) are higher than the rate
of return for domestic asset (r* > r), domestic investor will hold foreign rather
than domestic assets.

To do that, they need to convert domestic currency to foreign currencies and use
foreign currencies to purchase the foreign assets.

This process is equivalent to domestic investors selling domestic currency to buy

(demand) foreign currencies and use them to purchase foreign assets.

Demand for foreign currency will increase and there will be capital outflows.

If the rate of return for domestic asset are higher than the foreign assets(r* < r),
foreign investor will hold domestic assets.

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To do that, they need to buy domestic currency using foreign currencies and use
them to purchase domestic assets.

Supply of foreign currency will increase and there will be capital inflows.

We can thus conclude that,

r > r*
r < r*

Capital Flows
Inflow
Outflow

Investors Actions
Sell FC to buy DC
Sell DC to buy FC

Impact on foreign currency market

Excess Supply of FC
Excess Demand for FC

7. The Balance of Payments

-

The balance of payments keeps records of an open economys sources of foreign

currency, and the uses of foreign currency

There are three accounts in the balance of payments. They are:

1) The current account
2) The capital account
3) Changes in government reserves

A complete picture of BOP is shown below,

Foreign currency
Sources of
Current Account
Capital Account
Reserves

Export (X)
Foreigners buying domestic assets
Reduction in reserves
(M supply decreases)

Uses of
Import (IM)
Locals buying foreign assets
Increase in reserves
(M supply increases)

Apart from a statistical discrepancy, the current account, the capital account and
the foreign currency reserve sum to zero by construction. That is:

BOP = 0

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