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Open Economy in the Long Run
Intermediate Macroeconomic TheoryMacroeconomic Analysis
University of North Texas
ECON 3560 / 5040 Open Economy in the Long Run
Outline
1 International Flows of Capital and Goods
2 Saving and Investment in a Small Open Economy
3 Exchange Rates
ECON 3560 / 5040 Open Economy in the Long Run
Outline
1 International Flows of Capital and Goods
2 Saving and Investment in a Small Open Economy
3 Exchange Rates
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
Y > C + I + G⇒ NX > 0 (trade surplus)
Y < C + I + G⇒ NX < 0 (trade deficit)
Y = C + I + G⇒ NX = 0 (balanced trade)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
S > I ⇒ NX > 0
S < I ⇒ NX < 0
S = I ⇒ NX = 0
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
International Flows of Capital and Goods
National income accounts identity
⇒ Y = Cd + Id + Gd + EX =
⇒ Y = C + I + G + EX − IM
1 International flow of goods and services: NX = Y − (C + I + G)
2 International flow of (financial) capital: S − I = NX
The national income accounts identity shows the internationalflow of funds to finance capital accumulation and theinternational flow of goods and services are two sides of thesame coin
ECON 3560 / 5040 Open Economy in the Long Run
Outline
1 International Flows of Capital and Goods
2 Saving and Investment in a Small Open Economy
3 Exchange Rates
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
A small economy has a negligible effect on world saving andworld investment
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open Economy
Assuming a small open economy with perfect capital mobility,r = r∗
The model
1 Y = F(K, L) = Y
2 C = C(Y − T)
3 I = I(r∗)
4 G = G
Trade balance is determined net capital outflow at the worldinterest rate
⇒ NX = S − I = (Y − C − G)− I(r∗)
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
The Classical Model for a Small Open EconomyHow Policies Influence the Trade Balance
Assumption: a position of balanced trade (NX = 0)
1 Fiscal policy at home
↑ G(↓ T) ⇒ NX < 0
2 Fiscal policy abroad
↑ G∗(↓ T∗) ⇒ NX > 0
3 Shifts in investment demand
↑ I ⇒ NX < 0
ECON 3560 / 5040 Open Economy in the Long Run
Outline
1 International Flows of Capital and Goods
2 Saving and Investment in a Small Open Economy
3 Exchange Rates
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
⇒ How much can be exchanged for one dollar? U102/$1
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
⇒ How much can be exchanged for one yen? $0.0098/U1
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rates
Nominal exchange rate (e): the relative price of the currency oftwo countries
Nominal exchange rates are quoted as
1 Foreign currency per unit of domestic currency (dollar):europrean term
2 Domestic currency (dollars) per unit of foreign currency:american Term
Depreciation is a decrease in the value of a currency relative toanother currency
Appreciation is an increase in the value of a currency relative toanother currency
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesReal Exchange Rates
Real exchange rate (ε): the relative price of the goods of twocountries (= terms of trade)
⇒ ε = ePP∗
1 If ε is high (real appreciation), foreign goods are relatively cheap,and domestic goods are relatively expensive
2 If ε is low (real depreciation), foreign goods are relativelyexpensive, and domestic goods are relatively cheap
⇒ NX = NX(ε)
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesReal Exchange Rates
Real exchange rate (ε): the relative price of the goods of twocountries (= terms of trade)
⇒ ε = ePP∗
1 If ε is high (real appreciation), foreign goods are relatively cheap,and domestic goods are relatively expensive
2 If ε is low (real depreciation), foreign goods are relativelyexpensive, and domestic goods are relatively cheap
⇒ NX = NX(ε)
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesReal Exchange Rates
Real exchange rate (ε): the relative price of the goods of twocountries (= terms of trade)
⇒ ε = ePP∗
1 If ε is high (real appreciation), foreign goods are relatively cheap,and domestic goods are relatively expensive
2 If ε is low (real depreciation), foreign goods are relativelyexpensive, and domestic goods are relatively cheap
⇒ NX = NX(ε)
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesReal Exchange Rates
Real exchange rate (ε): the relative price of the goods of twocountries (= terms of trade)
⇒ ε = ePP∗
1 If ε is high (real appreciation), foreign goods are relatively cheap,and domestic goods are relatively expensive
2 If ε is low (real depreciation), foreign goods are relativelyexpensive, and domestic goods are relatively cheap
⇒ NX = NX(ε)
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesReal Exchange Rates
Real exchange rate (ε): the relative price of the goods of twocountries (= terms of trade)
⇒ ε = ePP∗
1 If ε is high (real appreciation), foreign goods are relatively cheap,and domestic goods are relatively expensive
2 If ε is low (real depreciation), foreign goods are relativelyexpensive, and domestic goods are relatively cheap
⇒ NX = NX(ε)
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesThe Determinants of the Real Exchange Rate
From NX = NX(ε) and S − I = NX,
⇒ At the equilibrium real exchange rate, the supply of dollarsavailable for net capital outflow balances the demand for dollarsby foreigners buying our net exports
How policies influence the real exchange rate
1 Fiscal policy at home
2 Fiscal policy abroad
3 Shifts in investment demand
4 Protectionist trade policies
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesCase Study: The Reagan Deficits Revisited
Reagan policies during early 1980s: (T − G) ⇓
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesCase Study: The Reagan Deficits Revisited
Reagan policies during early 1980s: (T − G) ⇓
-
-
↓
↑
↓
↑
↑
↓
-
-
↓
↑
↑
↓
-
↑
↓
↑
129.4
-2.0
19.4
6.3
17.4
3.9
115.1
-0.3
19.9
1.1
19.6
2.2
closed economy
small open economy
actual change
ε
NX
I
r
S
G – T
1980s1970s
Data: decade averages; all except r and ε are expressed as a percent of GDP; ε is a trade-weighted index.
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
The determinants of the nominal exchange rate:
ε = ePP∗ ⇒ e = ε · P∗
P
1 Given ε, if ↑ P, a dollar is worth less and a dollar will buy fewerforeign currency (↓ e)
2 Given ε, if ↑ P∗, a dollar is worth more and a dollar will buy moreforeign currency (↑ e)
Inflation differential and nominal exchange rate
%∆e = %∆ε + (%∆P∗ −%∆P)
⇒ If a country has a high (low) rate of inflation relative to theUS, a dollar will buy an increasing (decreasing) amount of theforeign currency overtime
ECON 3560 / 5040 Open Economy in the Long Run
Exchange RatesNominal Exchange Rate and Inflation
Inflation differential and nominal exchange rate
Percentage changein nominalexchange rate
10
9
8
7
6
5
4
3
2
1
0
-1
-2
-3
-4
Inflation differential
Depreciationrelative to U.S. dollar
Appreciationrelative to U.S. dollar
-1-2-3 10 2 3 4 5 6 87
France
Canada
SwedenAustralia
UK
Ireland
Spain
South Africa
Italy
New Zealand
NetherlandsGermany
Japan
Belgium
Switzerland
ECON 3560 / 5040 Open Economy in the Long Run
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