Ch15 all macro__lecture_ppt

© 2015 Pearson Education, Inc

Chapter 15

Open Economy Macroeconomics

15 Open Economy Macroeconomics

Chapter Outline

15.1 Exchange Rates

15.2 The Foreign Exchange Market

EBE How did George Soros make $1 billion?

15.3 The Real Exchange Rate and Exports

15.4 GDP in the Open Economy



Key Ideas

1. The nominal exchange rate is the rate at

which one country’s currency can be

exchanged for the currency of another

country.

2. In a flexible exchange rate system, the

nominal exchange rate is determined by

supply and demand in the foreign exchange

market.© 2015 Pearson Education, Inc


Key Ideas

3. Fixed or managed exchange rates are

controlled by the government.

4. The real exchange rate is the ratio of the

prices (for example, all converted to dollars)

of a basket of goods and services in two

countries and thus influences net exports

from one country to the other.



Key Ideas

5. A decline in net exports reduces labor

demand and GDP and might cause

unemployment.


15.1 Exchange Rates

Many countries have their own currencies for

use in economic transactions.


15.1 Exchange Rates

The nominal exchange rate is the price of one

(domestic) country’s currency in units of another

(foreign) country’s currency:

Units of foreign currency =

1 Unit of domestic currencye


15.1 Exchange Rates

When a nominal exchange rate rises, we say

that the domestic currency is appreciating.

When a nominal exchange rate falls, we say

that the domestic currency is depreciating.


15.1 Exchange Rates

The nominal exchange rate can be rewritten as

the price of another (foreign) country’s currency

in units of one (domestic) country’s currency.

1 Units of domestic currency =

1 Unit of foreign currencye


15.1 Exchange Rates

There is a nominal exchange rate for each

currency pair.

Exhibit 15.1 The Nominal Exchange Rates e and 1/e on January 2, 2014


15.1 Exchange Rates

A country can adopt one of the following:

1. Flexible exchange rate: The government does

not intervene in the foreign exchange market.

2. Fixed exchange rate: The government fixes a

value and intervenes to maintain that value.

3. Managed exchange rate: A system between the

flexible and fixed exchange rates.


15.1 Exchange Rates

Exhibit 15.2 Yuan‒Dollar and Euro‒Dollar Exchange Rates from 1999 to January 2014


The foreign exchange market is the global

financial market in which currencies are traded

and nominal exchange rates are determined.



The foreign exchange market can be analyzed

using the supply and demand model.

The price is the exchange rate e (yuan per

dollar).

The quantity is the amount of dollars traded in

the foreign exchange market.



The demand curve represents traders who are

trying to buy dollars in the foreign exchange

market with Chinese yuan.

Question: Who is part of the demand curve?

• Air China buying a U.S. Boeing Dreamliner

• Apple buying parts from Chinese Foxconn

• Chinese government buying U.S. treasury bonds

• U.S. investor buying Chinese Alibaba stock



Question: Who is part of the demand curve?

Answer:








Exhibit 15.3, Panel (a) The Foreign Exchange Market Under a Flexible Exchange Rate Regime


The supply curve represents traders who are

trying to obtain Chinese yuan by selling dollars in

the foreign exchange market.

Question: Who is part of the supply curve?







Question: Who is part of the supply curve?

Answer:









Exhibit 15.3, Panel (b) The Foreign Exchange Market Under a Flexible Exchange Rate Regime

Under a flexible exchange rate regime, the

equilibrium exchange market is the exchange rate

that equates the quantity supplied and the quantity

demanded.





Exhibit 15.3, Panel (c) The Foreign Exchange Market Under a Flexible Exchange Rate Regime

Question: What happens to the yuan–dollar

exchange rate if Air China unexpectedly faces a

higher demand for air travel in China?




Exhibit 15.4 The Foreign Exchange Market After a Rightward

Shift in the Dollar Demand Curve


Under a managed or fixed exchange rate regime,

the government announces a target, or “pegged”

exchange.

However, the government must be prepared to

sell or buy its currency whenever the pegged

exchange rate ePegged is above or below the

equilibrium exchange rate e*.




Exhibit 15.5 The Foreign Exchange Market Under a Pegged

Exchange Rate That Overvalues the Dollar Relative to the Yuan



Exhibit 15.6 The Foreign Exchange Market Under a Pegged Exchange

Rate That Undervalues the Dollar Relative to the Peso


Question: How did

George Soros make $1

billion?

Data: Exchange rate

and reserves data for

the United Kingdom

from 1991 to 1992.



From 1990 to 1992, the British pound had an

exchange rate that was pegged against the

German mark.

In the summer of 1992, changing market forces

led the British pound to become overvalued; the

British government spent about $24 million of

foreign currency reserves to defend the pegged

rate.



Exhibit 15.7 The Mark–Pound Exchange Rate (Marks per Pound)

from January 1991 to December 1992



Question: How did George Soros make $1

billion?



Answer: George

Soros bet against the

British pound just

before the depreciation

of the pound.

How did he do it?

Throughout 1992, Soros borrowed $10 billion

worth of pounds to buy German marks.

On Black Wednesday, the British pound

depreciated by 12%, so Soros’s marks were

worth more in terms of pounds.

Soros paid off his pound debt and had $1 billion

left in profits.



U.S. importers like Walmart compare the cost of

a good from China and from the United States in

the same currency:


Dollar price of U.S. toy

Dollar price of Chinese toy


U.S. importers like Walmart compare the cost of

a good from China and from the United States in

the same currency:


Dollar price of U.S. toy =

1Yuan price of Chinese toy

e

Dollar price of U.S. toy ´ e

Yuan price of Chinese toy


The real exchange rate is the ratio of the dollar

price of a basket of goods and services in the

United States divided by the dollar price of the

same basket of goods and services in a foreign

country:


Dollar price of U.S. basket =

Yuan price of Chinese basket

eE


Question: Does the real exchange rate follow

the nominal exchange rate?

Data: The nominal and the real pound‒dollar

exchange rates from 1950 to 2010




Exhibit 15.8 The Nominal and the Real Pound-Dollar Exchange Rates

from 1950 to 2010


Question: Does the real exchange rate follow the

nominal exchange rate?

Answer: Not always. In our example, the real

exchange rate fell from 1950 to 1966, when the

nominal exchange rate was fixed. After 1967, the

real and nominal exchange rates moved together,

although the real exchange rate keeps falling

further behind.



Question: What happens to U.S. exports to China

and Chinese exports to the United States when the

real exchange rate goes up?

Question: What happens to U.S. exports to China

and Chinese exports to the United States when the

real exchange rate goes down?




Exhibit 15.9 The Relationship Between the Real Exchange

Rate and Trade Flows



Exhibit 15.10 The Real Exchange Rate (E) and Net Exports


National income accounting identity:

Question: Why has the Chinese government

kept the yuan undervalued?


= + + + Y C I G X M


Answer: A weaker yuan leads to an overvalued

yuan‒dollar real exchange rate E.

An increase in E leads to a trade deficit in the

United States (XU.S. < MU.S.) and therefore a

trade surplus in China (XChina > MChina).



Exhibit 15.11 U.S. Trade Balance with China 1999 to 2013



Question: What is the impact of a U.S. trade

deficit for U.S. employment?




Exhibit 15.12 Employment Falls When the Real Exchange

Rate Appreciates


Question: Can U.S. monetary policy respond to

the appreciation of the real exchange rate?

Answer: The U.S. Fed can pursue an

expansionary monetary policy to decrease the

real exchange rate.

How?



An expansionary monetary policy lowers U.S.

interest rates.

Chinese investors reduce their holdings of U.S.

assets, which decreases the demand for U.S.

dollars in the foreign exchange market.

This will cause the real yuan–dollar exchange

rate E to fall and thus U.S. net exports to

increase.



Question: What is the implication for the

depreciation of the pound on Black Wednesday?

Answer: The sharp depreciation of the pound led

to a decline in the pound’s real exchange rate, an

expansion of British net exports, and a

corresponding increase in economic activity.


E = UK prices ´ e

German prices


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