LECTURE 10 The open economy Øystein Børsum 21 st March 2006.
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Transcript of LECTURE 10 The open economy Øystein Børsum 21 st March 2006.
LECTURE 10 The open economy
Øystein Børsum
21st March 2006
Overview of forthcoming lectures
Lecture 10: Open economy Features of a small, open economy with perfect capital mobility
Lecture 11: Open economy and the market for foreign exchange (Prof. Nymoen) The AD-AS framework for the open economy The market for foreign exchange and the domestic money market
Lecture 12: Fixed and floating exchange rates (Prof. Nymoen) Macroeconomic policy under a fixed and floating exchange rate regimes. Inflation targeting
Lecture 13: Choice of exchange rate regime The source of perturbations to the economy and the optimal exchange
rate regime
PART 1
Assumptions and evidence of the open economy
Overview of assumptions and evidence of the open economy
Strong growth in exports and international capital flows motivates modeling the open economy. An economy like Norway, and most economies indeed, are small and specialized (engages in trade but cannot influence global macroeconomic conditions)
There is a market for foreign currency both spot and forward. Under certain conditions – perfect capital mobility and risk-neutral investors – the expected future spot price equals today’s forward price (uncovered interest rate parity)
In the long run, relative purchasing power parity is a reasonable condition. This implies real interest rate parity
Strong growth in international trade and capital flows
World exports, portfolio investments and foreign direct investments, 1970-1996. Bill. 1996-dollars
The forward price for foreign currency
Spot price of foreign currency What if you need to buy foreign currency one year from now? Currency forward contract: Agreement today to buy a
specified amount of foreign currency in one year, where the price is determined today
By a no arbitrage condition, the forward price is determined by the spot price of foreign currency and the interest rate differential between the two currencies
Instead of buying a forward contract, consider the equivalent strategy of borrowing today in your own currency, buy currency spot today and invest the foreign currency
Determining the forward price by no arbitrage
Suppose you need 1$ in one year (in period t + 1)
Buy $ in the spot market today for
if = foreign rate of interestEt = Spot exchange rate (price of one unit of foreign currency in terms of the domestic currency)
Finance your purchase by a one-year loan in your home currency
When the loan is due, you must pay
i = domestic rate of interest
Notice that this strategy is completely risk-free: You know for sure that you obtain 1 dollar in one year, and how much you must to pay for it now
1 + i f
11 + i f
Et
1 + i f
Et (1 + i)
Covered interest rate parity (CIP)
Ẽt = Forward exchange rate (Ft ; t+1 is an alternative notation)
By log-approximation we can simplify to
ẽt = ln Ẽt
If investors are risk neutral, the forward rate must equal the expected future exchange rate. This gives uncovered interest rate parity
e e+1 = expected future exchange rate (log form)
Covered and uncovered interest rate parity
1 + i f
EtFt ; t+1 = Ẽ+1 = = (1 + i) (1 + i) = (1 + i f)Et
Ẽ+1
i = i f + ẽ+1 - e
i = i f + e e+1 - e
The evidence on nominal interest rate convergence in Europe is very convincing
Difference between domestic ten-year government bond yield and the corresponding EU average, 1994-2000. Percentage points
Source: IMF International Financial Statistics.
International capital mobility and interest rate parity
Assume that Domestic and foreign assets are perfect substitutes Investors can reallocate their portfolios instantaneously and
costlessly Investors are risk neutral
Then both covered interest rate parity and uncovered interest rate parity will hold
The real exchange rate and the international terms of trade
The real exchange rate is a measure of international competitiveness Example: The price of foreign goods measured in kroner relative
to the price of Norwegian goods measured in kroner
The international terms of trade
fr EPE
P
1Terms of trade
r f
P
E EP
The development of the real exchange rate depends on inflation differentials and the nominal exchange rate
ln ln
ln ln
fr r f
f f
EPe E e p p
P
p P p P
1
1 1 1
(9)
, ,
r r f
f f f
e e e
e e e p p p p
1
1 1 1
(9)
, ,
r r f
f f f
e e e
e e e p p p p
Use a log-approximation
Insert the lagged real exchange rate to obtain an expression for the change in the real exchange rate
Relative purchasing power parity
In long-run equilibrium, the real exchange rate must be stable
Relative purchasing power parity (RPPP)
Reasonable that the purchasing power of a country in the long run is independent from inflation differentials or changes in the nominal exchange rate
1r re e fe
The evidence on relative purchasing power parity between Denmark and Germany is convincing
The bilateral exchange rate and the relative price level between Denmark and Germany
Source: Chart 4.1 of Monetary Policy in Denmark, Danmarks Nationalbank, 2003.
Relative purchasing power implies real interest rate parity in the long run
Uncovered interest rate parity:
In long-run equilibrium, exchange rate expectations are correct and we have relative purchasing power parity
Real interest rate parity
Conclusion: In the long run, the domestic real interest rate is tied to the foreign real interest rate. This holds regardless of the exchange rate regime
1f ei i e e
1 1 1 1 1 e ee e e e e e e
1 1 1 (RPPP)fe
1 1f fi i
Over time, real interest rate differentials tend to disappear
Long-term real interest rate differential between various countries, 1920-1990. Percentage points
Source: Centre for European Policy Studies, Adjusting to Leaner Times, 5th Annual Report of the CEPS Macroeconomic Policy Group, Brussels, July 2003
Key assumptions when modeling the open economy
The economy is small Global macroeconomic conditions can be taken as given
The economy is specialized Domestically produced goods are imperfect substitutes for foreign goods
(relative prices may change)
International capital mobility is perfect and investors are risk neutral Uncovered interest rate parity holds
Assumptions about the long-run macroeconomic equilibrium: Relative purchasing power parity holds Real interest rate parity holds