Chapter 14

Money in the
Open
Economy

Copyright 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 14 Topics
Exchange rates and purchasing power parity.
Flexible and fixed exchange rates.
Monetary small open economy fixed and
flexible exchange rates.
Capital controls.

Copyright 2008 Pearson Addison-

14-2

Equation 14.1
The purchasing power parity relationship prices
are equalized across countries in terms of the
currency of one country.

Copyright 2008 Pearson Addison-

14-3

Table 14.1 Purchasing Power

Parity and the Big Mac Index

Copyright 2008 Pearson Addison-

14-4

Figure 14.1 The Real Exchange Rate

for Canada vs. the United States

Copyright 2008 Pearson Addison-

14-5

A Monetary SOE Flexible

Exchange Rate
Model is identical to the small open economy
model with production and investment in
Chapter 13, with an added money market.
The nominal exchange rate is essentially
determined by nominal money demand and
supply.

Copyright 2008 Pearson Addison-

14-6

Figure 14.2 The Goods Market in the

Monetary Small Open-Economy Model

Copyright 2008 Pearson Addison-

14-7

Equation 14.2
In the monetary SOE model, we assume that
purchasing power parity always holds.

Copyright 2008 Pearson Addison-

14-8

Equation 14.3
Money demand depends on P, Y, and the world
real interest rate r*.

Copyright 2008 Pearson Addison-

14-9

Equation 14.4
Substituting in the money demand equation using
the purchasing power parity relationship, and
equating money demand with money supply
gives:

Copyright 2008 Pearson Addison-

14-10

Figure 14.3 The Money Market in the

Monetary Small Open-Economy Model
with a Flexible Exchange Rate

Copyright 2008 Pearson Addison-

14-11

Figure 14.4 An Increase in the Money Supply in

the Monetary Small Open-Economy Model with
a Flexible Exchange Rate

Copyright 2008 Pearson Addison-

14-12

Main Results with Flexible

Exchange Rate
Money is neutral the price level and nominal
exchange rate increase in proportion to the
money supply increase.
A flexible exchange rate implies that the
domestic price level is insulated from
movements in the foreign price level.
A change in the world real interest rate will
affect the domestic price level.
Copyright 2008 Pearson Addison-

14-13

Figure 14.5 An Increase in the Foreign Price

Level in the Monetary Small Open-Economy
Model with a Flexible Exchange Rate

Copyright 2008 Pearson Addison-

14-14

Figure 14.6 An Increase in the World

Real Interest Rate with a Flexible
Exchange Rate

Copyright 2008 Pearson Addison-

14-15

Monetary SOE Model Fixed

Exchange Rate
In this version of the model, the domestic money
supply becomes endogenous rather than the
exchange rate.
The money supply changes to equate money
supply and money demand at the fixed exchange
rate.

Copyright 2008 Pearson Addison-

14-16

Figure 14.7 The Money Market in the

Monetary Small Open-Economy Model
with a Fixed Exchange Rate

Copyright 2008 Pearson Addison-

14-17

Table 14.2 A Simplified

Government Balance Sheet

Copyright 2008 Pearson Addison-

14-18

Main Results with a Fixed

Exchange Rate
The SOE cannot have a monetary policy that is
independent of what happens in the rest of the
world.
An increase in the foreign price level causes a
proportionate increase in the domestic price
level.
A change in the world real interest rate has no
effect on the price level.
Copyright 2008 Pearson Addison-

14-19

Figure 14.8 An Increase in the Foreign

Price Level in the Monetary Small OpenEconomy Model with a Fixed Exchange Rate

Copyright 2008 Pearson Addison-

14-20

Figure 14.9 An Increase in the World

Real Interest Rate with a Fixed
Exchange Rate

Copyright 2008 Pearson Addison-

14-21

Capital Controls
Capital controls can dampen the effects of
macroeconomic shocks that come from abroad.
However, capital controls cause inefficiencies in
world credit markets.

Copyright 2008 Pearson Addison-

14-22

Figure 14.10 A Devaluation in

Response to a Temporary Total Factor
Productivity Shock

Copyright 2008 Pearson Addison-

14-23

Figure 14.11 A Temporary Total Factor

Productivity Shock, With and Without
Capital Controls

Copyright 2008 Pearson Addison-

14-24

Figure 14.12 A Total Factor Productivity

Shock Under a Fixed Exchange Rate,
With and Without Capital Controls

Copyright 2008 Pearson Addison-

14-25