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Open Economy Macroeconomics
- Exchange Rates
- Trade and Capital Flows
Textbook Reference: Chapters 14 & 15
Main Concepts
Exchange rates – real and nominal
Purchasing power parity
Demand and Supply for currency
Monetary policy and exchange rates
Fixed and Flexible regimes
Current, capital and financial accounts
Saving, investment and the current account

Review Questions
Question 1
Define the nominal and real exchange rates. How are the two concepts related? Which
exchange rate is most important for a country’s ability to export and import goods and
Nominal exchange rate is the relative price of two different currencies. It is the rate at which two
currencies can be traded for each other. This is a bilateral exchange rate – which is what we focused
on in lectures.
We defined e = no. of units of foreign currency per one unit of domestic currency = $US/$AU = 0.925
(as at 21 May 2014), i.e. AU$1 can be purchased for US$0.925. This is called an indirect quote, since
it is in terms of the foreign currency. The direct quote is the inverse ⁄ , or the Australian dollar
price of the foreign currency, i.e. US$1 can be purchased for AU$( ⁄
An increase in e is an appreciation of the AUD and a fall is a depreciation of the AUD (against the
Real (bilateral) exchange rate is the relative price of goods and services between two countries. You
can look at an individual good or at a price index for all goods and services. Precisely, the real
exchange rate is the price of the average domestic good or service relative to the price of the
average foreign good or service, when prices are expressed in terms of a common currency.
Real exchange rate = (e×P)/Pf or P/(Pf/e) , where Pf is foreign price level and P is domestic price level.
The real exchange rate is what matters for a country’s net exports. The real exchange rate tells us
how expensive domestic goods and services are relative to foreign goods and services, and thus it is
the type of exchange rate most directly relevant to a country’s ability to export. In sum, it is a
measure of international competitiveness.

(ii) a fall in the Demand curve or (iii) some combination of both. What we need for a depreciation of the AUD is (i) an increase in the Supply curve. In addition. services and assets. Use the demand and supply model of the exchange rate to provide a good explanation for this depreciation of the Australian dollar? Australian residents supply $AU to buy USD denominated goods. US residents) demand $A to purchase Australian goods. Most likely cause of depreciation is a significant fall in the demand for the $AU – so the demand curve shifts inwards. Supply increases (decreases) if the demand for imports (M) or financial capital outflows (KO) increase (decrease). Fall in previously very high terms of trade (ie ratio of export prices to import prices) – reduced demand for $A. Non-residents (eg. Period June-Dec 2008 represents the beginning of the global recession associated with the GFC. there was a reasonable expectation that demand for Australian produced commodities and resources would fall. Demand increases (decreases) if the demand for exports (X) or financial capital inflows (KI) increase (decrease). . With the outlook for China uncertain. services and assets. there was probably some increase in the supply of $A as domestic and foreign investors shifted out of Australian dollar denominated assets and into what were perceived to be the relatively less risky US government bonds.Question 2 Over the period June to December 2008 the value of the Australian dollar fell from 96 US cents to 69 US cents.

and (b) the capital account balance? Show that in each case the identity that the trade balance plus the net capital inflows equals zero applies. ( ( ) ) . With perfect capital mobility it will equal the world real interest rate rW. She uses the Pounds received to buy shares in a British firm. A French firm accepts the dollars as payment for drilling equipment. oil purchase by Australia => current account debit (import) Purchase of Australian bonds => capital account credit (capital inflow) Question 4 Use a diagram to show the effects of each of the following on the capital inflow of a country that is a net borrower from abroad. (i) An Australian exporter sells software to the UK. S is national or domestic saving I is national or domestic investment KI is the capital inflow line. r is the domestic real interest rate. Note that it is equal to net exports or the trade deficit. software sale to UK => current account credit (export) purchase of British shares => capital account debit (capital outflow) (ii) An East Timorese firm receives Australian dollars from selling oil to Australia.Question 3 How does each of the following transactions affect: (a) the current account balance. The French firm uses the dollars to buy Australian government bonds.

Domestic savings are unchanged. and there is an increase in KI to fund the additional level of investment.( ) ( ) so thate is a net capital inflow. and there is a fall in KI. and there is an increase in KI to fund the existing level of investment. the S line shifts to the left. Domestic savings decrease whereas investment is unchanged. . See the following diagram. (ii) The government budget deficit increases When the government budget deficit increases. When investment opportunities in the country improve due to an increase in resource prices. the I line shifts to the right. which is unchanged is funded by domestic saving (iv) There is an increase in the country’s risk premium This is more difficult. But you could think of a country risk premium as a wedge between the world real interest rate rW and the domestic real interest rate. The country has to pay r = rW + rp for its capital inflows. S shifts to the right as domestic savings increase. In the above model there is no country risk premium. (iii) The domestic private sector increases their level of saving When the domestic private sector increases their level of saving. and a trade deficit. as more of investment. Domestic saving will increase and investment will decrease. Here is what happens in each of the four cases: (i) Investment opportunities in the country improve due to an increase in resource prices.

if a central bank uses monetary policy to set the value of the exchange rate. This would increase the demand for the currency. If. (See Bernanke section 15. the central bank would lose control of the money supply and therefore could not target interest rates.Discussion Questions Question 5 (i) What are the costs and benefits of international capital flows? Are high levels of net capital inflows a cause of concern for policymakers? Is there an economic case for restrictions on some types of foreign investment (eg. Reduced uncertainty may lead to increased trade. benefits. In general to make an economic case against foreign investment it would be necessary to identify some form of market failure that resulted in a level of foreign investment that was too high in some sectors of the economy. if the exchange rate target is a long way above the fundamental value of the exchange rate then the currency may be subject to speculative attacks. Such forms of market failure are rarely identified. .g. it is not able to use monetary policy to achieve domestic objectives. (Use S and I in an open economy model to illustrate this). agricultural land and minimal resources)? Discuss. for example the central bank wanted to decrease inflation. (ii) What are the economic costs and benefits of central bank intervention to stabilize (or target) a country’s real exchange rate? Stabilising a country’s exchange rate will tend to make it more predictable and this may reduce the degree of uncertainty in international trade in goods and assets. On the cost side. Main issues – capital inflows can be used to augment domestic savings to fund investment. Policymakers see issue in terms of costs vs.4). increasing foreign liabilities. But Australia has proved resilient to shocks – negating this argument. It was argued in the 1980s that high levels of foreign debt was “unsustainable” and made Australia vulnerable to external shocks (so cost > benefit). the central banks foreign exchange reserves would increase. However emphasise that net capital inflows have implications: e. by contracting the money supply and increase interest rates there would be an increase in capital inflows as foreigners would wish to purchase higher yielding domestic financial assets. and if the central bank has an explicit exchange rate target. This allows a higher rate of economic growth and higher domestic consumption. An increase in foreign exchange reserves corresponds with a higher money supply which would negate the initial monetary contraction. Thus. returns from capital investments accrue overseas. Also on the cost side.