Exercises, Part VI: THE OPEN ECONOMY

Note: The exchange rate is defined as the price of domestic currency in terms of foreign
currency. An increase in the exchange rate represents an appreciation.

6.1 Interest Parity

Consider a world with only two countries: Micro and Macro. Assume their interest rates are
10% and 7% respectively. How would an investor choose between holding Micro and Macro
bonds?. Compute the expected change in the exchange rate.

6.2 Financial Markets in an Open Economy

This year (2004) Ms McCornik has refused to sell her Scottish castle at the price of 100
pounds. She is convinced that she will be able to sell it in 5 years (in 2009) to her Swedish
partner at the price of 175 euro. Knowing that the expected nominal interest rate is 5% and
that the fixed exchange rate euro/£ is 1.40 euro for one pound, do you think that Ms
McCornik’s took the correct decision?

6.3 The Open Economy and Financial Markets

Consider a world with two countries: Abacus and Beltrolux. Both countries issue bonds with
same characteristics in terms of maturity and risk. Nevertheless, the return from Abacus’s
bonds is 8% while that from Beltrolux’s bonds is 4%. What should be the expected change in
the exchange rate for an investor to be indifferent between the two investment opportunities?
Explain your answer.

6.4 The Balance of Payments and the Equilibrium Exchange Rate

Assume that Sweden and Norway trade only with each other. Assume also that in Sweden the
expenditure in domestic goods is equal to residents’ expenditure.
a) Define the domestic demand for goods and the total demand for domestic goods.
Disaggregate each of them in their components. Discuss the situation of Norway’s trade
balance using a graph.

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b) Suppose Norway’s trade balance is given by:
NX = –0.4Yn + 0.2Ys – l0ε
where
Yn = 1,150 = Norwegian income
Ys = 2,250 = Swedish income
ε = real exchange rate
Pn = 80 = Norwegian price level
Ps = 100 = Swedish price level
Compute the nominal exchange rate E which ensures that trade is balanced (NX = 0).

6.5 Production and the Current Account

Consider an economy characterized by the following equations:

C = 100 + 0.8(1 – 0.25)Y
I = 340
Q = 110 + 0.3Y
G = 120
X = 250
ε =1
a) Compute the equilibrium level of output.
b) Determine the current account level corresponding to the equilibrium level of output.
Graphically represent your results.

6.6 Production and the Current Account

The small open economy A is in equilibrium and has a balanced current account. The
government of country A thinks that the equilibrium level of output is too low and decides to
depreciate the real exchange rate. Assuming that the Marshall-Lerner conditions hold, what is
the effect on the equilibrium level of output and on the current account?

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6.7 The Multiplier in an Open Economy

Consider two open economies A and B, where A is relatively more open than B.
a) Assuming that ε = 1 , consider the same change in the autonomous spending of both
countries. Compare the effect on the level of output in the two countries. Use algebra and
explain the intuition behind your results.
b) Compare the effect of the policy in a) on the current account in the two countries.

6.8 Economic Policy and Exchange Rate Policy

Over the last years Japan has experienced a decrease in its economic growth rate and a trade
surplus. Two strategies are suggested in order to increase Japanese output:
i) an increase in public expenditure;
ii) a depreciation of the yen, the Japanese currency.
a) Explain and show graphically in which way these two policies affect output.
b) Which of the two policies would be preferred by the US, an important trade partner of
Japan?

6.9 Fiscal Policy and Flexible Exchange Rates

Consider an open economy characterized by the following equations:

C = c0 + c1 (Y–T)
I =I0 – bi + dY
G = G0
T = T0
NX = X0 – mY – υε
M
= Y L(i )
P
Prices are fixed, the exchange rate is flexible and there is perfect mobility of capital. Net
exports depend negatively on the level of output/income and negatively on the real exchange
rate. X0 is the autonomous demand for exports. Assume that the government implements a
restrictive fiscal policy with the purpose of reducing the public debt. Analyze and show
graphically the effects of such policy on:
• the equilibrium level of output/income and the interest rate;
• the exchange rate;
• net exports.

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6.10 Monetary Policy with Flexible Exchange Rates
Consider two countries, A and B, with flexible exchange rates, perfect mobility of capital and
constant prices.
a) What are the effects of a contractionary monetary policy in A on the interest rate, output
and the exchange rate? Explain.
b) Assume that interest rate of A determines the world interest rate. Starting from an
equilibrium, what are the effects in country B of the contractionary monetary policy in A?

6.11 Fiscal Policy and Fixed Exchange Rates

Argentina is an open economy with a fixed exchange rate and perfect mobility of capital.
Assuming that prices are fixed, show the effects of a contractionary fiscal policy and explain
the adjustment process which leads the economy to equilibrium.

6.12 Fiscal Policy and Fixed Exchange Rates

At the end of 1989 the German trade balance is in surplus. In light of Germany’s positive
economic performance, the G7 countries ask Germany to pay for NATO’s military
expenditures.
a) Assume that prices are constant, there is perfect mobility of capital and a fixed exchange
rate for the mark (the German currency). Analyse the consequences of such a policy on
German output, investment and trade balance.
b) Instead, consider an appreciation of the mark. What are the effects of such a policy on
German output and trade balance? Will they be in contrast or not with the effects of the
policy in point a)? Explain.

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6.13 Fiscal Policy and Fixed Exchange Rates
Consider a group of countries among whom there is free trade and perfect movements of
capital. Assume that these countries apply a fixed exchange rates policy. For many years the
trade balances of these countries have been in equilibrium thus not creating problems for the
stability of the exchange rate agreement. In 1993 the government of A increases government
expenditure, while country B decides to expand monetary policy in order to increase
investment.
a) Using the IS-LM model, describe both graphically and in words the effects of the policy in
A. How will tax revenues change?
b) Will country B be able to increase its investment in the long run? Explain why.
c) Assume that A and B continue to apply the described policies for many years. What will
be the effects on the exchange rate agreement?

6.14 Economic Policy and Fixed Exchange Rates

Country A has entered into a fixed exchange rate agreement. According to this agreement, the
government budget cannot be in deficit. In order to stimulate the economy the government
signs an agreement with the producers to lower the sensitivity of investment to the interest
rate. Describe and show graphically the effects of this change on output and the interest rate.

6.15 Fiscal Policy and Flexible Exchange Rates

Consider an open economy with flexible exchange rates. Assume the government decides to
increase taxes. Analyse, both graphically and in words, the effects of such a policy on output
and the trade balance (assume that the Marshall-Lerner condition holds).

6.16 Exchange Rate Revaluation

Consider a model with a fixed exchange rate and flexible prices. At time t0 country A is in
equilibrium and revalues its exchange.
a) Discuss the adjustment process both in the short run and in the medium run.
b) Show the adjustment process of the real exchange rate ε graphically both in the short run
and in the medium run.

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SOLUTIONS

6.1 Interest Parity

International capital flows are due to differences in the interest rates, after taking into
consideration the expected change in the exchange rate. According to the interest parity
condition the expected return from investing in domestic bonds should be equal to the
expected return from investing abroad. Hence, because of arbitrage, the domestic interest rate
is approximately equal to the foreign interest rate minus the expected depreciation in the
exchange rate. Analytically:

Ete+1 − Et
it = it* − .
Et

In the given example we expect a depreciation of 3% of the exchange rate of Micro’s currency
with respect to Macro’s currency (or, equivalently, an appreciation of 3% of Macro’s
currency).

6.2 Financial markets in an Open Economy

Mrs McCornik’s choice is correct if the present discounted value of selling in 5 years,
denominated in the same currency (i.e. pounds), is greater than the value of selling today, i.e.
100 pounds.
NPV in £ = ⎡⎣175 euro /(1 + 0.05)5 ⎤⎦ ⋅ (1/1.40) ≅ 97,940 < 100

Equivalently:
100 ⋅ (1.05)5 = 127, 628 > 175 1.4 = 125
127, 628 ⋅1.4 = 178, 679 > 175
Hence, Mrs McCornick has taken the wrong decision. She would have gained 100 pounds
selling the castle in 2004, while the present value of selling in 5 years is only 97.4.

6.3 The Open Economy and Financial Markets

Applying the uncovered interest parity condition
Ete+1 − Et
it = it* −
Et
the exchange rate of Abacus is expected to depreciate by 4%.

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6.4 The Balance of Payments and the Equilibrium Exchange Rate
a) Demand for domestic goods: Z = (C + I + G) + X – IM
Domestic demand for goods: DD = C + I + G
In Sweden Z=DD, so trade is balanced, NX=0. Trade is balanced in Norway as well since
Sweden and Norway trade only with each other.

DD ZZ

Y* Y

NX

NX

b) NX =–- 0.4Yn + 0.2Ys – 10 ε = 0

EP
ε= = 0.04Yn − 0.02Ys
P*
10
E= [0.04 × 1,150 − 0.02 × 2,250] = 1.25
8
1.25 Swedish kronor are needed in order to buy 1 Norwegian krona.

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6.5 Production and the Current Account

a) In equilibrium Y = Z
Z = C + I + G + NX
NX = X – IM = 250 – (110+0.3Y) = 140 – 0.3Y
1
Y= (700) = 1, 000
1 − 0.8(1 − 0.25) + 0.3
b) NX = 140 – 300 = – 160
The trade balance is in deficit.

Z
ZZ

1000 Y
NX

Y
-160

NX

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6.6 Production and the Current Account

Graphically, the policy makes the ZZ curve shifts up. There is an increase in output and in
income. Moreover, the current account becomes positive (surplus) since Y’ is smaller than
YTB’ (for which the current account is zero). In fact, if the Marshall-Lerner condition holds,
the effects of a decrease in ε (depreciation) on exports are bigger than those on imports.

Z DD ZZ'

ZZ

Ytb=Ye Y' Ytb' Y

6.7 The Multiplier in an Open Economy

a) The equilibrium condition for the goods market is:

Y = C + I + G + X − IM / ε
Assuming that ε = 1 and calling with q1 the marginal propensity to import, the previous
condition can be rewritten as:
Y = c0 + c1 (Y − T ) + I + G + X − q1Y ,
where we used
IM = q1Y
Finally, we have:
1
Y= (c0 − c1T + I + G + X )
1 − c1 + q1 .
The effect on the equilibrium level of output of an exogenous change in public expenditure
(the same holds for a change in the investment) is given by:
1
∆Y = ∆G
1 − c1 + q1 .
The multiplier is the bigger the smaller q1 (the marginal propensity to import). Hence, the
change is greater for country B (the relatively more closed economy). Intuitively, in a more

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open economy (country A) a part of the increased demand goes to imports and not to home
products.
b) By the reasoning in a), the more open the economy the higher the imports, the worse is the
current account. Therefore, the effect will be bigger in country A

6.8 Economic Policy and Exchange Rate Policy

Z
ZZ'

ZZ

Y
NX

Y Y' NX Y

a) An increase in public expenditure G leads to an increase in demand. ZZ shifts upwards. In

the new equilibrium, output will be greater and, because of the multiplier effect, the
change in the output will be larger than the change in G. The trade surplus will decrease
because of the increase in imports. A devaluation of the yen will increase the demand for
domestic goods leading to an increase in output (ZZ shifts upwards). The trade surplus
will increase as well (NX shifts upwards, B representing the new trade surplus).

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 Z
ZZ'

ZZ

NX

B
A NX'
NX
Y Y' Y

b) USA would prefer the increase in G because it helps to reduce the imbalance in trade.
With G going up, Japan’s NX goes down while with the devaluation of the yen NX goes
up.

6.9 Fiscal policy and Flexible Exchange Rates

A restrictive fiscal policy decreases demand and, therefore, production. As production

decreases, money demand decreases and this leads to a decrease in the interest rate. Because
of this, bonds become less attractive and there is a depreciation of the domestic currency.

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Graphically:

i i
LM

E'
IS

IS'

Y' Y Y E' E E

The decrease in production has a negative effect on imports. The depreciation has a negative
effect on imports and a positive effect on exports. Finally, the restrictive fiscal policy will
increase net exports with a positive effect on the current account.

6.10 Monetary Policy with Flexible Exchange Rates

a) Country A
i i
LM'
E'

IS

LM

Y' Y Y E E’ E

Because of the monetary contraction, the interest rate increases leading to an appreciation
of the exchange rate. This implies a loss in competitiveness and an increase in the demand
for imports (domestic goods become too expensive with respect to goods from country B).
b) The monetary contraction in A leads to an increase not only in the domestic interest rate
but also in the world interest rate. Hence, country B will experience an outflow of capital
leading to a depreciation of its exchange rate. Because of this, country B’s goods will
become even more competitive.

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6.11 Fiscal Policy and Fixed Exchange Rates

i LM1 i

LM0
E1 E0
A

IS1 IS0

Y EA E E

A restrictive fiscal policy will reduce aggregate demand, so the IS curve shifts left. With a
flexible exchange rate the equilibrium would move from E0 to A. However, the reduction in i
would require a depreciation of the exchange rate. Hence, with a fixed exchange rate the
central bank will intervene in order to defend the parity. To this purpose the central bank will
buy domestic money, so the LM curve will shift up. The new equilibrium is E1.

6.12 Fiscal Policy and Fixed Exchange Rates

a) i LM0

LM1
i=i*
E0 E1

IS0 IS1

Because of the increase in public expenditure the IS shifts right to IS1. In order to maintain
the exchange rate constant, the central bank has to adopt an expansionary monetary
policy. We will have an increase in output, an increase in investments (since Y goes up)
and a decrease in the trade balance.
b) Because of the exchange rate appreciation domestic goods become less competitive.
Hence we have a worsening of the trade balance, which partly offsets the increase in
output.

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6.13 Fiscal Policy and Fixed Exchange Rates
a) G increases. The IS shifts right to IS1. This implies an increase in the interest rate which
would lead to an inflow of capitals and thus to an appreciation of the exchange rate if the
exchange rate were flexible. In order to respect the exchange rate agreement, the central
bank has to expand monetary policy, so the interest rate remains unchanged and the output
increases even more.
Tax revenues increase since Y has increased. (and so Yd).

i LM0

LM1

E0 E1

IS0 IS1

Y
b) An expansionary monetary policy has no effects in a fixed exchange rates regime: an
increase in the nominal money stock leads to a decrease in the interest rate which implies
an outflow of capitals and a depreciation of the exchange rate. In order to avoid this, the
central bank has to reduce the monetary stock until the interest rate remains unchanged.
c) In country B, the central bank continue to reduce money reserves and so it may very well
be the case that at some point in time it cannot defend the parity any longer. In country A,
the central bank accumulates reserves.

6.14 Economic Policy and Fixed Exchange Rates

Graphically:
i
IS'
IS LM
B LM'

A
C

Y Y' Y'' Y

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The decrease in the sensitivity of investment to the interest rate rotates the IS curve clockwise.
The new IS’ will be steeper and will have a higher vertical intercept. This has a positive effect
on output and in the new equilibrium (B) domestic interest rate will be greater than the world
interest rate. In order to defend the exchange rate, an accommodating monetary policy is
needed. This will accentuate the positive effect on output. In the final equilibrium (C), output
will be even greater while interest rate will remain unchanged.

6.15 Fiscal Policy and Flexible Exchange Rates

i i

LM

i0

i1

IS
IS'

Y1 Y0 Y E1 E0 E

We have a fiscal contraction. Hence, the IS shifts downwards and both interest rate and output
decrease. Because of the reduction in i there is an outflow of capital leading to a depreciation
of the exchange rate with an increase in the trade balance. The trade balance gets better also
because of the reduction in output.

Alternatively, we can consider the DD-ZZ and NX graphs. Because of the fiscal contraction,
the DD shifts downwards. This implies a reduction in output and the trade balance gets better
(movement along the original NX). Because of the depreciation of the exchange rate (due to
the outflow of capital) the NX shifts up to NX’, thus making even better the trade balance.

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6.16 Exchange Rate Revaluation

a)
AD A
P
AD’
AS’
P0 0
P1 1
P2 2

Y
Y1 Yn

b) In the short run. the revaluation of the nominal exchange rate leads to the revaluation of
the real exchange rate ε. Because of this, domestic goods are less competitive on the
international market. The AD curve shifts left to AD’ (from 0 to 1). Production and prices
decrease. Because of the reduction in prices, the effect on the real exchange rate is
mitigated. The decrease in production under its natural level makes the supply curve move
rightwards till we get back to the medium run equilibrium level of production (2). During
the adjustment process prices continue to decrease and thus increase the real exchange
rate. The country becomes more competitive and production increases. At 2, production
and ε are back at their initial values (the revaluation is completely offset), but with a lower
level of domestic prices.

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