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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

1 The purchasing power parity relationship – prices are equalized across countries in terms of the currency of one country.Equation 14. Copyright © 2008 Pearson Addison- 14-3 .

Table 14.1 Purchasing Power Parity and the Big Mac Index Copyright © 2008 Pearson Addison- 14-4 .

the United States Copyright © 2008 Pearson Addison- 14-5 .Figure 14.1 The Real Exchange Rate for Canada vs.

• The nominal exchange rate is essentially determined by nominal money demand and supply. Copyright © 2008 Pearson Addison- 14-6 .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.

2 The Goods Market in the Monetary Small Open-Economy Model Copyright © 2008 Pearson Addison- 14-7 .Figure 14.

we assume that purchasing power parity always holds.Equation 14.2 In the monetary SOE model. Copyright © 2008 Pearson Addison- 14-8 .

and the world real interest rate r*.3 Money demand depends on P.Equation 14. Copyright © 2008 Pearson Addison- 14-9 . Y.

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 .

• A flexible exchange rate implies that the domestic price level is insulated from movements in the foreign price level.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 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 .

6 An Increase in the World Real Interest Rate with a Flexible Exchange Rate Copyright © 2008 Pearson Addison- 14-15 .Figure 14.

Copyright © 2008 Pearson Addison- 14-16 .Monetary SOE Model – Fixed Exchange Rate • In this version of the model. • The money supply changes to equate money supply and money demand at the fixed exchange rate. the domestic money supply becomes endogenous rather than the exchange rate.

Figure 14.7 The Money Market in the Monetary Small Open-Economy Model with a Fixed Exchange Rate Copyright © 2008 Pearson Addison- 14-17 .

2 A Simplified Government Balance Sheet Copyright © 2008 Pearson Addison- 14-18 .Table 14.

• An increase in the foreign price level causes a proportionate increase in the domestic price level.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. • A change in the world real interest rate has no effect on the price level. Copyright © 2008 Pearson Addison- 14-19 .

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.

Figure 14.9 An Increase in the World Real Interest Rate with a Fixed Exchange Rate Copyright © 2008 Pearson Addison- 14-21 .

• However. Copyright © 2008 Pearson Addison- 14-22 . capital controls cause inefficiencies in world credit markets.Capital Controls • Capital controls can dampen the effects of macroeconomic shocks that come from abroad.

10 A Devaluation in Response to a Temporary Total Factor Productivity Shock Copyright © 2008 Pearson Addison- 14-23 .Figure 14.

With and Without Capital Controls Copyright © 2008 Pearson Addison- 14-24 .11 A Temporary Total Factor Productivity Shock.Figure 14.

12 A Total Factor Productivity Shock Under a Fixed Exchange Rate.Figure 14. With and Without Capital Controls Copyright © 2008 Pearson Addison- 14-25 .