Macroeconomics & The global

economy

Session 7: The Open Economy - II

The exchange rate between two countries is
the price at which residents of those countries
trade with each other.

• Nominal and Real exchange rates

2
The nominal exchange rate
e = nominal exchange rate,
the relative price of
domestic currency
in terms of foreign currency
(e.g. Nepali Rs. 86 per US Dollar)
• Demand and Supply for the currency determines the
exchange rate.
• Important factor: trade and Investment requirements
e S$

e0 A

D$

$
Dollar Value of Transactions
Suppose there is an increase in the demand for U.S. Dollars in Nepal
(for importing goods and services or going abroad). How will this
affect the nominal exchange rate for US dollar in Nepal?
D$ shifts rightward and
e S$
increases the nominal
exchange rate, e. This is known
e1 B as appreciation of the dollar.
e0 A
Events which decrease the
demand for the dollar, and thus
D$ 
decrease e, would be a
D$
depreciation of the dollar.
$
Dollar Value of Transactions
 Understanding Real Exchange Rate
• A Japanese businessman
thinks that the cars made
in the US are far better
than those made in
Japan.

• The car model he likes in

Japan costs 2400,000
Japanese Yen. The existing
spot (nominal) exchange
rate is 120 Yen/dollar.
 Understanding Real Interest Rate
• So, the exchanges 2400,000
Japanese Yen for $20,000
the same car.

• However, the same car in

US costs only $10,000.

• What are his impressions

about the US and
Japanese currencies?
 Understanding Real Interest Rate
Impression:
1. Overvaluation of Japanese
currency:
He can buy more cars (2 cars) in
US than Japan with same
amount of money. The Japanese
Yen is overvalued
2. Real exchange rate is different
from nominal exchange rate:
1 American car = 0.5 Japanese
Car (as US car costs half the
price of the car in Japan).
 The real exchange rate
ε = real exchange rate,
the relative price of
the lowercase domestic goods
Greek letter in terms of foreign goods
epsilon
(e.g. How many Nepali KFC baskets can
you buy with the amount you pay for 1
U.S. KFC basket?)
 Relationship between ‘e’ and ‘e ’

Real Nominal Exchange Rate at Home x Price of Domes. Goods

Exchange =
Rate Price of Foreign Goods

Real Nominal Relative

Exchange = Exchange X Price of P = Price of Domestic
Rate Rate Goods Goods
e = e X (P / P*)
P* = Price of Foreign
Goods
The real exchange rate with KFC
Costs of KFC basket in Nepal = Rs. 900
Costs of same KFC basket in US = $10
If the nominal exchange rate is Rs. 112/dollar,
1) What is the real exchange rate?
2) Is Nepalese currency overvalued or undervalued
compared to US currency?
The real exchange rate with KFC
Costs of KFC basket in Nepal = Rs. 900
Costs of same KFC basket in US = $10
If the nominal exchange rate is Rs. 73/dollar,
1) What is the real exchange rate? – 1.23
2) Is Nepalese currency overvalued or undervalued
compared to US currency? - Overvalued
 Relationship between NX and ε ?

ε  Nepalese goods become more expensive

relative to US goods
 EX, IM
 NX
 The net exports function
• The net exports function reflects this inverse
relationship between NX and ε :
NX = NX(ε )

ε1

NX(ε )
NX
 How ε is determined
• The accounting identity says NX = S – I
• We saw earlier how S – I is determined:
– S depends on domestic factors (output, fiscal
policy variables, etc)
– I is determined by the world interest
rate r *
• So,

NX (ε )  S  I (r *)
 How ε is determined
Neither SS nor
Neither nor II S 1  I (r *)
depend
depend on on εε,, ε
so
so the
the net
net capital
capital
outflow
outflow curve
curve isis
vertical.
vertical.

ε1
εε adjusts
adjusts to
to
equate
equate NX
NX NX(ε )
with
with net
net capital
capital
NX
outflow, SS -- II..
outflow, NX 1
 Next, four applications:

Impact on Real Exchange Rate due to:

1. Expansionary Fiscal policy at home
2. Expansionary Fiscal policy abroad
3. Domestic increase in investment demand
4. Trade policy to restrict imports
 1. Fiscal policy at home

AA fiscal
fiscal expansion
expansion S 2  I (r *)
reduces
reduces national
national ε S 1  I (r *)
saving,
saving, net
net capital
capital
outflow,
outflow, and
and the
the ε2
supply
supply of of NPR
NPR
against
against dollars
dollars
in
in the
the foreign
foreign ε1
exchange
exchange market…
market…
NX(ε )
…causing
…causing the
the real
real NX
exchange
exchange rate
rate toto rise
rise NX 2 NX 1
and
and NX
NX to
to fall.
fall.
 2. Fiscal policy abroad
Expansionary
Expansionary Fiscal
Fiscal
Policy
Policy abroad
abroad S 1  I (r1 *)
increases
increases world
world ε S 1  I (r2 *)
interest
interest rate
rate r*,
r*,
reduces
reduces investment
investment
in
in Nepal,
Nepal, increasing
increasing ε1
net
net capital
capital outflow
outflow
(S>I)
(S>I) and
and the
the supply
supply
of
of NPR
NPR against
against ε2
dollars
dollars in
in the
the foreign
foreign
exchange
exchange market…
market… NX(ε )

…causing NX
…causing the
the real
real NX 1 NX 2
exchange
exchange rate
rate to
to fall
fall
and
and NX
NX to
to rise.
rise.
 3. Increase in investment demand at home
An
An increase
increase inin S1  I 2
investment
investment in in Nepal
Nepal ε S1  I 1
reduces
reduces net
net capital
capital
outflow
outflow (S<I)
(S<I) and
and the
the
supply
supply of
of NPR
NPR against
against ε2
dollars
dollars in
in the
the foreign
foreign
exchange
exchange market…
market… ε1

NX(ε )
…causing
…causing the the
NX
real
real exchange
exchange NX 2 NX 1
rate
rate to
to rise
rise and
and
NX
NX toto fall.
fall.
 4. Trade policy to restrict imports

At
At any
any given
given value of εε,,
value of
an ε S I
an import
import quota
quota
 IM
IM  NXNX
(Note:
(Note: Net
Net Export
Export == ε2
Export
Export –– Import)
Import)
ε1
NX (ε )2
Trade
Trade policy
policy doesn’t
doesn’t NX (ε )1
affect or II ,, so
affect SS or so
capital
capital flows
flows andand the
the NX
NX1
supply
supply ofof NPR
NPR against
against
US
US Dollar
Dollar remain
remain fixed.
fixed.
Thank You