1

A Quick Recap of the last lecture

2
 INVESTMENT DEMAND

r Investment is still a downward-

sloping function of the interest
rate
but the exogenous
r* world interest
rate… …determines
the country’s
I (r )
level of
I (r* ) S, I investment.
3
 HAD THE ECONOMY BEEN
A CLOSED ONE
r S
THE INTEREST
RATE WOULD
ADJUST TO
EQUATE
INVESTMENT
AND SAVING:
r
I (r )

S, I
I(r) = S
4
 IN A SMALL OPEN ECONOMY
r
WHAT IS S
‘SMALL’?

The exogenous NX
world interest r*
rate determines
investment… r
difference
between saving I (r )
and investment
determines net I S, I
capital outflow
and net exports
5
 CONSIDER EFFECTS OF THREE CHANGES

• Fiscal policy at home

• Fiscal policy abroad
• An increase in investment demand

6
 FISCAL POLICY AT HOME
r
S 2 S1
An increase in G
or decrease in T NX2
reduces saving. r
1
*

NX1

I (r )

I S, I

7
 FISCAL POLICY ABROAD
r S1
Expansionary
NX2
fiscal policy
abroad raises r2*
NX1
the world
interest rate. r
1
*

Results:
I  0 I (r )
NX  I  0
S, I
I (r )
2
*
I (r1* )

8
AN INCREASE IN INVESTMENT DEMAND
r
S

r*
EXERCISE:
Use the model to NX1
determine the impact
of an increase in
investment demand I (r )1
on NX, S, I, and
net capital outflow. I1 S, I

9
 r
S
ANSWERS: NX2
I > 0, r*
S = 0,
net capital NX1
outflow and I (r )2
NX fall by the
amount I I (r )1

I1 I2 S, I

10
Let us now
Introduce
Exchange
Rate …

11
 EXCHANGE RATE MOVEMENTS

• An increase in the exchange rate (based

on how we defined it) is called an
appreciation

• A decrease in the exchange rate (based

on how we defined it) is called a
depreciation

12
 Rise & fall in e
• Consider e the nominal Exchange Rate on Nov 07, 2017
Indian Rupee 1.00 INR inv. 1.00 INR
exchange rate. a rise in e
US Dollar 0.015381 65.016619
means that we can buy more Euro 0.013292 75.234994
dollars for instance, with one British Pound 0.011712 85.378962
rupee – the rupee is ‘more Australian Dollar 0.020101 49.748933
powerful’, has Canadian Dollar 0.019655 50.877311
‘appreciated’ Singapore Dollar 0.020969 47.688382
• A fall in e means that we can Swiss Franc 0.015358 65.111512
buy less dollars with a rupee Malaysian Ringgit 0.064978 15.389846
– the rupee has become Japanese Yen 1.755246 0.569721

‘more weak’, has Chinese Yuan 0.102075 9.796713

‘depreciated’
06-Nov- 31-Oct- 29-Sep- 31-Aug- 31-Jul- 30-Jun- 31-May- 28-Apr- 31-Mar- 01-Feb- 31-Jan- 30-Dec- 30-Nov- 28-Oct-
Date
2017 2017 2017 2017 2017 2017 2017 2017 2017 2017 2017 2016 2016 2016

US
64.7267 64.7745 65.3552 64.0154 64.0773 64.7379 64.5459 64.2170 64.8386 67.6458 67.8125 67.9547 68.5260 66.8566
Dollar
13
 Rise & Fall in ε
• Consider ε the real exchange rate.
• Real exchange rate: ε is the relative price of
domestic goods in terms of foreign goods (e.g. number of Korean
TVs per Indian Pashmina shawl)
• A rise is called real appreciation, it means that we can buy more
foreign goods with one Indian good. Foreign goods are cheaper,
Indian goods are more expensive than before the rise. Exports
fall, imports rise, net exports fall.
• In the real world: We can think of ε as the relative price of a
basket of domestic goods in terms of a basket of foreign goods
• In our macro model: There’s just one good, “output.” so ε is the
relative price of one country’s output in terms of the other
country’s output. So that, ε = (e P)/P*

14
Exchange Rate in Reality

15
 Exchange Rate of Rupee (Financial Year Average)
Deutsche
Pound Japanese Deutsche Pound Japanese Mark/Eur
Year US Dollar Sterling Yen Mark / Euro Year US Dollar Sterling Yen o
1970-71 7.56 18.00 2.08 2.0490 1993-94 31.37 47.21 29.11 18.74
1971-72 7.47 18.40 2.04 2.1974 1994-95 31.40 48.82 31.63 20.20
1972-73 7.68 18.84 3.00 2.4392 1995-96 33.45 52.35 34.84 23.40
1973-74 7.79 18.80 3.00 3.0075 1996-97 35.50 56.36 31.59 22.92
1974-75 7.94 18.80 3.00 3.1917 1997-98 37.16 61.02 30.30 20.96
1975-76 8.68 18.39 3.00 3.4458 1998-99 42.07 69.55 33.13 24.18
1976-77 8.98 15.57 3.00 3.6308 1999-00 43.33 69.85 39.06 44.79
1977-78 8.59 15.43 3.33 3.8358 2000-01 45.68 67.55 41.41 41.48
1978-79 8.23 15.97 4.00 4.2200 2001-02 47.69 68.32 38.18 42.18
1979-80 8.10 17.66 3.58 4.4717 2002-03 47.69 74.82 39.74 48.09
1980-81 7.91 18.50 3.75 4.1875 2003-04 48.40 77.74 40.71 53.99
1981-82 8.97 17.11 3.94 3.8607 2004-05 44.93 82.86 41.80 56.55
1982-83 9.67 16.14 3.89 3.9600 2005-06 44.27 79.05 39.14 53.91
1983-84 10.34 15.42 4.38 3.9402 2006-07 45.25 85.64 38.73 58.05
1984-85 11.89 14.87 4.87 3.9877 2007-08 40.26 80.84 35.35 57.06
1985-86 12.23 16.85 5.62 4.5553 2008-09 45.99 78.32 46.17 65.06
1986-87 12.78 19.07 8.02 6.2970 2009-10 47.44 75.78 51.14 67.05
1987-88 12.97 22.09 9.41 7.4004 2010-11 45.56 70.88 53.27 60.23
1988-89 14.48 25.60 11.30 8.0494 2011-12 47.92 76.39 60.75 65.89
1989-90 16.65 26.92 11.66 9.0922 2012-13 54.41 85.97 65.85 70.07
1990-91 17.94 33.19 12.79 11.4351 2013-14 60.50 96.31 60.40 81.17
1991-92 24.47 42.52 18.44 14.6248 2014-15 61.14 98.57 55.83 77.52
1992-93 30.65 51.69 24.59 19.5877 2015-16 65.47 98.73 54.59 72.29
16
2016-17 67.07 87.69 62.04 73.61
 10.00
20.00
30.00
40.00
50.00
60.00
70.00
80.00

0.00
1970-71
1972-73
1974-75
1976-77
1978-79
1980-81
1982-83
1984-85
1986-87
1988-89
1990-91
1992-93
1994-95
1996-97
1998-99
2000-01
2002-03
INR-USD exchange rate

2004-05
2006-07
2008-09
2010-11
2012-13
2014-15
2016-17
Exchange Rate of INR

17
 Nominal Effective Exchange Rate (NEER) and
Real Effective Exchange Rate (REER) Indices

The REER has four parameters/variables pertaining

to country/currency coverage (n), relative prices
(P/Pi), weights (wi) and exchange rates (e/ei).

• REER is the nominal effective exchange rate (a measure of the value of a currency against a weighted average of several
foreign currencies) divided by a price deflator or index of costs.
• An increase in REER implies that exports become more expensive and imports become cheaper; therefore, an
increase indicates a loss in trade competitiveness. 18
 Why is GM used?
• It is common practice to use geometric averages rather than arithmetic averages
for calculating effective exchange rates.
• Exchange rate indices based on geometric averaging have the convenient feature
that the logarithm of the index is equal to the arithmetic average of the logarithms
of the underlying bilateral rates.
• Moreover, a percentage change in the geometrically averaged effective exchange
rate between two periods is independent of the base period.
• However, when an arithmetic average is applied, it is affected by all movements
since the base period.
• Moreover, for geometrically averaged EERs, proportionally equivalent currency
appreciations and depreciations have the same effect (with opposing signs) on the
overall index, whereas there is an upward bias in arithmetically averaged indices.
• For example, under a geometric EER, a ceteris paribus appreciation of 5% (x1 =x0
*1.05) in the currency of a trading partner would produce a symmetric effect of a
depreciation of 4.76% (x1 =x0 /1.05).

19
 Indices Of Real Effective Exchange Rate (REER) And
Nominal Effective Exchange Rate (NEER) Of The Indian Rupee
(36- Currency Bilateral Weights) (Financial Year - Annual Average)

20
Nominal versus Real Exchange Rate

21
 How have
exchange rates
of a few major
currencies moved?

Source: US Fed St Louis. https://fred.stlouisfed.org

22
Euro-USD Story
How does Exchange rate
impact NX?

29
 Rise and Fall in ε
• A fall in ε is called real depreciation.
• We can buy less foreign goods with one unit of the Indian
good.
• Foreign goods are more expensive, Indian goods are more
cheap than before the fall in the real exchange rate. Imports
fall, exports rise, net exports rise.

30
 THE NET EXPORTS FUNCTION

• The net exports function reflects this negative

relationship between NX and ε :
NX = NX (ε )

SO, ε MUST ADJUST TO ENSURE

31
 HOW ε IS DETERMINED
Neither S nor I
ε S 1  I (r *)
depend on ε, so
the net capital
outflow curve is
vertical.

ε1
NX (ε )

ε adjusts to NX
equate NX NX 1
with net
capital outflow,
S - I. 32
 SUPPLY AND DEMAND
IN THE FOREIGN EXCHANGE MARKET
demand:
Foreigners ε S 1  I (r *)
need rupees to
buy Indian net
exports.

supply: ε1
Net capital
outflow (S - I ) NX(ε )
is the supply
of rupees to NX
NX 1
be invested
abroad.
33
 SOME EXPERIMENTS
FISCAL POLICY AT HOME
FISCAL POLICY ABROAD
AN INCREASE IN INVESTMENT DEMAND
TRADE POLICY TO RESTRICT IMPORTS

34
 FISCAL POLICY AT HOME
A fiscal expansion S 2  I (r *)
reduces national ε S 1  I (r *)
saving, net capital
outflow, and the
supply of rupees ε2
in the foreign
exchange market… ε1

NX(ε )

…causing the real NX

NX 2 NX 1
exchange rate to
rise and NX to fall.
35
 FISCAL POLICY ABROAD
An increase in r*
reduces investment, S 1  I (r1 *)
increasing net capital ε S 1  I (r2 *)
outflow and the supply
of rupees in the foreign
exchange market… ε1

ε2

NX(ε )

…causing the real NX 2 NX

NX 1
exchange rate to fall
and NX to rise.
36
 INCREASE IN INVESTMENT DEMAND
An increase in S1  I 2
investment reduces net
capital outflow and the ε S1  I 1
supply
of rupees in the foreign
exchange market… ε2

ε1

NX(ε )
…causing the
real exchange
NX 1 NX
rate to rise and NX 2
NX to fall.

37
 TRADE POLICY TO RESTRICT IMPORTS
At any given value of
ε, an import quota ε S I
 IM  NX
 demand for ε2
rupees shifts right
ε1
NX (ε )2
Trade policy
doesn’t affect S or NX (ε )1
I , so capital flows
and the supply of NX
NX1
rupees remain fixed.

38
 TRADE POLICY TO RESTRICT IMPORTS
Results:
ε S I
ε > 0
(demand
increase) ε2
NX = 0
(supply fixed) ε1
IM < 0 NX (ε )2
(policy)
NX (ε )1
EX < 0
(rise in ε ) NX
NX1

39
 THE DETERMINANTS OF THE
NOMINAL EXCHANGE RATE
• Start with the expression for the real exchange rate:

e P
ε 
P*

• Solve for the nominal exchange rate:

P*
e  ε 
P 40
 THE DETERMINANTS OF THE
NOMINAL EXCHANGE RATE
• So e depends on the real exchange rate and the
price levels at home and abroad…
…and we know how each
of them is determined: M*
 L (r *   *,Y * )
*

P*
P*
e  ε 
P
M
 L (r *   ,Y )
NX (ε )  S  I (r *) P

41
 THE DETERMINANTS OF THE
NOMINAL EXCHANGE RATE
P*
e  ε 
P
• Rewrite this equation in growth rates

e ε P * P ε
  *    *  
e ε P P ε

• For a given value of ε, the growth rate of e

equals the difference between foreign and
domestic inflation rates.
42
 PURCHASING POWER PARITY (PPP)
Two definitions:
– A doctrine that states that goods must sell
at the same (currency-adjusted) price in all
countries.
– The nominal exchange rate adjusts to
equalize the cost of a basket of goods across
countries.
Reasoning:
– Arbitrage, the law of one price
43
 PURCHASING POWER PARITY (PPP)
• PPP: e P = P* Cost of a basket of
foreign goods, in
foreign currency.

Cost of a basket of Cost of a basket of

domestic goods, in domestic goods, in
foreign currency. domestic currency.
 Solve for e : e = P*/ P
 PPP implies that the nominal exchange rate
between two countries equals the ratio of the
countries’ price levels.

44
 PURCHASING POWER PARITY (PPP)
• If e = P*/P,
P P P *
then ε e *   * 1
P P P
and the NX curve is horizontal:
ε
S I Under PPP,
changes in
(S – I ) have no
ε =1 NX impact on ε or e.

NX
45
 DOES PPP HOLD IN THE REAL WORLD?
• No, for two reasons:
– International arbitrage not possible
• Non-traded goods
• Transportation costs
– Different countries’ goods not perfect substitutes.
• Nonetheless, PPP is a useful theory:
– It’s simple & intuitive
– In the real world, nominal exchange rates tend toward
their PPP values over the long run.

46
 The Economist Big Mac index:
Intuitive Fiction
 The Big Mac index was invented by The
Economist in 1986 as a light-hearted guide to
whether currencies are at their “correct” level.
 It is based on the theory of purchasing-power
parity (PPP), the notion that in the long run
exchange rates should move towards the rate
that would equalise the prices of an identical
basket of goods and services (in this case, a
burger) in any two countries.
 For example,
 The average price of a Big Mac in America in
July 2017 was $5.30
 In China it was only $2.92 at market
exchange rates.
 So the "raw" Big Mac index says that the
yuan was undervalued by 45% at that time.
 Burgernomics was never intended as a precise
gauge of currency misalignment, merely a tool
to make exchange-rate theory more digestible.
 Yet the Big Mac index has become a global
standard, included in several economic
textbooks and the subject of at least 20
academic studies.
47
http://www.economist.com/content/big-mac-index
Thank You

48