Macroeconomic Theory and

Policy

PGDM : 2016 – 18
Term 2 (September – December, 2016)
(Lectures on Open Economy)
National Income Accounting for an Open
Economy
• The National Income Identity for an Open
Economy
– It is the sum of domestic and foreign expenditure on
the goods and services produced by domestic factors
of production:
Y = C + I + G + EX – IM
where:
• Y is GDP
• C is consumption
• I is investment
• G is government purchases
• EX is exports
• IM is imports
National Income Accounting for an Open
Economy
• An Imaginary Open Economy
– Assumptions of the model:
• There is an economy, Agraria, that can only produce wheat.
• Each citizen of Agraria is both a consumer and a farmer of wheat.
• The Agrarian government appropriates part of the crop to feed its
army.
• Agraria can import milk from the rest of the world in exchange for
exports of wheat.
– The price of milk is 0.5 bushel of wheat per gallon, and at this price
Agrarians want to consume 40 gallons of milk.
National Income Accounting for an Open
Economy

National Income Accounts for Agraria, an Open Economy

(bushels of wheat)
National Income Accounting for an Open
Economy
• The Current Account and Foreign
Indebtedness
– Current account (CA) balance
• The difference between exports of goods and services
and imports of goods and services (CA = EX – IM)
• A country has a CA surplus when its CA > 0.
• A country has a CA deficit when its CA < 0.
• CA measures the size and direction of international
borrowing.
– A country’s current account balance equals the change in its
net foreign wealth.
National Income Accounting for an Open
Economy

– CA balance is equal to the difference between

national income and domestic residents’ spending:
Y – (C+ I + G) = CA
• CA balance is goods production less domestic demand.
• CA balance is the excess supply of domestic financing.
– Example: Agraria imports 20 bushels of wheat and exports only
10 bushels of wheat .The current account deficit of 10 bushels is
the value of Agraria’s borrowing from foreigners, which the
country will have to repay in the future.
 National Income Accounting for an Open
Economy
• Saving and the Current Account
– National saving (S)
• The portion of output, Y, that is not devoted to household
consumption, C, or government purchases, G.
• It always equals investment in a closed economy.
– A closed economy can save only by building up its capital stock
(S = I).
– An open economy can save either by building up its capital stock
or by acquiring foreign wealth (S = I + CA).
• A country’s CA surplus is referred to as its net foreign
investment.
National Income Accounting for an Open
Economy
• Private and Government Saving
– Private saving (Sp)
• The part of disposable income that is saved rather than
consumed
Sp = I + CA – Sg = I + CA – (T – G) = I + CA + (G – T) (12-2)
– T is the government's “income” (its net tax revenue)
– Sg is government savings (T-G)
– Government budget deficit (G – T)
• It measures the extent to which the government is
borrowing to finance its expenditures.
Variables that Influence Net Exports

• Consumers’ preferences for foreign and domestic goods

• Prices of goods at home and abroad

• Incomes of consumers at home and abroad

• The exchange rates at which foreign currency trades

for domestic currency
• Transportation costs

• Government policies
Twin Deficit

Y = C + I + G + NX + NFE
(Y – C – T) +(T – G) = I + NX + NFE
SPr+ BA = I + NX + NFE

If BA < 0 we have Budget Deficit

If NX < 0 we have Trade Deficit

When for an economy both BA and NX are negative the economy

is said to have a Twin Deficit.
Variables that affect NX and CAB

What do you think would happen to

India’s Current Account Balance if:
A. The U.S.A. experiences a recession
(falling incomes, rising unemployment)
B. Indian consumers decide to be patriotic and
buy more products “Made in India.”
C. Prices of goods produced in the U.S. A. rise faster
than prices of same goods produced in India.
Answers

A. The U.S.A. experiences a recession

(falling incomes, rising unemployment)
India’s net exports would fall due to a fall in US
consumers’ purchases of Indian exports. CAB
will decline….

B. Indian consumers decide to be patriotic and

buy more products “Made in India.”
India’s net exports would rise due to a fall in
imports. CAB will rise….
Answers

C. Prices of U.S.A. goods rise faster than prices

of Indian goods
This makes Indian goods more attractive relative
to U.S.A.’s goods.
Exports to the U.S.A. increase, imports from the
U.S.A decrease, so India’s net exports increase.
CAB will rise….
Trade Surpluses & Deficits

NX measures the imbalance in a country’s trade

in goods and services.
– Trade deficit:
an excess of imports over exports
– Trade surplus:
an excess of exports over imports
– Balanced trade:
when exports = imports
 Nominal Exchange Rates

• The nominal exchange rate indicates how much domestic currency can be
obtained with one unit of the foreign currency.

• For example, if the nominal exchange rate is 60 Rs. per dollar, one dollar
can be exchanged for 60 Rs.

• Transactions between currencies take place in the foreign exchange

market.

• Denote the nominal exchange rate (or simply, exchange rate) as enom in
units of the foreign currency per unit of domestic currency.
 Real Exchange Rates (Terms of Trade)

• The real exchange rate indicates how much of a foreign good

can be obtained for one unit of a domestic good.

• Although countries produce many goods, and price indexes should

be used to get P and Pfor,. To simplify matters, assume that each
country produces a unique good.

• If a country’s real exchange rate is rising, its goods are becoming

more expensive relative to the goods of the other country.

• The real exchange rate is the price of domestic goods relative to

foreign goods, or
e = enom × P/ Pfor
Compute a real exchange rate

enom = 10 pesos per $

price of a tall Starbucks Latte
P = $3 in U.S., Pfor = 24 pesos in Mexico
A. What is the price of a U.S. latte measured in
pesos?
B. Calculate the real exchange rate,
measured as Mexican lattes per U.S. latte.
Answers

enom = 10 pesos per $

price of a tall Starbucks Latte
P = $3 in U.S., Pfor = 24 pesos in Mexico
A. What is the price of a U.S. latte in pesos?
enom x P = (10 pesos per $) x (3 $ per U.S. latte)
= 30 pesos per U.S. latte
B. Calculate the real exchange rate.
enom x P 30 pesos per U.S. latte
=
Pfor 24 pesos per Mexican latte
= 1.25 Mexican lattes per U.S. latte
Compute a real exchange rate

Suppose the nominal exchange rate is 60 Rs. per dollar, a

Chicken burger costs 150 Rs. in India and $4 in the U.S.

The price of a U.S. Chicken burger relative to an Indian

Chicken burger is 0.625 U.S. Chicken burger per Indian
Chicken burger

The real exchange rate is 0.625 USD per INR.

Appreciation (or “strengthening”) and Depreciation (or
“weakening”) of Nominal Exchange Rate

• In a flexible-exchange-rate system:
– When enom falls, the domestic currency has become weaker
and has undergone a nominal depreciation i. e., a
decrease in the value of a currency as measured by the
amount of foreign currency it can buy

– When enom rises, the domestic currency has become

stronger and has undergone a nominal appreciation
depreciation i. e., an increase in the value of a currency as
measured by the amount of foreign currency it can buy
 Nominal Exchange Rates

• Under a flexible-exchange-rate system or floating-exchange-rate system,

exchange rates are determined by supply and demand and may change
every day.

• This is the current system for major currencies

• In the past, many currencies operated under a fixed-exchange-rate system,

in which exchange rates were determined by governments.

• The exchange rates were fixed because the central banks in those countries
offered to buy or sell the currencies at the fixed exchange rate.

• Though major currencies are in a flexible-exchange-rate system, some

smaller countries fix their exchange rates.
Revaluation and Devaluation of Nominal Exchange
Rate

• In a fixed-exchange-rate system:
– When enom falls, the domestic currency has become weaker
and has undergone a nominal devaluation.

– When enom rises, the domestic currency has become

stronger and has undergone a nominal revaluation.
Appreciation and Depreciation of Real Exchange
Rate

• In a flexible-exchange-rate system:
– When e falls, the domestic currency has become weaker
and has undergone a real depreciation.

– When e rises, the domestic currency has become stronger

and has undergone a real appreciation.
 Revaluation and Devaluation of Real Exchange
Rate

• In a fixed-exchange-rate system:
– When e falls, the domestic currency has become weaker
and has undergone a real devaluation.

– When e rises, the domestic currency has become stronger

and has undergone a real revaluation.
 Fixed or Floating Exchange Rate Regime?

• We will discuss it while discussing

the Open Economy
Macroeconomics…..
 Purchasing-Power Parity (PPP)

• A theory of exchange rates whereby a unit of any

currency should be able to buy the same quantity
of goods in all countries

• Implies that nominal exchange rates adjust to

equalize the price of a basket of goods across
countries
 Purchasing Power Parity

• To examine the relationship between the nominal exchange rate and the
real exchange rate, think first about a simple case in which all countries
produce the same goods, which are freely traded.

• If there were no transportation costs, the real exchange rate would have to
be e = 1, or else everyone would buy goods where they were cheaper.

• Setting e = 1 yields:
P = Pfor/enom
enom = Pfor / P

• This means that similar goods have the same price in terms of the same
currency, a concept known as purchasing power parity, or PPP.
 Indian CPI and US CPI

• Indian CPI: 131.4 as of October 2016

• US CPI: 241.86 as of October 2016

• If the theory of PPP holds then enom should be

(241.86/ 131.4) = 1.84

• But the actual enom (1/68 = .014) <<< 1.84.

• Why?
 Purchasing Power Parity

• PPP does not hold in the short run.

– Countries actually produce different goods.
– Some goods are not traded internationally.
– There are transportation costs.
– There are also legal barriers to trade.
 Mc Parity

• As a test of the PPP hypothesis, the Economist magazine periodically

reports on the prices of Big Mac hamburgers in different countries.

• In 2006, the prices, when translated into dollar terms using the nominal
exchange rate, range from just over $1.31 in China to over $5.21 in
Switzerland, so PPP definitely doesn’t hold.

• The hamburger price data forecast movements in exchange rates.

• Because hamburger prices might be expected to converge,
– countries in which Big Macs are expensive may experience a
depreciation,
while
– countries in which Big Macs are cheap may experience an appreciation.
Mc Parity
 Nominal and Real Exchange Rates

• Changes in the real exchange rate can be decomposed into its

parts:

• Δe/e = Δenom / enom + ΔP/P – Δ Pfor / Pfor

• This can be rearranged as:

Δenom / enom = Δe/e + πfor – π
where, π is the domestic inflation rate and πfor is the inflation
rate in the foreign country
 Real and Nominal Exchange Rates and Inflation

• Δenom / enom = Δe/e + πfor – π

• When the real exchange rate does not change, Δe/e = 0, the
result is relative purchasing power parity.

• Relative purchasing power parity works as a description of exchange-rate

movements in high inflation countries.

• In such countries, movements in relative inflation rates are much larger

than movements in real exchange rates.

• A nominal appreciation (depreciation) is due to either:

– A real appreciation (depreciation), and/or
– A lower (higher) rate of inflation relative to the foreign country.
 Real and Nominal Exchange Rates and Inflation

• The change in nominal exchange rate only reflects changes in relative

inflation between domestic and foreign country.
• Δenom / enom = πfor – π

• If the domestic country has a low rate of inflation relative to foreign

country, one domestic currency will buy increasing amount of foreign
currency over time. Therefore, enom appreciates….

• If the domestic country has a high rate of inflation relative to foreign

country, one domestic currency will buy decreasing amount of foreign
currency over time. Therefore, enom depreciates….
 Real Effective Exchange Rate (REER)

• Real Effective Exchange Rate (REER) is a measure of the trade-

weighted average exchange rate of a currency against a basket of
currencies after adjusting for inflation differentials with regard
to the countries concerned and expressed as an index number
relative to a base year.

• Reference:
• http://www.livemint.com/Money/ljlA4jljjKqHVzO4hEWlcO/Real-
effective-exchange-rate.html
• http://macroeconomicanalysis.com/macroeconomics-
wikipedia/real-effective-exchange-rate-reer/
• https://rbi.org.in/SCRIPTs/BS_ViewBulletin.aspx?Id=14850
 Real and Nominal Exchange Rates and Inflation:
Monetary Policy

• This analysis also shows how monetary policy affects the

nominal exchange rates. A high growth in the money supply
leads to high inflation. A consequence of high inflation is a
depreciating currency : high π implies falling enom.

• In other words, just as growth in the amount of money raises the

price of goods measured in terms of money, it also tends to raise
the price of foreign currencies measured in terms of domestic
currency.
 Exchange Rate Determination

• In a flexible exchange-rate system, exchange rates are determined in

the foreign exchange market where the demand for the currency
equals the supply of the currency.

• The supply of Rs. comes from domestic residents who want to buy:
– Foreign made goods and services (imports),
– Foreign real and financial assets.

• The demand for Rs. comes from foreign residents who want to buy:
– Domestic made goods and services (exports),
– Domestic real and financial assets.
 Exchange Rate Determination

• Factors that increase the supply of the currency:

– An increase in domestic output, Y.
– A decrease in the domestic real interest rate, r.
– An increase in the foreign real interest rate, rfor .
– A shift in domestic demand toward foreign goods, services, or assets.

• Factors that increase the demand for the currency:

– An increase in foreign output, Yfor .
– A decrease in the foreign real interest rate, rfo.
– An increase in the domestic real interest rate, r.
– A shift in rest of world demand towards domestic goods, services, or
assets.
 Exchange Rate Determination

Exchange
Rate (enom )
S (dc)

e*nom
E

D (dc)
Domestic
Currency
dc*
Net Export Function

e  domestic goods become more expensive relative to

foreign goods
 EX, IM
 NX

• Thus, the net exports function reflects this inverse

relationship between NX and e:
NX = NX (e ); NX´(e ) < 0
The NX Curve for the Domestic Country

so domestic
When e is net exports
relatively low, will
domestic goods be high
e1
are relatively
inexpensive NX(e)
0 NX
NX(e1)
The NX Curve for the Domestic Country

e At high enough values

of e,
e2 domestic goods
become so expensive
that we export
less than we
import

NX(e)
0 NX
NX(e2)
 The Mundell-Fleming Model

• The Mundell-Fleming model is an economic model first set

forth by Robert Mundell and Marcus Fleming.

• The model is an extension of the IS-LM model. Whereas the

traditional IS-LM Model deals with economy under autarky
(or a closed economy), the Mundell-Fleming model tries to
describe an open economy.
 The Mundell-Fleming Model
• Typically, the Mundell-Fleming model portrays the relationship
between the nominal exchange rate and an economy's output (unlike
the relationship between interest rate and the output in the IS-LM
model) in the short run.

• The Mundell-Fleming model has been used to argue that an economy

cannot simultaneously maintain
– a fixed exchange rate,
– free capital movement, and
– an independent monetary policy.

• This principle is frequently called the “Unholy Trinity” the

“Irreconcilable Trinity”, the “Inconsistent trinity” or the “Mundell-
Fleming trilemma”.
 The Mundell-Fleming Model
• Key assumptions:
Small open economy with perfect capital mobility.
r = r*
• Prices are fixed : both domestic and foreign; so the entire
framework is based on Nominal exchange Rate

• Goods market equilibrium---the IS* curve:

Y  C  I (r * )  G  NX (enom )

• Money market equilibrium---the LM* curve:

S
M 
   L (r * , Y )
 P 
The IS* curve: Goods Market Eq’m

Y  C  I (r * )  G  NX (enom )

The IS* curve is drawn for enom

a given value of r*.
Intuition for the slope:
 enom   NX   Y

IS*

Y
The LM* curve: Money Market Eq’m
S
M 
   L ( r *
, Y)
 P
The LM* curve enom LM*
• is drawn for a given
value of r*
• is vertical because:
given r*, there is
only one value of Y
that equates money demand
with supply, Y
regardless of enom.
General Equilibrium in the Mundell-Fleming
model
Y  C  I (r * )  G  NX (enom )
S
M 
   L ( r *
, Y) enom
 P LM*

equilibrium
exchange
rate

IS*
equilibrium Y
level of
income
Floating & fixed exchange rates

• In a system of floating exchange rates, enom is allowed to

fluctuate in response to changing economic conditions.

• In contrast, under fixed exchange rates, the central bank

trades domestic for foreign currency at a predetermined
price.

• We now consider fiscal, monetary, and trade policy: first in

a floating exchange rate system, then in a fixed exchange
rate system.
Fiscal policy under floating exchange rates

Y  C  I (r * )  G  NX (enom )
S
M 
   L ( r *
, Y)
 P enom LM 1*
At any given value of e,
a fiscal expansion increases enom2
Y,
enom1
shifting IS* to the right.
IS 2*
Results:
IS 1*
 enom > 0, Y = 0 Y
Y1
Lessons about fiscal policy
• In a small open economy with perfect capital
mobility, fiscal policy cannot affect real GDP.
• “Crowding out”
• closed economy:
Fiscal policy crowds out investment by causing
the interest rate to rise.
• small open economy:
Fiscal policy crowds out net exports by causing
the exchange rate to appreciate.
Monetary policy under floating exchange rates

Y  C  I (r * )  G  NX (enom )
S
M 
   L ( r *
, Y)
 P enom
LM 1*LM 2*
An increase in M shifts
LM* right because Y must
rise to restore eq’m in the enom2
money market.
enom1
Results:
IS 1*
 enom < 0, Y > 0 Y
Y1 Y2
Lessons about monetary policy
• Monetary policy affects output by affecting
one (or more) of the components of aggregate demand:
closed economy: M  r  I  Y
small open economy: M   enom  NX  Y

• Expansionary mon. policy does not raise world

aggregate demand, it shifts demand from foreign to
domestic products.
Thus, the increases in income and employment
at home come at the expense of losses abroad.
Trade policy under floating exchange rates
Y  C  I (r * )  G  NX (enom )
S
M 
   L ( r *
, Y)
 P enom
LM 1*
At any given value of e,
a tariff or quota reduces enom2
imports, increases NX,
and shifts IS* to the right. enom1
IS 2*
Results: IS 1*
Y
 enom > 0, Y = 0 Y1
Lessons about trade policy
• Import restrictions cannot reduce a trade deficit.
• Even though NX is unchanged, there is less trade:
– the trade restriction reduces imports
– the exchange rate appreciation reduces exports
Less trade means fewer ‘gains from trade.’
• Import restrictions on specific products save jobs in the
domestic industries that produce those products, but
destroy jobs in export-producing sectors.
Hence, import restrictions fail to increase total
employment.
Worse yet, import restrictions create “sectoral shifts,”
which cause frictional unemployment.
Fixed exchange rates
• Under a system of fixed exchange rates, the country’s
central bank stands ready to buy or sell the domestic
currency for foreign currency at a predetermined rate.
• In the context of the Mundell-Fleming model,
the central bank shifts the LM* curve as required to
keep e at its preannounced rate.
• This system fixes the nominal exchange rate. In the
long run, when prices are flexible, the real exchange
rate can move even if the nominal rate is fixed.
Fiscal policy under fixed exchange rates

Under floating
Under floating rates, a
rates,
fiscal
fiscalpolicy ineffective
expansion at
would
changing output.
raise e. enom
Under
To keepfixed rates,
e from rising,
LM 1*LM 2*
fiscal policybank
the central is very
musteffective at
changing output.
sell domestic currency,
which increases M
and shifts LM* right. enom1
IS 2*
Results: IS 1*
Y
 enom = 0, Y > 0 Y1 Y2
Monetary policy under fixed exchange rates

An increase
Under in M
floating would shift
rates,
LM* rightpolicy
monetary and reduce e.
is very
effective at changing output. enom
To prevent the fall in e, LM 1*LM 2*
Under fixed rates,
the central bank must
monetary policycurrency,
buy domestic cannot be
used to affect output.
which reduces M and enom1
shifts LM* back left.
Results: IS 1*
Y
 enom = 0, Y = 0 Y1
Trade policy under fixed exchange rates

Under floatingon
A restriction rates,
imports puts
import restrictions
upward doe.not
pressure on
affect Y or NX. enom
LM 1*LM 2*
Under
To keep e from
fixed rates,
rising,
the central
import bank must
restrictions
sell domestic currency,
increase Y and NX.
which increases M
andthese
But, LM* right.
shifts gains comeat the enom1
expense of other countries, as IS 2*
the policy merely shifts
Results: IS 1*
demand from foreign to Y
egoods.
domestic = 0, Y > 0 Y1 Y2
M-F: Summary of policy effects

type of exchange rate regime:

floating fixed
impact on:

Policy Y enom NX Y e NX

fiscal expansion 0    0 0

mon. expansion    0 0 0

import restriction 0  0  0 

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