Open Economy and Exchange Rates

and
IS-LM model and the Aggregate Demand Curve

Lectures 12 and 13
Openness in Goods and Financial Markets
• Openness has three distinct dimensions:

• Openness in goods markets. Free trade restrictions include tariffs and quotas.

• Openness in financial markets. Capital controls place restrictions on the

ownership of foreign assets.

• Openness in factor markets. The ability of firms to choose where to locate

production, and workers to choose where to work. The European Union (EU)
is an example of this.
International Economics-How are the linkages captured in data?

• Current Account Transactions • Capital Account Transactions

• Trade in goods (merchandise trade) • Inflow and outflow of capital
• Trade in services • Includes foreign direct investment, foreign portfolio
• Other current account transactions capital flows
• Remittances • Other debt creating capital flows like external commercial
borrowing
• Profits, Dividends
• Aid, grants etc.

Exchange rates

Foreign Exchange Reserves

3
 These days Capital account tend to
dominate for many countries

• Current Account Transactions • Capital Account Transactions

• Trade in goods (merchandise trade) • Inflow and outflow of capital
• Trade in services • Includes foreign direct investment,
• Other current account transactions foreign portfolio capital flows
• Remittances • Other debt creating capital flows like
external commercial borrowing
• Profits, Dividends
• Aid, grants etc.

Exchange rates

Foreign Exchange Reserves

5
The Choice between Domestic
Goods and Foreign Goods
• When goods markets are open, domestic consumers must
decide not only how much to consume and save, but also
whether to buy domestic goods or to buy foreign goods.

• Central to the second decision is the price of domestic

goods relative to foreign goods, or the exchange rate.

6
 • An exchange rate can be defined as a price
of one country’s money in terms of
another country.

What is an • Each country measures the price of its

exchange goods and services using a particular scale
of measurement.
rate?
• The exchange rate provides a conversion
tool which allows expressing prices of one
country in terms of the units of
measurement of the other country.
Nominal Exchange Rates
• Nominal exchange rates between two currencies can be
quoted in one of two ways:

• As the price of the domestic currency in terms of the

foreign currency.

• As the price of the foreign currency in terms of the

domestic currency.

• Note that both the conventions are used in textbooks. In

India, we generally express it as INR/$ terms

8
Money and exchange rates
• Roles of money in an economy
• Medium of transactions
• Store of value
• Unit of accounts

What can qualify as money?

9
 • Under the gold standard system, countries fixed the value of their
currencies in terms of a specific amount of gold.
A very brief
• The government or the central bank ensured complete two-way
history of convertibility between money and gold. That means that the
central bank would freely exchange money to gold at the specified
exchange rate and vice versa.

rates • To ensure this convertibility, the amount of money issued by the

central bank was tied to the amount of gold in its reserve.

• Given that each currency was tied to a specific amount of gold,

bilateral exchange rates were automatically fixed.

Introduction of
• For example, if Britain fixes the value of pound to £10 per ounce of
Gold Standard gold and USA fixes the value of dollar to $20 per ounce of gold,
(1870–1914) them the bilateral dollar to pound exchange rate is fixed as $2/£.
 JM Keynes
Harry Dexter White

https://www.imf.org/external/pubs/ft/fandd/1998/09/boughton.htm
Features of the Bretton Woods System

• A system of adjustable peg was established

• This was a gold exchange standard where most currencies were
pegged into dollar and the dollar was pegged into gold
 • The system dissolved between 1968 and 1973. In August
1971, U.S. President Richard Nixon announced the
"temporary" suspension of the dollar's convertibility into
gold.

• While the dollar had struggled throughout most of the

1960s within the parity established at Bretton Woods, this
crisis marked the breakdown of the system. An attempt to
revive the fixed exchange rates failed, and by March 1973
Collapse of the the major currencies began to float against each other.
Bretton Woods
• Since the collapse of the Bretton Woods system, IMF
members have been free to choose any form of exchange
arrangement they wish (except pegging their currency to
gold):

• But no new global system of fixed rates was started

again.
Since
BWs…
Nominal Exchange Rates:
Appreciation and Depreciation
• The nominal exchange rate is the price of the foreign
currency in terms of the domestic currency.

• An appreciation of the domestic currency is an increase in

the price of the domestic currency in terms of the foreign
currency, which corresponds
to a increase in the exchange rate.

• A depreciation of the domestic currency is a decrease in

the price of the domestic currency in terms of the foreign
currency, or a decrease in the exchange rate.

16
Nominal Exchange Rates:
Revaluations and Devaluations

When countries operate under fixed exchange

rates, that is, maintain a constant exchange rate
between them, two other terms used are:
Revaluations, rather than appreciations, which
are decreases in the exchange rate, and

Devaluations, rather than depreciations, which

are increases in the exchange rate.

17
Exchange Rate and Depreciation…Scenario 1

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20,000 10 400 50 20,000 0

50 200 4 150 600 30000 10 500 30 15000 15000

18
Exchange Rate and Depreciation…Scenario 2

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20000 10 400 50 20000 0

50 200 4 110 440 22000 10 500 48 24000 -2000

19
Exchange Rate and Depreciation…3

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20,000 10 400 50 20,000 0

50 200 4 150 600 30000 10 500 30 15000 15000

Cost of Export
production Volume of Export Revenue Import Import Volume of Trade
Rs/$ (in Rs) Price in $ exports Revenue ($) (Rs) Price in $ price in Rs imports Import cost Balance

40 200 5 100 500 20000 10 400 50 20000 0

50 200 4 110 440 22000 10 500 48 24000 -2000

20
 Marshall-Lerner Condition

Marshall-Lerner condition states that a depreciation of domestic

currency can improve a country’s balance of payments only when
the sum of the price elasticity of demand of exports and the price
elasticity of demand for imports exceeds unity.

 x + m  1
 • A depreciation of the home currency causes foreign goods to
become more expensive (in terms of home currency),
reducing demand of imports relative to domestic alternatives.

• A depreciation makes the home country’s exports cheaper

Exchange Rate than other suppliers in the foreign market (in terms of foreign
currency). So, in the foreign market it draws demand away
from foreign suppliers
and
Depreciation • This process is called expenditure switching

• Whether expenditure switching will lead to an improvement

in the home country’s current account will depend upon the
price elasticities of demand for imports and exports

22
Other Effects of depreciation
• But for the home country, depreciation can
also be inflationary
• More expensive imports
• Increased aggregate demand may become
inflationary if capacity constraints exist

• What happens if a country is highly import

dependent for its exports?
• Impact of depreciation is less

Cost of Export
production Volume of Export Revenue
Rs/$ (in Rs) Price in $ exports Revenue ($) (in Rs)

40 200 5 100 500 20,000

50 240 4.8

If imported inputs are used, then a depreciation can increase cost of 23

production as imported inputs become more expensive
Other Effects of depreciation
• But for the home country, depreciation can
also be inflationary
• More expensive imports
• Increased aggregate demand may become Therefore, any decision to devalue a currency must depend on
inflationary if capacity constraints exist the estimated net effect on depreciation.
The channels are:
 Impact through exports and its price elasticities
• Sometimes devaluation is called “beggar thy  Impact through imports and its price elasticities and import
neighbour” policy intensity of domestic economy
• But what happens if every country  Impact on foreign debt held by domestic players
devalues?  Possible retaliation by competing countries

• depreciation increases external debt

burden of domestic players in terms of
domestic currency
Impact on external Commercial Borrowing
(What is a natural hedge?)

24
Summing up
If the Marshal-Lerner conditions are satisfied, an exchange rate
depreciation can improve a country’s trade balance

However, the positive impact of depreciation on exports will be

less if there are imported inputs in the production of exports

Also, a domestic inflation (due to say, expansionary monetary or

fiscal policy) can affect a country’s competitiveness in the export
market
Because of these, policymakers often track both nominal
exchange rate and real exchange rate of a country

25
 • Present-day exchange rates are determined by
the interaction of a host of factors, including
• domestic price levels and inflation,
• trade balances,
• interest rate differentials,
What Determines • returns of asset prices
Exchange Rates • expectations.

• These can be captured by the parity conditions:

• Purchasing Power Parity
• Interest rate parity
Purchasing Power Parity (1 of 3)
• Purchasing power parity is the application of the law of
one price across countries for all goods and services, or
for representative groups (“baskets”) of goods and
services.

PUS = ( EUS$/C$ ) × ( PCanada )

PUS = level of average prices in the U.S.

PCanada = level of average prices in Canada

EUS$/C$ = U.S.doller / Canadian doller exchange rate

Purchasing Power Parity (2 of 3)
• Purchasing power parity (PPP) implies that the exchange rate is
determined by levels of average prices

PUS
E US$ =
C$
PCanada
• If the price level in the United States is US$200 per basket, while
the price level in Canada is C$400 per basket, PPP implies that
the C$/US$ exchange rate should be
C$400 / US$200 = C$2 / US$1.
• Predicts that people in all countries have the same purchasing
power with their currencies: 2 Canadian dollars buy the same
amount of goods as 1 U.S. dollar, since prices in Canada are
twice as high.
The Big Mac index is a popular
index but at the policy level,
PPP is calculated by a
comprehensive programme
run by the World Bank…
Purchasing Power Parity (3 of 3)
• Purchasing power parity (PPP) comes in two forms:
• Absolute PPP: purchasing power parity that has already been discussed.
Exchange rates equal the level of relative average prices across countries.

PUS Absolute PPP does

E$ / € = not explain exchange
PEU rate values very well
• Relative PPP: changes in exchange rates equal changes in prices (inflation)
between two periods:
A better predictor of
(E$ / €,t − E$ / €, t −1 ) the exchange rate is
=  US,t −  EU,t the relative PPP
E$ / €, t −1
where  = inflation rate from perid t − 1 to t
t
According to the PPP theory…
Country Price of a specific commodity basket Implied Exchange Rate
USA 5 dollar
India 300 Rs 60 Rs/USD

Country Price of a specific commodity basket Implied Exchange Rate

USA 5 dollar
India 350 Rs 70 Rs/USD

Country Price of a specific commodity basket Implied Exchange Rate

USA 6 dollar
India 375 Rs 62.5 Rs/USD

Relative inflation plays an important role in

indicating the implied exchange rate
 Key Takeaway!!
If Country A is experiencing higher inflation vis-à-
vis country B, then country A’s currency is likely to
depreciate against the currency of country B

35
 Key Takeaway!!
If Country A is experiencing higher inflation vis-à-
vis country B, then country A’s currency is likely to
depreciate against the currency of country B

36
Outflow of FIIs from India
In Rs Crores

FII FII FII Net Purchase

Date
Gross Purchase Gross Sales / Sales

Jan-21 168,241.42 159,260.61 8,980.81

Feb-21 223,030.67 180,986.21 42,044.46
Mar-21 190,759.51 189,514.29 1,245.22
Apr-21 133,795.77 145,835.20 -12,039.43
May-21 166,976.74 172,992.08 -6,015.34
Jun-21 170,188.95 170,214.84 -25.89
Jul-21 125,896.68 149,090.07 -23,193.39
Aug-21 175,168.36 177,736.88 -2,568.52
Sep-21 217,636.41 216,722.64 913.77
Oct-21 185,566.83 211,139.02 -25,572.19
Nov-21 204,204.04 244,105.96 -39,901.92
Dec-21 146,073.90 181,567.49 -35,493.59
Jan-22 141,177.65 182,524.00 -41,346.35
Feb-22 136,263.82 181,983.89 -45,720.07
Mar-22 203,610.95 246,892.26 -43,281.31
Apr-22 147,478.46 188,131.17 -40,652.71
May-22 184,378.97 238,671.44 -54,292.47
Jun-22 120,951.61 179,063.98 -58,112.37
Jul-22 143,497.20 150,064.91 -6,567.71
Aug-22 193,337.27 171,311.65 22,025.62
Sep-22 191,146.65 209,454.95 -18,308.30
Oct-22 178,270.46 178,759.52 -489.06
Nov-22 221,844.65 199,298.31 22,546.34
Dec-22 139,091.40 153,322.49 -14,231.09
Jan-23 155,345.35 196,810.08 -41,464.73

37
Relationship between interest rates and exchange rates

• To compare the rate of return on a deposit in domestic currency with one in foreign currency,
consider
• the interest rate for the foreign currency deposit
• the expected rate of appreciation or depreciation of the foreign currency relative to the
domestic currency.

• For the short run analysis we assume prices do not change and risk and liquidity concerns are
uniform across currencies.
How does one choose between home and
foreign bonds?

• Suppose a U.S. resident has a dollar to invest. Let i be the interest rate on U.S. bonds and i* the interest rate on Japanese
bonds. Consider the choice between U.S. and Japanese bonds. Exchange rate at period t is 1$ = Et Yen.

• Option 1: Buy U.S. bonds

▪ The return on one dollar equals 1+ it dollars at the end of the year.
•
• Option 2: Buy Japanese bonds.
▪ Exchange one dollar for Et yen.
▪ Invest Et yen in Japanese bonds, with a return of (1+i*t)Et yen
▪ Exchange (1+i*t)/Et yen for (1+i*t)Et/Et+1 dollars at the end of the year.

• As Et+1 is unknown at the time of investing

Choice between domestic and foreign bonds

• The return on one dollar equals (1+i*t)Et/Et+1 dollars.

• The expected return on one dollar equals (1+i*t)Et/Eet+1 dollars.

• (Note that to transfer the return from the second option into dollars, the investor must exchange the return at the future period’s exchange
rate Et+1, which is unknown at time t. The investor’s expectation of the future exchange rate is given by Eet+1. If investors care only about
expected returns and not about risk, then they will choose the option with the higher expected return.)

• If both U.S. and Japanese bonds are to be held by the private sector, it must be that the expected returns are the same under either option.
In other words,

1+ i = (1+i*t)Et/Eet+1
Domestic Bonds Versus Foreign Bonds

•What combination of domestic and foreign bonds should

financial investors choose in order to maximize expected
returns?
 Et 
(1 + i ) = (1 + i*) e 
 Et +1 
The right side gives the
expected return from
foreign bonds, also in
The left side gives the terms of domestic
return from domestic In equilibrium, the currency.
bonds , in terms of two expected
domestic currency. returns must be
equal.
Domestic Bonds Versus Foreign Bonds

•What combination of domestic and foreign bonds should

financial investors choose in order to maximize expected
returns?
 Et 
(1 + i ) = (1 + i*) e 
 Et +1 
The right side gives the
expected return from
foreign bonds, also in
The left side gives the terms of domestic
return from domestic In equilibrium, the currency.
bonds , in terms of two expected
In reality the right hand side will also
domestic currency. returns must be
include other factors/uncertainties
equal. which may affect the return from
foreign assets
Nominal Interest Rate differential can be explained
• Does this equation explain why the nominal
interest rates can be different between two
countries?

• Assume the interest rate (i) in USA to be 2

percent

• The interest rate (i*) in India to be 6 percent

• This implies that Et+1 will have to be 83.14 to

maintain the equilibrium

• In other words, expected value of the foreign

currency can explain why nominal interest rate
differentials may persist
Relationship between exchange rate and interest rate

• This relation tells us that the current exchange rate depends on the
domestic interest rate, on the foreign interest rate, and on the
expected future exchange rate (ceteris paribus):

▪ An increase in the domestic interest rate leads to an increase in the

exchange rate. (why?)

▪ An increase in the foreign interest rate leads to a decrease in the

exchange rate. (why?)

This equation is also called the Uncovered

Interest Rate Parity Equation
If there is a fixed exchange rate and free movement of capital

 Et 
(1 + i ) = (1 + i*) e 
 Et +1 

1+ it e
E t = * E t +1
1+ it

If the exchange rate is fixed, that is Et= Et+1, then i=i*

The Impossible Trinity
A nation cannot simultaneously
have:
Free capital
1) free capital flows, flows
Option 1
2) independent monetary policy, (is allowing free capital Option 2
flows and maintaining
3) a fixed exchange rate independent monetary
(is allowing free capital flows
keeping a fixed exchange
policy, but giving up a fixed rate, but giving up
exchange rate. ) independent monetary
policy.)

A nation must choose one side of this

triangle and give up the opposite Independent Fixed
Option 3
corner. monetary (is keeping monetary policy exchange
independent, yet fixing the
policy exchange rate. Doing this
rate
requires limiting capital flows)
A large NOMINAL interest rate differential may trigger “Carry Trade”
(This is more likely between developed countries)

A carry trade is a financial strategy used by investors to profit from the difference in interest rates
between two countries. Here’s how it typically works:
1.Borrowing in a Low-Interest Currency: The investor borrows money in a country with a low-
interest rate. For instance, they might take out a loan in Japanese yen if Japan has near-zero interest
rates.
2.Investing in a High-Interest Currency: The investor then converts this borrowed money into a
currency of a country with higher interest rates and invests it in assets such as bonds, which pay
higher interest rates. For example, they might convert the yen into Australian dollars to buy
Australian bonds.
3.Earning the Interest Rate Differential: The investor profits from the difference between the low
borrowing cost in the first country and the high investment return in the second country. The larger
the gap between the interest rates of the two countries, the more profitable the carry trade.
Exchange Rate Overshooting
• The exchange rate is said to overshoot when its
immediate response to a change is greater than its long-
run response.
• Overshooting is predicted to occur when monetary policy
has an immediate effect on interest rates, but not on
prices and (expected) inflation.
• Overshooting helps explain why exchange rates are so
volatile.
Stated Policy of RBI to intervene in the forex market
• The Reserve Bank of India’s policy on the exchange rate of the rupee has been to allow it to be determined by
market forces. It intervenes only to maintain orderly market conditions by containing excessive volatility in the
exchange rate, without reference to any pre-determined level or band.

• This is called ‘managed floating’. But what is the exchange rate that the RBI targets?

Too much depreciation,

RBI sells dollars
Rs/$

depreciation

Too much appreciation, RBI

buys dollars

time
Stated Policy of RBI to intervene in the forex market

In the absence of any intervention by the

Reserve Bank in the foreign exchange
market, surges and sudden stops in capital
flows and the associated disorderly
movements in the exchange rate can often
have a deleterious impact on trade and
investment, besides endangering overall
macroeconomic and financial stability.
Sterilization of Capital Flows

https://www.imf.org/external/pubs/ft/issues7/issue7.pdf
Therefore, in an Open Economy

A depreciation will decrease imports, an

appreciation will increase imports

A depreciation will increase exports, an

appreciation will decrease exports
A higher domestic interest rate
leads to a higher exchange
rate—an appreciation.
Therefore, an increase in
interest rate will reduce
consumption and investment

As a higher domestic interest

rate leads to a higher exchange
rate—an appreciation.

An increase in interest rate will

also lead a decrease in NX
Macroeconomics
The Aggregate Demand (AD) Curve
To Recap..Objectives of economic policies are to:

• Government policies are used to stabilize the economy

• Generate enough employment,
• control of inflation,
• and manage balance of payments

• These goals are achieved through use of fiscal, monetary and exchange rate policies.

• In order to make good policies, the government and central bank need to consider how
households and firms think about the future and what may disrupt their plans.

• IS-LM model is a useful (but not a perfect) toolkit to understand the economic
implications of government policies
Recap…
 Using the IS-LM Model to derive the AD curve
• We now consider how the IS–LM model can also be viewed as a theory of aggregate demand.

• We defined the IS and LM curves in terms of equilibrium in the goods and money markets, respectively.
Aggregate demand summarizes equilibrium in both of these markets.

• Recall that the IS–LM model is constructed on the basis of a fixed price level. For a given value of the price
level and the nominal money supply, the position of the LM curve is fixed.

• The real money supply changes if either the nominal money supply or the price level changes.

• Thus, we can see that changes in the price level are associated with changes in the equilibrium level of
GDP and interest rates. This is the relationship that is summarized by the aggregate demand curve.
IS–LM and aggregate demand

• So far, we’ve been using the IS–LM model to analyze the

short run, when the price level is assumed to be fixed.
• However, a change in P would shift LM and would
therefore affect Y.
• The aggregate demand curve captures this relationship
between P and Y.

• In other words, we derive the AD curve from the IS-LM

model by mapping the relationship among the variables
from an r,y plane to a P,y plane.
 Recap…Deriving the LM curve

As income increases from Y1 to Y2, money demand shifts

out, increasing the interest rate. The LM curve summarizes
these changes in the money market equilibrium.
Shifting the LM curve (when we increase prices)
Why is the AD curve downward sloping?
• If the price level is high, other things being equal, the real
money supply is low.

• This implies high interest rates and thus low investment and
output.

• If the price level falls, then the real money supply increases.

• Equilibrium in the money market implies that interest rates

must fall.

• Equilibrium in the goods market thus implies that GDP must

rise, since investment rises.

• Thus, we find that the aggregate demand curve is downward

sloping; high values of the price level are associated with low
levels of GDP and vice versa.

• Notice that the reason this curve slopes down is subtle; it is

not like the regular microeconomic demand curve for a good.
 What causes the AD curve to shift

• Any event that causes either the IS or the LM to shift will lead to a shift of the AD
curve. For example:

• Any expansionary Monetary or Fiscal Policy will shift the AD curve to the right

• Similarly, any contractionary Monetary or Fiscal Policy will shift the AD curve to
the left
Shortcomings of the IS-LM model
• First is the fact that the IS–LM model is a static model. With no reference to time, the IS–LM model
restricts in important ways the behavior of some of the variables within the model.
• For example, money is postulated to act as a medium of exchange. Without a reference to time, the effects of the
“store of value” function of money cannot be represented properly in an IS–LM model.

• Many policies work with significant and varying time lags. This aspect is not captured in the IS-LM model

• Its structural equations are postulated and are not derived from utility or profit maximization
• Though these can be incorporated from empirical studies/estimations

• Assumption of fixed price and short-run application may restrict its usefulness

• It is alleged that the model mixes up stocks (Money supply, the LM side) and flows (Investment, saving,
the IS side)

• Role of expectations are not explicitly incorporated in the model

https://www.stlouisfed.org/publications/regional-economist/2023/may/examining-long-
variable-lags-monetary-policy
From Credit, Money and Aggregate Demand by Bernanke and Blinder

https://www.ssc.wisc.edu/~mchinn/bernanke_blinder_AEAPP1988.pdf
 Chapters 12 and 13 of your textbook

Suggested reading - A Technical Note on the IS-

LM and AS-AD models (Uploaded)

Readings A note on Sterilization (Uploaded)

Selected part of Chapter 18 of Blanchard’s book

for Open Economy Macroeconomics (Uploaded)