Openness in Good

and Financial Market,

and its implication to
Output and Exchange
Rate

Based on Ch 17-19

(This PPT is only used for

teaching in Undergraduate
Class, Department of
Economics FEB UI.)
Outline

1. Openness in Good and Financial Market

2. Goods Market in Open Economy
3. Output, Interest Rate and Exchange Rate

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1. Openness in Good and Financial Market
Openness has three distinct dimensions:
1. Openness in goods markets : the ability of consumers
and firms to choose between domestic goods and foreign
goods
• Free trade restrictions include tariffs and quotas.
2. Openness in financial markets : the ability of financial
investors to choose between domestic assets and foreign
assets
• Capital controls place restrictions on the ownership of foreign
assets.
3. Openness in factor markets : The ability of firms to
choose where to locate production, and workers to
choose where to work. Example : NAFTA, AFTA

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Opennes in Good Market
( Export – Import )
•A good index of openness is When goods markets are
the proportion of aggregate open, domestic
output composed of tradable consumers must decide
goods—or goods that not only how much to
compete with foreign goods in consume and save, but
either domestic markets or also whether to buy
foreign markets. domestic goods or to buy
•Estimates are that tradable foreign goods.
goods represent around 30 - Central to the second
50% of aggregate output in decision is the price of
the Indonesia today. domestic goods relative to
foreign goods, or the (real)
exchange rate.

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Indonesia Export – •Indonesia Net Exports
Import Volume ( USD ) as Ratios of GDP 1960
- 2019

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Nominal Exchange Rates
•The nominal exchange rate is the price of the foreign currency in
terms of the domestic currency or could be vice versa.
–Note that in Indonesia we use the first definition  price of
foreign currency ( USD ) in terms of Domestic currency
( IDR )
– e.g as per May 1st  1 USD = 14.500 IDR

 An appreciation of the domestic currency is an increase in

the price of the domestic currency in terms of the foreign
currency
 Revaluation in the case of fixed exchanged rates system
 A depreciation of the domestic currency is a decrease in the
price of the domestic currency in terms of the foreign
currency
 Devalution in the case of fixed exchanged rates system

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From Nominal ER to Real ER
EP
 *
P
E = Nominal ER, P = Domestic Price , P*=Overseas Price

example
 If the price of a porsche in USA is USD300rb, and a USD is
worth 15000 IDR, then the price of this car in IDR is 300rb
x 15000 = 4.5M
 If a similar car worth Rp 4.6M in Indonesia, then the
relative price of a porsche $4.6/$4.5 = 1.022  2.2% more
expensive in Indonesia

• To generalize this example to all of the goods in the economy, we

compare a price index for the economy (the GDP deflator) to the
other economy

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From Bilateral to Multilateral Exchange Rates
Equivalent names for the relative price
•Bilateral exchange rates are of foreign goods vis á vis U.S. goods
exchange rates between two are:
countries. Multilateral The real multilateral U.S. exchange
exchange rates are exchange rate.
rates between several
The U.S. trade-weighted real
countries.
exchange rate.
• For example, to measure the
average price of U.S. goods The U.S. effective real exchange
relative to the average price of rate.
goods of U.S. trading partners, • The real effective exchange rate
we use the U.S. share of import (REER) is the weighted average of a
and export trade with each country's currency in relation to an
country as the weight for that index or basket of other major
country, or the multilateral real currencies. The weights are determined
U.S. exchange rate. by comparing the relative trade balance
of a country's currency against that of
each country in the index

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 Figure 18 - 5
•The Indonesia Real
Effective Exchange Rate
since 2010

•The increase in the

Real Effective Exchange
Rate illustrates that the
value of exports is more
expensive and the value
of imports is cheaper,
this increase indicates a
decrease in trade
competitiveness, and
vice versa.

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Openness in Financial Markets
• The purchase and sale of foreign assets implies buying or
selling foreign currency /foreign exchange.
• The balance of payments (BOP) account summarizes a
country’s transactions with the rest of the world
• Showing whether it is surplus or deficit

• BOP usually consist of two account

- Current Account Balance :
 Trade Balance : Export – import of goods and service
 Income Balance : inflow/outflow of funds due to payments or receipts
related to asset ownership or employment
 Transfer Balance: inflow/outflow of funds without any specific
economic activities such as foreign aid, grant
-Capital Account Balance
• Records flow of capital or investment : FDI and Portfolio investment

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Facts

Table 18-2 The U.S. Balance of Payments, 2003, in Billions of U.S. Dollars
Current Account
Exports 1,018
Imports 1,508
Trade balance (deficit = ) (1) -490
Investment income received 275
Investment income paid 258
Net investment income (2) 17
Net transfers received (3) -68
Current account balance (deficit = -) (1) + (2) + (3) -541
Capital Account
Increase in foreign holdings of U.S. assets (4) 856
Increase in U.S. holdings of foreign assets (5) 277
Capital account balance (deficit = -) (4)  (5) 579
Statistical discrepancy -38

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The Choice Between
Domestic and Foreign Assets

 The choice between domestic goods and

foreign goods depends primarily on the
real exchange rate.
 The choice between domestic assets and
foreign assets depends primarily on their
relative rates of return, which depend on
domestic interest rates and foreign
interest rates, and on the expected
depreciation of the domestic currency.

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Interest Rates and Exchange Rates

( 1 i t* )
•The relation between the domestic ( 1 i t ) 
nominal interest rate, the foreign nominal [ 1 ( E te1  E t )/ E t )]
interest rate, and the expected rate of
appreciation of the domestic currency  e
expectation domestic = expectation of * E t 1  E t
foreign  arbitrage or: i t i t
Et
Arbitrage implies that the domestic interest rate must be (approximately )
equal to the foreign interest rate plus the expected depreciation rate of the
foreign currency.
 Interest parity condition
 unless countries are willing to tolerate large movements in their
exchange rate, domestic and foreign interest rates are likely to move
largely together

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 2. Goods Market in Open Economy

•The goods market is in equilibrium when domestic

output equals the demand – both domestic and foreign –
for domestic goods:

Y Z
•Collecting the relations we derived for the components
of the demand for domestic goods, Z, we get:

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 Figure 19 - 2

Y= output
DD = domestic demand
AA = domestic demand for domestic
goods
ZZ = demand for domestic goods
Income increases  go to both
domestic and foreign goods  AA
( and ZZ ) is flatter than DD

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 change in demand  change in output

Figure 19 - 3
•The Effects of an Increase
in Government Spending

An increase in government
spending leads to an increase in
output and to a trade deficit.
( import increases, but export
doesnt change.
Government spending on output
is smaller than it would be in a
closed economy. This means the
multiplier is smaller in the open
economy . ( the slope is flatter )

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■ An increase in domestic demand leads to an increase in domestic output but leads
also to a deterioration of the trade balance. (We looked at an increase in government
spending, but the results would have been the same for a decrease in taxes, an
increase in consumer spending, and so on.)
■ An increase in foreign demand (which could come from the same types of changes
taking place abroad) leads to an increase in domestic output and an improvement in the
trade balance

implications:
1. Shocks to demand in one country affect all other countries.
• The stronger the trade links between countries, the stronger the interactions,
and the more countries will move together
2. These interactions complicate the task of policy makers, especially in the
case of fiscal policy.
Consider a group of countries, all doing a large amount of trade with each other Suppose all
there is a global recession  each country might be reluctant to take measures to increase
domestic demand ( import )  each country might just wait for the other countries to increase their
demand  recession is going longer ( policy coordination vs policy/trade war

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 Depreciation and the Trade Balance:
The Marshall-Lerner Condition

•The Marshall-Lerner condition is the condition

under which a real depreciation (an increase in )
leads to an increase in net exports.

N X  X ( Y  , )  IM ( Y , )/ 

the real depreciation affects the trade balance through three

separate channels:
 Exports, X, increase.
 Imports, IM, decrease
 The relative price of foreign goods in terms of domestic

goods, 1/ , increases.

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The Effects of a Depreciation ( Monetary Policy – assume that monetary
authority can influence e.r)

Figure 19 – 4 again
The depreciation leads to a
shift in demand, both
foreign and domestic,
toward domestic goods.
This shift in demand leads,
in turn, to both an increase
in domestic output and an
improvement in the trade
balance.

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Suppose output is at its natural level, but the economy is running a large trade
deficit. The government would like to reduce the trade deficit while leaving output
unchanged so as to avoid overheating. What should it do ?  Combining
Exchange-Rate and Fiscal Policies

Figure 19 - 5
•Reducing the Trade Deficit
Without Changing Output

Depreciation  export rises

( improves trade deficit )  output
increases
Fiscal contraction  improves trade
deficit  output decreases

To reduce the trade deficit without

changing output, the government must
both achieve a depreciation and
decrease government spending.

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 •The alternative way of looking at equilibrium from the condition that
investment equals saving :

Y  C  I  G  IM /  X
S Y CT
S  I  G  T  IM /  X
N X  X  IM / 
N X  S ( T G ) I
The current account balance is equal to saving—the sum of private saving
and public saving—minus investment.
A current account surplus implies that the country is saving more than it
invests.
A current account deficit implies that the country is saving less than it invests.

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 N X  S ( T G ) I
•From the equation above, we conclude:
 An increase in investment must be reflected in either an
increase in private saving or public saving, or in a
deterioration of the trade balance.
 An increase in the budget deficit must be reflected in an
increase in either private saving, or a decrease in
investment, or a deterioration of the trade balance.
 A country with a high saving rate must have either a high
investment rate or a large trade surplus.

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 3. Output, the Interest Rate, and the Exchange
Rate

•Previously, we treated the exchange rate as one of the policy

instruments available to the government. But the exchange
rate is not a policy instrument. This fact raises two obvious
questions: What determines the exchange rate? How can
policy makers affect it?
•It is very important to know the path of e.r in influencing the
economy

 The model developed in this part is an extension of the

open economy IS-LM model, known as the Mundell-Fleming
model.

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Equilibrium in the Goods Market

•The main implication of this equation

we make two simplifications:
is that both the real interest rate and
 Both the domestic and the
the real exchange rate affect demand
foreign price levels are given;
and, in turn, equilibrium output:
 the nominal and the real
 An increase in the real interest
exchange rate move together:
rate leads to a decrease in
investment spending, and to a P*
decrease in the demand for
1  E
P
domestic goods.
 An increase in the real exchange  There is no inflation, neither
rate leads to a shift in demand actual nor expected.
toward foreign goods, and to a  e  0, so r  i
decrease in net exports.
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Equilibrium in Financial markets
•People choose Bond and Money as asset
• People have a choice between domestic bonds and foreign bonds.
•Financial investors, domestic or foreign, go for the highest expected rate of
return, ignoring risk. This implies that, in equilibrium, both domestic bonds
and foreign bonds must have the same expected rate of return
 Interest parity condition

*  Et 
(1 i t )  (1 i t )   e 
 E t 1 
The left side of the equation gives the return, in terms of domestic currency,
from holding domestic bonds. The right side of the equation gives the
expected return, also in terms of domestic currency, from holding foreign
bonds

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•If the expected future exchange rate is
given, then:
This relation tells us that the current
1 i t e exchange rate depends on the domestic
E t  * E t 1
1 i t interest rate, on the foreign interest rate, and
on the expected future exchange rate.
• An increase in the domestic interest rate
The current exchange rate is: leads to an increase in the exchange
rate.
• An increase in the foreign interest rate
1i e leads to a decrease in the exchange rate.
E *E • An increase in the expected future
1i exchange rate leads to an increase in the
current exchange rate.

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 Figure 20 - 1
•The Relation Between the
Interest Rate and the
Exchange Rate Implied by
Interest Parity

A higher domestic interest

rate leads to a higher
exchange rate – an
appreciation.

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Putting Goods and Financial Markets Together

•The open-economy versions of the IS and LM

relations are:

 * 1 i e
IS : Y  C ( Y  T )  I ( Y ,i )  G  N X  Y ,Y , * E 
 1i 
M
LM :  Y L (i )
P
 Changes in the interest rate affect the economy directly through
investment,
 indirectly through the exchange rate.

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 Figure 20 - 2
•The IS-LM Model in
the Open Economy

An increase in the interest rate

reduces output both directly
and indirectly (through the
exchange rate). The IS curve
is downward sloping. The
LM curve is horizontal ( i = i*)

First effect : higher i  lower

investment  lower output
Second effect : higher i
appreciation  lower NX 
lower output

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The Effects of Policy
in an Open Economy

Figure 20 - 3
•The Effects of an
Increase in
Government
Spending

An increase in government
spending leads to an increase
in output. If the central bank
keeps the interest rate
unchanged, the exchange The increase in government spending shifts the IS
rate also remains unchanged curve to the right. It shifts neither the LM curve nor
the interest-parity curve.

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4. Intro : Exchange Rates Regimes
We have assumed so far that the central bank chose
the interest rate and let the exchange rate adjust
freely in whatever manner was implied by equilibrium
in the foreign exchange market. In many countries,
this assumption does not reflect reality.

Central banks act under implicit or explicit exchange

rate targets and use monetary policy to achieve those
targets.

These exchange rate arrangements (or regimes,as

they are called) come under many names

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4. Intro : Exchange Rates Regimes
•Flexible exchange rates : have no explicit exchange rate
targets.
•Fixed exchange rates : maintain a fixed exchange rate in
terms of some foreign currency. Some peg their currency to
the dollar , euro, currency board, or a basket of currencies
•Crawling peg : various degrees of commitment to an
exchange rate target.
•Group of countries to maintain their bilateral exchange rates
(the exchange rate between each pair of countries) within
some bands  Euro ,

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Effect of Policy under Fixed e.r
•Under a fixed exchange rate and perfect capital mobility, the domestic
interest rate must be equal to the foreign interest rate  the central
bank gives up monetary policy as a policy instrument.

Although the country retains control of fiscal policy, one policy instrument is not
enough. For example a fiscal expansion can help the economy get out of a
recession, but only at the cost of a larger trade deficit  this requires a
depreciation

Thus, Fixed e.r is not a good idea

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• There is wide agreement among economists that flexible
exchange regimes generally dominate fixed exchange rate
regimes, except in two cases:
1. When a group of countries is highly integrated and forms
an optimal currency area
2. When a central bank cannot be trusted to follow a
responsible monetary policy under flexible exchange rates.
In this case, a strong form of fixed exchange rates, such as
dollarization or a currency board, provides a way of tying
the hands of the central bank.

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