Lecture Notes: Open Economy and Exchange Rates

Introduction to Open Economy

• Revisiting the early parts of the course focusing on short-term models in an open economy.
• Emphasis on the concept of openness and key relative prices in an open economy.

Real Exchange Rate

• Definition: Relative prices of domestic goods versus foreign goods, adjusted to a common currency.
• Real Appreciation: Domestic goods become more expensive relative to international goods when the real exchange rate increases.
• Real Depreciation: Domestic goods become cheaper relative to foreign goods when the real exchange rate decreases.

Openness in Financial Markets

• Decision to invest in domestic vs. foreign assets.
• Importance of expected relative returns rather than current exchange rates.
• Example: Comparing US and UK bonds, considering both interest rates and expected exchange rate changes.
• Interest Rate Parity Condition: In equilibrium, returns on domestic and foreign investments should be equal, adjusted for expected currency appreciation/depreciation.

Two Concepts of Openness

1. Goods Market Openness: Ability to buy goods domestically or abroad.
2. Financial Market Openness: Ability to invest in domestic or international financial assets.

Transition to Goods Market Focus

• Temporarily focusing only on goods market openness, exploring imports and exports.
• Revisiting the AS-AD model, incorporating imports and exports.

Distinction Between Domestic and Domestic Demand for Goods

• Domestic Demand for Goods: Demand by residents, includes consumption, investment, and government expenditure.
• Demand for Domestic Goods: Includes domestic demand minus imports, plus exports.

Imports and Exports Functions

• Exports (X): Increase with foreign output (Y*) and decrease with real exchange rate appreciation.
• Imports (IM): Increase with domestic output and real exchange rate appreciation.*

Equilibrium in Open Economy

• ZZ Curve: Represents demand for domestically produced goods, accounting for imports and exports.
• Multiplier Effect: Lower in an open economy due to part of demand going to foreign goods.
• Trade Balance: Point where domestic demand for goods equals demand for domestically produced goods.

Fiscal Policy and Trade Balance

• Fiscal expansion results in higher output but can lead to trade deficits.
• Higher foreign demand (e.g., China's growth) boosts domestic output without increasing trade deficits.

Exchange Rate Influence

• Depreciation improves trade balance by making domestic goods cheaper.
• Integrated policy response: depreciating currency can improve trade and control output through fiscal adjustments.

Conclusion

• Open economy introduces new dynamics with goods and financial market openness.
• Importance of relative prices and exchange rates in determining demand and investment decisions.
• Upcoming lecture to integrate financial market openness for a comprehensive model.