Open Economy Macroeconomics

Chapter 29 Open Economy Macroeconomics Questions

• How is the nominal exchange rate between two currencies defined?

Answer: The nominal exchange rate is the price of one country’s currency in units of another country’s currency. Specifically, the nominal exchange rate is the number of units of foreign currency that can be purchased with one unit of domestic currency.The nominal exchange rate (e) is calculated as

• When is a currency said to appreciate or depreciate?

Answer: When the nominal exchange rate goes up, the domestic currency appreciates against the foreign currency, and the domestic currency is said to be strong. When the nominal exchange rate goes down, the domestic currency depreciates against the foreign currency, and the domestic currency is said to be weak.The appreciation of one currency implies the depreciation of the other. For example, suppose the nominal exchange rate between the U.S. dollar and the Chinese yuan changes from10 yuan to 1 U.S. dollar to 8 yuan to the dollar. Each dollar buys fewer yuan, 8 instead of 10. The yuan has become costlier for buyers using the dollar. Reciprocally (literally), the yuan has appreciated. A yuan originally could only buy .1 U.S. dollars; now it can buy .125. The dollar has become “cheaper” in terms of yuan; it takes fewer yuan to “buy” one dollar. The yuan is said to have appreciated against the U.S. dollar, and conversely, the dollar has depreciated against the yuan.

• Distinguish among flexible, fixed, and managed exchange rates.

Answer: If the government does not intervene in the foreign exchange market, then the country has a flexible exchange rate, which is also referred to as a floating exchange rate. If the government sets a long- run value for the exchange rate and intervenes to defend that value, then the country has a fixed exchange rate. If the government intervenes actively in the foreign exchange market without setting a particular value for the exchange rate, then the country has a managed exchange rate. The values of managed exchange rates do change, but the fluctuations are relatively smooth when they occur.

• What are the advantages of undervaluation and overvaluation of a currency to an economy? What are

the disadvantage of each?

Answer:

Solutions Manual for Economics 3rd Global Edition By Daron Acemoglu, David Laibson, John List (All Chapters 1-29, Arranged Reverse 29-1)

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Chapter 29 | Open Economy Macroeconomics 355 Students benefit from a graphic description of the process of undervaluation of the domestic currency (overvaluation of the dollar). Continuing with the example of the yuan, Chinese authorities desire to establish a weak yuan by pegging an exchange rate at e Pegged

(the solid purple line) which is above the equilibrium exchange rate e * . This means that a dollar at the pegged exchange rate can buy more yuan at the pegged rate than the equilibrium rate. If the pegged rate is effective (binding) the supply of dollars in China will be greater than the demand implying that Chinese authorities must buy the surplus dollars equal to the distance between the supply and demand curves (the black arrow at the bottom of the graph). This process increases foreign reserves, in this case dollars, by Chinese authorities.We will continue with the example of the Mexican peso to describe the consequences of overvaluation of the domestic currency (undervaluation of the dollar). By pegging an exchange rate at e Pegged

(the solid purple line) which is below the equilibrium exchange rate e * , a dollar can buy fewer pesos. If the pegged rate is effective (binding) the demand for dollars in Mexico will be greater than the supply implying that Mexican authorities must sell dollars and purchase pesos in a quantity equal to the distance between the demand and supply curves (the black arrow at the bottom of the graph). This process decreases foreign reserves, in this case dollars, by Mexican authorities.Producers in countries with undervalued domestic currencies, e Pegged

find it easier to export their goods and services because the pegged exchange rate is above the flexible rate e *

meaning that the foreign buyers face a lower price.Foreign lenders often prefer to make loans denominated in dollars to countries histories of inflation and debt crises. Borrowers, both public and private in foreign countries like Mexico benefit if they can borrow at the flexible rate e *

and repay at the undervalued dollar rate of e Pegged.. Overvaluation also keeps the prices of consumer goods low for domestic buyers. Finally, in a country may associate a strong or appreciating currency with a strong country creating support for political leaders.The disadvantages of an undervalued domestic currency and overvalued domestic currency are the flip side of the advantages. Consumers in countries like China, which maintained an undervalued domestic currency, will pay higher prices, reducing their standard of living. Producers in countries like Mexico, which maintained an overvalued domestic currency, will find it harder to export. A country forced to move toward the flexible exchange rate may face a political backlash from groups that benefited from the pegged rate.

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Chapter 29 | Open Economy Macroeconomics 356 A floating exchange rate (the equilibrium, e * ), is the easiest to maintain. However, because a country defending an undervalued domestic currency can do so more easily than a country defending an overvalued domestic currency. It can buy excess dollars or some other foreign currency with printed local currency. A country defending an overvalued currency must do so by using reserves of the undervalued foreign currency to purchase the excess supply of the domestic currency and thus supplying the excess demand for the foreign currency.

• What does the demand curve for dollars show? Why does the demand curve for dollars slope

downward?Answer: The demand curve for dollars represents the relationship between the quantity of dollars demanded and the nominal exchange rate between the dollar and another currency—say, the euro. The demand for dollars in exchange for euros is downward sloping because a higher exchange rate increases the price of U.S. goods faced by European firms and consumers, reducing their quantity of goods demanded and thus the quantity of dollars demanded.

• What does the supply curve for dollars show? Why does the supply curve for dollars slope upward?

Answer: The dollar supply curve represents the relationship between the quantity of dollars supplied and the nominal exchange rate between the dollar and another currency—say, the euro. The supply of dollars in exchange for euros is upward sloping because a higher exchange rate increases the quantity of goods supplied by European firms to the U.S. market, thus raising their dollar earnings and the quantity of dollars supplied to the foreign exchange market.

• What does it mean to say that, at an exchange rate of $1 = 70 INR, the U.S. dollar is overvalued and

the Indian rupee (INR) is undervalued?Answer: When we say that the dollar is overvalued with respect to the rupee, we mean that the dollar is worth more rupees than it would have been under a flexible exchange rate regime. Currencies may be overvalued or undervalued in a fixed or managed exchange rate regime. Suppose the Indian central bank pegs the rupee to the dollar. An undervalued rupee means that the exchange rate (rupee per dollar) at this peg is higher than the exchange rate that would have prevailed under a flexible exchange rate regime.When the price in the foreign exchange market is higher than the equilibrium price, the quantity of dollars supplied to the market is greater than the quantity demanded in exchange for rupees. In order to maintain the peg, the Indian authorities need to buy up these surplus dollars in exchange for rupees.

• Why might a country peg its exchange rate at a level that overvalues its own currency?

Answer: In many cases, countries maintain overvalued exchange rates. There are several reasons for this: ●Most countries regularly borrow from foreign lenders. In developing countries like Mexico, these loans are typically denominated in dollars. Thus, Mexican borrowers receive dollars when they take out their loan and pay back dollars, not pesos, at the end of the loan period. If the peso appreciates after the loan is made, the number of pesos that are needed to pay back dollar-denominated debts will decrease.●An undervalued dollar—and by implication, an overvalued peso—lowers the cost that Mexican consumers pay in pesos to import goods from the United States. Consequently, the Mexican government can keep prices and inflation low by keeping the dollar undervalued and the peso overvalued.●Another reason why countries maintain an overvalued fixed exchange rate is because a fall in the value of a currency is often perceived as a failure of government policies. This perception can be a problem for incumbent politicians in democratic countries.

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Chapter 29 | Open Economy Macroeconomics 357

• How is the real exchange rate for the United States calculated?

Answer: The real exchange rate for the United States is defined as the ratio of the dollar price of a basket of goods and services in the United States divided by the dollar price of the same basket of goods and services in a foreign country. The real exchange rate between the U.S. dollar and the Indonesian rupiah is

calculated as follows:

or

• How does a change in a country’s real exchange rate affect its net exports?

Answer: When the real exchange rate increases, a country imports more from and exports less to foreign economies, reducing its net exports. Conversely, when the real exchange rate depreciates, a country imports less from and exports more to foreign economies, increasing its net exports. For example, when the U.S. dollar appreciates against the Chinese yuan, the United States imports more from China and exports less to China.

• All else being equal, explain how an increase in the real interest rate is likely to affect a country’s net

exports, labor demand, and level of employment.Answer: An increase in interest rates in the United States, relative to rates in other countries, implies that foreign investors will receive higher returns on their investments than they could elsewhere. Hence, with the increase in interest rates, foreigners will increase their demand for U.S. assets. Because assets in the United States are denominated in U.S. dollars, the demand for dollars will increase. This will shift the demand curve for dollars to the right. Given flexible exchange rates, this leads to an appreciation of the dollar relative to other currencies. An appreciation of the U.S. dollar means that American goods are more expensive for foreigners to buy, so exports will decline. Conversely, foreign goods are cheaper for Americans to buy, so imports increase. An increase in imports coupled with a decrease in exports means that net exports decline.The decrease in demand for U.S. products due to lower exports results in a decrease in demand for the labor to produce those products. This is reflected in a leftward shift of the labor demand curve, and the new equilibrium level of employment will thus be lower.

• The economy of Freedonia is currently faced with high unemployment. Explain how the Freedonian

central bank could increase net exports and lower unemployment.Answer: Two measures the bank could pursue are as follows: ●Enact expansionary monetary policy to lower interest rates. The overall stimulatory effects of this policy were discussed in previous chapters but also relate to the open economy issues that are the subject of the present chapter. Lower rates mean a decreased demand for domestic assets and therefore a decreased demand for domestic currency. This, in turn, leads to a decline in the nominal exchange rate and thus a decline in the real exchange rate. The decline in the real exchange rate means that domestic goods are cheaper for foreigners to buy and that foreign goods are more expensive for domestic purchasers to buy.Exports will increase, imports decline, so net exports go up. As net exports increase, demand for domestic goods increases, and so the demand for labor to produce those goods increases. This results in an increase in employment as the labor demand curve shifts to the right..

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