Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 14 Money in the Open Economy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved.

Chapter 14

Money in the Open Economy

Copyright © 2008 Pearson Addison-Wesley. All rights reserved. 14-2

Chapter 14 Topics

• Exchange rates and purchasing power parity.

• Flexible and fixed exchange rates.

• Monetary small open economy – fixed and flexible exchange rates.

• Capital controls.


Equation 14.1

The purchasing power parity relationship – prices are equalized across countries in terms of the currency of one country.


Table 14.1 Purchasing Power Parity and the Big Mac Index


Figure 14.1 The Real Exchange Rate for Canada vs. the United States


A Monetary SOE – Flexible Exchange Rate

• Model is identical to the small open economy model with production and investment in Chapter 13, with an added money market.

• The nominal exchange rate is essentially determined by nominal money demand and supply.


Figure 14.2 The Goods Market in the Monetary Small Open-Economy Model


Equation 14.2

In the monetary SOE model, we assume that purchasing power parity always holds.


Equation 14.3

Money demand depends on P, Y, and the world real interest rate r*.


Equation 14.4

Substituting in the money demand equation using the purchasing power parity relationship, and equating money demand with money supply gives:


Figure 14.3 The Money Market in the Monetary Small Open-Economy Model with a Flexible Exchange Rate


Figure 14.4 An Increase in the Money Supply in the Monetary Small Open-Economy Model with a Flexible Exchange Rate


Main Results with Flexible Exchange Rate

• Money is neutral – the price level and nominal exchange rate increase in proportion to the money supply increase.

• A flexible exchange rate implies that the domestic price level is insulated from movements in the foreign price level.

• A change in the world real interest rate will affect the domestic price level.


Figure 14.5 An Increase in the Foreign Price Level in the Monetary Small Open-Economy Model with a Flexible Exchange Rate


Figure 14.6 An Increase in the World Real Interest Rate with a Flexible Exchange Rate


Monetary SOE Model – Fixed Exchange Rate

• In this version of the model, the domestic money supply becomes endogenous rather than the exchange rate.

• The money supply changes to equate money supply and money demand at the fixed exchange rate.


Figure 14.7 The Money Market in the Monetary Small Open-Economy Model with a Fixed Exchange Rate


Table 14.2 A Simplified Government Balance Sheet


Main Results with a Fixed Exchange Rate

• The SOE cannot have a monetary policy that is independent of what happens in the rest of the world.

• An increase in the foreign price level causes a proportionate increase in the domestic price level.

• A change in the world real interest rate has no effect on the price level.


Figure 14.8 An Increase in the Foreign Price Level in the Monetary Small Open-Economy Model with a Fixed Exchange Rate


Figure 14.9 An Increase in the World Real Interest Rate with a Fixed Exchange Rate


Capital Controls

• Capital controls can dampen the effects of macroeconomic shocks that come from abroad.

• However, capital controls cause inefficiencies in world credit markets.


Figure 14.10 A Devaluation in Response to a Temporary Total Factor Productivity Shock


Figure 14.11 A Temporary Total Factor Productivity Shock, With and Without Capital Controls


Figure 14.12 A Total Factor Productivity Shock Under a Fixed Exchange Rate,With and Without Capital Controls

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Copyright © 2008 Pearson Addison-Wesley. All rights reserved. Chapter 14 Money in the Open Economy