Macroeconomics

Session 16: International Linkages

Dr. Jithin P
IIM Raipur
 Types of Exchange Rate
System

Fixed exchange rate system

• Under this system, the exchange rate for the
currency is fixed by the government. Thus, the
government is responsible for maintaining the
stability of the exchange rate.
• Each country maintains the value of its currency
in terms of some ‘external standard’ like gold,
silver, another precious metal, or another
country’s currency.
Changes in Demand and Supply: Exchange Rate
fluctuations in a Fixed Exchange Rate System
• In a fixed/pegged exchange rate environment, the exchange rate of a country is
fixed against a foreign currency (e.g. $1=Rs 50).
• The Central Bank is committed to maintain the pegged rate.
• Intervention is the buying and selling of foreign exchange by the central bank.
• An increase in domestic interest rate leads to an increase in supply of dollar.
• This leads to an increase in excess supply of dollar at the pegged exchange rate.
• The Central Bank buys the dollar, which, in turn, leads to an increase in bank
reserves.
• The buying of forex in the foreign exchange market leads to an increase in money
supply.
Exchange Rates
per US Dollar, 2000
to 2019 (Fixed ER
Regime)
Flexible Exchange rate system
• In a flexible exchange rate system, the value of the
currency is allowed to fluctuate freely as per the changes in
the demand and supply of the foreign exchange.
• Under this system, the exchange rate for the currency is
fixed by the forces of demand and supply of different
currencies in the foreign exchange market.
• This system is also called the Floating Rate of Exchange or
Free Exchange Rate. It is so because it is determined by the
free play of supply and demand forces in the international
money market.
• The exchange rate is determined through interactions of
banks, firms, and other institutions that want to buy and
sell foreign exchange in the foreign exchange market.
Flexible Exchange rate system
Demand for US dollars
• The demand for US dollar increases when there is an increase
in
• (a) India’s Demand for US goods and services (imports)
• (b) US interest rate relative to domestic interest rate (want to
buy US financial assets)
• (c) Expected change in exchange rate (depreciation of Rupee)
• All of them will shift the demand for dollar curve to right and
will lead to an increase in exchange rate (i.e. value of 1 dollar
increase from Rs 50 to Rs 55) It is called depreciation of rupee.
The rupee has depreciated by 10%.
Flexible Exchange rate system
Supply of US dollars
• The supply of US dollar increases when there is an increase
in
• US Demand for Indian goods and services (our exports)
• India’s interest rate relative to US interest rate (want to
buy Indian financial assets)
• Rupee is expected to appreciate
• All of them will shift the supply of dollar curve to right and
will lead to a decrease in exchange rate (i.e. value of 1 dollar
decreases from Rs 50 to Rs 45) It is called appreciation of
rupee.
Changes in Demand and Supply: Exchange Rate fluctuations in a
Managed Floating Exchange Rate System

• The managed floating exchange rate system is a mixture

of a flexible exchange rate system (the float part) and a
fixed exchange rate system (the managed part).
• It is also known as dirty floating.
• The Central Banks intervene to buy and sell foreign
currencies in an attempt to moderate exchange rate
movements whenever they feel that such actions are
appropriate.
• India has had a managed floating exchange rate system
since 1993.
What determines Net Exports?

• Net export (NX): The difference between export and

import. It is one of the important components of
aggregate demand.
• What determines net exports? How net exports
determine our GDP?
• In an open economy, domestic consumers, investors,
government have to make a decision: whether to buy
domestic goods or foreign goods .
• It depends on:(i) relative price or real exchange rate
(RER). The RER is the price of foreign goods relative to
the price of domestic goods, (ii) foreign income (Yf), and
domestic income (Y)
Net Exports
• Net exports, (X-M), is the excess of exports over imports
• NX depends on
✓ Domestic income, 𝑌
✓Foreign income, 𝑌𝑓
✓Real exchange rate, 𝑅
𝑁𝑋 = 𝑋 𝑌𝑓 , 𝑅 − 𝑀 𝑌, 𝑅 = 𝑁𝑋 𝑌, 𝑌𝑓 , 𝑅
• A rise in foreign income, other things being equal, improves the home
country’s trade balance and therefore raises the home country’s aggregate
demand.
• A real depreciation by the home country improves the trade balance and
therefore increases aggregate demand.
• A rise in home income raises import spending and hence worsens the trade
balance.
Goods market equilibrium
• Marginal propensity to import = fraction of an extra dollar of income spent on
imports
• IS curve now includes NX as a component of AD:

IS : Y = DS (Y , i ) + NX (Y , Y f , R )
• A real depreciation increases the demand for domestic goods → shifts IS to the
right
• An increase in Yf results in an increase in foreign spending on domestic goods→
shifts IS to the right
 Goods Market Equilibrium
• Higher foreign spending on our goods
raises demand and requires an
increase in output at given interest
rates
– Rightward shift of IS

• Full effect of an increase in foreign

demand is an increase in interest rates
and an increase in domestic output
and employment

©McGraw-Hill Education.
 Capital Mobility
• High degree of integration among financial markets → markets in which bonds and
stocks are traded
• Start our analysis with the assumption of perfect capital
mobility
– Capital is perfectly mobile internationally when investors can
purchase in any country, quickly, with low transaction costs , and in
unlimited amounts
– Asset holders willing and able to move large amounts of funds across
borders in search of the highest return or lowest borrowing cost
– Interest rates in a particular country can not get too far out of line
without bringing capital inflows/outflows that bring it back in line

©McGraw-Hill Education.
The Balance of Payments and Capital Flows

• Assume a home country faces a given price of imports, export

demand, and world interest rate, and capital flows into the home
country when the interest rate is above world rate.
• Balance of payments surplus is: BP = NX (Y , Y f , R) + CF (i − i f )
• where CF is the capital account surplus
• The trade balance is a function of domestic and foreign income
• The capital account depends on the interest differential
Determinants of BOP and overall BOP
Equilibrium (Foreign Exchange Market)
Foreign exchange market reaches equilibrium:
• When demand for dollars is equal to supply of dollars or
• When receipts are equal to payments in BOPs accounts or
• When the sum of current account and capital account is
equal to zero
• When the overall balance of payments is in balance
• This implies that if the sum of current and capital account is
positive(negative), the overall BOP is in surplus (deficit) and
the foreign exchange market is in disequilibrium.
Derivation of Balance of Payments(BP)
Curve

• The BP curve shows a combination of domestic interest rate (i) and

real GDP (Y) at which foreign exchange market/ over all balance of
payment reaches equilibrium.
• Current Account (Trade) balance= 𝑓(𝑌, 𝑅, 𝑌𝑓 )
• Capital Account balance= f 𝑖, 𝑖𝑓
Where, Y=domestic real GDP, 𝑌𝑓 =foreign real GDP,
R=real exchange rate, i=domestic interest rate, 𝑖𝑓 =foreign interest rate
• Assumption: free mobility of goods and services and capital
• The BP curve shows a combination of domestic interest rate (i) and
real GDP (Y) at which foreign exchange market/ over all balance of
payment reaches equilibrium, keeping other things (𝑌𝑓 , 𝑃, 𝑃𝑓 , 𝑅)
constant.
 Upward sloping BP Curve

• The BP curve tells us that an increase in

domestic income(Y), which worsen the current
account (trade) balance, has to be accompanied
by an increase in domestic interest rate, which
improves the capital account so that the overall
BOP/foreign exchange market reaches
equilibrium.
• It is upward slopping because an increase in
GDP calls for an increase in domestic interest
rate to maintain overall BOP equilibrium.
• Any point below(above) and to the right (left) of
BP curve indicates an overall BOP deficit
(surplus).
Horizontal BP
• The slope of BP curve depends on the
degree of substitutability between
domestic and foreign financial assets.
• If the domestic and foreign financial assets
are close substitutes, the curve will be
flatter (international capital is more
interest elastic).
• If they are perfect substitutes, the BP
curve will be a horizontal line (international
capital is perfectly interest elastic).
Output Determination (IS-LM Model) in an Open Economy

• The effects of policies (adjustment process)

depend on exchange rates regime, ie
whether the country has a fixed or a
flexible exchange rate regime.
• Let us consider some countries where the
exchange rate is fixed (Hong Kong, Oman,
Qatar etc).
Monetary Policy is Ineffective under a Fixed Exchange Rate System

• Consider a monetary expansion that starts from

point E shifts LM down and to the right to E’
• At E’ there is a large payments deficit, and
pressure for the exchange rate to depreciate
• Central bank must intervene, selling foreign
money, and receiving domestic money in
exchange
• Supply of money falls, pushing up interest rates
as LM moves back to original position
• Conclusion: When there is a fixed exchange rate
system and perfect capital mobility, central bank
cannot conduct an independent monetary policy. The
home country’s interest rate is determined by foreign
(US) interest rate.