Topic 6

Open Economy II
Explanation and notes
• 6.1 Nominal and Real Exchange Rates
• 6.2 Determine Exchange Rate
• 6.3 Policies and Exchange Rate
• 6.4 Purchasing Power Parity
6.1: Nominal and Real Exchange rates
• Nominal Exchange rate: only the “exchange rate”
• Example: MYR4.4 = USD1
• When Exchange Rate “depreciates”, or cheaper
• Our products are cheaper, which we should export more
• Net export is higher
• A problem
• It ignores “inflation“
• Example
• Currency depreciates 10%  our products 10% cheaper  we sell
10% MORE  export increased 10%
• But if inflation is 10%  our products 10% more expensive  we sell
10% LESSER  export decreased 10%
• At last  no change at net export
• Nominal exchange rate only captures “exchange rate” but ignore
“inflation”
• We need something capture both to reflect how exchange rate affects
the trade
• Real Exchange Rate  captures both “exchange rate” and “inflation”
• Reflects better the “purchasing power”
6.2 Determine Exchange Rate
• Then how exchange rate is determined?
• Two factors
• Net capital outflow, NCO
• Net export (or trade balance), NX
Net capital outflow, NCO
• Net capital outflow = Saving – Investment
• Or NCO = S – I
• Saving is the LOCAL supply of loanable fund
• Investment is the LOCAL demand of loanable fund

• When Saving > Investment

• Supply is MORE than demand, the market is HAVING additional fund
• The additional fund from local is flowing OUT
• Saving is the LOCAL supply of loanable fund
• Investment is the LOCAL demand of loanable fund

• When Saving < Investment

• Supply is LESSER than demand, the market NEEDS additional fund
from other countries
• the additional fund from foreign is flowing IN
• Net Capital OUTFLOW, NCO = S – I
• S > I  capital flow out
• NCO positive
• S < I  capital flow in
• NCO negative
• Since NCO is come from Saving and Investment, both are NOT
affected by Exchange Rate
• It is affected by Interest Rate, NOT exchange rate
• NCO is therefore “vertical” sloping
Net Export, NX
• Net export = Export – Import
• Or, NX = X – M
• Export is higher when currency is cheaper (depreciate) as the local
products are cheaper
• Export is lower when currency is expensive (appreciate) as the local
products are expensive

• NX is NEGATIVE related with Exchange Rate

• Negative relationship = downward sloping
• NX is thus downward sloping
6.3 Policies and Exchange Rate
• Any policy that affecting either NCO or NX will affecting the Exchange
Rate
• Fiscal Policy: Affecting the TAX and/or Government SPENDING
Fiscal Expansion
• Fiscal Expansion
• Gov’t spends more (higher G)
• Or
• Lower Tax (lower T)  gov’t income lower
• Gov’t spends more or gov’t income lower = PUBLIC SAVING lower

• Recall: public saving = Gov’t income – Gov’t spending

• Or T – G
• Lower public saving = lower Saving
• NCO = S – I
• Lower Saving = lower NCO
• Lower NCO = lesser capital flow out
• Lesser capital flow out = lesser LOCAL currency available in the market
• Lesser supply causing local currency appreciate
• Currency appreciate causing local products expensive
• Thus, lower export = lower NX
• Still, Fiscal Expansion
• But now it is at “foreign country”
• A major economy that will affect others
• The foreign country spends more or lower tax
• The foreign country having lower PUBLIC SAVING = lower Saving
• The foreign country having lower saving = lower supply of loanable
fund
• Lower supply of loanable fund = higher interest rate
• The foreign country is a “major economy” that affecting others
• Higher interest of the foreign country causing

• Example
• US interest rate is 5%
• MY interest rate is 3%
• If possible, we prefer to save in US = fund is flowing OUT from MY to
US
• The fund is flowing OUT from local to foreign
• More fund flowing out = higher NCO

• We want to invest at US, we need USD

• When we need USD, we need to BUY USD by SELLING MYR

• SELLING local currency = more supply of local currency in market

• More supply = local currency depreciates
• Local currency depreciates = our products cheaper
• Our products cheaper = we sell more = higher export = higher NX
Investment
• NCO = S – I
• Investment higher = lower NCO

• Local market NEEDS more fund

• Lesser extra fund available to flow out = lower capital outflow
• Lesser capital outflow = we demand lesser foreign currency
• And we sell lesser local currency

• Sell lesser local currency = lesser supply of local currency in market

• Lesser supply = local currency appreciates

• Local currency appreciates = local products expensive = lower NX

Trade policy
• Restrict import = lower import
• NX = X – M
• Lower import = lower M = higher NX

• We buy lesser from foreign, we need to pay lesser to foreign sellers

• We need lesser foreign currency = we sell lesser local currency

• Sell lesser local currency = lesser supply = local currency appreciates

• Local currency appreciates = our products expensive = we sell lesser
• We sell lesser = lower export = lower NX

• Initially, lower import = higher NX

• It causes currency appreciates
• In turn, lower export = lower NX
• NX remained
• Affecting the Trade Balance without adjusting NCO will have NO LONG
RUN impact on the economy

• Example
• US in 1980s and 1990s
6.4 Purchasing Power Parity (PPP)
• The idea is the similar product in TWO countries should reflect the
Exchange Rate

• Example
• MYR4.4 = USD1
• Then a chicken rice selling at MYR4.4 in MY should sell at USD1 at US
• If it is not, then “arbitrage” available
• Example
• MYR4.4 = USD1
• Then a chicken rice selling at MYR4.4 in MY should sell at USD1 at US

• If the chicken rice is selling at USD1.2 in US

• It is “cheaper” at MY and “expensive” in US
• We can easily make profit through “buy low sell high”

• We buy the chicken rice at MY at MYR4.4

• Then we sell it at US at USD1.2

• Based on MYR4.4 = USD1

• The revenue of USD1.2 can convert to MYR5.28
• A profit of “MYR1.28” through buy low sell high
• If everyone is doing the same
• All buy chicken rice in MY and selling it at US
• Then convert USD to MYR = selling USD and buying MYR
• Selling USD = more supply USD = USD depreciates
• Buying MYR = more demand MYR = MYR appreciates

• Then chicken rice will make the exchange rate becomes

• MYR4.4 = USD1.2
• Then we can no longer make profit from chicken rice

• The idea of “purchasing power parity”

• PPP might not perfectly reflect in real world
• Transportation cost
• Resource to produce
• Preference of customers
• They all make the price not similar in different countries

• It is, however, a good reference