Lecture 17 - Open Economy II
1. Exchange Rate Volatility and Motivation
This figure shows substantial fluctuations in the nominal exchange rate, specifically the dollar price of £1, over time. The key insight is that exchange rates behave like asset prices rather than stable relative prices. They respond rapidly to macroeconomic conditions, expectations, and financial flows. The scale and persistence of these movements indicate that simple trade-based mechanisms alone cannot explain exchange rate dynamics, particularly in the short run.
The lecture motivates two complementary frameworks:
- Purchasing Power Parity (PPP) for long-run exchange rate determination
- A full open economy model incorporating capital flows and interest rates
Exchange rates are determined in asset markets as well as goods markets. PPP captures goods-market arbitrage, while the open economy model incorporates financial market equilibrium.
- Exchange rates are highly volatile
- Inflation explains long-run trends
- Financial markets dominate short-run movements
2. Purchasing Power Parity (PPP)
Definition and Formal Structure
Purchasing Power Parity (PPP): a long-run theory stating that identical goods should cost the same across countries when expressed in a common currency.
The PPP condition:
This implies that the nominal exchange rate adjusts to equalise price levels internationally.
Arbitrage and the Law of One Price
PPP is founded on arbitrage:
- If goods are cheaper abroad → import and sell domestically
- If goods are cheaper domestically → export
This ensures convergence of prices across countries.
If a Big Mac is cheaper in the US than the UK, traders will buy in the US and sell in the UK, pushing US prices up, UK prices down, or adjusting the exchange rate.
Implications for Exchange Rates
PPP implies:
- Exchange rates reflect relative price levels
- Inflation differentials drive exchange rate movements
Higher domestic inflation → currency depreciation
Example:
- UK inflation > US inflation
→ UK goods become expensive
→ demand for £ falls
→ £ depreciates
Integration with Monetary Theory
PPP works in tandem with the quantity theory of money:
- Money supply ↑ → price level ↑
- Price level ↑ → exchange rate depreciates
Thus:
Monetary expansion → inflation → depreciation
This creates a chain:
3. Empirical Evidence: Hyperinflation
This figure demonstrates the German hyperinflation (1921–1924), showing a close co-movement between:
- Money supply
- Price level
- Exchange rate
As money supply increased dramatically, inflation surged, and the currency depreciated rapidly. When monetary growth stabilised, both prices and the exchange rate stabilised.
This provides a near textbook example of PPP holding strongly.
In extreme inflation, monetary factors dominate all other influences, making PPP highly predictive.
Use hyperinflation as empirical validation of PPP in long-run answers
4. Limitations of PPP
PPP is not a complete theory:
- Non-tradable goods (services cannot be arbitraged)
- Product differentiation (BMW vs Toyota)
- Transaction and transport costs
- Market frictions
PPP assumes perfect arbitrage and identical goods, which rarely holds in reality. Therefore, real exchange rates vary over time.
- PPP works best in the long run
- Poor predictor of short-run exchange rates
5. Transition: Why PPP is Not Enough
PPP explains long-run exchange rates but:
- Says nothing about trade deficits
- Ignores capital flows
- Cannot explain short-run volatility
This motivates a broader framework: the open economy model.
6. Structure of the Open Economy Model
The model integrates two key markets:
- Loanable funds market
- Foreign exchange (forex) market
Assumptions:
- Real GDP fixed (factor supply + technology)
- Price level fixed (short-run focus)
7. Market for Loanable Funds
This diagram extends the closed economy framework to include international investment. National saving finances both domestic investment and foreign investment (NCO).
Core Identity
Net Capital Outflow (NCO): the net purchase of foreign assets by domestic residents.
Interest Rate Determination
- Supply:
- Demand:
Higher
→ saving ↑, investment ↓, NCO ↓
Key Insight
Unlike the closed economy:
- This market determines both
The interest rate equilibrates intertemporal consumption and investment decisions, while also determining international capital allocation.
8. NCO and Interest Rates
This figure shows a negative relationship between the real interest rate and net capital outflow.
- High
- Low
The existence of negative NCO reflects international borrowing.
Investors chase returns. If UK interest rates rise, global capital flows into the UK.
9. Foreign Exchange Market
The forex market determines the real exchange rate.
- Supply of pounds =
- Demand for pounds =
The supply curve is vertical because NCO is determined in the loanable funds market.
Mechanism
Higher
→ exports ↓, imports ↑ → NX ↓
Thus:
- Exchange rate adjusts to balance NX and NCO
10. General Equilibrium
This figure integrates the entire model:
- Loanable funds → determines
- Together determine external balance
11. Trade Policy
Import Quotas
An import quota initially increases net exports by reducing imports. However, this raises demand for domestic currency, leading to appreciation. The appreciation reduces exports, offsetting the initial increase.
Key Result
Trade policy does not affect net exports in equilibrium
Because:
Thinking protectionism improves trade balance. It only changes composition.
12. Capital Flight
Capital flight increases NCO due to perceived risk.
Effects:
- Demand for loanable funds ↑
- Interest rate ↑
- Currency supply ↑ → depreciation
Capital flight reflects a shift in global portfolio preferences due to risk, illustrating the role of expectations and credibility.
13. Budget Deficits and Twin Deficits
Budget deficits reduce national saving, shifting supply of loanable funds left.
Mechanism:
- Appreciation →
Twin deficits: simultaneous budget deficit and trade deficit.
- Fiscal deficit crowds out investment
- Leads to capital inflow
- Causes currency appreciation
- Worsens trade balance
14. Final Synthesis
The open economy is governed by two key equilibrium conditions:
- Loanable funds market → determines
- Forex market → determines
These jointly determine:
- Saving
- Investment
- Capital flows
- Trade balance
Always link
Bibliography
Mankiw, N.G. and Taylor, M.P. (2023) Macroeconomics. 6th edn. Andover: Cengage Learning EMEA.
Jensen, M.K. (2026) ECON1002 Open Economy Macroeconomics II Lecture Slides. University of Nottingham. oai_citation:0‡Week_9_1.pptx