Open Economies

Vipul Mathur ⇤

November 28, 2018

1 Law of One Price

The nominal exchange rate is the price of one currency in terms of another currency. If there are two countries US

and India, then the exchange rate of US dollar is the price of dollar in terms of rupees. The law of one price, states

that under free competition and in the absence of trade impediments, a good must sell for a single price regardless

of where in the world it is sold. Therefore, if the price of the good in the domestic economy, say US, is P dollars,

and if the exchange rate of 1dollar in terms of rupees is given by E then,

P⇤
P =
E

where P ⇤ in Indian rupee is the price of the good in India. We can also write the above as

P⇤
E=
P

Now, imagine that there is a US i-phone and Indian i-phone. The US iphone is priced at P dollars. So if you sell a

US iphone in US, you will get P dollars. If you take these P-dollars and convert them into rupees, you will get EP

rupees. Suppose that Indian i-phone is priced at P ⇤ rupees, so in EP rupees, you will be able to get EP
P⇤ Indian

iphones (assume iphone is divisible). So effectively, one US iphone fetches you EP

P⇤ Indian iphones. More generally
⇤ Prepared for Macroeconomics course. E-mail: vipul@iimcal.ac.in

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we can write that
EP
1U S good = Indian goods
P⇤

or, more generally we can write

1 domestic good = ✏ foreign goods

Therefore, by this token, ✏ becomes the real exchange rate between the two countries:

EP
✏=
P⇤

2 Interest Parity Conditions

Imagine there are two countries: United States and India. Now let’s say you are a global investor sitting in New

York and you have some D dollars with you. You have two assets where you can invest: either you can invest in

US Treasury Bonds or you can invest in Indian Government Bonds.

US Treasury Bonds: For you to be able to invest in these bonds, you need to have dollars. Luckily, you have D

dollars with you, which you can readily invest. The bond promises to pay an interest rate of iU
t
S
which will accrue

to you next period, t + 1. So the dollars which you will have in period t + 1 will be

D(1 + iU S
t ) dollars (1)

Indian Government Bonds: For you to be able to invest in these bonds, you need to have Rupees. Unfortunately,

you don’t have immediate rupees but only dollars. So you will have to convert your D dollars to some rupees first

- today, which is t. Let’s say that in time period t for each dollar you get Et rupees. So for D dollars, you will get

Et D rupees. Also note, that by this token, Et becomes the exchange rate for 1 dollar, in terms of rupees. Now,

this Indian bond promises to pay you iIN

t
D
in period t + 1. But remember that since this is an Indian bond, the

payment will be in terms of rupees. So let’s say you invest in this bond at time t, so that the money you will have

in t + 1 will be

Et D(1 + iIN
t
D
) rupees

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 Now, you are a US investor, so naturally you will want to convert these rupees back to dollars at some exchange

rate. At time period t, you can only have an expectations about the exchange rate that would prevail in time period

t + 1. Let’s say that exchange rate is Et+1

e
.

So the money in dollars that you will have in time period t + 1 will be

Et D(1 + iIN
t
D
)
e dollars (2)
Et+1

Now in the international asset markets, the two assets should give the same payoffs because otherwise, by arbitrage

mechanism, there will be opportunities to make profits, which over time, will be driven to zero. Therefore, the

resultant dollars in time period t + 1 should be equal from both the assets:

Equating (1) with (2)

Et D(1 + iIN
t
D
)
D(1 + iU S
t )= e
Et+1

Rearranging the terms yields us

Et
(1 + iU S IN D
t ) = (1 + it ) e
Et+1

More generally, if we treat US as the domestic currency, IND as the foreign currency and E as the price of dollars

in terms of rupees, we can write the above as

Et
(1 + it ) = (1 + i⇤t ) e (3)
Et+1

where it is the nominal interest rate in the domestic country, i⇤t is the nominal interest rate in the foreign country.

The relation embodied in equation (3) is called as the (un-covered) interest rate parity condition (UIP).

Let’s rewrite UIP as

(1 + i⇤t )
(1 + it ) = e
Et+1
Et

or,
1
(1 + it ) = (1 + i⇤t )[ Ee
]
1+ ( Et+1
t
1)

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or,
e
Et+1 Et
(1 + it ) = (1 + i⇤t )[1 + ( )] 1
Et

Taking logs on both sides

e
Et+1 Et
log(1 + it ) = log(1 + i⇤t ) log[1 + ( )]
Et

To expand this we will use a simple result that

log(1 + x) ⇡ x for small values of x

Using this result we can rewrite the UIP as

e
Et+1 Et
it ⇡ i⇤t ( ) (4)
Et

This is a powerful result, which tells you the relationship between the nominal interest rates of two countries and

the nominal exchange rate between the two currencies of those two countries. Let’s look at the exchange rate term

closely: Et+1
e
is the expected exchange rate; if Et+1
e
is higher than Et then it is equivalent to suggesting that you are
e
Et+1 Et
expecting the currency to appreciate. So ( Et ) is the expected rate of appreciation of the domestic currency.

Therefore, UIP tells us that:

Domestic nominal rate = f oreign nominal rate expected rate of appreciation

Now, UIP holds when the two assets (in our example, the US bonds and Indian bonds) have (1) similar duration

(2) similar risk features and (3) zero transaction costs of exchanging currencies.

Typically, in forex markets, at any point in time there are two prices: spot price, St which is the exchange rate

at period t and a variety of forward prices, Ft+i for all the future periods t + i > t. These forward prices are a

feature of the "forward contracts" which the traders enter into with each so as to "cover" their risks arising from

uncertain movements in the exchange rate in future. When we use spot and forward prices in the UIP, we can write

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it as
St
(1 + it ) = (1 + i⇤t ) (5)
Ft+1

Note that the forward rate is not the expected rate anymore. It is already known at period t. The relationship in

equation (5) is called as the covered interest rate parity condition.

Ft+1 St
Additionally, the difference between the forward and spot rates, St ⌘ f , is called as the forward premium and

the above is often written as

f = i⇤t it

Of these two conditions, which of them holds true in reality? Empirically, CIP is found to be true more or less,

but there are departures from UIP. This means that forward rate Ft+i is not an unbiased predictor of the future

spot prices, Et+1

e
.

3 Real Interest Rates

Now, having established the parity for nominal interest rate, we can use the relation to rewrite the parity in real

interest rate terms. We know from the Fisher equation that

1 + it
1 + rt = e
1 + ⇡t+1

or,
e
1 + it = (1 + rt ) ⇤ (1 + ⇡t+1 )

We can substitute for (1 + it ) and similarly, for (1 + i⇤t ) into the UIP to get:

e (1 + rt⇤ ) ⇤ (1 + ⇡t+1
⇤e
)
(1 + rt ) ⇤ (1 + ⇡t+1 )= e
Et+1
Et

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or,
⇤e
(1 + ⇡t+1 )
(1 + rt ) = (1 + rt⇤ ) E e
t+1 e )
⇤ (1 + ⇡t+1
Et

or,
⇤e
Pt+1
P ⇤
(1 + rt ) = (1 + rt⇤ ) E e t P e
E t ⇤ Pt
t+1 t+1

or,
Et PPt⇤
(1 + rt ) = (1 + rt⇤ ) t
e
e Pt+1
Et+1 ⇤e
Pt+1

Now, we know that the real exchange rate

Pt
e t = Et
Pt⇤

so, we can rewrite the parity relation as

et
(1 + rt ) = (1 + rt⇤ ) (6)
eet+1

or, approximating as before

eet+1 et
rt = rt⇤ (7)
et

4 Exchange rates determination

We can rewrite the UIP in equation (3) as

(1 + it ) e
Et = E
(1 + i⇤t ) t+1

Similarly, for the next time period, t + 1, we can write

(1 + iet+1 ) e
Et+1 = Et+2
(1 + i⇤e
t+1 )

We can keep on doing this for future time periods, and at the end we can substitute all these relations into UIP to

give us
(1 + it ) (1 + iet+1 ) ...(1 + iet+n ) e
Et = Et+n+1
(1 + i⇤t ) (1 + i⇤e ⇤e
t+1 ) ...(1 + it+n )

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There are three conclusions to be drawn here:

1. The exchange rate today can move due to interest rates in both the economies.

2. Signals about the future interest rates can lead to adjustment in the exchange rate today.

3. Expectations about the future exchange rate can move the exchange rate today. Since these expectations can

change frequently, the movement in the exchange rate today can be frequent and perhaps also large. This

renders the exchange rate as intrinsically volatile.

One can also derive a similar expression for the real exchange rate as

e e
(1 + rt ) (1 + rt+1 ) ...(1 + rt+n ) e
et = ⇤ ⇤e ⇤e ) et+n+1 (8)
(1 + rt ) (1 + rt+1 ) ...(1 + rt+n

Generally, its easier to predict the real exchange rate because the long-run value is pinned at 1 and the real rates

tend to be less volatile (where as nominal exchange rate also involve a prediction on the future inflation rates via

the nominal rates).

5 Impossible Trinity

The Mundell-Fleming economic trilemma was formulated by Mundell and Fleming from the classic IS-LM model

in a small open economy in the early 1960s. There are three commendable monetary policy goals:

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 1. exchange rate stability: to promote stability in trade and investment by reducing exchange rate volatility and

preferable, cheaper exchange rate to remain competitive on the global marketplace

2. capital markets integration/openness: open its capital markets to allow full cross-border capital mobility to

promote efficient capital allocation and risk sharing, permit global portfolio for domestic players and attract

foreign investments

3. sovereign monetary policy: run a domestic independent monetary policy to manage its business cycles, manage

interest rates to stimulate the economy.

The Impossible Trinity is a hypothesis which states that a country can only choose 2 of these 3 objectives.

6 Mundell-Fleming Hypothesis

Now, recall that the real exchange rate is given by

EP
✏=
P⇤

In simple words, real exchange rate is the real terms of trade of goods and services across two countries. In the long-

run, we expect this to acquire a value of 1, but ofcourse, in the short-run, when both the countries are constantly

being subjected to shocks, this value will deviate from 1.

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 In presence of sticky-inflation (or prices) both P and P ⇤ are rather slow to adjust. Which means that P
P⇤ would

be rather sluggish, and not change much. So effectively, the changes in ✏ will come from changes in E mostly.

Let’s dig a little deeper and try to understand why E can change. E in the long run is pinned down by monetary

aggregates in respective countries. So shocks to monetary factors can change E. Further, in the short run, E is

being determined by the supply and demand in the forex market. The participants in the foreign markets are the

legitimate exporters/importers, traders and also speculators. When the changes happen at the exporters/importers

side, one would expect these changes to originate from the real sector of the economy. So E can change due to real

factors too.

Now, when only the monetary factors change, nothing on the real side changes. So one would not want the real

terms of trade to get affected (or, ✏). However, when the economy is subjected to real shocks, such as productivity

or preferences, you would want the real terms of trade to optimally reflect that change. By keeping E fixed, ✏ is

insulated from monetary shocks, whereas, by keeping E flexible (or floating), ✏ can respond to real shocks. This is

the essence of Mundell-Fleming dictum in the choice of exchange rates. The underlying assumption ofcourse, is the

sticky inflation assumption.

7 Sterilized Intervention

If a central bank is committed to maintaining a fixed level of exchange rates, it would have to often intervene

in the foreign exchange markets, and buy or sell foreign currency to alleviate the pressure on the exchange rate.

Such intervention, necessarily imply changing the supply of domestic currency - and therefore, stoking inflationary

pressures in the domestic economy.

To avoid such impact on the domestic economy, resulting from foreign-exchange interventions, the central bank

normally conducts sterilized interventions. At the same time as it buys or sells foreign currencies, adding or

subtracting reserves to the banking system, it conducts an offsetting open-market operation. If it has bought

foreign currency, it sterilizes the purchase by selling government bonds to the same amount, reabsorbing the newly

created reserves. And if it has sold foreign currency, it sterilizes the sale by buying government bonds, replacing

the newly depleted reserves.

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8 Balassa-Samuelson Effect

One reason for the lower relative price of nontradables in poor countries was suggested by Bela Balassa and Paul

Samuelson. The Balassa-Samuelson theory assumes that the labor forces of poor countries are less productive than

those of rich countries in the tradables sector but that international productivity differences in nontradables are

negligible. If the prices of traded goods are roughly equal in all countries, however, lower labor productivity in the

tradables industries of poor countries implies lower wages than abroad, lower production costs in nontradables, and

therefore a lower price of nontradables. Rich countries with higher labor productivity in the tradables sector will

tend to have higher nontradables prices and higher price levels.

9 Marshall-Lerner Condition

If you are exporting QEX quantity, the nominal value of your sales is P QEX denominated in your domestic currency.

If you are importing, QIM quantity, then the nominal value of your purchases is P ⇤ QIM denominated in foreign

currency. Now, if every unit of domestic currency is worth E units of foreign currency - which is the exchange rate

too - then, every unit of foreign currency is worth 1

E units of domestic currency. Therefore, the nominal value of
⇤ IM
P Q
imports in domestic currency will be E .

Consequently, the net exports in nominal value, denominated in domestic currency would be

P ⇤ QIM
P (N X) = P QEX
E

or, in real terms

P ⇤ QIM
N X = QEX
EP

or,

QIM
N X = QEX EP
P⇤

or,

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 QIM
N X = QEX
e

Now, QEX and QIM are themselves a function of the real exchange rate, e. So we denote this dependence as

QEX (e) and QIM (e). What we also understand is that exports reduce and imports increase when the real exchange

rate appreciates. Or, in other words:

@QEX (e)
< 0
@e
@QIM (e)
> 0
@e

QIM
But, how does the N X change with respect to e. To answer that let’s look at the term e . As e increases,
IM
Q
QIM will increase, but so will the denominator. The net effect on the fraction e is therefore ambiguous. More

formally,
@N X @QEX (e) 1 @QIM (e) QIM
= + 2
@e @e e @e e

Now suppose that you start with a balanced trade, such that N X = 0, then

QIM (e)
QEX (e) =
e
or, QIM = eQEX (e)

Using this relation, we can rewrite the above as

@N X @QEX (e) 1 @QIM (e) QEX (e)

= +
@e @e e @e e

Multiply both sides by e

QEX (e)

e @N X e @QEX (e) 1 @QIM (e)

[ ] = [ ] +1
QEX (e) @e QEX (e) @e QEX (e) @e

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or,
@QEX (e) @QIM (e)
e @N X QEX (e) QIM (e)
[ EX ] = @e @e
+1
Q (e) @e e e

The change in N X upon an increase in e, will be negative if:

@QEX (e) @QIM (e)

QEX (e) QIM (e)
@e @e
+1<0
e e

or
@QIM (e) @QEX (e)
QIM (e) QEX (e)
@e @e
>1
e e

@QIM (e)
QIM (e)
Now, @e is the elasticity of imports with respect to exchange rate, and this is a positive number because we
e
@QEX (e)
@QIM (e) QEX (e)
know @e > 0. And @e is the elasticity of exports with respect to exchange rate, and this is a negative
e
EX
@Q (e)
number because @e < 0 - but also note that this term enters with a negative sign. So one can write in terms

of magnitudes, that if

| elasticity of imports | + | elasticity of exports |> 1

then
@N X
<0
@e

This is the Marshall-Lerner condition.

9.1 J-curve:

Movements in quantities do not happen instantaneously, unlike the movement in exchange rates. So, its likely, that

starting from a position of balanced trade, when the real exchange rate depreciates, the price effect may dominate

the quantity effect for some time after the depreciation. This means, that the net exports will witness a deficit

initially, and only after some time when quantities would have changed too, the quantity effect would dominate

over the price effect and the net exports will move into a surplus territory. This transition of NX across time, is

called as a J-curve dynamics - named after the shape of the transitional curve.

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10 Back to the (open economy) Short-run Model

So far in our analysis of the short-run model we had assumed N X term to be zero because we were working with

a closed economy throughout. But now, having determined some dynamics of the open economy we can relax that

assumption. The first point to realize is that the N X terms enters into the GDP Identity which gave us the IS

curve for the closed economy. We would want to follow a similar route and preferably, have a relation between N X

and real rates. From our discussion we know that

N X " when e # and vice versa

We also know from our equation (8) that

e # when r # or r⇤ "

Generalizgin the r⇤ as some real interest rate in the world, we can write that

e # when (r rw ) #

Combining it with N X we can say that

N X " (r rw ) #

In our ad-hoc way we will impose a linear structure on this relationship and write it as

N Xt = aN X bN X (rt rw )

where aN X is the aggregate demand shock on the net-exports and bN X is the sensitivity of net-exports with respect

to movement in domestic and world interest rates. Once we have this linear relationship we can just substitute this

into the GDP identity, trace through the similar steps as in deriving the IS curve, and we will have a new IS curve

for the open economy as

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 yet = aC + aI + aG 1 + aN X + bN X (rw r) (bI + bN X ) (rt r)
|{z} | {z } | {z }
output gap aggregate demand aggregate sensitivity

In the long-run all the real rates would converge: rt = rw = r; aC + aI + aG + aN X = 1; yet = 0. The dynamics

of this now open-economy augmented IS curve will be similar to the original closed economy IS curve, except that

there are three additional terms: aN X , bN X and rw . Shocks to any of these will have implications on the intercept

or/and the slope term. (please refer to slides for more on this). This completes our analysis of the short-run model

in the open-economy setup!

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