OPEN ECONOMY MACROECONOMICS

Unit -1: Exchange Rates (20 Lectures)

CHAPTER 13 Introductions to Exchange Rates and the Foreign Exchange Market
CHAPTER 14 Exchange Rates I: The Monetary Approach in the Long Run
CHAPTER 15 Exchange Rates II: The Asset Approach in the Short Run

Unit- 2: The Balance of Payments (5 Lectures)

CHAPTER 18 Balance of Payments II: Output, Exchange Rates, and Macroeconomic Policies in
the Short Run

Unit- 3: Applications and Policy Issues (20 Lectures)

CHAPTER 19 Fixed Versus Floating: International Monetary Experience
CHAPTER 20 Exchange Rate Crises: How Pegs Work and How They Break
CHAPTER 22 Topics in International Macroeconomics

CHAPTER 13
Introduction to Exchange Rates and the Foreign Exchange Market

(a) International trade

Exchange rates affect:
●​ Imports (goods we buy from abroad)
●​ Exports (goods we sell to other countries)
If a country’s currency:
●​ Weakens → exports become cheaper, imports become costlier
●​ Strengthens → exports become costlier, imports become cheaper

(b) International investment

Foreign exchange is also needed for:
●​ Multinational companies investing in factories abroad
●​ Investors buying foreign stocks and bonds

➡️
●​ Portfolio diversification by fund managers
Without the foreign exchange market, global trade and investment cannot
function.

An exchange rate (E) is simply:

The price of one country’s currency written in terms of another
country’s currency.
 ●​ One currency is treated as home (domestic)

📌
●​ The other is treated as foreign
It is called a relative price because it compares two currencies, not one.

Exchange rate = units of home currency per unit of foreign currency

India’s exchange rate → ₹/$

If one currency can buy more of another currency, it has appreciated (become
stronger).​

If one currency can buy less of another currency, it has depreciated (become weaker).

●​ Appreciation: Currency becomes stronger → buys more foreign currency

●​ Depreciation: Currency becomes weaker → buys less foreign currency
These two always happen together, one for each currency.

Depreciation of a currency means an increase in the domestic price of foreign currency.

Appreciation and depreciation are mirror images because exchange rates are
reciprocals and always move in opposite directions.

Bilateral exchange rate - It is the exchange rate between two currencies only.

Multilateral (Effective) exchange rate : EER

A multilateral exchange rate measures the average change in a country’s currency

against a group (basket) of currencies.

●​ Uses a basket of currencies

●​ Each currency is given a trade weight
●​ More trade = more importance
Overall exchange rate change = average of bilateral changes, weighted by trade
importance

Not all trading partners matter equally.

 ●​ If a country trades more with partner A → A’s currency gets higher weight
●​ If it trades less with partner B → B’s currency gets lower weight

Who does the Home country trade with?

1.​ Country 1 → 40% of trade
2.​ Country 2 → 60% of trade

What happens to the Home currency?

➢​ Against Country 1:​
→ Home currency appreciates by 10% (that is good for Home)
➢​ Against Country 2:​
→ Home currency depreciates by 30% (that is bad, and with the bigger
partner)

Step 1 : Convert appreciation/depreciation into signs

Appreciation of home currency → write as −
Depreciation of home currency → write as +
So:
●​ +10% appreciation → −10%
●​ −30% depreciation → +30%

Step 2 : Multiply by trade weights ; Now just do a weighted average.

Country 1
●​ Change = −10%
●​ Weight = 0.40​
​ ​ ​ ​ −10% × 0.40 = −4%
Country 2
●​ Change = +30%
●​ Weight = 0.60​
​ ​ ​ ​ 30% × 0.60 = 18%

Step 3: Add them

−4% + 18% = +14%

The +14% means : Home’s currency depreciated by 14% overall

Partner % FX change Trade share Contribution

Country 1 −10% 0.40 −4%

 Country 2 +30% 0.60 +18%

Total +14%

Each bilateral appreciation or depreciation is multiplied by the trading partner’s share in

total trade, and the weighted changes are added to obtain the overall movement of the
currency.

1.​ Exchange rate changes affect foreign prices

Foreign goods become cheaper or costlier in home currency
2.​ Relative prices change
Goods from different countries become more or less competitive
3.​ When home currency depreciates:
Home exports become cheaper for foreigners
Imports become more expensive for residents
4.​ When home currency appreciates:
Home exports become more expensive for foreigners
Imports become cheaper for residents

Exchange rate regime : The system or policy a government follows for managing its
currency.
These regimes reflect:
●​ Government choices
●​ Policy priorities
●​ Economic conditions

Two main types of exchange rate regimes :

(A) Fixed (or pegged) exchange rate regime

●​ The exchange rate:
○​ stays constant
○​ or moves only within a very small range
●​ It is fixed against a base currency (like the dollar or euro)
●​ A currency can stay fixed only if the government intervenes in the foreign
exchange market.
●​ Without government action market forces would push the rate up or down

(B) Floating (or flexible) exchange rate regime

●​ Exchange rates are determined by:
○​ demand and supply
 ○​ market forces
●​ The government does not try to fix the rate
●​ Currency can:
○​ appreciate or depreciate
○​ daily, monthly, or even minute-to-minute

Free float: Market-determined exchange rate

Band: Fixed rate within a narrow range
Managed (dirty) float: Mostly market-driven, occasional government control
Exchange rate crisis: Sudden, massive depreciation
Crawling peg/band: Gradual, planned depreciation
Freely falling regime: Extremely rapid collapse
Dollarization: Using another country’s currency officially

Currency Union (Monetary Union)

●​ A currency union exists when two or more countries adopt a common
currency.
●​ Member countries give up national currencies and share monetary policy.
●​ Presence of a transnational monetary authority (single central bank).
●​ Monetary policy is jointly decided, not national.
●​ Exchange rates do not exist between member countries.​

Why countries choose a currency union

●​ Exchange rate stability
●​ Lower transaction costs
●​ Deeper economic integration
●​ Credible monetary policy​

Cost
●​ Loss of monetary sovereignty
●​ No independent interest rate or exchange rate policy

Dollarization
Meaning
●​ Dollarization occurs when a country unilaterally adopts another country’s
currency.
●​ Usually the U.S. dollar, but can also be the euro, Australian dollar, or New
Zealand dollar.
●​ No shared central bank
●​ No say in monetary policy of the issuing country
 ●​ Decision is one-sided​

Reasons for Dollarization

1.​ Very small size
○​ Cost of running a central bank is too high
○​ Example: Pitcairn Islands use the New Zealand dollar
2.​ Poor monetary credibility
○​ History of high inflation or currency crises
○​ Country “imports” a credible foreign monetary policy​

Types of Dollarization
●​ De jure: Official government decision
●​ De facto: Public voluntarily switches due to loss of faith in local currency​

Consequences
●​ Eliminates exchange rate risk
●​ Improves price stability
●​ Loss of independent monetary policy
●​ No lender of last resort​

The foreign exchange market is the global market where currencies are traded and
exchange rates are determined by demand and supply. It is an over-the-counter market
with no central location and operates continuously across time zones.

Transaction costs (spreads; market frictions) are the difference between the
buy price and sell price. For individuals it can be large due to banks, agents,
middlemen but for big banks and firms spread is tiny.

Derivatives in the forex market:

Forex derivatives are contracts that let people agree today on exchanging currencies in the
future, often to manage risk or to bet on exchange rate movements.
●​ They are contracts, not immediate exchanges
●​ Their value comes from the spot exchange rate
●​ They allow:
○​ Different delivery times (future dates)
○​ Special conditions (options)
Main purpose is Hedging → avoiding risk and Speculation → taking risk to earn profit

1.​ Forwards​
A forward contract is a private, OTC agreement to buy or sell currencies at a
predetermined exchange rate on a specified future date.
 2.​ Swaps
A swap combines a spot exchange today and a forward exchange in the future.
3.​ Futures
4.​ Options
Gives the buyer the right, not the obligation, to trade at a fixed exchange rate on
a future date.

These are called derivatives because their value is derived from the spot exchange
rate.

Forwards Futures

Customized Standardized

OTC (private) Traded on an exchange

Same parties must settle Can be resold

Flexible maturity Fixed maturity dates

More liquid and tradable

Hedging Speculation

Avoids risk Takes risk

Protects income Seeks profit

Used by firms Used by traders/investors

Private Actors
The main private actors in the foreign exchange market are traders working for
commercial banks. These banks trade both for profit and on behalf of clients
engaged in international trade and investment.
Interbank Trades : The forex market is dominated by a small number of large
banks whose profit-seeking trades determine exchange rates.
Large corporations and nonbank financial institutions may also trade directly in the
forex market to reduce transaction costs.

Government Actions
Extreme action: Capital controls (blocking the market) are restrictions on cross-border
financial transactions
Less extreme action: Central bank intervention by governments trying to control the
exchange rate price.

To maintain a fixed or pegged exchange rate, the central bank:

●​ stands ready to buy or sell its own currency
●​ in exchange for a foreign base currency
●​ at a fixed price
This requires foreign exchange reserves (dollars, euros, etc.)

Problems with intervention using reserves

(a) Costly
●​ Foreign reserves tie up national resources which could be used for more
productive investment
(b) Limited
●​ Reserves are not infinite, If they run out central bank cannot defend the peg and
market forces take over
This is exactly how exchange rate crises occur.

Arbitrage
means to buy low and sell high for a profit. If such profit opportunities exist in a
market, then it is considered to be out of equilibrium.
In the foreign exchange market, arbitrage occurs when the same currency trades at
different spot exchange rates in different locations. Traders buy the currency where it is
cheap and sell where it is expensive. This process continues until exchange rates are
equal across markets. The no-arbitrage condition, which defines equilibrium, requires
that spot exchange rates be the same in all locations.

Triangular arbitrage involves exploiting inconsistencies among three exchange rates.

An arbitrage opportunity exists if the direct exchange rate between two currencies
differs from the rate implied by converting through a third currency.

A vehicle currency is a third currency used to facilitate exchange between two other
currencies.
●​ It is not the home currency of either party
●​ It is chosen because it is liquid, widely traded and cheap to use​

Two ways to handle exchange rate risk

(A) Hedge the risk → riskless arbitrage
●​ Use a forward contract
●​ Lock in today the future exchange rate
 ●​ This leads to Covered Interest Parity (CIP)​

(B) Don’t hedge → risky arbitrage

●​ Use future spot rate
●​ Leads to Uncovered Interest Parity (UIP)

What is a forward rate?

●​ F$/€ = forward exchange rate
●​ It is the rate agreed today for exchanging euros and dollars one year from now
●​ Removes all exchange rate uncertainty

Arbitrage disappears when:

●​ Dollar return on dollar deposits​
=
●​ Dollar return on euro deposits (hedged)
That gives the Covered Interest Parity condition:

Covered Interest Parity (CIP)

When exchange rate risk is fully hedged using a forward contract, investors
earn the same return in all currencies.

What determines the forward rate?

Rearrange the CIP equation:

The forward rate depends on:

1.​ Spot exchange rate
2.​ Dollar interest rate
3.​ Euro interest rate

CIP UIP

Uses forward contract Uses future spot rate

 Exchange rate risk Exchange rate risk
hedged remains

Riskless arbitrage Risky arbitrage

Uncovered Interest Parity (UIP)

When investors do not hedge exchange rate risk, arbitrage becomes risky and leads to
uncovered interest parity.
No expected profit from risky arbitrage occurs when:

UIP links:
●​ Interest rates
●​ Expectations
●​ Spot exchange rate

What determines the spot rate?

Rearrange the UIP equation:

The spot rate balances:

●​ interest rate differences
●​ expected future exchange rate

If both parity conditions hold, the forward rate must equal the expected future spot rate.

A country with a higher interest rate must have a currency that is expected to
depreciate.
A lower euro interest rate can still be attractive if the euro is expected to appreciate.
 CHAPTER 14
Fixed Versus Floating: International Monetary Experience

In the long run, exchange rates adjust to offset inflation differences between
countries.
Purchasing Power Parity (PPP)
●​ If one country has higher inflation
●​ Its currency will depreciate
●​ So that relative prices across countries stay similar

(a) Law of One Price (LOOP)

Applies to one single good
If there are no trade barriers and markets are competitive, identical goods sold in
different countries must sell for the same price when expressed in a common currency.

(b) Purchasing Power Parity (PPP)

Applies to a basket of goods
Overall price levels across countries should be equal when expressed in a common
currency.

Integrated markets
When no arbitrage opportunity exists = market equilibrium

Under absolute PPP The exchange rate equals the ratio of prices of the same good
across countries.

PPP holds when: Absolute Purchasing Power Parity

Real Exchange Rate = 1

Nominal Exchange Rate Real Exchange Rate

$ per € baskets per basket

Currency concept Goods concept

Financial Economic purchasing power

All this rests on strong assumptions:

●​ frictionless trade
●​ identical goods
●​ flexible prices
●​ perfect competition

Relative PPP : The rate of depreciation of the nominal exchange rate equals the
inflation differential between the two countries.

Absolute PPP Relative PPP

Talks about price levels Talks about inflation rates

Strong, rarely holds exactly Weaker, holds better in practice

Implies relative PPP Does not require absolute PPP

Short-run deviations from PPP persist due to transaction costs, non-traded goods,
imperfect competition, and price stickiness.

Money is a store of value, unit of account, and medium of exchange.

In the long run, money supply is controlled by the central bank.

The Demand for Money: A Simple Model

Nominal Income = P × Y
Quantity Theory of Money (Simple Model)

Md = demand for money​

Lˉ = constant (how much money is needed per ₹1 of income)
P = Price level
Y = Real output/income

If prices rise → you need more money

If income rises → you need more money
Real money demand depends only on real income
In the simple quantity theory, money demand is proportional to nominal income.
Exchange Rate Forecasts Using the Simple Model
It combines:
Quantity Theory of Money → money determines prices
Purchasing Power Parity (PPP) → prices determine exchange rates

If you can forecast future money supply and output, you can forecast future exchange
rates.
The monetary approach is useful for long-run exchange rate forecasting under flexible
prices.

SECTION 5: Monetary Regimes and Exchange Rate Regimes

●​ To control inflation in the long run, countries must choose a nominal anchor, and
that choice determines how the exchange rate behaves.
●​ A nominal anchor is a variable that the government or central bank commits to
control in the long run in order to keep inflation stable.
●​ A nominal anchor is a policy target used to stabilize inflation in the long run.
●​ A country can have only ONE nominal anchor in the long run.

Types of Nominal Anchors

inflation can be controlled by targeting one of three variables:

(A) Exchange Rate Target

Home inflation = exchange rate depreciation + foreign inflation
●​ Fix or tightly manage the exchange rate
●​ Domestic inflation follows foreign inflation
●​ If you tie your currency to a stable country, you “import” their low inflation.
●​ No monetary independence
●​ If foreign inflation rises → domestic inflation rises
●​ Exchange rate regime - fixed or managed

(B) Money Supply Target

●​ Control money → control prices.
●​ Fix money growth at a constant rate
●​ Inflation becomes predictable
●​ Exchange rate regime - floating

(C) Inflation Target (via Interest Rate Policy)

 ●​ Control interest rates → influence inflation expectations → stabilize prices.
●​ Central bank sets interest rates
●​ Targets a specific inflation rate (e.g., 2%)
●​ Exchange rate regime - floating

CHAPTER 19
Fixed Versus Floating: International Monetary Experience

Why exchange rates affect national wealth

When the exchange rate changes, the value of foreign-currency assets and debts
(measured in local currency) changes

Liability dollarization
Liability dollarization means a country’s debts are in foreign currency (usually dollars)​
But its income, taxes, and GDP are in local currency​
This makes exchange rate changes very powerful and risky.

Wealth = total assets − total liabilities

When a country has foreign-currency liabilities exceeding foreign-currency assets, a

depreciation increases the domestic value of debt and reduces national wealth, making
depreciation potentially destabilizing.

Contractionary depreciation occurs when a fall in the exchange rate reduces output
because higher import costs and foreign-debt burdens outweigh export-led demand
gains.

Original sin = a country’s inability to borrow internationally in its own currency

For developing countries: Almost all external debt is in foreign currency

Causes of original sin

●​ Weak institutions
●​ Poor macroeconomic management
●​ High inflation in the past
●​ Loss of creditor confidence
●​ Domestic currency bond markets failed to develop
●​ Creditors demanded foreign-currency debt

Original sin leads to:

●​ Liability dollarization
 ●​ Currency mismatch
●​ Large wealth losses after depreciation
●​ Contractionary depreciations

Countries can escape original sin if they:

●​ Improve institutions
●​ Maintain low inflation
●​ Follow credible fiscal & monetary policy
●​ Build trust over time
●​ Accumulate large foreign exchange reserves
●​ Reduce dollar borrowing
●​ Try to match assets and liabilities

Benefits of a Fixed Exchange Rate:

1.​ Reduces exchange rate uncertainty
2.​ Encourages international trade
3.​ Promotes foreign investment
4.​ Reduces hedging costs for firms
5.​ Pegging the currency to a low-inflation foreign currency increases policy credibility
6.​ Helps control inflation expectations
7.​ Prevents destabilizing wealth effects
8.​ Limits exchange rate movements
9.​ Prevents large negative valuation effects
10.​Avoids contractionary depreciations

Moral Hazard Problem

Moral hazard arises when economic agents take excessive risks because they expect
to be protected from losses.
Private firms borrow in foreign currency
Exchange rate depreciation increases their debt burden
Firms expect government rescue; Transfers private losses to the public sector

Chapter 20
Exchange Rate Crises

An exchange rate crisis occurs when a fixed (pegged) exchange rate suddenly
collapses, leading to a large and rapid depreciation of the currency.

Economic costs:
●​ Advanced countries: Growth often recovers quickly
●​ Emerging markets: Deep recessions, lost output, long recovery
 ●​ Social and economic consequences: High unemployment, Banking system
distress
●​ Political costs: Loss of credibility of policymakers, leadership changes

Three major types of crises:

1.​ Exchange rate crisis – collapse of a currency peg
2.​ Banking crisis – banks fail or become insolvent
3.​ Default crisis – government cannot repay debt
Can be a Twin crisis or Triple crisis.

Section 2: How Pegs Work – The Mechanics of a Fixed Exchange Rate

Fixed exchange rate:

●​ Central bank buys/sells foreign reserves
●​ Keeps exchange rate constant
●​ Requires reserves
A country can fix its exchange rate if and only if it has reserves.

Higher backing ratio = safer peg (Shows how much money is backed by reserves)

Sterilization
Sterilization is a policy by which the central bank offsets changes in domestic credit by
selling or buying foreign reserves so that the money supply remains unchanged under a
fixed exchange rate.
Under a fixed exchange rate: Money supply must stay fixed
When Domestic credit increases:
Central bank sterilizes
●​ Central bank sells foreign reserves
●​ Takes money back from economy
●​ Money supply returns to original level
Repeated sterilization reduces reserves

Section 3: How Pegs Break I – Inconsistent Fiscal Policies

Fiscal Dominance
Fiscal dominance exists when:
●​ The government runs persistent budget deficits
●​ It cannot borrow from markets
●​ So it forces the central bank to finance the deficit
Fiscal policy → wants money creation
Exchange rate policy → requires fixed money supply

What happens over time?

●​ Government keeps monetizing deficits

●​ Domestic credit rises steadily
●​ Central bank sells reserves to defend peg
●​ Reserves move toward zero

In the myopic case, the crisis happens when reserves reach zero, and the exchange
rate depreciates discontinuously.

Investors are rational and forward-looking.

speculative attack: causes an earlier collapse
●​ Everyone converts domestic currency into foreign reserves
●​ Central bank loses all remaining reserves at once
●​ Happens before reserves reach zero
●​ Investors avoid losses

The first-generation crisis model shows that a fixed exchange rate cannot survive
persistent monetization of fiscal deficits. When domestic credit expands continuously,
reserves inevitably decline, and rational investors trigger a speculative attack before
reserves are exhausted, causing a sudden collapse of the peg.

Section 4: How Pegs Break II — Contingent Monetary Policies

Second-generation models of currency crises.

A peg may collapse even when fundamentals are not bad, simply because the
government chooses to abandon it in bad times.

Peg is: Strong in good times, Conditional in bad times

Trade-off:
●​ Keeping the peg → tight monetary policy → high interest rates
●​ Abandoning the peg → monetary expansion → recession relief, but loss of
credibility
●​
The decision depends on:
●​ Size of the recession
●​ Market expectations about government behavior
Small Recession, Peg Credible: Peg survives because the cost of defending it is
manageable.

Large Recession, Peg Credible: Government has strong reputation, Peg is defended
successfully

Large Recession, Peg Not Credible: Government has weak credibility, The
expectation of devaluation makes defending the peg more painful, which confirms the
expectation. This is a self-fulfilling crisis.

Benefits of a peg:
●​ Low inflation
●​ Exchange rate stability
●​ Credibility and discipline
●​ Lower risk premium

Costs of a peg:
●​ Loss of monetary independence
●​ Cannot cut interest rates in recessions
●​ Defending peg can deepen downturns
●​ Vulnerable to speculative attacks

Second-generation models emphasize that exchange rate crises can arise from
contingent policy commitments. When defending a peg during a severe recession
becomes too costly, expectations of devaluation raise interest rates and deepen the
downturn, leading governments to abandon the peg even when fundamentals are
otherwise sustainable.

What Helps Reduce the Risk of Crises?

1️⃣ Sound fiscal policy
●​ Low and sustainable deficits

📌
●​ No pressure on central bank to print money
Most important condition for a durable peg.

2️⃣ Strong reserve backing

●​ High backing ratio (reserves / money supply)

📌
●​ Allows the central bank to absorb shocks
But: large reserves are costly to hold.

3️⃣ Credible policy framework

●​ Clear commitment to the peg
●​ Consistent past behavior
📌
●​ Independent central bank
Credibility reduces speculative attacks.

4️⃣ Strong financial system

●​ Well-capitalized banks
●​ Limited currency mismatch

📌
●​ Clear lender-of-last-resort rules
Prevents banking crises from spilling into currency crises.

5️⃣ Choosing the right exchange rate regime

●​ Hard pegs (currency boards): more credibility, less flexibility
●​ Floats: flexibility, but more volatility

📌
●​ Soft pegs: most crisis-prone
There is no perfect regime.

Chapter 22

A Simple Balassa–Samuelson Model

The economy has two sectors:

1.​ Tradable goods sector​

2.​ Nontradable goods sector

Changes in Productivity

Higher productivity → higher wages in tradables

Wage increases spill over to nontradables

Prices of nontraded goods rise

Overall price level rises

Countries with higher productivity have higher price levels → real exchange rate
appreciation
Persistent deviations from PPP are not anomalies but systematic outcomes
of productivity differences, nontraded goods, and imperfect arbitrage in the
global economy.

From Chapter 22 Topics in International Macroeconomics

Explain Section 2 Exchange Rates in the Short Run: Deviations from Uncovered
Interest Parity
which is from pages 13 to 26
Cover all the subtopics:
The Efficient Markets Hypothesis
Expected Profits
Actual Profits
The UIP Puzzle
Limits to Arbitrage
Trade Costs Are Small
Risk Versus Reward
The Sharpe Ratio and Puzzles in Finance
Predictability and Nonlinearity
Conclusion
Make it all easy to understand
 CHAPTER 18
Balance of Payments II: Output, Exchange Rates, and Macroeconomic
Policies in the Short Run

Mundell (1961): Flexible exchange rates are great because they automatically balance trade, fix
unemployment in weak countries, and control inflation in strong ones.
Ford (1962): Fixed exchange rates are disliked because they make recessions worse—but
people forget that they also make economic booms stronger.

➔​ Exchange rates became a big deal after the 2008 crisis.

➔​ Some countries panic when their currency changes a lot, others don’t—because it
affects economies differently.
➔​ To understand this, economists connect exchange rates with output, trade, and policies
using an open-economy IS-LM model.
➔​ In the short run, output is driven by demand, not prices as they are sticky.
➔​ Exchange rate systems (fixed vs. floating) decide how well policies work.

1. Demand in the Open Economy