David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

CHAPTER 25 Open economy macroeconomics
Conversely, the anticipation of a period oflow interest rates (relative to trading partner countries) induces
an initial depreciation of the exchange rate, so that it is likely to rise thereafter. The prospect of future
capital gains prevents a capital outflow when interest rates are low.
Hence, beliefs about current and future monetary policy can have a dramatic effect on the initial level of the
exchange rate and competitiveness. In effect, the exchange rate is pricing beliefs about the entire future of
monetary policy, both at home and abroad. Changing the current interest rate for a short time will have only
a small effect on this calculation. However, a credible change in monetary policy for a sustained period will
cause a large re-evaluation of the correct path for the exchange rate. This can have a large effect in the short run.
Thus in an open economy with floating exchange rates, monetary policy affects aggregate demand not
merely through the effect of interest rates on consumption and investment demand. Changing the
anticipated path of interest rates can have a large effect on the exchange rate and competitiveness. This
effect on aggregate demand may be large. Because the effect of interest rates on competitiveness operates
in the same direction as the domestic effect - lower interest rates boost domestic spending, but also induce
a lower exchange rate and greater competitiveness, boosting net exports - monetary policy is more
powerful under floating exchange rates than in a closed economy.
Fiscal policy
Under floating exchange rates, this effect of interest rate changes on competitiveness reinforces the power
of monetary policy, but undermines the power of fiscal policy.
Suppose the government undertakes a fiscal expansion, raising government spending. This increases
aggregate demand. Whether monetary policy follows an inflation target, a Taylor rule or a nominal money
target, the boom induces the central bank to raise interest rates. The higher interest rate induces an
immediate appreciation of the nominal exchange rate to choke off a capital inflow: if the exchange rate is
high enough, people will believe it will fall from now on.
In a closed economy, higher interest rates partially crowd out private expenditure by reducing consumption
and investment demand. But in an open economy with floating exchange rates, the induced exchange rate
appreciation also reduces competitiveness and the demand for net exports, further dampening the power
of fiscal expansion to stimulate aggregate demand in the short run.
A 30-year look at sterling
II
We show the nominal effective exchange rate ( eer) against a
basket of the currencies most important for the UK's
international trade, weighted by their importance in UK
trade. We also show the real effective exchange rate (rer),
adjusting the nominal exchange rate for movements of
relative prices at home and abroad (using the same
weights as used to construct the nominal effective
exchange rate).
The figure on the right shows the nominal
and real sterling exchange rates since 1980.
Notice the high correlation between movements in the
nominal exchange rate and real exchange rate. In the
short run, most changes in the real exchange rate are
caused by changes in the nominal exchange rate, not by
changes in domestic and foreign prices.
Sterling nominal and real exchange rates,
1980-2009 (2002 = 100)
130
120
110
100
90
80
70
60
50
I -+- eer
.. rer I
40 -1--..-
0 N 'Ot" --0 CO 0 N '