Macroeconomics (ECON 1211)Lecturer: Dr B. M. Nowbutsing

Topic: Open economy macroeconomics

29.2

1. Open economy Macroeconomics … is the study of economies in which international

transactions play a significant role

– international considerations are especially important for open economies like the UK, Germany, the Netherlands and of major interest to Mauritius

Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world

– especially via the exchange rate.

29.3

2. Some Keys Terms

The foreign exchange (forex) market exchanges one national currency for another. The price at which two currencies are exchanged is called the exchange rate.

The international (domestic) value of the domestic currency is the quantity of foreign (domestic) currency per unit of the domestic (foreign) currency

A country’s effective exchange is an average or its exchange rate against all its trade partners, weighted by the relative size of trade with each country

29.4

3. The Foreign Exchange Market - the international market in which one national currency can be exchanged for another.

The price at which two currencies exchange is the

exchange rate.

DD

DD shows the demand forpounds by Americans wantingto buy British goods/assets.

Quantityof pounds

Exc

hang

e ra

te (

$/£)

Suppose 2 countries: UK & USA

SSSS shows the supply of poundsby UK residents wishing to buyAmerican goods/assets.

e0 Equilibrium exchange rate is e0

SS1

If UK residents want more $at each exchange rate, thesupply of £ moves to SS1

e1

New equilibrium at e1.

29.5

4. Alternative exchange rate regimes

In a fixed exchange rate regime– the national governments agree to

maintain the convertibility of their currency at a fixed exchange rate.

A currency is convertible – If the central bank will buy or sell as

much of the currency as people wish to trade at the fixed exchange rate

29.6

4. Alternative exchange rate regimes

The central intervenes in the forex market when it is forced to buy or sell pounds (rupees) to support the fixed exchange rate.

In a fixed exchange rate, a devaluation (revaluation) is a fall (rise) in the exchange rate governments commit themselves to maintain.

29.7

4. Alternative exchange rate regimes

In a flexible exchange rate regime– the exchange rate is allowed to attain its

free market equilibrium level without any government intervention using exchange reserves.

29.8

5. Intervention in the forex market

Quantity of £s

$/£ SS

DD

e1

Suppose the government is committed to maintaining theexchange rate at e1 ...

When demand is DD, no intervention is needed ... there is a balance in transactions between the countries.

The Bank of England mustsupply AC £s in return for $,which are added to reserves.

DD1

If the demand for pounds is DD1 there is excess demand AC.A C

DD2 The reverse occurs if demand is at DD2.

E

29.9

6. The Balance of Payments

… a systematic record of all transactions between residents of one country and the rest of the world

Current account– records international flows of goods, services,

income and transfer payments

Capital account– records transactions involving fixed assets

Financial account– records transactions in financial assets

29.10

The UK balance of payments, 1980-1998

-25-20-15-10-505

10152025

£ b

illio

n a

t c

urr

en

t p

ric

es

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

Current

Capital

Financial

Err & om

Source: Economic Trends Annual Supplement

29.11

8. Floating Exchange Rates and the Balance of Payments

If the exchange rate is free to move to its equilibrium, there is no need for intervention

any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts

if there is intervention, it is recorded as part of the financial account.

29.12

9. International Competitiveness The competitiveness of UK goods in

international markets depends upon:– the nominal exchange rate– relative inflation rates

Overall competitiveness is measured by the real exchange rate– which measures the relative price of

goods from different countries when measured in a common currency

29.13

9. International Competitiveness

RER = (E x P) / P*E: nominal exchange rate

P: domestic sterling price of UK goods

P*: dollar price of US goods Purchasing Power Parity exchange

rate is the path of nominal exchange rate that maintains a constant exchange rate.

29.14

10. Relative Prices and the Nominal Exchange Rate, UK & USA

0.5

1

1.5

2

2.5

3

$/£

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

Rel

ativ

e p

rice

(U

K/U

SA

)

Relative price(UK/USA)

Exchange rate ($/£)

29.15

11. The Real £/$ Exchange Rate

0

0.5

1

1.5

2

2.5

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998

£/$

The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

29.16

12. Components of the Balance of Payments

The current account is influenced by:– Competitiveness (imports, exports and net interest on

foreign assets)– domestic and foreign income

The capital & financial accounts are influenced by:– relative interest rates

which affect international capital flows.

Perfect capital mobility– occurs when there are no barriers to capital flows, and

investors equate expected total returns on assets in different countries

29.17

13. Internal and External Balance Internal balance

– a situation for a country when aggregate demand is at the full-employment level (C+ I + G)

External balance– a situation for a country when the current account

of the balance of payments just balances ( X – Z)

The combination of internal and external balance is the long-run equilibrium for the economy.

29.18

13. Internal and External Balance The point of the internal and external balance

is the intersection of the two axes, with neither boom nor slump, with neither a current account deficit nor surplus

Shocks move the economy away from internal and external balance

For example, the top left corner shows a combination of domestic slump and a current account surplus.

29.19

14. Shocks may move an economy away from internal and external balance:

BoomSlump

Surplus

Deficit

More saving,tighter fiscal &monetary policy

Foreign boom,lower realexchange rate

Foreign slump,higher realexchange rate

Less saving,easier fiscal &monetary policy

29.20

15. The Long Run Equilibrium Exchange Rate In the LR both internal and external must hold. It requires

that

Y* = Y = (C + I + G) + (X- Z)

In external balance, net exports (X – Z) = 0

Internal balance requires that C + I + G = Y*

Net exports depends only on RER

There is a unique exchange rate that makes the net exports

equal to zero. Given domestic and foreign levels of

potential output, a lower real exchange real exchange rate

raises export demand and reduces import demand

29.21

15. The Long Run Equilibrium Exchange Rate

NX

NX NX’

R0R1

Trade balance at Ro.

A resource discovery shifts NX to NX’

RER appreciate to R1 to maintain trade balance in the LR

29.22

16. Foreign Debt and Foreign Assets

CA (Creditor)

CA

CA

(Debtor)

R0R1

For a CA balance, a debtor country needs a low Ro to be competitive

A creditor country has a high RER to reduce competitiveness and run a trade deficit, financed by interest earned on foreign assets