open economy new

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MACROECONOMICS

BCOM 21043

Topic 7

Open Economy Macroeconomics


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The concept of open economy

Interaction among the countries in the world

Import and export transactions

Analysis of economic development and policy

formulation.


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BOP cont

General definition

A systematic statement all of economic transactions

of a country with the rest of the world occurredduring a given period, usually one year.

Payments to foreigners are debits to the BOP

account.

All receipts are credits to the BOP account.


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Payments and receipts can be in respect of the

following

Visible items

Goods

Invisible items

Services

Capital transfers

BOP cont


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Balance of payments (BOP)

A systematic record of economic transactions

between countries

Both visible and invisibles transactions are

included.

The period is one year in general

Double entry book keeping system is

operated.


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Purpose of preparing the BOP

To take the stock of countrysForeign receipts and payment obligations

Assets and liabilities arising out of international

transactions.

To yield the necessary information on the

strength and weaknesses of the country in

international economic relations.

To analyze the overall gains and losses from

the international economic transactions.

For future policy formulation purposes


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BOP Accounts

Current account

Records the transactions relating to the visible and

invisible transactions

Visible balance shows the value of import and

exports of physical products

Invisible balance shows the value of the services

rendered and hired.


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Capital account

Shows the transactions relating to the long-term

movements of capital

Inflows and outflows of capital including foreign

investments, gold and foreign exchange reserves

BOP Accounts


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May be either

Equilibrium

Disequilibrium

Surplus in BOP

Deficit in BOP

Position of the BOP


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Types of disequilibrium in BOP

Cyclical disequilibrium

Due to cyclical pattern of income, different income

elasticitis and different price elasticities

Structural disequilibrium

Due to changes in technology, taste and attitude

towards foreign investments


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Secular disequilibrium

Due to changes in economic growth.

At the initial stage there may be disequilibrium due

to lack of funds to finance imports

Fundamental disequilibrium

Long-term disequilibrium in BOP

Types of disequilibrium in BOP


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Methods to correct the disequilibrium in BOP

Deflation

Exchange depreciation

Encouraging exportsDiscouraging imports

Exchange control

Capital movements


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Exchange Rates (ER)

The international trade is operated through theexchange rate system as a medium of settling

transactions.

ER

Is the price a currency in terms of another currency

Is the price between two countries at which

residents of those countries trade with each other.


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ER

Example

1 US $ = SLR. 120

1 UK = SLR. 155

1 Indian Rupee = SLR 3


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BOP and ER

BOP and ER are more related because the

settlement of BOP is done using these ERs.


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Nominal ER and Real ER

Nominal ER (NER)

Is the relative of the currency of two countries

(basically the ER)

Whenever the people use the term of ER, it implies

the Nominal ER

Example: NER between Sri Lanka and USA is Rs.

112/ US$


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Real ER (RER)

Is the relative price of the goods of two

commodities.

This measures the actual purchasing power of

domestic goods in terms of foreign currency.



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Real ER


RER =NER * Price of Domestic Goods

Price of Foreign Goods

E =e * P

P*

E RER

e NER

P Domestic Price

P* - Foreign price


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If the RER is high

Foreign goods are relatively cheap

Domestic goods are relatively expensive

If the RER is low

Foreign goods are relatively expensive

Domestic goods are relatively cheap



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Determination of ER in Free Exchange Market

In a free exchange market, the price of ER is

decided by the two forces of,

Demand

supply


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Demand for foreign exchange

Demand for dollars by Sri Lankan to purchase

foreign goods & services and assets.

Supply of foreign exchange

Supply of Sri Lankan rupees to foreign countries to

exchange our products.

Determination of ER in Free Exchange Market


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1.00

1.20

1.40

1.60

1.80

2.00

2.20

0

$

price

of

Q of

Determination of the rate of exchangeDetermination of the rate of exchange


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Types of Exchange Rates

Fixed exchange rate

Flexible exchange rate


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Fixed exchange rate system

Fixed exchange rateThe ER is fixed between the domestic and foreign

currencies by the monetary authority of a country

and is not allowed to fluctuate beyond a limit.

Government intervenes to fix the prices for

ERs.

On behalf of the government Central Bank ready to

buy and sell their currencies at a fixed price

generally in terms of US$.


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Upper intervention limit

Lower intervention limit

RS/US$

Quantity of foreign currency

Rs. 100


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What determine the amount of intervention

that a central bank has to do in a fixed

exchange rate system

The BOP measures the amount of foreign

exchange intervention needed from the

central bank



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For example

If Sri Lanka is running a deficit balance in its BOP

and therefore,

Demand for US$ in exchange for SLR exceedsthe supply US$ in exchange for SLR from USA.

Then central bank would buy the excess rupees , paying

for them with US$.



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Merits of fixed exchange rate system

Promote international trade

As, exporters and importers know in advance the

amounts they have to pay and receive

Improve the international capital movements

Because of the certainty in ER.

For developing countries this facilitate to

achieve the planned economic development.


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Since it is not permanently fixed, the foreigninvestors are discouraged to invest in long-

term investments.

The countries will lose their freedom to

formulate independent monetary policies.

It does not show the true cost-price

relationship between countries.

Demerits of fixed exchange rate system


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Flexible or floating exchange rate system

Exchange rate will determine freely by the demand

and supply.Therefore, the countries do not have to pay with

gold and thereby countries can protect their gold

reserves.

The countries are independent in choosing their oftheir monetary policies as their own internal

policies.

This leads to an inflation and creation ofemployment opportunities.


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Flexible ER system

Clean floating

Central bank stand aside and allows exchange rate to be

freely determine in foreign exchange market.

Dirty floating

The ERs are intervened by the Central bank to decide itsprice up to some extent.

Flexible or floating exchange rate system


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Merits of flexible ER system

More beneficial international lending

It absorb the changes occurred in abroad

Brings the equilibrium in the BOP


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Instability and uncertainty

Leads to reduce the volume of the international trade

Frequent fluctuation in ERs leads to destabilizeeconomic conditions

Exchange depreciation leads to inflationary situation

in local rises

Demerits of flexible ER system


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Purchasing Power Parity (PPP)

Predicts that ERs between two countries will

adjust in the long-run to reflect the price level

differences in countries.

Explains how the law of one price applied to

the international market place.

This applied where the international arbitrage

possible.


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According to this rule, the dollar must have

same purchasing power in every country at the

international trade

In following cases PPP rule will fail

Most of the goods are not easily tradable

In case of tradable goods, they are not always

perfect substitutions.

Purchasing Power Parity (PPP)


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Open economy macroeconomics: Policy issues

Economic

policies

Monetarypolicies

Fiscal

policies

Fixed ER

Floating ER

Fixed ER

Floating ER

Ineffective

Effective

Effective

I ff ti

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