Macroeconomics (ECON 1211) Lecturer: Dr B. M. Nowbutsing Topic: Open economy macroeconomics.
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Transcript of 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