UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

1

Chapter18

1. OpennessinGoodsMarket

Exports&Imports

ChoicebetweenDomesticandForeignGoods:

ξ Inaclosedeconomy,peoplefaceonedecision,saveorbuy

ξ Inanopeneconomy,theyfacetwodecision

o Saveorbuy

o Ifbuy,whetherdomesticorforeign

1.1 NominalExchangeRates

ξ Thisisthepriceofthedomesticcurrencyintermsoftheforeigncurrency,denotebyE.

o Nominalappreciationofthedomesticcurrency–anincreaseinthepriceofthedomesticcurrencyintermsofaforeigncurrency

o Nominaldepreciationofthedomesticcurrency–andecreaseinthepriceofthedomesticcurrencyintermsofaforeigncurrency

ξ Underafixedexchangeratesystem,theterminologyusedisrevaluationanddevaluation.

1.2 RealExchangeRates

ε = EPP *

ξ Thisisthepriceofonecountriesgoodsintermsofanother.

ξ Therealexchangerateisconstructedbymultiplyingthedomesticpricelevel(P)bythenominalexchangerate(E)andthendividingbytheforeignpricelevel(P*)

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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o Increaseintherealexchangerate,anincreaseintherelativepriceofdomesticgoodsintermsofforeigngoods,iscalledarealappreciation

o Decreaseintherealexchangerate,adecreaseintherelativepriceofdomesticgoodsintermsofforeigngoods,iscalledarealdepreciation

ξ Observations:

o IfEhasincreased–thedomesticcurrencyhasgoneupandthisisanominalappreciation

o IfP/P*hasdecrease–thepricelevelofthedomesticcurrencyhasdecreasedandtherebyadecreaseintherelativepriceofdomesticgoodsintermsofforeigngoods.

2. OpennessinFinancialMarkets

ξ Thisallowsthecountrytoruntradesurplusesandtradedeficits.RecallthatacountryrunningatradedeficitisbuyingmorefromtherestoftheworldthanitissellingtotherestoftheWorld.

ξ Inordertopaythedifferencebetweenwhatitbuysandwhatitsells,thecountrymustborrowfromtherestoftheworld.Itborrowsbymakingitattractiveforforeigninvestorstoincreasetheirholdingsofdomesticassets,i.e.tolendtothecountry.

BalanceofPayments

ξ CurrentAccount

o Exports

o Imports

Thesetwoformthetradedeficitorsurplusofacountry

o Investmentincome

Thecountry’sincomereceivedfromholdingforeignassetsminustheincomepaidtoforeignersforholdingdomesticassets.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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Nettransfersi.e.countriesgiveandreceiveforeignaid–negativeamountwouldmeanthecountryisanetdonorofforeignaid.

o Thesumofnetpaymentstoandfromtherestoftheworldiscalledthecurrentaccountbalance.

ξ CapitalAccount

o IncreaseinForeignHoldingsofdomesticassets–increasetheCapitalAccount

o IncreaseindomesticholdingsofForeignassets–reduceCapitalAccount

TheendresultisNetCapitalFlow

• Usually,NetCapitalFlowandCurrentbalancewouldbeequalgiventhereisnostatisticaldiscrepancy.

3. ThechoicebetweenDomesticandForeignAssets

ξ Thechoiceofholdingdomesticmoneyversusforeignmoney,andthechoiceofholdingdomesticinterest­payingassetsversusforeigninterestpayingassets.

ξ However,theformerdecisionisnotsoimportantsincemostconsumersholdcurrencyfortransactionsandholdingforeignmoneydoesnothelpthemcarryoutdomestictransaction.Thefocusthenshouldbeontheseconddecision.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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3.1 UncoveredInterestparity

(1+ it ) = (1+ it*)( Et

Et+1e )

ξ Observations:

o Theassumptionthatfinancialinvestorswillholdonlybindswiththehighestexpectedrateofreturnistoostrong:

Ignorestransactioncosts

Ignoresrisks

o Basedonthistheory,thedecisionwhethertoinvestabroadorathomedependsonmorethaninterestrates.Italsodependsontheexpectedmovementsintheexchangerateinthefuture.

3.2 InterestRatesandExchangeRates

(1+ it ) =(1+ it

*)[1+ (Et+1

e − Et ) / Et ]

ξ Observations

o Thisgivesarelationbetweendomesticnominalinterestrate, it ,theforeignnominalinterestrate, it

* ,andtheexpectedrateofappreciationofthedomesticcurrency, (Et+1

e − Et ) / Et .

o Agoodapproximationtothisequationisbelow:

it ≈ it* − (Et+1

e − Et

Et

)

o Therefore,domesticinterestratemustbeequaltotheforeigninterestrateminustheexpectedappreciationrateofthedomesticcurrency.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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o Orthedomesticinterestratemustbeequaltotheforeigninterestrateminustheexpecteddepreciationrateoftheforeigncurrency.

o Note:thedifferencebetweentheinterestratesmustbegreater(assumethatforeigninterestrateishigher)thandepreciationoftheforeigncurrencytomaketheforeignbondsmoreattractive.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

6

Chapter19

4. Demandfordomesticgoodsinanopeneconomy

Z ≡ C + I +G − IM / ε + X

ξ Thefirstthreetermsareidenticaltotheclosedeconomy

ξ IM/ε isthevalueofimportsintermsofdomesticgoods.Where1/ε isthepriceoftheforeigngoodsintermsofdomesticgoods.Thisisdeductedfromthedomesticoutput

ξ Xisthevalueofexports,whichisaddedtodomesticoutput.

4.1 DeterminantsofC,IandG

ξ Thesameequationasbeforeholdstrue:

C + I +G = C(Y − T+) + I(Y

+,r−) +G

ξ Observations:

o Cisstilldependontheconsumer’sincomeandwealthonlycompositionofconsumptionspendingbetweendomesticandforeigngoodsdiffer.Thesameholdstrueforinvestment.

4.2 DeterminantsofImports

IM = IM (Y+,ε+)

ξ Observations:

o Anincreaseindomesticincome,Y,leadstoanincreaseinimports

o Anincreaseintherealexchangerate,ε ,leadstoanincreaseinimports,IMsincethevalueofimportsintermsofdomesticgoodsgoesupsinceforeigngoodsarecheaper.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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o Note:1/ε goesdownandthiscanaffectthefinalvalueofIM/ε

4.3 DeterminantsofExports

X = X(Y *+,ε−)

ξ Observations:

o Increaseinforeignincome,Y*,leadstoanincreaseinexports

o Increaseintherealexchangerate,ε ,leadstoandecreaseinexports,becausehigherthepriceofdomesticgoodsintermsofforeigngoods,thelowertheforeigndemandfordomesticgoods–higherε lowerexports

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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Panel(C)andPanel(d)representafterExportsareaddedintoaneconomy’sGDP.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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ξ Observations

o Panel:(a)DDrepresentsthedomesticdemandforgoods[C+I+G]

o Panel:(b)AArepresentsthefunctionafterImportshavebeendeductedfromthedomesticdemand.

ThedistancebetweenDDandAAequalsthevalueofimports,IM/ε .

Becausethequantityofimportsincreasewithincome,thedistancebetweenthetwolinesincreasewithincome.

• AAisflatterthanDD.Therefore,asincomeincreasesadditionaldomesticdemandfallsonforeigngoodsratherthandomesticgoods,i.e.demandfordomesticgoodsincreaseslowerthantotaldomesticdemand.

• Since,someadditionaldemanddoesfallondomesticgoods,AAhasapositiveslope.

o Panel:(c)addexports,sinceexportsdonotdependondomesticincome,thedistancebetweenAAandZZisconstantandhenceparallel.

o Panel:(d)NetExports(NX)areadecreasingfunctionofoutput.Asoutputincreases,importsincreaseandexportsareunaffected,sonetexportsdecrease.

Therefore,atYTB ,TBfortradebalance,thelevelofimportsandexportsareequal.ButaswemoveuptheZZline(rightofYTB ),importsincreaseduetoincreaseincomebutexportsstayconstantandNXbecomesnegativeandresultsinatradedeficit.

IfonemovesdowntheZZcurve(leftofYTB ),importsdecreaseasexportsstayconstantandresultsintradesurplus.

o Note:thatthestartingpointdoesnotnecessarybeatatradebalance,whereaneconomy’scurrentoutputcanbewherethereisatradedeficitorsurplus.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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5. EquilibriumOutputandtheTradeBalance

Y = Z

ξ Domesticoutputequaldemand

Y = C(Y − T ) + (I(Y ,r) +G − IM (Y ,ε) / ε + X(Y *,ε)

5.1ChangesinEquilibrium

1. IncreaseinDomesticDemand

ξ TheincreaseisviagovernmentspendingresultingintheZZtoshifttoZZ’asshownbelow:

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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ξ Observations:

o OutputincreasesfromYtoY’

o AssumethatatY,theeconomyhasatradebalance,thentheincreasewouldresultinthecountry’stradebalancetogotowardsadeficit(BC),asincreaseincomeincreaseimportswhileexportsstayconstant.

o Furthermore,theeffectofanincreaseingovernmentspendingislessthaninaclosedeconomysincepartoftheincreaseinincomegoestowardsimportsandthusanoutflowofmoneyfromthedomesticeconomyandoutput.

Note:theZZisflatterthanDDandthisinitselfshowsthatmultiplierinanopeneconomyissmaller.

Therefore,theincreaseindemanddomesticgoodswhenincomeincreasesinlessinanopeneconomy(someincomespendonforeigngoods)thaninanclosedeconomy(thefullincreaseinincomeisusedinthedomesticmarket)

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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2. IncreaseforeignDemand

ξ Observations

o ThedirecteffectoftheincreaseinforeignoutputisanincreaseinexportsandresultsinZZtoshifttoZZ’asthedomesticdemandforgoodsincrease.ThedomesticoutputincreasestoY’andnewequilibriumisatA’.

o TheincreaseΔX leadstoanincreaseinNXsinceNX=X–IM.TheresultisashiftoftheNXline.ThechangeinNX=A’C.

o Itmustbenotedthatthetradebalancecannotdeteriorate.ThedemandfordomesticgoodsshiftsfromZZtoZZ’,thelineDD,whichgivesdomesticdemandforgoodsasafunctionofoutput,doesnotshift.Therefore,atnewoutput,Y’,domesticdemandisDCbuttheequilibriumisA’andthedifferenceA’Cistheincreaseinnetexport.Since,ZZisabovetheDDline,thuseventhoughimportsincrease,theincreasedoesnotoffsettheincreaseinexports,andthetradebalanceimproves

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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6. FiscalPolicyrevisited:

ξ Fromtheabovechangeswecanobservethat:

o Theshockstodemandinonecountryaffectallothertradingpartnercountries.

o Fiscalpolicydecisionsaffectdomesticaswellasforeigndemand

Increasesingovernmentspendingincreasesdomestictradedeficitbutincreasesexportsofanothercountryorcountries.

o Solution:Coordinationoffiscalpolicy

Problems:

• Somecountriesmighthavetodomorethanothersandmaynotwanttodoso.

• Countrieshaveastringincentivetopromiseandthennotdeliveronthatpromise.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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7. Depreciation,TradeBalanceandOutput

ε ≡EPP*

ξ Giventhisequation,theMarshall‐LearnerConditioncanwrittenas:

NX = X(Y *,ε) − IM (Y ,ε) / ε

Realdepreciation­ ε

Resultsinthreescenarios:

1. Exports,Xincrease

2. Imports,IM,decrease

3. Therelativepriceofforeigngoodsintermsofdomesticgoods, 1ε,increase.This

increasetheimportbill,IM/ε andthesamequantityofimportscostmore.

Therefore,fortradebalancetoimprovefollowingdepreciation,exportsmustincreaseenoughandimportsmustdecreaseenoughtocompensatefortheincreaseinpriceofimports.

ΔNXNX

=Δεε

+ΔXX

−ΔIMIM

〉0

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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8. CombiningExchangeRateandFiscalPolicies

ξ Toreducethetradedeficit,thegovernmentmustbothdepreciatethecurrencyanddecreasegovernmentspending.

ξ However,thereareuncertaintyasthetablebelowshows:

ExchangeRateandfiscalpolicy

InitialConditions TradeSurplus TradeDeficit

LowOutput ε ?G ε G?

HighOutput ε G? ε ?G

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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9. Saving,InvestmentandtheTradeBalance

Y = C + I +G − IM / ε + X

ξ SubtractC+Tfrombothsides,andusethefactthatprivatesavingisgivenbyS=Y‐C‐T,toget

S = I +G − T − IM / ε + X

ξ UseNX=X–IM/ε andreorganizetoget:

NX = S + (T −G) − I

ξ Observations:

o Tradesurplus–acountrysavesmorethanitinvests

S + (T −G) ≥ I

o Tradedeficit–acountryinvestsmorethanitsaves

S + (T −G) ≤ I

o Ifsavingsisheldconstant:

IfIincrease=NXdecreases–Tradedeficit

IfBudgetdeficitincrease(GincreaseorTdecrease)=NXdecreases–Tradedeficit

PublicSavings/GovernmentBudget

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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Chapter20

10. EquilibriumintheGoodsMarket

Y = C(Y − T+) + I(Y

+, i−) +G + NX(Y

−,Y *

+,E−)

ξ WhereNX(Y− ,Y*

+,ε−) ≡ X(Y *

+,ε−) − IM (Y

+,ε+) / ε

−

ξ Assumptions:

o Realandnominalinterestratearethesame,r=i

o Anincreaseinthenominalexchangerateleadstoanonetooneincrease

intherealexchangeratei.e. PP*

= 1 ,henceE=ε

11. EquilibriuminFinancialmarkets

MP

= YL(i)

ξ Thesameassumptionsasthecloseeconomy:

o Interestratemustbesuchdemandofmoneyequalsupplyofmoney

o Increaseinmoneysupplydecreasesinterestrate

o Increaseinmoneydemandorincreaseinoutputleadstoanincreaseinterestrate

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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12. DomesticBondsversusForeignBonds

(1+ it ) = (1+ it*)( Et

Et+1e )

ξ Multiplybothsides:

Et = (1+ it1+ it

* )Et+1e

ξ Weshalltaketheexpectedfutureexchangerateastheexpectedexchangerate,

Et = (1+ it1+ it

* )Ee

ξ Observations:

o Thecurrentexchangeratedependsonthedomesticinterestrate,foreigninterestrateandonexpectedfutureexchangerate.

o Foreigninterestrate=exchangerate

o Expectedexchangerate=exchangerate

o Domesticexchangerate=exchangerate

Thechangeininterestratewouldbeequaltothedepreciationorappreciationoftheexchangerate.

Therefore,itmustbetruethatanincreaseindomesticinterestraterelativetotheforeigninterestrateleadstoanappreciation.

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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ξ Ahigherdomesticinterestrateleadstoahigherexchangerate–anappreciation

ξ Therefore,onecansubstitutethisEt ,inthemainISequationtoget:

IS :Y = C(Y − T+) + I(Y

+, i−) +G + NX(Y

−,Y *

+,(1+ it1+ it

* )Ee

−

)

LM : MP

= YL(i)

ξ Note:Changesintheinterestrateaffecttheeconomydirectly.Throughinvestmentandthusoutput,andindirectlythroughtheexchangerate.

o Increaseininterestrate,decreaseinvestmentandincreaseexchangerateandthusdecreaseoutputoverall.

o Decreaseininterestrate,increaseinvestmentanddecreaseexchangerateandthisincreaseoutputoverall.

UshanPremaratne

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UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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1. EffectsofFiscalPolicyinanOpenEconomy

Increaseingovernmentspending

ξ TheincreaseingovernmentspendingwouldincreaseoutputfromYtoY’.

ξ Thiswouldalsoincreaseinterestrateandthereforeappreciatetheexchangerate.

o Thisappreciationoftheexchangewoulddecreaseexportsandhencedomesticdemandforgoods

o Increaseininterestratewoulddecreasethedomesticdemandforgoods.

Theyoveralloffsettosomeeffectthegovernmentspendingondemandandoutput.

Differentvariable:

• Consumptiongoesupasthereisanincreaseinincome

• GovernmentSpendinggoesupbyassumption

• Investmentmightincrease,decreaseorremainunchangedandhenceambiguousintheshortrun.

• NetExportsdecreasesince

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BSP2001–Macroeconomics–OpenMarkets

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o Theincreaseinoutputincreaseinimportsand

o Theappreciationdecreaseinexports

2. EffectsofMonetaryPolicyinanOpenEconomy

ξ Amonetarycontractionleadstoadecreaseinoutput,anincreaseintheinterestrateandanappreciation.

ξ Thereductioninoutputwouldincreaseinterestrates

ξ Theincreaseininterestrate:

o Domesticbondsmoreattractiveandhenceappreciatethecurrency

o However,thehigherinterestrateandappreciationleadstoareductionofoutputandasoutputfalls,incomedecreaseanddemandformoneyfallandtheinterestratefalls.

o Therefore,thisoffsettheinitialincreaseintheinterestrateandsomeoftheinitialappreciation

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BSP2001–Macroeconomics–OpenMarkets

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13. FixedExchangeRate

ξ Centralbanksactunderimplicitandexplicitexchange‐ratetargetsandusemonetarypolicytoachievethosetargets.

ξ Somecountriesoperateunderfixedexchangerates.Thesecountriesmaintainafixedexchangerateintermsofsomeforeigncurrency.Somepegtheircurrencytothedollar.

o Thedecreaseinexchangerateiscalleddevaluation

o Theincreaseinexchangerateiscalledrevaluation

ξ Somecountriesoperateunderacrawlingpeg.Thesecountriestypicallyhaveinflationratesthatexceedthetargetcountry(often,U.S.)inflationrate.

13.1 Pegs,CrawlingPegs,Bands,theEMS,andtheEuro

ξ Somecountriesmaintaintheirbilateralexchangerateswithinsomebands.ThemostprominentexampleistheEuropeanMonetarySystem(EMS).

ξ UndertheEMSrules,membercountriesagreedtomaintaintheirexchangeratevis‐á‐vistheothercurrenciesinthesystemwithinnarrowlimitsorbandsaroundacentralparity.

ξ Somecountriesmovedfurther,agreeingtoadoptacommoncurrency,theeuro,ineffect,adoptinga“fixedexchangerate.”

13.2 PeggingtheExchangeRate,andMonetaryControl

ξ PeggingtheexchangerateatacertainvalueEmeansthatthecountrychoosesEasthecurrentexchangerate.

ξ Iftheinvestorsbelievethattheexchangewillremainpeggedatthatvalueinfuture,thentheexpectationofthefutureexchangeratewillalsobeE.Thisturnstheinterestparityrelationinto:

UshanPremaratne

BSP2001–Macroeconomics–OpenMarkets

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ξ Underafixedexchangerateandperfectcapitalmobility,thedomesticinterestratemustbeequaltotheforeigninterestrate.

ξ Therefore,undermoneysupplyanddemand:

MP

= YL(i*)

ξ Monetarycontrol:Supposethereisanincreaseindomesticoutput,whichincreasesthedemandformoney.

o Forpeggedeconomies,CentralBankhastoincreasethesupplyofmoneyinordertomaintaintheinterestrateconstant.

ξ Henceunderfixedexchangerate,theCentralBankdoesnothavecontroloverthedomesticinterestrate.