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

Open economy Macroeconomics n … 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 n Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world – especially via the exchange rate.

Some Keys Terms n The foreign exchange (forex) market exchanges one national currency for another. The price at which two currencies are exchanged is called the exchange rate. n The international (domestic) value of the domestic currency is the quantity of foreign (domestic) currency per unit of the domestic (foreign) currency n 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

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 for pounds by Americans wanting to buy British goods/assets. Quantity of pounds Exchange rate ($/£) Suppose 2 countries: UK & USA SS SS shows the supply of pounds by UK residents wishing to buy American goods/assets. e0e0 Equilibrium exchange rate is e 0 SS 1 If UK residents want more $ at each exchange rate, the supply of £ moves to SS 1 e1e1 New equilibrium at e 1.

Alternative exchange rate regimes n In a fixed exchange rate regime – the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. n 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

Alternative exchange rate regimes n The central intervenes in the forex market when it is forced to buy or sell pounds (rupees) to support the fixed exchange rate. n In a fixed exchange rate, a devaluation (revaluation) is a fall (rise) in the exchange rate governments commit themselves to maintain.

Alternative exchange rate regimes n 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.

Intervention in the forex market Quantity of £s $/£ SS DD e1e1 Suppose the government is committed to maintaining the exchange rate at e 1... When demand is DD, no intervention is needed... there is a balance in transactions between the countries. The Bank of England must supply AC £s in return for $, which are added to reserves. DD 1 If the demand for pounds is DD 1 there is excess demand AC. AC DD 2 The reverse occurs if demand is at DD 2. E

The Balance of Payments n … a systematic record of all transactions between residents of one country and the rest of the world n Current account – records international flows of goods, services, income and transfer payments n Capital account – records transactions involving fixed assets n Financial account – records transactions in financial assets

29.9 The UK balance of payments, Source: Economic Trends Annual Supplement

Floating Exchange Rates and the Balance of Payments n If the exchange rate is free to move to its equilibrium, there is no need for intervention n any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts n if there is intervention, it is recorded as part of the financial account.

International Competitiveness n The competitiveness of UK goods in international markets depends upon: – the nominal exchange rate – relative inflation rates n 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

International Competitiveness n RER = (E x P) / P* E: nominal exchange rate P: domestic sterling price of UK goods P*: dollar price of US goods n Purchasing Power Parity exchange rate is the path of nominal exchange rate that maintains a constant exchange rate.

Relative Prices and the Nominal Exchange Rate, UK & USA Relative price (UK/USA) Exchange rate ($/£)

The Real £/$ Exchange Rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

Components of the Balance of Payments n The current account is influenced by: – Competitiveness (imports, exports and net interest on foreign assets) – domestic and foreign income n The capital & financial accounts are influenced by: – relative interest rates n which affect international capital flows. n Perfect capital mobility – occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries

Internal and External Balance n Internal balance – a situation for a country when aggregate demand is at the full-employment level (C+ I + G) n External balance – a situation for a country when the current account of the balance of payments just balances ( X – Z) n The combination of internal and external balance is the long-run equilibrium for the economy.

Internal and External Balance n 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 n Shocks move the economy away from internal and external balance n For example, the top left corner shows a combination of domestic slump and a current account surplus.

Shocks may move an economy away from internal and external balance: Boom Slump Surplus Deficit More saving, tighter fiscal & monetary policy Foreign boom, lower real exchange rate Foreign slump, higher real exchange rate Less saving, easier fiscal & monetary policy

The Long Run Equilibrium Exchange Rate n In the LR both internal and external must hold. It requires that Y* = Y = (C + I + G) + (X- Z) n In external balance, net exports (X – Z) = 0 n Internal balance requires that C + I + G = Y* n Net exports depends only on RER n 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

The Long Run Equilibrium Exchange Rate NX NX’ R0R0 R1R1 n Trade balance at R o. n A resource discovery shifts NX to NX’ n RER appreciate to R1 to maintain trade balance in the LR

Foreign Debt and Foreign Assets CA (Creditor) CA (Debtor) R0R0 R1R1 n For a CA balance, a debtor country needs a low Ro to be competitive n A creditor country has a high RER to reduce competitiveness and run a trade deficit, financed by interest earned on foreign assets