Principles of Economics Open-Economy Macroeconomics Tomislav Herceg

Flow of goods and services Exports (EX) are domestically produced goods & services sold abroad Imports (IM) are foreign-produced goods & services sold domestically Net exports (NX, trade balance) = exports – imports Trade surplus: when EX > IM Trade deficit: when IM > EX Balanced trade: when IM = EX

Flow of financial resources Net capital outflow (NCO, net foreign investment) = purchase of foreign assets by domestic residents – purchase of domestic assets by foreigners Net capital outflow is equal to net exports In an open trade: Y = C + I + G + NX Since S = Y – C – G then S = I + NX. Since NX = NCO then S = I + NCO (savings can be used to purchase capital domestically or abroad)

Summary Trade deficit Trade surplus Balanced trade NX < 0 NX > 0 EX < IM EX > IM EX = IM Y < C + I + G Y > C + I + G Y = C + I + G S < I S > I S = I NCO < 0 NCO > 0 NCO = 0

Exchange rates Nominal exchange rate (e) is a rate at which one currency is traded for another Appreciation is an increase in the value of a currency as measured by the amount of the foreign currency it can buy Depreciation is a decrease in the value of a currency as measured by the amount of the foreign currency it can buy Real exchange rate (er)is the rate at which goods of one country can be traded for the goods of another: er = e∙pd/pf

Purchasing power parity (PPP) First theory of exchange rate determination PPP is a theory which states that a unit of a currency should be able to buy the same amount of goods in all countries, hence: e = pf/pd Under PPP nominal and real exchange rate are equal Common currency area is a geographical area covering several countries that use common currency Purchasing power standard (PPS) is a fictional currency that expresses a purchasing power in EU.

Limitations of PPP Not all goods can be traded (e.g. haircuts, these goods are called non-tradeables) Goods are not always perfect substitutes when produced in different countries (e.g. economic nationalism)

Market for loanable funds Supply of loanable funds: savings (S) Demand for loanable funds: domestic investment (I) + net capital outflow (NCO) Real interest rate S = supply S = I + NCO I+NCO = demand Quantity of loanable funds

Market for foreign currency exchange Supply of currency comes from net capital outflow, while demand for currency comes from net exports Note: NCO defines supply of foreign exchange and demand for loanable funds Real exchange rate NCO = supply NX = NCO NX = demand Quantity of currency exchanged

Simultaneous equilibrium Real interest rate S = supply Real interest rate S = I + NCO NCO I+NCO = demand Quantity of loanable funds Net capital outflow Real exchange rate NCO = supply NX = NCO NX = demand Quantity of currency exchanged

The Effects of Budget Deficit Real interest rate S2 S = S1 Real interest rate S = I + NCO NCO I+NCO = demand Quantity of loanable funds Net capital outflow Budget deficit reduces supply of loanable funds which causes interest rates to rise, hence net capital outflow falls reducing supply of domestic currency on exchange market Real exchange rate s2 NCO = S1 NX = NCO NX = demand Quantity of currency exchanged

The Effects of Import Quota Real interest rate S = S1 Real interest rate S = I + NCO NCO I+NCO = demand Quantity of loanable funds Net capital outflow Trade policy is a government policy whose prime goal is to affect the quantity of goods and services that a country imports or exports It affects only exchange rate, not the trade balance since NX = NCO = S – I and S and I are not affected by trade policy Real exchange rate NCO = S1 NX = NCO D2 Quantity of currency exchanged NX = D1

The Effects of Capital Flight Real interest rate D2 S Real interest rate S = I + NCO NCO2 I+NCO = D1 Quantity of loanable funds NCO1 Net capital outflow Increase in net capital outflow causes demand for loanable funds to increase which causes interest rates to increase. Also supply of domestic currency on the exchange market increases thus depreciating domestic currency. Real exchange rate s2 NX = NCO NX = demand NCO = S1 Quantity of currency exchanged

Problem 1 Japanese car costs 500 000 yen and similar German car costs 10 000 €. Yen/€ exchange rate is 100. What are the nominal and the real exchange rates? ey/€ = 100, e€/y = 0.01 er, y/€ = 10000×100/500000 = 2 b) How would we call a situation in which 1€ would now buy 80 yen instead of 100? It would mean € depreciated against yen and yen appreciated against €

Problem 2 Explain effects of the following actions on exports, imports and capital flows: Agrokor (Cro) buys Mercator (Slo) Croatian net capital outflow rised (NCO) b) Croatian export rises and import drops due to recession Net exports rise

Problem 3 A Big Mac costs 3₤ in London and 15 HRK in Zagreb. Exchange rate HRK/ ₤ = 10 HRK. Does PPP hold? ePPP = 15/3 = 5 – no, it does not hold b) Find real exchange rate HRK/ ₤ er = 3×10/15 = 2 (if er = e then PPP holds) With the same amount of money consumer can buy 1 Big Mac in Croatia and 2 Big Macs in UK

Problem 4 Exchange rates on 11 January 2014 published by Croatian National Bank are: 1 € = 7.669 HRK 1 USD = 6.493 HRK 100 JPY = 5.446 HRK 1 CHF = 6.386 HRK If exchange rate parity holds, find exchange rates for € against all other currencies

Problem 5 Market for Euro is given with the following table: What is the equilibrium exchange rate? What defines supply & demand for Euro? What should ECB do if it wants to reach exchange rate 1.5 USD/EUR? USD/EUR Supply of Euro (100 Bill.) Demand for Euro (100 Bill.) 1.1 200 260 1.3 220 1.5 240 180 1.7 140

Solution 1.3 where S = D Supply is net capital outflow (NCO) and demand is net exports (NX) Increase demand for € by 6000 Bill.

Problem 6 Price of a Big Mac is 3.57$ in the USA and 18 HRK in Croatia. Exchange rate is 6.493 HRK for 1$. Does PPP hold? If not, find undevaluation/overvaluation of HRK

Solution PPP = Pd/Pf = 18/3.57 = 5.04. However e = 6.493, hence PPP does not hold %over/underval. = (PPP-e)×100%/e = (5.04-6.493)×100%/6.493 = -22.38%