11/2/04dr. pk basu and dr. rod duncan eco 120 macroeconomics week 12 open economy & exchange...

11/2/0411/2/04 Dr. PK Basu and Dr. Rod DuncanDr. PK Basu and Dr. Rod Duncan

ECO 120 Macroeconomics

Week 12

Open Economy &Exchange Rate

LecturerDr. Rod Duncan


Closed and Open Economies

A closed economy is one that does not interact with other economies in the world.

There are no exports, no imports, and no capital flows.

An open economy is one that interacts freely with other economies around the world.


An Open Economy

An open economy interacts with other countries in two ways.

It buys and sells goods and services in world product markets.It buys and sells capital assets in world financial markets.

The Australian economy is a medium-sized open economy—it imports and exports relatively large quantities of goods and services.


Exports and Imports

Exports are domestically produced goods and services that are sold abroad.Imports are foreign produced goods and services that are sold domestically.Net exports (NX) or the trade balance is the value of a nation’s exports minus the value of its imports.

NX = X - M


Australian Trade in Goods (1949-1995)

0

20000

40000

60000

80000

100000

120000

1949 1956 1963 1970 1977 1984 1991

Mill

ion

A$

ExportsImports


Net Exports

A trade surplus is a situation where net exports (NX) are positive.

Exports > Imports

A trade deficit is a situation where net exports (NX) are negative.

Imports > Exports


Net Exports (1949-1996)

-12000

-10000

-8000

-6000

-4000

-2000

0

2000

4000

Mill

ions

A$

-24

-21

-18

-15

-12

-9

-6

-3

0

3

6

% o

f GD

P

In A$

% of GDP


Foreign Trade and Equilibrium GDP

Aggregate Expenditure = C + I + G Aggregate Expenditure = C + I + G + NX+ NX

Level of X depends on Level of X depends on foreignforeign countries’ income, countries’ income, notnot domestic domestic income income

Level of M Level of M isis dependent on dependent on domesticdomestic income or GDP. income or GDP.


Factors That Affect Net Exports

•The tastes of consumers for domestic and foreign goods.•The prices of goods at home and abroad.•The exchange rates at which people can use domestic currency to buy foreign currencies.•The costs of transporting goods from country to country.•The policies of the government toward international trade.


Exchange Rate

The exchange rate is the rate at which a person can trade the currency of one country for the currency of another.The nominal exchange rate is expressed in two ways.

•In units of foreign currency per one Australian dollar•In units of Australian dollars per one unit of the foreign currency


Exchange Rate

At an exchange rate between the US dollar and the Australian dollar is 0.70 US cents to one Australian dollar.

•One Australian dollar trades for 0.70 of US$. [This is the form we will use.]•One US$ trades for 1.43 (1/0.7) of an Australian dollar.


Determination of exchange rates

The market price of something is The market price of something is determined in the market.determined in the market.

Under the Floating Rate system, price of a Under the Floating Rate system, price of a currency (its exchange rate) in the currency (its exchange rate) in the international market for currency is international market for currency is determined by its determined by its DemandDemand and and SupplySupply..

A$ is a floating currency - floated in A$ is a floating currency - floated in December 1983.December 1983.


Value of A$ (1949-1996)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

US$

0

50

100

150

200

250

300

350

400

450

Japa

nese

Yen

Yen/A$

US$/A$



Demand for A$ (people who want to Demand for A$ (people who want to buy A$):buy A$): By overseas buyers of Australian By overseas buyers of Australian

goods and services (including their goods and services (including their tourist visits to Australia)tourist visits to Australia)

By overseas investors who want to By overseas investors who want to buy Australian physical and financial buy Australian physical and financial assets.assets.



Supply of A$ (people who want to sell Supply of A$ (people who want to sell A$):A$): By Australian importers (including By Australian importers (including

overseas trips by Australians)overseas trips by Australians) By Australian investors who want to buy By Australian investors who want to buy

physical and financial assets overseas.physical and financial assets overseas.


Appreciation/Depreciation

If a dollar buys more foreign currency, there is an appreciation of the dollar -- say, one A$ buys one US$ instead of 70 US cents at present.

If it buys less there is a depreciation of the dollar -- say, one A$ buys 50 US cents instead of 70 US cents at present.


Demand for A$

As exchange rate (US$ per A$) increases (say, from US$ 0.70 to US$ 1), exports become more expensive. Overseas buyers will buy less of Australian goods and services. Demand for A$ falls.

(Just opposite when the value of A$ decreases)

So, Demand curve for A$ (or any other currency) is downward sloping - as exchange rate increases, demand for the currency falls, and vice versa.


Supply of A$

•As exchange rate increases (say, from US$ 0.70 to US$ 1), imports become cheaper. Australians will buy more of foreign (imported) goods and services. Supply of A$ increases. (Just opposite when the value of A$ decreases)

So, Supply curve of A$ (or any other currency) is upward sloping - as exchange rate increases, supply

of the currency increases, and vice versa.



Exchange rate (cost of 1 A$ in terms of US$)

Amount of A$

Demand for A$

Supply of A$


Balance of Payments

Reflected in international balance of payments accounts.

Records all transactions between the entities in Australia and those in foreign nations

Two basic accounts:•Current Account•Capital Account


Balance of Payments

Current account of a country’s international transaction refers to the record of receipts from the sale of goods and services to foreigners (exports), the payments for goods and services bought from foreigners (imports), and also property income (such as interest and profits) and current transfers (such as gifts) received from and paid to foreigner.

Capital account is a summary of country’s asset transactions with the rest of the world.


Balance of Payments

Current Account Balance (+,-) = Capital Account Balance (+,-)

Demand for A$ equals Supply of A$.

If we have a current account deficit (we are importing more than we are exporting), then we must also have

a capital account deficit (investors overseas are accumulating Australian assets).


CAD (Current Account Deficit) and Exchange Rate

CAD impacts on :Inflow of foreign investment - higher the CAD, higher the surplus in capital account - higher investment in Australia by the foreigners - higher the demand for A$.Outflow of foreign currency - income (interest & profit) on foreign investment goes out of the country- higher the CAD, higher the demand for foreign currency - higher the supply of A$. Exact impact depends on relative strengths of the

two opposing forces.


Current Account Deficits (1949-1996)

-30000

-28000

-26000

-24000

-22000

-20000

-18000

-16000

-14000

-12000

-10000

-8000

-6000

-4000

-2000

0

2000

4000

Mill

ions

A$

-20

-15

-10

-5

0

5

% o

f GD

P

In A$

% of GDP


Is the Current Account Deficit a Problem?

Represents a debt we will have to Represents a debt we will have to repay in the future.repay in the future.

Just as for a household, the extent of Just as for a household, the extent of the problem depends on our ability the problem depends on our ability to service the debt- but notice that to service the debt- but notice that CAD as a percentage of GDP (ability CAD as a percentage of GDP (ability to service debt) is still low.to service debt) is still low.


Terms of Trade

The ratio of average price of goods The ratio of average price of goods and services exported by a country and services exported by a country to the average price of its imports.to the average price of its imports.

If prices of imported goods are rising at a If prices of imported goods are rising at a faster rate than the prices of exported faster rate than the prices of exported goods, then the terms of trade for that goods, then the terms of trade for that economy is considered as deteriorating. economy is considered as deteriorating. The economy is loosing in the process The economy is loosing in the process of foreign trade.of foreign trade.


Terms of Trade in Australia

Australia mainly exports agricultural, Australia mainly exports agricultural, primary and mineral products to the rest of primary and mineral products to the rest of the world.the world.

It imports manufacturing goods.It imports manufacturing goods. As a result, it has faced gradual As a result, it has faced gradual

deterioration in terms of trade.deterioration in terms of trade.


Terms of Trade (1949-1995)

0

25

50

75

100

125

150

175

200

Mill

ion

A$


Purchasing Power Parity (PPP)

The purchasing-power parity theory is the simplest and most widely accepted theory explaining the variation of currency exchange rates.

According to the purchasing-power parity theory, a unit of any given currency should be able to buy the same quantity of goods in all countries.


Intuition for PPP

In an open economy, I have the choice of buying an orange in Australia or an orange from Indonesia and importing the orange back to Australia.

If transport costs are low, the price of traded goods should be the SAME, once we translate into a common currency.

This is called the law of one price.


Purchasing-Power Parity

Law of one price Law of one price when converted to a common currency when converted to a common currency

value through the exchange rate, the value through the exchange rate, the price of identical goods should be the price of identical goods should be the same across countriessame across countries

PPd d = E x P= E x Po/s, o/s, where, Pwhere, Pdd=domestic =domestic priceprice P Po/so/s= foreign = foreign priceprice

E = exchange rate E = exchange rate


Problems with Relying on PPP

presence of non-traded goodspresence of non-traded goods product differentiationproduct differentiation differences in consumption patterns and differences in consumption patterns and

preferences across countriespreferences across countries transportation coststransportation costs tariffs and other forms of industry tariffs and other forms of industry

assistance distort relative prices assistance distort relative prices between countriesbetween countries


Macroeconomics - JacksonChapters : 4, 7 & 18

References

11/2/04dr. pk basu and dr. rod duncan eco 120 macroeconomics week 12 open economy & exchange...

Documents