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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
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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
BSP2001–Macroeconomics–OpenMarkets
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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
UshanPremaratne
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.
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