THE OPEN ECONOMY: INTERNATIONAL ASPECTSOF THE MACRO-ECONOMY

1. The balance of payments

2. The foreign exchange (forex) market

3. Fixed v floating exchange rates

4. Single currency areas

5. Globalisation and macro policy

What is the balance of payments?

Why are policy makers concerned about the BP?

How can govts ‘correct’ a BP problem?

How are exchange rates determined?

How can the CB affect the exchange rate?

Is a single currency for Europe desirable?

Should the G3 (G7) co-ordinate their macro-policies?

THE BALANCE OF PAYMENTS

• records all flows of money between countries

• BP = current acc + capital acc

Current account (or financial account) - exports minus imports of goods / services - govt transfers (e.g. EU taxes / subsidies)

Capital account - fixed investment (FDI) - bonds, equities, deposits (portfolio investment)

UK Current accountExports +165Imports -192Services +11Net income +7Net govt transfers -4 Balance -13

UK Capital accountFDI (net) +173Portfolio (net) -143Short-term flows (net) -23Balance +10

Reserves +1Error -2Balance of payments 0

Surpluses and deficits in the BP

Surplus: BP > 0 - foreign exchange reserves increase - accumulation of foreign assets - exchange rate ‘too high’ Deficit: BP < 0 - foreign exchange reserves decline - loss of foreign exchange reserves - deficit has to be financed (borrowing) - loss of control over domestic assets - downward pressure on exchange rate; inflationary

Determinants of the BP

BP = exports - imports + net capital flows

• exports = f (exch rate, competitiveness, world income)

• imports = f (exch rate, competitiveness, income)

• net capital flows = f (r / world r, country risk)

Model: BP = f ( e, w/w*, y*, y, r/r*)

e = exchange rate (£/$)w = real wage; w* = world real wagey = income y* = world incomer = interest rate r* = world interest rate

Govt intervention to ‘correct’ the BP

• exchange rate policy: buying / selling domestic currency

• fiscal / monetary policy to control AD - raise / lower r (capital account) - change G or T (trade account)

• supply-side policies - improve competitiveness via labour market flexibility

THE FOREX MARKET

The exchange rate

e = £ per $ (or s = $ per £)

Determination of e: a simple model

Demand for £s (= supply of $s)• importers of UK goods / services• tourists visiting UK• foreign students in UK universities• foreigners investing in UK• UK citizens with foreign income

Supply of £s (= demand for $s)• opposite to above

Model: e = f ( x - m, r - r*)

When will exchange rate appreciate?

Current account:• demand for exports increases• demand for imports decreases• competitiveness increases (w / w* increases)

Capital account:• inflow of foreign investment (r / r* increases)

FIXED v FLOATING EXCHANGE RATES

Advantages of a fixed exchange rate

• certainty for exporters / importers/ investors

• ‘no speculators’ within single currency area

• imposes constraints on govt macro policy - constrained by effect on BP - constrained by effect of policies on inflation - govt has to achieve BP equilibrium over medium term

Disadvantages of a fixed exchange rate

• economic policy will be constrained by fixed ER - chronic BP deficit requires deflationary policy - conflict between full employment and BP equilibrium

• sudden ‘shocks’ cannot be absorbed by ER adjustment - shocks affect ‘real’ economy if prices are fixed

• fixed ER encourages ‘protectionism’ - due to impact of shocks on ‘real’ variables

• speculators cause financial / political crises

Advantages of floating exchange rates

• govt ignores ER; no intervention needed

• no need to worry about BP

• economy is insulated from shocks (absorbed by ER)

• govt can concentrate on internal policy objectives (inflation, unemployment, income distribution)

Disadvantages of floating exchange rates

• exchange rate can be volatile in the short run - causes uncertainty (harmful to investment / trade)

• capital flows can cause ER to get ‘out of line’ with its underlying (fundamental) value

• loss of BP constraint on macro-policy may lead to inflationary bias - with a fixed ER, govt has to respond to BP deficits

SINGLE CURRENCY AREAS

Advantages of a single currency

• lower transactions costs (no currency conversions)

• increased price competitiveness - transparent pricing across countries • elimination of exchange rate uncertainty - encourages trade - encourages investment (inc. FDI)

• lower inflation and interest rates - central bank independent of member govts - member states have to keep wage increases in line to maintain competitiveness

Disadvantages of a single currency

• surrenders economic sovereignty to supra-national authority - no control over monetary policy - no control over exchange rate

• deflationary effects in countries with high wage pressures

• increase in regional disparities due to greater factor mobility

• potential loss of control over fiscal policy - cannot use monetary expansion to pay for increase in G - tight control over govt borrowing (fiscal balance needed)

Why might the Euro Zone not be an optimal currency area?

• labour markets are not flexible enough - wages may be sticky downwards - labour is not sufficiently mobile to respond to changes in demand - effects of changes in euro ER will vary between member states / regions

• But: alternative methods of dealing with adverse effects of structural change - structural funds for re-training - structural funds for encouraging indigenous growth - infrastructure policies to revive declining regions

GLOBALISATION AND MACRO POLICY

Interdependence

• world’s economies increasingly inter-dependent

• steadily increasing world trade - dependent on each other’s demand for exports

• vast increase in financial flows due to liberalisation of financial markets - abolition of controls on currency movements - financial markets affect each other (instantaneously) - Fed has profound effect on rest of world’s economies

Co-operation between G7: policy harmonisation

• need for policy harmonisation to prevent world-wide recession / inflation

- exchange rates should not be ‘out of line’ (need to keep current accounts in reasonable balance)

- inflationary pressures are easily transmitted to other countries

- co-ordination of interest rates may be needed to prevent adverse capital flows

• G7 needs to deal with the problem of developing country debt