Lecture 9

🎗️
lecture 9: macroeconomics for an

open economy
I. balance of payments
1. balance of payments
current account
capital account/financial account
net errors and omissions
overall balance
reserve and related items
2. accounting methods
transactions which involve a flow of payment into our country has a plus sign (credit
items)/inflow of payment.
transactions which involve a flow of payments out of our country has a minus sign (debit
items)/outflow of payment.
inflow > outflow → balance is positive → surplus.
inflow < outflow → balance is negative → deficit.
3. the relation of net exports and net capital flows
export = domestic residents receive and hold foreign currencies = outflow of capital
import = foreigners receive and hold domestic currencies = inflow of capital
export - import = outflow of capital - inflow
net exports = net capital outflow (NX = NCO)
4. relationship of saving and investment for open economy
macroeconomic identity for open economy:
total expenditures - total income = Te
lecture 9: macroeconomics for an open economy 1

→ Yincome = Yexpenditure - Te = C + I + G + NX - Te

→ Td + C + S = C + I + G + NX - Te
→ S - I + T - G = NX
→ SP + SG = I + NX

→ SN = I + NX

→ SN = I + NCO

II. how to exchange rate determined?

1. defintion of exchange rate
the nominal exchange rate tells us
the price of a foreign currency in terms of domestic currency (E)
the price of domestic currency in terms of foreign currenct (e)
exchange rates
real exchange rate is the nominal exchange rate adjusted for relative prices between
f
×E n
countries under consideration Er = P P d
real exchange rate tells us which goods, domestic or foreign, are more competitive in
terms of price.
nominal vs real exchange rate
nominal exchange rate real exchange rate
- price of foreign currency in terms of domestic - quantity of domestic goods to exchange for one
currency (En ) unit of foreign good (Er )

example: suppose that nominal exchange rate between VND and USD is 25000 VND/USD. a
jacket’s price is 500000 in Vietnam. a jacket’s price is 40 USD in US. calculate real exchange
rate between VN and USD. briefly explain the meaning of real exchange rate.
2. the first theory to determine exchange rate
purchasing power parity theory (PPP) 1920s - Gastav Cassell
arbitrage forces will lead to the equalization of good prices intentionally once the
price of goods are measured in the same currency “law of one price”
then, real exchange rate is equal to 1, then nominal exchange rate is equal to the ratio
of prices in 2 countries

how to determine equilibrium exchange rate
d
absolute PPP: En = PP f
relative PPP: %En = %Pd - %Pd
depreciation rate of domestic currency = domestic inflation rate - foreign inflation

rate
3. theory of UIP
uncovered interest parity condition (UIP)
UIP says that the expected rate of depreciation of domestic currency is equal to the
interest rate differential between domestic and foreign bonds
the condition is to ensure the indifference between holding domestic and foreign
assets, e.g the same rate of return.
4. foreign exchange market
from USD to VND
supply of USD
demand of USD
from VND to USD
supply of VND
demand for USD
how to determine equilibrium exchange rate
supply-demand approach: exchange rate/price of foreign currency is determined by

the supply of and demand for foreign currency.
the demand for foreign currency comes from domestic residents who want to
buy foreign goods or assets.
the supply of foreign currency comes from foreign residents who want to buy
domestic goods or assets.

III. the exchange rate regimes
1. flexible/floating exchange rate
2. fixed exchange rate
advantage and disadvantage of fixed exchange rate system
advantages
stable exchange rate makes trade and investment easier
allow government to achieve certain objectives such as trade balance, economic

growth, external debt
disadvantages
government intervention can be harmful for the economy (inflation, running out
of foreign reserves)
limitations of a central bank’s actions
fixed exchange rates can become unfixed when it is largely deviated from long-
run equilibrium exchange rate, then it can create enormous monetary instability
3. partially flexible exchange rate
partially flexible exchange rate mechanisms
if there is a fundamental misalignment in exchange rate, policymakers allow private

forces to determine it - flexible exchange rate.
if there us speculation on currency or too large adjustment in currency’s value in a

short time or adjustments won’t achieve balance of payments goals, the
policymakers have interventions, either supporting or pushing down currency’s
value - fixed exchange rate

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🎗️

lecture 9: macroeconomics for an

capital account/financial account

net errors and omissions

reserve and related items

inflow > outflow → balance is positive → surplus.

inflow < outflow → balance is negative → deficit.

3. the relation of net exports and net capital flows

import = foreigners receive and hold domestic currencies = inflow of capital

export - import = outflow of capital - inflow

net exports = net capital outflow (NX = NCO)

4. relationship of saving and investment for open economy

macroeconomic identity for open economy:

total expenditures - total income = Te

lecture 9: macroeconomics for an open economy 1

II. how to exchange rate determined?

the nominal exchange rate tells us

the price of a foreign currency in terms of domestic currency (E)

the price of domestic currency in terms of foreign currenct (e)

nominal vs real exchange rate

nominal exchange rate real exchange rate

2. the first theory to determine exchange rate

purchasing power parity theory (PPP) 1920s - Gastav Cassell

lecture 9: macroeconomics for an open economy 2

relative PPP: %En ﻿= %Pd ﻿- %Pd ﻿

depreciation rate of domestic currency = domestic inflation rate - foreign inflation

uncovered interest parity condition (UIP)

4. foreign exchange market

from USD to VND

from VND to USD

demand for USD

how to determine equilibrium exchange rate

supply-demand approach: exchange rate/price of foreign currency is determined by

lecture 9: macroeconomics for an open economy 3

2. fixed exchange rate

advantage and disadvantage of fixed exchange rate system

stable exchange rate makes trade and investment easier

allow government to achieve certain objectives such as trade balance, economic

limitations of a central bank’s actions

3. partially flexible exchange rate

partially flexible exchange rate mechanisms

if there is a fundamental misalignment in exchange rate, policymakers allow private

if there us speculation on currency or too large adjustment in currency’s value in a

lecture 9: macroeconomics for an open economy 4

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relative PPP: %En = %Pd - %Pd