MACROECONOMICS- PPT 12

LEARNING OBJECTIVES
 To understand
 Open Economy Macro economy
 Openness in Goods and Money Market
 Exchange rate and its determination
 Exchange Rate Systems
 Exchange rate and macroeconomic policies
 Balance of Payments

2
Open Economy Macro Economy
 OPENNESS OF AN ECONOMY
 Openness has three distinct dimensions:

o Openness in goods markets.

o Openness in financial markets.
o Openness in factor markets.

Note: we shall discuss openness in goods & financial market only

4
OPENNESS IN GOODS MARKET
 When goods markets are open, domestic consumers must decide
not only how much to consume and save, but also whether to buy
domestic goods or to buy foreign goods.

5
DEMAND FOR DOMESTIC
GOODS/PRODUCT MARKET
 Closed economy

Y = C + I +G
Where
C = (Y-T) is consumption which is a direct function of disposable
income
I = I (i) is investment which is a indirect function of interest rate ‘i’
G = autonomous

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DEMAND FOR DOMESTIC GOODS/PRODUCT MARKET

 Open economy

Y = C + I +G + X - M

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DETERMINANTS OF IMPORTS
 M = M (Y,E)
(  , )
M is the part of the domestic demand falling on foreign goods

 An increase in domestic income, Y leads to an increase in imports.

So ‘M’ is a direct function of ‘Y’
 An increase in exchange rate ‘E’ leads to an increase in imports
‘M’. So ‘M’ is a direct function of ‘E’

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DETERMINANTS OF EXPORTS (X)
 X = X (Y*,E)
(  , )

Exports are a part of foreign demand that falls on domestic goods.

They depend on
 Foreign income Y*. Higher Y*, higher exports and so on. So X is a
direct function of Y*
 Exchange rate ‘E’. Higher the price of domestic goods in terms of
foreign goods, lower would be foreign demand for the good that is
lower would be exports and so on. So X is an indirect function of ‘E’

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DEMAND FOR DOMESTIC GOODS IN
EXPANDED FORM

Y = C (Y – T) + I (i)+ G + X (Y*, E) – M (Y, E)

10
OPENNESS IN FINANCIAL MARKETS
Openness in financial markets allows:
 Financial investors to diversify—to hold both domestic and foreign
assets and speculate on foreign interest rate movements.

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THE CHOICE BETWEEN DOMESTIC AND
FOREIGN ASSETS
 The decision whether to invest abroad or at home depends not
only on interest rate differences, but also on your expectation of
what will happen to the nominal exchange rate.

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FINANCIAL MARKET/MONEY
MARKET
 Closed economy: People have demand for two financial
assets: money & bond

M/P = L1 (Y) + L2 (i)

Transaction demand Speculative demand
 L1 (Y) → this is a direct function of ‘Y’
 L2 (i) → this is an indirect function of ‘i’

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OPENNESS IN FINANCIAL
MARKET/MONEY MARKET
 Open Economy
 An additional consideration is: Now people have a choice between
domestic bonds & foreign bonds

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DOMESTIC BONDS VS FOREIGN BONDS
 Assumption: Investors always go in for the highest expected rate of
return
 The above implies that in equilibrium both domestic bonds &
foreign bonds must have the same expected rate of return;
otherwise investors would be willing to hold only one or the other
but not both
 Thus, the following arbitrage relation- interest parity condition
must hold:

(1 + it) = (1 + it*) (Et/(Eet+1)

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EXPLAINING THE EQUATION
(1 + it) = (1 + it*) (Et/(Eet+1)
Where
it → domestic interest rate
it* → foreign interest rate
Et → current exchange rate
Eet+1 → future expected exchange rate
The LHS of the equation gives the return, in terms of domestic
currency form holding domestic bonds & the RHS gives the
expected return, also in terms of domestic currency from holding
foreign bonds.

A good approximation of the equation above is given by:

it~ it* - (Eet+1 - Et)/Et 16

LIMITATIONS
The assumption that financial investors will hold only the
bonds with the highest expected rate of return is
obviously too strong, for two reasons:
 It ignores transaction costs.
 It ignores risk.

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QUESTION
 Suppose 1 year nominal interest rate is 2% in US and
5% in UK.
 Should you hold U.K. bonds or U.S. bonds?

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 ANSWER
 Should you hold U.K. bonds or U.S. bonds?
 It depends on whether you expect the pound to depreciate vis-
á-vis the dollar over the coming year.
 If you expect the pound to depreciate by more then 3.0%, then
investing in U.K. bonds is less attractive than investing in U.S.
bonds.
 If you expect the pound to depreciate by less than 3.0% or even
to appreciate, then the reverse holds, and U.K. bonds are more
attractive than U.K. bonds.

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IMPORTANCE OF EXCHANGE RATE
IN OPEN ECONOMY
We have set the stage for the study of an open economy:

 The choice between domestic goods and foreign goods depends

primarily on the real exchange rate, i.e. nominal exchange rate
adjusted for price levels in the trading countries.

 The choice between domestic assets and foreign assets depends

primarily on their relative rates of return, which depend on
domestic interest rates and foreign interest rates, and on the
expected depreciation of the domestic currency.

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Exchange Rate and its Determination
FOREIGN EXCHANGE RATE
 Foreign Exchange rate is the price of one currency in terms
of another currency
 It is determined in the foreign exchange market where
different currencies are traded

22
TWO IMPORTANT CONCEPTS
 Nominal Exchange Rate
 Real Exchange Rate

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NOMINAL EXCHANGE RATE (E)
 Nominal exchange rates between two currencies can be quoted in
one of
two ways:

 As the price of the domestic currency in terms of the foreign

currency.

 As the price of the foreign currency in terms of the domestic

currency.

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NOMINAL EXCHANGE RATE (E)
 Let the nominal exchange rate (E) be defined as the price of the
foreign
currency in terms of the domestic currency (as done in India).

An appreciation of the domestic currency is an increase in the price

of
the domestic currency in terms of the foreign currency, which
corresponds to a decrease in the exchange rate.
A depreciation of the domestic currency is a decrease in the price
of the
domestic currency in terms of the foreign currency, or a increase
in the
exchange rate.

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HOW IS E DETERMINED?
 Exchange rate (E) as has been defined is the price of foreign
currency in terms of domestic currency
 Like the price of any commodity, it is also determined by the
forces of demand and supply in foreign exchange markets

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HOW IS E DETERMINED IN SHORT
RUN?
 Two approaches to determining exchange rates in the
short run:
 Asset market approach that emphasizes the
demand for the stock of domestic assets
 Approach that emphasizes the demand for flows
of exports and imports over short periods
 The asset market approach is said to be more
accurate because export and import transactions are
small relative to the amount of domestic and foreign
assets at any given time

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APPROACH RELATED TO EXPORTS AND IMPORTS OF
GOODS: SUPPLY CURVE OF FOREIGN CURRENCY OF
FACED BY A COUNTRY
 The supply curve of a foreign currency for a country derives from
the demand for the exports of the country.

 This is because when paying for the country’s exports that are
invoiced in foreign currency, the foreign country provide the
domestic country with the foreign currency; and when exports of
the domestic country are invoiced in domestic currency, the
foreign country must sell their currency for the needed currency of
this country

 In either case, sale of exports result in the foreign country’s

currency being supplied to a country

 The amount of foreign currency supplied to a country = the value

of its exports
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APPROACH RELATED TO EXPORTS AND IMPORTS OF
GOODS: DEMAND CURVE FOR FOREIGN CURRENCY
OF A COUNTRY
 A country’s demand curve for a foreign currency shows the value
of the foreign currency that is demanded at each possible
exchange rate by the country

 Because the need to buy a foreign currency by a country stems

from the need to pay for the imports from the foreign country.

 Thus a countries demand curve for a foreign currency is derived

from the country’s import demand curve, which shows the quantity
of imports by the country at each price of imports

 The amount of foreign currency demanded by a country= the value

of its imports

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EQUILIBRIUM EXCHANGE RATE

Exchange rate E (Re/$)

S$. The equilibrium exchange rate is

that at which the quantity of
currency supplied equals the
E1 quantity demanded.
E0

E2

D$.

Q0
Demand and supply of dollars

Note: as E falls US becomes a cheaper and more attractive place for buying
and investing. So, D$ increase and hence D$ is downward sloping. While As E 30
increases the US finds India more attractive for buying and investing in. So S $
is upward rising.
ANALYSIS OF CHANGES IN EXCHANGE
RATES
 Changes in imports from a foreign country which
changes the country’s demand for foreign currency. If
imports to the country increases, the demand for
foreign currency by the country increases and vice
versa.
 Changes in exports to the foreign country which
changes the supply of foreign currency to the country.
If exports by the country increases, the supply of
foreign currency to the country increases and vice
versa.

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E DETERMINED IN SHORT RUN - ASSET
MARKET APPROACH
 Supply Curve for Domestic Assets
 Assume that domestic assets are denominated in dollars and foreign
assets are denominated in euros
 Assume further that the quantity of dollar assets supplied (bank
deposits, bonds and equities etc.) is fixed with respect to the
exchange rate, so that the supply curve, S, is vertical
 Demand Curve for Domestic Assets
 If there is capital mobility so that assets are traded freely between
countries, the most important determinant of the quantity of
domestic assets demanded is the expected return of domestic assets
relative to foreign assets Eet+1, such as interest and an expected
change in value
 The demand curve is downward sloping because a lower value of the
exchange rate implies that the dollar is more likely to rise in value
(appreciate), which will in turn raise the expected return on dollar
(domestic) assets and thus the quantity of dollar assets demanded
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EQUILIBRIUM IN THE FOREIGN
EXCHANGE MARKET

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EQUILIBRIUM IN THE FOREIGN
EXCHANGE MARKET
 The foreign exchange market is in equilibrium when
the quantity of dollar assets demanded equals the
quantity supplied
 An exchange rate higher than the equilibrium
exchange rate of E* implies that the quantity of dollar
assets supplied is greater than the quantity demanded
(excess supply)
 An exchange rate lower than the equilibrium
exchange rate of E* implies that the quantity of dollar
assets supplied is less than the quantity demanded
(excess demand)

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RELATION BETWEEN REAL AND
NOMINAL EXCHANGE RATE
The real exchange rate is the price of domestic good in terms of
foreign good or vice versa. It equals the domestic price level times
the nominal exchange rate divided by the foreign price level

ε = PE/P*
Where ε → the real exchange rate
E→ the nominal exchange rate
P→ domestic price level
P*→ foreign price level

Note: in the short run both P & P* are constants. So any change in
nominal exchange rate has a one to one reflection on real
exchange rate. Ex: if rupee appreciates vis-à-vis dollar by 5% (a
nominal appreciation of 5%) & if prices in USA & India do not
35
change, US goods would be 5% cheaper compared to Indian
goods (a 5% real depreciation)
PURCHASING POWER PARITY & LONG RUN EXCHANGE
RATES

 In the short run, market determined exchange rates are highly

volatile in response to monetary policy, political events & changes
in expectations.
 Over longer run, exchange rates are determined primarily by
relative prices of goods in different countries
 An important implication of above is the purchasing-power-parity
theory of exchange rates
 Under this theory, a nations exchange rate will tend to equalize
the cost of buying traded goods at home with cost of buying those
goods abroad – refers to the real exchange rate
 Thus, SR exchange rate/spot exchange rate is the one we get to
see in the interest parity condition and hence its gets influenced
by returns on domestic and financial assets i.e. due to changes in
money market. Whereas, a country’s long run exchange rate is
influenced by goods prices and hence due to changes in the
country’s goods market 36
FUNDAMENTAL FORCES AND EXCHANGE
RATES
 The fundamental forces affecting exchange rates are changes
in:
 A country’s income
 A country’s prices
 The interest rate in a country
 A country’s trade policy

37
EXCHANGE RATE DYNAMICS
 To avoid the problems caused by fluctuating exchange rates,
governments (central banks) sometimes intervene to fix
exchange rates by buying and selling its currency
 If government buys its currency, it can increase its value
 If government sells its currency, its value decreases

38
 CURRENCY SUPPORT
 Currency support is the buying of a currency by a central bank to
maintain its value at a level above its long-run equilibrium value

Price of Yuan
(in $)

Excess supply Supply

The government
$1.50 purchases this excess
(using official reserves)
$1.30
and closes the difference,
thus
D1
maintaining equilibrium

D0
Yuan 39
QD QE QS
Exchange Rate Systems
TYPES OF EXCHANGE RATE
 In the context of an open economy the exchange rate system is
very important.

 Floating/Flexible Exchange Rate system - In a system of floating

exchange rates, E is set by market forces of demand and supply
and is allowed to fluctuate in response to changing economic
conditions. In other words, the exchange rate E adjusts to
achieve simultaneous equilibrium in the goods market and
money market.

 Fixed exchange rate system - Under fixed exchange rates, the

central bank of the country trades domestic for foreign currency
at a predetermined price. Under a fixed exchange rate, the
central bank announces a value for the exchange rate and
stands ready to buy and sell the domestic currency to keep the
exchange rate at its announced level (as discussed in currency
support).
41
FLOATING VS. FIXED EXCHANGE
RATES
Argument for floating rates:
 allows monetary policy to be used to pursue other goals (stable
growth, low inflation).
Arguments for fixed rates:
 avoids uncertainty and volatility, making international
transactions easier.
 disciplines monetary policy to prevent excessive money growth
& hyperinflation.

42
Exchange Rate and Macroeconomic Policies
 MONETARY POLICY’S EFFECT ON EXCHANGE RATES

 Monetary policy affects exchange rates in three primary ways:

 Its effect on the interest rate
 Its effect on income
 Its effect on price levels and inflation

44
THE EFFECT ON EXCHANGE RATES VIA INTEREST RATES

Interest rates in U.S. increase

Demand for the U.S. interest-bearing assets increases

Demand for dollars to buy U.S. assets increases

The increase in the demand for dollars causes the price of dollars to
increase

45
THE EFFECT ON EXCHANGE RATES VIA INCOME OR PRICE LEVELS
Income or prices increase in the U.S.

Imports increase

Demand for foreign currency to buy imports increases which means

the supply of the dollar increases

The increase in supply of the dollar causes the price of the

dollar to decrease
46
THE NET EFFECT OF MONETARY POLICY ON EXCHANGE RATES
 Expansionary monetary policy lowers exchange rates
 It decreases the relative value of a country’s currency

Exchange
i rate

Exchange Exchange
M Y Imports rate Rate

Exchange
Competitiveness
P rate (LR)

47
THE NET EFFECT OF MONETARY POLICY ON EXCHANGE RATES
 Contractionary monetary policy increases exchange
rates
 It increases the relative value of a country’s currency

Exchange
i rate

M Imports Exchange Exchang

Y rate e Rate

Exchange
P Competitiveness
rate (LR)

48
 THE NET EFFECT OF FISCAL POLICY ON EXCHANGE RATES
 The effect of expansionary fiscal policy on exchange rates is not so
clear

Exchange
i rate
Expansionary

?
Fiscal policy

Exchange Exchang
Y Imports rate e Rate
?
Exchange
Competitiveness
P rate (LR)

49
 THE NET EFFECT OF FISCAL POLICY ON EXCHANGE RATES
 The effect of contractionary fiscal policy on exchange rates is not so
clear

Exchange
Contractionary

i rate
Fiscal policy

?
Exchang
Imports Exchange
Y rate
e Rate
?
Exchange
P Competitiveness
rate (LR)

50
Case Study
CASE STUDY: THE MEXICAN PESO CRISIS
35
U.S. Cents per Mexican Peso

30

25

20

15

10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
52
CASE STUDY: THE MEXICAN PESO
CRISIS
35
U.S. Cents per Mexican Peso

30

25

20

15

10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
53
UNDERSTANDING THE CRISIS
 In the early 1990s, Mexico was an attractive place for foreign
investment.

 During 1994, political developments caused an increase in

Mexico’s risk premium ( ):
 peasant uprising in Chiapas
 assassination of leading presidential candidate

 Another factor: The Federal Reserve raised U.S. interest rates

several times during 1994 to prevent U.S. inflation. (∆i* > 0)

54
UNDERSTANDING THE CRISIS
 These events put downward pressure on the peso.

 Mexico’s central bank had repeatedly promised foreign investors

that it would not allow the peso’s value to fall, so it bought
pesos and sold dollars to “prop up” the peso exchange rate.

 Doing this requires that Mexico’s central bank have adequate

reserves of dollars.
Did it?

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DOLLAR RESERVES OF MEXICO’S
CENTRAL BANK

December
December1993
1993………………
……………… $28
$28billion
billion
August
August17,
17,1994
1994………………
……………… $17
$17billion
billion
December
December1,
1,1994
1994……………
…………… $$99billion
billion
December
December15,
15,1994
1994…………
…………$$77billion
billion

During 1994, Mexico’s central bank hid the fact that its
reserves were being depleted.

56
  THE DISASTER 
 Dec. 20: Mexico devalues the peso by 13% (fixes e at 25 cents
instead of 29 cents)

  ↑; Investors are SHOCKED! – they had no idea Mexico was

running out of reserves.

 Investors dump their Mexican assets and pull their capital out of
Mexico.

 Dec. 22: central bank’s reserves nearly gone. It abandons the

fixed rate and lets e float.

 In a week, e falls another 30%.

57
THE RESCUE PACKAGE
 1995: U.S. & IMF set up $50b line of credit to provide loan
guarantees to Mexico’s govt.

 This helped restore confidence in Mexico, reduced the risk

premium.

 After a hard recession in 1995, Mexico began a strong recovery

from the crisis.

58
THE IMPOSSIBLE TRINITY

A nation cannot have free Free capital

capital flows, independent flows
monetary policy, and a fixed
exchange rate
simultaneously. Option 1 Option 2
A nation must choose (U.S.) (Hong Kong)
one side of this triangle and
give up the opposite corner.

Independent Fixed
Option 3 exchange
monetary
(China) rate
policy
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CASE STUDY:
THE CHINESE CURRENCY CONTROVERSY
 1995-2005: China fixed its exchange rate at 8.28 yuan per dollar,
and restricted capital flows.

 Many observers believed that the yuan was significantly

undervalued, as China was accumulating large dollar reserves.

 U.S. producers complained that China’s cheap yuan gave Chinese

producers an unfair advantage.

 President Bush asked China to let its currency float; Others in the
U.S. wanted tariffs on Chinese goods.

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CASE STUDY:
THE CHINESE CURRENCY CONTROVERSY
 If China lets the yuan float, it may indeed appreciate.

 However, if China also allows greater capital mobility, then Chinese

citizens may start moving their savings abroad.

 Such capital outflows could cause the yuan to depreciate rather than
appreciate.

61
Balance of Payments (Self study)
WHAT IS BOP?
 A nation’s BOP is a systematic statement of all its economic
transactions with the rest of the world during a given year.
 Each transaction is entered in the BOP as a credit or a debit.
A credit transaction is one that leads to the receipt of a
payment from foreigners while a debit transaction leads to a
payment to foreigners.
 The main components of BOP are –
• Current account
• Financial account

63
BASIC ELEMENTS OF BOP
(TABLE 1)
I. Current account
Merchandise (or trade balance)
Services
Investment income
Unilateral transfers
II. Capital account
Private
Government
Official reserve changes
Other

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CURRENT ACCOUNT
 The total items under section I table 1 is the balance on
current account. This includes all items of income and
outlay- imports and exports of goods and services,
investment income, transfer payments.

65
CURRENT ACCOUNT

 Trade balance consists of merchandise imports and exports

 The main categories of service transactions are travel and

transportation, receipts and payments on foreign investments
and military transactions.

 Investment income includes the earnings on foreign investment

such as earnings on US assets abroad

 Unilateral transfers refer to gifts made by individuals and the

government to foreigners & gifts received from foreigners

 The exports of goods & services, income from foreign investment

& receipt of unilateral transfers are entered in the current account
as credits (+) because they lead to receipt of payments from
foreigners. On the other hand, import of goods & services,
expenditure on foreign assets & granting of unilateral transfers
are entered as debits (-) because they lead to payments to
foreigners 66
FINANCIAL ACCOUNT- PRIVATE & GOVERNMENT (REFERRED TO AS
CAPITAL ACCOUNT)
 This shows the change in the nation’s assets abroad & foreign
assets in the nation.
 It includes direct investments (such as the building of a foreign
plant), the purchase or sale of foreign securities (stocks, bonds and
treasury bills), and the change in the nation’s non bank and bank
claims on and liabilities to foreigners during the year
 Increase in nation’s assets abroad & reduction in foreign assets in
the nation (other than official reserve assets) are capital outflows
or debits (-) because they lead to payment to foreigners. On the
other hand, decrease in nations assets abroad & increase in foreign
assets in the nation (other than official reserve assets) are capital
inflows or credits (+) because they lead to receipts from foreigners.
Eg : when Indian corporate stocks are sold abroad, Indian assets
increase abroad, India fetches foreign currency. This is credit.

67
OFFICIAL RESERVE ACCOUNT – REFERRED TO AS
FINANCIAL ACCOUNT

 Measures the change in a nation’s official reserve assets & the

change in foreign official assets in the nation during the year

 Official reserve assets include the gold holdings of the nation’s

monetary authorities, special drawing rights (SDRs), the nations
reserve position in the IMF and the official foreign currency
holdings of the nation

 An increase in the nation’s official reserve assets abroad are

debits (-) while an increase in foreign official assets in the nation
are credits(+)

68
DOUBLE ENTRY BOOKKEEPING
 Each international economic transaction is entered either as a
credit or as a debit in the nation’s balance of payments. But
every time a credit or a debit transaction is entered, an offsetting
debit or credit respectively of the same amount is also recorded
in one of the two accounts. This double entry book keeping

 The reason for this is that every transaction has two sides- we
sell something and we receive payment for it & we buy
something and we must pay for it.

 Example:
An Indian tourist in London spends Rs 50,000 for hotels & meals-
India debits the service category of its current account for Rs
50,000 and credits its capital account for Rs. 50,000.

69
STATISTICAL DISCREPANCY
 Theoretically double entry book- keeping should result in total
credits being equal to total debits when the two accounts of the
BOP are taken together. However, because of recording errors
and omissions, this equality does not usually hold. Thus a
special entry called statistical discrepancy is necessary to
balance the nation’s BOP statement.

70
DISEQUILIBRIUM IN THE BOP
 In the accounting sense BOP always balances. But this
trivial balance in the BOP of a country does not mean
that the BOP is always in equilibrium.
 There can be disequilibrium i.e. a deficit or a surplus
in the BOP of a country though the BOP always
balances in the accounting or ex-post sense

71
UNDERSTANDING THE
DISEQUILIBRIUM IN THE BOP
 To understand this, we divide all the transactions
recorded in the accounting balance into two major
categories-
 Autonomous transactions
 Accommodating transactions

 Understanding of these two accounts is important to

understand the BOP identity

72
AUTONOMOUS TRANSACTIONS
 These are those transactions which are undertaken for
their own sake, normally in response to business
considerations and incentives and sometimes in
response to political considerations as well.

 These transactions take place independently of the

balance of payments position of the reporting country.

 Examples: these include virtually all exports & imports

of goods & services, unilateral transfers, direct
investment or portfolio investment motivated by a
desire to earn either a higher return or to find a safe
refuge.

73
ACCOMMODATING TRANSACTIONS
 These are those transactions that do not take place for
their own sake, but because autonomous transactions are
such as to leave a gap to be filled.

 These are those transactions that occur as a direct

consequence of the BOP situations.

 Example: include the sale of gold or foreign currencies by

central bank with a view to filling the gap between the
receipts & payments of foreign exchange by the residents
country and a loan received by the monetary authorities
of the reporting country from foreign government with
the purpose of filling the gap between the autonomous
receipts and autonomous payments.

74
THE BOP IDENTITY AND EXCHANGE
RATES
 The balance of payments identity implies that the sum of
the balance of current account, capital account, and
financial account (BCA + BKA + BFA) is equal in size, but
opposite in sign, to the change in the balance of official
reserves (BRA):
BCA + BKA + BFA = - BRA. (autonomous =
accommodating)

 If a country is under flexible exchange rate system ,

central banks do not engage in official reserve
transactions and hence BRA is near zero. Thus, the overall
balance must balance, i.e., BCA + BFA = - BKA.
 If a country is under the fixed exchange rate system, then
75
it can a have an overall BOP surplus or deficit as the
central bank will accommodate it via official reserve
transactions.
Thank You

76