Lecture 5: Open Economy Macroeconomics 1 The Exchange Rate and the Balance of Payments. Reading: BFD ch. 29

Transcription

1 Lecture 5: Open Economy Macroeconomics 1 The Exchange Rate and the Balance of Payments. Reading: BFD ch. 29 Key issue: That when agents (consumers & firms) in different countries trade with each other, an exchange of currencies takes place. 1. Globalisation Comparative Advantage (Increasing) Openness see exports chart. Foreign Exchange Market Transactions In the goods and services (Current account) and assets (Capital account). 2. Equilibrium Output A revision of the goods market. Planned Aggregate Expenditure and the international sector: AE = C + I + G + X M. X = Exports M = Imports Determining imports and exports levels M = my 0 < m < 1 (the Marginal Propensity to Import) Y = GDP X = X 0 i.e. Imports are endogenous and Exports are exogenous (autonomous).

2 Imports, M Exports, X M = my X 0 X Net Exports (NX = X M) 0 Y 0 Y Y 0 Y Planned 45 Aggregate C + I + G = AE (no trade) Expenditure C + I + G + X M (with trade) NX Trade makes the Planned Aggregate Expenditure line flatter. At low income, the economy benefits from positive net exports. At high incomes imports exceed exports and spending leaks abroad. The Keynesian multiplier is reduced when the economy is open. When government spending (or investment) increases and incomes and consumption rise, some of the extra spending that results is on foreign products and not on domestically produced goods and services.

3 3. Financial matters: Imports, Exports and the Exchange Rate Definitions The Nominal Exchange Rate is the price of one unit of foreign currency in terms of domestic currency. e.g. E = = (one Euro costs 64p). Euro If the exchange rate goes up, then the pound loses value. E.g. the exchange rate might increase to 0.70 it costs more to obtain a Euro. When exchange rates are fixed, then the exchange rate changes after a devaluation or a revaluation. When exchange rates are flexible, then the exchange rate is continually fluctuating depreciating or appreciating. If the exchange rate goes up the currency will have either devalued or depreciated. The Real Exchange Rate - Rip-Off Britain? The real exchange rate gives a measure of the relative price of goods and services in different countries. Demand for imports and exports depend on their Relative Price. E.g. Westlife CDs: Relative Price (of European CDs) = R = Exchange Rate * Price of Westlife CD in Europe P = E * Price of Westlife CD in UK P EU UK The relative price may fall if 1. The price of CDs in Euros falls; 2. The price of CDs in Pounds rises; 3. The sterling/euro exchange rate falls. If the relative price falls, then European imports into the UK would rise. This also holds at the aggregate level.

4 For example suppose a CD in the UK costs 13 and in Holland costs 16 Euros. Given an exchange rate of 0.64 then the relative price of European CDs is PEU 16 R = E * = 0.64 * = P 13 UK That is, the Dutch pay 79% as much for their Westlife CDs. If the Real Exchange Rate is below one then the is said to be overvalued. Conversely when R>1 the is said to be undervalued. If the Real Exchange Rate = 1 then we have Purchasing Power Parity.

5 The Effects of a depreciation on Equilibrium Income Imports, M Exports, X M X Net Exports (NX = X M) 0 Y 0 Y 1 Y Y 0 Y 1 Y NX 0 NX 1 AE 1 Planned 45 Aggregate AE 0 Expenditure Y 0 Y 2 Y 1 The Depreciation increases exports and reduces imports at every level of income (top graph). This leads to a shift in Net Exports (middle graph) The increase in Net Exports increases Aggregate Expenditure

6 The Effects of exchange rate depreciation on the IS curve Interest Rate, r IS after depreciation IS before depreciation Output, Y. An increase in the exchange rate shifts the IS curve to the right The depreciation means that foreign goods become relatively more expensive. In general R E * P P WORLD =. UK So if the (nominal) exchange rate changes, or the aggregate price level in the world relative to the aggregate price level in the UK changes, goods market equilibrium will change (a shift in the IS curve).

7 4. The Foreign Exchange (Forex) Market in a floating exchange rate regime. Nominal Demand for s (Supply of Euros) Exchange Rate /EURO E * Supply of s (Demand for Euros) Quantity of s Equilibrium in the forex market occurs where the quantity demanded of a foreign currency equals the quantity of that currency supplied. At low exchange rates, then it costs less to buy one Euro. Conversely it costs more to buy a with Euros. Demand for s will be low because UK goods are relatively more expensive. s are bought with Euros and so the supply of Euros is the same as the demand for s and will be an upward sloping function of the nominal exchange rate. Demand for Euros will be high because European goods are relatively cheaper. Euros are bought with s and so the demand for Euros is the same as the supply s and will be a downward sloping function of the nominal exchange rate. Market forces ensure the equilibrium exchange rate E * is obtained.

8 5. The Balance of Payments A record of a country s international transactions. Current Account (Trade in Goods and Services) Capital Account (purchases and sales of Assets) BP surplus (defecit) when the current account balance plus the capital account balance is greater (less) than zero.