PRINCIPLES OF MACROECONOMICS. Chapter 31 Open Economy Macroeconomics

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1 PRINCIPLES OF MACROECONOMICS Chapter 31 Open Economy Macroeconomics Overview In this chapter we introduce open-economy macroeconomics and examine the importance of international trade (exports and imports of goods and services, net capital outflow, real and nominal exchange rates, and purchasing-power parity), which for simplicity s sake in most of our analysis so far we assumed that it didn t exist; in other words, we assumed a closed economy. Here we relax that assumption. We develop the concept of internal and external balance, the determination of the exchange rate under different exchange rate regimes, and examine the accounting measure we call balance of payments. Learning Outcomes: Upon completion of this chapter, students should understand: how net exports measure the international flow of goods and services. how net capital outflow measures the international flow of capital. why net exports must always equal net foreigh investment. how saving, domestic investment, and net capital outflow are related. the meaning of the nominal exchange rate and the real exchange rate. purchasing-power parity as a theory of how exchange rates are determined. The Importance of International Trade In today s age of globalisation, international trade becomes increasingly more important for many countries. Gone are the days of international isolation and trade protectionism. In the context of the World Trade Organization, the trade in goods and services, and the movement of capital is conducted without any restrictions. So, it may be fair to say that most countries today are open economies, with a substantial portion of their GDP attributed to the value of exports and imports. Definitions related to international trade and the balance of payments: Closed economy: an economy that does not interact with other economies in the world. Open economy: an economy that interacts freely with other economies around the world. Exports: goods and services that are produced domestically and sold abroad. Imports: goods and services that are produced abroad and sold domestically. Net exports: the value of a nation s exports minus the value of its imports, also called the trade balance. NX = Exports - Imports 1

2 Trade balance: the value of a nation s exports minus the value of its imports, also called net exports. Trade surplus: an excess of exports over imports. Trade deficit: an excess of imports over exports. Balanced trade: a situation in which exports equal imports. The Figure below shows data for exports and imports for Cyprus for the period It can be seen that throughout the period, Cyprus is experiencing a widening trade deficit, which by 2006 has grown to 2.5 billion. Cyprus is a very open economy, with the total of imports and exports comprising a very large percentage of GDP. Exports and Imports for Cyprus, ,500,000 3,000,000 2,500,000 '000s 2,000,000 1,500,000 1,000, , Factors that influence a country s Exports, Imports, and Net Exports a. The tastes of consumers for domestic and foreign goods. b. The prices of goods at home and abroad. c. The exchange rates at which people can use domestic currency to buy foreign currencies. d. The incomes of consumers at home and abroad. e. The cost of transporting goods from country to country. f. The policies of the government toward international trade. The Balance of Payments The balance of payments is an accounting system by which all transactions with the rest of the world are recorded. The various transactions that enter in the balance of payments include exports and imports of goods and services, the movement of capital for investment purposes (both for direct business investment in plant and 2

3 equipment as well as investments in securities or in bank deposits), official and private transfers of capital in the form of loans, grants, gifts, repatriation of profits, payment of factor income (wages, dividends, etc), and many other visible and invisible transactions. International transactions may be between individuals, businesses, institutions or governments. A general form of these accounts follows: + Exports of physical goods (f.o.b.) - Imports of physical goods (f.o.b.) = Trade Balance + Invisible receipts (e.g., foreign exchange receipts from tourism, sale of services, etc) - Invisible payments (e.g., payments of residents visiting other countries, buying of services, etc) = Invisible Balance Trade Balance + Invisible Balance = Current Account Balance +/- Short-term capital flows +/- Long-term loans +/- Other long-term capital flows = Capital Account (or Net Capital Movement) Current Account Balance + Capital Account Balance + Errors and Omissions = Overall Balance of Payments The actual balance of Payments for Cyprus for 2006 is as follows Balance of Payments for Cyprus, 2006 million ITEMS CREDIT DEBIT NET CURRENT ACCOUNT 5, , GOODS, SERVICES AND INCOME 4, , GOODS AND SERVICES 3, , GOODS , ,301.2 SERVICES 3, , ,958.8 INCOME , Compensation of employees Investment Income , CURRENT TRANSFERS General government Other sectors CAPITAL AND FINANCIAL ACCOUNT Capital Account Financial Account Direct Investment Portfolio Investment 1, , Financial Derivatives 8.3 Other Investment 3, , ,065.2 Official Reserve Assets NET ERRORS AND OMISSIONS Source: Central Bank of Cyprus 3

4 Determining the Current Account of the Balance of Payments Exports: Note that tourist services (hotels, restaurant meals, etc) and the provision of offshore services (accounting and legal services) are considered as exports of services (invisibles) because they are offered to foreign nationals. The higher the income held by citizens in other countries, the higher should be our exports to these countries. Secondly, the lower the Cyprus real exchange rate, the greater is Cyprus competitiveness and thus the larger are Cypriot exports. Changes in income levels in countries abroad will affect imports relatively quickly, whereas changes in relative competitiveness will take longer to filter through. If Cyprus s position deteriorates relative to its trading partners, then eventually this will have an impact on exporters and they may be forced to withdraw from a non-profitable market. Imports: Imports (consumer goods, raw materials, capital equipment, as well as services, such as paying tuition fees to foreign universities, or buying consultancy service from foreigners) tend to be higher, the higher the incomes of Cypriots. International competitiveness again does have an effect however, although like the case with exports, this normally takes some time to make an appreciable difference. Additional factors, which also affect the current account, are government spending for military equipment. Added to this we have the net inflow of interest, dividends and profit arising from Cypriot individuals holdings in countries abroad. Determining the Capital Account (CA) There have been some key changes in the international capital market over the last 20 years. Firstly controls on the movement of capital have been abolished between the advanced countries. Flow of capital can now take place freely. Trillions of $s are now capable of being instantly switched internationally between countries and currencies in order to seek a higher return. Net capital outflows: the purchases of foreign assets by domestic residents minus the purchases of domestic assets by foreigners. The flow of capital abroad takes two forms. 1. Foreign direct investment occurs when a capital investment is owned and operated by a foreign entity. 2. Foreign portfolio investment involves an investment that is financed with foreign money but operated by domestic residents. A number of factors influence a country s Net Capital Outflows, such as: a. The real interest rates being paid on foreign assets. b. The real interest rates being paid on domestic assets. c. The perceived economic and political risks of holding assets abroad. d. The government policies that affect foreign ownership of domestic assets. Capital movements across countries are frequently motivated by speculation. Speculation is the purchase of an asset for subsequent resale, in the belief that the total return interest plus capital gain exceeds the total return on other assets. The interest parity condition, formalises the conditions for making gains by dealing in foreign currency. If there is parity, then gains are normally cancelled out. The Equality of Net Exports and Net Capital Flows (CA) Net exports and net capital flows each measure a type of imbalance in a world market. a. Net exports measure the imbalance between a country s exports and imports in world markets for goods and services. 4

5 b. Net capital outflow measures the imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners in world financial markets. For an economy, net exports must be equal to net capital outflow. Remember that every international transaction involves exchange. When a seller-country transfers a good or service to a buyer-country, the buyer-country gives up some asset to pay for the good or service. Thus, the net value of the goods and services sold by a country (net exports) must equal the net value of the assets acquired (net capital outflow). Saving, Investment, and International Flows Recall that GDP (Y) is the sum of four components: consumption (C), investment (I), government purchases (G) and net exports (NX). In other words, Y = C + I + G + NX. We also found that national saving is equal to the income of the nation after paying for current consumption and government purchases. In other words: S = Y C G. By rearranging the equation for GDP we get: Y C G = I + NX. But the left-hand side is saving (S), so the above equation becomes S = I + NX. Because net exports (NX) and net capital flows (CA) are equal, we can rewrite this as: S = I + CA This implies that saving is equal to the sum of domestic investment (I) and net capital flows or the position of the capital account (CA). When a Cypriot saves 1 of his income, this Euro can be used to finance accumulation of domestic capital or it can be used to finance the purchase of capital abroad. Note that, in a closed economy (with no international trade and capital movements) net capital flows would be zero and saving would simply be equal to domestic investment. The Exchange Rate This is the rate (the price) at which a foreign currency is exchanged for local currency (or put differently, it is the local equivalent of foreign currency). For instance, if the exchange rate between the Euro and the US Dollar (USD) at a moment in time is (as seen in the table below which shows the cross exchange rates of major currencies as at 12:00 noon on 27 March 2008), it means that one Euro is worth, or can be exchanged for, USD (one American dollar and 57 dollar-cents). Notice that the exchange rate between the USD and the EURO can be expressed also as , which means that one dollar can be exchanged for (or EURO Cents). Cross-Rates of Major Currencies on 27 March 2008 Currency U.S. $ en Euro Can $ U.K. AU $ Swiss Franc 1 U.S. $ = en = Euro = Can $ = U.K. = AU $ = Swiss Franc = Source: Yahoo Finance (online). Available at 5

6 The international value of the domestic currency is the amount of foreign currency that each unit of domestic currency commands. The domestic price of foreign currency is the quantity of domestic currency per unit of foreign currency. Effective exchange rates are a good measure of a country s international competitiveness. These are the weighted average of individual bilateral exchange rates (i.e. the average of exchange rates with all trading partners, weighted by the relative size of trade with each country). The Foreign Exchange Market (The Forex market) This is the market where one currency is traded (exchanged) for another. Much like in any other market, the forces of supply and demand determine the current exchange rate, and indicate the relative valuations of one currency against another. The currencies of various countries are bought and sold each business day in the foreign exchange markets of New York, London, Paris, Frankfurt, Tokyo and other financial centers. These markets are not located in any specific place in these cities; rather, they are networks of relationships among central banks, commercial banks, and other currency traders The relationship between local and international currencies can be represented by the usual demand and supply interaction, where in the place of price we would put the exchange rate, and in the place of quantity we would put the quantity demanded and supplied of foreign exchange. Equilibrium in the FX market, just like in any market, is reached where demand equals supply. The following figure shows how the exchange rate of Cyprus pounds in terms of US dollar is determined in the foreign exchange market. The curve D represents the demand for CYP by US citizens. The American s demand for Cypriot pounds is derived demand. It derives from the desire of Americans to buy Cypriot goods and services (such as halloumi cheese, potatoes, tourist services, education at European University Cyprus, etc) or to buy assets in Cyprus (buy houses, stocks in Cypriot companies, deposit money in Cypriot banks, etc). The curve S shows the supply of CYPs by Cypriot citizens. Why do they want to sell CYP? In order to acquire US dollars to buy US goods or assets. The equilibrium exchange rate is e 0. If Cypriots want more US dollars at each exchange rate (perhaps to buy more American products), then the Supply curve of CYP moves to the right to S 1, and the economy moves to a new equilibrium at E 1. Note that the supply of CYP (much like the money supply may be assumed to be fixed in the short-run, in which case the SS curve is vertical). The analysis, of course, that follows does not change. The Market for Foreign Exchange Real exchange rate $/ S 0 S 1 e 0 E 0 E e 1 E 1 D Q 0 Q 1 Quantity of CYP 6

7 Determinants of the Demand for Foreign Exchange The demand for foreign exchange derives from: The demand for international trade by a country s residents: to buy foreign goods and services, to travel or to study abroad, to hire a foreign consultant, etc ; Speculation: the positioning by some FX market players (primarily banks and FX traders) against the (usually short-term) outcome of the exchange rate of one currency versus another; Investments: to invest in a foreign-denominated security (stock or bond), or to buy property in a foreign country; and International finance, whereby governments, international agencies and corporations may wish to borrow in a currency other than their national currency. It is estimated that the majority of FX trading is carried out by FX speculators rather than by real international trade! Changes in Demand or Supply of Foreign Exchange As in other markets, if we assume now that Cypriots wish to buy more US$s at each exchange rate because they perceive American goods to be more attractive now (for instance, because of lower prices, or better quality, or more fashionable, or more effective advertising, etc), or because they want to buy American bonds or stocks in IBM or Microsoft, then the supply of C s will shift out from SS to SS 1. In the process, the equilibrium international value of the C versus the US$ will fall, from e 0 to e 1. If we now assume that the demand by Americans for Cypriot goods and/or assets change, at any/every exchange rate, then it is the DD curve that will shift. Appreciation and Depreciation of Foreign Exchange When the $/C exchange rate rises (say from $1.50 to the C to $1.75), we say that the C appreciates. This means that the international value of the Cyprus pound rises. It now buys more dollars, and by extension, more American goods. In that case, we say that the Cypriot pound strengthens. When, on the other hand, the $/C exchange rate falls (say from $1.75/C it goes back down to $1.50), we say that the C depreciates, and the international value of the Cyprus pound falls. Effectively, American goods have become more expensive because now Cypriots require more C to buy the dollar-valued goods. In that case, we say that the Cypriot pound weakens. The Real Exchange Rate The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another. The real exchange rate is the relative price of goods from different countries when measured in a common currency. The real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in the local currencies. real exchange rate = Nominal exchange rate Domestic price Foreign price The real exchange rate of the Cyprus pound with respect to the US is expressed as: (e $/ x p Cyprus )/ p us $. The real exchange rate for Cyprus pound falls if either the nominal exchange rate falls, the Cyprus price of Cypriot goods falls or the $ price of US goods rises. Any of these changes reduce Cyprus pound s real exchange rate and make Cyprus more competitive (and the US less competitive). 7

8 The real exchange rate is a key determinant of how much a country exports and imports. Of course, when studying an economy as a whole, macroeconomists focus on the overall price level instead of the prices of individual goods and services. So, price indexes (such as the retail or consumer price indexes) are used to measure the level of overall prices. Assume that P is the price index for the United States, P* is a price index for prices abroad, and e is the nominal exchange rate between the U.S. dollar and foreign currencies. real exchange rate = e P P * The real exchange rate measures the price of a basket of goods and services available domestically relative to the price of a basket of goods and services available abroad. A depreciation in the U.S. real exchange rate means that U.S. goods have become cheaper relative to foreign goods. U.S. exports will rise, imports will fall, and net exports will increase. Likewise, an appreciation in the U.S. real exchange rate means that U.S. goods have become more expensive relative to foreign goods. U.S. exports will fall, imports will rise, and net exports will decline. The Purchasing-Power Parity (PPP) Theory To guide a government on the path of keeping the real exchange rate at its initial level, the government would need to follow the Purchasing Power Parity (PPP) exchange rate path (i.e. by doing this the path of the nominal exchange rate keeps a constant real exchange rate). The purchasing-power parity is a theory of exchange rate determination, whereby a unit of any given currency should be able to buy the same quantity of goods in all countries. The foundations of this theory lie with the law of one price, which suggests that a good in perfect competition (where there are no restrictions in the exchange of goods) must be able to be sold for the same price in all locations. If a good sold for less in one location than another, a person could make a profit by buying the good in the location where it is cheaper and selling it in the location where it is more expensive. The process of taking advantage of differences in prices in different markets is called arbitrage. Note what will happen as people take advantage of the differences in prices. The price in the location where the good is cheaper will rise (because the demand is now higher) and the price in the location where the good was more expensive will fall (because the supply is greater). This will continue until the two prices are equal. The same logic should apply to currency. A U.S. dollar should buy the same quantity of goods and services in the United States and Japan; a Japanese yen should buy the same quantity of goods and services in the United States and Japan. Purchasing-power parity suggests that a unit of all currencies must have the same real value in every country. If this was not the case, people would take advantage of the profit-making opportunity and this arbitrage would then push the real values of the currencies to equality. Implications of Purchasing-Power Parity The PPP theory implies that the nominal exchange rate between the currencies of two countries will depend on the price levels in those countries. In other words, if a dollar buys the same amount of goods and services in the United States (where prices are measured in dollars) as it does in Japan (where prices are measured in yen), then the nominal exchange rate (the number of yen per dollar) must reflect the prices of goods and services in the two countries. Suppose that P is the price of a basket of goods in the United States (measured in dollars), P* is the price of a similar basket of goods in Japan (measured in yen), and e is the nominal exchange rate (the number of yen each dollar can buy). a. In the United States the purchasing power of $1 is 1/P. b. In Japan, $1 is exchanged for e units of yen, with the purchasing power of e/p*. 1/ P = e / P * 8

9 c. Purchasing-power parity implies that the two must be equal: d. Rearranging, we get: 1 = ( ep) / P * Note that the left-hand side is a constant and the right-hand side is the real exchange rate. This implies that if the purchasing power of a dollar is always the same at home and abroad, then the real exchange rate cannot change. Rearranging again we see that: e = P / P * This implies that the nominal exchange rate is determined by the ratio of the foreign price level to the domestic price level. This means that nominal exchange rates will change when price levels change. Because the nominal exchange rate depends on the price levels, it must also depend on the money supply and money demand in each country. a. If the central bank increases the supply of money in a country and raises the price level, it also causes the country s currency to depreciate relative to other currencies in the world. b. When a central bank prints a large amount of money, that money loses value both in terms of the goods and services it can buy and in terms of the amount of other currencies it can buy. Exchange Rate Regimes Over the last century the world has gone through a number of different exchange rate systems (or regimes), form the gold standard in the beginning of the 20 th century to the Bretton Woods system of fixed exchange rates pegged to the dollar (the dollar standard) in the post-wwii period ( ), to the flexible or floating exchange rate systems (or dirty floats), with managed intervention, that the majority of countries follow these days. In a fixed exchange rate regime, governments intervene to stabilise the value of their currency against that of others at a desirable level. The currency is convertible if the central bank is willing to buy/sell as much of it as people wish to trade at the fixed exchange rate. The following figure illustrates this mechanism. Intervention in the Foreign Exchange Market Real exchange rate $/ F S e 1 A E C D 1 D 2 D Quantity of CYP At E, the market demand for foreign exchange (D) equals its supply (S) and the market is in equilibrium. If we assume now that an exogenous factor increases the demand for by Americans for CYP, the demand curve D moves to D 1. If the exchange rate were allowed to fluctuate according to market forces, then it would 9

10 move to point F. If, however, the monetary authorities decide to maintain the value of the C at e 1, there would be an excess demand of EC. To maintain the rate at e 1, the Central Bank of Cyprus itself supplies the extra C s it prints them and sells them in exchange for e 1 x EC $s which are added to its foreign exchange reserves the foreign currency held by domestic banks. Conversely, if market forces reduce the demand for C to D 2, then at the stable exchange rate of e 1 there are excess C s, and to defend the exchange value, the Central Bank of Cyprus must demand AE of C s, which it pays for by selling AE x e 1 worth of $s from its foreign exchange reserves. This is an example of Central Bank Intervention. Intervening in such a manner can only be a temporary approach. In the long run, unless the demand for the C increases, it would be necessary to devalue the. Under floating exchange rates, the exchange rate is allowed to find its equilibrium without intervention of the central bank. Dirty floating is where the central bank intervenes temporarily to prevent large or destabilising shifts in the exchange rate, before normally allowing the rate to find its own level in the long run. Exchange Rates and Balance of Payments Policy We have shown above that the relative prices of goods and services can change as result of changes in the exchange rate, thus making domestic goods relative to foreign goods more or less competitive (in other words, less or more costly, respectively). The exchange rate then can be used by the monetary authorities for balance of payments stabilization policy. A depreciation of the local currency makes domestic goods more attractive (more competitive) and can thus improve the current account balance of the balance of payments. Changing the exchange rate is not achieved unilaterally or directly (except in cases of official devaluation of the national currency). Rather the monetary authorities attempt to move the exchange rates in the desired direction indirectly by changing domestic interest rates, the money supply, or by intervening directly in the foreign exchange market to buy or sell foreign currencies from their reserves. For instance a sale of foreign currency increases their supply versus the domestic currency and tends to stabilize or increase the local currency s value versus the foreign currencies. Let s examine the transmission mechanism through which an interest rate increase in the US may impact on the securities markets and/ or on the real economy. (a) First of all, an increase in the interest rate would make investments in the money and bond markets in the US more attractive (higher return) and would tend to encourage foreigners to send money to be deposited with the US banks or buy US Government bonds. This of course is achieved by exchanging their currencies for US dollars. In the process, the demand for dollars increases and the exchange value of the dollar versus the foreign currencies strengthens. Thus, from the capital account point of view, this has a positive impact. (b) The strengthening of the dollar, however, makes American goods more expensive (less competitive), and would, other things being equal, tend to discourage US exports and encourage imports of foreign goods and services. Therefore, from the current account point of view, this has a negative impact on the overall balance of payments. We see therefore that policy makers should take into consideration the total picture of the state of the economy when considering interest rate changes. Of course the interest rate is not the only determinant of the demand and supply of foreign exchange. The relative price levels in various countries are also important. If inflation is much higher in one country than in others, then over time the goods and services produced by that country would become less and less competitive. Consumers around the world would shift away from its products in search of cheaper substitutes. Eventually, market forces will bring about a depreciation of its currency. This will equalize the purchasing power parities between the local economy and its trading partners. The national income of countries around the world can also affect the demand and supply of foreign currencies again through the current account. If for instance national income rises in the U.S. due to 10

11 expansionary monetary and fiscal policies, the consumption of all goods and services, including foreign ones, will increase. The demand for foreign currencies will increase, as Americans need to pay for imports. 11