Open Economy Macroeconomics

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Balance of payment accounts
Give us a summary of all the transactions with folks in other countries
Made up of current and financial accounts => should equal each other
Graphically represent the balance of payment accounts
Pg. 3 Open Economy Macroeconomics
Current account
Summarizes net value of all goods, services, factor income, and remittances flowing in and out of country
Trade balance plus cash payments for a variety of smaller things
Financial account
Tracks all financial flows into and out of country => gov’t sale/purchase of assets and sale/purchase of financial assets
In the US, what has been the trend with CA and FA?
CA => deficit, FA=> surplus
What determines capital inflows? (2)
1. Government actions (ours and foreign govts)
2. Private decisions in conjunction with the loanable funds market
Country with higher interest rate will import more foreign money and country with lower interest rate will export more money
Differences in demand for loanable funds (6)
Fast growing economies have better opportunities
Fast growing economies generally have higher ROR
Countries with low levels of physical capital tend to have higher ROR
Nations with more political stability are more attractive for investment
Large markets tend to attract more FDI
Relationships tend to be stronger where there is shared culture
Differences in supply for loanable funds (2)
High savings rates increase supply
Government budget surpluses/deficits
Forex Market
Foreign Exchange Market
Bring in one form of currency and swap for another currency at some price (exchange rate)
Currency can buy more of another form of currency than it used to
Currency can by less of another currency than it used to
What do importers like? Exporters?
Importers => appreciated dollar, depreciated foreign currency
Exporters => depreciated dollar, appreciated foreign currency
Nominal exchange rate
Graphically represent the Forex Market
Pg. 8 Open Economy Macroeconomics notes
Why is demand in Forex Market downward sloping? Supply upward sloping?
As you move down demand schedule, dollar = depreciating => more exports but in order to buy those exports, need dollars => increase demand for dollars
As you move up supply schedule, dollar = appreciating => more imports so to pay for them we use dollars and bring dollars to Forex market
Graphically represent an increase in capital flows to the US
Pg. 9 Open Economy Macroeconomics notes
How does a change in the US BOP on the FA affect CA? Why?
An increase in FA => decrease by same amount in CA
A decrease in FA => increase by same amount in CA
Dollar depreciation/appreciation will change NX which changes CA
Real exchange rate => NER * price level 1/price level 2
Purchasing power parity
NER at which a given basket of goods and services would cost the same amount in both countries
Two types of exchange rate regimes
1. Fixed exchange rate => govt actively manages money supply to ensure that NER is maintained
2. Floating exchange rate => govt doesn’t actively do anything, but rate is determined entirely by market
Three ways in which a govt can maintain a fixed exchange rate
1. Buy/sell currency if too much/not enough is on the market => exchange market intervention
2. Change interest rates => more people will want to hold currency if increase interest rate and if decrease less people will want to hold currency
3. Capital controls => if surplus, restrict people from bringing currency to Forex => less supply, reduce surplus; if shortage, make it hard for foreigners to get currency
Graphically represent a currency shortage and surplus caused by a fixed exchange rate
Pg. 11 Open Economy Macroeconomics Notes
Advantages/disadvantages to fixed exchange rate (2/3)
Advantages => Eliminates exchange rate uncertainty, prevents nations from engaging in inflationary actions because engaging in inflationary practices would change NER and cause fixed exchange rate to collapse
Disadvantages => have to keep large foreign exchange reserves which are very low interest bearing, if using monetary policy to maintain rate can’t use it to stabilize economy, if use capital controls to maintain rate reduce international flow of goods
Foreign exchange reserve
Currency of a different country that is used to maintain fixed exchange rate of country
Impossible trinity
Idea that countries can only have two out of the following three options => independent monetary authority, free capital controls, stable exchange rate
When a govt pursues a reduction in the value of its currency => increases NX
When a govt pursues an increase in the value of its currency => decreases NX
How does a decrease in the interest rate to close a recessionary gap affect the exchange rate?
Low interest rate => less demand to hold currency
In addition, more people will be looking to invest their currency else where with higher interest rate => increase supply of currency
Categories: Macroeconomics