Open Economy Macroeconomics- Balance of Payments and Exchange Rate…
Open Economy Macroeconomics- Balance of Payments and Exchange Rate Determination
Shifts in Supply and Demand for Foreign Exchange
4. Changes in Interest Rates
Usually used to prevent depreciation of the exchange rate.
ieuro < ius Capital outflow e
ieuro > ius Capital inflow e
Interest rates can be used to influence capital flows.
Can be a self fulfilling prophesy.
Following the depreciation, return to € and make a capital gain.
Move funds out of € to a hard currency such as the $.
May be due to high inflation, BP deficit, budget deficits, recession, high unemployment.
Suppose iinvestors anticipate a depreciation of the € exchange rate.
2. Relative inflation rates.
Countries with high inflation rates tend to have weak exchange rates.
Result is e depreciation.
Supply curve to the right.
Demand curve to the left,
Decrease in Imports, decrease in payments, supply of euro decreases and the curve shifts to the left causing an appreciation of the euro
For example. An increase in Exports, causes and increase in the demand and an appreciation of the euro (and vice versa)
1.Changes in Exports and Imports
Equilibrium in the FXM
At an ER lower than this ($0,96) there is and excess demand for euro and a BP surplus which will lead to an appreciation in a floating ER regime
At an ER higher than this ($1.2), there is an excess supply and a BP deficit which will lead to a depreciation in a floating ER regime
The equilibrium exchange rate is determined by the intersection of demand and supply (at $1)
Exchange Rate Determination
Location: For constant e:
Increase in receipts, demand curve moves to the right.
Increase in payments, supply curve moves to the right.
Supply curve slopes upward
Demand curve slopes downward
Any transaction that gives rise to a payment abroad leads to a supply of euro
Any transaction that gives rise to a receipt of foreign currency leads to a demand for euro
Determinants of Exchange Rates
Slope of supply and demand curves.
Payments (Imports): Supply of Euro.
Receipts (Exports): Demand for Euro.
Supply and demand for euro (€) on foreign exchange market determines e.
Implications of Exchange Rate Movements
Changes in e can result in large profits or losses for importers and exporters.
: Impact on Exporters: Irish firm sells table to a UK firm at a cost of 100 euro. Yesterday’s ER €1=£0.85; UK citizen pays £85. Today’s ER €1=£0.95; UK citizen pays £95. The stronger euro has increased the price to foreigners. Irish business struggles to sell the table. Tomorrow €1= £.75; UK citizen pays £75. The weak euro has reduced the cost to foreigners. Irish business will find it easier to sell tables to the UK. Appreciating Euro: Bad for exports. Depreciating Euro: Good for exports
go to slides 27 of topic 10
Thus e is another instrument of economic policy. Policy-maker can contrive to improve competitiveness by under-valuing e. Over-valued e can have a detrimental effect on key macroeconomic variables.
: Importing from Abroad
Buying a table from UK. Table costs £100. Yesterday’s ER €1=£0.85; Cost to Irish citizen is 100/.85 = €117.6. ER €1=£0.95; Cost to Irish citizen is 100/0.95=€105.26. Appreciating ER means cheaper imports so more of them are bought. Tomorrows ER €1=£0.75 (is depreciation). Cost to Irish Importers is €133.33. Conclusion: Appreciating euro: decrease in exports; increase imports. Depreciating euro; increase exports, decrease in imports
Balance of payments and international transactions underlie the foreign exchange market. Market where one currency is exchanged for another. No exact location. Spans the globe. At any time of day or night there is a market open somewhere in the world.
Direct quote: domestic currency in terms of foreign currency
Indirect quote: Foreign price per unit of domestic currency
A closed economy
is one which does not interact with other economies in the world- no exports, imports or capital flow
An open economy
is one that interacts freely with other economies around the world.
Interacts with other countries in two ways, it buys and sells goods and services in world product markets and secondly it buys and sells capital assets in the worlds financial market
Factors that effect net exports:
- Consumer tastes for domestic and foreign goods, the prices of goods at home and aboard, the exchange rates, incomes of consumers at home and abroad, costs of transporting the goods, and policies of the government towards international trade
are goods and services that are produced domestically and sold abroad
are goods and services produced abroad and sold domestically
are the value of a nations exports minus the value of its imports
net exports are also called the
A trade deficit
is when the net exports are negative = imports>exports
A trade surplus
is when next exports are positive = exports>imports
refers to the situation where next exports are zero dues to imports and and exports being equal
Net capital outflow
refers to the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners.
Foreign direct Investment (Assets for the production of something)
Portfolio Investment (not direct control of something)
Variables that influence NCO:
The real interest rates being paid on foreign assets. The real interest rates being paid on domestic assets. The perceived economic and political risks of holding assets abroad. The government policies that affect foreign ownership of domestic assets.
Net capital outflow:
if the NCO is positive:
domestic citizens buy more foreign assets than foreign citizens buy domestic assets AND IF... If
NCO is negative:
Domestic citizens buy fewer foreign assets than foreign citizens buy domestic assets
For an economy as a whole, NX and NCO must balance each other so that:
NCO = NX
Net exports is a component of GDP: Y = C + I + G + NX............….National saving is the income of the nation that is left after paying for current consumption and government purchases:Y - C - G = I + NX
National saving (S) equals Y - C - G so:
S = I + NX or..
Savings= Domestic income+ net capital outflow
nominal exchange rate
is the rate at which a person can trade the currency of one country for the currency of another.
The nominal exchange rate is expressed in two ways: In units of foreign currency per domestic currency. In domestic currency per unit of the foreign currency.
refers to an increase in the value of a currency as measured by the amount of foreign currency it can buy.
refers to a decrease in the value of a currency as measured by the amount of foreign currency it can buy.
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 compares the prices of domestic goods and foreign goods in the domestic economy.
real exchange rate = nominal exchange rate * domestic price / foreign price
Implication: The nominal exchange rate changes when price levels change. If the euro price level increases, this causes the currency to depreciate. If the euro price falls, this causes the currency to appreciate
Purchasing power parity
is a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries.
Exchange rates move to ensure ppp.
The process of taking advantage of differences in prices in different markets is called arbitrage.
If the law of one price were not true, unexploited profit opportunities would exist.
A good must sell for the same price in all locations.
It is based on a principle called the law of one price.
Based on the idea that the prices of similar goods expressed in a common currency should be the same in all countries
Appreciation vs depreciation
euro net exports fall.
Means that euro goods have become more expensive compared to foreign goods.
in the euro real exchange rate:
As a result, euro exports rise, and euro imports fall, and both of these changes raise net exports.
This encourages consumers both at home and abroad to buy more euro goods and fewer goods from other countries.
Means that euro goods have become cheaper relative to foreign goods.
(fall) in the euro real exchange rate: