Transcript
8/3/2019 Open Economy New
1/36
1
MACROECONOMICS
BCOM 21043
Topic 7
Open Economy Macroeconomics
8/3/2019 Open Economy New
2/36
2
The concept of open economy
Interaction among the countries in the world
Import and export transactions
Analysis of economic development and policy
formulation.
8/3/2019 Open Economy New
3/36
3
BOP cont
General definition
A systematic statement all of economic transactions
of a country with the rest of the world occurredduring a given period, usually one year.
Payments to foreigners are debits to the BOP
account.
All receipts are credits to the BOP account.
8/3/2019 Open Economy New
4/36
4
Payments and receipts can be in respect of the
following
Visible items
Goods
Invisible items
Services
Capital transfers
BOP cont
8/3/2019 Open Economy New
5/36
5
Balance of payments (BOP)
A systematic record of economic transactions
between countries
Both visible and invisibles transactions are
included.
The period is one year in general
Double entry book keeping system is
operated.
8/3/2019 Open Economy New
6/36
6
Purpose of preparing the BOP
To take the stock of countrysForeign receipts and payment obligations
Assets and liabilities arising out of international
transactions.
To yield the necessary information on the
strength and weaknesses of the country in
international economic relations.
To analyze the overall gains and losses from
the international economic transactions.
For future policy formulation purposes
8/3/2019 Open Economy New
7/36
7
BOP Accounts
Current account
Records the transactions relating to the visible and
invisible transactions
Visible balance shows the value of import and
exports of physical products
Invisible balance shows the value of the services
rendered and hired.
8/3/2019 Open Economy New
8/36
8
Capital account
Shows the transactions relating to the long-term
movements of capital
Inflows and outflows of capital including foreign
investments, gold and foreign exchange reserves
BOP Accounts
8/3/2019 Open Economy New
9/36
9
May be either
Equilibrium
Disequilibrium
Surplus in BOP
Deficit in BOP
Position of the BOP
8/3/2019 Open Economy New
10/36
10
Types of disequilibrium in BOP
Cyclical disequilibrium
Due to cyclical pattern of income, different income
elasticitis and different price elasticities
Structural disequilibrium
Due to changes in technology, taste and attitude
towards foreign investments
8/3/2019 Open Economy New
11/36
11
Secular disequilibrium
Due to changes in economic growth.
At the initial stage there may be disequilibrium due
to lack of funds to finance imports
Fundamental disequilibrium
Long-term disequilibrium in BOP
Types of disequilibrium in BOP
8/3/2019 Open Economy New
12/36
12
Methods to correct the disequilibrium in BOP
Deflation
Exchange depreciation
Encouraging exportsDiscouraging imports
Exchange control
Capital movements
8/3/2019 Open Economy New
13/36
13
Exchange Rates (ER)
The international trade is operated through theexchange rate system as a medium of settling
transactions.
ER
Is the price a currency in terms of another currency
Is the price between two countries at which
residents of those countries trade with each other.
8/3/2019 Open Economy New
14/36
14
ER
Example
1 US $ = SLR. 120
1 UK = SLR. 155
1 Indian Rupee = SLR 3
8/3/2019 Open Economy New
15/36
15
BOP and ER
BOP and ER are more related because the
settlement of BOP is done using these ERs.
8/3/2019 Open Economy New
16/36
16
Nominal ER and Real ER
Nominal ER (NER)
Is the relative of the currency of two countries
(basically the ER)
Whenever the people use the term of ER, it implies
the Nominal ER
Example: NER between Sri Lanka and USA is Rs.
112/ US$
8/3/2019 Open Economy New
17/36
17
Real ER (RER)
Is the relative price of the goods of two
commodities.
This measures the actual purchasing power of
domestic goods in terms of foreign currency.
Nominal ER and Real ER
8/3/2019 Open Economy New
18/36
18
Real ER
Nominal ER and Real ER
RER =NER * Price of Domestic Goods
Price of Foreign Goods
E =e * P
P*
E RER
e NER
P Domestic Price
P* - Foreign price
8/3/2019 Open Economy New
19/36
19
If the RER is high
Foreign goods are relatively cheap
Domestic goods are relatively expensive
If the RER is low
Foreign goods are relatively expensive
Domestic goods are relatively cheap
Nominal ER and Real ER
8/3/2019 Open Economy New
20/36
20
Determination of ER in Free Exchange Market
In a free exchange market, the price of ER is
decided by the two forces of,
Demand
supply
8/3/2019 Open Economy New
21/36
21
Demand for foreign exchange
Demand for dollars by Sri Lankan to purchase
foreign goods & services and assets.
Supply of foreign exchange
Supply of Sri Lankan rupees to foreign countries to
exchange our products.
Determination of ER in Free Exchange Market
8/3/2019 Open Economy New
22/36
fig
1.00
1.20
1.40
1.60
1.80
2.00
2.20
0
$
price
of
Q of
Determination of the rate of exchangeDetermination of the rate of exchange
8/3/2019 Open Economy New
23/36
23
Types of Exchange Rates
Fixed exchange rate
Flexible exchange rate
8/3/2019 Open Economy New
24/36
24
Fixed exchange rate system
Fixed exchange rateThe ER is fixed between the domestic and foreign
currencies by the monetary authority of a country
and is not allowed to fluctuate beyond a limit.
Government intervenes to fix the prices for
ERs.
On behalf of the government Central Bank ready to
buy and sell their currencies at a fixed price
generally in terms of US$.
8/3/2019 Open Economy New
25/36
25
Fixed exchange rate system
Upper intervention limit
Lower intervention limit
RS/US$
Quantity of foreign currency
Rs. 100
8/3/2019 Open Economy New
26/36
26
What determine the amount of intervention
that a central bank has to do in a fixed
exchange rate system
The BOP measures the amount of foreign
exchange intervention needed from the
central bank
Fixed exchange rate system
8/3/2019 Open Economy New
27/36
27
For example
If Sri Lanka is running a deficit balance in its BOP
and therefore,
Demand for US$ in exchange for SLR exceedsthe supply US$ in exchange for SLR from USA.
Then central bank would buy the excess rupees , paying
for them with US$.
Fixed exchange rate system
8/3/2019 Open Economy New
28/36
28
Merits of fixed exchange rate system
Promote international trade
As, exporters and importers know in advance the
amounts they have to pay and receive
Improve the international capital movements
Because of the certainty in ER.
For developing countries this facilitate to
achieve the planned economic development.
8/3/2019 Open Economy New
29/36
29
Since it is not permanently fixed, the foreigninvestors are discouraged to invest in long-
term investments.
The countries will lose their freedom to
formulate independent monetary policies.
It does not show the true cost-price
relationship between countries.
Demerits of fixed exchange rate system
8/3/2019 Open Economy New
30/36
30
Flexible or floating exchange rate system
Exchange rate will determine freely by the demand
and supply.Therefore, the countries do not have to pay with
gold and thereby countries can protect their gold
reserves.
The countries are independent in choosing their oftheir monetary policies as their own internal
policies.
This leads to an inflation and creation ofemployment opportunities.
8/3/2019 Open Economy New
31/36
31
Flexible ER system
Clean floating
Central bank stand aside and allows exchange rate to be
freely determine in foreign exchange market.
Dirty floating
The ERs are intervened by the Central bank to decide itsprice up to some extent.
Flexible or floating exchange rate system
8/3/2019 Open Economy New
32/36
32
Merits of flexible ER system
More beneficial international lending
It absorb the changes occurred in abroad
Brings the equilibrium in the BOP
8/3/2019 Open Economy New
33/36
33
Instability and uncertainty
Leads to reduce the volume of the international trade
Frequent fluctuation in ERs leads to destabilizeeconomic conditions
Exchange depreciation leads to inflationary situation
in local rises
Demerits of flexible ER system
8/3/2019 Open Economy New
34/36
34
Purchasing Power Parity (PPP)
Predicts that ERs between two countries will
adjust in the long-run to reflect the price level
differences in countries.
Explains how the law of one price applied to
the international market place.
This applied where the international arbitrage
possible.
8/3/2019 Open Economy New
35/36
35
According to this rule, the dollar must have
same purchasing power in every country at the
international trade
In following cases PPP rule will fail
Most of the goods are not easily tradable
In case of tradable goods, they are not always
perfect substitutions.
Purchasing Power Parity (PPP)
8/3/2019 Open Economy New
36/36
36
Open economy macroeconomics: Policy issues
Economic
policies
Monetarypolicies
Fiscal
policies
Fixed ER
Floating ER
Fixed ER
Floating ER
Ineffective
Effective
Effective
I ff ti
top related