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Balance of Payments and Foreign Exchange
Dynamics
– SD Macroeconomic Modeling –
Kaoru Yamaguchi, Ph.D. ∗
Doshisha Business SchoolDoshisha University
Kyoto 602-8580, JapanE-mail: [email protected]
Abstract
This paper tries to model a dynamic determination of foreign ex-change rate in an open macroeconomy in which goods and services arefreely traded and financial capital flows efficiently for highest returns. Forthis purpose it becomes necessary to employ a new method contrary tostandard methods of dealing with a foreign sector as adjunct to macroe-conomy; that is, an introduction of another macroeconomy as a foreignsector. Within this new framework of open macroeconomy, transactionsamong domestic and foreign sectors are handled according to the prin-ciple of accounting system dynamics developed by the author, and thebalance of payments is attained. For the sake of simplicity of analyzingforeign exchange dynamics, macro variables such as GDP, its price leveland interest rate are treated as outside parameters. Then, eight scenariosare produced and examined to see how exchange rate, trade balance andfinancial investment, etc. respond to such outside parameters. To oursurprise, expectations of foreign exchange rate turn out to play a crucialrole for destabilizing trade balance and financial investment. The impactof official intervention on foreign exchange and a path to default is alsodiscussed.
∗This paper is submitted to the 25th International Conference of the System DynamicsSociety, Boston, USA, July 29 - August 2, 2007. In September 2006, I made a visit to thefollowing colleagues: Mr. David Wright, Senior Lecturer, Univ. of Bergen, Norway, andDr. Burkhard Schade, Dr. Wolfgang Schade and his research group at Fraunhofer Institute,Karlsroohe, Germany. I’m very thankful for the dialogues with them and advices offeredto me on the subject of this macroeconomic modeling series, which gave me very valuableopportunities to reconsider my present on-going research for further improvements. Thisresearch is partly supported by by the grant awarded by the Japan Society for the Promotionof Science.
1
D B S -07-01
1 Open Macroeconomy as a Mirror Image
This is the fourth paper of a series of macroeconomic modeling that tries tomodel macroeconomic dynamics. In the first paper [5], money supply and cre-ation processes of deposits were modeled. Analytical method employed in themodel is the principle of accounting system dynamics developed by the author[4]. In the second paper [6], dynamic determination processes of GDP, interestrate and price level were modeled on the basis of the same principle, and foursectors of macroeconomy were introduced such as producers, consumers, banksand government. The third paper [7] tried to integrate real and monetary sec-tors that had been analyzed separately in the previous two models; that is, byadding the central bank, five sectors of the macroeconomy were fully integratedtogether with a labor market. Figure 1 illustrates an overview of our macroe-conomic system and shows how the five macroeconomic sectors, still excludingforeign sector, interact with one another and exchange goods and services formoney.
Consumer
(Household)
Producer
(Firm)
Banks
Central Bank
Government
Foreign
Sector
National Wealth(Capital
Accumulation)
GrossDomesticProducts(GDP)
Labor & Capital
Wages & Dividens (Income)
SavingLoan
Investment (PP&E)
Investment
(Housing)
Investment (Public
Facilities)
Income Tax Corporate Tax
Consumption
Public ServicesPublic Services
Money Supply
Export
Import
Production
Population / Labor Force
Figure 1: Macroeconomic System Overview
As a natural step of the research, we are now in a position to open ourmacroeconomy to a foreign sector so that goods and services are freely tradedand financial assets are efficiently invested for higher returns. The analyticalmethod employed here is the same as the previous papers; that is, the one basedon the principle of accounting system dynamics.
The method requires to manipulate all transactions among macroeconomicsectors, and when applied to a foreign sector, it turns out to be necessary to in-troduce another macroeconomy as a reflective image of domestic macroeconomy.Contrary to a method employed in standard international economics textbooks
2
such as [1] and [2], a foreign sector is no longer treated as an additional macroe-conomic sector adjunct to a domestic macroeconomy.
To understand this, for instance, consider a transaction of importing goods.They add to the inventory of importers (a red disk numbered 1 in Figure 3 be-low), while the same amount is reduced from the inventory of foreign exporters(a red disk numbered 4 in Figure 4 below). To pay for the imported goods, im-porters withdraw their deposits from their bank and purchase foreign exchange,(red disks numbered 2 and 3 in Figures 3 and 6 below), which is then sent to thedeposit account of foreign exporters’ bank that will notify the receipts of exportpayments to exporters (red disks numbered 3 and 4 in Figures 7 and 4 below).In this way, a mirror image of domestic macroeconomy is needed for a foreigncountry as well to describe even domestic transaction processes of goods andservices. Similar manipulations are also needed for the transactions of foreigndirect and financial investment. Figure 2 expresses our image of modeling openmacroeconomy by the principle of accounting system dynamics.
Consumer( Househol d)
Pr oducer ( Fi r m)
Commer ci al Banks
Cent r al Bank
Gover nment
Nat i onalWeal t h
( Capi t alAccumul at i on)
Gr ossDomest i cPr oduct s
( GDP)
Labor & Capi t al
Wages & Di vi dens( I ncome)
Savi ng Loan
I nvest ment( PP&E)
I nvest ment( Housi ng)
I nvest ment( Publ i c
Faci l i t i es)
I ncome Tax Cor por at e Tax
Consumpt i on
Publ i cSer vi ces
Publ i cSer vi ces
Money Suppl y
Expor t
I mpor t
Pr oduct i on For ei gnConsumer
( Househol d)
For ei gnPr oducer
( Fi r m)
For ei gn Commer ci al Banks
For ei gn Cent r al Bank
For ei gn Gover nment
For ei gnNat i onalWeal t h
( Capi t alAccumul at i on)
For ei gnGr oss
Domest i cPr oduct s
( GDP)
For ei gn Labor& Capi t al
For ei gn Wages &Di vi dens ( I ncome)
For ei gnSavi ng
For ei gnLoan
For ei gnI nvest ment
( PP&E)
For ei gnI nvest ment( Housi ng)
For ei gn I nvest ment( Publ i c Faci l i t i es)
For ei gnI ncome Tax
For ei gnCor por at e Tax
For ei gnConsumpt i on
For ei gn Publ i cSer vi ces
For ei gn Publ i cSer vi ces
For ei gnMoneySuppl y
For ei gnPr oduct i on
Di r ect andFi nanci alI nvest ment
For ei gnI nvest ment
For ei gn Sec t or as an I mage of Domes t i c Macr oeconomy
Figure 2: Foreign Sector as a Mirror Image of Domestic Macroeconomy
2 Open Macroeconomic Transactions
Modeling open macroeconomy was hitherto considered to be easily completedby merely adding a foreign sector, and this paper is supposed to be the last onein our SD macroeconomic modeling series as stated in [7] : “our next and finalpaper in this series of macroeconomic modeling will be to open the integratedmodel to foreign sector.” The introduction of a foreign country as a mirrorimage of domestic macroeconomy makes our analysis rather complicated.
To overcome the complexity, we are forced, in this paper, to focus only on amechanism of the transactions of trade and foreign investment in terms of thebalance of payments and dynamics of foreign exchange rate. For this purpose,
3
transactions among five domestic sectors and their counterparts in a foreigncountry are simplified as follows.
Producers
Major transactions of producers are, as illustrated in Figure 3, summarized asfollows.
• GDP (Gross Domestic Product) is assumed to be determined outside theeconomy, and grows at a growth rate of 2% annually.
• Produces are allowed to make direct investment abroad as well as finan-cial investment out of their financial assets consisting of stocks, bondsand cash1, and receive investment income from these investment abroad.Meanwhile, they are also required to pay foreign investment income (re-turns) to foreign investors according to their foreign financial liabilitiesand equity .
• Produces now add net investment income (investment income received lesspaid) to their GDP revenues (the added amount is called GNP (Gross Na-tional Product)), and deduct capital depreciation (the remaining amountis called NNP (Net National Product)).
• NNP thus obtained is completely paid out to consumers, consisting ofworkers and shareholders, as wages to workers and dividend to sharehold-ers.
• Producers are thus constantly in a state of cash flow deficits. To makenew investment, therefore, they have to borrow money from banks, butfor simplicity no interest is assumed to be paid to the banks.
• Producers imports goods and services according to their economic activi-ties, the amount of which is assumed to be 10% of GDP in this paper.
• Similarly, their exports are determined by the economic activities of aforeign country, the amount of which is also assumed to be 10% of foreignGDP.
• Foreign producers are assumed to behave similarly as a mirror image ofdomestic producers as illustrated in Figure 4.
1In this paper, financial assets are not broken down in detail and simply treated as financialassets. Hence, returns from financial investment are uniformly evaluated in terms of depositreturns.
4
Inve
nto
ry
Cash/
Dep
osi
ts(
Pr
oduc
ers)
1
2
Ex
por
ts
14
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rec
t A
sset
sA
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dD
ir
ect
Inv
estm
ent
Abr
oad
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rec
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t
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nanc
ial
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estm
ent
Imp
orts
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orei
gnE
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nge
Rate
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orts
(
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l)
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ice
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rts
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ri
ce
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ts>
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and
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ndex
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orts
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urv
e
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orei
gnD
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ect
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estm
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oad
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E)
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ice
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nge
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ice
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me
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rts
(r
eal
)>
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orts
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ff
ici
ent
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niti
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gnE
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ai
ned
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ning
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oduc
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ent
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ome
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eign
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estm
ent
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ome
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mpor
ts>
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nanc
ial
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abi
li
ties
Abr
oad
12
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eign
F
ina
nci
al
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estm
ent
Abr
oad
1
4
114
1
2
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xpe
cte
dR
etur
n on
Dep
osi
tsA
broa
d>
GD
P(
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l)
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nanc
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Asset
sA
broa
dF
ina
nci
al
Inv
estm
ent
Abr
oad
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orei
gnF
ina
nci
al
Inv
estm
ent
Abr
oad
(F
E)
>
Inv
estm
ent
Abr
oad
Fi
nanc
ial
Inv
estm
ent
Inc
ome
Ini
tial
G
DP
Gr
owth
R
ate
of
GD
P
<I
nter
est
Ar
bitr
age
Adj
uste
d>
Cha
nge
in
Ini
tial
GD
P
Ti
me
for
Cha
nge
in
GD
P
Di
rec
tI
nves
tmen
tI
ndex
Di
rec
t I
nves
tmen
tI
ndex
T
abl
e
Fi
nanc
ial
Inv
estm
ent
Ind
ex
Fi
nanc
ial
I
nves
tmen
tI
ndex
T
abl
e
GD
P
<G
DP
>
NN
P
<F
orei
gnE
xcha
nge
Rate
>
Inv
estm
ent
Dom
esti
cA
bsor
pti
on
<I
nves
tmen
t>
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row
ing
<D
omes
tic
Abs
orpt
ion
>
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xpo
rts
>
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NP
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mpor
ts>
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nves
tmen
t>C
ash
Fl
owD
efi
ci
t
Capi
tal
(P
P&
E)
Deb
t(
Pr
oduc
ers)
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orr
owi
ng>
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over
nmen
tE
xpe
ndi
tur
e>
Pr
ice
<P
ri
ce>
Fi
nanc
ial
Asset
s<I
nves
tmen
t I
ncom
e><F
orei
gn
Inv
estm
ent
Inc
ome>
<D
ir
ect
Inv
estm
ent
Abr
oad>
Di
rec
tI
nves
tmen
tI
ncom
e
21
<F
orei
gnI
nves
tmen
tI
ncom
e (
FE
)>
Capi
tal
For
eign
D
ir
ect
Inv
estm
ent
Abr
oad
<F
orei
gnE
xcha
nge
Rate
>
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orei
gn
Di
rec
tI
nves
tmen
t A
broa
d>1
<F
orei
gn
Fi
nanc
ial
Inv
estm
ent
Abr
oad>
Dep
rec
iati
on
Dep
rec
iati
onR
ate
Di
rec
tI
nves
tmen
tR
ati
o
Fi
nanc
ial
Inv
estm
ent
Rati
o
<C
onsum
pti
on>
GN
P
<G
NP
>
<G
NP
>
Figure 3: Transactions of Producers
5
Fore
ign
Inve
ntory
For
eign
Cash/
Dep
osi
ts
14
1
2
For
eign
Di
rec
t A
sset
sA
broa
d
Ex
por
ts
(r
eal
)
For
eign
Pr
ice
For
eign
D
ir
ect
Inv
estm
ent
Abr
oad
(F
E)
Ex
por
ts(
For
eign
Imp
orts
)
Imp
orts
(F
orei
gnE
xpo
rts
)
<P
ri
ce
ofE
xpo
rts
(
FE
)>
Dem
and
I
ndex
f
orE
xpo
rts
(
rea
l)
Ex
por
tsD
emand
C
urv
e
Pr
ice
ofI
mpor
ts
<F
orei
gnE
xcha
nge
Rate
>
For
eign
D
ir
ect
Inv
estm
ent
(F
E)
For
eign
F
ina
nci
al
Inv
estm
ent
(F
E)
For
eign
I
mpor
tsC
oef
fi
ci
ent
<D
ir
ect
Inv
estm
ent
Abr
oad>
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mpor
ts(
rea
l)
>
For
eign
Ret
ai
ned
Ear
ning
sF
orei
gnI
nves
tmen
tI
ncom
e (
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)
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estm
ent
Inc
ome(
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)
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nves
tmen
tI
ncom
e(F
E)
>
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orei
gnI
nves
tmen
tI
ncom
e (
FE
)>
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xpo
rts
(F
orei
gnI
mpor
ts)
>
<I
niti
al
For
eign
Ex
cha
nge
Rate
>
For
eign
Fi
nanc
ial
Li
abi
li
ties
Abr
oad
Fi
nanc
ial
Inv
estm
ent
Abr
oad
(F
E)
1
4
12
1
2
1
4
<E
xpe
cte
dR
etur
n on
Dep
osi
ts
Abr
oad
(F
E)
>
For
eign
GD
P(
rea
l)
<F
ina
nci
al
Inv
estm
ent
Abr
oad>
For
eign
Fi
nanc
ial
Asset
s
Abr
oad
For
eign
F
ina
nci
al
Inv
estm
ent
Abr
oad
(F
E)
For
eign
Inv
estm
ent
Abr
oad
(F
E)
For
eign
F
ina
nci
al
Inv
estm
ent
Inc
ome
(F
E)
Ini
tial
For
eign
G
DP
Gr
owth
R
ate
of
For
eign
G
DP
<I
nter
est
Ar
bitr
age
(
FE
)A
djus
ted>
Cha
nge
in
Ini
tial
F
orei
gnG
DP
Ti
me
for
C
hang
ei
n F
orei
gn
GD
P
Di
rec
t I
nves
tmen
t(
FE
)
Ind
ex
<D
ir
ect
Inv
estm
ent
Ind
ex
Tabl
e>
Fi
nanc
ial
Inv
estm
ent
(F
E)
Ind
ex
<F
ina
nci
al
Inv
estm
ent
Ind
exT
abl
e>
<F
orei
gnP
ri
ce>
For
eign
G
DP
For
eign
Dom
esti
cA
bsor
pti
on
For
eign
I
nves
tmen
t
<F
orei
gnE
xcha
nge
Rate
>
<F
orei
gnG
DP
>
For
eign
NN
P
For
eign
Capi
tal
(P
P&
E)
<F
orei
gn
Gov
ernm
ent
Ex
pend
itu
re>
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orei
gnI
nves
tmen
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eign
C
ash
Fl
ow
Def
ici
t
<F
orei
gnD
omes
tic
Abs
orpt
ion
>
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mpor
ts(
For
eign
Ex
por
ts)
>
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orei
gn
NN
P>
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orei
gnI
nves
tmen
t>
<E
xpo
rts
(F
orei
gnI
mpor
ts)
>
For
eign
Bor
row
ing
For
eign
D
ebt
(P
rod
ucer
s)
<F
orei
gnB
orr
owi
ng>
For
eign
Fi
nanc
ial
Asset
s
<F
orei
gnI
nves
tmen
tI
ncom
e (
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)>
<I
nves
tmen
tI
ncom
e(F
E)
>
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orei
gn
Di
rec
tI
nves
tmen
t A
broa
d(
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)>
For
eign
D
ir
ect
Inv
estm
ent
Inc
ome
(F
E)
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nves
tmen
tI
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eign
Capi
tal
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rec
tI
nves
tmen
tA
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)<D
ir
ect
Inv
estm
ent
Abr
oad
(F
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gnE
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nge
Rate
>
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ina
nci
al
Inv
estm
ent
Abr
oad
(F
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1
41
2
For
eign
Dep
rec
iati
on
For
eign
Dep
rec
iati
onR
ate
For
eign
D
ir
ect
Inv
estm
ent
Rati
o
For
eign
F
ina
nci
al
Inv
estm
ent
Rati
o
<F
orei
gn
Con
sum
pti
on>
For
eign
GN
P
<F
orei
gnG
NP
>
<F
orei
gnG
NP
>F
orei
gn
Pr
ice
Cha
nge
For
eign
P
ri
ce
Cha
nge
Ti
me
Figure 4: Transactions of Foreign Producers
6
Consumers and Government
Transactions of consumers and government are illustrated in Figure 5, some ofwhich are summarized as follows.
• Consumers receive the amount of NNP as income, out of which 20% islevied by the government as income tax. The remaining amount becomestheir disposable income.
• Consumers spend 60% of their disposable income and save the remainingas deposits with banks.
• Government only spends the amount it receives as income tax, and itsbudget is assumed to be in balance.
Deposi t s( Consumer s)
ConsumerEqui t y
I ni t i al Deposi t s( Consumer s)
Ret ai nedEar ni ngs
( Gover nment )Cash
( Gover nment )
I ncome Tax
Tax Revenues
I ncome Tax Rat e
<Tax Revenues>
Savi ng
<I ncome Tax>
Gover nmentExpendi t ur e
<NNP><NNP>
Consumpt i on
<Consumpt i on>
Net For ei gnI nvest ment
<I nvest ment >
<Depr eci at i on>
Figure 5: Transactions of Consumers and Government
Banks
Transactions of banks are illustrated in Figure 6, some of which are summarizedas follows.
• Banks receive deposits from consumers and make loans to producers.
• Banks are obliged to deposit a portion of the deposits as required reserveswith the central bank, but such activities are not considered in this paper.
• Banks buy and sell foreign exchange at the request of producers and thecentral bank.
• Their foreign exchange are held as bank reserves and evaluated in termsof book value. In other words, foreign exchange reserves are not depositedwith foreign banks. Thus net gains realized by the changes in foreignexchange rate become part of their retained earnings (or losses).
7
• Foreign currency is assumed to play a role of key currency or vehiclecurrency. Accordingly foreign banks need not set up foreign exchangeaccount. This is a point where a mirror image of open macroeconomicsymmetry breaks, as illustrated in Figure 7.
Central Bank
In the integrated model [7], the central bank played an important role of pro-viding a means of transactions and store of value; that is, currency, and itssources of assets against which currency is issued were assumed to be gold andgovernment securities. Transactions of the central bank here are exceptionallysimplified, as illustrated in Figure 8, so long as necessary for the analyticalpurpose in this paper.
• The central bank can control the amount of money supply through mon-etary policies such as the manipulation of required reserve ratio and openmarket operations. However, such a role of money supply by the centralbank is not considered here.
• The central bank is allowed to intervene foreign exchange market; thatis, it can buy and sell foreign exchange to keep a foreign exchange ratiostable. These transactions are manipulated with commercial banks, whichinescapably change the amount of currency outstanding and, hence, moneysupply. In this paper, however, such an effect of money supply on interestrate is assumed to be out of consideration.
• Foreign exchange reserves held by the central bank is assumed to be de-posited with foreign banks so that it receives interest payments.
• The central bank of foreign country is excluded simply because foreigncurrency is assumed to be a vehicle currency, and it needs not to holdforeign reserves (that is, its own currency) to stabilize its own exchangerate in this simplified open macroeconomy.
3 The Balance of Payments
All transactions with a foreign country such as foreign trade and foreign invest-ment (that is, payments and receipts of foreign exchange) are booked accordingto a double entry bookkeeping rule, and such a bookkeeping record is called thebalance of payments. According to [1] in page 295, all payments are recorded inthe debit side with a minus sign, while all receipts are recorded in the credit sidewith plus sign. Hence, by definition, the balance of payments are kept in bal-ance all the time. It consists of current account, capital and financial account,and net official reserve assets.
8
2
Req
uire
d
Res
erve
s
(Ban
ks)
3
<F
ore
ign
Exc
hang
e S
ale>
2
<F
ore
ign
Exc
hang
e
Sal
e>
3
2
<F
ore
ign
Exc
hang
e
Pur
chas
e>
3
Fore
ign
Exc
hang
e
(Ban
ks)
<E
xport
s><
Impo
rts>
3
11
<F
ore
ign
Exc
hang
e
Pur
chas
e><
Fore
ign
Exc
hang
e S
ale>
Fore
ign
Exc
hang
e
(Book V
alue
)
<F
ore
ign
Exc
hang
e
(FE
)>
Ret
aine
d
Ear
ning
s
(Ban
ks)
Net
Gai
ns b
y
Cha
nges
in
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ign
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hang
e R
ate
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et G
ains
by
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nges
in
Fo
reig
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nsA
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stm
ent
Tim
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ign
Inve
stm
ent
Inco
me>
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ign
Exc
hang
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ate>
Cash/
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ts(
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<E
xpo
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Dep
osi
ts
in
Dep
osi
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t
4
Vaul
t C
ash
(B
ank
s)
23
3<F
orei
gn
Fi
nanc
ial
Inv
estm
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9
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10
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Current account consists of trade balance of goods and services and netinvestment income. Capital account is an one-way transfer of fund by the gov-ernment that is excluded from our analysis here. Financial account consistsof direct and financial foreign investment. Figure 9 illustrates all transactionswhich enter into the balance of payments account.
Figure 10, obtained from one of our simulation runs, displays relative posi-tions of current account, capital and financial account, and net official reserveassets (or changes in reserve assets). A numerical value of the balance of pay-ments is shown in the figure as being in balance all the time; that is a zero value.
11
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12
Bal ance of Payment s
2
1
0
- 1
- 20 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Cur r ent Account : r un" Capi t al & Fi nanci al Account " : r unChange i n Reser ve Asset s : r unBal ance of Payment s : r un
Figure 10: A Simulation of Balance of Payments
4 Determinants of Trade
Let M and X be real imports and exports, and Y and P be real GDP and itsprice level, respectively. Counterpart variables for a foreign country is denotedwith a subscript f . A foreign exchange rate E is defined as a price of foreigncurrency (which has a unit of FE here) in terms of domestic dollar currency; forinstance, 1.2 dollars per FE. Then, a price of imports is calculated as PM = PfE.
Imports are here simply assumed to be a function of real GDP and price ofimports such that
M = M(Y, PM ), where∂M
∂Y> 0 and
∂M
∂PM< 0. (1)
Gr aph Lookup - I mpor t s Demand Curve
5
00 2
Figure 11: Normalized DemandCurve
This implies that imports increases asdomestic economic activities, hence GDP,expand, and decreases as price of importsrises as a standard downward-sloping de-mand curve conjectures. Figure 11 illus-trates one of such demand curves employedin this paper in which demand is normalizedbetween a scale of zero and five on a verti-cal axis against a price level of between zeroand two on a horizontal axis.
From these simple assumptions, we can
13
derive the following relations:
M = M(Y, PM ) = M(Y, PfE), (2)
∂M
∂Pf=
∂M
∂PM
∂PM
∂Pf=
∂M
∂PME < 0 (3)
∂M
∂E=
∂M
∂PM
∂PM
∂E=
∂M
∂PMPf < 0 (4)
These relations imply that imports decrease as foreign price of imports increasesand/or foreign exchange rate appreciates.
In our model, imports function is further simplified as a product of importsdetermined by the size of GDP and a normalized demand curve such that
M = M(Y, PM ) = M(Y )D(PM ) = mY D(PfE) (5)
where m is a constant coefficient of imports on GDP.Exports are nothing but imports of a foreign country, and similarly deter-
mined as a mirror image of domestic imports function such that
X = X(Yf , PM,f ), where∂X
∂Yf> 0 and
∂X
∂PM,f< 0. (6)
This implies that exports increase as foreign economic activities, hence foreignGDP, expand, and decreases as price of imports in a foreign country rises as astandard downward-sloping demand curve conjectures.
Price of imports in a foreign country is calculated by a domestic price andforeign exchange rate such that PM,f = P/E. Hence, we obtain the followingrelations:
X = X(Yf , PM,f ) = X(Yf , P/E), (7)
∂X
∂P=
∂X
∂PM,f
∂PM,f
∂P=
∂X
∂PM,f
1E
< 0 (8)
∂X
∂E=
∂X
∂PM,f
∂PM,f
∂E=
∂X
∂PM,f(− P
E2) > 0. (9)
Thus, exports decrease as a domestic price rises. Meanwhile, whenever foreignexchange appreciates, our products become cheaper in a foreign county andexports increase.
Exports are similarly broken down as a product of foreign imports and nor-malized demand curve of foreign country, which is assumed to be exactly thesame as domestic demand curve for imports.
X = X(Yf , PM,f ) = X(Yf )D(PM,f ) = mfYfD(P/E) (10)
where mf is a constant import coefficient of a foreign country.
14
Let us define trade balance as
TB(E;Y, Yf , P, Pf ) = X(E;Yf , P ) − M(E;Y, Pf ) (11)
Then we have∂TB
∂Y= −∂M
∂Y< 0,
∂TB
∂Yf=
∂X
∂Yf> 0, (12)
∂TB
∂P=
∂X
∂P< 0,
∂TB
∂Pf= − ∂M
∂Pf> 0. (13)
∂TB
∂E=
∂X
∂E− ∂M
∂E> 0. (14)
The last relation indicates that a trade balance is an increasing function offoreign exchange rate. The relation is also confirmed in our model as illustratedin the two diagrams of Figure 12 in which upward-sloping blue curves are ob-tained from our simulation runs. As an mirror image, foreign trade balanceis shown to be a decreasing function of foreign exchange rate, as indicated bydownward-sloping red curves.
Tr ade Bal ance vs E
8 Dol l ar / Year8 FE/ Year
4 Dol l ar / Year4 FE/ Year
0 Dol l ar / Year0 FE/ Year
- 4 Dol l ar / Year- 4 FE/ Year
- 8 Dol l ar / Year- 8 FE/ Year
0. 940 0. 950 0. 960 0. 970 0. 980 0. 990 1For ei gn Exchange Rat e
Tr ade Bal ance : r un Dol l ar / Year" For ei gn Tr ade Bal ance ( FE) " : r un FE/ Year
Tr ade Bal ance vs E
8 Dol l ar / Year8 FE/ Year
4 Dol l ar / Year4 FE/ Year
0 Dol l ar / Year0 FE/ Year
- 4 Dol l ar / Year- 4 FE/ Year
- 8 Dol l ar / Year- 8 FE/ Year
1 1. 020 1. 040 1. 060For ei gn Exchange Rat e
Tr ade Bal ance : r un Dol l ar / Year" For ei gn Tr ade Bal ance ( FE) " : r un FE/ Year
Figure 12: Trade Balance vs Foreign Exchange Rate
National Income Identity
Let us now briefly summarize our model in terms of national income account asfollows:
Y = C(Y − T ) + I + G + TB(E) (15)
That is to say, GDP is the sum of consumption spending, investment, govern-ment expenditure and trade balance. In our model of foreign trade, investmentis calculated to make this equation an identity all the time.
Private saving is defined as Sp = Y − T − C. Government saving is definedas Sg = T −G. Then national saving is obtained as a sum of these savings suchthat
S = Sp + Sg = Y − C − G, (16)
15
which reduces toS − I = TB(E). (17)
Saving less investment is called net foreign investment, which is equal to tradebalance. This becomes another way of describing the above national incomeidentity in terms of net foreign investment and trade balance.
5 Determinants of Foreign Investment
Foreign investment consists of direct investment and financial investment such asstocks, bonds and cash, which constitute financial assets. In this paper financialassets are not specified without losing generality as already mentioned in thefootnote above. Foreign investments are here assumed to be determined on aprinciple of foreign exchange market efficiency under the uncovered interest rateparity (UIP) condition as explained in standard textbooks such as [1] and [3].
Let i and R be interest rate and a rate of return from financial investment,and Ee be an expected foreign exchange rate. A rate of return from a bankdeposit is the same as the interest rate:
R = i (18)
An expected return from a deposit with a foreign bank is calculated as
Rf = (1 + if )Ee
E− 1 (19)
Thus we obtain∂Rf
∂E= − (1 + if )Ee
E2< 0 (20)
∂Rf
∂Ee=
(1 + if )E
> 0 (21)
This implies that a rate of return from foreign financial investment decreases ifforeign exchange rate appreciates, but it increases when foreign exchange rateis expected to appreciate.
Let us define an expected return arbitrage as
A(E, Ee; i, if ) = Rf (E, Ee; if ) − R(i) (22)
and net capital flow(NCF ) as
NCF = Foreign Investment Abroad − Investment Abroad (23)
This is the amount of capital we receive from foreign country’s investment lessthe amount we invest abroad. Under the assumption of an efficient financialmarket, if expected returns are greater in a foreign country and an expectedreturn arbitrage becomes positive, then financial capital continues to outflowuntil the arbitrage ceases to exist. In a similar fashion, if expected returns aregreater in a domestic market and an expected return arbitrage becomes negative,
16
then financial capital continues to inflow until the arbitrage disappears. Hence,so long as a foreign exchange market is efficient, the relation between net capitalflow and an expected return arbitrage become as follows:{
NCF < 0 if A > 0NCF > 0 if A < 0 (24)
It is unrealistic, however, to assume an indefinite outflow of capital even ifA > 0, or an indefinite inflow of capital even if A < 0. So it is assumed herethat the maximum amount of direct and financial investment made available peryear is a finite portion of domestic investment and financial assets. Yet, actualamount of financial investment is further assumed to be dependent on a level ofan expected return arbitrage by its factor. Figure 13 illustrates table functionsof investment levels that are assumed in our model in terms of expected returnarbitrate.
Gr aph Lookup - Di r ect I nvest ment I ndex Tabl e
1. 2
- 0. 4- 0. 2 0. 2
Gr aph Lookup - Fi nanci al I nvest ment I ndex Tabl e
1. 1
- 1. 1- 0. 2 0. 2
Figure 13: Direct and Financial Investment Indices
Specifically, left-hand diagram shows a table function of direct investment,which assumes that between the arbitrage range of -0.01 and 0.01 direct in-vestment is not made. Right-hand diagram shows a table function of financialinvestment, which assumes that between the arbitrage range of -0.01 and 0.01financial capital flows slowly between a portion of -0.02 and 0.02. These as-sumptions are made to reflects a realistic situation in which direct investmentis not so sensitive to the arbitrage values compared with financial investment.
In this way net capital flow could be described as a function of an expectedreturn arbitrage such that
NCF = NCF (A(E, Ee)), where∂NCF
∂A< 0 (25)
It is important to note, however, that this functional relation holds only in theneighborhood of equilibrium, so do the following relations as well.
∂NCF
∂E=
∂NCF
∂A
∂A
∂E=
∂NCF
∂A
∂Rf
∂E> 0 (26)
17
∂NCF
∂Ee=
∂NCF
∂A
∂A
∂Ee=
∂NCF
∂A
∂Rf
∂Ee< 0 (27)
Whenever a foreign exchange rate begins to appreciate, an expected returnarbitrage declines, and capital begins to inflow, causing a positive net capitalflow. When foreign exchange rate is expected to appreciate, an expected returnarbitrage increases and capital begins to outflow, causing a negative net capitalflow. In this way, changes in a foreign exchange rate and its expectations playa crucial role for financial investment.
It is examined in our model that these relations only hold in the neighbor-hood of equilibrium. In Figure 14, net capital flow is shown to be an increasing
NCF vs E
0
- 1
- 2
- 3
- 40. 940 0. 950 0. 960 0. 970 0. 980 0. 990 1
For ei gn Exchange Rat e
Dol
lar
/Yea
r
Net Capi t al I nf l ow : r un
NCF vs E
6
4. 5
3
1. 5
01 1. 010 1. 020 1. 030 1. 040 1. 050 1. 060 1. 070
For ei gn Exchange Rat e
Dol
lar
/Yea
r
Net Capi t al I nf l ow : r un
Figure 14: Net Capital Inflow vs Foreign Exchange Rate
function only when a foreign exchange rate is around the equilibrium; that is,between 0.983 and 1.018. This may indicate a limitation of the above mathe-matical method of economic analysis which has been dominantly used in manytextbooks. In other words, mutually interdependent economic behaviours can-not be fully captured unless they are simulated in a system dynamics modelsuch as the one in this paper.
6 Dynamics of Foreign Exchange Rates
How are the foreign exchange rate and its expectations determined, then? For-eign exchange rate is here simply assumed to be determined by the excess de-mand for foreign exchange; that is, a standard logic of price mechanism ineconomic theory. From the left-hand diagram of Figure 9, demand for foreignexchange is shown to stem from the need for payments due to imports, directand financial investment abroad, and foreign investment income, as well as for-eign exchange purchase by the central bank. Supply of foreign exchange resultsfrom the receipts from foreign country due to exports, foreign direct and finan-cial investment abroad, and investment income from abroad, as well as foreignexchange sale by the central bank.
18
Hence, excess demand for foreign exchange is calculated as follows:
Excess Demand for Foreign Exchange= Imports - Exports
+ Investment Abroad - Foreign Investment Abroad+ Foreign Investment Income - Investment Income+ Foreign Exchange Purchase - Foreign Exchange Sale
= − Trade Balance (TB)− Net Capital Flow (NCF )− Net Investment Income (NII)+ Net Exchange Reserves (NER)
(28)
Net investment income is derived from the financial assets invested abroadand here assumed to be dependent only on domestic and foreign interest rates.Net exchange reserves depend on the official foreign exchange intervention.Therefore, NII and NER are not dependent on foreign exchange rate and itsexpectations.
With these relations taken into consideration, dynamics of foreign exchangerate is mathematically expressed as a function of excess demand for foreignexchange, which in turn becomes a function of E and Ee as follows:
dE
dt= Ψ(−TB(E) − NCF (E, Ee) − NII + NER) = Ψ(E,Ee) (29)
On the other hand, a formation of expected foreign exchange rates is difficultto formalize. Here it is simply assumed that actual expectations of foreignexchange rate fluctuates randomly around the current exchange rate by thefactor of random normal distribution of Nrandom(m, sd) where (m, sd) denotesmean and standard deviation, and accordingly an expected foreign exchangerate is obtained as an adaptive expectation against the actual expectation ofrandom normal distribution.
Mathematically, dynamics of the expected foreign exchange rate thus definedis described as
dEe
dt= Φ(Nrandom(m, sd)E − Ee) = Φ(E, Ee) (30)
Thus, expected foreign exchange rate can be easily adjusted to the actual trendsand volatilities of various economic situations by refining values in mean andstandard deviation. Figure 15 illustrates how foreign exchange rate and itsexpectation are modeled in our economy.
Now dynamic modeling of foreign exchange rate in our open macroeconomyis complete. It consists of three equations: (15), (29), and (30), out of whichthree variables E, Ee and TB are determined, given parameters outside such as
19
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e of
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ay
ment
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(F
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tmen
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nge
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ustm
ent
Ti
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ofF
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pecta
tion
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ensi
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(T
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e)
Adj
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Ex
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n F
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mean
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on
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Figure 15: Determination of Foreign Exchange
GDP, its price level and interest rate, as well as random normal distribution ofexpected foreign exchange rate. Schematically, it is written as
(Y, Yf , P, Pf , i, if , Nrandom) =⇒ (E, Ee, TB) (31)
Figure 16 draws a theoretical gist of our open macroeconomic framework as asimplified causal loop diagram of the dynamics of foreign exchange rate in ouropen macroeconomy.
20
GDP ( Y)
Tr adeBal ance
For ei gnExchange
Rat e
Random Nor malDi s t r i but i on
Expect edFor ei gn
ExchangeRat e
NetCapi t al
Fl ow
I nt er es tRat e ( i )
Pr i ce ( P)
Of f i ci alI nver vent i on
GDP ( Yf )
Pr i ce ( Pf )
I nt er es tRat e ( i f )
Figure 16: Causal Loop Diagram of the Foreign Exchange Dynamics
7 Behaviors of Current Account
An Equilibrium State (S)
We are now in a position to examine how our open macroeconomy behaves.Let us start with an equilibrium state of trade and foreign exchange. Domesticand foreign GDPs are assumed to grow at an annual rate of 2%. Randomnormal distribution for the expected foreign exchange rate is assumed to havea zero mean value and 0.1 value of standard deviation. Figure 17 illustratesthe equilibrium state under such circumstances. Macroeconomic figures suchas consumption spending, investment, government expenditures, exports andimports are shown to be growing, while trade balance is in equilibrium at a zerovalue in the left-hand diagram. On the other hand, a constant foreign exchangerate at one dollar per FE and its fluctuating expected rates are shown in theright-hand diagram.
Nat i onal I ncome Spendi ng
800
600
400
200
00 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Y
ear
Cons umpt i on : Equi l i br i umI nves t ment : Equi l i br i umGover nment Expendi t ur e : Equi l i br i umExpor t s : Equi l i br i umI mpor t s : Equi l i br i umTr ade Bal ance : Equi l i br i um
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : Equi l i br i umFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : Equi l i br i um
Figure 17: Equilibrium State of Trade and Foreign Exchange Rate (S)
In this state of equilibrium, financial investment is not yet considered. Hence,
21
in spite of non-zero expected return arbitrate, caused by the fluctuations ofestimated foreign exchange rates, capital flows are not provoked, and accordinglytrade balance stays undisturbed.
Change in real GDP (S1)
Several scenarios can be considered that lead economic behaviors out of theabove equilibrium state. Let us start with two simple cases in which no capitalflows are allowed; that is, our dynamic system of foreign exchange rate is nowsimply described as
dE
dt= Ψ(−TB(E)) (32)
As a first scenario, suppose a foreign real GDP decreases by 60 (billion)dollars at the year 7 due to a recession in a foreign country. The effect of thisrecession appears first of all as a sudden drop in our exports which are wholydependent on foreign economic activities. This sudden plunge in exports causesa trade deficit. This will begin to increase demand for foreign exchange, becauseimports become relatively larger than exports, which in turn will cause foreignexchange rate to appreciate. The appreciation of foreign exchange rate makesimported goods more expensive, and eventually curbs the imports and tradebalance will be gradually restored. In due course a new equilibrium state offoreign exchange rate will be attained at 1.056 dollars per FE (an appreciationrate of 5.6%)
In this way a flexible foreign exchange rate plays a decisive role of restoringtrade imbalance as illustrated in Figure 18. Trade balance in a foreign countrymoves exactly into the opposite direction, so that a perfect mirror image oftrade balance is created as reflected in the right-hand diagram.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : GDP( f ) pl ungeFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : GDP( f ) pl unge
Tr ade Bal ance
8
4
0
- 4
- 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : GDP( f ) pl unge" For ei gn Tr ade Bal ance ( FE) " : GDP( f ) pl unge
Figure 18: Foreign GDP Plunge and Restoring Trade Balance (S1)
Change in Price (S2)
As a second scenario, let us consider an opposite situation in which a foreignprice rises by 10% due to an economic boom in a foreign country. The inflation
22
makes imported goods more expensive and imports are suddenly suppressed,causing a surplus trade balance. Trade surplus will bring in more foreign ex-change, causing a foreign exchange rate to depreciate. The depreciated foreignexchange rate now makes imported goods relatively cheaper and stimulates im-ports again. In this way trade balance will be restored and a new level ofexchange rate is attained in due course at 0.97 dollars per FE (a depreciationrate of 3 %) as illustrated in Figure 19.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : For ei gn I nf l at i onFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : For ei gn I nf l at i on
Tr ade Bal ance
6
3
0
- 3
- 60 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : For ei gn I nf l at i on" For ei gn Tr ade Bal ance ( FE) " : For ei gn I nf l at i on
Figure 19: Foreign Inflation and Restoring Trade Balance (S2)
8 Behaviors of Financial Account
Expectations and Foreign Investment (S3)
In the above equilibrium state, standard deviation of random normal distribu-tion is assumed to be 0.1, and expected foreign exchange rates are allowed tomove randomly. Accordingly, non-zero return arbitrage caused by such fluctua-tions of foreign exchange rate could have triggered capital inflows and outflowsunder the assumption of efficient financial market. Yet, in order to see the effectof economic activities and price levels on trade balance and exchange rate, fi-nancial investment is excluded from the analysis. In this sense, the equilibriumstate discussed above is not a real equilibrium state under free capital flows.
From now on let us consider three cases in which free capital flows are allowedfor higher returns. In other words, behaviors of three variables E,Ee and TBare fully analyzed under the three equations: (15), (29), and (30).
As a scenario 3, let us consider the original equilibrium state again and seewhat will happen if free capital flows are additionally allowed for higher returns.As a source of financial investment, 20 % of domestic investment is assigned todirect investment abroad, and 30 % of financial assets are allowed for financialinvestment. The actual financial investment, however, depends on the scale ofinvestment indices illustrated in Figure 13 above.
Figure 20 illustrates a revised equilibrium state under free flows of capi-tal. Top-right figure shows the existence of the expected return arbitrage under
23
the fluctuations of expected foreign exchange rates. The emergence of the arbi-trage undoubtedly trigger capital flows of financial investment for higher returns,breaking down the original equilibrium state of trade balance, as shown in thebottom two diagrams. In this way, the original equilibrium state of trade iseasily thrown out of balance by merely introducing random expectations of for-eign exchange rate under an efficient capital market. In other words, randomexpectations among financial investors are shown to be a cause of trade turbu-lence, and hence economic fluctuations of boom and bust in international trade.What surprised me is that a flexible foreign exchange rate can no longer restorea trade balance. This is an unexpected simulation result in this research.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : Expect at i onFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : Expect at i on
I nt er es t Ar bi t r age
0. 02
0. 01
0
- 0. 01
- 0. 020 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
1/Y
ear
I nt er es t Ar bi t r age Adj ust ed : Expect at i on" I nt er es t Ar bi t r age ( FE) Adj ust ed" : Expect at i on
Tr ade Bal ance
10
5
0
- 5
- 100 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : Expect at i on" For ei gn Tr ade Bal ance ( FE) " : Expect at i on
Expor t s - I mpor t s
200 Dol l ar / Year10 Dol l ar / Year
150 Dol l ar / Year5 Dol l ar / Year
100 Dol l ar / Year0 Dol l ar / Year
50 Dol l ar / Year- 5 Dol l ar / Year
0 Dol l ar / Year- 10 Dol l ar / Year
0 6 12 18 24 30 36 42 48 54 60Ti me ( Year )
Expor t s : Expect at i on Dol l ar / YearI mpor t s : Expect at i on Dol l ar / YearTr ade Bal ance : Expect at i on Dol l ar / Year
Figure 20: Random Expectations and Foreign Investment (S3)
Change in Interest Rate (S4)
Under the situation of the above scenario 3, let us additionally suppose, as sce-nario 4, that a domestic interest rate suddenly plummets by 2% and becomes 1%from the original 3% at the year 7. This drop may be caused by an increase inmoney supply. The lowered interest rate surely drives capital outflows abroad.This in turn will increase the demand for foreign exchange, and a foreign ex-change rate will begin to appreciate. The appreciation of foreign exchange ratemakes exports price relatively cheaper, and trade balance turns out to becomesurplus. Figure 21 illustrates how a plummet of interest rate appreciates foreign
24
exchange rate and improve a trade balance.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : I nt er es t Pl ummetFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : I nt er es t Pl ummet
I nt er es t Ar bi t r age
0. 04
0. 02
0
- 0. 02
- 0. 040 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
1/Y
ear
I nt er es t Ar bi t r age Adj ust ed : I nt er es t Pl ummet" I nt er es t Ar bi t r age ( FE) Adj ust ed" : I nt er es t Pl ummet
Tr ade Bal ance
40
20
0
- 20
- 400 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : I nt er es t Pl ummet" For ei gn Tr ade Bal ance ( FE) " : I nt er es t Pl ummet
Expor t s - I mpor t s
200 Dol l ar / Year40 Dol l ar / Year
150 Dol l ar / Year29. 5 Dol l ar / Year
100 Dol l ar / Year19 Dol l ar / Year
50 Dol l ar / Year8. 5 Dol l ar / Year
0 Dol l ar / Year- 2 Dol l ar / Year
0 6 12 18 24 30 36 42 48 54 60Ti me ( Year )
Expor t s : I nt er es t Pl ummet Dol l ar / YearI mpor t s : I nt er es t Pl ummet Dol l ar / YearTr ade Bal ance : I nt er es t Pl ummet Dol l ar / Year
Figure 21: Interest Plummet under Random Expectations (S4)
Left-hand diagram of Figure 22 illustrates the balance of payments underthe original equilibrium state (scenario 3). Current account is shown to bein deficit all the time, and in order to finance it financial account has to bein surplus. Under the same situation, a domestic interest rate is additionallylowered (scenario 4). Right-hand diagram indicates how lowered interest ratestimulates the economy and improves a deficit state of the balance of payments.
Bal ance of Payment s
20
10
0
- 10
- 200 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Cur r ent Account : Expect at i on" Capi t al & Fi nanci al Account " : Expect at i onChange i n Reser ve Asset s : Expect at i onBal ance of Payment s : Expect at i on
Bal ance of Payment s
80
40
0
- 40
- 800 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Cur r ent Account : I nt er es t Pl ummet" Capi t al & Fi nanci al Account " : I nt er es t Pl ummetChange i n Reser ve Asset s : I nt er es t Pl ummetBal ance of Payment s : I nt er es t Pl ummet
Figure 22: Comparison of the Balance of Payments between S3 and S4
25
Change in GDP and Free Capital Flow (S5)
Let us revisit the scenario 3. Then as a scenario 5, let us additionally assume adecrease in foreign GDP by 60 (billion) dollars at the year 7 due to a recessionin a foreign country as in the scenario 1. Furthermore, the central bank isnow assumed to hold foreign exchange reserves of 100 (billion) dollars that aredeposited with foreign banks.
As already discussions in the scenario 1, foreign exchange rate continues toappreciate, yet trade balance is no longer attained and trade deficits continuesfor a foreseeable future due to the disturbance caused by free capital flows asexplored in the scenario 3. Top diagrams of Figure 23 illustrate these situa-tions. Bottom-left diagram indicates current account deficits in the balance ofpayments, which has to be offset by the net inflow of capital.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : GDP- Capi t al Fl owFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : GDP- Capi t al Fl ow
Tr ade Bal ance
20
10
0
- 10
- 200 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : GDP- Capi t al Fl ow" For ei gn Tr ade Bal ance ( FE) " : GDP- Capi t al Fl ow
Bal ance of Payment s
20
10
0
- 10
- 200 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Cur r ent Account : GDP- Capi t al Fl ow" Capi t al & Fi nanci al Account " : GDP- Capi t al Fl owChange i n Reser ve Asset s : GDP- Capi t al Fl owBal ance of Payment s : GDP- Capi t al Fl ow
For ei gn Exchange Res er ves
800
600
400
200
00 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
For ei gn Exchange Reser ves : GDP- Capi t al Fl owI ni t i al For ei gn Exchange Reser ves : GDP- Capi t al Fl ow
Figure 23: Foreign GDP Plunge and Foreign Investment (S5)
Bottom-right diagram shows that foreign exchange reserves by the centralbank continues to grow at a rate of the foreign interest rate of 3 %. From awell-known principle of a doubling time of exponential growth, the reserves keepdoubling approximately every 23 years.
26
9 Foreign Exchange Intervention
Official Intervention and Default (S6)
In the scenario 5 above, our macroeconomy continues to suffer from a continualdepreciation of domestic currency (or an appreciation of foreign exchange rate),and deficits in trade and accordingly in current account. Surely, such a criticalmacroeconomic situation in a competitive international economic environmentcannot be left uncontrolled. To prevent such an economic crisis let us introduce,as scenario 6, an official intervention to the foreign exchange market; specifically,the central bank (and government) begins to sell foreign exchange in order toreduce foreign exchange rate, say, to 1.02 dollars per FE; that is, by 2 % of theoriginal equilibrium exchange rate.
As Figure 24 illustrates, even under such circumstances trade and currentaccount deficits continue to persist. Gradually, the foreign exchange reservesbegins to decline due to the official intervention, and becomes lower than theoriginal reserve level of 100 (billion) dollars around the year 40 and completelygets depleted around the year 50, as indicated in the bottom right-hand diagram.This implies the government is forced to declare financial default, that is, aneconomic destruction, unless successfully eliciting an emergent loan from theinternational institutions such as the IMF.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : I nt er vent i onFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : I nt er vent i on
Tr ade Bal ance
20
10
0
- 10
- 200 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : I nt er vent i on" For ei gn Tr ade Bal ance ( FE) " : I nt er vent i on
Bal ance of Payment s
60
30
0
- 30
- 600 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Cur r ent Account : I nt er vent i on" Capi t al & Fi nanci al Account " : I nt er vent i onChange i n Reser ve Asset s : I nt er vent i onBal ance of Payment s : I nt er vent i on
For ei gn Exchange Res er ves
800
400
0
- 400
- 8000 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
For ei gn Exchange Reser ves : I nt er vent i onI ni t i al For ei gn Exchange Reser ves : I nt er vent i onFor ei gn Exchange Reser ves : GDP- Capi t al Fl ow
Figure 24: Official Intervention and Default (S6)
27
Zero Interest Rate and Default (S7)
To avoid such financial default, now suppose, as scenario 7, money supply isincreased to stimulate the economy and a domestic interest rate is lowered by3%; that is, a zero interest rate is introduced from the original 3%. This policyof zero interest rate surely improves trade balance and the balance of paymentsas Figure 25 indicates. Yet, under the official intervention of keeping a foreignexchange rate below 1.02 dollars per FE, the central bank (and the government)is forced to keep selling foreign exchange reserves2. The original 100 (billion)dollars of foreign exchange reserves will be completely depleted around the year12 as the bottom right-hand diagram indicates. Therefore, this zero interestpolicy does not work unless the government can successfully borrow foreignexchange from the international institutions such as the IMF.
For ei gn Exchange Rat e
1. 2
1. 1
1
0. 9
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/F
E
For ei gn Exchange Rat e : Def aul tFor ei gn Exchange Rat e : bas eExpect ed For ei gn Exchange Rat e : Def aul t
Tr ade Bal ance
60
30
0
- 30
- 600 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Y
ear
Tr ade Bal ance : Def aul t" For ei gn Tr ade Bal ance ( FE) " : Def aul t
Bal ance of Payment s
200
100
0
- 100
- 2000 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Y
ear
Cur r ent Account : Def aul t" Capi t al & Fi nanci al Account " : Def aul tChange i n Res er ve As s et s : Def aul tBal ance of Payment s : Def aul t
For ei gn Exchange Res er ves
800
- 400
- 1, 600
- 2, 800
- 4, 0000 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
For ei gn Exchange Reser ves : Def aul tI ni t i al For ei gn Exchange Reser ves : Def aul tFor ei gn Exchange Reser ves : GDP- Capi t al Fl ow
Figure 25: Zero Interest Rate and Default (S7)
No Official Intervention (S8)
Let us further suppose that the central bank (and the government) gives upofficial intervention and stops selling foreign exchange to avoid a depletion ofits foreign reserves. This scenario 8 surely brings about a further appreciation
2To be precise, for maintaining the rate below this level, the central bank (and the gov-ernment) has to keep selling 60 (billion) dollars of foreign exchange annually instead of 20(billion) dollars in the previous scenario
28
of foreign exchange rate. But to our surprise, after attaining a highest value of1.212 dollars at the year 41, it begins to depreciate as the top left-hand diagramof Figure 26 illustrates. Moreover, trade balance and the balance of paymentsare getting improved, and foreign exchange reserves keeps growing according tothe same figure. This is another counter-intuitive result in a sense that officialintervention to foreign exchange market won’t work to save the economic crisis.
In this way, so long as the working of our domestic macroeconomy is con-cerned, combined policies of zero interest rate and no official intervention seemto work. Yet, from a foreign country’s point of view, the same policies worsenits economy as a mirror image of our economy. Hence, a so-called trade warbecomes unavoidable in the international macroeconomic framework. Our sim-ple open macroeconomic model has successfully exposed one of the fundamentalcauses of economic conflicts among nations.
For ei gn Exchange Rat e
1. 3
1. 175
1. 05
0. 925
0. 80 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/FE
For ei gn Exchange Rat e : No I nt er vent i onFor ei gn Exchange Rat e : baseExpect ed For ei gn Exchange Rat e : No I nt er vent i on
Tr ade Bal ance
40
20
0
- 20
- 400 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Tr ade Bal ance : No I nt er vent i on" For ei gn Tr ade Bal ance ( FE) " : No I nt er vent i on
Bal ance of Payment s
200
100
0
- 100
- 2000 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
/Yea
r
Cur r ent Account : No I nt er vent i on" Capi t al & Fi nanci al Account " : No I nt er vent i onChange i n Reser ve Asset s : No I nt er vent i onBal ance of Payment s : No I nt er vent i on
For ei gn Exchange Res er ves
800
600
400
200
00 6 12 18 24 30 36 42 48 54 60
Ti me ( Year )
Dol
lar
For ei gn Exchange Reser ves : No I nt er vent i onI ni t i al For ei gn Exchange Reser ves : No I nt er vent i onFor ei gn Exchange Reser ves : GDP- Capi t al Fl ow
Figure 26: No Official Intervention (S8)
10 Missing Feedback Loops
We have now presented eight different scenarios of international trade and finan-cial investment, which indicates capability of our open macroeconomic modeling.Yet, our generic model is far from a complete open macroeconomy, because sig-nificant economic variables such as GDP, its price level and interest rate aretreated as outside parameters, and no feedback loops exist in the sense that
29
they are affected by the endogenous variables such as a foreign exchange rateand its expectations. Schematically, one-way direction of decision-making in theequation (31) has to be made two-way such that
(Y, Yf , P, Pf , i, if , Nrandom) ⇐⇒ (E,Ee, TB) (33)
Mundell-Fleming Model
Compared with our model, one of the repeatedly used open macroeconomicmodel in standard international economics textbooks is the Mundell-Flemingmodel that is described, according to [2], as
Y = C(Y − T ) + I(i)) + G + TB(E) (34)Ms
P= L(i, Y ) (35)
i = if (36)
This macroeconomic model indeed determines Y, E and i. In other words, sig-nificant economic variables such as GDP and interest rate are simultaneouslydetermined in the model. In comparison, our model consisting of the threeequations: (15), (29), and (30), determines only three variables E,Ee and TB,and fails to determine Y and i.
Hence, Mundel-Fleming model could be said to be a better presentation ofopen macroeconomy. Yet, it lacks a mechanism of determining money supplyMs and a price level P . In this sense, it is still far from a complete openmacroeconomic model.
Missing Loops
It is now clear from the above arguments that for a complete open macroeco-nomic model some missing feedback loops have to be supplemented. They couldconstitute the following in our model:
• Imports and exports are assumed to be determined by the economic ac-tivities of GDPs, which are in turn affected by the size of trade balance.Yet, they are missing.
• Foreign exchange intervention by the central bank (and the government)such as the purchase or sale of foreign exchange surely changes the amountof currency outstanding and money supply, which in turn must affect aninterest rate and a price level. Yet, they are being fixed.
• A change in interest rates affects investment, which in turn determinesthe level of GDP. Yet, investment is not playing such a role.
• A change in price level must also affect consumption spending and hencereal GDP. Yet, these loops are missing.
30
• Official intervention must influence speculations and estimations on for-eign exchange and investment returns among international financial in-vestors. Yet, these fluctuations are only given by outside random normaldistribution.
Let us add these missing feedback loops to the causal loop diagram of theforeign exchange dynamics in Figure 16. Then we obtain a complete feedbackloop diagram as illustrated in Figure 27.
GDP ( Y)
Tr adeBal ance
For ei gnExchange
Rat e
Random Nor malDi s t r i but i on
Expect edFor ei gnExchange
Rat e
NetCapi t al
Fl ow
I nt er es tRat e ( i )
Pr i ce ( P)
Of f i ci alI nver vent i on
GDP ( Yf )
Pr i ce ( Pf )
I nt er es tRat e ( i f )
Net ExchangeReser ves
Money Suppl y
I nvest ment
<Of f i ci alI nver vent i on>
Figure 27: Missing Feedback Loops Added to the Foreign Exchange Dynamics
Obviously, our open macroeconomic model is not complete until these miss-ing loops are incorporated in the model. Specifically, the third paper [7] haspresented a model which determines GDP, money supply, a price level, invest-ment and interest rate, to name but a few. Therefore, our next challenge is tointegrate the model with our present foreign exchange model by crating a wholeimage of domestic macroeconomy as its foreign sector macroeconomy. I hope theintegration will complete our research for this macroeconomic modeling series.
11 Conclusion
This is the fourth paper in our series of system dynamics macroeconomic mod-eling, and supposed to be the last one for presenting a generic macroeconomicmodel. It turns out, unfortunately, that our open macroeconomic modelingneeded another model of the balance of payments and dynamics of foreignexchange rate. Consequently, the approach in this paper led by the logic of
31
accounting system dynamics became an entirely new one in the field of interna-tional economics.
Under the framework, a double-booking accounting of the balance of pay-ments is modeled. Then determinants of trade and foreign direct and financialinvestment are analytically examined together with an introduction of differen-tial equations of foreign exchange rate and its expected rate.
Upon a completion of the model, eight scenarios are are produced and ex-amined by running various simulations to obtain some behaviors observed inactual international trade and financial investment. It is a surprise to see howan equilibrium state of trade balance is easily disturbed by merely introducingrandom expectations among financial investors under the assumption of effi-cient financial market. To indicate the capability of our model furthermore,the impact of official intervention on foreign exchange and a path to default isdiscussed.
Finally, several missing feedback loops in our model are pointed out formaking it a complete open macroeconomic model. This task of completion willinevitably lead to our next and hopefully last research in this system dynamicsmacroeconomic modeling series in our next paper.
References
[1] Paul R. Krugman and Maurice Obstfeld. International Economics: Theory& Policy, Seventh Edition. Pearson International Edition, Boston, Mas-sachusetts, 2006.
[2] N. Gregory Mankiw. Macroeconomics. Worth Publishers, New York, 5thedition, 2003.
[3] Lucio Sarno and P. Taylor, Mark. The Economics of Exchange Rates. Cam-bridge University Press, Cambridge, U.K., 2002.
[4] Kaoru Yamaguchi. Principle of accounting system dynamics – modelingcorporate financial statements –. In Proceedings of the 21st InternationalConference of the System Dynamics Society, New York, 2003. System Dy-namics Society.
[5] Kaoru Yamaguchi. Money supply and creation of deposits : SD macroeco-nomic modeling (1). In Proceedings of the 22nd International Conference ofthe System Dynamics Society, Oxford, England, 2004. The System DynamicsSociety.
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