ECO1000Economics

Semester One, 2004Lecture Nine

Class Test 2 Reminder For Internal Students Wednesday May 26 25 multiple Choice Questions Based on the work covered from week six to

week 12: Lectures 6 – 10 Modules 3, 4, 5, 6 and 7 Chapters 7, 8, 9, 10, 11, 12, 13, 14, 15, 16.

Same On-Line Format as Test One

Outline or Plan of Today’s Lecture Material Covered: Module Six Reading: Text Chapters 14 and 15 Topics: The Open Economy

Purpose or Objectives of Today’s Lecture You will be able to:

Define an open economy Give an overview of some of the key variables

associated with international economic interactions

Develop a model of the interaction of those key variables

Show how the variables change under different scenarios

What is an Open Economy?

An Open Economy

An open economy interacts with other countries in two ways It buys and sells goods and services in world

product markets. It buys and sells capital assets in world financial

markets. A ‘closed economy’ has little or no such

interaction

Why have a closed economy?

Fear of foreign cultural & moral influences Political and military security Aiming for strategic self-sufficiency Protecting strategic industries Protecting ‘infant’ industries Protecting employment

The Case for Open Economies Comparative advantage

‘everyone is better off with trade’ Development through competition Flow of technology & ideas Reduces international military tension ‘It can’t be stopped’

The flow of capital Communications and cultural incursions

The Flow of Goods and Money

The Flow of Goods: Net Exports Exports are domestically produced and sold

abroad. Imports are foreign-produced and sold

domestically. A trade deficit is a situation where net exports

(exports – imports, NX) are negative,

Imports > Exports A trade surplus is a situation where net exports

(NX) are positive,

Exports > Imports

Factors That Affect Net Exports

Tastes of consumers for domestic and foreign goods.

The prices of goods at home and abroad. The exchange rates at which people can

use domestic currency to buy foreign currencies.

Costs of transporting goods. Government policies toward international

trade.

The Flow of Money: Net Foreign Investment (NFI) Net foreign investment is the difference

between foreign assets purchased by domestic residents and domestic assets purchased by foreigners.

Example, an Australian buys stock in Microsoft and an American buys stock in Telstra.

The difference between the two is net foreign investment.

Net Foreign Investment (NFI)

If Australian residents buy more financial assets abroad than foreigners spend on Australian financial assets, there is a net capital outflow from Australia.

If foreigners buy more Australian financial assets than Australian residents spend on foreign financial assets, then there will be a net capital inflow into Australia.

Equality of NX and NFI An interesting identity must hold through all of

these flows of goods and capital.

NX = NFI An increase in net exports must mean that more

foreign currency is flowing into the economy (and vice versa).

So an increase (decrease) in NX must be met with a corresponding (increase) (decrease) in NFI.

International Prices: Exchange Rates

Real and Nominal Exchange Rates International transactions are influenced

by international prices. The two most important international

prices are: the nominal exchange rate; and the real exchange rate.

The Nominal Exchange Rate

The 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 one Australian

dollar In units of Australian dollars per one unit of the

foreign currency

The Nominal Exchange Rate: Example Assume the exchange rate between the US dollar and

the Australian dollar is $1AUS to US 75 cents. Then: One $AUS trades for US 75 cents One $US dollar trades for $AUS 1/0.75) or $A1.33

(approx). If an Australian dollar buys more foreign currency,

there is an appreciation of the Australian dollar. eg one Australian dollar = 80 US cents

If it buys less there is a depreciation of the dollar. eg one Australian dollar = 60 US cents

The Real Exchange Rate The real exchange rate compares the prices

of domestic goods and foreign goods in the domestic economy.

The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

It is calculated by:

priceForeign

price Domestic x rate exchange Nominal

=rate exchange Real

The Real Exchange Rate: An Example New Zealand wine costs $NZ14 a bottle

A comparable wine Australia costs $A12 The nominal exchange rate is $A1 = $NZ1.10 Real exchange rate = (1.1 x 12)/14 =13.2/14 = 0.94 You would only get 0.94 bottle of NZ wine for 1

bottle of Australian wine Therefore, all things being equal, keep drinking

Australian wine

Exchange Rate Appreciation: An Example The exchange rate becomes $A1=$NZ1.20

(Appreciation of $A and/or depreciation of $NZ) Real exchange rate for wine = (1.2 x 12)/14 = 14.40/14 = 1.02 For the same Australian money you now get 1.02

bottles of NZ wine, or 1 bottle of NZ wine will be cheaper than an Australian bottle of wine.

Advantages of a Low Real Exchange Rate When a country’s real exchange rate is low,

its goods are cheap relative to foreign goods. Consumers both at home and abroad tend to

buy more of that country’s goods and fewer foreign produced goods.

How Are Exchange Rates Determined?

A Simple Theory: PPP

Purchasing-Power Parity A unit of any currency should be able to buy the

same quantity of goods in all countries (theoretically)

If prices in some countries are high there are opportunities for imports, which will drive down prices Arbitrage is the opportunity to buy in one

place and sell at a profit in another Therefore, the exchange rate between two

countries is affected by prices in those countries

Implications of PPP Nominal exchange rate depends on the price

level Increasing prices, relative to another country, may

result in a depreciation in the value of the currency

BUT… Not all goods are easily traded and there are

transactions costs Not all imported goods are perfect substitutes for

domestically produced goods

The Macroeconomics of an Open Economy: Theory

Determining Macroeconomic Variables in an Open Economy The important macroeconomic variables of an

open economy include: national saving domestic investment net foreign investment net exports

Determining the Values of the Macroeconomic Variables in an Open Economy

The values of the variables are determined through the interaction of: the loanable funds market (from an earlier

lecture); and the market for foreign-currency exchange

The Market for Loanable Funds

The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI).

At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment:

S = I + NFI

The Market for Loanable Funds

Demand for loanable funds (for domestic investment and net

foreign investment)

S = I + NFIEquilibrium real interest rate

Real Interest Rate

Equilibrium Quantity

Quantity of Loanable Funds

Supply of Loanable Funds (from national saving)

The Market for Foreign-Currency Exchange

Remember, for an economy as a whole, NFI = NX

NFI represents the quantity of dollars supplied for the purpose of buying assets abroad.

NX represents the quantity of dollars demanded for the purpose of buying Australian net exports of goods and services.

NX = NFI, represents the two sides of the foreign-currency exchange market in which Australian dollars are traded for foreign currencies.

The price that balances the supply and demand for foreign-currency is the real exchange rate.

The Market for Foreign-Currency Exchange

Equilibriumquantity

Quantity of Dollars Exchangedinto Foreign Currency

RealExchange

Rate

Equilibrium real

exchange rate

Supply of dollars(from net foreign investment)

Demand for dollars(for net exports)

The Market for Foreign-Currency Exchange The real exchange rate adjusts to balance the supply

and demand for dollars. At the equilibrium real exchange rate, the demand for

dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad.

The demand for foreign currency increases as the exchange rate decreases domestic (our) goods become cheaper to buy.

The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

The Linkage Between Markets

Equilibrium in the Open Economy Net foreign investment links the loanable

funds market and the foreign-currency exchange market. The key determinant of net foreign investment is

the real interest rate.

Equilibrium in the Open Economy In the market for loanable funds, net foreign

investment is a portion of demand. In the market for foreign-currency exchange, net

foreign investment is the source of supply. Prices in the loanable funds market and the foreign-

currency exchange market adjust simultaneously to balance supply and demand in these two markets.

As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange

Net foreigninvestment,NFI

RealInterest

Rate

Net ForeignInvestment

r 1

RealInterest

Rate

Quantity ofLoanable Funds

r1

Supply

Demand

Quantity ofDollars

RealExchange

Rate

E1

Supply

Demand

How Changes in Policy and Events Affect an Open Economy The magnitude and variation in important

macroeconomic variables depend on the following: Government budget deficits Trade policies Political and economic stability

Government Budget Deficits

In an open economy, government budget deficits...

...raise interest rates, which

...crowds out domestic investment,

...causes the dollar to appreciate, and

...pushes the trade balance toward a deficit.

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange

RealInterest

Rate

Quantity ofLoanable Funds

Quantity of Dollars

RealExchange

Rate

RealInterest

Rate

Net ForeignInvestment

S1

D

S1

D

NFI

r1

E1

1. A budget deficit reduces the supply of loanable funds...

S2

r2

S2

2. which increases the real interest

3. which in turn reduces net foreign investment.

4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency…

5. …which causes the real exchange rate to appreciate.

E2

Effect of Budget Deficits on the Loanable Funds Market A government budget deficit reduces national

saving, which...

...shifts the supply curve for loanable funds to the left, which

...raises interest rates. Therefore, higher interest rates reduce net

foreign investment.

Effect on the Foreign-Currency Exchange Market A decrease in net foreign investment reduces

the supply of dollars to be exchanged into foreign currency.

This causes the real exchange rate to appreciate.

Government Budget Surpluses… In an open economy: …Increase supply of loanable funds …Decrease Real Interest Rate …Increases NFI (the key determinant of NFI

is the real interest rate because you want to borrow money to invest abroad).

…Leads to a depreciation of the exchange rate.

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange

RealInterest

Rate

Quantity ofLoanable Funds

Quantity of Dollars

RealExchange

Rate

RealInterest

Rate

Net ForeignInvestment

S1

D

S1

D

NFI

r1

E1

1. A budget surplus increases the supply of loanable funds...

S2

r2

S2

2. which decreases the real interest

3. which in turn increases net foreign investment.

4. The increase in net foreign investment increases the supply of dollars to be exchanged into foreign currency…

5. …which causes the real exchange rate to depreciate.

E2

Trade Policy

A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports. Tariff: A tax on an imported good. Import quota: A limit on the quantity of a good

produced abroad and sold domestically.

The Effect of a Trade Policy (Tariff) In an open economy:

A Tariff affects NX Because NX are a source of demand for dollars

the tariff affects the demand for currency Because a tariff reduces imports, NX increases Because foreigners need dollars to buy NX, the

demand for dollars increases The real exchange rate appreciates This offsets the effect on NX of the decline in IM The trade balance remains the same after a tariff

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange

Net foreigninvestment,NFI

RealInterest

Rate

Net ForeignInvestment

r 1

RealInterest

Rate

Quantity ofLoanable Funds

r1

Supply

Demand

Quantity ofDollars

RealExchange

Rate

E1

Supply

Demand

Tariff increases demand for dollars and causes the exchange rate to appreciate which encourages imports and discourages exports, thereby offsetting the initial decline in imports caused by the tariff.

E2

D2

Political Instability and Capital Flight Capital flight is a large and sudden movement

of funds out of a country, usually due to political instability.

Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.

Effects of Capital Flight…

In an open economy: Say Australian’s think that there is a better place

to invest than Australia (maybe due to a sudden political or business scandal)

They demand loanable funds to invest overseas This increases the Australian real interest rate Increases NFI Increases the supply of AUS$ Which leads to a depreciation of the currency

(a) The Market for Loanable Funds (b) Net Foreign Investment

(c) The Market for Foreign-Currency Exchange

Net foreigninvestment,NFI

RealInterest

Rate

Net ForeignInvestment

r 1

RealInterest

Rate

Quantity ofLoanable Funds

r1

Supply

Demand

Quantity ofDollars

RealExchange

Rate

E1

Supply

Demand

In Light of the Objectives of this Lecture… We now know how to:

Describe an open economy Give an overview of some of the key open

economy variables Use a model to show the interaction of these

variables Show how the variables change under different

scenarios

Next Week

Material Covered: Module Seven Reading: Text Chapter 16 Topics: Aggregate Demand and Supply

THE END