PowerPoint to accompany Chapter 19 Macroeconomics in an Open Economy

PowerPoint

to accompany

Chapter 19

Macroeconomics in an Open Economy

Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

Learning Objectives

1. Explain the main components of the balance of payments and understand how it is calculated.

2. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports.

3. Understand how different exchange rate systems operate.

4. Discuss the three key aspects of the current exchange rate system.


Learning Objectives

5. Explain the saving and investment equation.

6. Explain the effect of a government budget deficit or surplus on investment in an open economy.

7. Discuss the difference between the effectiveness of monetary and fiscal policy in an open economy and in a closed economy.


Australian universities face crunch from rising dollar

The appreciation of the Australian dollar against major currencies increases the cost of studying in Australia for international students.


Open economy: An economy that has interactions in trade and finance with other economies.

Closed economy: An economy that has no interactions in trade or finance with

other economies.

LEARNING OBJECTIVE 1

The balance of payments: Linking Australia to the international economy


Balance of payments: The record of a country’s international trade, borrowing, lending, capital and investment flows with other countries.

Current account: The part of the balance of payments that records a country’s net

exports, net income and net transfers.

Australia’s current account is always in deficit.




Net exports (NX): The income received for the export of goods and services minus the amount paid for imports of goods and services.

Net exports fluctuate between positive and negative over time.

Balance of trade in goods and services: The difference between the value of the goods and services a country exports and the value of the goods and services a

country imports.



Balance on goods and services, Australia, 1960-2008: Figure 19.1

Source: Australian Bureau of Statistics (2009), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook.

-25 000

-20 000

-15 000

-10 000

-5 000

5 000

10 000

1960

1962

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Mill

ion

s o

f d

olla

rs

Balance on goods andservices

Balance on goods



Net income (NY): Income paid overseas on investments in Australia by residents of other countries, eg: profits, dividends and interest repayments on loans, minus income received by Australian residents from investments in other countries.




Net income is always in deficit for Australia.

Insufficient domestic saving leads to Australians borrowing from overseas – the interest repayment on loans is the largest deficit component of net income.

Foreign investment in Australia generates dividends and profits which flow back overseas.



Net income, Australia, 1960-2008: Figure 19.2

Source: Australian Bureau of Statistics (2009), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook.

-50

-45

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-35

-30

-25

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Bil

lio

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f d

oll

ars



Net transfers (NT): The difference between transfers made to residents of other countries and transfers received by Australian residents from other countries, including overseas aid, pensions and migrants’ funds.

Net transfers fluctuate between positive and negative over time.




The capital account: The part of the balance of payments that records migrants’

asset transfers, debt forgiveness and sales and purchases of non-produced, non-

financial assets.

The capital account usually has a small surplus, largely due to positive net migration.




The financial account: The part of the balance of payments that records purchases of physical and financial assets a country has made abroad and foreign purchases of physical and financial assets in the country.

Contains direct investment, portfolio investment, financial derivatives, other investments and Reserve Bank assets.

The financial account must always be in surplus, to balance the current account deficit.




The financial account.

Net foreign investment: The difference between capital outflows from a country

and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment.




The balance of payments always sums to zero.

A current account deficit will be exactly offset by a capital and financial account surplus.

Some countries have current account surpluses, which are exactly offset by capital and financial account deficits.



Balance of payments, Australia, 2007/08: Table 19.1

Source: Australian Bureau of Statistics (2009), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0.

Please insert Table 19.1 from page

615.



The balance of payments

A media commentator noted that exports of Australian goods were set to exceed imports for year 2009, hence he predicted that the Australian economy would no longer run a current account deficit.

Is the media commentator correct?

STEP 1: Review the material in the text book under the section ‘The balance of payments: Linking Australia to the international economy’.



The balance of payments

STEP 2: The media commentator is incorrect. He is confusing the balance on merchandise trade (exports of goods minus imports of goods), with the balance on the current account. The balance on merchandise trade is only one item in the current account, which includes the balance on goods and services, net income and net transfers.

Even if the balance on merchandise trade is positive, other components of the current account, especially net income, are likely to remain negative, with the overall current account remaining negative.



Nominal exchange rate: The value of one country’s currency in terms of another country’s currency.

The market exchange rate is determined by the interaction of demand for and supply of currency.


The foreign exchange market and exchange rates


Exchange rates in the financial pages

The financial pages of most newspapers provide information on exchange rates. Money changers, hotels and numerous websites also provide up-to-the-minute exchange rates.

MAKING THE CONNECTION19.1


Three sources of foreign currency demand for the Australian dollar:

1. Foreign firms and consumers who want to buy goods and services produced in Australia.

2. Foreign firms and consumers who want to invest in Australia (direct or portfolio investment).

3. Currency traders who believe that the value of the dollar in the future will be greater than its value today.



Exchange rate (¥/$)

Quantity of dollars traded

0


100

Supply

Equilibrium in the foreign exchange market: Figure 19.3

Demand

Shortage of dollars

Surplus of dollars

80

¥120

Demand for dollars in

exchange for yen.

Supply of dollars in exchange for

yen.


Currency appreciation: Occurs when the market value of a currency rises relative to another currency.

Currency depreciation: Occurs when the market value of a currency falls relative to another currency.




Shifts in the demand and supply curves for foreign exchange

Three main factors cause the demand and/or supply curves in the foreign exchange market to shift:

1. Changes in demand for Australian-produced goods and services and/or changes in the demand for foreign-produced goods and services.




Shifts in the demand and supply curves for foreign exchange

2. Changes in the desire to invest in Australia and/or changes in the desire to invest in foreign countries.

3. Changes in the expectations of currency traders about the likely future value of the dollar and/or the likely future value of foreign currencies.




Shifts in the demand for and supply of foreign exchange.

Income levels and economic growth rates in Australia and in other countries.

Changes in relative interest rates between countries.

Speculation.

Speculators: Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates.



Exchange rate (¥/$)

Quantity of dollars traded

0


120

S1

Shifts in demand and supply curves resulting in a higher exchange rate: Figure 19.4

D1

¥130

1. The supply curve of dollars shifts to

the right …

D2

S2

A

B

2. …while the demand curve for

dollars shifts further to the right …

3. … causing the equilibrium exchange

rate to rise.


How movements in the exchange rate affects exports and imports.

Exchange rate appreciation.

Revenue in Australian dollars falls for exporters whose goods are traded in $US.

Exports of goods and services fall for goods whose prices are determined in Australia, as they are now more expensive to overseas buyers.

Imports become cheaper.

Net exports fall, ceteris paribus, reducing the rate of increase of aggregate demand and real GDP.




How movements in the exchange rate affects exports and imports.

Exchange rate depreciation.

Revenue in Australian dollars rises for exporters whose goods are traded in $US.

Exports of goods and services increase for goods whose prices are determined in Australia, as they are now less expensive to overseas buyers.

Imports become more expensive.

Net exports rise, ceteris paribus, increasing the rate of increase of aggregate demand and real GDP.




Real exchange rate: The price of domestic goods and services in terms of foreign goods and services.


Real exchange rate = Nominal exchange rate x

level price foreign

level pricedomestic



Exchange rate determination

Suppose the Australian dollar and Japanese yen are initially in equilibrium at ¥100 = $1. Imagine now the Japanese economy experiences a strong recovery with rising GDP and falling unemployment, while conditions in the Australian economy remain stable.

How will this change the exchange rate between the dollar and the yen?



STEP 1: Review the material. This problem is about shifts in demand and supply for a currency, so you may like to review the section in the text book ‘How do shifts in demand and supply affect the exchange rate?’




STEP 2: Strong growth in Japan will lead to an increase in income for Japanese consumers, increasing demand for goods and services, including imported goods and services from trading partners such as Australia.

More importantly, demand for Australian resources to fuel Japanese production will also increase.

This will result in an increase in demand for the Australian dollar, as Japanese consumers and producers exchange yen for dollars to purchase Australian resources and other goods.

The Australian dollar will therefore appreciate against the yen.




Not all exchange rates are determined in the market.

A country’s exchange rate can be determined in several ways.

Exchange rate system: An agreement between countries on how exchange rates should be determined.


Exchange rate systems


Floating currency: The outcome of a country allowing its currency’s exchange rate to be determined by demand and supply.

Managed float exchange rate system: The current exchange rate system under which the value of most currencies is

determined by demand and supply, with occasional central bank or government intervention.




Fixed exchange rate system: A system under which countries agree to keep the exchange rates between their currencies fixed.

Pegging: The decision by one country to keep the exchange rate fixed between its currency and another currency.




The current exchange rate system has three important aspects.

1. Australia, like Britain, the USA, Japan and much of Europe, allow their currencies to float against other currencies, with occasional central bank intervention.

2. Many nations in the European Union have adopted the single currency, the Euro.

3. Some developing countries have attempted to keep their currencies fixed against the US dollar or another major currency.


The current exchange rate system

Trade-weighted index of the Australian dollar, 1970-2009: Figure 19.5

Source: Reserve Bank of Australia, Statistics (2009), Exchange Rates, Table F11, viewed 27 March 2009, at <www.rba.gov.au>

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ex (

1970

= 1

00)

Australian dollar floated



What determines exchange rates in the long run?

The theory of purchasing power parity.

Purchasing power parity: The theory that in the long run exchange rates move to equalise the purchasing power of different currencies.




Three real world complications keep purchasing power parity from being a complete explanation of exchange rates, even in the long run.

1. Not all products can be traded internationally.

2. Products and consumer preferences are different across countries.

3. Countries impose barriers to trade.




Barriers to trade include:

Tariff: A tax imposed by a government on imported goods which makes them more expensive on the domestic market.

Quota: A limit on the quantity of a good that can be imported.




The Big Mac theory of exchange rates.

The Big Mac Index shows what the exchange rate should be if purchasing power parity held for Big Macs.



The four determinants of exchange rates in the long run.

1. Relative price levels.

2. Relative rates of productivity growth.

3. Preferences for domestic and foreign goods.

4. Tariffs and quotas.




Current account balance (CAB) equals net foreign investment.

CAB = NX + NY + NT

Current Account Balance + Financial Account Balance = 0

or,

Current Account Balance = - Financial Account Balance

or,

Net Exports + Net Income + Net Transfers = Net Foreign Investment

Note: Assumes Capital Account balance is zero.


The international sector and national saving and investment


Domestic saving, domestic investment and net foreign investment

Private saving = national income – consumption - taxes

or, Sprivate = Y – C - T

Government saving = taxes – government spending

or, Spublic = T - G

National saving = private saving + public saving

or, S = Sprivate + Spublic




Domestic saving, domestic investment and net foreign investment

Remember the basic macroeconomic equation for GDP or national income:

Y = C + I + G + NX




Gross national income (GNY): Is equal to GDP (C+I+G+NX) plus the income transfers received from other countries, including

dividends and interest earned. It measures the total income that a country has for expenditure and saving.

GNY = C + I + G + NX + NY + NT

GNY = GDP + NY + NT




Recall that national saving is what remains after C and G have been paid for.

Therefore national saving can be expressed as:

S = GNY – C – G

= GDP + NY + NT – C – G

= (C + I + G + NX) + NY + NT – C – G




As the consumption and government expenditure parts of the equation cancel each other out this leaves:

S = I + NX + NY + NT

Recall that NX + NY + NT equals the current account balance (CAB), therefore:

S = I + CAB




Saving and investment equation: An equation showing that national saving is equal

to domestic investment plus net foreign investment.

National saving = domestic investment + net foreign investment

or, S = I + NFI




For Australia, net foreign investment is negative; its domestic saving is less than its

domestic investment.

Therefore, S – I = NFI




Fiscal policy revision:

Recall that if the Federal government runs a budget deficit, it must raise an amount equal to the deficit by selling bonds and securities.

To attract investors, the interest rates offered must be increased, which also causes other interest rates to rise.

Higher interest rates can lead to crowding out, as private investment and consumption are lowered.


The effect of a government budget deficit on investment


Fiscal policy revision:

Higher interest rates can also lead to an exchange rate appreciation, reducing net exports.

A budget deficit concurrent with a current account deficit is known as the twin deficits hypothesis.




The twin deficits hypothesis was widely discussed in Australia from the mid 1970s and through to the 1980s.

The theory appeared to be supported by the evidence during this time.

However, the twin deficits hypothesis does not match Australia’s experience in the

1990s and early 2000s, as large budget surpluses were accompanied by large current account deficits.



The twin deficits, 1974/75-2007/08: Figure 19.6

Sources: Australian Bureau of Statistics (2009), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Time Series Workbook; Australian Government (2007), 2007-08 Budget Overview, Appendix G, historical budget and net debt data, viewed 5 May 2008 at <www.ato.gov.au>; Australian Government (2008), 2008-09 Budget Overview, Appendix I, historical budget and net worth data, viewed 29 March 2009, at <www.ato.gov.au>

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Government budget

Current Account Deficit


http://www.ato.gov.au/

http://www.ato.gov.au/


Is Australia’s current account deficit a problem?

Australia’s current account is always in deficit.

Largely due to Australian net foreign investment being negative.

Australians borrows funds from overseas and foreigners purchase Australian assets.

Therefore there is an outflow of interest repayments and profits and dividends.





Net foreign debt: The difference between the amount Australia lends to other countries and the amount that Australia borrows from overseas.

Net foreign liability = net foreign debt liabilities + net foreign equity liabilities.

Both have risen significantly as a proportion of GDP over time.



Net foreign debt and total net foreign liabilities as a percentage of GDP, Australia, 1975/76-2007/08: Figure 19.7

Source: Australian Bureau of Statistics (2009), Balance of Payments and International Investment Position, Australia, Cat. No. 5302.0, Table 30 and Table 39, Time Series Workbook.

0

10

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r c

en

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f G

DP

Net Foreign Debt

Net Foreign Liabilities




The issues to consider include:

1. Australia must borrow from overseas to finance investment required for economic growth, as domestic savings are not sufficient to fund domestic investment.

2. Can Australia service its debt, and what proportion of GDP is required to service the debt?





3. What proportion of debt is private and what proportion is government?

Private debt does not burden tax payers.

For Australia, borrowing is essential to finance investment, and the debt burden is a relatively small proportion of GDP.





For some developing countries, debt servicing burdens are so high (much of which is government debt), that at times borrowing occurs to just to make the interest repayments on borrowing.

Spiralling debt for developing countries has led to debt forgiveness initiatives.




International debt relief for poor countries.

Debt reduction and forgiveness programs are currently operating in a large number of countries in Africa.



Monetary policy in an open economy.

Monetary policy has a greater impact on aggregate demand in an open economy than in

a closed economy.

Example: Expansionary monetary policy: interest rates are reduced.

Domestically, lower interest rates tend to increase investment and consumption spending.

In an open economy, lower interest rates also tend to lead to an exchange rate depreciation, which increases net exports, increasing aggregate demand.


Monetary policy and fiscal policy in an open economy


Fiscal policy in an open economy.

Fiscal policy has a smaller impact on aggregate demand in an open economy than

in a closed economy.

Example: Expansionary fiscal policy: increases in government purchases and/or tax cuts.

To fund expansionary policy more government bonds will be sold, putting upward pressure on interest rates.

Higher interest rates may lead to an exchange rate appreciation, reducing net exports, reducing the rate of increase of aggregate demand.


Monetary policy and fiscal policy in an open economy


Exchange rates between the Australian dollar and other currencies can be found in the nation’s newspapers and heard on television.

Currency values can be found even more easily on the internet. Go to the link below and find the current value of the Australian dollar against the US dollar, the Euro and the Japanese yen.

http://www.xe.com

Note: This is just one of may sites on the internet where exchange rates can be found.

Get Thinking!

http://www.xe.com/

An Inside LookFigure 1: Foreign portfolio investment in Australia and Australian portfolio investment abroad both increased significantly in 2006 and 2007.

Source: Australian Bureau of Statistics (2007), Balance of Payments and international InvestmentPosition, Australia, Cat. No. 5302.0, Time Series Workbook.


An Inside LookFigure 2: Direct foreign investment in Australia and Australian direct investment abroad both increased in 2006 and 2007.

Source: Australian Bureau of Statistics (2007), Balance of Payments and international InvestmentPosition, Australia, Cat. No. 5302.0, Time Series Workbook.



Key Terms Balance of payments

Balance of trade in goods and services

Capital account

Closed economy

Currency appreciation

Currency depreciation

Current account

Exchange rate system

Financial account

Fixed exchange rate system

Floating currency

Gross national income

Managed float exchange rate system

Net foreign investment

Net foreign debt

Nominal exchange rate

Open economy

Pegging

Purchasing power parity

Quota

Real exchange rate

Saving and investment equation

Speculators

Tariff


Q1. Nearly all economies of the world are:

a. Open economies.

b. Closed economies.

c. Closed economies about to become open in today’s global economy.

d. Open to trade but closed to investment and finance interactions with other economies.

Check Your Knowledge


Q1. Nearly all economies of the world are:

a. Open economies.

b. Closed economies.

c. Closed economies about to become open in today’s global economy.

d. Open to trade but closed to investment and finance interactions with other economies.



Q2. Which of the following are sources of foreign demand for Australian dollars:

a. Foreign firms and consumers who want to buy goods and services produced in Australia.

b. Foreign firms and consumers who want to invest in Australia.

c. Currency traders who believe that the value of the dollar in the future will be greater than its value today.

d. All of the above.



Q2. Which of the following are sources of foreign demand for Australian dollars:

a. Foreign firms and consumers who want to buy goods and services produced in Australia.

b. Foreign firms and consumers who want to invest in Australia.

c. Currency traders who believe that the value of the dollar in the future will be greater than its value today.




Q3. When will the demand curve for Australian dollar shift to the right?

a. When incomes in Japan fall.

b. When interest rates in Australia fall.

c. When speculators decide that the value of the Australian dollar will rise relative to the value of the yen.




Q3. When will the demand curve for Australian dollar shift to the right?

a. When incomes in Japan fall.

b. When interest rates in Australia fall.

c. When speculators decide that the value of the Australian dollar will rise relative to the value of the yen.




Q4. Which of the following happens in a managed float exchange rate system?

a. Countries agree to keep the value of their currencies constant.

b. Countries agree on how exchange rates should be determined.

c. Countries occasionally intervene to buy and sell their currency or other currencies to affect exchange rates.

d. Countries allow the currency’s exchange rate to be determined by supply and demand.



Q4. Which of the following happens in a managed float exchange rate system?

a. Countries agree to keep the value of their currencies constant.

b. Countries agree on how exchange rates should be determined.

c. Countries occasionally intervene to buy and sell their currency or other currencies to affect exchange rates.

d. Countries allow the currency’s exchange rate to be determined by supply and demand.



Q5. Among the important aspects of the exchange rate system today is that:

a. Many countries allow their currencies to float against other currencies.

b. Many countries in Western Europe have adopted a single currency, the Euro.

c. Some developing countries have attempted to keep their currency’s exchange rate fixed against a major currency such as the US dollar.




Q5. Among the important aspects of the exchange rate system today is that:

a. Many countries allow their currencies to float against other currencies.

b. Many countries in Western Europe have adopted a single currency, the Euro.

c. Some developing countries have attempted to keep their currency’s exchange rate fixed against a major currency such as the US dollar.



Documents

PowerPoint to accompany Chapter 19 Macroeconomics in an Open Economy