Transcript Lecture12_Duncan

ECO 120
Macroeconomics
Week 12
Open Economy &
Exchange Rate
Lecturer
Dr. Rod Duncan
11/2/04
Dr. PK Basu and Dr. Rod Duncan
Closed and Open Economies
A closed economy is one that does not interact with
other economies in the world.
There are no exports, no imports, and no capital
flows.
An open economy is one that interacts freely with other
economies around the world.
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Dr. PK Basu and Dr. Rod Duncan
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.
The Australian economy is a medium-sized open
economy—it imports and exports relatively large
quantities of goods and services.
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Dr. PK Basu and Dr. Rod Duncan
Exports and Imports
Exports are domestically produced goods and services
that are sold abroad.
Imports are foreign produced goods and services that
are sold domestically.
Net exports (NX) or the trade balance is the value of a
nation’s exports minus the value of its imports.
NX = X - M
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Dr. PK Basu and Dr. Rod Duncan
Australian Trade in Goods (1949-1995)
120000
Million A$
100000
80000
Exports
Imports
60000
40000
20000
0
1949 1956 1963 1970 1977 1984 1991
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Dr. PK Basu and Dr. Rod Duncan
Net Exports
A trade surplus is a situation where net exports (NX) are
positive.
Exports > Imports
A trade deficit is a situation where net exports (NX) are
negative.
Imports > Exports
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Dr. PK Basu and Dr. Rod Duncan
Net Exports (1949-1996)
4000
6
2000
3
0
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
0
-3
-6
-4000
-9
-6000
-12
% of GDP
-15
-8000
In A$
-18
-10000
-21
-12000
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Dr. PK Basu and Dr. Rod Duncan
% of GDP
Millions A$
-2000
Foreign Trade and Equilibrium GDP
Aggregate Expenditure = C + I + G + NX
 Level of X depends on foreign
countries’ income, not domestic income
 Level of M is dependent on domestic
income or GDP.
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Dr. PK Basu and Dr. Rod Duncan
Factors That Affect Net Exports
•The 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.
•The costs of transporting goods from country to
country.
•The policies of the government toward international
trade.
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Dr. PK Basu and Dr. Rod Duncan
Exchange Rate
The 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
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Dr. PK Basu and Dr. Rod Duncan
Exchange Rate
At an exchange rate between the US dollar and the
Australian dollar is 0.70 US cents to one Australian
dollar.
•One Australian dollar trades for 0.70 of US$. [This
is the form we will use.]
•One US$ trades for 1.43 (1/0.7) of an Australian
dollar.
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Dr. PK Basu and Dr. Rod Duncan
Determination of exchange rates



The market price of something is determined in
the market.
Under the Floating Rate system, price of a
currency (its exchange rate) in the international
market for currency is determined by its
Demand and Supply.
A$ is a floating currency - floated in December
1983.
11/2/04
Dr. PK Basu and Dr. Rod Duncan
Value of A$ (1949-1996)
1.6
450
1.4
400
350
1.2
US$
Yen/A$
250
0.8
200
0.6
US$/A$
150
0.4
100
0.2
50
0
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
0
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Dr. PK Basu and Dr. Rod Duncan
Japanese Yen
300
1
Determination of exchange rates

Demand for A$ (people who want to buy
A$):
 By overseas buyers of Australian goods
and services (including their tourist visits to
Australia)
 By overseas investors who want to buy
Australian physical and financial assets.
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Dr. PK Basu and Dr. Rod Duncan
Determination of exchange rates

Supply of A$ (people who want to sell A$):
 By Australian importers (including overseas
trips by Australians)
 By Australian investors who want to buy
physical and financial assets overseas.
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Appreciation/Depreciation
If a dollar buys more foreign currency, there is an
appreciation of the dollar -- say, one A$ buys one
US$ instead of 70 US cents at present.
If it buys less there is a depreciation of the dollar -say, one A$ buys 50 US cents instead of 70 US cents at
present.
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Dr. PK Basu and Dr. Rod Duncan
Demand for A$
As exchange rate (US$ per A$) increases (say,
from US$ 0.70 to US$ 1), exports become more
expensive. Overseas buyers will buy less of
Australian goods and services. Demand for A$
falls.
(Just opposite when the value of A$ decreases)
So, Demand curve for A$ (or any other currency)
is downward sloping - as exchange rate
increases, demand for the currency falls, and
vice versa.

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Dr. PK Basu and Dr. Rod Duncan
Supply of A$
•As exchange rate increases (say, from US$ 0.70 to
US$ 1), imports become cheaper. Australians will buy
more of foreign (imported) goods and services.
Supply of A$ increases.
(Just opposite when the value of A$ decreases)
So, Supply curve of A$ (or any other currency) is
upward sloping - as exchange rate increases, supply
of the currency increases,
and vice versa.
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Dr. PK Basu and Dr. Rod Duncan
Determination of exchange rates
Exchange
rate (cost of 1
A$ in terms
of US$)
Supply of A$
Demand for A$
Amount of A$
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Balance of Payments
Reflected in international balance of payments
accounts.
Records all transactions between the entities in
Australia and those in foreign nations
Two basic accounts:
•Current Account
•Capital Account
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Balance of Payments
Current account of a country’s international
transaction refers to the record of receipts from the sale
of goods and services to foreigners (exports), the
payments for goods and services bought from
foreigners (imports), and also property income (such as
interest and profits) and current transfers (such as gifts)
received from and paid to foreigner.
Capital account is a summary of country’s asset
transactions with the rest of the world.
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Dr. PK Basu and Dr. Rod Duncan
Balance of Payments
Current Account Balance (+,-)
=
Capital Account Balance (+,-)
Demand for A$ equals Supply of A$.
If we have a current account deficit (we are importing
more than we are exporting), then we must also have
a capital account deficit (investors overseas are
accumulating Australian assets).
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Dr. PK Basu and Dr. Rod Duncan
CAD (Current Account Deficit)
and Exchange Rate
CAD impacts on :
Inflow of foreign investment - higher the CAD,
higher the surplus in capital account - higher
investment in Australia by the foreigners - higher
the demand for A$.
Outflow of foreign currency - income (interest &
profit) on foreign investment goes out of the
country- higher the CAD, higher the demand for
foreign currency - higher the supply of A$.
Exact impact depends on relative strengths of the
two opposing forces.
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Dr. PK Basu and Dr. Rod Duncan
Current Account Deficits (1949-1996)
4000
5
2000
0
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
-2000
0
-4000
-6000
-5
-10000
% of GDP
Millions A$
-8000
-12000
-14000
-16000
% of GDP
-10
-18000
-20000
-22000
-15
-24000
-26000
In A$
-28000
-30000
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Dr. PK Basu and Dr. Rod Duncan
Is the Current Account Deficit a Problem?


Represents a debt we will have to repay in
the future.
Just as for a household, the extent of the
problem depends on our ability to service
the debt- but notice that CAD as a
percentage of GDP (ability to service debt)
is still low.
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Dr. PK Basu and Dr. Rod Duncan
Terms of Trade
The ratio of average price of goods
and services exported by a country
to the average price of its imports.
If prices of imported goods are rising at a
faster rate than the prices of exported
goods, then the terms of trade for that
economy is considered as deteriorating.
The economy is loosing in the process
of foreign trade.
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Dr. PK Basu and Dr. Rod Duncan
Terms of Trade in Australia



Australia mainly exports agricultural,
primary and mineral products to the rest of
the world.
It imports manufacturing goods.
As a result, it has faced gradual
deterioration in terms of trade.
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Dr. PK Basu and Dr. Rod Duncan
Terms of Trade (1949-1995)
200
175
Million A$
150
125
100
75
50
19
49
19
52
19
55
19
58
19
61
19
64
19
67
19
70
19
73
19
76
19
79
19
82
19
85
19
88
19
91
19
94
25
0
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Dr. PK Basu and Dr. Rod Duncan
Purchasing Power Parity (PPP)
The purchasing-power parity theory is the simplest and
most widely accepted theory explaining the variation of
currency exchange rates.
According to the purchasing-power parity theory, a
unit of any given currency should be able to buy the
same quantity of goods in all countries.
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Intuition for PPP
In an open economy, I have the choice of buying
an orange in Australia or an orange from
Indonesia and importing the orange back to
Australia.
If transport costs are low, the price of traded
goods should be the SAME, once we translate
into a common currency.
This is called the law of one price.
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Dr. PK Basu and Dr. Rod Duncan
Purchasing-Power Parity

Law of one price


when converted to a common currency
value through the exchange rate, the price
of identical goods should be the same
across countries
Pd = E x Po/s, where, Pd=domestic price
Po/s= foreign price
E = exchange rate
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Dr. PK Basu and Dr. Rod Duncan
Problems with Relying on PPP





presence of non-traded goods
product differentiation
differences in consumption patterns and
preferences across countries
transportation costs
tariffs and other forms of industry
assistance distort relative prices
between countries
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References
Macroeconomics - Jackson
Chapters : 4, 7 & 18
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Dr. PK Basu and Dr. Rod Duncan