Chapter 29Open economy macroeconomics

David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000

Power Point presentation by Peter Smith

29.2

Open economy macroeconomics

… is the study of economies in which international transactions play a significant role– international considerations are especially important

for open economies like the UK, Germany or the Netherlands

Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world– especially via the exchange rate.

29.3

The foreign exchange market - the international market in which one national currency can be exchanged for another.

The price at which two currencies exchange is the

exchange rate.

DD

DD shows the demand forpounds by Americans wantingto buy British goods/assets.

Quantityof pounds

Exc

hang

e ra

te (

$/£)

Suppose 2 countries: UK & USA

SSSS shows the supply of poundsby UK residents wishing to buyAmerican goods/assets.

e0 Equilibrium exchange rate is e0

SS1

If UK residents want more $at each exchange rate, thesupply of £ moves to SS1

e1

New equilibrium at e1.

29.4

Alternative exchange rate regimes

In a fixed exchange rate regime– the national governments agree to

maintain the convertibility of their currency at a fixed exchange rate.

In a flexible exchange rate regime– the exchange rate is allowed to attain its

free market equilibrium level without any government intervention using exchange reserves.

29.5

Intervention in the forex market

Quantity of £s

$/£ SS

DD

e1

Suppose the government is committed to maintaining theexchange rate at e1 ...

When demand is DD, no intervention is needed ... there is a balance in transactions between the countries.

The Bank of England mustsupply AC £s in return for $,which are added to reserves.

DD1

If the demand for pounds is DD1 there is excess demand AC.A C

DD2 The reverse occurs if demand is at DD2.

E

29.6

The balance of payments

… a systematic record of all transactions between residents of one country and the rest of the world

Current account– records international flows of goods, services,

income and transfer payments

Capital account– records transactions involving fixed assets

Financial account– records transactions in financial assets

29.7

The UK balance of payments, 1980-1998

-25-20-15-10-505

10152025

£ b

illio

n a

t c

urr

en

t p

ric

es

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

Current

Capital

Financial

Err & om

Source: Economic Trends Annual Supplement

29.8

Floating exchange rates and the balance of payments

If the exchange rate is free to move to its equilibrium, there is no need for intervention

any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts

if there is intervention, it is recorded as part of the financial account.

29.9

International competitiveness

The competitiveness of UK goods in international markets depends upon:– the nominal exchange rate– relative inflation rates

Overall competitiveness is measured by the real exchange rate– which measures the relative price of goods

from different countries when measured in a common currency

29.10

Relative prices and the nominal exchange rate, UK & USA

0.5

1

1.5

2

2.5

3

$/£

0.4

0.5

0.6

0.7

0.8

0.9

1

1.1

Rel

ativ

e p

rice

(U

K/U

SA

)

Relative price(UK/USA)

Exchange rate ($/£)

29.11

The real £/$ exchange rate

0

0.5

1

1.5

2

2.5

1971 1974 1977 1980 1983 1986 1989 1992 1995 1998

£/$

The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

29.12

Components of the balance of payments

The current account is influenced by:– competitiveness– domestic and foreign income

The capital & financial accounts are influenced by:– relative interest rates

which affect international capital flows.

Perfect capital mobility– occurs when there are no barriers to capital flows, and

investors equate expected total returns on assets in different countries

29.13

Internal and external balance

Internal balance– a situation for a country when aggregate demand

is at the full-employment level

External balance– a situation for a country when the current account

of the balance of payments just balances

The combination of internal and external balance is the long-run equilibrium for the economy.

29.14

Shocks may move an economy away from internal and external balance:

BoomSlump

Surplus

Deficit

More saving,tighter fiscal &monetary policy

Foreign boom,lower realexchange rate

Foreign slump,higher realexchange rate

Less saving,easier fiscal &monetary policy

29.15

Macroeconomic policy under fixed exchange rates Under fixed exchange rates, there is a crucial link

between external imbalance and domestic money

supply.

When the government intervene to maintain the

exchange rate, there is a direct effect on money supply.

Sterilization– an open market operation between domestic money and

domestic bonds to neutralize the tendency of balance of

payments surpluses and deficits to change domestic money

supply.

29.16

Monetary policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices

An increase in nominal money supply– tends to reduce interest rates– leads to a capital outflow– reducing money supply as the government

seeks to maintain the exchange rate so monetary policy is powerless

– the government cannot fix independent targets for both money supply and the exchange rate

– domestic and foreign interest rates cannot diverge

29.17

Fiscal policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices

An increase in government expenditure; in the short run

– stimulates output

– but also increases interest rates

– which leads to a capital inflow

– money supply expands to maintain the exchange rate

– there is no crowding-out

– as interest rates cannot rise

in the long run:– wages and prices adjust, affecting competitiveness

– the economy returns to potential output.

29.18

Monetary policy under floating exchange rates

Time

e

e1

Suppose the economy begins in equilibrium with the nominal exchange rate at e1.

t

A

At time t, nominal moneysupply is halved...

e2e2 will be the new equilibriumexchange rate once the economy has adjusted

But prices are sluggish, soin the short run, real money supply falls and domestic interest rates rise

e3B

To maintain equilibrium in the forex market, the exchange rate overshoots to e3

C

, adjusting along BC with wages & prices.

29.19

Monetary policy under floating exchange rates (2)

This analysis suggests that with

floating exchange rates,

monetary policy is highly effective in

the short run

but the effect is only transitional

29.20

Fiscal policyunder floating exchange rates

Following an increase in government expenditure ...

the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate– which dampens export demand

so fiscal policy is less effective under floating exchange rates.