ECO 120 Macroeconomics

Week 13

Open Economy &Exchange Rate

LecturerDr. Rod Duncan

Topics

• Definitions- net exports, balance of payments, current account balance, terms of trade

• Deriving the A$ exchange rate from the market for the Australian dollar

• Using purchasing power parity

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.

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.

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

Australian Trade in Goods (1949-1995)

0

20000

40000

60000

80000

100000

120000

Mill

ion

A$

ExportsImports

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

Net Exports (1949-1996)

-12000

-10000

-8000

-6000

-4000

-2000

0

2000

4000

Mill

ions

A$

-24

-21

-18

-15

-12

-9

-6

-3

0

3

6

% o

f GD

P

In A$

% of GDP

Net exports and domestic GDP

• Aggregate Expenditure = C + I + G + X - M

• Level of X depends on foreign countries’ income, not domestic income

• Level of M is dependent on domestic income or GDP.

What affects 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.

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

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.

Value of A$ (1949-1996)

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1.6

US$

0

50

100

150

200

250

300

350

400

450

Japa

nese

Yen

Yen/A$

US$/A$

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.

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.

• 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.

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.

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.

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.

Determination of exchange rates

Exchange rate (cost of 1 A$ in terms of US$)

Amount of A$

Demand for A$

Supply of A$

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

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.

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).

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.

Current Account Deficits (1949-1996)

-30000

-28000

-26000

-24000

-22000

-20000

-18000

-16000

-14000

-12000

-10000

-8000

-6000

-4000

-2000

0

2000

4000

Mill

ions

A$

-20

-15

-10

-5

0

5

% o

f GD

P

In A$

% of GDP

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.

Terms of TradeThe 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.

Terms of Trade (1949-1995)

0

25

50

75

100

125

150

175

200

Mill

ion

A$

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.

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.

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 is the domestic price, Po/s is the foreign price and E is the exchange rate.