Open Economy Macroeconomics Currency

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					A Macroeconomic Theory of
   the Open-Economy
Outline:
 Develop a model to study forces that
  determine the open economy
  variables (NX, NFI, RER)
 How are these variables related to
  one another?
Assumptions
 Real GDP is determined by factor
  supplies and level of technology
 Economy’s price level is given
 Real interest rate equals world
  interest rate due to perfect capital
  mobility.
Supply and demand in the open
economy
 Market for loanable funds
 Market for foreign currency exchange
Market for loanable funds
 S=I+NFI
 Supply of loanable funds comes from
  comes from national savings
 Demand for loanable funds comes
  from domestic investment
 The difference between S and I at
  world interest rate is the NFI
  (savings by foreigners).
Market for loanable funds:
Conclusions
   Open economy          • Closed economy
   Interest rate =       • Interest rate is
    world interest rate     determined by
   NFI exists              demand and
    because S is not        supply of loanable
    equal to I              funds
   NX is also            • S=I, NFI=0
    determined by the     • NX=0
    difference in S
    and I
The Market for Foreign-Currency
Exchange
   NFI=NX
   S-I=NX
   Imbalances on both sides of the equation
    are equal
   Positive NFI is the source for supply of
    domestic currency (Canadian$) in the
    foreign currency exchange market
   Positive NX is the source of demand for
    domestic currency (Canadian$) in the
    foreign currency exchange market
The Market for Foreign-Currency
Exchange
   Real Exchange Rate (RER) adjusts to
    balance the demand and supply of
    domestic currency (Can$).
   At the equilibrium RER, the demand for $
    to buy net exports exactly balances the
    supply of $ to be exchanged into foreign
    currency to buy assets abroad.
   What if the NFI is negative?
Simultaneous equilibrium in the
two markets
   We have studied coordination between 4
    macro variables: S, I, NFI, and NX
   NFI is the variable that links the two
    markets together
     In the loanable funds market it is the
      difference in the supply of loanable funds (S)
      and demand for loanable funds (I) at the world
      interest rate
     In the foreign currency exchange market
      positive NFI determines the supply of domestic
      currency.
Simultaneous equilibrium in the
two markets
   In the loanable funds market we
    determine S and I, which are determined
    by world interest rate and we determine
    NFI.
    In the foreign currency market we
    determine the real exchange rate (=
    price) which balances supply and demand
    for domestic currency.
   Together we have determined S, I, NFI,
    and RER.
Policies affecting an open economy
 Increase in world interest rates:
   Crowds out domestic investment and
   increases NFI
   Increases supply of domestic currency in
   the foreign currency exchange market
   RER depreciates, increasing NX.
Policies affecting an open economy
 Increase in government budget
  deficit:
    Reduces supply of loanable funds and
   crowds out domestic investment
    Decrease in NFI reduces the supply of
   domestic currency in foreign-currency
   exchange market
    RER appreciates and NX fall.
    What happens if there is a reduction in
   budget deficit?
Policies affecting an open economy
 Increase in government budget
  deficit: Impact
    Depreciation in domestic currency
   benefits exporters and hurts importers
Policies affecting an open economy
 Trade policy:
   Trade policy is a government policy that
    directly influences the quantity of goods
    and services that a country imports or
    exports.
   Restrictive trade policy: Imposition of an
    import quota
      Objective: to improve trade balance
Policies affecting an open economy
   Restrictive trade policy: Imposition of an
    import quota
      No impact on loanable fund market. No
     change in NFI.
      Import quota restricts imports and increases
     NX for any given RER.
      Increase in demand for domestic currency
     causes RER to appreciate.
      NX decline, canceling out the earlier increase.
     Therefore, no change in NX.
      Trade policies do not affect trade balance.
Policies affecting an open economy
   Restrictive trade policy: Imposition of an
    import quota
      Trade policies do not affect trade balance.
      Trade policies have microeconomic rather than
     macroeconomic effects.
      Trade restrictions reduce gains from trade and
     economic well-being.
Policies affecting an open economy
   Political instability and capital flight:
      Capital flight is a large and sudden reduction
     in the demand for assets located in a country.
   Implications for the economy experiencing
    capital flight:
      Savers to save the same amount of funds as
     before (to capital flight) must receive a risk
     premium in order to hold the domestic debt
      Borrowers must pay the risk premium in
     addition to the world interest rate to halt capital
     flight
      Supply of loanable funds remains same and
     demand decreases, increasing NFI before sale of
     domestic assets has been halted.
Policies affecting an open economy
   Political instability and capital flight
    (continued):
   Implications for the economy experiencing
    capital flight:
     Increase in NFI, increases supply of domestic
    currency (though in this case, a large portion of
    the supply of domestic currency comes from
    sale of domestic assets).
     RER depreciates.
     Capital flight from a country increases the
    domestic interest rates and depreciates the
    value of the domestic currency.

				
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posted:12/20/2010
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Description: Open Economy Macroeconomics Currency