5/4/21 CHAPTER MACROECONOMICS IN AN OPEN ECONOMY CONTENT The theory of advantage in international trade 2.The foreign exchange market The exchange rates The exchange rate regime The balance of payment The theory of advantage in international trade 1.1 The theory of absolute advantage - Adam Smith According to Adam Smith, a country is said to have an absolute advantage if it can produce a good at a lower cost than another country 5/4/21 => Brazil has an absolute advantage in producing bananas (8 to 1) The US has an absolute advantage in producing cars (5 to 2) Absolute advantage and labour costs •England has an absolute advantage in producing cloth (only requires 60 hours compared to Portugal’s 120) •Portugal has an absolute advantage in producing wine (only requires 70 hours compared to 110 hours in England 5/4/21 The theory of advantage in international trade 1.2 The theory of comparative advantage_David Ricardo Absolute advantage is concerned with producing at a lower cost Comparative advantage is concerned with producing at a lower opportunity cost (ie relatively better at producing) Having absolute advantage doesn’t necessarily mean an economy should produce that good It is not advisable to try and produce everything It is more helpful to consider comparative advantage • • • If the US produces clothing, the opportunity cost is 12/5 = 2.4 aeroplanes foregone If Brazil produces clothing, the opportunity cost is 1/4 = 0.25 aeroplanes foregone Therefore, the US should specialise in producing aeroplanes Brazil should specialise in producing clothing (even though it doesn’t have an absolute advantage) The foreign exchange market The foreign exchange market The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies This market determines the foreign exchange rate It includes all aspects of buying, selling and exchanging currencies at current or determined prices It has no physical location and operates 24 hours a day from p.m EST on Sunday until p.m EST on Friday because currencies are in high demand 5/4/21 Foreign Exchange Market Overview • The forex market is the largest financial market in the world Ex: According to the Bank of International Settlements (BIS), in April 2016, trading on forex markets averaged $5.1 trillion per day It was 27 times larger than the equities (stock) market, and four times larger than the entire global GDP • The foreign exchange market is also decentralized There is a global network of brokers and traders, linked by technology Participants in the market include banks, corporations, investment management firms, retail investors and central banks,… • The forex market is the only financial market that operates 24 hours a day, everywhere in the world However, it currently closes for two days plus an hour each week, from p.m Eastern Standard Time (EST) on Friday to p.m EST on Sunday.7 10 The Exchange rates 2.2 Exchange rates • Exchange rate is the value of one currency for the conversion to another foreign used to send money on international transfers • VD: Vietnamese dong equals 0.000043 United States Dollar United States Dollar equals 23,380.00 Vietnamese dong 11 In UK 12 5/4/21 In Vietnam 13 3.1 The equilibrium exchange rate • Demand - the demand for the currency that is being exchanged • Supply - the supply of the currency that e is being exchanged • Quantity - the quantity of the currency that is being exchanged • Price - some other currency that is being eo used to buy the currency that is being exchanged D S Q 14 3.1 The equilibrium exchange rate • The equilibrium exchange rate is the interaction of the supply of a currency and the demand for a currency e • As in any market, the foreign exchange market will be in equilibrium when the quantity supplied of a currency is equal to the quantity demanded of a eo currency • If the market has a surplus or a shortage, the exchange rate will adjust until an equilibrium is achieved D S Q 15 5/4/21 3.1 The equilibrium exchange rate When the value of a currency increases relative to another currency; a currency appreciates when you need more of another currency to buy a single unit of a currency: appreciate When the value of a currency decreases relative to another currency; a currency depreciates when you need less of another currency to buy a single unit of a currency: depreciate USD Before After 20.000 VND/USD 22.000 VND/USD ! "#.### VND USD/VND ! "".### USD/VND 16 3.2 The Real Exchange Rates The real exchange rate measures the price of foreign goods relative to the price of domestic goods Mathematically, the real exchange rate is the ratio of a foreign price level and the domestic price level, multiplied by the nominal exchange rate 𝑒% = 𝑒 × 𝑃∗ 𝑃 e: nominal exchange rates P*: foreign price P: domestic price 17 The exchange rate regime Exchange-rate regime: is the way an authority manages its currency in relation to other currencies and the foreign exchange market 18 5/4/21 19 The balance of payments The balance of payments, (also known as balance of international payments) and abbreviated B.O.P or BoP, of a country is the record of all economic transactions between the residents of the country and the rest of the world in a particular period of time (e.g a quarter of a year) 20 21 5/4/21 The balance of payments A complete BoP account comprises two broad accounts: (a) the current account; and (b) the capital and financial account (a) Current account • The current account measures the flows of goods, services, primary income and secondary income between residents and non-residents • The goods and services account records external transactions in goods and services The goods account covers principally exports and imports as shown in merchandise trade statistics (b) Capital and financial account • The capital account measures external transactions in capital transfers, and the acquisition and disposal of non-produced, non-financial assets (such as trademarks and brand names) 22 The balance of payments • Maintaining a balance of payments with the rest of the world is a macro-economic objective • If the balance of payments balances, then the combined receipts from selling goods and services abroad, and from the return on investments abroad, equals the combined expenditure on imports of goods and services, and investment income going abroad 23 24 5/4/21 25 26 ...5/4/21 => Brazil has an absolute advantage in producing bananas (8 to 1) The US has an absolute advantage in producing cars (5 to 2) Absolute advantage and labour... transfers • VD: Vietnamese dong equals 0.000043 United States Dollar United States Dollar equals 23, 380 .00 Vietnamese dong 11 In UK 12 5/4/21 In Vietnam 13 3.1 The equilibrium exchange rate • Demand... authority manages its currency in relation to other currencies and the foreign exchange market 18 5/4/21 19 The balance of payments The balance of payments, (also known as balance of international