open economy macroeconomics

Chapter 29 Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 29.1 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. 29.2 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 for pounds by Americans wanting to buy British goods/assets. Quantity of pounds Exchange rate ($/£) Suppose 2 countries: UK & USA SS SS shows the supply of pounds by UK residents wishing to buy American goods/assets. e 0 Equilibrium exchange rate is e 0 SS 1 If UK residents want more $ at each exchange rate, the supply of £ moves to SS 1 e 1 New equilibrium at e 1 . 29.3 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. 29.4 Intervention in the forex market Quantity of £s SS DD e 1 Suppose the government is committed to maintaining the exchange rate at e 1 When demand is DD, no intervention is needed there is a balance in transactions between the countries. The Bank of England must supply AC £s in return for $, which are added to reserves. DD 1 If the demand for pounds is DD 1 there is excess demand AC. A C DD 2 The reverse occurs if demand is at DD 2 . E 29.5 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 29.6 The UK balance of payments, 1980-1998 -25 -20 -15 -10 -5 0 5 10 15 20 25 £ billion at current prices 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 Current Capital Financial Err & om Source: Economic Trends Annual Supplement 29.7 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. 29.8 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 29.9 Relative prices and the nominal exchange rate, UK & USA 0.5 1 1.5 2 2.5 3 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 $/£ 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 Relative price (UK/USA) Relative price (UK/USA) Exchange rate ($/£) [...]... run: – wages and prices adjust, affecting competitiveness – the economy returns to potential output 29.16 Monetary policy under floating exchange rates e e3 e2 Suppose the economy begins in equilibrium with the nominal exchange rate at e1 At time t, nominal money B supply is halved C e will be the new equilibrium 2 e1 exchange rate once the economy has adjusted A t Time But prices are sluggish, so in... full-employment level 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 29.12 Shocks may move an economy away from internal and external balance: Surplus More saving, tighter fiscal & monetary policy Foreign boom, lower real exchange rate Slump Boom Less saving, easier fiscal & monetary... 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 29.14 Monetary policy under fixed . Chapter 29 Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith 29.1 Open economy macroeconomics . combination of internal and external balance is the long-run equilibrium for the economy. 29.13 Shocks may move an economy away from internal and external balance: Boom Slump Surplus Deficit More. adjust, affecting competitiveness – the economy returns to potential output. 29.17 Monetary policy under floating exchange rates Time e e 1 Suppose the economy begins in equilibrium with the