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Open Economy

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... of the USD in the ForEx Market. US Imports. US investment overseas. CBs. US: ... for historical oil price data US Dept. of Energy, http://tonto.eia.doe.gov ... – PowerPoint PPT presentation

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Title: Open Economy


1
Open Economy
2
Balance of Payments
  • Current Account
  • Trade, Income Flow, Unilateral Transfers
  • Financial Account
  • Investment Flow
  • Change in Reserve Holdings
  • See http//www.bea.gov/newsreleases/international/
    transactions/2007/xls/trans307.xls

3
Side note to see the current liquidity crisis,
note the BoP Investment flow for the third
quarter of 2007 http//www.bea.gov/newsreleases/
international/transactions/2007/xls/trans307.xls
4
BoP and the Currency Regime
  • Exchange Rate Translation mechanism
  • Floating Currency
  • March 1973 today
  • CA FA 0
  • Currency crisis is typically defined as rapid
    currency depreciation. No run on the national
    reserves is possible US 2002-present
  • USD, CD, EURO.
  • Fixed Currency
  • CA FA Change in Reserves
  • Currency crisis is possible, run on reserves is
    possible Russian Federation, August of 1998
  • Bulgaria, Romania
  • Managed currencies China, Russia.

5
Types of Fixed Currencies
  • Gold Standard
  • 1880s 1914
  • Revised Gold Standard
  • 1948 1972
  • Simple one currency fix
  • China prior to 2005
  • Argentina in late 1990s
  • Composite currency and fixes to composite
    currencies
  • SDR
  • Managed Exchange Rate
  • Russian Corridor in the 1990s
  • Chinese Currency today

6
ForEx Market Exchange rate determination, the
simple framework
  • Demand for the USD
  • US Exports
  • Foreign Investment into the US
  • CBs
  • Supply of the USD in the ForEx Market
  • US Imports
  • US investment overseas
  • CBs
  • US example of currency depreciation
  • China a managed exchange rate and the monetary
    expansion it causes in China, given its trade
    surplus
  • Russia in 1998 and the currency attack

7
Real exchange rate
  • Purchasing price parity
  • same things should cost the same price world
    over
  • REd NEd Pd/Pf 1 ? NEd Pf/Pd (absolute
    PPP)
  • Overvalued versus undervalued currency and the
    real exchange rate
  • Nominal exchange rate is driven by the difference
    in the rates of inflation
  • change in NE inflation f inflation d
    relative PPP
  • If (inflation f gt inflation d) then DC
    appreciates
  • If (inflation f lt inflation d) then DC
    depreciates
  • Inflation leading to currency value change
  • The effect can go the other way as well

8
Recent performance of the USD
/Euro
Source FederalReserve.gov http//www.federalrese
rve.gov/releases/h10/Hist/
9
Role of the exchange rate in the price of oil
Source for historical oil price data US Dept.
of Energy, http//tonto.eia.doe.gov/dnav/pet/pet_p
ri_spt_s1_d.htm
10
Back to the Model Small Open Economy
  • Incapable of causing changes in the worlds
    financial markets, i.e. is a price taker in
    financial markets, unable to influence the price
    of loanable funds in the global markets
    interest rate.

S (domestic foreign)
r
I
Fiscal Policy in a small open economy Monetary
Policy in a small open economy
11
example
  • Consider a closed economy with
  • Y20000
  • GT0
  • C10000.8(Y-T)
  • I5000-500 r
  • --------------------------------------------------
    ---------
  • What is the level of interest rate?
  • --------------------------------------------------
    ---------
  • Now, assume this is a small open economy and the
    global interest rate is 5
  • Would this country be a net borrower or lender?
  • What would the level of net exports be?
  • Now, assume that the level of government spending
    increases to 3000, would this country be a net
    borrower or lender? And what would the level of
    NX be?
  • Now assume that G is reduced to 0, but T is
    reduced to -1000, what would be the level of NX?
  • Now assume that GT0, but the investment
    function changes to I8000-500r
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