Title: Open Economy
1Open Economy
2Balance 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
3Side 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
4BoP 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.
5Types 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
6ForEx 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
7Real 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
8Recent performance of the USD
/Euro
Source FederalReserve.gov http//www.federalrese
rve.gov/releases/h10/Hist/
9Role 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
10Back 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
11example
- 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