Download Eco120Int_Lecture12

ECO 120
Macroeconomics
Week 12
Open Economy &
Exchange Rate
Lecturer
Dr. Rod Duncan
News
• Tutorial Revision
– Stuart Evennett is holding extra tutorial
sessions on Tuesday at 6pm in room C2-112
to review material from the tutorials. These
sessions are open to all students.
Topics
• Definitions- net exports, balance of
payments, current account balance, terms
of trade
• Deriving the A$ exchange rate from the
market for the Australian dollar
• Using purchasing power parity
Closed and open economies
• A closed economy is one that does not
interact with other economies in the world.
– There are no exports, no imports, and no
capital flows.
• An open economy is one that interacts
freely with other economies around the
world.
An open economy
• An open economy interacts with other
countries in two ways.
– It buys and sells goods and services in world
product markets.
– It buys and sells capital assets in world
financial markets.
• The Australian economy is a mediumsized open economy—it imports and
exports relatively large quantities of goods
and services.
Exports and imports
• Exports are domestically produced goods
and services that are sold abroad.
• Imports are foreign produced goods and
services that are sold domestically.
• Net exports (NX) or the trade balance is
the value of a nation’s exports minus the
value of its imports.
– NX = X - M
Australian Trade in Goods (1949-1995)
120000
80000
60000
40000
20000
0
19
49
19
53
19
57
19
61
19
65
19
69
19
73
19
77
19
81
19
85
19
89
19
93
Million A$
100000
Exports
Imports
Net exports
• A trade surplus is a situation where net
exports (NX) are positive.
Exports > Imports
• A trade deficit is a situation where net
exports (NX) are negative.
Imports > Exports
Millions A$
0
-6
-4000
-9
-6000
-12000
-12
% of GDP
-8000
-15
In A$
-18
-10000
-21
-24
% of GDP
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
Net Exports (1949-1996)
4000
6
2000
3
0
-2000
-3
Net exports and domestic GDP
• Aggregate Expenditure = C + I + G + X - M
• Level of X depends on foreign countries’
income, not domestic income
• Level of M is dependent on domestic
income or GDP.
What affects net exports?
• The tastes of consumers for domestic and
foreign goods.
• The prices of goods at home and abroad.
• The exchange rates at which people can use
domestic currency to buy foreign currencies.
• The costs of transporting goods from country to
country.
• The policies of the government toward
international trade.
Exchange rate
The exchange rate is the rate at which a person can
trade the currency of one country for the currency of
another.
The nominal exchange rate is expressed in two ways.
•In units of foreign currency per one Australian
dollar
•In units of Australian dollars per one unit of the
foreign currency
Exchange rate
At an exchange rate between the US dollar and the
Australian dollar is 0.70 US cents to one Australian
dollar.
•One Australian dollar trades for 0.70 of US$. [This
is the form we will use.]
•One US$ trades for 1.43 (1/0.7) of an Australian
dollar.
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
US$
1.6
450
1.4
400
Yen/A$
1.2
1
US$/A$
0.4
0.2
0
250
0.8
200
0.6
150
100
50
0
Japanese Yen
Value of A$ (1949-1996)
350
300
Determination of exchange rates
• The market price of something is determined in
the market.
• Under the Floating Rate system, price of a
currency (its exchange rate) in the international
market for currency is determined by its demand
and supply.
• A$ is a floating currency - floated in December
1983.
Determination of exchange rates
• Demand for A$ (people who want to buy
A$):
– By overseas buyers of Australian goods
and services (including their tourist visits to
Australia)
– By overseas investors who want to buy
Australian physical and financial assets.
• Supply of A$ (people who want to sell A$):
– By Australian importers (including overseas
trips by Australians)
– By Australian investors who want to buy
physical and financial assets overseas.
Appreciation/Depreciation
If a dollar buys more foreign currency, there is an
appreciation of the dollar -- say, one A$ buys one
US$ instead of 70 US cents at present.
If it buys less there is a depreciation of the dollar -say, one A$ buys 50 US cents instead of 70 US cents at
present.
Demand for A$
• As exchange rate (US$ per A$) increases (say,
from US$ 0.70 to US$ 1), exports become more
expensive. Overseas buyers will buy less of
Australian goods and services. Demand for A$
falls.
(Just opposite when the value of A$ decreases)
So, Demand curve for A$ (or any other currency)
is downward sloping - as exchange rate
increases, demand for the currency falls, and
vice versa.
Supply of A$
•As exchange rate increases (say, from US$ 0.70 to
US$ 1), imports become cheaper. Australians will buy
more of foreign (imported) goods and services.
Supply of A$ increases.
(Just opposite when the value of A$ decreases)
So, Supply curve of A$ (or any other currency) is
upward sloping - as exchange rate increases, supply
of the currency increases,
and vice versa.
Determination of exchange rates
Exchange
rate (cost of 1
A$ in terms
of US$)
Supply of A$
Demand for A$
Amount of A$
Sample question
1. The Australian mining boom causes an
increase in profitability of mining projects
in Australia.
(a) What impact will this boom have on FDI?
(b) How will this boom affect the A$? Show
on the market for A$.
(c) How will this boom affect Australian
exports and imports? What happens to
non-mining exports?
Balance of payments
Reflected in international balance of payments
accounts.
Records all transactions between the entities in
Australia and those in foreign nations
Two basic accounts:
•Current Account
•Capital Account
Balance of payments
•Current account of a country’s international
transaction refers to the record of receipts from the sale
of goods and services to foreigners (exports), the
payments for goods and services bought from
foreigners (imports), and also property income (such as
interest and profits) and current transfers (such as gifts)
received from and paid to foreigner.
•Capital account is a summary of country’s asset
transactions with the rest of the world.
Balance of payments
Current Account Balance (+,-)
=
Capital Account Balance (+,-)
Demand for A$ equals Supply of A$.
If we have a current account deficit (we are importing
more than we are exporting), then we must also have
a capital account deficit (investors overseas are
accumulating Australian assets).
CAD (Current Account Deficit)
and exchange rate
CAD impacts on :
•Inflow of foreign investment - higher the CAD,
higher the surplus in capital account - higher
investment in Australia by the foreigners - higher
the demand for A$.
•Outflow of foreign currency - income (interest &
profit) on foreign investment goes out of the
country- higher the CAD, higher the demand for
foreign currency - higher the supply of A$.
Exact impact depends on relative strengths of the
two opposing forces.
Current Account Deficits (19491996)
4000
5
2000
0
19
49
19
51
19
53
19
55
19
57
19
59
19
61
19
63
19
65
19
67
19
69
19
71
19
73
19
75
19
77
19
79
19
81
19
83
19
85
19
87
19
89
19
91
19
93
19
95
-2000
0
-4000
-6000
-5
-10000
% of GDP
Millions A$
-8000
-12000
-14000
-16000
% of GDP
-10
-18000
-20000
-22000
-15
-24000
-26000
-28000
-30000
In A$
-20
Is the Current Account Deficit a
Problem?
• Represents a debt we will have to repay in
the future.
• Just as for a household, the extent of the
problem depends on our ability to service
the debt- but notice that CAD as a
percentage of GDP (ability to service debt)
is still low.
Sample Question
The Chinese government recently began allowing
its currency (the “yuan”) to appreciate relative to
other currencies in the world, including the
Australian dollar.
(a) Assuming all other currencies stay the same,
what will the effect of this appreciation be on
Australian balance of payments?
(b) Assuming all other currencies stay the same,
what will the effect of this appreciation be on the
Australian economy- GDP, unemployment,
prices, etc.
Terms of Trade
The ratio of average price of goods
and services exported by a country
to the average price of its imports.
If prices of imported goods are rising at a
faster rate than the prices of exported
goods, then the terms of trade for that
economy is considered as deteriorating.
The economy is loosing in the process
of foreign trade.
19
49
19
52
19
55
19
58
19
61
19
64
19
67
19
70
19
73
19
76
19
79
19
82
19
85
19
88
19
91
19
94
Million A$
Terms of Trade (1949-1995)
200
175
150
125
100
75
50
25
0
Purchasing Power Parity (PPP)
The purchasing-power parity theory is the simplest and
most widely accepted theory explaining the variation of
currency exchange rates.
According to the purchasing-power parity theory, a
unit of any given currency should be able to buy the
same quantity of goods in all countries.
Intuition for PPP
In an open economy, I have the choice of buying
an orange in Australia or an orange from
Indonesia and importing the orange back to
Australia.
If transport costs are low, the price of traded
goods should be the SAME, once we translate
into a common currency.
This is called the law of one price.
Purchasing-Power Parity
• Law of one price
– When converted to a common currency value
through the exchange rate, the price of identical
goods should be the same across countries:
Pd = E x Po/s,
• Where Pd is the domestic price, Po/s is the
foreign price and E is the exchange rate.