Chapter 10 Macroeconomics in open

economy
Mentor Pham Xuan Truong
[email protected]
Content
I Basic concept
1. Balance of payment
2. Foreign exchange rate
II Macroeconomic theory of the open economy
3. The market for loanable funds
4. The market for foreign currency exchange
5. Equilibrium in the open economy
III How policies and events affect an open economy
I Basic concept
1. Balance of payments
The balance of payments (BoP) of a country is a systematic record of
all economic transactions between the residents of one country and
residents of foreign countries during a given period of time
Components of BoP
+ Current account: records transactions relating to export and import
of goods, services, unilateral transfers and international incomes. Thus,
balance on current account is mostly the value of exports minus the
value of imports, adjusted for international incomes and net transfers.
(The export and import of goods are called visible items whereas
invisible items include shipping, banking, insurance (service), gifts)
+ Capital (financial) account: records all international economic
transactions relating to change in assets-both financial and physical. It
is a record of short term and long term capital transactions, both
private and official. These are classifies into two categories - Direct
foreign investments and Portfolio investments
I Basic concept
1. Balance of payments
Structure of Bop
 Balance of payments is a complete record of Total
Receipts and Total Payments of a country in relation to
other countries over a given time period. Total
Receipts are called CREDIT and Total Payments are
termed as DEBIT.
 Credit side comprises of all those values received from
foreign countries. On the other hand, Debit side
comprises of all the payments made to other countries.
 It is maintained in a double entry book keeping
system.
 Structure Of BoP
CREDITS DEBITS
ITEMS OF CURRENT ACCOUNT
 Export of Goods  Import of Goods
 Exports of Services  Import of Services
 Unilateral Transfer Receipts (gifts,  Unilateral Transfer Payments (gifts,
indemnities from foreigners). indemnities to foreigners).
 Income receipts.  Income Payments
ITEMS OF CAPITAL ACCOUNT
 Capital Receipts ( borrowings from,  Capital Payments ( lending to, capital
capital repayments by or sale of assets to repayments to or purchase of assets from
foreigners). foreigners).
 I Basic concept
1. Balance of payments
 BALANCE OF TRADE-
Balance of Trade= Export of goods- Import of goods.
 BALANCE OF CURRENT ACCOUNT-
Balance of Current Account= Balance of Trade+ Balance
of Income + Balance of Transfers.
 BALANCE OF CAPITAL ACCOUNT-
Balance of Capital Account= Capital Receipts- Capital
Payments
 I Basic concept
2. Foreign exchange rate
 Exchange Rate refers to the rate at which the currencies of
different countries are traded. Economists distinguish between
two exchange rates: the nominal exchange rate and the real
exchange rate.
 The nominal exchange rate is the relative price of the
currency of two countries denoted as e. In this module, we
understand e as how many foreign currency unit to trade for
one domestic currency unit (e.g. 1VND = 0.00005 USD)
Appreciation (strengthen) = increase in the value of a currency
measured by the amount of foreign currency it can buy.
Depreciation (weaken) = decrease in the value of a currency
measured by the amount of foreign currency it can buy
 The real exchange rate is the relative price of the goods of two
countries. sometimes called the terms of trade denoted as e
 I Basic concept
2. Foreign exchange rate
Relationship between the real and nominal exchange rate
e = e × (P/P*)
P is the price level of the domestic country (measured in the domestic
currency) and P* is the price level of the foreign country (measured in
the foreign currency). Because nominal foreign exchange rate is
understood as how many foreign currency units to trade for one
domestic currency unit, so real foreign exchange rate is understood as
how many foreign goods units to trade for one domestic goods unit
Example: 1 laptop of US has price of 500 USD, 1 laptop of VN has
price of 11 million VND, 1VND = 0.00005 VND (1USD = 20000
VND)
e = 0.00005x(11.10^6/500) = 1.1
 If the real exchange rate is high, foreign goods are relatively cheap,
and domestic goods are relatively expensive. If the real exchange rate
is low, foreign goods are relatively expensive, and domestic goods are
relatively cheap.
I Basic concept
2. Foreign exchange rate
From the formula of real exchange rate, we have
e = e x (P*/P) or
%e = % e + (%P* - %P)

Change in Difference
Change in
nominal between
real
exchange inflation rate of
exchange
rate two countries
rate
 I Basic concept
2. Foreign exchange rate
There are three exchange rate systems
Fixed Exchange Rate System In a fixed exchange rate system, the rate of
exchange is fixed by the central bank of the country by official action, the
country’s central bank stands ready to buy and sell its currency at a fixed
price in terms of some other currency. Under this, authority for devaluation
or revaluation of currency rests with government of the country.

Flexible Exchange Rate System In a flexible exchange rate system, exchange

rate is left free to be determined in the foreign exchange market by the
forces of demand and supply. In this, central bank allows the exchange rate
to adjust to equate the supply and demand for foreign exchange.

Managed Flexible Exchange Rate System In managed flexible exchange rate

system, exchange rate is left free to be determined in the foreign exchange
market by the forces of demand and supply within a fluctuation band.
Over the band (above the maximum or below the minimum), central bank
 I Basic concept
2. Foreign exchange rate
Theory to explain exchange rate: Purchasing power parity
Parity means Equality
Purchasing-power Value of money in terms of quantity of
goods it can buy
The basic logic of purchasing-power parity based on law of
one price: a good must sell for the same price in all locations
or a unit of any given currency should be able to buy the
same quantity of goods in all countries
E.g. with 6.000 VND you can buy an Aquafina in FTU or
NEU or 6.000 VND in FTU or NEU has the same
purchasing power
I Basic concept
2. Foreign exchange rate
Theory to explain exchange rate: Purchasing power parity
Why we have law of one price ? Arbitrage activities Take advantage
of price differences for the same item in different markets
→ If 5 dollar can buy a bottle of water in USA and 100.000 VND
also can buy the same bottle in VN (otherwise, arbitrage activities
take place and the prices of the bottle in the two places adjusts to
the new stable level), then based on purchasing power parity we
have 5 dollar = 100.000 VND or 1 dollar = 20.000 VND
Theory of purchasing-power parity does not always hold in practice
1. Many goods are not easily traded
2. Even tradable goods are not always perfect substitutes
+ When they are produced in different countries
+ No opportunity for profitable arbitrage (tariff)
 I Basic concept
2. Foreign exchange rate
Big Mac index
Price of Predicted Actual
Country Big Mac Exchange rate Exchange rate

Venezuela 7,400 bolivar 2,170 bolivar/$ 2,147 bolivar/$

South Korea 2,900 won 850 won/$ 923 won/$
Japan 280 yen 82 yen/$ 122 yen/$
Sweden 33 kronor 10.1 kronor/$ 7.4 kronor/$
Mexico 28 pesos 9.7 pesos/$ 6.8 pesos/$
Euro area 3.06 euros 0.90 euros/$ 0.74 euros/$
Britain 1.99 pounds 0.58 pound/$ 0.50 pound/$
Appendix Uncovered interest rate parity (UIP)
Interest rate parity is a no-arbitrage condition representing
an equilibrium state under which investors will be indifferent
to interest rates available on bank deposits in two countries
Two assumptions central to interest rate parity are capital
mobility and perfect substitutability of domestic and
foreign assets. Given foreign exchange market equilibrium, the
interest rate parity condition implies that the expected return on
domestic assets will equal the exchange rate-adjusted expected
return on foreign currency assets. Investors cannot then earn
arbitrage profits by borrowing in a country with a lower interest
rate, exchanging for foreign currency, and investing in a foreign
country with a higher interest rate, due to gains or losses from
exchanging back to their domestic currency at maturity
 Appendix Uncovered interest rate parity
(UIP)
Formula of UIP

i domestic interest rate, i* foreign interest rate

E t+1 expected foreign exchange rate, Et current foreign
exchange rate
or
II Macroeconomic theory of the open economy
1 The market for loanable funds
In an open economy: S = I + NCO
(Saving = Domestic investment + Net capital outflow)
+ Supply of loanable funds: From national saving (S)
+ Demand for loanable funds: From domestic investment (I) and
net capital outflow (NCO)
Loanable funds - interpreted as domestically generated flow of
resources available for capital accumulation
Purchase of a capital asset: adds to the demand for loanable
funds
Asset – located at home: I
Asset – located abroad: NCO
If NCO > 0, net outflow of capital - adds to demand
If NCO < 0, net inflow of capital - reduce the demand
 National saving, domestic investment,& net capital outflow (a)

Panel (a) shows national saving and domestic investment as a percentage of GDP. You can see
from the figure that national saving has been lower since 1980 than it was before 1980. This fall
in national saving has been reflected primarily in reduced net capital outflow rather than in
reduced domestic investment.
 National saving, domestic investment,& net capital outflow (b)

Panel (b) shows net capital outflow as a percentage of GDP. You can see from the figure that
national saving has been lower since 1980 than it was before 1980. This fall in national saving
has been reflected primarily in reduced net capital outflow rather than in reduced domestic
investment.
II Macroeconomic theory of the open economy
1 The market for loanable funds
Higher real interest rate
+ Encourages people to save: Increases quantity of loanable funds supplied
+ Discourages investment: Decreases quantity of loanable funds demanded
+ Discourages domestic citizens from buying foreign assets: Reduces net
capital outflow
+ Encourages foreigners to buy domestic assets: Reduces net capital
outflow
Supply of loanable funds: Slopes upward
Demand of loanable funds: Slopes downward
At equilibrium interest rate: Amount that people want to save
exactly balances the desired quantities of domestic investment and
net capital outflow
 The market for loanable funds

Real
Interest Supply of loanable funds
Rate (from national saving)

Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)

Equilibrium Quantity of
quantity Loanable Funds

The interest rate in an open economy, as in a closed economy, is determined by the

supply and demand for loanable funds. National saving is the source of the supply of
loanable funds. Domestic investment and net capital outflow are the sources of the
demand for loanable funds. At the equilibrium interest rate, the amount that people
want to save exactly balances the amount that people want to borrow for the purpose of
II Macroeconomic theory of the open economy
2. The market for foreign-currency exchange
Identity: NCO = NX (Net capital outflow = Net exports)
If trade surplus, NX > 0
Foreigners - buy more domestic goods & services than
domestic citizens buy foreign goods & services
Domestic citizens– use foreign currency to buy foreign assets
→ Capital is flowing abroad, NCO > 0
If trade deficit, NX < 0
Domestic citizens - buy more foreign goods & services than
foreigners - buy domestic goods & services
Some of this spending financed by selling domestic assets
abroad
→ Foreign capital is flowing into domestic, NCO < 0
II Macroeconomic theory of the open economy
2. The market for foreign-currency exchange
 Supply of foreign-currency exchange
From Net capital outflow
Quantity of domestic currency supplied to buy foreign assets
Supply curve – vertical because quantity of domestic currency supplied
for net capital outflow does not depend on the real exchange rate
 Demand for foreign-currency exchange
From Net exports
Quantity of domestic currency demanded to buy net exports of goods and
services
Demand curve - downward sloping because a higher real exchange rate
makes domestic goods more expensive, thereby reducing the quantity of
domestic currency demanded to buy those goods
At equilibrium real exchange rate: Demand for domestic currency by
foreigners arising from home country’s net exports of goods & services
exactly balances supply of dollars from domestic citizens, arising from
home country’s net capital outflow
 The market for foreign-currency exchange

Real
Exchange Supply of dollars
Rate (from net capital outflow)

Equilibrium real
exchange rate

Demand for dollars

(for net exports)

Equilibrium Quantity of Dollars Exchanged

quantity into Foreign Currency

The real exchange rate is determined by the supply and demand for foreign-currency exchange. The
supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net
capital outflow does not depend on the real exchange rate, the supply curve is vertical. The demand
for dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and
thus increases the quantity of dollars demanded to pay for these net exports), the demand curve is
downward sloping. At the equilibrium real exchange rate, the number of dollars people supply to buy
foreign assets exactly balances the number of dollars people demand to buy net exports.
II Macroeconomic theory of the open
economy
2. The market for foreign-currency exchange
NX is the balance of current account in BoP (balance of
income and transfer are ignorable)
NCO is the adverse balance of capital account in BoP
NX = NCO via the activities of foreign exchange market
implies balanced BoP if flexible exchange maintains
In other words, the total value of CREDIT = the total value of
DEBIT. If using foreign exchange rate as E (how many
domestic currency units to exchange one foreign currency
unit). CREDIT now represents for supply of foreign currency;
DEBIT now represents for demand of foreign currency
 II Macroeconomic theory of the open
economy
2. The market for foreign-currency exchange
E.g. foreign exchange market in UK with domestic
currency is pound and foreign currency is dollar. UK
maintains managed flexible exchange rate system
II Macroeconomic theory of the open economy
3. Equilibrium in the open economy
We establish the link between the two markets
Market for loanable funds: S = I + NCO
Market for foreign-currency exchange: NCO=NX

Net-capital-outflow curve plays the role of linkage between

market for loanable funds and market for foreign-currency
exchange
Next slide, we will see how NCO depends on the interest
rate
How net capital outflow depends on the interest rate
Real
Interest
Rate

Net capital outflow 0 Net capital outflow Net Capital

is negative is positive Outflow

Because a higher domestic real interest rate makes domestic assets more attractive, it
reduces net capital outflow. Note the position of zero on the horizontal axis: Net capital
outflow can be positive or negative. A negative value of net capital outflow means that the
economy is experiencing a net inflow of capital.
II Macroeconomic theory of the open economy
3. Equilibrium in the open economy
Simultaneous equilibrium in two markets
Market for loanable funds
Supply: national saving
Demand: domestic investment & net capital outflow
Equilibrium real interest rate, r
Net capital outflow
Slopes downward
Equilibrium interest rate, r
Market for foreign-currency exchange
Supply: net capital outflow
Demand: net exports
Equilibrium real exchange rate, E
II Macroeconomic theory of the open economy
3. Equilibrium in the open economy
Simultaneous equilibrium in two markets
- Equilibrium real interest rate, r: Price of goods and services in the
present relative to goods and services in the future
- Equilibrium real exchange rate, e: Price of domestic goods and
services relative to foreign goods and services

- e and r - adjust simultaneously to balance supply and demand in both

markets Loanable funds and Foreign-currency exchange
- e and r in equilibrium determine
+ National saving
+ Domestic investment
+ Net capital outflow
+ Net exports
 The real equilibrium in an open economy
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real Real
Interest Interest
Supply
Rate Rate

r1 r1

Net capital
Demand outflow, NCO

Quantity of Net capital outflow

Loanable Funds
Real
Supply
In panel (a), the supply and demand for Exchange
loanable funds determine the real interest rate. Rate
In panel (b), the interest rate determines net
capital outflow, which provides the supply of E1
dollars in the market for foreign-currency
exchange.
In panel (c), the supply and demand for dollars Demand
in the market for foreign-currency exchange
determine the real exchange rate. Quantity of Dollars
(c) The Market for Foreign-Currency Exchange
III How policies and events affect an open
economy
1 Government budget deficit (increasing government
spending)
Negative public saving
Reduces national saving
Reduces supply of loanable funds
Increase in interest rate
Reduces net capital outflow
Crowd-out domestic investment
Decrease in supply of foreign-currency exchange
Exchange rate appreciates
Net exports fall
Push the trade balance toward deficit
 The effects of a government budget deficit
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real 1. A budget deficit reduces Real
Interest the supply of loanable funds . . . Interest
Rate S2 Rate
S1
r2 3. . . . which in
r2
B A turn reduces
r1 r1 net capital
2. . . . outflow.
which
increases Demand
the real NCO
interest Quantity of Net capital outflow
rate . . . Loanable Funds
When the government runs a budget deficit, it Real 4. The decrease
S2 S1
reduces the supply of loanable funds from S 1 to Exchange in net capital
S2 in panel (a). The interest rate rises from r 1 to r2 Rate outflow reduces
to balance the supply and demand for loanable E2 the supply of dollars
funds. In panel (b), the higher interest rate E1 to be exchanged
reduces net capital outflow. Reduced net capital into foreign
outflow, in turn, reduces the supply of dollars in 5. . . . Which currency . . .
the market for foreign-currency exchange from S 1 causes the real
Demand
to S2 in panel (c). This fall in the supply of dollars exchange rate
causes the real exchange rate to appreciate from to appreciate. Quantity of Dollars
E1 to E2. The appreciation of the exchange rate (c) The Market for Foreign-Currency Exchange
 III How policies and events affect an open
economy
2 Trade policy
Trade policy is the government policy directly influences the quantity
of goods and services that a country imports or exports. Several tools:
Tariff (tax on imports) Import quota (Limit on quantity of imports)
Decrease imports
Increase in net exports
Increase in demand for foreign-currency exchange
Real exchange rate appreciates
 Discourage exports
No change in real interest rate
No change in net capital outflow
No change in net exports
→ Trade policies do not affect the country’s trade balance NX = NCO = S
– I. Trade policies affect specific Firms or Industries or targeted Countries
 The effects of an import quota
(a) The Market for Loanable Funds (b) Net Capital Outflow
Real Real
Interest Interest
Supply
Rate Rate
3. Net exports,
however, remain
the same.
r1 r1

Demand NCO
Quantity of Loanable Funds Net capital outflow
When the U.S. government imposes a quota on Real
the import of Japanese cars, nothing happens in Exchange Supply
Rate 2. . . . And causes
the market for loanable funds in panel (a) or to net
the real exchange
capital outflow in panel (b). The only effect is a rise E2
rate to appreciate.
in net exports (exports minus imports) for any
given real exchange rate. As a result, the demand E1
1. An import
for dollars in the market for foreign-currency
exchange rises, as shown by the shift from D 1 to D2 quota increases
the demand for
D2 in panel (c). This increase in the demand for D1 dollars . . .
dollars causes the value of the dollar to appreciate
from E1 to E2. This appreciation of the dollar tends Quantity of Dollars
to reduce net exports, offsetting the direct effect of (c) The Market for Foreign-Currency Exchange
 III How policies and events affect an open
economy
3 Political instability and capital flight
Political instability leads to capital flight
Capital flight = Large and sudden reduction in the demand
for assets located in a country
Capital flight affects both markets
Investors will sell domestic assets & buy foreign assets
Net-capital-outflow curve – increases: supply of domestic
currency in the market for foreign-currency exchange increases
Demand curve in the market for loanable funds – increases
Interest rate – increases
The domestic currency – depreciates
 The effects of capital flight
(a) The Market for Loanable Funds in Mexico (b) Mexican Net Capital Outflow
Real 3. . . . Which increases Real
Interest D2 the interest rate. Interest 1. An increase
Rate Rate in net capital
D1 Supply
outflow . . .
r2 r2

r1 r1

2. . . . increases the demand

for loanable funds . . . NCO2
NCO1
Quantity of Loanable Funds Net capital outflow
If people decide that Mexico is a risky place to keep their
savings, they will move their capital to safer havens such Real 4. At the same time, the
S1 S2
as the U.S., resulting in an increase in Mexican net Exchange increase in net capital
capital outflow. The demand for loanable funds in Mexico Rate outflow increases the
rises from D1 to D2, as shown in panel (a), and this drives supply of pesos . . .
up the Mexican real interest rate from r1 to r2. Because E1
net capital outflow is higher for any interest rate, that 5. . . . which causes
curve also shifts to the right from NCO1 to NCO2 in panel E 2 the peso to depreciate
(b). At the same time, in the market for foreign-currency
exchange, the supply of pesos rises from S1 to S2, as Demand
shown in panel (c). This increase in the supply of pesos
causes the peso to depreciate from E1 to E2, so the peso Quantity of Pesos
becomes less valuable compared to other currencies. (c) The Market for Foreign-Currency Exchange
III How policies and events affect an open
economy
4 Other policies and events
- Tax: increase - decrease
- Monetary policy: replace loanable funds market by
money market
- Investment policy: encourage – discourage
Key concepts
- Balance of payment, current account, capital account
- Net capital outflow
- Foreign exchange rate, fixed exchange rate system,
flexible exchange rate system, managed flexible
exchange rate system
- Nominal foreign exchange, real foreign exchange
- Purchasing power parity, one price law