8. Open Economy, Exchange Rates, PPP Flashcards
What is the balance of trade?
Net exports are the value of exports minus value of imports, also known as the trade balance
Trade surplus, trade deficit and balanced
What is the international flow of goods
The factors that effect the trade balance:
- Tastes and preferences
- Prices of good home/abroad
- Exchange rates - SPICED - use domestic currency to buy foreign currencies
- Incomes of consumers home/abroad
- Cost of transport goods
- Government policies towards international trade
What is Net Capital Outflow (NCO)? What factors affect it?
- Purchase of foreign assets by domestic residents - purchase of domestic assets by foreigners
Takes two forms:
FDI - e.g. buying BMW car factory
Foreign portfolio investment is purchasing assets in another country e.g. buying shares in BMW
Factors:
- Real interest rate paid on foreign assets/domestic assets
- Perceived economic and political risks of holding assets abroad
- Government policies affecting foreign ownership of domestic assets
What is the equation relating NCO to exports?
Net Exports = Net Capital Outflow
This holds as an accounting identity
If NX > 0 (surplus):
- Selling more goods than buying
- From net sales of goods and services country receives foreign currency
This is a foreign asset (NCO), may be invested abroad (still NCO)
- As such, NCO = NX > 0
What are the national accounts of an open economy?
Open econmy:
Y = C + I + G + NX
S = Y - C - G = I + NX
Since NX = NCO, implies that S = I + NCO
In short,
National savings = domestic investment + net capital outflow
- When the UK saves a £ this may be used to accumulate capital at home or abroad
What are the accounts of international flows for a surplus
(NX > 0)
Since Y = C + I + G + NX
S = Y - C - G = I + NX
(Note NX = S - I > 0)
- I = S - NCO < S: National savings are greater than investments
If instead NX < 0, then I = S-NCO > S: national savings less than investments (foreigners “do part”)
What are the possible outcomes and accounts for an open economy?
Trade deficit:
X<M
NX < 0
NCO < 0
Y < C + I + G
Savings < investment
Balanced
X = M
NX = 0
NCO = 0
Y = C + I + G
Savings = Investment
Trade surplus:
X > M
NX > 0
NCO > 0
Y > C + I + G
Savings > Investment
What are nominal exchange rates and how do they change
NER:
- Rate a person can trade currency between countries
Appreciation - increase in value, measured by amount one unit can buy
- One can buy mor eforeign currency for domestic currency
Depreciation - decrease in value of currency, measured by amount of foreign currency it can buy
- Means one can buy less foreign currency
What are real exchange rates?
Ratio at which someone can trade goods and services of one country for goods and services of another
RER =
(NER x Domestic Price Level) / Foreign Price
e.g. take price of banana, costs £P in UK
exchange to $ - NER x P
Divide with price of banana in us P*, to get exchange rate - how many US bananas a UK banana is worth
Simply:
Real Exchange Rate = (exP) / P*
In reality, how are real exchange rates calculated?
- Uses price index - basket
- E - nominal exchange rate beween UK and foreign currencies
P = price index for UK basket
P* = price index for foreign basket
So full equation is quantity of the basket of goods a domestic unit of the bakset can buy abroad
What is a depreciation?
WPICED - UK goods cheaper relative to foreign goods
- More competitive
- Consumers at home/abroad buy more UK goods, import fewer from other countries
- High net exports - high exports, low imports
What is PPP? What is the rule that makes this hold?
Purchasing Power Parity:
- Unit of any given currency should be able to buy same quantity of goods in all quantities
This to say Real exchange rate E must be equal to 1: 1 = eP/P*
Abitrage - if real exchange rates differ, one can buy in one country, sell in another and make a profit
- Such a property continues until equality in prices sets in
What are the implications of PPP:
NER between countries reflects the price level in those countries. This is clear since:
1 = eP/P* if, and only if, e = P*/P
So if relative prices change, e must also change
For example, if domestic price P rise faster than P*, e must decline and you get fewer dollars per pound (pound depreciates)
WHat is the effect of an increase in money supply on PPP?
Increase money supply increases prices
- When a country increases money supply faster than other countries, its exchange rate should depreciate
- More generally, high inflation in the UK than the rest of the world would cause depreciation of the £
What are the limitations of PPP?
- Doesnt always hold in practice, maybe in long run - in the short run other factors influence nominal exchange rates
Evidenced by fact that real exchnage rates are not constant over time:
1. Many goods not easily traded
2. Tradable goods not perfect substitutes - may have different characteristics e.g. car market
3. Transaction costs inhibit profit arbitrage
Nonetheless PPP is a good starting point to understand currency movements in the long run
- Doesnt say much about trade deficits or currency market in the short run
