The Open Economy Flashcards
Nominal exchange rate definition
The price of one currency in terms of another
Real exchange rate definition
The relative price of domestic goods in terms of foreign goods
Real exchange rate formula and how to know which is cheaper
Exchange rate x Domestic price (P) / Foreign Price (P*)
If answer is less than one, domestic is cheaper than foreign
What is a net exporter/importer
Net exporter-when exports>imports
Balance of payments
Records financial transactions flowing in and out an economy
Forms of transactions in BOP (3) and which account are they recorded in
Trade in goods/services-current account
Capital movements-capital account
Financial flows-financial account
Capital account
Records capital transfers of non-produced, non-financial assets. E.g copyright, patents, trademarks
Financial account components (5)
FDI
Portfolio investment
Transactions in financial derivatives
Reserve assets
Other
Difference between FDI and portfolio investment
Control- FDI allows investor to have direct influence over firm
Derivatives and examples
Financial instruments e.g options, futures and swaps.
Reserve assets
Foreign exchange reserves that the central bank holds e.g bonds, other currencies etc.
Is an increase in FCR a negative or positive entry on BOP
Negative as money going out in exchange for FCR
What does other component include
Borrowing and lending
Is borrowing and lending in other component positive or negative in BOP
Borrowing-positive-money inflow
Lending-negative-outflow
Autonomous transactions and name them from each account
Autonomous transactions are for own benefit.
Current account items are autonomous as we import items for personal benefit
Capital account items are autonomous
Financial account (only FDI and portfolio are autonomous)
Accomodating transactions and example
Undertaken for BOP purposes.
All other items on financial account are accomodating-essential to balance out the BOP
Two ways an open economy interacts with other countries. and equation that links them
Buying/selling goods and services (net exports NX)-current account
Buying/selling assets (net capital outflow NCO)-capital/financial account
CA+KFA=0 (BALANCE EACH OTHER!)
Closed economy identity vs Open economy national income identity
Total expenditure=total output
Vs
C+I+G+NX
Domestic spending can exceed output (import>exports)-trade deficit
Output can also exceed domestic spending (exports>imports)-trade surplus
Net capital outflow formula (NCO)
Capital outflow (CO) -Capital inflow (CI)
Capital outflow vs inflow
Outflow is purchase of foreign financial assets by domestics
Inflow is purchase of domestic financial assets by foreigners
Capital and financial account (KFA) and net capital outflow (NCO) relationship and why
KFA=-NCO
Thus means NCO<0 so CI>CO, Payments from foreigners (CI) are positive in BOP, but enters NCO negatively. This is because it is money we owe to others as they purchased an asset from us therefore NCO negative
Foreigners BUYING OURASSETS=negative NCO
Net buyer or seller of financial assets???
CO>CI. NCO Surplus-we buy more foreign assets
CI>CO. NCO Deficit-we sell more domestic assets (so saving>investment, so we lend out)
Basically opposite of how trade balances work.
Trade surplus-sell more than buy
NCO surplus-buy more than sell
What domestic citizens need foreign currency for (2), and so what do they do
Imports
Capital outflows
So supply domestic currency
IM+CO
What foreign citizens need domestic currency for (2)
Exports
Capital inflows (from domestic POV-BUYING ASSETS FROM DOMESTICS)
So demand domestic currency
EX+CI
Supply and demand is IM+CO=EX+CI and can be rearranged as..
And how can it be seen in BOP formula
Ex-IM=CO-CI which is just NX=NCO
BOP=CA+KFA=0
Where CA=NX KFA=-NCO
NCO balance in a trade deficit
Trade deficit means import>exports so NX<0
As NX=NCO NCO is also <
As a result of increased income from selling their exports, foreigners can spend more on domestic assets (CI). So NCO will mean CI>CO (we sell more domestic financial assets to foreigners) which is also a NCO deficit
AND BECAUSE KFA=-NCO, it is a KFA surplus
Loanable funds market for an open economy IN TERMS OF BORROWING AND LENDING (where NCO>0 or NCO<0)
NCO<0-more domestic assets are sold. So this is net borrowing-we are borrowing savings (in exchange for our assets) from foreigners (can then be invested)
NCO>0-saving>investment we buy more foreign assets than we sell. So we are lending (in exchange for foreign assets) to foreign economy (which they can invest)
Supply of funds in open economy formula
Supply= Savings (S)- NCO
SUPPLY=INVESTMENT IN CLOSED ECONOMY, BUT IN AN OPEN ECONOMY THERE IS INFLOWS AND OUTFLOWS OF MONEY SO NCO INCLUDED.
SO
Savings-NCO=Investment
Savings=Investment+NCO
Savings-Investment=NCO
S-i=NCO Significance
If NCO positive
It means S>I, which means savings is left, which is lent abroad
If NCO negative
I>S, which means THEY WANT TO INVEST MORE THAN THEY SAVE, AND the difference in money wanted to invest is borrowed from abroad
Relationship between NCO and interest rate r
As domestic interest rate goes up. Investment more attractive, creating CI>CO , so NCO falls.
Inverse relationship-HIGHER INTEREST=LOWER NCO
LFM diagram axes
R-interest rate y axis
NCO-x axis
Diagram to represent NCO and interest rate relationship
Downward sloping NCO
Dotted vertical line through NCO
Left of the line=NCO<0 as interest rate gets higher, more foreigners purchase domestic assets (CI>CO) so explains why NCO<0
Right of the line NCO>0 as lower interest means we buy more foreign assets so CO>CI, so explains why NCO>0
LFM model diagram for open economy
Supply (saving) still vertical
Demand=Investment+NCO
As remember Saving=Investment+NCO
Axis of foreign exchange market (FEM) model
Y axis- real exchange rate
X axis- NCO/NX
Where does the supply of domestic currency come from in the FEM model? And why?
NCO, as S-I=NCO.
If NCO is positive, S>I, so economy saves more than invests, and so domestic currency is supplied.
NCO is the supply of domestic currency, as S-I
What is NCO determined by?
Real interest rate
Higher r=lower NCO as more capital inflows (CI>CO)
What does supply for FEM look like on diagram
Vertical line.
What does demand for domestic currency depend on and why?
Because we assume homogeneity with goods and services, we say it depends on the real exchange rate.
(Due to homogeneity we ignore possible things such as quality, trade restrictions etc).
Relationship between exchange rate and demand for currency
Inverse.
Strong rate=exports expensive, so export demand falls, demand for domestic currency falls.
What does demand for domestic currency look like on diagram
Downward sloping, denoted NX
FEM demand curve diagram
Dotted vertical line through the middle
Left of the line=NX<O, as we buy more imports and sell less exports as the exchange rate increases
Right of the line=NX>O, as a fall in exchange rate means we buy less imports and sell more exports.
LFM and FEM axis’s and supply and demand denotations.
LFM-real interest rate and NCO
Supply-Savings (vertical-fixed)
Demand-Investment+NCO (depends on interest rate)
FEM-real exchange rate and NX
Supply-supply for domestic currency (vertical-fixed)
Demand-demand for domestic currency. (Depends on exchange rate)
Expansionary fiscal policy on FEM (hint:links to LFM too)
1.An increase in G will decrease saving in the LFM, pushing interest rate up.
2.Increased interest causes increases in capital inflows, so NCO falls
3.Fall in NCO reduces available pounds for NX (fall in supply), causing an appreciation, so exports get more expensive, so demand for NX falls.
Effects of import quota on FEM model
Imports restricted, so we have a shift in NX curve to the right for any given exchange rate. (we demand domestic currency (NX) as we no longer can buy imports)
The trade balance remains the same, as NCO is unchanged and so is NX, only change is an appreciation in exchange rate. Quota does not impact saving, investment or NCO.
(Think about in real life, no additional goods are actually being sold to foreigners, the domestic consumers are just switching to domestic goods, so it is not an export, and so trade balance remains the same, despite us demanding domestic currency again)
Remember demand for domestic currency is from G&S exports and capital inflows, but QUOTA doesn’t impact CI, hence why unchanged LFM model.
FEM for a small open economy assumptions (3)
Too small to influence real interest rate, so have to accept a world interest rate. (R*)
Perfect capital mobility
Domestic and foreign bonds are perfect substitutes (financial assets yield same return)
Domestic expansionary fiscal policy for small economy
As, small, real interest rate is unchanged. (r=r*)
Fiscal reduces saving (S-I=NCO), so NCO falls. (CI>CO)
Increased capital inflows appreciate currency, thus reducing export demand worsening NX.
Expansionary fiscal policy by large economies on FEM for a small country
As large contribute to overall world saving, world real interest rate r* increases (unlike small)
As small countries have to accept r*, Investment decreases in small economy, as more expensive to invest.
NCO=S-I so NCO increases, CO>CI so we supply our currency.
Therefore exchange rate depreciates and NX improves
How do we find NX=NCO
Work out what domestic currency is demanded for, equated to what foreign currency is demanded for
EX+CI=IM+CO
