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THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments 2. The foreign exchange (forex) market 3. Fixed v floating exchange.

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Presentation on theme: "THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments 2. The foreign exchange (forex) market 3. Fixed v floating exchange."— Presentation transcript:

1 THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments 2. The foreign exchange (forex) market 3. Fixed v floating exchange rates 4. Single currency areas 5. Globalisation and macro policy

2 What is the balance of payments? Why are policy makers concerned about the BP? How can govts correct a BP problem? How are exchange rates determined? How can the CB affect the exchange rate? Is a single currency for Europe desirable? Should the G3 (G7) co-ordinate their macro-policies?

3 THE BALANCE OF PAYMENTS records all flows of money between countries BP = current acc + capital acc Current account (or financial account) - exports minus imports of goods / services - govt transfers (e.g. EU taxes / subsidies) Capital account - fixed investment (FDI) - bonds, equities, deposits (portfolio investment)

4 UK Current account Exports+165 Imports -192 Services +11 Net income +7 Net govt transfers -4 Balance -13 UK Capital account FDI (net)+173 Portfolio (net)-143 Short-term flows (net) -23 Balance+10 Reserves +1 Error -2 Balance of payments 0


6 Surpluses and deficits in the BP Surplus: BP > 0 - foreign exchange reserves increase - accumulation of foreign assets - exchange rate too high Deficit: BP < 0 - foreign exchange reserves decline - loss of foreign exchange reserves - deficit has to be financed (borrowing) - loss of control over domestic assets - downward pressure on exchange rate; inflationary

7 Determinants of the BP BP = exports - imports + net capital flows exports = f (exch rate, competitiveness, world income) imports = f (exch rate, competitiveness, income) net capital flows = f (r / world r, country risk) Model:BP = f ( e, w/w*, y*, y, r/r*) e = exchange rate (£/$) w = real wage; w* = world real wage y = incomey* = world income r = interest rater* = world interest rate

8 Govt intervention to correct the BP exchange rate policy: buying / selling domestic currency fiscal / monetary policy to control AD - raise / lower r (capital account) - change G or T (trade account) supply-side policies - improve competitiveness via labour market flexibility


10 The exchange rate e = £ per $ (or s = $ per £) Determination of e: a simple model Demand for £s (= supply of $s) importers of UK goods / services tourists visiting UK foreign students in UK universities foreigners investing in UK UK citizens with foreign income Supply of £s (= demand for $s) opposite to above

11 Model:e = f ( x - m, r - r*) When will exchange rate appreciate? Current account: demand for exports increases demand for imports decreases competitiveness increases (w / w* increases) Capital account: inflow of foreign investment (r / r* increases)

12 FIXED v FLOATING EXCHANGE RATES Advantages of a fixed exchange rate certainty for exporters / importers/ investors no speculators within single currency area imposes constraints on govt macro policy - constrained by effect on BP - constrained by effect of policies on inflation - govt has to achieve BP equilibrium over medium term

13 Disadvantages of a fixed exchange rate economic policy will be constrained by fixed ER - chronic BP deficit requires deflationary policy - conflict between full employment and BP equilibrium sudden shocks cannot be absorbed by ER adjustment - shocks affect real economy if prices are fixed fixed ER encourages protectionism - due to impact of shocks on real variables speculators cause financial / political crises

14 Advantages of floating exchange rates govt ignores ER; no intervention needed no need to worry about BP economy is insulated from shocks (absorbed by ER) govt can concentrate on internal policy objectives (inflation, unemployment, income distribution)

15 Disadvantages of floating exchange rates exchange rate can be volatile in the short run - causes uncertainty (harmful to investment / trade) capital flows can cause ER to get out of line with its underlying (fundamental) value loss of BP constraint on macro-policy may lead to inflationary bias - with a fixed ER, govt has to respond to BP deficits

16 SINGLE CURRENCY AREAS Advantages of a single currency lower transactions costs (no currency conversions) increased price competitiveness - transparent pricing across countries elimination of exchange rate uncertainty - encourages trade - encourages investment (inc. FDI) lower inflation and interest rates - central bank independent of member govts - member states have to keep wage increases in line to maintain competitiveness

17 Disadvantages of a single currency surrenders economic sovereignty to supra-national authority - no control over monetary policy - no control over exchange rate deflationary effects in countries with high wage pressures increase in regional disparities due to greater factor mobility potential loss of control over fiscal policy - cannot use monetary expansion to pay for increase in G - tight control over govt borrowing (fiscal balance needed)

18 Why might the Euro Zone not be an optimal currency area? labour markets are not flexible enough - wages may be sticky downwards - labour is not sufficiently mobile to respond to changes in demand - effects of changes in euro ER will vary between member states / regions But: alternative methods of dealing with adverse effects of structural change - structural funds for re-training - structural funds for encouraging indigenous growth - infrastructure policies to revive declining regions

19 GLOBALISATION AND MACRO POLICY Interdependence worlds economies increasingly inter-dependent steadily increasing world trade - dependent on each others demand for exports vast increase in financial flows due to liberalisation of financial markets - abolition of controls on currency movements - financial markets affect each other (instantaneously) - Fed has profound effect on rest of worlds economies

20 Co-operation between G7: policy harmonisation need for policy harmonisation to prevent world-wide recession / inflation - exchange rates should not be out of line (need to keep current accounts in reasonable balance) - inflationary pressures are easily transmitted to other countries - co-ordination of interest rates may be needed to prevent adverse capital flows G7 needs to deal with the problem of developing country debt

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