Chapter 29 Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

29.1 Open economy macroeconomics n … is the study of economies in which international transactions play a significant role – international considerations are especially important for open economies like the UK, Germany or the Netherlands n Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world – especially via the exchange rate.

29.2 The foreign exchange market - the international market in which one national currency can be exchanged for another. The price at which two currencies exchange is the exchange rate. DD DD shows the demand for pounds by Americans wanting to buy British goods/assets. Quantity of pounds Exchange rate ($/£) Suppose 2 countries: UK & USA SS SS shows the supply of pounds by UK residents wishing to buy American goods/assets. e0e0 Equilibrium exchange rate is e 0 SS 1 If UK residents want more $ at each exchange rate, the supply of £ moves to SS 1 e1e1 New equilibrium at e 1.

29.3 Alternative exchange rate regimes n In a fixed exchange rate regime – the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. n In a flexible exchange rate regime – the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves.

29.4 Intervention in the forex market Quantity of £s $/£ SS DD e1e1 Suppose the government is committed to maintaining the exchange rate at e 1... When demand is DD, no intervention is needed... there is a balance in transactions between the countries. The Bank of England must supply AC £s in return for $, which are added to reserves. DD 1 If the demand for pounds is DD 1 there is excess demand AC. AC DD 2 The reverse occurs if demand is at DD 2. E

29.5 The balance of payments n … a systematic record of all transactions between residents of one country and the rest of the world n Current account – records international flows of goods, services, income and transfer payments n Capital account – records transactions involving fixed assets n Financial account – records transactions in financial assets

29.6 The UK balance of payments, Source: Economic Trends Annual Supplement

29.7 Floating exchange rates and the balance of payments n If the exchange rate is free to move to its equilibrium, there is no need for intervention n any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts n if there is intervention, it is recorded as part of the financial account.

29.8 International competitiveness n The competitiveness of UK goods in international markets depends upon: – the nominal exchange rate – relative inflation rates n Overall competitiveness is measured by the real exchange rate – which measures the relative price of goods from different countries when measured in a common currency

29.9 Relative prices and the nominal exchange rate, UK & USA Relative price (UK/USA) Exchange rate ($/£)

29.10 The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

29.11 Components of the balance of payments n The current account is influenced by: – competitiveness – domestic and foreign income n The capital & financial accounts are influenced by: – relative interest rates n which affect international capital flows. n Perfect capital mobility – occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries

29.12 Internal and external balance n Internal balance – a situation for a country when aggregate demand is at the full-employment level n External balance – a situation for a country when the current account of the balance of payments just balances n The combination of internal and external balance is the long-run equilibrium for the economy.

29.13 Shocks may move an economy away from internal and external balance: Boom Slump Surplus Deficit More saving, tighter fiscal & monetary policy Foreign boom, lower real exchange rate Foreign slump, higher real exchange rate Less saving, easier fiscal & monetary policy

29.14 Macroeconomic policy under fixed exchange rates n Under fixed exchange rates, there is a crucial link between external imbalance and domestic money supply. n When the government intervene to maintain the exchange rate, there is a direct effect on money supply. n Sterilization – an open market operation between domestic money and domestic bonds to neutralize the tendency of balance of payments surpluses and deficits to change domestic money supply.

29.15 Monetary policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices n An increase in nominal money supply – tends to reduce interest rates – leads to a capital outflow – reducing money supply as the government seeks to maintain the exchange rate n so monetary policy is powerless – the government cannot fix independent targets for both money supply and the exchange rate – domestic and foreign interest rates cannot diverge

29.16 Fiscal policy under fixed exchange rates Assume: perfect capital mobility, sluggish prices n An increase in government expenditure; n in the short run – stimulates output – but also increases interest rates – which leads to a capital inflow – money supply expands to maintain the exchange rate – there is no crowding-out – as interest rates cannot rise n in the long run: – wages and prices adjust, affecting competitiveness – the economy returns to potential output.

29.17 Monetary policy under floating exchange rates Time e e1e1 Suppose the economy begins in equilibrium with the nominal exchange rate at e 1. t A At time t, nominal money supply is halved... e2e2 e 2 will be the new equilibrium exchange rate once the economy has adjusted But prices are sluggish, so in the short run, real money supply falls and domestic interest rates rise e3e3 B To maintain equilibrium in the forex market, the exchange rate overshoots to e 3 C, adjusting along BC with wages & prices.

29.18 Monetary policy under floating exchange rates (2) n This analysis suggests that with floating exchange rates, n monetary policy is highly effective in the short run n but the effect is only transitional

29.19 Fiscal policy under floating exchange rates n Following an increase in government expenditure... n the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate – which dampens export demand n so fiscal policy is less effective under floating exchange rates.