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
Imports
Services
Net income
Net govt transfers
Balance
UK Capital account
FDI (net)
Portfolio (net) -143
Short-term flows (net) -23
Balance +10
Reserves
Error
Balance of payments

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 = income y* = world income
r = interest rate r* = 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

9. THE FOREX MARKET

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
world’s economies increasingly inter-dependent
steadily increasing world trade
- dependent on each other’s 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 world’s 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