1. ECO1000 Economics Semester One, 2004 Lecture Nine

2. Class Test 2 Reminder For Internal Students Wednesday May 26 25 multiple Choice Questions Based on the work covered from week six to week 12:  Lectures 6 – 10  Modules 3, 4, 5, 6 and 7  Chapters 7, 8, 9, 10, 11, 12, 13, 14, 15, 16. Same On-Line Format as Test One

3. Outline or Plan of Today’s Lecture Material Covered: Module Six Reading: Text Chapters 14 and 15 Topics: The Open Economy

4. Purpose or Objectives of Today’s Lecture You will be able to:  Define an open economy  Give an overview of some of the key variables associated with international economic interactions  Develop a model of the interaction of those key variables  Show how the variables change under different scenarios

5. What is an Open Economy?

6. An Open Economy An open economy interacts with other countries in two ways  It buys and sells goods and services in world product markets.  It buys and sells capital assets in world financial markets. A ‘closed economy’ has little or no such interaction

7. Why have a closed economy? Fear of foreign cultural & moral influences Political and military security Aiming for strategic self-sufficiency Protecting strategic industries Protecting ‘infant’ industries Protecting employment

8. The Case for Open Economies Comparative advantage  ‘everyone is better off with trade’ Development through competition Flow of technology & ideas Reduces international military tension ‘It can’t be stopped’  The flow of capital  Communications and cultural incursions

9. The Flow of Goods and Money

10. The Flow of Goods: Net Exports Exports are domestically produced and sold abroad. Imports are foreign-produced and sold domestically. A trade deficit is a situation where net exports (exports – imports, NX) are negative, Imports > Exports A trade surplus is a situation where net exports (NX) are positive, Exports > Imports

14. Factors That Affect Net Exports Tastes of consumers for domestic and foreign goods. The prices of goods at home and abroad. The exchange rates at which people can use domestic currency to buy foreign currencies. Costs of transporting goods. Government policies toward international trade.

15. The Flow of Money: Net Foreign Investment (NFI) Net foreign investment is the difference between foreign assets purchased by domestic residents and domestic assets purchased by foreigners. Example, an Australian buys stock in Microsoft and an American buys stock in Telstra. The difference between the two is net foreign investment.

16. Net Foreign Investment (NFI) If Australian residents buy more financial assets abroad than foreigners spend on Australian financial assets, there is a net capital outflow from Australia. If foreigners buy more Australian financial assets than Australian residents spend on foreign financial assets, then there will be a net capital inflow into Australia.

17. Equality of NX and NFI An interesting identity must hold through all of these flows of goods and capital. NX = NFI An increase in net exports must mean that more foreign currency is flowing into the economy (and vice versa). So an increase (decrease) in NX must be met with a corresponding (increase) (decrease) in NFI.

18. International Prices: Exchange Rates

19. Real and Nominal Exchange Rates International transactions are influenced by international prices. The two most important international prices are:  the nominal exchange rate; and  the real exchange rate.

20. The Nominal Exchange Rate The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another. The nominal exchange rate is expressed in two ways.  In units of foreign currency per one Australian dollar  In units of Australian dollars per one unit of the foreign currency

21. The Nominal Exchange Rate: Example Assume the exchange rate between the US dollar and the Australian dollar is $1AUS to US 75 cents. Then:  One $AUS trades for US 75 cents  One $US dollar trades for $AUS 1/0.75) or $A1.33 (approx). If an Australian dollar buys more foreign currency, there is an appreciation of the Australian dollar.  eg one Australian dollar = 80 US cents If it buys less there is a depreciation of the dollar.  eg one Australian dollar = 60 US cents

23. The Real Exchange Rate The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy. The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies. It is calculated by:

24. The Real Exchange Rate: An Example New Zealand wine costs $NZ14 a bottle A comparable wine Australia costs $A12 The nominal exchange rate is $A1 = $NZ1.10 Real exchange rate = (1.1 x 12)/14 =13.2/14 = 0.94 You would only get 0.94 bottle of NZ wine for 1 bottle of Australian wine Therefore, all things being equal, keep drinking Australian wine

25. Exchange Rate Appreciation: An Example The exchange rate becomes $A1=$NZ1.20  (Appreciation of $A and/or depreciation of $NZ) Real exchange rate for wine = (1.2 x 12)/14 = 14.40/14 = 1.02 For the same Australian money you now get 1.02 bottles of NZ wine, or 1 bottle of NZ wine will be cheaper than an Australian bottle of wine.

27. Advantages of a Low Real Exchange Rate When a country’s real exchange rate is low, its goods are cheap relative to foreign goods. Consumers both at home and abroad tend to buy more of that country’s goods and fewer foreign produced goods.

28. How Are Exchange Rates Determined? A Simple Theory: PPP

29. Purchasing-Power Parity A unit of any currency should be able to buy the same quantity of goods in all countries (theoretically) If prices in some countries are high there are opportunities for imports, which will drive down prices  Arbitrage is the opportunity to buy in one place and sell at a profit in another Therefore, the exchange rate between two countries is affected by prices in those countries

30. Implications of PPP Nominal exchange rate depends on the price level Increasing prices, relative to another country, may result in a depreciation in the value of the currency BUT… Not all goods are easily traded and there are transactions costs Not all imported goods are perfect substitutes for domestically produced goods

31. The Macroeconomics of an Open Economy: Theory

32. Determining Macroeconomic Variables in an Open Economy The important macroeconomic variables of an open economy include:  national saving  domestic investment  net foreign investment  net exports

33. Determining the Values of the Macroeconomic Variables in an Open Economy The values of the variables are determined through the interaction of:  the loanable funds market (from an earlier lecture); and  the market for foreign-currency exchange

34. The Market for Loanable Funds The demand for loanable funds comes from domestic investment (I) and net foreign investment (NFI). At the equilibrium interest rate, the amount that people want to save exactly balances the desired quantities of investment and net foreign investment: S = I + NFI

35. The Market for Loanable Funds Demand for loanable funds (for domestic investment and net foreign investment) S = I + NFI Equilibrium real interest rate Real Interest Rate Equilibrium Quantity Quantity of Loanable Funds Supply of Loanable Funds (from national saving)

36. The Market for Foreign-Currency Exchange Remember, for an economy as a whole, NFI = NX  NFI represents the quantity of dollars supplied for the purpose of buying assets abroad.  NX represents the quantity of dollars demanded for the purpose of buying Australian net exports of goods and services. NX = NFI, represents the two sides of the foreign-currency exchange market in which Australian dollars are traded for foreign currencies. The price that balances the supply and demand for foreign- currency is the real exchange rate.

37. The Market for Foreign-Currency Exchange Equilibrium quantity Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Equilibrium real exchange rate Supply of dollars (from net foreign investment) Demand for dollars (for net exports)

38. The Market for Foreign-Currency Exchange The real exchange rate adjusts to balance the supply and demand for dollars. At the equilibrium real exchange rate, the demand for dollars to buy net exports exactly balances the supply of dollars to be exchanged into foreign currency to buy assets abroad. The demand for foreign currency increases as the exchange rate decreases  domestic (our) goods become cheaper to buy. The supply curve is vertical because the quantity of dollars supplied for net foreign investment is unrelated to the real exchange rate.

39. The Linkage Between Markets

40. Equilibrium in the Open Economy Net foreign investment links the loanable funds market and the foreign-currency exchange market.  The key determinant of net foreign investment is the real interest rate.

41. Equilibrium in the Open Economy In the market for loanable funds, net foreign investment is a portion of demand. In the market for foreign-currency exchange, net foreign investment is the source of supply. Prices in the loanable funds market and the foreign- currency exchange market adjust simultaneously to balance supply and demand in these two markets. As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.

42. (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Net foreign investment, NFI Real Interest Rate Net Foreign Investment r 1 Real Interest Rate Quantity of Loanable Funds r1r1 Supply Demand Quantity of Dollars Real Exchange Rate E1E1 Supply Demand

43. How Changes in Policy and Events Affect an Open Economy The magnitude and variation in important macroeconomic variables depend on the following:  Government budget deficits  Trade policies  Political and economic stability

44. Government Budget Deficits In an open economy, government budget deficits......raise interest rates, which...crowds out domestic investment,...causes the dollar to appreciate, and...pushes the trade balance toward a deficit.

45. (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Real Interest Rate Quantity of Loanable Funds Quantity of Dollars Real Exchange Rate Real Interest Rate Net Foreign Investment S1S1 D S1S1 D NFI r1r1 E1E1 1. A budget deficit reduces the supply of loanable funds... S2S2 r2r2 S2S2 2. which increases the real interest 3. which in turn reduces net foreign investment. 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… 5. …which causes the real exchange rate to appreciate. E2E2

46. Effect of Budget Deficits on the Loanable Funds Market A government budget deficit reduces national saving, which......shifts the supply curve for loanable funds to the left, which...raises interest rates. Therefore, higher interest rates reduce net foreign investment.

47. Effect on the Foreign-Currency Exchange Market A decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency. This causes the real exchange rate to appreciate.

48. Government Budget Surpluses… In an open economy: …Increase supply of loanable funds …Decrease Real Interest Rate …Increases NFI (the key determinant of NFI is the real interest rate because you want to borrow money to invest abroad). …Leads to a depreciation of the exchange rate.

49. (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Real Interest Rate Quantity of Loanable Funds Quantity of Dollars Real Exchange Rate Real Interest Rate Net Foreign Investment S1S1 D S1S1 D NFI r1r1 E1E1 1. A budget surplus increases the supply of loanable funds... S2S2 r2r2 S2S2 2. which decreases the real interest 3. which in turn increases net foreign investment. 4. The increase in net foreign investment increases the supply of dollars to be exchanged into foreign currency… 5. …which causes the real exchange rate to depreciate. E2E2

50. Trade Policy A trade policy is a government policy that directly influences the quantity of goods and services that a country imports or exports.  Tariff: A tax on an imported good.  Import quota: A limit on the quantity of a good produced abroad and sold domestically.

51. The Effect of a Trade Policy (Tariff) In an open economy:  A Tariff affects NX  Because NX are a source of demand for dollars the tariff affects the demand for currency  Because a tariff reduces imports, NX increases  Because foreigners need dollars to buy NX, the demand for dollars increases  The real exchange rate appreciates  This offsets the effect on NX of the decline in IM  The trade balance remains the same after a tariff

52. (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Net foreign investment, NFI Real Interest Rate Net Foreign Investment r 1 Real Interest Rate Quantity of Loanable Funds r1r1 Supply Demand Quantity of Dollars Real Exchange Rate E1E1 Supply Demand Tariff increases demand for dollars and causes the exchange rate to appreciate which encourages imports and discourages exports, thereby offsetting the initial decline in imports caused by the tariff. E2E2 D2D2

53. Political Instability and Capital Flight Capital flight is a large and sudden movement of funds out of a country, usually due to political instability. Capital flight has its largest impact on the country from which the capital is fleeing, but it also affects other countries.

54. Effects of Capital Flight… In an open economy:  Say Australian’s think that there is a better place to invest than Australia (maybe due to a sudden political or business scandal)  They demand loanable funds to invest overseas  This increases the Australian real interest rate  Increases NFI  Increases the supply of AUS$  Which leads to a depreciation of the currency

55. (a) The Market for Loanable Funds(b) Net Foreign Investment (c) The Market for Foreign-Currency Exchange Net foreign investment, NFI Real Interest Rate Net Foreign Investment r 1 Real Interest Rate Quantity of Loanable Funds r1r1 Supply Demand Quantity of Dollars Real Exchange Rate E1E1 Supply Demand

56. In Light of the Objectives of this Lecture… We now know how to:  Describe an open economy  Give an overview of some of the key open economy variables  Use a model to show the interaction of these variables  Show how the variables change under different scenarios

57. Next Week Material Covered: Module Seven Reading: Text Chapter 16 Topics: Aggregate Demand and Supply

58. THE END