Open Economy

Open Economy PowerPoint PPT Presentation

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Open Economy

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1. Open Economy

2. Balance of Payments Current Account Trade, Income Flow, Unilateral Transfers Financial Account Investment Flow Change in Reserve Holdings See

3. Side note: to see the current liquidity crisis, note the BoP Investment flow for the third quarter of 2007

4. BoP and the Currency Regime Exchange Rate – Translation mechanism Floating Currency March 1973 – today CA + FA = 0 Currency crisis is typically defined as rapid currency depreciation. No run on the national reserves is possible: US 2002-present USD, CD, EURO…. Fixed Currency CA + FA = Change in Reserves Currency crisis is possible, run on reserves is possible: Russian Federation, August of 1998 Bulgaria, Romania… Managed currencies: China, Russia….

5. Types of Fixed Currencies Gold Standard 1880’s – 1914 Revised Gold Standard 1948 – 1972 Simple one currency fix China prior to 2005 Argentina in late 1990’s Composite currency and fixes to composite currencies SDR Managed Exchange Rate Russian Corridor in the 1990’s Chinese Currency today

6. ForEx Market: Exchange rate determination, the simple framework Demand for the USD US Exports Foreign Investment into the US CBs Supply of the USD in the ForEx Market US Imports US investment overseas CBs US: example of currency depreciation China: a managed exchange rate and the monetary expansion it causes in China, given its trade surplus Russia in 1998 and the currency attack

7. Real exchange rate Purchasing price parity “same things should cost the same price world over” REd = NEd * Pd/Pf = 1 ? NEd = Pf/Pd (absolute PPP) Overvalued versus undervalued currency and the real exchange rate Nominal exchange rate is driven by the difference in the rates of inflation %change in NE = inflation f – inflation d [relative PPP] If (inflation f > inflation d) then DC appreciates If (inflation f < inflation d) then DC depreciates Inflation leading to currency value change The effect can go the other way as well

8. Recent performance of the USD

9. Role of the exchange rate in the price of oil

10. Back to the Model: Small Open Economy Incapable of causing changes in the world’s financial markets, i.e. is a price taker in financial markets, unable to influence the price of loanable funds in the global markets – interest rate.

11. example Consider a closed economy with Y=20000 G=T=0 C=1000+0.8*(Y-T) I=5000-500 r ----------------------------------------------------------- What is the level of interest rate? ----------------------------------------------------------- Now, assume this is a small open economy and the global interest rate is 5% Would this country be a net borrower or lender? What would the level of net exports be? Now, assume that the level of government spending increases to 3000, would this country be a net borrower or lender? And what would the level of NX be? Now assume that G is reduced to 0, but T is reduced to -1000, what would be the level of NX? Now assume that G=T=0, but the investment function changes to: I=8000-500r

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