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5.

The open economy


5.1 Current-account, capital account, and
the balance of payments
5.2 The exchange rate
5.3 Capital-account: open and closed
5.1 Current account,
capital account,
and balance of payments
Again, national income accounts
Y=C+G+I+XM
YCGI =XM
YTC+TGI =XM
(Y T C) + (T G) I = X M

SP + SG I = X M

S I=XM
Why M X is foreign saving
SI =XM
S + (M X) = I
S + SF = I
To the extent the country can import more than it
exports, investment is financed
imported consumer goods frees resources for domestic
investment
imported investment goods add directly to investment
Why M X is foreign saving
The balance of payments (BOP) is a record of all
transactions between residents and foreigners over
a period:
receipts of foreign currency
minus: payments of foreign currency

Therefore a positive (negative) BOP means the


economy is gaining (losing) foreign exchange
during the period.
Why M X is foreign saving
Balance of payments (BOP) divided into two parts:
Current Account (CA): transactions between
foreigners and residents involving currently
produced goods and services
Capital Account (KA): transactions between foreigners
and residents involving sales and purchases of
assets
The Current Account (CA)
Receipts (+) Payments ( )
Exports of goods Trade balance Imports of goods
Exports of non-factor Imports of non-factor services
services X M [GDP]

Exports of factor services Imports of factor services


X M [GNI]

Inward transfers Outward transfers


Current account [GNI]

Net exports of factor services + Net transfers = Net primary income


The Capital Account (KA)
Receipts (+) Payments ( )
Foreign loans to residents Loans made to foreigners
Foreign direct investment Filipino direct investment abroad
Foreign portfolio investment Filipino portfolio investment
Amortisation of loans made to Amortisation of foreign loans
foreigners
Capital account

So the capital account is equal to net foreign borrowing.


KA > 0 means the country is a net borrower
KA < 0 means the country is a net lender
Why CA is foreign saving
BOP = CA + KA
BOP > 0 means the country is accumulating foreign
exchange reserves.
BOP < 0 means the countrys reserves are being
depleted.
BOP = 0 means the reserves are neither being
augmented nor depleted (e.g., under a perfectly
flexible exchange rate system).
Why CA is foreign saving
If BOP = 0, then
CA = KA
M X = KA
But KA is net foreign borrowing. So
M X = CA = KA
is how much foreigners lend us in the net.
It is how much of their own saving we are able to use. So it is
equal to foreign saving SF, and
S + (M X) = I
S + SF = I
5.2 The capital account

Closed and open


Closed and open KA
The capital account may be closed or open:
Closed: foreigners nor residents are not allowed to
acquire each others assets or borrow from each
other (e.g., Cuba or North Korea).
Open: no restrictions on acquisition of each others
assets by both foreigners and residents, or on
overseas borrowing (US, EU countries, or
Singapore).
Closed and open KA
Most cases are somewhere in between, with
government restrictions on any or all of the
following:
foreign borrowing by domestic firms
acquisition of personal assets abroad by residents
portfolio investments by foreigners and residents
direct foreign investments in certain areas (e.g., nationality
requirements)
Open KA
Suppose the capital account of a country is fully open
and it is integrated with capital markets with the rest
of the world.
Foreigners and residents can borrow and lend with
each other.
Then the world interest rate will coincide with the
domestic interest rate: r = rW.
(Example: interest rates in EU countries)
Open KA
If r = rw, then the current account will be determined by
the saving-investment gap:
I(rW) S = SF = KA
= CA
=MX
The amount of foreign borrowing will determine how
much imports can exceed exports.
Open KA
r
S
The difference between
investment and saving is the
CA deficit (or surplus)

rW
I(r)

(M X) S, I
Closed KA
Suppose there is absolutely no foreign borrowing,
lending, or investment (e.g., Sudan, Ethiopia, or
North Korea).
Then by necessity KA = CA = 0 = (M X).
(M X) = 0
= I(r) S
which determines r = r. Then all investment must be
financed by domestic saving.
Closed KA
To the extent that some lending becomes available,
e.g., ODA, then a deficit becomes possible. (Note
this will not generally make domestic interest rates
equal world interest rates.)
Then (M X) = KA > 0
I(r) S = KA > 0,
which gives a new level of r = r.
Closed KA
r
S
M X = 0 implies that
investment cannot exceed
domestic saving

r0

rW
I(r)

MX=0 S, I
Closed KA with limited
access
r
to foreign borrowing
S
M X = KA > 0

The availability of foreign borrowing


allows the country to run a deficit,
reduce interest rates, and raise
r0 investment.

r1

rW
I(r)
KA > 0

MX=0 S, I
Open KA and fiscal policy
r
S
Higher G or lower T will
reduce saving S

and cause a deficit or


increase an existing one.

rW
I(r)

S, I
Open KA and higher
r
world interest rates
S
and cause a current
account surplus or reduce
an existing deficit.

rW

Higher world interest rates


reduce investment
spending
rW
I(r)

S, I
Closed KA and fiscal policy
Under a closed KA, expansionary fiscal policy will
raise interest rates and reduce investment.
But the CA will remain dependent on available
borrowing, KA = 0 or KA > 0.
Higher world interest rates will not affect an economy
with a closed capital account.
Dilemmas of the capital account
A closed capital account would unduly restrict the
countrys capacity to finance investment, hence
sacrifice growth.
But a fully open capital account makes the country
vulnerable to external shocks, like higher world
interest rates.
An anomaly
With an open capital account, investment and saving
should not be closely related to each other. This is
because any difference between the two can
always be made up for by borrowing or lending at
the world interest rate.
Empirically, however, saving and investment are
observed to be closely related to one another
(Feldstein-Horioka result). This is one of the biggest
paradoxes in macroeconomic theory.
5.2 Exchange rates
Exchange rates
An exchange rate is the price of one currency in terms
of another.
Examples:
P43 per US$ 100 per US$
US$1.50 per US$1.3 per euro
Appreciation: rise in the value of one currency in terms
of another
Depreciation: fall in the value of one currency in terms
of another
Conventions
Rate of depreciation: Let E = P/$
(new rate old rate)/(old rate)
d1 = (E1 E0)/E0
= (43 40)/40 or about 7.5 percent.
Alternatively, let 1/E = $/P:
d2 = [(1/E1) (1/E0)] / (1/E0)
= [(E1 E0)/ E0 E1] / (1/E0)
= (E1 E0)/E1
= (40 43)/43 or 6.9 percent
But here we use E = P/$. So a depreciation means a higher E,
while appreciation means a lower E.
Real exchange rate
ei = (peso price of foreign good i)
(peso price of local good i)
= (Epi) /Pi or E(pi/Pi)

Note that if ei is rising, the foreign good becomes less


competitive while the local goods appears cheaper.
ei can be higher if:
(a) E rises or the home currency depreciates;
(b) the foreign price pi rises; or
(c) the domestic price Pi falls.
Macro equivalent
Suppose e is the exchange rate, p is the foreign price
level (e.g., CPI) and P is the domestic price level.
The real exchange rate is defined as
e = E(p/P).
If e rises, the country gains in competitiveness and the
attractiveness of its products relative to foreign
ones.
e affects the Current Account
A higher e
makes home products look more attractive to
residents and foreigners alike; makes exports
X rise with e
makes foreign goods look expensive hence
reduces M.
Altogether, a higher e will raise net exports X M.
Current account and e
e
X-M

deficits

surpluses

0 XM
How is e determined?
e
SI
X-M

The real exchange


rate settles where
SI=XM

SI

0 X M
Open capital account
Algebraically:
S(YF) I(r) = X(e) M(e)
r = rW
So we can substitute:
S(YF) I(rW) = X(e) M(e)
which is used to determine e = e.
Open capital account
With an open capital account:
the world interest rate determines the saving-
investment gap and net foreign borrowing
which determines the supply of foreign exchange
which sets the real exchange rate.
Closed capital account
Algebraically:
S(YF) I(r) = X(e) M(e)
M(e) X(e)= 0, or KA0
Note that
M(e) X(e) = KA0
Is sufficient to determine e = e . Therefore
M(e) X(e) = M X.
Then
S(YF) I(r) = (M X)
is used to determine r = r.
Closed capital account
With a closed capital account
the fixed amount of lending determines available
foreign exchange and net exports
which determines the investment-saving gap
which determines the home interest rate.
Fiscal policy and the exchange rate
e
SI
X-M

e0
and causes foreign borrowing,
increases available foreign
exchange, and causes
real appreciation

e1

0
X M
Higher G lowers saving
Fiscal policy and the exchange rate
Open capital account
High government spending or low taxes reduces domestic
saving.
But investors can always borrow at the world interest rate and
do so.
The inflow of foreign exchange causes the currency to
appreciate.
Currency appreciation worsens the current account.
Fiscal policy and the exchange rate
Closed capital account
High government spending or low taxes reduce domestic
saving.
It raises domestic interest rates and reduces investment by
the same amount
so that the investment-saving gap is just equal to the
current account deficit
No change in the real exchange rate.
Summarising
The real exchange rate e is determined by
S(YF) I(rW) = X(e) M(e).
The price level P is determined by
M/P = L(rW,YF).
The nominal exchange rate E is
determined by
e = Ep/P.
Summarising
One implication:
At full employment, an increase in money
supply will cause a nominal (but not a real) currency
depreciation. The trade balance will not be affected.
At full employment, a bigger budget deficit will
cause real (and nominal) currency appreciation.
Sample question
What happens to the current-account
balance, the real and the nominal exchange
rate when ___?
(a) consumer spending falls.
(b) demand for money falls.
(c) protectionism reduces imports.
1. A fall in consumption
e
SI
X-M
e1
raises the CA surplus
and causes a real currency
e0 depreciation.

0
Higher saving X M
1. A fall in consumption
Higher saving reduces the amount of foreign
borrowing needed to finance investment which
remains the constant at I = I(rW).
The supply of dollars is reduced.
The peso depreciates.
Currency depreciation improves the current
account.
Real currency depreciation equals nominal
depreciation because prices have not changed.
2. Money demand falls
This means M/P > L(rW, YF)
So the price level P must rise to restore equality.
But e = Ep/P, and since e is unaffected, if P rises,
then E must also increase to keep e constant.
The current account is unchanged since it depends
only on e which is unchanged.
Money demand falls
With excess money supply, people try to exchange
pesos for dollars.
But the dollars available is fixed by the difference
between saving and investment.
So the peso depreciates nominally.
But this causes the price level to increase, since the
real exchange rate has not changed.
Higher prices restore equality of money supply and
demand.
Protectionism
Protectionism reduces imports and raises net exports
at all e.
This would have increased dollars available.
But there is no additional demand for dollars beyond
that dictated by S I.
So all that happens is that the peso appreciates.
Protection reduces
e
imports
Protection increases net exports
SI and foreign exchange .

X-M

e0
Greater supply of foreign currency
e1
causes currency to appreciate.

0
X M
But foreign exchange used
is fixed by S-I gap
Protection
Protection reduces the desired imports at all
exchange rates.
This by itself increases the dollars available.
But no more dollars are needed than is determined by
S I.
Greater supply and unchanged demand for dollars
means the peso appreciates.
Open economy
1. Suppose money supply increases in an open economy
(remember here r = rW).
This means M/P > L(rW, YF)
So the price level P must rise to restore equality.
But e = Ep/P, and since e is unaffected, if P rises, then E
must also increase to keep e constant.
The current account is unchanged since it depends only on
e which is unchanged.
In the long run, increasing money supply without
commensurate output growth will lead to inflation and a
nominal depreciation.
Open economy
With excess money supply, the domestic price level
rises.
Foreign goods become attractive and people want to
buy these; but the amount of dollars available is
fixed (by the difference between saving and
investment).
So as people try to change pesos to dollars, the peso
depreciates nominally.
The higher prices restore the equality of money supply
and demand.
Open economy
2. Suppose the government raises spending in an open
economy.
Saving falls but investment is the same, so foreign borrowing
increases; more dollars flow in and the peso appreciates in
real terms (but how?)
The money-market equilibrium is unaffected, so the price level
is unchanged.
As more dollars chase a fixed quantity of pesos, the nominal
exchange rate must fall to accomplish the real appreciation.
So, in an open economy, despite deficit spending, price
stability and a stable currency are possible at the cost of a
higher debt (e.g., Marcos period).
Open economy
3. Suppose income increases in an open economy.
Saving rises but investment is the same; so foreign borrowing
and the supply of dollars falls; the peso must depreciate in
real terms (question is: how?)
At the same time, money demand has risen due to rising
income. Excess money demand bids up the domestic price
level. This accomplishes a real depreciation (or the nominal
exchange rate may also rise).
So, rising income in an open economy is associated with
falling indebtedness, higher prices, and currency
depreciation.
End of chapter

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