Chapter 29 Open economy macroeconomics

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Chapter 29Open economy macroeconomics

• MIS 112
• Spring 2003

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Open economy macroeconomics

• 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
• Domestic macroeconomic policy in such countries
  cannot ignore the influence of the rest of the
  world
• especially via the exchange rate.

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• 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.
• For Turkish residents an exchange rate of x/TL
  measures the international value of TLThe number
  of units of foreign currency (dollars) that
  exchanges for one unit of domestic currency TL

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Example

• Currently 1 is1.5 million TL or
• TL1,500,000/ 1,500,000 is required to purchase
  one dollar but
• the notion of exchange rate in our analysis is
  just the reverse
• the question should be asked in the reverse
  direction
• how many dollars (amount of foreign currency) is
  required to purchase one TL 6.6610-7/TL is the
  exchange rate

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• Where as in daily life we are interested in how
  many TL is required to purchase 1
• this is the reverse of definition of exchange
  rate presented in this chapter

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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 shows the demand for TL by others wanting to
buy Turkish goods/assets.
When Turkey is selling goods to foreigners they
bring Turkish exporter exchange this with TL
so TL demand increase.
e0
Exchange rate (/TL)
e1
When foreigners want to buy Turkish assets
shears or bond they bring and demand TL
DD
As the exchange rate falle Turkish goods become
cheaper to foreigners hence export demand
increases
Quantity of TL
.
The demand for TL is downward sloping
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• Suppose the price of Turkish goods is the same
• what happens if e? that is say dollar value of
  TL? from 8.010-6 to 6.010-6
• if the tone of wheat is 1 million
• for foreigners it decreases from
• 11068.010-7 8.010-1 to 11066.0.10-7
  6.010-1 or from 0.8 to 0.6
• wheat is cheaper for foreigners so export demand ?

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Foreigners
dollar
Turkish exporters
wheat
Turkish exporters convert dollars to TL so when
exporting wheat TL demand increases if e ?
exports demand ? and TL demand?
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Supply of foreign exchange - the international
market in which one national currency can be
exchanged for another.
The price at which two currencies exchange is the
exchange rate.
SS shows the supply for TL by Turkish residents
wishing to buy foreign goods/assets.
When Turkey is buying goods form foreigners they
need Turkish importer exchange TL with so TL
supply increase to the forex market.
SS
e0
Exchange rate (/TL)
e1
When Turks want to buy foreign assets shears or
bond they need and supply TL to the forex market
As the exchange rate falls foreign goods become
expensive to Turkish importers hence import
demand decreases .
Quantity of TL
The supply for TL is upward sloping
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• Suppose the price of foreign goods is the same
• what happens if e? that is say dollar value of
  TL? from 8.010-7 to 6.010-7
• if unit price of a chip is 500
• for Turkish citizens its price increases from
• 500/8.010-76.25108 to 500/6.010-78.3108
• chip is expensive for Turkish citizens so
  imports demand ?
• hence demand ? and TL supply in the forex
  market ?,

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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.
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The foreign exchange market - the international
market in which one national currency can be
exchanged for another.
Equilibrium exchange rate is e0 The quantity of
TL supplied and demanded is equal
If at each TL price demand by foreigner for
Turkish goods and assets increases
DD schedule for TL will shift to the right from
DD to DD1
SS
DD1
Will increase
DD
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The foreign exchange market - the international
market in which one national currency can be
exchanged for another.
Equilibrium exchange rate is e0 The quantity of
TL supplied and demanded is equal
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• When the -TL exchange rate increases
• the TL has appreciated
• the international value of TL has risen
• When the -TL exchange rate falls
• the TL has depreciated
• the international value of TL is lower

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Alternative exchange rate regimes

• In a fixed exchange rate regime
• the national governments agree to maintain the
  convertibility of their currency at a fixed
  exchange rate
• A currency is convertible
• if CB agree to buy or sell as much of the
  currency as people wish to trade at the fixed
  exchange rate
• The foreign exchange reserves
• are the stock of foreign currency held by the CB

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Intervention in the forex market
Suppose the government is committed to
maintaining the exchange rate at e1 ...
SS
/
B
e1
D
DD
Quantity of s
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Intervention in the forex market
Suppose the demand schedule for TL shifts to DD2
SS
/
B
e1
D
DD
Quantity of s
When demand is DD, no intervention is needed ...
there is a balance in transactions between the
countries.
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• If demand for TL on average is DD2
• CB will be running down forex reserves to support
  TL at e1
• TL is overvalued or at a higher international
  value than is warranted by its long run
  equilibrium position
• As reserves start to run out
• the gov. may try to borrow forex from IMF but
  this a temporary solution

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• Unless the demand for TL increases in the
  long-run
• it will be necessary to devaluate TL
• in a fixed exchange rate regime
• a devaluation (revaluation) is reduction
  (increase) in the ex rate that government commit
  themselves to maintain

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The 2000 stabilisation program

• The -TL exchange rate was high
• There is an excess supply of TL or an excess
  demand for dollar
• As TL is convertible
• CB uses its dollar reserves to supply any dollar
  demanded
• After some point devaluation is inevitable

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• 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.

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Floating exchange rates forex market
As the demand curve for TL fluctuates from DD1 to
DD2
SS
/TL
B
e1
A
e1
e2
D
DD
Quantity of TLs
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After 2001 Financial Crisis

• Exchange rates are floating in Turkey
• The C.B. Intervensiton to the forex market is at
  a minimum level

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The balance of payments

• a systematic record of all transactions between
  residents of one country and the rest of the
  world
• Consider Turkey as the domestic country
• all inflows of TL are recorded as
• exports Turkish goods are out flowing
• dollars is flowing in which are
• converted to TL so there is a inflow of TL
• all outflows of TL are recorded as -
• imports dollars is out
• CB takes TL and pays dollars to foreigners
• so TL is out of the system

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The balance of payments

• Current account
• records international flows of goods, services,
  income and transfer payments
• Visible trade export or imports of goods
• cars
• Invisible trade export or import of services
• banking, shipping, tourism
• net exports X - M of visibles and invisibles
• transfers foreign aid, income from abroad
• net transfers net foreign aid net income from
  abroad
• current accountnet exportsnet transfers

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The balance of payments

• Capital account
• records transactions involving financial assets
• When Turkish residents buy foreign assets
• outflow of money
• capital account is -
• When foreigners buy Turkish assets
• inflow of money
• capital account is
• Trade balance current account capital account
  adjustments

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The balance of payments

• Trade balance current account capital account
  adjustments
• Whenever there is a net inflow of money to the
  domesitc country TB is
• Whenever there is a net outflow of money to the
  domestic country TB is -

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The balance of payments

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

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Floating exchange rates and the balance of
payments

• If the exchange rate is free to move to its
  equilibrium, there is no need for intervention
• any current account imbalance is exactly matched
  by an offsetting balance in capital/financial
  accounts
• TB 0 CurA Cap A/Fin A so
• Cur A - Cap A/Fin A
• if there is a CurA surplus there is CapA deficit
  or vica versa

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Floating exchange rates and the balance of
payments

• If the exchange rate is free to move to its
  equilibrium, there is no need for intervention
• TL demanded TL supplied
• inflows of TL outflows so TB 0
• any current account imbalance is exactly matched
  by an offsetting balance in capital/financial
  accounts
• if there is some slight intervention, it is
  recorded as part of the financial account.

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Fixed exchange rates

• Balance of payments need not be zero
• when there is a deficit,
• total outflows gt total inflows
• on the Cur ACap A
• supply of TL to the forex gt demand for TL
• to import
  to export
• CB has to offset this excess supply of TL by
  demanding an equivalent quantity of TL
• CB runs down forex reserves selling to buy TL
• in the balance of payments this shows up as
  offical finaning

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• When there is a balance of payments surplus
• CB buy forex reserves so
• reserves increase
• When there is a BP deficits
• reserves must be sold
• Trade balance Official Financing

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International competitiveness

• The competitiveness of Turkish goods in
  international markets depends upon
• the nominal exchange rate
• relative inflation rates
• 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

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Real exchange rate

• Suppose 1 is 1 billion TL
• lets redefine exchange rate as the amount of
  dollars required to purchase one billion TL (not
  1 TL)
• e 1/bTL
• if e ? to 0.666(2/3) /bTL
• Can we say any thing about the effect of the
  change of the quantity of exports or imports?

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• Consider a shirt whose price is
• 10 in US
• 10 million in Turkey
• What can we say about competitveness of Turkish
  economy
• Price of shirt in US
• Price of shirt in Turkey

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• Turkey has a higher inflation rate than most of
  the world or US
• Suppose inflation rate in Turkey is 50 and in US
  is 5 during the same period
• if there were no change in prices foreigners has
  to bring 6.666 s to purchase the same shirt but
• The price of shirt increased as well from 10 to
  15 billion TL

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• So foreigners has to pay
• 0.66615 10 to purchase the same shirt
• no change in the purchasing power of foreigners
• PUS/PTr 10/6.6661510/101 same
• The two shirts has the same price
• Competitiveness of Turkey and US are stell the
  same
• Is it the end of the story?

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No

• Since there is also a slight inflation in the
  world (5)
• the purchasing power of the 10 last year and
  today is not the same
• the purchasing power of 10 has decline to
• 10(1/1.05)9.52 or
• the equivalence of yesterdays 10 is
• 10.5 today

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• With the same 10 foreigners can purchase
• 150.6666/1.050.952 shirts in Turkey
• PUS/PTr 10.5/6.6661510.5/101.05
• US shirt is a bit expensive
• Considering exchange rate depreciation, and
  inflation in Turkey and US
• In this example the competitiveness of Turley is
  increased
• Whereas competitiveness of uS has decreased

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• The competitiveness depends on
• change in nominal exchange rate
• change in the price level in Turkey
• inflation rate in Turkey
• changes in inflation rate in the rest of the
  world (US)

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Real Exchange Rate

• Real exchange rate is define as
• the nominal rate multiplied
• by the ratio of domestic to foreign prices
• er Pdomestic e
• Pforeigners
• or in particular
• er PTurley e
• PUS

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Competitiveness and Real Exchange rate

• An increase in Turkish er makes Turkey less
  competitive relative to US or others
• A fall in Turkish er makes Turkey more
  competitive relative to US or others

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Purchasing Power Parity

• The purchasing power parity PPP
• exchange rate path is the path of the nominal
  exchange rate that would keep the real exchange
  rate constant over a given period

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The current account is influenced by

• Exports
• foreign income
• the higher the level of income in the rest of the
  world
• the higher will be the demand for the domestic
  (Turkish) exports
• YW ? ?X ?

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• Competitiveness
• the lower the real exchange rate of the domestic
  country (Turkey)
• or the higher the competitiveness of the domestic
  country (Turkey)
• the higher will be the demand for the domestic
  countrys (Turkish) exports
• er ? or competitiveness? ?X?

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• Exports response quickly to changes in the level
  of world income
• A reduction in competitiveness is likely to
  reduce exports gradually
• exporters may be unsure whether the decline in
  competitiveness is
• temporary or
• permanent

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• Imports
• domestic income
• the higher the level of income in the domestic
  country (Turkey)
• the larger will be the demand for domestic
  (Turkish) imports
• YD ? ?Z?

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• Competitiveness
• the higher the real exchange rate of the domestic
  country (Turkey)
• or the lower the competitiveness of the domestic
  country (Turkey)
• the higher will be the demand for the domestic
  countrys (Turkish) imports
• er ? or competitiveness? ?Z?

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• Imports response more quickly to changes in the
  level of domestic income than to changes in the
  real exchange rate
• If sustained, a change in the real exchange rate
  will eventually have significant effects on the
  level of imports as well as exports

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Other items on the current account

• Foreign aid
• military expenditures
• Net flow of interest, dividend and profit income
  between countries

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Capital Accout is influenced

• The capital account is influenced by
• relative interest rates
• which affect international capital flows.
• Perfect capital mobility
• an enormous quantity of funds will be transferred
  from one currency to another whenever the rate of
  return on assets in one country is higher than in
  another
• Perfect capital mobility
• occurs when there are no barriers to capital
  flows, and investors equate expected total
  returns on assets in different countries

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• Speculation
• is the purchase of an asset for subsequent
  resale,
• in the belief that the total return
• interest or dividendthe capital gain
• will exceed the total return that can be obtained
  in other assets

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• You have 100 million to invest for a year
• Turkish interest rates are 50 per annum
• interest rates in US are 0
• lending in Turkey
• 100(10.5)150 m TL

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• buy at the beginning of the year
• lend in for a year
• convert the money back in to TL at teh end of the
  year
• Exchange rate 1/mTL
• 100 mTL will by 100
• at the end of the year at a zero interest rate
  100 at the end of the year
• TL has depreciated by 50 during a year

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• At the end of the year
• e 0.666 /mTL
• 100 will convert back to 100/0.666150m TL at
  the end of the year
• You end up with 150 mTL whether you lend in or
  TLs during the year

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• Return on foreign domestic
• foreign interest currency
• lending rate depreciation

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• return on foreign landing gt return on domestic
  lending (domestic interest)
• huge capital outflow
• return on domestic lending gt return on foreign
  landing
• huge capital inflow
• return on domestic lending return on foreign
  landing
• net flow of capital account is almost zero