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Lecture 12 Open-Economy

Lecture 12 Open-Economy . Open and Closed Economies. A closed economy is one that does not interact with other economies in the world. There are no exports, no imports, and no capital flows. An open economy is one that interacts freely with other economies around the world.

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Lecture 12 Open-Economy

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  1. Lecture 12 Open-Economy

  2. Open and Closed Economies • A closed economy is one that does not interact with other economies in the world. • There are no exports, no imports, and no capital flows. • An open economy is one that interacts freely with other economies around the world. • 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.

  3. Trade Balance • Exports are goods and services that are produced domestically and sold abroad. • Imports are goods and services that are produced abroad and sold domestically. • Net exports (NX) are the value of a nation’s exports minus the value of its imports. • Net exports are also called the trade balance. • A trade deficit is a situation in which net exports (NX) are negative. • Imports > Exports • A trade surplus is a situation in which net exports (NX) are positive. • Exports > Imports • Balanced trade refers to when net exports are zero—exports and imports are exactly equal.

  4. Foreign Exchange Rate •  An exchange rate between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency.For example, if the exchange rate of taka in terms of US dollar is 80 taka then it implies that $1 is equivalent to 80 taka or we need 80 taka to buy $1. • In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. 

  5. Determination of Exchange Rate • The exchange rate between domestic currency and foreign currency is determined by the supply and demand of foreign currency. In the figure we have the demand curve and supply curve of dollar ( in X axis we have the quantity of dollar and in Y axis we have the price of dollar in terms of taka that means how much 1 dollar is worth off). From the figure we can see that the equilibrium price of dollar in terms of taka is $1= 80 tk. and the total amount of dollar in the economy is $20 billion.

  6. 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 U.S. dollar. • And in units of U.S. dollars per one unit of the foreign currency. • Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one dollar. • One U.S. dollar trades for 80 yen. • One yen trades for 1/80 (= 0.0125) of a dollar.

  7. Demand and Supply Curve of Currency • Why does demand curve of dollar slopes downward? Explanation: The demand curve of foreign currency like US dollar shows how demand of dollar changes with the price of dollar. The demand curve of dollar is downward sloping because if the price of dollar falls then people will demand more dollar. The main demand of dollar comes from the importers. • Why does supply curve of dollar slopes upward? Explanation: The supply curve of dollar shows how the supply of dollar changes with the price of dollar. The supply curve of dollar is upward sloping because if the price of dollar increases then people will increase the supply of dollar. For Bangladesh main suppliers of dollar are exporters and migrants.

  8. Depreciation of Local Currency • Depreciation of local currency implies that there is a fall in value of the local currency in terms of foreign currency. If taka is depreciated against dollar then this implies that the value of taka is decreased. For example: Suppose the exchange rate of taka in terms of dollar was $1=80 taka. Now there is a depreciation of taka and the new exchange rate is $1=85 taka. So we need more taka to buy same amount of dollar as before. • How there can an depreciation of a local currency : If there is an increase in demand of dollar then there will a depreciation of taka

  9. Appreciation of Local Currency • Appreciation of local currency implies that there is an increase in value of the local currency in terms of foreign currency. If taka is appreciated against dollar then this implies that the value of taka has increased. For example: Suppose the exchange rate of taka against dollar was $1=80 taka. Now there is an appreciation of taka and the new exchange rate is $1=75 taka. So we need less taka to buy same amount of dollar as before which implies that the value of taka has increased ( appreciated) • How there can an appreciation of a local currency : If there is an increase in supply of dollar then there will an appreciation of taka

  10. Different Exchange Rate Regime • There mainly three types of exchange rate regime: 1) Floating/Flexible Exchange Rate Regime 2) Fixed Exchange Rate Regime 3) Managed Float Regime

  11. Floating Exchange Rate Regime • In this regime exchange rate is determined in the market that means by the supply and demand of foreign currency. Govt has no influence ( that means govt. don’t intervene ) in the foreign exchange market. • Exchange rate is determined by the intersection of demand and supply of foreign currency.

  12. Fixed Exchange Rate Regime • In this regime exchange rate is determined by the govt. not by the market demand and supply. So govt. fixes a rate at which the foreign currency will be transacted. For example: the govt. can fix the exchange rate at $1= 85 taka which is higher than the equilibrium exchange rate $1= 80 taka ( determined by the market). Or the govt. can fix the exchange rate at $1=75 taka which is lower than the equilibrium exchange rate. • If the govt. fixes the exchange rate higher than equilibrium exchange rate then there will be an excess supply of dollar. • If the govt. fixes the exchange rate lower than equilibrium exchange rate then there will be an excess demand of dollar.

  13. Govt. can influence the foreign exchange market by devaluation and revaluation Devaluation: The govt. can reduce the value ( devalue ) of the local currency so that a unit of the domestic currency can buy fewer units of foreign currencies than before. For example: in the previous graph it will be a situation like $1= 85 taka set by the govt. Revaluation: The govt. can increase the value of the local currency so that a unit of the domestic currency can buy more units of foreign currencies than before. For example: when the govt. sets the exchange rate $1= 75 taka, it is actually increasing the value of taka that means revaluating.

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