Class Test 2

1. Class Test 2 • Wednesday May 28 • Will set aside a room for those who wish to sit a paper-based test (still open book) • Email in a copy of answers if in doubt about correct submission • 25 multiple choice questions • Covers Lectures 6 – 10 • Chapters 7-16

2. Lecture 9: The Open Economy Principles and Macroeconomics

3. Lecture Objectives • 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

4. Assumptions • Taking a long-run perspective • GDP determined by available technology and factors of production • Economy’s price level is given • Uses the principles of supply and demand

5. 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

6. 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

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

8. The Flow of Goods: Net Exports • A trade deficit is a situation where net exports (NX) are negative. Imports > Exports • A trade surplus is a situation where net exports (NX) are positive. Exports > Imports

9. 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.

10. 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. • eg An Australian resident buys stock in the Toyota corporation and a New Zealand resident buys stock in BHP.

11. 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.

12. 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.

13. The Nominal Exchange Rate • The nominal exchange rateis 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

14. The Nominal Exchange Rate • Assume the exchange rate between the US dollar and the Australian dollar is $1AUS to US 65 cents. Then: • One $AUS trades for US 65 cents • One $US dollar trades for $AUS 1/0.65) or $1.54 (approx).

15. The Nominal Exchange Rate • If a dollar buys more foreign currency, there is an appreciation of the dollar. • eg one Australian dollar = 70 US cents • If it buys less there is a depreciation of the dollar. • eg one Australian dollar = 60 US cents

16. The Real Exchange Rate • The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.

17. Calculating the Real Exchange Rate • The real exchange rate depends on the nominal exchange rate and the prices of goods in the two countries measured in local currencies.

18. 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

19. Example: a change in the value of the currency • 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.

20. The 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.

21. 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 2 countries is affected by prices in those countries

22. Implications of PPP • Increasing prices, relative to another country, may result in a depreciation in the value of the currency • BUT • Not all goods are easily traded • Not all imported goods are perfect substitutes for domestically produced goods

23. The Macroeconomics of an Open Economy

24. 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.

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

26. 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

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

28. The Market for Foreign-Currency Exchange • For an economy as a whole, NFI = NX must balance each other out. • NFIrepresents 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.

29. The Market for Foreign-Currency Exchange • 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.

30. The Market for Foreign-Currency Exchange • 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.

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

32. 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.

33. The Linkage between markets

34. 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.

35. 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.

36. Equilibrium in the Open Economy • As they do, they determine the macroeconomic variables of national saving, domestic investment, net foreign investment, and net exports.

37. (a) The Market for Loanable Funds (b) Net Foreign Investment Real Real Supply Interest Interest Rate Rate r1 r 1 Net foreign Demand investment, NFI Quantity of Net Foreign Loanable Funds Investment Real Supply Exchange Rate E1 Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

38. 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

39. 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.

40. Real Real Interest Interest Rate Rate Net Foreign Quantity of Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment Real Exchange Rate (c) The Market for Foreign-Currency Exchange Quantity of Dollars

41. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S1 Demand NFI Real S1 Exchange Rate Demand Quantity of Dollars (c) The Market for Foreign-Currency Exchange

42. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S1 A r1 r1 Demand NFI Real S1 Exchange Rate E1 E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

43. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S1 A r1 r1 Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S1 Exchange Rate E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

44. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S2 S1 A r1 r1 Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S1 Exchange Rate E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

45. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S2 S1 B r2 r2 A r1 r1 Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S2 S1 Exchange Rate E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

46. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S2 S1 B r2 r2 A r1 r1 2. which increases the real interest Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S2 S1 Exchange Rate E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

47. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S2 S1 B r2 r2 A r1 r1 3. which in turn reduces net foreign investment. 2. which increases the real interest Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S2 S1 Exchange Rate E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

48. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S2 S1 B r2 r2 A r1 r1 3. which in turn reduces net foreign investment. 2. which increases the real interest Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S2 S1 Exchange 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… Rate E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

49. Real Real Interest Interest Rate Rate Quantity of Net Foreign Loanable Funds Investment (a) The Market for Loanable Funds (b) Net Foreign Investment S2 S1 B r2 r2 A r1 r1 3. which in turn reduces net foreign investment. 2. which increases the real interest Demand NFI 1. A budget deficit reduces the supply of loanable funds... Real S2 S1 Exchange 4. The decrease in net foreign investment reduces the supply of dollars to be exchanged into foreign currency… Rate E2 5. …which causes the real exchange rate to appreciate. E1 Demand (c) The Market for Foreign-Currency Exchange Quantity of Dollars

50. 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.