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THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments

THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments 2. The foreign exchange (forex) market 3. Fixed v floating exchange rates 4. Single currency areas 5. Globalisation and macro policy. What is the balance of payments?

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THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments

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  1. THE OPEN ECONOMY: INTERNATIONAL ASPECTS OF THE MACRO-ECONOMY 1. The balance of payments 2. The foreign exchange (forex) market 3. Fixed v floating exchange rates 4. Single currency areas 5. Globalisation and macro policy

  2. What is the balance of payments? Why are policy makers concerned about the BP? How can govts ‘correct’ a BP problem? How are exchange rates determined? How can the CB affect the exchange rate? Is a single currency for Europe desirable? Should the G3 (G7) co-ordinate their macro-policies?

  3. THE BALANCE OF PAYMENTS • records all flows of money between countries • BP = current acc + capital acc • Current account (or financial account) • - exports minus imports of goods / services • - govt transfers (e.g. EU taxes / subsidies) • Capital account • - fixed investment (FDI) • - bonds, equities, deposits (portfolio investment)

  4. UK Current account Exports +165 Imports -192 Services +11 Net income +7 Net govt transfers -4 Balance -13 UK Capital account FDI (net) +173 Portfolio (net) -143 Short-term flows (net) -23 Balance +10 Reserves +1 Error -2 Balance of payments 0

  5. Surpluses and deficits in the BP Surplus: BP > 0 - foreign exchange reserves increase - accumulation of foreign assets - exchange rate ‘too high’ Deficit: BP < 0 - foreign exchange reserves decline - loss of foreign exchange reserves - deficit has to be financed (borrowing) - loss of control over domestic assets - downward pressure on exchange rate; inflationary

  6. Determinants of the BP • BP = exports - imports + net capital flows • exports = f (exch rate, competitiveness, world income) • imports = f (exch rate, competitiveness, income) • net capital flows = f (r / world r, country risk) • Model: BP = f ( e, w/w*, y*, y, r/r*) • e = exchange rate (£/$) • w = real wage; w* = world real wage • y = income y* = world income • r = interest rate r* = world interest rate

  7. Govt intervention to ‘correct’ the BP • exchange rate policy: buying / selling domestic currency • fiscal / monetary policy to control AD • - raise / lower r (capital account) • - change G or T (trade account) • supply-side policies • - improve competitiveness via labour market flexibility

  8. THE FOREX MARKET

  9. The exchange rate • e = £ per $ (or s = $ per £) • Determination of e: a simple model • Demand for £s (= supply of $s) • importers of UK goods / services • tourists visiting UK • foreign students in UK universities • foreigners investing in UK • UK citizens with foreign income • Supply of £s (= demand for $s) • opposite to above

  10. Model: e = f ( x - m, r - r*) • When will exchange rate appreciate? • Current account: • demand for exports increases • demand for imports decreases • competitiveness increases (w / w* increases) • Capital account: • inflow of foreign investment (r / r* increases)

  11. FIXED v FLOATING EXCHANGE RATES • Advantages of a fixed exchange rate • certainty for exporters / importers/ investors • ‘no speculators’ within single currency area • imposes constraints on govt macro policy • - constrained by effect on BP • - constrained by effect of policies on inflation • - govt has to achieve BP equilibrium over medium term

  12. Disadvantages of a fixed exchange rate • economic policy will be constrained by fixed ER • - chronic BP deficit requires deflationary policy • - conflict between full employment and BP equilibrium • sudden ‘shocks’ cannot be absorbed by ER adjustment • - shocks affect ‘real’ economy if prices are fixed • fixed ER encourages ‘protectionism’ • - due to impact of shocks on ‘real’ variables • speculators cause financial / political crises

  13. Advantages of floating exchange rates • govt ignores ER; no intervention needed • no need to worry about BP • economy is insulated from shocks (absorbed by ER) • govt can concentrate on internal policy objectives • (inflation, unemployment, income distribution)

  14. Disadvantages of floating exchange rates • exchange rate can be volatile in the short run • - causes uncertainty (harmful to investment / trade) • capital flows can cause ER to get ‘out of line’ with its • underlying (fundamental) value • loss of BP constraint on macro-policy may lead to • inflationary bias • - with a fixed ER, govt has to respond to BP deficits

  15. SINGLE CURRENCY AREAS • Advantages of a single currency • lower transactions costs (no currency conversions) • increased price competitiveness • - transparent pricing across countries • elimination of exchange rate uncertainty • - encourages trade • - encourages investment (inc. FDI) • lower inflation and interest rates • - central bank independent of member govts • - member states have to keep wage increases in line • to maintain competitiveness

  16. Disadvantages of a single currency • surrenders economic sovereignty to supra-national • authority • - no control over monetary policy • - no control over exchange rate • deflationary effects in countries with high wage pressures • increase in regional disparities due to greater • factor mobility • potential loss of control over fiscal policy • - cannot use monetary expansion to pay for increase in G • - tight control over govt borrowing (fiscal balance needed)

  17. Why might the Euro Zone not be an optimal currency area? • labour markets are not flexible enough • - wages may be sticky downwards • - labour is not sufficiently mobile to respond • to changes in demand • - effects of changes in euro ER will vary between • member states / regions • But: alternative methods of dealing with adverse effects of • structural change • - structural funds for re-training • - structural funds for encouraging indigenous growth • - infrastructure policies to revive declining regions

  18. GLOBALISATION AND MACRO POLICY • Interdependence • world’s economies increasingly inter-dependent • steadily increasing world trade • - dependent on each other’s demand for exports • vast increase in financial flows due to liberalisation • of financial markets • - abolition of controls on currency movements • - financial markets affect each other (instantaneously) • - Fed has profound effect on rest of world’s economies

  19. Co-operation between G7: policy harmonisation • need for policy harmonisation to prevent world-wide • recession / inflation • - exchange rates should not be ‘out of line’ • (need to keep current accounts in reasonable balance) • - inflationary pressures are easily transmitted to other • countries • - co-ordination of interest rates may be needed to • prevent adverse capital flows • G7 needs to deal with the problem of developing country • debt

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