Open-Economy Macroeconomics: Basic Concepts Course Instructor: Dr. Amarendu Nandy Assistant Professor Indian Institute of Management, RanchiClosed vs. Open Economies e Aclosed economy does not interact with other economies in the world. o There are no exports, no imports, and no capital flows. e An open economy interacts freely with other economies around the world. o 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.Closed vs. Open Economies O © Openness of an economy covers three important aspects: © Goods Market Openness — refers to free exchange of commodities across national borders. This has been growing as many LDCs have moved towards a policy of greater integration with global markets. © Capital Market Openness — relates to international trade in financial assets (Capital refers to financial, not physical, capital). Investors today have more freedom to choose between domestic and foreign assets. It is now much easier for foreigners to acquire assets in India (share of an Indian company, Gol bond). Indian firms have greater ability to raise to finance abroad due to relaxation of capital controls. ‘© Factor Market Openness — refers to the ease with which factors of production can move across geographical boundaries without facing serious restrictions.Closed vs. Open Economies e Degree of Openness © Total foreign trade (export + import) as a proportion of GDP » India — 8 percent in 1970 to around 48 percent in 2013 © Value of import duties as a proportion of value of imports — reduction implies greater openness (lower import restrictions) » 53 percent in 1987; 46 percent in 1991 to approx. 20 percent in recent years.Macroeconomic Variable Determination in an Open Economy e The important macroeconomic variables of an open economy include: © net exports (NX) © net capital outflow (NCO) © nominal exchange rates (e) © real exchange rates (eP/P*) © real interest rates (r) © Loanable funds (LF=I=S) ° The values of these variables are determined through the interaction of: the Loanable Funds Market, the Net Foreign Investment Market, and the Market for Foreign-Currency Exchange.The Flow of Goods & Services e Exports: domestically-produced g&s sold abroad e Imports: foreign-produced g&s sold domestically e Net exports (NX), aka the trade balance = value of exports — value of importsThe Flow of Goods & Services ¢ A trade deficit is a situation in which net exports (NX) are negative. o Imports > Exports e A trade surplus is a situation in which net exports (NX) are positive. o Exports > Imports ¢ Balanced trade refers to when net exports are zero—exports and imports are exactly equal.Variables that affect NX What do you think would happen to India’s net exports if: A. U.S. experiences a recession (falling incomes, rising unemployment) B. Indian consumers decide to be patriotic and buy more products “Made in India” C.. Prices of goods produced in U.S. rise faster than prices of goods produced in the IndiaAnswers A. U.S. experiences a recession (falling incomes, rising unemployment) India’s net exports would fall due to a fallin U.S. consumers’ purchases of Indian exports B. Indian consumers decide to be patriotic and buy more products “Made in India” India’s net exports would rise due to a fallin importsAnswers —O C. Prices of U.S. goods rise faster than prices of Indian goods This makes Indian goods more attractive relative to U.S. goods. Exports to U.S. increase, imports from U.S. decrease, So India’s net exports increase.Variables that Influence Net Exports Consumers’ preferences for foreign and domestic goods Prices of goods at home and abroad. Incomes of consumers at home and. abroad The exchange rates at which foreign currency trades for Coinage? gay domestic currency ss Transportation costs Govt. policies towards international tradeINDIA BALANCE OF TRADE osm sn 20000 2006 2008 i 2012 2014 SOURCE: WH. TRADNCECONOMIS.COM | MNSTRY OF COMMERCE AND MOUSTRY, NOUUS BALANCE OF TRADE 20000 oa 5 70000 2006 2008 2010 2012 2014The Flow of Capital ¢ Net capital outflow (NCO): purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners + E.g. — An Indian resident buys stock in the Toyota Corporation and (-) a Malaysian buys stock in Infosys. ¢ NCO is also called net foreign investment (NFI). « Alternatively, NCO is the net flow of funds being invested abroad by a country during a certain period of time. A positive NCO means that the country invests outside more than the world invests in it; a negative one, that the world invests in the country more than the country invests in the world.The Flow of Capital ‘The flow of capital abroad takes two Differences between FDI & Fil Foreign direct investment (FDI) flows into the primary Forei 7 i. ' market whereas foreign institutional investment (FI!) © Foreign direct investment: foyc into the secondary market, that is, into the stock Sere market. All other differences flow from this pri F primary manage the foreign investment, _gifference. e.g., Nirula’s opens a fast-food outlet in New York. FDI is perceived to be more beneficial because it increases production, brings in more and better products and services besides increasing the employment Cp erent) ‘opportunities and revenue for the Government by way of investment: taxes. Domestic residents purchase Foreign stocks or bonds, Fil, on the other hand, is perceived to be inferior to FDI supplying “loanable funds” toa because it only widens and deepens the stock foreign firm. ‘exchanges and provides a better price discovery process for the scrips. There is a widespread notion that Fil inflows are hot money - that it comes and goes, creating volatility in the stock market and exchange rates.The Flow of Capital NCO measures the imbalance in a country’s trade in assets: o When NCO > 0, “capital outflow” Domestic purchases of foreign assets exceed foreign purchases of domestic assets. o When NCO < 0, “capital inflow” Foreign purchases of domestic assets exceed domestic purchases of foreign assets.Variables that Influence NCO Real interest rates paid on foreign assets ¢ Real interest rates paid on domestic assets e Perceived economic and political risks of holding foreign assets ¢ Govt. policies affecting foreign ownership of domestic assetsThe Equality of NX and NCO e An accounting identity: NCO = NX © arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) e When a foreigner purchases a good from India, o India’s exports and NX increase o the foreigner pays with currency or assets, so India acquires some foreign assets, causing NCO to rise.The Equality of NX and NCO e An accounting identity: NCO = NX o arises because every transaction that affects NX also affects NCO by the same amount (and vice versa) e When an Indian citizen buys foreign goods, o India’s imports rise, NX falls o The Indian buyer pays with Indian rupees or assets, so the other country acquires Indian assets, causing India’s NCO to fall.Saving, Investment, and International Flows of Goods & Assets Y=C+1I+G+NX accounting identity Y-C-G=I+NX rearranging terms S=I+NX since S=Y-C-G S=I+NCO since NX = NCO o When S > J, the excess loanable funds flow abroad in the form of positive net capital outflow. o When S < J, foreigners are financing some of the country’s investment, and NCO < o.International Flows of Goods and Trade Deficit Capital: Summary Balanced Trade Trade Surplus Exports < Imports Net exports < 0 WesCo caG) Saving < Investment Net capital outflow < 0 Exports = Imports Net exports = 0 Y=C+I+G Saving = Investment Net capital outflow = 0 Exports > Imports Net exports > 0 VWs (Gsr far G Saving > Investment Net capital outflow > 0Case Study: The U.S. Trade Deficit e Is the USS. trade deficit a problem? o The extra capital stock from the ’90s investment boom yielded reasonable returns. © The fall in saving of the ’80s and 00s, while not desirable, at least did not depress domestic investment, as firms could borrow from abroad. e Acountry, like a person, can go into debt for good reasons or bad ones. e A trade deficit is not necessarily a problem, but might be a symptom of a problem.Case Study: The U.S. Trade Deficit ¢ So far, the U.S. earns higher interest rates on foreign assets than it pays on its debts to foreigners. ¢ But if U.S. debt continues to grow, foreigners may demand higher interest rates, and servicing the debt would become a drain on U.S. income.The Nominal Exchange Rate ¢ Nominal exchange rate: the rate at which one country’s currency trades for another. It is thus a bilateral concept. e We express all exchange rates as foreign currency per unit of domestic currency.Effective Exchange Rate (-~* It is the weighted average of nominal rates, the weights being the shares of the respective countries in the trade of the country (either export or import) for which the EER is being calculated. e Example: suppose India trades only with the USA (share 60%) and Japan (share 40%) & NERs of the rupee are 50 for the dollar & 10 for the yen. « EER = 0.6(50) + 0.4(10) = 34 « Interpretation: For Rs. 34 one can buy a basket consisting of 0.6 dollar and 0.4 yen.Appreciation and Depreciation e Appreciation (or “strengthening”): an increase in the value of a currency as measured by the amount of foreign currency it can buy ¢ Depreciation (or “weakening”): a decrease in the value of a currency as measured by the amount of foreign currency it can buy Terminology for Changes in Exchange Rates Type of exchange Exchange rate increases Exchange rate decreases rate system (currency strengthens) (currency weakens) Flexible exchange rates Appreciation Depreciation Fixed exchange rates Revaluation DevaluationThe Real Exchange Rate e Real exchange rate: the rate at which the g&s of one country trade for the g&s of another e Realexchangerate= _©*_ where P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate, i.e., foreign currency per unit of domestic currencyExample With One Good e A Big Mac costs $2.50 in U.S., 400 yen in Japan ° e=120 yen per $ e ex P= price in yen of a U.S. Big Mac = (120 yen per $) x ($2.50 per Big Mac) = 300 yen per U.S. Big Mac ¢ Compute the real exchange rate: exP 300 yen per U.S. Big Mac P= 400 yen per Japanese Big Mac 0.75 Japanese Big Macs per US Big MacInterpreting the Real Exchange Rate “The real exchange rate = 0.75 Japanese Big Macs per U.S. Big Mac” Correct interpretation: To buy a Big Mac in the U.S., a Japanese citizen must sacrifice an amount that could purchase 0.75 Big Macs in Japan.The Real Exchange Rate With Many Goods P = Indian price level, e.g., Wholesale/Consumer Price Index, measures the price of a basket of goods P* = foreign price level Real exchange rate = (ex P)/P* = price of a domestic basket of goods relative to price of a foreign basket of goods ¢ RER is often taken as a measure of the country’s international competitiveness. ¢ If Indian real exchange rate appreciates, Indian goods become more expensive relative to foreign goods.Real Effective Exchange Rate This is the overall RER for the economy. It is the weighted average of the RERs for all its trade partners, the weights being the share of the respective countries in its foreign trade. « Example: assume India has a single trading partner-the USA. So, EER = NER & REER = RER; e = nominal exchange rate = 40, P* = $4 & P = Rs.10, hence RER = 16. * 16 units of the home good are needed to buy 1 unit of USA good.India’s REER (Base: 1993-4 = 100) O 2003-04 69.97 99.17 2004-05 69.58 101.78 2005-06 72.28 107.30 2006-07 69.49 105.57 2007-08 74.76 114.23 2008-09 65.07 104.34 2009-10 62.87 104.56 Source: Economic Survey 2010-11Spot Exchange Rate The spot rate of exchange between two countries is the rate applicable for immediate delivery (within 2 days). e Example: Price PC = $100; e = 30 & the domestic price (fixed) Rs. 40,000. Profit = Rs. 37,000 e Rupee depreciate e = 40; profit = Rs. 36,000.Forward Exchange Rate « The forward exchange rate applies to agreements for an exchange of two currencies at an agreed date in future. « The date of exchange as well as the rate of exchange are fixed in advance at the time of writing the contract. The chief utility of forward rate is that it provides protection against exchange rate risk created by possible future variation in the spot rate. * 30 day forward contract ef = 35; Guaranteed profit = Rs.36,500 (minus the fee charged by the bank.)Nominal Depreciation and Real Depreciation * Example: e = 40 ($1=Rs. 40), price of refrigerator made in India = Rs. 40,000 > Will sell for $1000 in the USA. * Rupee depreciates so that e = 50. Refrigerator becomes cheaper in dollars ($800) and thus more competitive with refrigerators from other countries to the US market and its demand (our exports) will increase. * However, if along with the depreciation of the rupee our price level (P) also rises to the same extent, there may not be any change in the RER and export will not rise. * Consider this: If e = 50, and domestic price of refrigerator is now = Rs. 50,000, the dollar price stays the same as before ($1000), and there will be no effect on competitiveness and sales. * The nominal depreciation (rise in e) has failed to generate real depreciation. Exports will not change. For real depreciation to take place, nominal depreciation must not be offset by domestic inflation (rise in P).The Law of One Price e Law of one price (LOOP): the notion that a good should sell for the same price in all markets o Suppose coffee sells for Rs. 400/kg in Kochi and Rs. 700/kg in Ranchi, and can be costlessly transported. o There is an opportunity for arbitrage, making a quick profit by buying coffee in Kochi and selling it in Ranchi. o Such arbitrage drives up the price in Kochi and drives down the price in Ranchi, until the two prices are equal.Purchasing-Power Parity (PPP) ¢ Purchasing-power parity: a theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries o based on the law of one price (LOOP) o implies that nominal exchange rates adjust to equalize the price of a basket of goods across countriesPurchasing-Power Parity (PPP) e Example: The “basket” contains a Big Mac. P = price of US Big Mac (in dollars) P* = price of Japanese Big Mac (in yen) e = exchange rate, yen per dollar e According to PPP, exP= P* , \ price of Japanese Big Mac, in yen = Solve for e:PPP and Its Implications ¢ PPP implies that the nominal exchange rate between two countries should equal the ratio of price levels. If the two countries have different inflation rates, then e will change over time: c If inflation is higher in U.S. than in the India, then P* rises faster than P, so e rises — the rupee appreciates against the dollar. o Ifinflation is higher in India than in U.S., then P rises faster than P*, so e falls — the rupee depreciates against the dollar.Exchange Rates © e Purchasing Power Parity © When PPP doesn’t hold, we can decompose changes in the real exchange rate into parts Ae/e = Aenom/enom + AP/P — APror/Pror © This can be rearranged as Ae rom/Cnom = Ae/e + Teor — TExchange Rates e Purchasing Power Parity © Thus a nominal appreciation is due to a real appreciation or a lower rate of inflation than in the foreign countryExchange Rates ~~ O e Purchasing Power Parity o In the special case in which the real exchange rate doesn’t change, so that Ae/e = 0, the resulting equation is called relative purchasing power parity, since nominal exchange- rate movements reflect only changes in inflation » Relative purchasing power parity works well as a description of exchange-rate movements in high-inflation countries, since in those countries, movements in relative inflation rates are much larger than movements in real exchange ratesImplications of Purchasing-Power Parity Ifthe purchasing power of the rupee is always the same at home and abroad, then the exchange rate would be constant. ¢ The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries and the real exchange rate would be equal to 1. ¢ Therefore, if a central bank prints large quantities of money, the price level rises and its value in buying goods and services and other currencies falls.Indexes (Jan. 19215 100) 1,000,000,000,000,000} 10,000,000, 000} Money supply Price level 1921 1922 1923 1924 1925,Limitations of PPP Theory Two reasons why exchange rates do not always adjust to equalize prices across countries: e Many goods cannot easily be traded o Examples: haircuts, going to the movies © Price differences on such goods cannot be arbitraged away e Foreign, domestic goods not perfect substitutes © E.g., some Indian consumers may prefer Toyotas over Tatas, or vice versa © Price differences reflect taste differencesLimitations of PPP Theory e Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends. e For example, PPP implies: the greater a country’s inflation rate, the faster its currency should depreciate (relative to a low-inflation country like the US). e The data support this prediction...Inflation & Depreciation in a Cross-Section 10,000.0 1,000.0 Avg annual depreciation 100.0 relative to US dollar 10.0 | 1993-2003 (log scale) 0.1 of 31 Countries Romania—* = Mrpertintal 1 Canada = ~Japan T NS : a” “Mexico " Kehya s Ukrdine / _ Brazil 0.1 1.0 Avg annual CPI inflation T 10.0 100.0 1,000.0Exchange rate pass-through * Exchange rate pass-through (ERPT) is the percentage change in local currency import prices resulting from a one percent change in the exchange rate between the exporting and importing countries «The transmission mechanism of pass-through works in two stages. © Inthe first stage, a depreciation increases prices of imported consumption and intermediate goods. © Inthe second stage, it affects prices of domestically produced goods through supply and demand channels. * By affecting the price of intermediate goods, it affects the cost of production and hence prices of domestically produced goods. * Because of rise in import prices, demand shifts to domestically produced goods, leading to further increase in domestic prices. * Degree and timing of pass-through is important for forecasting inflation. * Setting of effective monetary policy in response to inflation shocks require knowledge about ERPT.Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/EInterest Rate Parity Interest rate parity is the asset e Each $1 invested in the US will equivalent of PPP. It states that be worth $1.05 in a year. How all assets should be expected to about each $ invested in earn the same return Europe? « For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/EInterest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return « For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E e Each $1 invested in the US will be worth $1.05 in a year. How about each $1 invested in Europe? © $1= (1/115) = .87E .87E(1.07) = .93E -93E ($1.10/E) = $1.02Interest Rate Parity Interest rate parity is the asset equivalent of PPP. It states that all assets should be expected to earn the same return « For example, suppose that the interest rate in the US is 5%, the interest rate in Europe is 7%,, the current exchange rate is $1.15/E and the anticipated exchange rate in a year is $1.10/E e Each $1 invested in the US will be worth $1.05 in a year. How about each $1 invested in Europe? © $1= (1/115) = .87E .87E(1.07) = .93E -93E ($1.10/E) = $1.02 e Even with the higher return in Europe, the 5% appreciation of the dollar makes the US asset a better investment. Therefore, funds will flow to the US.Interest Rate Parity « Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (1+) = (14i*)(e'/e)Interest Rate Parity C7) « Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (141) = G+i*)(e/e) « Amore useful form is i-i* = % change ine e For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the YenInterest Rate Parity « Interest parity states that exchange rates should be expected to adjust such that assets pay equal returns across countries (141) = G+i*)(e/e) « Amore useful form is i-i* = % change ine e For example, if the interest rate in the US is 5% and the interest rate in Japan is 2%, the dollar should depreciate by 3% against the Yen « Interest rate parity fails just as badly as PPP.Interest Rate Parity & PPPInterest Rate Parity & PPP ¢ Recall that PPP gives the following: % change in e = Inflation — Inflation* « Interest Parity gives the following: i-i* = % change ineInterest Rate Parity & PPP ¢ Recall that PPP gives the following: % change in e = Inflation — Inflation* « Interest Parity gives the following: i-i* = % change ine ° Combining them gives us i-i* = Inflation — Inflation*Interest Rate Parity & PPP 7 Recall that PPP gives the following: 9% change in e = Inflation — Inflation* « Interest Parity gives the following: i-i* = % change ine ° Combining them gives us i-i* = Inflation — Inflation* i- Inflation = i* - Inflation*Interest Rate Parity & PPP a Recall that PPP gives the following: 9% change in e = Inflation — Inflation* « Interest Parity gives the following: i-i* = % change ine ° Combining them gives us i-i* = Inflation — Inflation* i- Inflation = i* - Inflation* r=r*