Open Economy Macro BOP

Open Economy Macroeconomics
The Final Frontier

Closed Economy
Macroeconomics
• Y = C + I + G (Goods Market)
• S = I + (G-T) (Asset Market)
• There is only one medium of exchange ($)
Open Economy Macroeconomics
• NX = Exports – Imports
– NX < 0 : Trade Deficit
– NX > 0 : Trade Surplus
• Y = C + I + G + NX
• S = I + (G-T) + NX
Output/Income in the Open
Economy
• Trade Deficits imply NX< 0

• Therefore, Y- (C + I + G) = NX < 0
• Countries that run trade deficits are
consuming more that they earn
Savings in the Open Economy
• Again, a trade deficit implies NX<0

• Therefore, S – (I – (G-T)) = NX < 0
– A country with a trade deficit is borrowing
from the rest of the world
– That is, foreign countries are acquiring
domestic assets
Balance of Payments Accounting
• Anything that we buy or sell to the rest of

the world must be paid for.
– The current account (CA) tracks the flow of
goods and services between the US and the rest
of the world
– The capital & financial account tracks the
payments for those goods & services (KFA)
– CA + KFA = 0
The Current Account
• Any transaction that represents a flow of funds out of the
US is represented by debit (-). Transactions that represent
a flow of money into the US are represented by a credit(+)
The Current Account
• Any transaction that represents a flow of funds out of the US is
represented by debit (-). Transactions that represent a flow of
money into the US are represented by a credit(+)
– Net Exports of Goods and Services
Exports (+)
Imports (-)
– Net Income From Abroad (NFP)
Income Earned by US nationals abroad (+)
Income earned by foreign nationals in the US (-)
– Net Unilateral Transfers
Payments from foreign countries (+)
Payments to foreign Countries (-)
The US Current Account (in
Billions of $s)
• Net Exports of Goods & Services
– Services: $52
– Goods: -$652
-$600
• Net Factor Payments: -$12
• Net Unilateral Transfers: -$72
Current Account Balance: -$684
The Capital & Financial Account
• Again, any transaction that represents funds
flowing into (out of) the US are credits (debits) in
the KFA
The Capital & Financial Account
• Again, any transaction that represents funds
flowing into (out of) the US are credits (debits) in
the KFA
– Financial assets
Foreign acquisition of US assets (+)
US acquisition of foreign assets (-)
– Official Reserve Assets
Foreign acquisition of US reserve assets (+)
US acquisition of foreign reserve assets (-)
The US Capital & Financial
Account (in billions of $s)
• Private Assets
– Foreign acquisition of US assets: $1,060
– US acquisition of foreign assets: -$472
$588
• Official Reserve Assets
– Foreign acquisition of US ORA: $22
– US acquisition of foreign ORA: $2
$24
• US KFA account balance: $612
• Note: CA (-$684) + KFA ($612) = -$72 (statistical discrepancy)
Example
• Suppose that you purchase a case of French wine
for $1500 (for simplicity, assume that you pay
with cash)
Balance of Payments Accounts
Current Account Capital & Financial Account
Exports Financial assets:
Foreign acquisition of US
Goods:
assets:
Services:
US acquisition of foreign
Imports assets
Goods: -$1500 Official Reserve Assets
Services: Foreign acquisition of US
Net Factor Income: ORA:
Net Unilateral Transfers: US acquisition of foreign
ORA:
Example
with cash)
– Case #1: The French wine distributor uses the $1500 to
purchase a computer from Dell
Goods: $1500
assets:
Services:
Imports assets
ORA:
Example
with cash)
buy a US T-Bill.
Goods:
assets: $1500
Services:
Imports assets:
ORA:
Example
with cash)
buy a US T-Bill.
buy Euros from the Federal Reserve
Goods:
assets:
Services:
Imports assets:
Net Factor Income: ORA: $1500
ORA:
Payments to Iraq
• In 2003, The US government approved an $87 billion aid
package to Iraq. How will this be reflected in the BOP
accounts?
Goods:
assets:
Services:
Imports assets:
Goods: Official Reserve Assets
Net Unilateral Transfers: -$87B US acquisition of foreign
ORA:
Payments to Iraq
• In 2003, the US government approved an $87 billion aid
accounts?
– The $87 billion payment is represented by a debit under
unilateral transfers
– Most of that money was used to pay US soldiers and
US reconstruction companies (around $70B)
Goods:
assets:
Services:
Imports assets:
Net Factor Income: $70B ORA:
ORA:
Payments to Iraq
• The US government just approved an $87 billion aid
accounts?
– Most of that money is being used to pay US soldiers
and US reconstruction companies (around $70B)
– The rest will be used to buy US goods or US assets
(either by Iraq or by other countries)
Goods: $5B
assets: $5B
Services: $7B
Imports assets:
ORA:
Payments to Iraq
• The US government just approved an $87 billion aid
accounts?
– Most of that money is being used to pay US soldiers
and US reconstruction companies (around $70B)
– The rest will be used to buy US goods or US assets
(either by Iraq or by other countries)
• How would the BOPs change if this $87B was a loan
rather than aid?
Goods: $5B
assets: $5B
Services: $7B
Imports assets: -$87B
ORA:
The Balance of Payments
• There are two possible definitions for the

balance of payments:
– Current Account + Net foreign acquisition of
US assets
-$684 + $588 = -$96
– Net acquisition of Foreign Official Reserve
Assets: $24
• The difference is the statistical discrepancy
Trade Deficits vs. Balance of
Payments Deficits
• The US currently has a growing trade deficit.
– There more demand for foreign currencies (to buy
foreign goods) that demand for US dollars (to buy US
goods). Does this mean that the dollar should
depreciate?
-160
-140
-120
-100
20
-80
-60
-40
-20
0
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
Current Account
US Balance of Payments
-200
-150
-100
50
-50
0
100
150
200
250
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
FKA
Current Account
-200
-150
-100
50
-50
0
100
150
200
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
BOP
ORA
US Trade Weighted Exchange
Rate Index
140
130
120
110
100
ECU/$
90
80
70
60
50
Jan-87
Jan-89
Jan-99
Jan-03
Jan-85
Jan-91
Jan-93
Jan-95
Jan-97
Jan-01
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
Exchange Rates
• If the exchange rate (e) is defined as the dollar price of a
unit of foreign currency
for example, 1 Euro = $1.33
– An increase (decrease) in e represents a dollar depreciation
(appreciation)
Exchange Rates
• If the exchange rate (e) is defined as the foreign currency
price of a dollar
for example, $1 = E .75
– An increase (decrease) in e represents a dollar appreciation
(depreciation)
The Dollar vs. The Euro
1.2
1.15
1.1
1.05
1
$/Euro
0.95
0.9
0.85
0.8
0.75
Jan-02
Jan-03
Jan-99
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
Jul-02
Jul-03
Cross Rates
• Note that most currency prices are related to the dollar.
For example, the British pound sells for $1.93/GBP
• We can use any two dollar exchange rates to find the
“cross rates” (non-dollar exchange rates)
Cross Rates
• Note that most currency prices are related to the dollar.
For example, the British pound sells for $1.93/GBP
• We can use any two dollar exchange rates to find the
“cross rates” (non-dollar exchange rates)
• For example, if the exchange rate for Japanese yen is
Y109.62/$, then the price of a GBN in Yen is
E = 102(Y/$) * 1.93 ($/GBP)
= 196.86(Y/GBP)
Adding Net Exports to Capital
Markets
• Without access to world capital 20
markets, a country’s private
saving is the sole source of 16
funds. Therefore, the domestic
interest rate must adjust to
12
insure that S = I + (G-T)
• In this example, the domestic 8
interest rate is equal to 10% and
S = I +(G-T) = 300 4
• What will happen if we expose
this country to trade? 0
0 100 200 300 400 500
Markets
• Suppose that the prevailing 20
world (real) interest rate is 6%
16
12
0
0 100 200 300 400 500
Markets
world interest rate is 6%
• At 6%, 16
– S = $100
– I + (G-T) = $500 12
– NX = $100 - $500 = -$400
8
0
0 100 200 300 400 500
Markets
16
12
0
0 100 200 300 400 500
Markets
– S = $500 16
– I + (G-T) = $100
– NX = $500 - $100 = $400 12
0
0 100 200 300 400 500
Where does the world interest
rate come from?
• Aggregate world savings is the 20
sum of private savings across
countries 16
• Aggregate Private Investment
and Government Deficits are 12
also summed over all countries
8
• By definition, NX summed
over all countries must equal 4
zero. Therefore, at the world
equilibrium interest rate, 0
S = I + (G-T)
0
0
00
00
00
00
00
• In this example, r = 11% 20
30
40
50
10
Example: An increase in
productivity
• Suppose that trade is initially 20
balanced. A rise in
productivity increases 16
investment demand
12
0
0
0
00
00
00
00
00
20
30
40
50
10
productivity
balanced. A rise in
investment demand 16
• In a closed economy, interest
rates would rise 12
0
0
0
00
00
00
00
00
20
30
40
50
10
productivity
balanced. A rise in
investment demand 16
• In a closed economy, interest
rates would rise 12
• In an open economy, the trade 8
deficit would increase. In the
4
case, the deficit increases from
zero to -$15,000 0
• Do interest rates rise at all?
0
0
00
00
00
00
00
20
30
40
50
10
World Capital Markets
• A country’s ability to influence world interest rates
depends on its size relative to the world economy (recall,
global interest rates are determined such that global capital
markets clear)
• The US makes up roughly 35% of the global economy.
Therefore, the US can significantly influence global
interest rates (as can Japan, EU, and China)
• The rest of the world has little influence unless it acts as a
unified group (Latin American Financial Crisis, Asian
Crisis)
Exchange Rates and Price Levels
• The Law of One Price (LOOP) P* = E190 (E Price in Europe)
states that the same product eP* = ($1.17/E)(E190)
should cost the same in every = $222.30
location
• For example, suppose that the
price of a television is $200 in
the US and E190 in Europe.
The current exchange rate is
$1.17/E
• What should happen here?
• The Law of One Price (LOOP) P* = E190 (E Price in Europe)
states that the same product
eP* = ($1.17/E)(E190)
should cost the same in every
location = $222.30
price of a television is $200 in
the US and E190 in Europe.
The current exchange rate is
$1.17/E
• What should happen here?
• A profit can be made by buying
TVs in the US and selling them
in Europe.
• The Law of One Price (LOOP)
states that the same product
location
• LOOP states that in
equilibrium, no such profits can
occur. Therefore, P = eP*
• If the price of a TV is $200 in
the US and E190 in Europe, the
implied exchange rate is
$1.05/E
• The Law of One Price (LOOP) P = $200
states that the same product P* = E190
location
P = eP*
• LOOP states that in
equilibrium, no such profits can
occur. Therefore, P = eP* e = P/P* = $200/E190
• If the price of a TV is $200 in = $1.05/E
the US and E190 in Europe, the
implied exchange rate is
$1.05/E
Purchasing Power Parity
• Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
price indices
P = eP*
• A more useful form of PPP is
%Change in e = Inflation – Inflation*

price indices
P = eP*
• A more useful form of PPP is
%Change in e = Inflation – Inflation*
• For example, if the US inflation rate (annual) is 4% while the annual

European inflation rate is 2%, the the dollar should depreciate by 2%
over the year.
PPP and the “Fundamentals”
• Again, recall that PPP gives the following formula for the
nominal exchange rate:
e = P/P*
e = P/P*
• Further, the quantity theory give the price level as a
function of money and output
P = MV/Y
e = P/P*
• Further, the quantity theory give the price level as a
function of money and output
P = MV/Y
• Combining the two,
e = (V/V*)(M/M*)(Y*/Y)
• V,M,and Y are exchange rate “fundamentals”
PPP and the Real Exchange Rate
• While the nominal exchange rate is defined as the
dollar price of foreign currency, the real exchange
rate is defined as the price of foreign goods in
terms of domestic goods
q = eP*/P
PPP and the Real Exchange Rate
• While the nominal exchange rate is defined as the
dollar price of foreign currency, the real exchange
rate is defined as the price of foreign goods in
terms of domestic goods
q = eP*/P
• PPP implies that the real exchange is

always constant (actually, its equal to 1)
0
100
150
200
250
300
50
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Yen/$
Nominal/Real Exchange Rates
0
100
150
200
250
300
350
50
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Real
Yen/$
Nominal/Real Exchange Rates
The Hamburger Standard and
LOOP
• The Economist regularly calculates the

LOOP predicted exchange rates using a
McDonalds Big Mac as the commodity
e = P/P*
• This has become known as “
the hamburger standard”
Explaining Deviations from PPP
• Transportation costs, tariffs, taxes, etc.

interfere with LOOP
• Non-Traded goods
• Price indices are constructed differently
• Fixed prices in the short run
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
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 is the asset • 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?
interest rate in the US is 5%,
the interest rate in Europe is
$1.10/E
all assets should be expected to about each $1 invested in
• For example, suppose that the • $1 = (1/1.15) = .87E
interest rate in the US is 5%, .87E(1.07) = .93E
the interest rate in Europe is .93E ($1.10/E) = $1.02
$1.10/E
all assets should be expected to about each $1 invested in
• For example, suppose that the • $1 = (1/1.15) = .87E
interest rate in the US is 5%, .87E(1.07) = .93E
the interest rate in Europe is .93E ($1.10/E) = $1.02
• Even with the higher return in
exchange rate in a year is Europe, the 5% appreciation of
$1.10/E the dollar makes the US asset a
better investment. Therefore,
funds will flow to the US.
• Interest parity states that exchange rates

should be expected to adjust such that assets
pay equal returns across countries
(1+i) = (1+i*)(e’/e)
• Interest parity states that exchange rates should be
expected to adjust such that assets pay equal returns across
countries
(1+i) = (1+i*)(e’/e)
• A more useful form is
i – i* = % change in 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 parity states that exchange rates should be expected
to adjust such that assets pay equal returns across countries
(1+i) = (1+i*)(e’/e)
• A more useful form is
• 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
• Recall that PPP gives the following:
% change in e = Inflation – Inflation*
• Interest Parity gives the following:
• Combining them gives us
i – i* = Inflation – Inflation*
i – Inflation = i* - Inflation*
i – Inflation = i* - Inflation*
r = r*

Open Economy Macro BOP

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Open Economy Macro BOP

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Open Economy Macroeconomics

The Final Frontier

• Trade Deficits imply NX< 0

• Again, a trade deficit implies NX<0

• Anything that we buy or sell to the rest of

• There are two possible definitions for the

• A more useful form of PPP is

%Change in e = Inflation – Inflation*

• A more useful form of PPP is

%Change in e = Inflation – Inflation*

• For example, if the US inflation rate (annual) is 4% while the annual

• PPP implies that the real exchange is

• The Economist regularly calculates the

• Transportation costs, tariffs, taxes, etc.

• Interest parity states that exchange rates

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