MACROECONOMICS FOR

AN OPEN ECONOMY
Nguyễn Việt Hưng
CONTENTS
 Understanding balance of payments
 How is exchange rate determined?
 Exchange rate mechanisms

2
BALANCE OF PAYMENTS
Definition

A country’s record of all transactions between its

residents and the residents of all foreign nations

Rules of recording transactions

 Transactions which involve a flow of payments
into our country have a plus sign (credit items)
 Transactions which involve a flow of payments
out of our country have a minus sign (debit items)

3
 THE STRUCTURE OF BOP
1. Current Account
 Measures flows of payments between countries for currently
produced goods and services

2. Capital Account
 Measures flows of payments between countries for assets such
as stocks, bonds, and real estate

3. Official Transactions Account

 Records amount of foreign currencies that a nation buys or sells

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CURRENT ACCOUNT
 Trade balance sub-account
 Net investment income sub-account
 Net transfer sub-account

Sum of these four sub-accounts gives us

current account balance

5
CAPITAL ACCOUNT
 Capital inflows are a decrease in the country’s
holding of foreign assets or an increase in
liabilities to foreigners (plus sign)
 Capital outflows are an increase in the country’s
holdings of foreign assets or a decrease in
liabilities to foreigners (minus sign)

These items are normally distinguished according

to short-term or medium-to-long term nature.

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OFFICIAL TRANSACTIONS
ACCOUNT
 Sum of current and capital account measures
the private net receipts of dollar and is
called balance of payments
 If it is positive, then we call balance of payments
surplus
 If it is negative, then we call balance of
payments deficit

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OFFICIAL TRANSACTIONS
ACCOUNT
 If there is deficit in BOP, the Central Bank must
sell foreign currency/buy domestic currency to
prevent the downward pressure on the value of
domestic currency from happening
 The holding of assets (foreign currency reserves)
of CB will go down or liabilities to foreigners
(IMF) of CB will go up (plus sign)

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OFFICIAL TRANSACTIONS
ACCOUNT
 If there is surplus in BOP, the Central Bank must
buy foreign currency/sell domestic currency to
prevent the upward pressure on the value of
domestic currency from happening
 The holding of assets (foreign currency reserves)
of CB will go up or liabilities to foreigners (IMF)
of CB will go down (minus sign)

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP
TO THE INTERNATIONAL FLOWS
 Net exports is a component of GDP:
Y = C + I + G + NX
 National saving is the income of the nation
that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX

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SAVING, INVESTMENT, AND THEIR RELATIONSHIP
TO THE INTERNATIONAL FLOWS

 National saving (S) equals Y - C - G so:

S – I = NX
or
Saving - Domestic = Net Capital
Investment Outflow

Net Capital Net

=
Outflow Exports
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SAVING, INVESTMENT, AND THEIR RELATIONSHIP
TO THE INTERNATIONAL FLOWS
 Net exports (NX) and net capital outflow
(NCO) are closely linked.
 For an economy as a whole, NX and NCO
must balance each other so that:
NCO = NX

12
 The Internationalization of the U.S. Economy

Percent
of GDP

15

Imports

10
Exports

0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000

13
National Saving, Domestic Investment, and Net
Foreign Investment

(a) National Saving and Domestic Investment (as a percentage of GDP)

Percent
of GDP
20

Domestic investment
18

16

14

12 National saving

10
1960 1965 1970 1975 1980 1985 1990 1995 2000

14
National Saving, Domestic Investment, and Net
Foreign Investment

(b) Net Capital Outflow (as a percentage of GDP)

Percent
of GDP
4

2
Net capital
1 outflow

–1

–2

–3

–4
1960 1965 1970 1975 1980 1985 1990 1995 2000

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DETERMINANTS OF TRADE BALANCE
 Trade balance depends on
 Tastes of consumers for domestic and foreign
goods
 Prices of goods at home and abroad
 Exchange rate
 Incomes of consumers
 Cost of transporting goods from country to
country
 Government policies toward international trade

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DETERMINANTS OF NET CAPITAL
OUTFLOW
 Net capital outflow depends on
 Real interest rate paid on foreign assets
 Real interest rate paid on domestic assets
 Perceived economic and political risks of holding
assets abroad
 Government policies that affect ownership of
domestic assets

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EXCHANGE RATES

18
EXCHANGE RATES
The nominal exchange rate tells us the price of a
foreign currency in terms of domestic currency

Real exchange rate is the nominal exchange rate

adjusted for relative prices between countries under
consideration
f n
P  E
Er 
Pd
Real exchange rate tells us which goods, domestic or
foreign, are more competitive in terms of price

19
 d
P
Exchange rate is defined Er  f
inversely in this diagram. P  En
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HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
 Purchasing Power Parity Theory
 A simple approach – supply and demand
analysis

21
HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
 Purchasing power parity theory (PPP) 1920s–
Gustav Cassell
 Arbitrage forces will lead to the equalization of
goods prices internationally once the price of
goods are measured in the same currency “law of
one price”
 Then, real exchange rate is equal 1, then
nominal exchange rate is equal to the ratio of
prices in two countries

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HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
d
 Absolute PPP P
En  f
P

n d f
 Relative PPP % E  % P  % P

i.e.
Depreciation rate of
domestic currency  Domestic
inflation rate
 Foreign
inflation rate

23
 Money, Prices, and the Nominal Exchange Rate
During the German Hyperinflation
Indexes
(Jan. 1921 5 100)

1,000,000,000,000,000

Money supply
10,000,000,000

Price level
100,000

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925
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HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
 If current exchange rate is E = 20.000
VND/USD; inflation rate in Vietnam is 10%;
inflation rate in US is 3%; so what is the
forward exchange rate after one year
according to Relative PPP theory?

25
HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
 Supply-demand approach: Exchange
rate/price of foreign currency is determined
by the supply of and demand for foreign
currency.
 The demand for foreign currency comes from domestic
residents who want to buy foreign goods or assets
 The supply of foreign currency comes from foreign
residents who want to buy domestic goods or assets

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HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
 When price of foreign currency goes up (ex
rate increases), the domestic goods and
assets become cheaper in the eye of
foreigners and more foreign currency is
supplied to buy domestic goods and assets
 The supply curve of foreign currency,
therefore, is upward sloping

27
HOW TO DETERMINE
EQUILIBRIUM EXCHANGE RATE
 When price of foreign currency goes up (ex
rate increases), the foreign goods and assets
become more expensive in the eye of
domestic residents. They don’t want to buy
foreign goods and assets, so demand for
foreign currency decreases.
 The demand curve for foreign currency,
therefore, is downward sloping
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Exchange rate
(VND/USD)
SUSD

E0

DUSD

QUSD

29
FUNDAMENTAL FACTORS
DETERMINING EXCHANGE RATES
 Changes in a country’s income
 Changes in a country’s price
 Changes in interest rates
 Changes in risk perception with respect to
currencies
 Changes in trade policy

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EXCHANGE RATE MECHANISMS
 Flexible/floating exchange rate mechanism
 Fixed exchange rate mechansim
 Partially flexible exchange rate mechanism
(managed floating ex rate)

31
EXCHANGE RATE MECHANISMS
 Under flexible exchange rate mechanism,
exchange rate is completely determined the
foreign exchange market without any
intervention of Central bank.
 Exchange rate easily varies in day-to-day
trading due to expectations and speculations
rather than fundamental factors.

32
EXCHANGE RATE MECHANISMS
 Under fixed exchange rate mechanism, the
government can fix its exchange rate by
exchange rate intervention – buying or
selling foreign currency to maintain the
equilibrium of the market at the fixed
exchange rate.

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EXCHANGE RATE MECHANISMS

 To overvalue Exchange rate

(VND/USD)
domestic currency, SUSD
Central bank must sell S’USD
foreign currency/buy
domestic currency
 Itsforeign reserves can 19200

be run out of A B
18000
 Trade balance
deteriorates and low DUSD
Shortage of USD
economic growth
QUSD

34
EXCHANGE RATE MECHANISMS
 To devalue
domestic currency, Exchange rate
(VND/USD)
Surplus of USD

Central bank must SUSD

buy foreign
currency/sell 20000
A
domestic currency B
19200
 Itsforeign reserves
increase
 Trade balance and D’USD
DUSD
economic growth
can improve
QUSD

35
ADVANTAGES AND DISADVANTAGES
OF ALTERNATIVE EX RATE SYSTEMS
 The advantages and disadvantages of this ex
rate system are the reverse of those of the
other ex rate system

36
ADVANTAGES AND DISADVANTAGES
OF FIXED EXCHANGE RATE SYSTEM
 Advantages:
 Stable exchange rate makes trade and
investment easier
 Allow government to achieve certain objectives
such as trade balance, economic growth,
external debt

37
ADVANTAGES AND DISADVANTAGES
OF FIXED EXCHANGE RATE SYSTEM
 Disadvantages
 Government intervention can be harmful for the
economy (inflation, running out of foreign reserves)
 Limitations on a Central bank’s actions
 Fixed exchange rates can become unfixed when it
is largely deviated from long-run equilibrium
exchange rate, then it can create enormous
monetary instability

38
 PARTIALLY FLEXIBLE EX RATE
MECHANISM
 If there is a  If there is speculation on currency
fundamental
misalignment in
exchange rate,
policymakers allow
private forces to
determine it – flexible
exchange rate
or too large adjustment in
currency’s value in a short time or
adjustments won’t achieve balance
of payments goals, the
policymakers have interventions,
either supporting or pushing down
currency’s value – fixed exchange
rate
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