Topic 02 - Introduction to Open Economy Macroeconomics PDF

University of the Philippines Los Baños Economics 103 Topic 2 Introduction to Open Economy Macroeconomics Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños...

University of the Philippines Los Baños Economics 103 Topic 2 Introduction to Open Economy Macroeconomics Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines LEARNING OBJECTIVES At the end of the topic, the learners should be able to: discuss key macroeconomic theories and concepts in open economies demonstrate understanding of basic macroeconomic tools and concepts Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines REFERENCES Dornbusch, R., S. Fisher and R. Startz (DFS), 2018. Macroeconomics, 13th edition, McGraw-Hill, Ch. 13, pp. 295-304 Mankiw, G. 2016. Macroeconomics, 9th ed., Worth Publishers, Ch. 6, pp. 139-173 Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  OPEN ECONOMY MACRO(OEM) OEM deals with the macro aspects/issues of open economies Open economy: allows Macro aspects: econ growth, transactions with the rest of inflation, unemployment, the world (ROW), at least BOP, exchange rate, and including trade of some implications of policies goods across countries Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  BALANCE OF PAYMENTS(BOP) Summary of econ transactions of a country with the ROW Includes: Flows: Components: payments for & Debit: imports, Current Account receipts of goods, capital outflows, (CA) services and assets interest payments Capital Account gifts & transfers on foreign debt (KA) for which no Credit: exports, Official Reserve service is capital inflows, Transactions rendered in return remittances of (ORT) OFWs Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines BALANCE OF PAYMENTS(BOP) KA CA (+FA) ORT trade balance transactions on (TB) = exports capital assets (i.e. stock of transactions of less imports the central assets) interest bank that payments transactions on cause changes financial assets in its official dividends (e.g. gold, direct reserves investments, net transfers bonds, etc.) Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines BALANCE OF PAYMENTS(BOP) BOP must always balance CA + KA + ORT = 0 BOP: CA + KA = -ORT ≡ ΔF Surplus: CA + KA > 0; ΔF > 0 (accumulating foreign exchange) Deficit: CA + KA < 0; ΔF < 0 (losing foreign exchange) Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  NATIONAL INCOME ACCOUNTING IN AN OPEN ECONOMY Closed Economy Open Economy 𝑌𝑁 = 𝐶𝑁 + 𝐼𝑁 + 𝐺𝑁 𝑌𝑁 = 𝐴𝑁 + (𝑋𝑁−𝑀𝑁) 𝑌𝑁 = 𝐴𝑁 𝑌𝑁 = 𝐴𝑁 + 𝐶𝐴𝐵 where: YN – nominal GDP/GNI, AN – domestic absorption, CN – private consumption, IN – private investment (and government investment), GN – government spending (consumption), (XN – MN) – current account balance (CAB); XN – exports, MN –imports Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  Current Account Balance (CAB) 𝑌𝑁= 𝐴𝑁 + 𝐶𝐴𝐵; 𝐶𝐴𝐵 = (𝑋𝑁−𝑀𝑁) 𝑌𝑁 − 𝐴𝑁 = 𝐶𝐴𝐵 (absorption approach to CAB) Surplus: CAB > 0; 𝑌𝑁> 𝐴𝑁 (income is greater than expenditures) Deficit: CAB < 0; 𝑌𝑁< 𝐴𝑁 (income is less than expenditures) Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines By rearranging components of the national income accounts, CAB can be rewritten and interpret as: (𝒀𝑵−𝑪𝑵 − 𝑪 𝑮) − (𝑰 +𝑰 𝑮) = 𝑪𝑨𝑩 𝑵 𝑵 𝑵 GN Savings – GN Investment = CAB If GN Savings < GN Investment; then CAB < 0 [(𝒀𝑵+𝑻𝑹𝑵 − 𝑻𝑿𝑵 − 𝑪𝑵) − 𝑰𝑵] + 𝑻𝑿𝑵 − 𝑻𝑹𝑵 − 𝑪 𝑮 − 𝑰 𝑮 = 𝑪𝑨𝑩 𝑵 𝑵 [𝑆𝑁−𝐼𝑁] +GB =CAB If P Savings > P Investment & GB is balanced; then CAB > 0 If P Savings = P Investment & GB is in deficit; then CAB < 0 If CAB = 0, a GB deficit can be financed by net private savings. Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines FOREIGN EXCHANGE AND EXCHANGE RATE Foreign exchange - includes foreign currency, bank deposits denominated in foreign currency and other short term claims on foreigners that are expressed in foreign currency Exchange rate (e) – price of foreign exchange e = quantity of domestic currencies (e.g. PHP) needed to buy one unit of foreign currency (e.g. USD) Depreciation/Devaluation: ↑e Appreciation/Revaluation: ↓e Note: Depreciation/appreciation under flexible e regime while devaluation/revaluation under fixed e regime Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines FOREIGN EXCHANGE AND EXCHANGE RATE Foreign exchange market - market in which individuals, banks and firms buy and sell foreign exchange Actors: individuals (e.g. tourists, exporters, importers, investors, etc), commercial banks, foreign exchange brokers, central banks Functions: Clearing (primary function) and Credit Clearing: It facilitates transactions between buyers and sellers of foreign exchange. Credit: In the case where an importer in the home country may need time to sell the goods that it is buying from an exporter in foreign country, the bank in the home country may facilitate payment arrangements through the bank in the foreign country. Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines FOREIGN EXCHANGE AND EXCHANGE RATE Types of foreign exchange markets Forward market: currency Spot market: currency transactions that involve transactions that involve delivery and payment after delivery and payment an agreed period (usually, within two working days. a few months). The price at The price at which the which the currencies are currencies are traded is traded is called the forward called the spot rate rate Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines FOREIGN EXCHANGE AND EXCHANGE RATE Demand for foreign Supply for foreign exchange: quantity of forex exchange: quantity of forex that domestic residents want that domestic residents want to buy at alternative prices to sell at alternative prices (exchange rates). It represents (exchange rates). It represents outflows of the CA and KA inflows of the CA and KA Equilibrium: Intersection of supply and demand for foreign exchange determines the equilibrium e. It corresponds to absence of BOP surplus/ deficit or CA+KA=0 Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  Disequilibrium in the forex market: e is above or below its equilibrium value excess demand for forex or a BOP deficit BOP deficit can lead to loss of forex reserves exchange rate is over-valued If markets were allowed to adjust freely, the exchange rate will depreciate (↑e) Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  Fixed e Floating e authorities intervene in market freely markets & set the value of e determines e if e is over-valued, CB has absence of BOP to sell forex (loss of forex deficit/surplus reserves) in order to defend the currency variability of the exchange rate if e is under-valued, country can encourage Managed Float: floating exports but authorities intervene Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines WATCH: ONLINE RESOURCES The Balance of Payments https://www.youtube.com/watch?v=y3bdt3Scmlg Balance of Payments (Current Account, Financial Account and Capital Account) https://www.youtube.com/watch?v=bel_y5ka80M Introduction to Exchange Rates and Foreign Exchange Markets https://www.youtube.com/watch?v=EiXYP93hvGQ Floating and Fixed Exchange Rates - Macroeconomics https://www.youtube.com/watch?v=_pL_5trI6YY Fixed vs Floating Exchange Rates (Arguments For and Against) https://www.youtube.com/watch?v=5FaNeRH- GLY Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines QUICK CHECK! If a country saves more than it is investing domestically, AGREE! or DISAGREE! then the CAB > 0 or there is external lending to the ROW Under-valued exchange happens when the demand for foreign currency is greater than the supply and can lead to forex AGREE! or DISAGREE! reserves accumulation. Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines LEARNING OBJECTIVES At the end of the topic, the learners should be able to: discuss key macroeconomic theories OR and concepts in open economies demonstrate understanding of basic macroeconomic tools and concepts OR Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines END OF TOPIC 2 Topic 2: Introduction to Open Economy Macroeconomics Next Topic: IS-LM Analysis under Flexible Exchange Rate Regime Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines  Thank You! Office of the Chancellor University of of University the thePhilippines Philippines Los Los Baños Baños, www.uplb.edu.ph | [email protected] College, LosCollege, Laguna, Baños, Laguna 4031 Philippines 4031 Philippines