7. Open Economy(1)
Transcript of 7. Open Economy(1)
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Last classes: human capital
Relationship between education, health and
income
Human capital approach
Inequalities in education and health outcomes
Performance of education and health systems
Conditional Cash Transfers
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Class material
Class Fri 1 Nov (postponed from Wed 30 Oct)
T&S Ch13: p. 638-649
Mankiw et al, 4thCanadian edition, p. 278-283
(electronic copy posted on course website)
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Learning objective
What is the balance of payments (BoP)?
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Balance of payments (BoP)
The BoP summarizes a countrys financialtransactions with the outside world
i.e. transactions related to trade, foreign investment,
foreign aid, remittances, foreign loans
It consists of three accounts:
1. current account
2. capital account
3. cash account Inflows enter as positive (credit / receipt)
Outflows enter as negative (debit / payment)
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Understand balance of payments (BoP)
Current account+ exports, - imports (= also called trade balance)+ investment income, - debt service payments, + netremittances & transfers
Capital account+ foreign private investment, + foreign loans,- amortization, - foreign assets, - resident capital outflow
Cash or international reserve account+ foreign currency in cash, + gold, + deposits with IMF
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A Hypothetical BoP Table for a Developing Nation(Attention: big typo mistake in Table 13.3 in new edition!!!)
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Learning objective
What is an exchange rate and what drives
exchange rate movements?
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Nominal exchange rate
An exchange rate is a price
Nominal exchange rate The rate at which a person can trade the currencyof
one country for that of another
Example: 80 Yen for 1 Dollar
Appreciation When 1 $ gives you moreof the foreign currency
i.e. from 80 to 90 Yen
Depreciation When 1 $ gives you lessof the foreign currency
i.e. from 80 to 70 Yen
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Real exchange rate
Real exchange rate:
The rate at which a person can trade a good / serviceofone country for that of another
Example: 0.5 kilo Russian wheat for 1 kilo Cad. wheat
Real exchange rate =(nominal exchange rate * domestic price)/foreign price
The real exchange rate a key determinant of how mucha country imports / exports
In the above example Canadian wheat is 50% cheaper thanRussian wheat. Buyers will thus prefer to buy Canadianwheat which is good for Canadian exports.(assuming equal quality of wheat)
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What determines exchange rates?
Theory of purchasing power parity Law of one price: a good must sell for the same price
everywhere (due to arbitrage: i.e. profit by buying wherecheap & reselling where more expensive)
This law also applies to currencies: a currency must havethe same purchasing power in every country
Consequence: The nominal exchange rate thus reflects differences price
levels between two countries
Changes in domestic prices thus lead to changes in thenominal exchange rate (everything else equal)
Prices, and thus the exchange rate, also depends onmoney supply (monetary policy) & money demand
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Hyperinflation in Germany
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What determines exchange rates?
The theory of purchasing power parityexplains long termchanges in nominal andreal exchange rates quite well
But short termdeviations between real andnominal exchange rates are quite common,due to:
Non-tradables & imperfect substitutes
Governments exchange rate policies(to be explained in trade theme)
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Learning objective
Why are current and capital account deficits a
problem and how can they be reduced?
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Table 13.4 Before and After the 1980s Debt Crisis:
Current Account Balances and Capital Account Net financial Transfers of
Developing Countries, 1978-1990 (billions of dollars)
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Payment deficits are a problem (i)
When current and capital accounts are both in deficitonly the cash account remains:
International reserves are like bank accounts; they can beused to pay bills
But, if reserves are not replenished, they will sooner orlater be depleted
A BoP crisis arises when a country does not have anyfunds to pay its international bills (= liquidity
problem) Consequence: the rest of the world will not want to do
business with the country
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Payment deficits are a problem (ii)
A BoP crisis is a symptom
Generally, the underlying problem is that thecountrys economy and economic policies are(perceived as) not sustainable in the long term
Exports too expensive, too large budget deficits, too highdebt, too high inflation, unattractive investment climateetc.
In other words: the underlying problem is oftenstructural
Long term solutions are only available throughsubstantial changes in economy and policy
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Alternative ways of reducing & financing
current & capital account deficits(and more on this in next classes )
Borrow from abroad
but: borrowing means debt, which means interest paymentsand amortizations
Devalue official exchange rate this stimulates exports and discourages imports
Encourage foreign investment
Restrictive fiscal and monetary policies
Structural adjustment Stabilization policies
Special drawing rights (SDRs)
provide short term relief for BoP problems
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In sum
An open economy is a country that has economic relationswith other countries (= most countries)
Balance of payments & exchange rates are key concepts tounderstand when analyzing open economies
Too high current and capital account deficits can lead to abalance of payments crisis, which often kick starts a bigeconomic recession
A crisis is only a symptom of a underlying structural problemsin the domestic economy and the way its managed
The remaining course themes will focus on economic relationsbetween countries (international trade & finance) and whatthis means for developing countries economies