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EC111 MACROECONOMICS Spring Term 2012

Lecturer: Jonathan Halket
Week 22
Topic 8: OPEN ECONOMY MACROECONOMICS
So far we have considered only a closed economy. Now we turn to looking at
macroeconomics when the economy is open to transactions with the rest of the world
through trade and payments.
The key distinction between international transactions and internal transactions is that
the former involve the exchange of one currency for another. If a UK resident wants to
buy something produced abroad then she must first buy foreign currency in exchange
for pounds, in order to pay the foreign producer. In practice it is often the retailer (or
his supplier) who does this. Similarly a foreign purchaser wishing to buy something
produced in the UK must buy pounds in exchange for foreign currency.
The balance of payments account of a country records the total value of transactions
which involve an exchange between home and foreign currency. The balance of
payments accounts form part of the national accounts, and are recorded in terms of the
domestic currency. Transactions that appear in the balance of payments accounts are
normally divided into current account transactions, capital account transactions and
official financing.
A simplified version of the Balance of Payments
Credit Debit Net
Exports of goods Imports of goods Visible trade balance
Invisible exports Invisible imports Invisibles balance
= Current account balance (1)
Investment from abroad
by foreign residents
Investment abroad by
domestic residents
=Capital account balance (2)
Official financing (3)

Note that the sum of (1) + (2) + (3) must add up to zero. For every pound sold in return
for foreign currency, someone must have bought a pound and sold units of foreign
currency.
If more pounds are sold by UK residents than are bought by foreigners for transactions
in goods and services, then the value of imports exceeds the value of exports and there is
a deficit on the current account. This is a current account deficit (sometimes referred to
as the trade deficit). In this case there must be an offsetting surplus on the capital
account plus official financing.

2

If there is a deficit on the current and capital accounts combined, more pounds have
been sold than have been bought for private transactions. The Bank of England must
have bought pounds in exchange for foreign currency. Its foreign currency reserves will
have declined.
In reality things are more complicated.

Note that:
Britain normally has a deficit on visible trade and a surplus on invisibles.
What we think of as the capital account is now (5) + (6) + (7).
Official financing is (8).
In the statistics the Balance of payments as a whole does not add up to zero.
Why not?

Question: How does my holiday in France enter the accounts?

3

The exchange rate
We define the exchange rate, e, as the number of units of foreign currency per pound.
Thus if the market rate of the pound against the US dollar is 1 = $1.55 then e = 1.55; or
if 1 = 1.14 then e = 1.14. We can think of the exchange rate for each foreign currency
or as a pound valued against a weighted average of foreign currencies. For simplicity we
assume there is one overseas country whose currency is the Euro.
The demand for imports and exports.
Imports are goods and services produced abroad that are purchased (directly or
indirectly) by domestic residents (households, firms or the government). The amount
imported depends on national income, Y, and the exchange rate, e. We assume that
prices (in national currencies) are fixed so that the relative price of imports to
domestically produced goods depends only on the exchange rate.

Where f
1
is the marginal propensity to import and F is the quantity (value) of goods and
services imported











An appreciation of the exchange rate makes foreign goods cheaper relative to those
produced at home. This induces some switching of expenditure away from home
produced goods towards foreign goods. As an example, at e = 1 a good priced at 100
abroad will cost a UK purchaser 100. At e = 1.25 the same good will cost only 100/1.25
= 80. At each level of income more imports will be bought and so the import function
shifts up.
F
Slope = MPI
Y
e = 1
e = 1.25
4

Similar reasoning applies to the demand by foreigners for British goods. Their demand
will depend on their income but also on the relative price of goods imported from
Britain compared with their domestically produced goods. We can write the export
function as:

Where X is the amount of exports and Y
F
is the national income of the foreign country
(the rest of the world).











An appreciation of the pound from e = 1 to e = 1.25 will reduce the amount of goods that
foreigners wish to buy (for a given income). For example a good priced at 100 in
Britain will cost the foreign purchaser 100 at e = 1.0 but it will cost 125 at e = 1.25.
Thus an appreciation increases imports and reduces exports because it makes British
goods more expensive relative to those produced abroad. A depreciation has the
opposite effect, reducing imports and increasing exports.


The I S curve with international trade
Imports and exports appear on the expenditure side of the national accounts. Exports
represent expenditure on domestic goods by foreigners so it must be added to total
expenditure on home produced goods by domestic residents.
X
Y
F
e = 1.25
e = 1
5

But imports represent spending on foreign goods by domestic residents. This is part of
total expenditure (e.g for consumption or investment) but not part of expenditure on
domestic goods. It must therefore be deducted (from C, I and G) because it does not
have a counterpart in value added.
National income is now:

And the behavioural relationships are:




National income is determined (through the multiplier) as:
















IS (e = 1.0)
IS (e = 1.25)
Y

r
6

Note that:
An appreciation of the exchange rate shifts the IS curve to the left. British goods
become less competitive so buyers at home and abroad switch towards foreign
goods, reducing their expenditure on British produced goods.

The presence of international trade reduces the value of the multiplier. E.g. if c =
0.75 and f
1
= 0.25, then the closed economy multiplier, 1/(1 c) would be 4, but
the open economy multiplier 1/(1 c + f
1
) would be only 2.

Changes in foreign income will affect domestic income because it shifts the
demand for exports, working through the multiplier:
_________________________

A rise in domestic national income will worsen the balance of payments. Since
the BP (surplus) is:


A rise in domestic national income, e.g. as a result of an increase in G will
increase F but not X, so debits increase relative to credits.

An appreciation of the exchange rate will worsen the balance of payments since
an increase in e (see above) will reduce exports and increase imports. Note also
that if the domestic price level increases that would have the same effect. We
would then need to consider the real exchange rate as reflecting the relative
price of home to foreign goods: , where P
F
is the foreign price level.

Note that if the balance of payments is not zero then we are assuming there must
be compensating adjustments elsewhere in the accounts, either the capital
account or official financing.









7

The foreign exchange market
We can depict the demand for domestic currency (pounds) in exchange for foreign
currency in a manner similar to that for other markets. For the moment, we assume
that this arises only from current account transactions, i.e. import and export of goods
and services.
Demand for pounds is associated with exports. The lower the exchange rate the more
competitive are British goods in foreign markets and the greater will be the demand for
pounds in exchange for foreign currency.
The supply of pounds is associated with imports. The higher the exchange rate the more
competitive are foreign produced goods in the domestic market and the more pounds
will be supplied by domestic residents in exchange for foreign currency.












Equilibrium in this market is at e*. If national income increases, demand for imports,
and therefore for foreign currency, rises. If nothing else happens (e.g. on the capital
account) then the equilibrium exchange rate must fall.
If the exchange rate is allowed to find its equilibrium level through market forces then
this is called a free float. But central banks often intervene.

S
1
e



e*

S
2

D
1
8

A fixed exchange rate
(Begg, 25.2)
For most of the last 40 years the UK as had a floating exchange rate, but for most of the
previous century the exchange rate was fixed.











Under fixed exchange rates the central bank must maintain an exchange rate that is not
necessarily the equilibrium exchange rate e*. If the fixed exchange rate is , then there
is excess supply of z pounds. The Bank must therefore buy z in exchange for foreign
currency (using its foreign currency reserves) in order to keep the exchange rate at . [If
there had been excess demand then the Bank would have to sell pounds and buy foreign
currency.] This is the official financing component that appears in the balance of
payments accounts.
The excess supply of z in the diagram is equivalent to the balance of payments deficit.
As the Bank buys domestic currency, this is withdrawn from circulation, which in turn
reduces high powered money. The domestic money supply will therefore be reduced as
a result of the contraction of deposits operating through the money multiplier
(assuming the Bank takes no other action).
This has implications for the effectiveness of fiscal and monetary policy, but first we
need to look at the international capital market.



z

e



e*

D

9

I nternational capital mobility
So far we have ignored the capital account of the balance of payments and we have
assumed that there are no international transactions in bonds or other assets. We have
assumed that financial capital is not internationally mobile. We can relax this
assumption and recognise that international investors will shift their portfolios of
financial assets (think of them as bonds) towards the country with the higher interest
rate.
Now the overall balance of payments includes the current account and the capital
account. The higher the interest rate the more foreign investors will buy pounds to
make financial investments in Britain (or UK residents switch from foreign assets) the
more positive will be the capital account balance. So we redefine the expression for BP
(suplus) to include the capital account and introduce a term in the interest rate
differential between home and abroad.

Setting the overall balance of payments to be equal to zero and inverting, we have\:

Note that there is an upward sloping relationship between national income at home and
the interest rate. This is the BP curve, more precisely the BP = 0 curve.













BP ( = 0)
BP curve
IS (e = 1.25)
Y

r

BP ( = )
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Note that the BP curve represents points where BP = 0.
There a number of things that shift the BP curve.
An increase in foreign income, Y
F,
shifts the BP curve down

An appreciation of the exchange rate, e, shifts the BP curve up

An increase in the foreign interest rate, r
F
, shifts the BP curve up (by the same
amount as the increase in r
F
.
But the most important thing to note is that the slope of the BP curve depends on the
parameter , which is represents the responsiveness of international capital flows to the
interest rate differential between home and abroad. The larger is , the flatter is the BP
curve.
In what follows we shall focus on the two extreme cases.

No international capital mobility
In this case we have = 0. This is equivalent to saying there is no capital account. So the
BP curve is:

As before, when we had only the current account, BP is independent of the interest rate
and the BP curve is therefore vertical. But note that:
For a given level of national income Y, it will be shifted to the left or right by
changes in Y
F
or e.
To the right of the BP = 0 curve, the balance of payments is in deficit; points to
the left the balance of payments is in surplus.
Perfect international capital mobility
In this case we have = . This means that a small interest rate differential causes
massive shifts in international capital. It is equivalent to perfect competition in the
international capital market. This means that no interest rate differential can emerge.

So the second term on the right is zero and we have r = r
F
. The BP curve is horizontal at
the international interest rate r
F
.


11

We look fiscal and monetary policy under four sets of assumptions or special cases.
Note: in what follows we are assuming that prices are fixed and there is excess supply of
labour so we can use the standard IS/LM analysis.
Case 1: A fixed exchange rate (e = ) and no international capital mobility ( = 0)

Fiscal Policy













The economy starts from a position where BP = 0. The government increases its
expenditure, shifting the IS curve to the right. The balance of payments moves into
deficit as income (and imports) increases.
As the Bank buys pounds to maintain the fixed exchange rate (to prevent it from
depreciating) the money supply will fall. This shifts the LM curve progressively to the
left. The BP deficit will be eliminated when the LM curve has been shifted far enough to
the left to restore the original level of income (at which BP was zero).
Fiscal policy is completely ineffective because it has been counteracted by the effects of
the balance of payments deficit on the money supply. National income has not changed
but the interest rate is now higher than before.

LM
2
IS
1
BP ( = 0)
LM
1
Y

r

IS
2
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Monetary Policy













If expansionary monetary policy is adopted, the increase in the money supply would
shift the LM curve to the right. As before, the increase in national income leads to a
balance of payments deficit. And as before the Bank buys pounds causing the LM curve
to shift progressively back to the left.
Once income has returned to its original level there is no balance of payments deficit
and no further shift of the LM curve. National income has not changed and neither has
the interest rate. Thus monetary policy is also ineffective.
In these two cases the Bank could try and counteract the effect of balance of payments
deficit on the exchange rate by the money supply by buying bonds in exchange for
pounds. This is sometimes called sterilisation. But it cannot go on indefinitely
because, as long as there is a balance of payments deficit, the Bank will have to run
down its reserves of foreign currency. Eventually those reserves will become so depleted
that the fixed exchange rate can no longer be maintained.
IS
1
BP ( = 0)
LM
1
Y

r
LM
2