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• Y = G + I + G (Goods Market)
• S = I + (G-T) (Asset Market)
• There is only one medium of exchange ($)
Open Economy Macroeconomics
• NX = Exports – Imports
– NX < 0 : Trade Deficit
– NX > 0 : Trade Surplus
Open Economy Macroeconomics
• NX = Exports – Imports
– NX < 0 : Trade Deficit
– NX > 0 : Trade Surplus
• Y = C + I + G + NX
• S = I + (G-T) +NX
Output/Income in the Open
Economy
-160
-140
-120
-100
0
20
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
Current Account
US Balance of Payments
-50
-200
-150
-100
0
50
100
150
200
250
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
FKA
Current Account
US Balance of Payments
-50
-200
-150
-100
0
50
100
150
200
Jan-80
Jan-82
Jan-84
Jan-86
Jan-88
Jan-90
Jan-92
Jan-94
Jan-96
Jan-98
Jan-00
Jan-02
BOP
ORA
US Balance of Payments
US Trade Weighted Exchange
Rate Index
140
130
120
110
100
ECU/$
90
80
70
60
50
Jan-89
Jan-97
Jan-99
Jan-85
Jan-87
Jan-91
Jan-93
Jan-95
Jan-01
Jan-03
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
• If the exchange rate (e) is defined as the dollar price of a
unit of foreign currency
for example, 1 Euro = $1.15
– An increase (decrease) in e represents a dollar depreciation
(appreciation)
Exchange Rates
• The nominal exchange rate reflects the relative value of
one currency in terms of another.
• BE CAREFUL!!!! WATCH THE UNITS!!!!
• If the exchange rate (e) is defined as the foreign currency
price of a dollar
for example, 1dollar = E .87
– 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-99
Jan-03
Jul-99
Jan-00
Jul-00
Jan-01
Jul-01
Jan-02
Jul-02
Jul-03
Cross Rates
• Note that most currency prices are related to the dollar.
For example, the British pound sells for $1.72/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 $1.72/GBP
• We can use any two dollar exchange rates to find the
“cross rates” (non-dollar exchange rates)
• For example, if the exchange rate for Japanese yen is
Y109.62/$, then the price of a GBN in Yen is
E = 109.62(Y/$) * 1.72 ($/GBP)
= 188.55(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
12
interest rate must adjust to
insure that S = I + (G-T) 8
• In this example, the domestic
interest rate is equal to 10% and 4
S = I +(G-T) = 300
0
• What will happen if we expose 0 100 200 300 400 500
this country to trade?
Adding Net Exports to Capital
Markets
• Suppose that the prevailing 20
world (real) interest rate is 6%
16
12
0
0 100 200 300 400 500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing 20
world interest rate is 6%
• 16
At 6%,
– S = $100 12
– I + (G-T) = $500
8
– NX = $100 - $500 = -$400
4
0
0 100 200 300 400 500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing 20
world interest rate is 14%
16
12
0
0 100 200 300 400 500
Adding Net Exports to Capital
Markets
• Suppose that the prevailing 20
world interest rate is 14%
– S = $500 16
– I + (G-T) = $100 12
– NX = $500 - $100 = $400
8
0
0 100 200 300 400 500
Where does the world interest
rate come from?
• Aggregate world savings is the sum 20
of private savings across countries
• Aggregate Private Investment and 16
Government Deficits are also
summed over all countries 12
0
00
00
00
00
00
10
20
30
40
50
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
10
20
30
40
50
Example: An increase in
productivity
• Suppose that trade is initially 24
balanced. A rise in
20
productivity increases
investment demand 16
0
0
0
00
00
00
00
00
10
20
30
40
50
Example: An increase in
productivity
• Suppose that trade is initially 24
balanced. A rise in
20
productivity increases
investment demand 16
0
00
00
00
00
00
10
20
30
40
50
• Do interest rates rise at all?
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)
states that the same product
should cost the same in every
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
Exchange Rates and Price Levels
• The Law of One Price (LOOP) P* = E190 (E Price in Europe)
states that the same product
should cost the same in every
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
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?
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
location = $222.30
• 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?
• A profit can be made by buying
TVs in the US and selling them
in Europe.
Exchange Rates and Price Levels
• The Law of One Price (LOOP)
states that the same product
should cost the same in every
location
• LOOP states that in
equilibrium, no such profits can
occur. Therefore, P = eP*
Exchange Rates and Price Levels
• The Law of One Price (LOOP)
states that the same product
should cost the same in every
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
Exchange Rates and Price Levels
• The Law of One Price (LOOP) P = $200
states that the same product P* = E190
should cost the same in every
location
P = eP*
• 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
Exchange Rates and Price Levels
• The Law of One Price (LOOP) P = $200
states that the same product P* = E190
should cost the same in every
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
$1.05/E
Purchasing Power Parity
• Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
Purchasing Power Parity
• Purchasing power parity (PPP) is simply LOOP applied to general
price indices
P = eP*
0
Jan-85
Jan-86
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Yen/$
Nominal/Real Exchange Rates
50
100
150
200
250
300
350
0
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