open economy

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ECO-506: Macroeconomic Theory II

Lectures 1-6

By : WAQAS AHMED

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Introduction

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Topics to be Covered

1. Balance of Payments

2. IS-LM-FB Model

3. Effectiveness of Fiscal and Monetary Policies

4. Exchange Rate Concepts

5. Perfect and Imperfect Capital Mobility

6. Problems of Stabilization in Global Framework

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Balance of Payments

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What is BOP?Which are two main accounts of BOP?

What is Current account Balance?If a country has negative CAB then what options are

available for that country?

What is Capital Account?How many parts of Capital Account exist?

Four Possible Situations of BOP.

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What is BOP?

• The balance of payments is a systematic record of the transactions of the residents of a country with the rest of the world during a particular period of time.

• There are two main accounts of BOP(see Summary of BOP data of Pakistan):

1. Current Account 2. Capital Account• The current Account records trade in goods,

services, income and current transfers.• The Capital account records purchase and sales of

assets, such as stocks bonds and lands.

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If a country has negative CAB then what options are available for that country?

• Country can sell her assets abroad• Country can borrow from other countries or IMF• Use foreign currency reserves• Achieve balance in CAB

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What is Capital Account?

The Capital account records purchase and sales of assets, such as stocks bonds and lands.

How many parts of Capital Account exist?Transaction of the Private SectorTransaction of the Government

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Four Possible Situations of BOP

1. Current Account Surplus

Equivalent Capital Account Deficit

No Problem

2. Current Account Deficit

Equivalent Capital Account Surplus

No Problem

3. Current Account Surplus

Capital Account Surplus

Rise in Reserves of Central Bank

4. Current Account Deficit

Capital Account Deficit

Fall in Reserves of Central Bank

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If a country has negative CAB then what options are available for that country?

• Country can sell her assets abroad• Country can borrow from other countries or IMF• Use foreign currency reserves• Achieve balance in CAB

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Exchange Rate Concepts

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What is Exchange Rate?Fixed, Flexible and Managed Exchange Rate

Regimes?Difference between:

Depreciation and DevaluationAppreciation and Revaluation

What is Purchasing Power Parity(PPP)?What is Real Exchange Rate?Reversing of Real exchange Rate to PPP

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What is Exchange Rate?

Exchange Rate is the price of one currency in terms of another.

Interbank closing rates for dollar on 02-03-2009

Buying Rs 79.88 Selling Rs 79.92

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Exchange Rate Regimes

• In a fixed exchange rate system foreign central banks stand ready to buy and sell their currencies at a fixed price in terms of dollar.

• In a flexible(floating) exchange rate system, the central banks allow the exchange rate to adjust to equate the supply and demand for foreign currency.

• When central banks intervene to buy and sell foreign currencies in attempts to influence exchange rates the system is known as managed floating or dirty floating.

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Depreciation and DevaluationA devaluation takes place when the price of foreign currencies under a fixed rate regime is increased by official action. Whereas, depreciation takes place when, under floating exchange rate regime domestic currency becomes less expensive in terms of foreign currency.

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Appreciation and RevaluationA revaluation takes place when the price of foreign currencies under a fixed rate regime is decreased by official action. Whereas, appreciation takes place when, under floating exchange rate regime domestic currency becomes more expensive in terms of foreign currency.

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What is Purchasing Power Parity(PPP)?Two currencies are at Purchasing Power Parity(PPP)

when a unit of domestic currency can buy the same baskets of goods at home or abroad.

What is Real Exchange Rate?The real exchange rate is the ratio of foreign to

domestic prices, measured in the same currency.R= e Pf /P

If RER=1 the currencies are at PPP.Why Reversing of Real exchange Rate to PPP is Slow

Market baskets differ across countriesBarriers to movement of goods between countriesNon-traded goods are part of price indexes

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Goods Market Equilibrium

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Domestic Spending=DS=C+I+GSpending on Domestic Goods=C+I+G+(X-Q)

NX=f(Y, Yf, R)Marginal Propensity to ImportRepercussion Effects