CHAPTER FOUR

OPEN ECONOMY MACROECONOMICS

 Introduction
 Economies are linked via 2 broad channels:
1. Trade in goods and services
2. Finance
domestic vs. foreign assets held in portfolio.
 The transactions among countries extend to
transfer payments, borrowing & lending, etc.
 Domestic macroeconomic policy in open
economies cannot ignore the influence of the
ROW.
 4.1.1 Exchange Rates & Exchange Rate Regimes
 Foreign exchange – all currencies other than the
domestic currency of a given country.
 The foreign exchange (forex) market – the
international market in which one national
currency is traded for another.
 Exchange rate – the price of one currency in
terms of another.
 Exchange rates are quoted as:
 Foreign currency units per unit of domestic
currency ($0.059/ETB1), or
 domestic currency units per unit of foreign
currency (ETB17/$1).
 Which method is employed is not important.
 Two different exchange rate systems (ERS):
 Fixed exchange rate system
 Floating exchange rate system
 4.1.1 Exchange Rates & Exchange Rate Regimes
 In a fixed ERS, central banks stand ready to buy
& sell their currencies at a fixed ER.
 Central banks hold foreign reserves to sell them
when they have to intervene in the foreign
exchange market.
 Under floating ERS, the forces of demand &
supply determine the exchange rate, and central
banks do not intervene.
Nominal ER: the rate at which one country’s
currency trades for another.
Real ER: the rate at which g & s of one country
trade for g & s of another.
Real ER is price of a domestic basket of g & s
relative to price of a foreign basket of g & s.
Real ER depends on nominal ER & prices of g & s
in the 2 countries measured in a currency.
 4.1.1 Exchange Rates & Exchange Rate Regimes
Nominal ER (in DC/FC)  Foreign Price
Real ER 
Domestic Price
e  P*
E
P
Appreciation/Revaluation: rise in the value of a
currency as measured by the amount of foreign
currency it can buy.
 Depreciation/Devaluation: fall in the value of a
currency as measured by the amount of foreign
currency it can buy.
 Real ER is a key determinant of how much a
country exports and imports.
 Appreciation of Ethiopian real ER means
Ethiopian goods become more expensive relative
to foreign goods, & thus Ethiopia loses
competitiveness in the global market.
 4.1.2 The Balance of Payments (BoP)
 BoP - a summary of the transactions b/n
residents & non-residents of a country over a
given period.
 International transactions are classified as
credits (+) or debits (–).
 Credit transactions are those that involve the
receipt of payments from foreigners.
 Debit transactions are those that involve the
making of payments to foreigners.
BoP statistics are divided into 2 main sections
the current account (CA) &
the capital account (KA).
The CA items refer to income flows,
The KA records changes in assets & liabilities.
BoP always balances, but CA can be in surplus
while KA is in deficit.
 BALANCE OF PAYMENTS
A. CURRENT ACCOUNT (CA)
Goods Exports +
Goods Imports –
(1) Net Export of Goods [Visible Trade Balance] ?
Export of Services +
Import of Services –
(2) Net Export of Services ?
Interest Income, Dividends & Profits received +
Interest Income, Dividends & Profits Paid –
(3) Net Income from Abroad ?
Unilateral Receipts from ROW +
Unilateral Payments to ROW –
(4) Net Unilateral Receipts ?
Balance on CA (1 + 2 + 3 + 4)
 B. CAPITAL ACCOUNT (KA)
(5) Inward Foreign Investment +
(6) Investment Abroad –
(7) Short, Medium & Long Term Borrowing from ROW +
(8) Short, Medium & Long Term Lending to ROW –
(9) Repayments on Loans to ROW –
(10) Repayments on Loans Received from ROW +
Balance on KA (5+6+7+8+9+10)
(11) Changes in Reserves: rise (–), fall (+)
(12) IMF borrowing from (+) Repayments to (–)
Official Financing Balance (OFB) (11+12)
Statistical Errors & Omissions (SEO) 0 – (CA+KA+OFB)
Official Settlement Balance (OSB) – OFB or (CA+KA+SEO)
 4.1.3 Some Open Economy Identities
An additional injection (export expenditure) & an
additional leakage (import expenditure).
 The basic national income identity is:

 Deducting taxation T from both sides:

 Using S = Yd – C and rearranging:

 Upon rearranging:
 4.1.4 Open Economy Multipliers
Assumptions underlying multiplier analysis:
1. Both domestic prices & ER are fixed
2. The economy is at less than full emp’t so that rises
in dd result in expansion of output (Y), &
3. The authorities adjust the MS to changes in Md by
pegging the domestic interest rate (r).
Rises in Y that lead to rise in Md would with a
fixed Ms lead to rise in domestic r; as it is
assumed that authorities passively expand M s
to meet rise in Md, r does not change.
There is no inflation resulting from rise in M s
as it is merely a response to rise in Md.
 4.1.4 Open Economy Multipliers

Y  C  I G  X M
C  Ca  c(Y  T ) M  M a  m(Y  T )
1
Y [Ca  I  G  X  M a  (m  c)T ]
sm
dY 1
 0
dG s  m
dY 1
 0
dX s  m
 4.1.4 Open Economy Multipliers

CA  X  M
CA  X  M a  mY  mT
m
CA  X  M a  [C a  I  G  X  M a  (m  c)T]  mT
sm
dCA m smm dCA s
 1   0
dX sm sm dX sm
dCA  m
 0
dG s  m
 4.1.5 The Marshall–Lerner Condition & the J-Curve
Effect
 Devaluation and CA
 Nominal ER (= e) is defined (Birr/$)
 e = Devaluation/depreciation of Birr.

CA  X  eM dCA  dX  edM  Mde

dCA dX dM de
 e M
de de de de
 ER-Elasticities of X & M:
dX / X de
X   dX   X . . X
de / e e
dM / M de
M    dM   M . .M
de / e e
 4.1.5 The Marshall–Lerner Condition & the J-Curve
Effect
dCA  X .de. X  M .de.M
 e M
de e.de e.de
 Assuming balanced trade (X = eM) initially:
dCA  X .e.M
   M .M  M
de e
dCA
 M ( X   M  1)
de
dCA
 0 (Devaluation improves CA ) iff
de
 X   M The
1 MLC
 4.1.5 The Marshall–Lerner Condition & the J-Curve
Effect
 Devaluation has two effects:
 Price effect (Export becomes cheaper &
import becomes more expensive).
 Volume effect (XV increases & MV falls).
 The CA balance improves only if the volume
effect is stronger than the price effect.
 It takes time for XV to rise and for MV to fall.
 MLC may not be fulfilled in the short run
although it generally holds over the long run.
 Reasons for slow short run responsiveness of XV
& MV & greater long run responsiveness:
 A time lag in consumer responses.
 A time lag in producer responses.
 Imperfect competition.
 Domestic prices of exports may not remain
 4.2.1 The IS-LM-BP Model
Deriving the IS, LM & BP curves:
1. IS:

C  C a  cY  cT
I  I a  br
M  M a  mY  mT
1
r  [(1  c  m)Y  Ca  (c  m)T  I a  G  X  M a ]
b
 Shifters of the IS curve:
 Ca, Ia, G, X?,
 T, Ma
 4.2.1 The IS-LM-BP Model
2. LM:
 (M/P)S = (M/P)D
1 M
r  (kY  )
h P
 Shifters of the LM curve: M, P?.

3. BP:
 External Balance: balance in the ss of & dd for
the currency with no need for the authorities to
change their holdings of forex reserves.
 If there is a CA deficit, there needs to be an
offsetting surplus in the KA (and vice versa) so
that dR = 0.
CA = – KA
 4.2.1 The IS-LM-BP Model
With exogenous exports & imports a positive
function of Y, higher level of Y implies smaller CA
S deficit.
surplus or larger CA
 Net capital inflow (K) is a positive function of
domestic interest rate (r).
 Assuming r* is fixed, higher r implies greater
D
capital inflow or smaller capital outflow.

 K > 0 (net inflow); K < 0 (net outflow).

 BP curve shows various combinations of Y & r
for which BoP is in eqlm:
X  M  K (r  r*)  0
 A CA surplus requires a K outflow to ensure BoP
eqlm; a CA deficit requires a K inflow.
 High YCA deficitK inflow neededhigh r.
 4.2.1 The IS-LM-BP Model
 The slope of the BP schedule is determined by
degree of K-mobility; higher degree of K-
mobility, flatter BP schedule.
 The three possible cases of BP curve
 perfectly mobile K (horizontal BP)
 perfectly immobile K (vertical BP)
 imperfectly mobile K (upward-sloping BP)
CA   KA
X  M a  mY   g (r  r*)
1
r  [ M a  mY  gr *  X ]
g
 Shifters of the BP curve: X?, Ma, r*.
 4.2.2 A Small Open Economy with Perfect Capital
Mobility
 Implications of high capital mobility for a small
country that cannot influence r*.
 Choice of ER regime has implications for the
effectiveness of monetary & fiscal policy.

1) Fixed ER Regime()
 Fiscal Policy is effective.
 Monetary policy is ineffective.

2) Flexible ER Regime():
 Fiscal Policy is ineffective.
 Monetary policy is effective.
4.2.2 A Small Open Economy with Perfect Capital
Mobility
4.2.2 A Small Open Economy with Perfect Capital
Mobility