Open Economy and Exchange Rates

Annotations:

• countries trade with one another to obtain goods and services that they cannot produce or to take advantage of the fact that other countries can produce themselves at lower cost than they can (comparative advantage)

Annotations:

• The price of one countries currency e,g, Japanese yen or NZ$ dollar, in terms of another country's currency.  e.g. in japanese yen, the price of the surf board costs 20,000円 and the exchange rate in NZ$ dollar is 87.9円  thefore we use the formula e/p  will be 20,000/87.9 = 227.5 in NZ$

1. Foreign Exchange rate

   Annotations:

   • All currencies other than domestic currency of a given  country or when one country's currency can be exchanged for another
   1. Demand for NZ doallr

      Annotations:

      •    The demand curve for dollars represents the demand by foreigners for NZ currency.   The demand curve is downward sloping.  If E↑, the dollar is more expensive to foreigners so they buy fewer dollars. The demand curve for dollars shifts right (increase in demand ) when foreigners want to:  - Buy more NZ exports (goods and services) increse in EX or export   - Invest more in New Zealand (by buying New Zealand assets) increase in I (investment)  
   2. Supply of NZ dollars

      Annotations:

      •  NZ citizens’ supply of dollars to buy foreign goods and investments   The supply curve is upward sloping.   If E↑, foreign currency and foreign goods are cheaper, so NZ residents supply a greater quantity of dollars. The supply curve of dollars shifts when NZ residents wish to:- Buy more imported goods- Invest more in foreign countries  
   3. Currency Depreciation

      Annotations:

      • it is a loss of value of a country's currency with respect to one or more foreign reference.  if exchange rate of NZ$ decreases therefore it has depreciation . this can be determined by the fluctuation (it changes either increase or decrease) of the exchange.
   4. Currency Appreciation

      Annotations:

      • sometimes exchange rates tend to increase or unofficial increase of the exchange rate and this is due to the market forces and this shifts the Exchange rate to increase which shifts the supply curve due to the increase in cost.
2. Balance of payment

   Annotations:

   • the record of country's transactions in goods, services, and assets with the rest of the world; also record of a country's sources (supply) and use demand of foreign exchange    it is divided into two accounts - current account  - capital account
   1. The current Account

      Annotations:

      • Net exports of goods (Export - imports)  + net exports of services (Export of service - Import of service)  + net investment income  + net transfer payment  = the balance on current account  - it shows how much nation has spent on foreign goods, services, investment income payments and transfers relative to how much it has earned from other countries. 
      1. Balance of trade

         Annotations:

         • the difference between a country;s exports of goods and services and imports of goods and services 
      2. Trade Deficit

         Annotations:

         • it occurs when a country's exports of goods and services are LESS than its imports of goods and services (X<M)
   2. The Capital Account

      Annotations:

      • the capital of account of the balance of payments records the changes in these assets and liabilities.
3. Domestic Price

   Annotations:

   •    •domestic currency per unit of foreign currency e.g. NZ$1.11 per AU$1.00   
4. it is determined by Exports and Imports
5. Equilibrium exchange rates

   Annotations:

   • equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied.
   1. Shifts in Demand of any currency's in the foreign exchange market

      Annotations:

      • the higher price level in one country will cause the other countrie's import to be relatively less expensive. therefore first country will increase spending on imports, shifting the second countries demand to the right. at the same, second country will find first country's goods to be more expensive causing the supply to shifts to the left therefore it appreciates 
6. Floating exchange rate
   1. Fixed vs floating exchange rate

      Annotations:

      •    Advantages of fixed exchange rates  - certainty  - prevents 'irresponsible' government policies  Disadvantages of fixed exchange rates - exchange rate policy may conflict with other macro objectives - danger of using deflation to manipulate trade (which risks retaliation by the trade partner) - problems of international liquidity - inability to adjust to shocks speculation  
   2. Speculation

      Annotations:

      • The choice to buy an asset today depends on beliefs of the future value of the asset. For internationally traded assets, it also depends on the expected exchange rate.  Speculators trade currency to take advantage of potential changes in future exchange rates. E.g.   If $1 buys 100 yen today but only buys 50 yen in one year, the yen appreciates against the dollar.
   3. Advantage

      Annotations:

      • •Automatic correction   •No problem of international liquidity and reserves   •Insulation from external economic events -  Governments are freer to choose domestic policy 
   4. Disadvantage

Annotations:

• aggregate expenditure in an open economy : AE = C + I+ EX - IM AE = aggregate expenditure C = consumption behavior of households I =  investment behavior of firms G = government spending EX =  net exports of goods and services

1. net exports of goods and services

   Annotations:

   • (EX - IM)  the difference between a country's total exports and total imports
   1. What determines the level of imports?

      Annotations:

      • IM = mY  when individual's income rises, imports tend to increase also. Y = income m = positive number (m is assumed to less than $1; otherwise, a $1 increase in income generate s an increase in imports more than  $1, which is unrealistic)
      1. Marginal propensity to import (MPM)

         Annotations:

         • the change in imports caused by a $1 change in income. 

1. price feed back effect

   Annotations:

   • the process by which a domestic price increase in one country can "feed back" on itself through exports and import prices. an increase in the price level in one country can drive up prices in other countries. this is in turn turn further increases the price level in the first country
2. Floating or market -determined exchange rates

   Annotations:

   • exchange rate that are determined by the unregulated forces of supply and demand.  government will still intervene to ensure exchange rate movements are "orderly"

Annotations:

• A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same therefore it is the balance on goods and services in other different countrry