Open Economy

Lecture : Economics for Finance

Open Economy

Master in Financial Mathematics

Ms.Chehara Dias Amaratunga

Masters in Accounting and Finance , University of Adelaide
Bsc. Economics and Management, University of London, LSE
Balance of payment
• This lesson focuses on the linkages between an economy with the rest of
the world.
• The ‘ balance of payments’ - net transactions between one country and the
rest of the world.
• The question is how is the balance of payment measured?
• What role does the exchange rate play in connecting the domestic
economy with foreign economies.
• Transactions that lead to a receipt of payment from foreigners such as a
commodity export or sale of assets abroad are recorded in the balance of
payments account as a credit.
• Transactions such as the payment of commodity imports or the purchase of
a foreign asset are recorded as a debit.
Determination of Exchange Rates
• Exchange rate determination is complex.
• The following exhibit provides an overview of the many
determinants of exchange rates.
• This road map was first organized by the three major
schools of thought (parity conditions, balance of
payments approach, asset market approach), and
secondly by the individual drivers within those
approaches.
• These are not competing theories but rather
complementary theories.

4
Determination of Exchange Rates

5
Parity Conditions Approach
• The theory of purchasing power parity is the most
widely accepted theory of all exchange rate
determination theories:
• PPP is the oldest and most widely followed of the
exchange rate theories.
• Most exchange rate determination theories have PPP
elements embedded within their frameworks.
• PPP calculations and forecasts are however plagued
with structural differences across countries and
significant data challenges in estimation.

6
Balance of Payments Approach
• The balance of payments approach is the second
most utilized theoretical approach in exchange rate
determination:

• The basic approach argues that the equilibrium exchange

rate is found when currency flows match with current and
financial account activities.

• This framework has wide appeal as BOP transaction data

is readily available and widely reported.

• Critics may argue that this theory does not take into
account stocks of money or financial assets.

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Asset Market Approach
• The asset market approach argues that exchange
rates are determined by the supply and demand
for a wide variety of financial assets:

• Shifts in the supply and demand for financial assets

alter exchange rates.
• Changes in monetary and fiscal policy alter expected
returns and perceived relative risks of financial assets,
which in turn alter exchange rates.

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Asset Market Approach
• The asset market approach assumes that foreigners are willing to hold
claims in monetary form which depend on an extensive set of
investment considerations or drivers (among others):
• Relative real interest rates
• Prospects for economic growth
• Capital market liquidity
• A country’s economic and social infrastructure
• Political safety
• Corporate governance practices
• Contagion (spread of a crisis within a region)
• Speculation

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Equilibrium Exchange Rate
Rs./$ Equilibrium
D

S
e0 = Rs.100

Qty
10
Nominal Exchange Rate Determination

• The Nominal exchange rate is defined as the

domestic currency price of a unit of foreign
exchange ( denoted by e).

• When the Rupee DEPRECIATES – e rises

• When the Rupee APPRECIATES - e falls

Nominal Exchange Rate Determination- Flexible
exchange rate
Rs./ $

S
S1
S
S2
e1

e2

DD
1

a c b Supply and Demand for $

Nominal exchange rate Determination- Fixed
exchange rate
Rs./$ SS
1

B
e2
A C
e1

DD
2

DD1

Qa Qc Supply and Demand for $

Real- Exchange Rate
• REX= e. P ( USA) */P (SL)
P( USA)* = the foreign currency
price of imports for imports
from the US

P (SL) = Domestic Price Index

for Sri Lanka

REX= Real Exchange rate

e= the nominal exchange rate:

domestic currency price of a
foreign currency
Purchasing Power Parity
• The “Law of ONE PRICE”
• P= eP*
• e = P/P*

All goods will cost the same when expressed in common currency and
the nominal exchange rate will be equal to the ratio of domestic to
international prices.

PPP holds when percentage change in the exchange rate is equal to the
inflation differential between the domestic and foreign countries.
What Changes the Equilibrium Rate?
• Inflation rates:
• Higher domestic inflation means less demand for local
goods and more demand for foreign goods (increased
demand for foreign currency).
• Interest rates:
• Higher domestic (real) interest rates attract investment
funds causing a decrease in demand for foreign currency
and an increase in supply of foreign currency.
• Economic growth:
• Stronger economic growth attracts investment funds
causing a decrease in demand for foreign currency and an
increase in supply of foreign currency.

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What Changes the Equilibrium Rate?
• Political & economic risk:
• Higher political or economic risk in the domestic country
results in increased demand and reduced supply of foreign
currency.
• Changes in future expectations:
• Any improvement in future expectations regarding the
domestic currency or economy will decrease the demand
for foreign currency and increase the supply of foreign
currency.
• Government intervention:
• Maintain weak currency to improve export competitiveness.

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Forecasting in Practice
• Numerous foreign exchange forecasting services
exist, many of which are provided by banks and
independent consultants.
• Some multinational firms have their own in-house
forecasting capabilities.
• Predictions can be based on elaborate
econometric models, technical analysis of charts
and trends, intuition.

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 Forecasting in Practice
• Technical analysts, traditionally referred to as chartists,
focus on price and volume data to determine past trends
that are expected to continue into the future.
• The single most important element of technical analysis is
that future exchange rates are based on the current
exchange rate.
• Exchange rate movements can be subdivided into three
periods:
• Day-to-day
• Short-term (several days to several months)
• Long-term

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Forecasting in Practice
• The longer the time horizon of the forecast, the
more inaccurate the forecast is likely to be.
• Whereas forecasting for the long run must depend
on the economic fundamentals of exchange rate
determination, many of the forecast needs of the
firm are short to medium term in their time
horizon and can be addressed with less theoretical
approaches.

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 Exchange rate determination and Balance of
Payment
• The Balance of Payments (BOP) reflects a country’s international
transactions between the residents country and the residents of the
rest of the world.

• The BOP consists of two main accounts. The current account and the
capital account.

• Current account ( known as the trade account)measures the trade

flow of goods and services ( factor and nonfactor ) as well as any net
transfers.
Exchange rate determination and Balance of
Payment
• Capital account reflects international financial transactions with the
rest of the world and shows how the current account deficit is
financed.

• The capital account includes net foreign direct investment and

portfolio and other investments.

• The overall balance is the sum of the current account and the capital
account. When the overall balance is negative there will be a
reduction in reserves.
Balance of Payments
• The BOP is a statistical record of the flow of all of
the payments in a given year between the
residents of a country and the rest of the world.

• Transactions are recorded on the basis of double

entry bookkeeping – by definition it has to
balance.

• The two main components are:

• Current Account
• Capital/ Financial Account

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Balance of Payments

24
Current Account (CA)
• This is record of a country’s trade in goods and services
in the current period.

• CA = Exports (X) – Imports (M)

• It is divided into 4 sub-categories:

• Goods trade
• Services trade
• Income
• Current transfers

• The sum of the four sub-categories = CA balance

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Capital Account (KA)
• This includes all short- and long-term transactions
pertaining to financial assets.
• KA = Capital Inflow (cr) – Capital outflow (dr)
• The two main components:
• Capital account.
• Financial account (direct, portfolio, other).

• KA balance = Sum of capital account and financial

account.

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Official Reserves
• Records the purchase or sale of official reserve assets by the
Central bank. These assets include
• Commercial paper, Treasury bills and bonds
• Foreign currency
• Money deposited with the IMF
• This account shows the change in foreign exchange reserves
held by the Central bank.
• Since the BOP must balance The Balance of
Payments Identity
CA + KA + RFX = 0
 CA + KA = – RFX

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Statistical Discrepancy (E&O)
• The identity CA + KA = – RFX assumes that all transactions are
measured accurately.

• Inaccurate recording of transactions (errors & omissions), results

in the above equality not holding. For BOP to balance,
• CA + KA + E&O = – RFX
• Assuming changes in official reserves, errors are approximately
zero:
Current Account = (–) Capital Account
 This will hold approximately for floating rate countries

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CA ≈ -KA

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BOP & Macroeconomic Variables
• A nation’s balance of payments interacts with
nearly all of its key macroeconomic variables.

• Interaction means that the BOP affects and is

affected by such key macroeconomic factors as:

• Gross Domestic Product (GDP)

• Exchange rate
• Interest rates
• Inflation rates

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BOP & Exchange Rates

• A country’s BOP can have a significant impact on

the level of its exchange rate and vice versa.

• The relationship between the BOP and exchange

rates can be illustrated by use of a simplified
equation that summarizes the BOP (see next
slide).

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BOP & Exchange Rates

(X – M) + (CI – CO) + (FI – FO) + FXB = BOP

Where:
X = exports of goods and services
Current Account Balance
M = imports of goods and services
CI = capital inflows Capital Account Balance
CO = capital outflows
FI = financial inflows Financial Account Balance
FO = financial outflows
FXB = official monetary reserves

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BOP & Exchange Rates
• Fixed Exchange Rate Countries
• Under a fixed exchange rate system, the government
bears the responsibility to ensure that the BOP is near
zero.

• Floating Exchange Rate Countries

• Under a floating exchange rate system,
surpluses/deficits influence exchange rate.

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Trade Balances & Exchange Rates
• A country’s import and export of goods and
services are affected by changes in exchange
rates.
• The transmission mechanism is in principle quite
simple: changes in exchange rates change relative
prices of imports and exports, and changing prices
in turn result in changes in quantities demanded
through the price elasticity of demand.
• Theoretically, this is straightforward, in reality
global business is more complex.

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Trade Balances & Exchange Rates

35
Interdependence and the
Gains from Trade
Gains from trade
• An economy that engages in international trade is an open economy.
• The advantages realised as a result of trade are called the gains from trade.

• Absolute advantage – in the production of a good, when the equal quantity

of resources can produce more of that good in the first country than in the
second.
• Comparative advantage - David Ricardo ( 1772- 1823) explains that the
gains from trade depend on the pattern of comparative not absolute
advantage. The gains from trade arises due to the opportunity costs in
different countries. World production of all goods can be increased if each
country transfers resources into the production of the products in which it
has a comparative advantage, which means those in which it has a lower
opportunity costs.
Opportunity Cost

• Opportunity cost is the value of the next best alternative forgone.

• Opportunity cost of a choice is what must be sacrificed when a

choice is made.

• Opportunity Cost = What is given up/ What is gained

Why does Trade take place in the World?
• Trade allows consumers to enjoy a greater variety of goods.

• Ex: Frank and Rose work 8 hours a day

Minutes needed to make 1 Number of ounces
ounce produced
Meat Potatoes Meat Potatoes
Frank 60 mint/ oz 15 min/oz 8 oz 32 oz
Rose 20 mint/oz 10 mint/oz 24 oz 48 oz
If Frank and Rose divide time equally : 4 hours
each to produce Meat and Potatoes

Number of ounces produced

and consumed
Meat Potatoes
Frank 4 oz 16 oz
Rose 12 oz 24 oz
 Meat (Oz)
Rose
Frank
Meat (Oz)

24

12
4 B
A

16 24 48 Potatoes
32 Potatoes
(Oz)
(Oz)
Specialisation and Trade
Meat Potatoes

Frank 0 32 oz
Gives Rose 15 oz
Gets from Rose 5 oz
Total after trade 5 oz 17 oz
Total without trade 4 oz 16 oz

Rose 18 oz 12 oz
Rose Gets 15 oz
Rose gives 5 oz
Total after trade 13 oz 27 oz
Total without trade 12 oz 24 oz
Frank Rose
 Meat (Oz)
Rose
Frank
Meat (Oz)

24

12
4 B
A

16 24 48 Potatoes
32 Potatoes
(Oz)
(Oz)

Absolute Advantage : The producer requires a smaller quantity of inputs to produce a good. Time is the
only input , and Rose has a lower cost of producing Potatoes and meat because she requires less time than
Frank
Comparative Advantage
• Another way of looking at the cost of producing output is through a
comparison of the opportunity cost
Frank
Opportunity cost of producing 1 oz of Meat= 4 oz of Patatoes
Opportunity cost of producting 1 oz of Patatoes= ¼ of meat

Rose
Opportunity cost of producing 1 oz of Meat= 2 oz of Patatoes
Opportunity cost of producing 1 oz of Patatoes= ½ oz of meat
Gain from Trade
Meat Patatoes
Frank Gets 5 oz of Meat Gives 15 oz of Potatoes
Rose Gives 5 oz of Meat Gets 15 oz of Potatoes

• Frank buys 1 oz of meat and 3 oz of Potatoes

• Rose buys 1 oz of Patatoes for 1/3 of meat

• If frank produced 1 oz of meat the opportunity cost of higher as 1 meat oz requires 4 oz of Potatoes

• If Rose produced 1 oz of Potatoes the Opportunity cost is ½ oz of meat

Both parties gained from trade and the price which they trade is between the two opportunity costs.