ECON1102 Study Guide - Final Guide: Foreign Portfolio Investment, Currency Appreciation And Depreciation, Portfolio Investment
Open Economy Macroeconomics
• Open economy - an economy that has interactions in trade or finance with other economies.
• Closed economy - an economy that has no interactions in trade or finance with other economies.
Economics 'Openness'
• Openness has three distinct dimensions:
1. Openness in good markets - a fully open economy has 'free trade'.
o Free trade restrictions include tariffs and quotas.
2. Openness in financial markets - a fully open economy allows for free flow of financial assets,
including money, into and out of the country.
o Capital controls place restrictions on the ownership of foreign assets.
3. Openness in factor markets - a fully open economy allows firms to choose where to locate
production, and workers choose where to work.
o Migration controls limit such access.
Open Economy Topics
1. Trade in International Goods and Services
• A negative NX means that the domestic macroeconomy is 'leaking' expenditure to the outside world, i.e.
that net domestic purchases are not staying at home but being devoted to foreign imports. Those
foreign countries are benefiting from the domestic dollars of the economy and overall domestic AD is
lower than it could be.
• Many developed economies are focusing on services exports rather than goods exports, the idea being
that lower cost manufacturing and goods production is more readily available in developing countries,
suggesting they specialise in exports of goods, while developed countries, having an advantage in highly
skills labour specialise in exporting services. Eg: Higher education.
2. International Trade Accounting
• Balance of Payments (BoP) - the record of a country's international trade, borrowing, lending, capital
and investment flows with other countries.
• There are two major accounts under the BoP.
1. Current account - records current or short-term flows of funds into and out of a country.
o The balance of trade in goods and services is the difference between the value of the goods
and services a country exports and the value it imports.
2. Capital account - records migrants' asset transfers, debt forgiveness and sales and purchases of
non-produced, non-financial assets.
o The largest part of this account is the financial account - records purchases of physical and
financial assets a country has made abroad and foreign purchases of physical and financial
assets in the country, including direct investment, portfolio investment, etc.
o Net foreign investment - the difference between capital outflows from a country and capital
inflows, also equal to net foreign direct investment plus net foreign portfolio investment.
BoP = 0
• A current account deficit will be exactly offset by a capital and financial account surplus, vice versa.
• The current account deficit will equal net foreign investment.
• This is achieved by adding a 'net errors and omissions' category to balance the accounts and meant to
capture mistakes in data collection and reporting.
• Intuitively this implies that a persistent deficit in trade must be financed by inflows of capital from
overseas and vice versa.
Solved Problem Slide 20
Domestic and International Balance
• AUS has been running a persistent trade deficit (i.e. NX < 0). What our accounts imply is that the country
must therefore 'finance' its deficit using 'savings' from overseas and this takes the form of foreign direct
investment by overseas investors in assets in Australia.
Issues to Consider:
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1. Normal economic activity requires borrowing. Australia does not have sufficient domestic saving levels
to fund investment. So, borrowing other countries' savings is required, by itself not a problem.
2. However, can AUS service its debt and what proportion of GDP is required to service the debt.
o Loan defaults, private or public, can lower a country's credit rating.
o But debt repayments as a proportion of GDP are very low in AUS - debt/GDP = 30%.
3. What proportion of total debt is private and what proportion is gov.?
o Private debt does not directly burden taxpayers but can cause other economic problems if too
high.
4. Use of debt proceeds: problems could arise if debt is due to gov. borrowing for non-productive
spending, eg: long-term borrowing for welfare payments.
3. Foreign Exchange (FX) Markets
Exchange Rate
• Exchange rate - relative price of one currency to another.
• We express such rates in terms of currency pairs.
• Currency appreciation - occurs when the market value of a currency rises relative to another currency.
• Currency depreciation - occurs when the market value of a currency falls relative to another currency.
• The 3 sources of foreign currency demanded for the AUS dollar:
1. Foreign firms and consumers that want to buy goods and services produced in AUS.
2. Foreign firms and consumers that want to invest in AUS.
3. Currency traders who believe that the value of the dollar in the future will be greater than its
value today.
• A number of factors cause the demand and/or supply curves in the FX market to shift:
o Changes in the overseas demand for exports and imports.
o Changes in the desire to invest in AUS and changes in the desire of AUS firms and individuals to
invest in foreign countries.
o Changes in the expectations of currency traders about the likely future value of the dollar and
the likely future value of foreign currencies.
o Changes in income levels and economic growth rates in AUS and in other countries - higher
income in a domestic economy leads to higher demand for the domestic currency.
o Changes in relative interest rates between countries – a higher domestic interest rate will
attract money from overseas and increase demand for the domestic currency, because one can
earn higher return on domestic currency denominated assets.
The Real v. Nominal Exchange Rate
• Nominal exchange rate - the value of one country's currency in terms of another country's currency.
• Real exchange rate – the price of domestic goods and services in terms of foreign goods and services.
• This effectively adjusts the nominal relative price of two currencies to the relative price level of the
doestic ecooy of oe coutry’s currecy.
• Real exchange rate = Nominal exchange rate x (domestic price level/foreign price level)
Alternative Exchange Rate Setting Mechanisms
• Exchange rate regime - the general method of exchange-rate determination.
• Free floating - exchange rates determined completely by supply and demand in unregulated FX
markets.
• While many countries have a market-determined exchange rate, a few do not.
• Some countries have fixed exchange rates, where the value of their currency is fixed against the value
of another currency.
• Others have managed exchange rates where the currency is allowed to float in a pre-defined range,
outside of which gov. intervention in markets is used.
4. Exchange Rates and NX
• One important aspect of exchange rate fluctuations from a macroeconomic perspective are how those
chages affect a coutry’s NX.
• When there is an exchange rate appreciation:
o The $A buys more $US while the $US buys less $A.
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Document Summary
Open economy macroeconomics: open economy - an economy that has interactions in trade or finance with other economies. Closed economy - an economy that has no interactions in trade or finance with other economies. Economics "openness: openness has three distinct dimensions, openness in good markets - a fully open economy has "free trade". Eg: higher education: international trade accounting, balance of payments (bop) - the record of a country"s international trade, borrowing, lending, capital and investment flows with other countries. Bop = 0: a current account deficit will be exactly offset by a capital and financial account surplus, vice versa. The current account deficit will equal net foreign investment. This is achieved by adding a "net errors and omissions" category to balance the accounts and meant to capture mistakes in data collection and reporting. Intuitively this implies that a persistent deficit in trade must be financed by inflows of capital from overseas and vice versa.
