TUTORIAL 10 (26 30 MAY) ANSWER KEY

Open Economy Macroeconomics

- Exchange Rates
- Trade and Capital Flows
Textbook Reference: Chapters 14 & 15
Main Concepts
Exchange rates real and nominal
Purchasing power parity
Demand and Supply for currency
Monetary policy and exchange rates
Fixed and Flexible regimes
Current, capital and financial accounts
Saving, investment and the current account

Review Questions
Question 1
Define the nominal and real exchange rates. How are the two concepts related? Which
exchange rate is most important for a countrys ability to export and import goods and
services?
Nominal exchange rate is the relative price of two different currencies. It is the rate at which two
currencies can be traded for each other. This is a bilateral exchange rate which is what we focused
on in lectures.
We defined e = no. of units of foreign currency per one unit of domestic currency = $US/$AU = 0.925
(as at 21 May 2014), i.e. AU$1 can be purchased for US$0.925. This is called an indirect quote, since
it is in terms of the foreign currency. The direct quote is the inverse , or the Australian dollar
price of the foreign currency, i.e. US$1 can be purchased for AU$(
)=AU$1.08.
An increase in e is an appreciation of the AUD and a fall is a depreciation of the AUD (against the
USD).
Real (bilateral) exchange rate is the relative price of goods and services between two countries. You
can look at an individual good or at a price index for all goods and services. Precisely, the real
exchange rate is the price of the average domestic good or service relative to the price of the
average foreign good or service, when prices are expressed in terms of a common currency.
Real exchange rate = (eP)/Pf or P/(Pf/e) , where Pf is foreign price level and P is domestic price level.
The real exchange rate is what matters for a countrys net exports. The real exchange rate tells us
how expensive domestic goods and services are relative to foreign goods and services, and thus it is
the type of exchange rate most directly relevant to a countrys ability to export. In sum, it is a
measure of international competitiveness.

Question 2
Over the period June to December 2008 the value of the Australian dollar fell from 96 US
cents to 69 US cents. Use the demand and supply model of the exchange rate to provide a
good explanation for this depreciation of the Australian dollar?

Australian residents supply $AU to buy USD denominated goods, services and assets.
Non-residents (eg. US residents) demand $A to purchase Australian goods, services and assets.
Demand increases (decreases) if the demand for exports (X) or financial capital inflows (KI) increase
(decrease). Supply increases (decreases) if the demand for imports (M) or financial capital outflows
(KO) increase (decrease). What we need for a depreciation of the AUD is (i) an increase in the Supply
curve; (ii) a fall in the Demand curve or (iii) some combination of both.
Period June-Dec 2008 represents the beginning of the global recession associated with the GFC. Most
likely cause of depreciation is a significant fall in the demand for the $AU so the demand curve
shifts inwards. With the outlook for China uncertain, there was a reasonable expectation that
demand for Australian produced commodities and resources would fall.
Fall in previously very high terms of trade (ie ratio of export prices to import prices) reduced
demand for $A.
In addition, there was probably some increase in the supply of $A as domestic and foreign investors
shifted out of Australian dollar denominated assets and into what were perceived to be the
relatively less risky US government bonds.

Question 3
How does each of the following transactions affect:
(a)
the current account balance; and
(b)
the capital account balance?
Show that in each case the identity that the trade balance plus the net capital inflows
equals zero applies.
(i)
An Australian exporter sells software to the UK. She uses the Pounds received to
buy shares in a British firm.
software sale to UK => current account credit (export)
purchase of British shares => capital account debit (capital outflow)

(ii)
An East Timorese firm receives Australian dollars from selling oil to Australia. A
French firm accepts the dollars as payment for drilling equipment. The French firm uses
the dollars to buy Australian government bonds.
oil purchase by Australia => current account debit (import)
Purchase of Australian bonds => capital account credit (capital inflow)

Question 4
Use a diagram to show the effects of each of the following on the capital inflow of a
country that is a net borrower from abroad.

r is the domestic real interest rate. With perfect capital mobility it will equal the world real interest
rate rW.
S is national or domestic saving
I is national or domestic investment
KI is the capital inflow line. Note that it is equal to net exports or the trade deficit.
(
(

)
)

so thate is a net capital inflow, and a trade deficit.

Here is what happens in each of the four cases:

(i)
Investment opportunities in the country improve due to an increase in resource
prices.
When investment opportunities in the country improve due to an increase in resource prices, the I
line shifts to the right, and there is an increase in KI to fund the additional level of investment.
Domestic savings are unchanged.

(ii)

The government budget deficit increases

When the government budget deficit increases, the S line shifts to the left, and there is an increase
in KI to fund the existing level of investment. Domestic savings decrease whereas investment is
unchanged.

(iii)

The domestic private sector increases their level of saving

When the domestic private sector increases their level of saving, S shifts to the right as domestic
savings increase, and there is a fall in KI, as more of investment, which is unchanged is funded by
domestic saving

(iv)

There is an increase in the countrys risk premium

This is more difficult. In the above model there is no country risk premium. But you could
think of a country risk premium as a wedge between the world real interest rate rW and the
domestic real interest rate. The country has to pay r = rW + rp for its capital inflows. See the
following diagram. Domestic saving will increase and investment will decrease.

Discussion Questions
Question 5
(i)
What are the costs and benefits of international capital flows? Are high levels of
net capital inflows a cause of concern for policymakers? Is there an economic case for
restrictions on some types of foreign investment (eg. agricultural land and minimal
resources)? Discuss.
(See Bernanke section 15.4). Main issues capital inflows can be used to augment domestic savings
to fund investment. (Use S and I in an open economy model to illustrate this). This allows a higher
rate of economic growth and higher domestic consumption.
However emphasise that net capital inflows have implications: e.g. increasing foreign liabilities,
returns from capital investments accrue overseas.
Policymakers see issue in terms of costs vs. benefits. It was argued in the 1980s that high levels of
foreign debt was unsustainable and made Australia vulnerable to external shocks (so cost >
benefit). But Australia has proved resilient to shocks negating this argument.
In general to make an economic case against foreign investment it would be necessary to identify
some form of market failure that resulted in a level of foreign investment that was too high in some
sectors of the economy. Such forms of market failure are rarely identified.

(ii)
What are the economic costs and benefits of central bank intervention to stabilize
(or target) a countrys real exchange rate?
Stabilising a countrys exchange rate will tend to make it more predictable and this may reduce the
degree of uncertainty in international trade in goods and assets. Reduced uncertainty may lead to
increased trade.
On the cost side, if the exchange rate target is a long way above the fundamental value of the
exchange rate then the currency may be subject to speculative attacks.
Also on the cost side, if a central bank uses monetary policy to set the value of the exchange rate, it
is not able to use monetary policy to achieve domestic objectives. If, for example the central bank
wanted to decrease inflation, by contracting the money supply and increase interest rates there
would be an increase in capital inflows as foreigners would wish to purchase higher yielding
domestic financial assets. This would increase the demand for the currency, and if the central bank
has an explicit exchange rate target, the central banks foreign exchange reserves would increase. An
increase in foreign exchange reserves corresponds with a higher money supply which would negate
the initial monetary contraction. Thus, the central bank would lose control of the money supply and
therefore could not target interest rates.