CHAPTER 19

MACROECONOMICS IN AN OPEN ECONOMY

Chapter Summary
The balance of payments is the record of a countrys trade, borrowing, lending, capital
and investment flows with other countries. The current, capital and financial accounts make up
the balance of payments. The current account records a countrys net exports, net primary
income and net secondary income (formerly called net transfers). The capital account records
relatively minor transactions which consist of assets people take with them when they enter or
leave the country, debt forgiveness, and sales and purchases of non-produced, non-financial
assets. The financial account shows purchases of physical and financial assets a country has
made abroad and foreign purchases of physical and financial assets in the country. 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 of the goods and services a country imports. The sum of the
current account, the capital account and the financial account must equal zero. Therefore, the
balance of payments must also equal zero.
The concept of exchange rates is very important in macroeconomics. The nominal
exchange rate is the value of one countrys currency in terms of another countrys currency.
Changes in exchange rates affect international trade. Exchange rates are determined in the
foreign exchange market by the demand and supply of a countrys currency. A currency
appreciation occurs when the market value of a currency rises relative to another currency. A
currency depreciation occurs when the market value of a currency falls relative to another
currency. Changes in the exchange rate are caused by shifts in currency demand or supply. The
three main sets of factors that cause the supply and demand curves in the foreign exchange
market to shift are changes in the demand for Australian produced goods and services and
changes in the demand for foreign-produced goods and services; changes in the desire to invest
in Australia and changes in the desire to invest in foreign countries; and changes in the

expectations of currency traders particularly speculators concerning the likely future values
of the Australian dollar and the likely future values of foreign currencies. An exchange rate
appreciation tends to decrease exports and increase imports, while a depreciation tends to
increase exports and decrease imports. The real exchange rate is the price of domestic goods and
services in terms of foreign goods and services.
It is very important to understand how exchange rate systems operate. When countries
agree on how exchange rates should be determined, economists say that there is an exchange
rate system. A currency floats when its exchange rate is determined by the demand for and
supply of currency. The current exchange rate system is a managed float exchange rate system
under which the value of most currencies is determined by demand and supply, with occasional
central bank or government intervention. A fixed exchange rate system is a system under which
countries agree to keep the exchange rates among their currencies fixed. Under the gold
standard, the exchange rate between two currencies was automatically determined by the
quantity of gold in each currency.
There are three key aspects of the current exchange rate system: (1) the Australian
dollar, like the US dollar and the British pound, floats against other major currencies, (2) most
countries in Western Europe have adopted a common currency the euro and (3) some
developing countries have fixed their currencies exchange rates against the US dollar or against
another major currency. The theory of purchasing power parity states that in the long run
exchange rates move to equalise the purchasing power of different currencies. When a country
keeps its currencys exchange rate fixed against another countrys currency, it is pegging its
currency. Pegging can result in problems similar to the problems countries encountered with
fixed exchange rates under the Bretton Woods System. If investors become convinced that a
country pegging its exchange rate will eventually allow the exchange rate to decline to a lower
level, the demand curve for the currency will shift to the left. This illustrates the difficulty of
maintaining a fixed exchange rate in the face of destabilising speculation.
The capital and financial accounts are equal to net capital flows, which are equal to net
foreign investment but with the opposite sign. Therefore, the current account balance must equal

net foreign investment. National saving is equal to private saving plus government (public)
saving. Private saving is equal to national income minus consumption and minus taxes.
Government saving is the difference between taxes and government spending. National income
(GDP) is equal to the sum of investment, consumption, government spending and net exports.
The sum of the domestic investment and the net foreign investment is the saving and investment
equation.
Australia has operated a current account deficit for many decades, largely due to interest
repayments on Australian borrowings from overseas, and dividends and profits paid to
foreigners who own assets and shares in Australia. Net foreign debt is the difference between
the amount Australia lends to other countries and the amount other countries lend to Australia.
Australias net foreign debt as a percentage of GDP has been increasing since the 1980s. Due to
low savings levels in Australia, borrowing from overseas is necessary to fund investment and
economic growth. The repayment of interest on net debt remains a relatively small proportion of
GDP and is generally not seen as a problem. The severe problems with large government debt in
some European countries since 2009 has shown how it can cripple economic growth and lead to
potential loan defaults.

Chapter Outline
The Balance of Payments: Linking Australia to the International Economy
1.

There are two types of economies:

A. An open economy interacts in trade or finance with other economies.
B. A closed economy has no interactions in trade or finance with other countries.
C. The balance of payments is the record of a countrys trade, borrowing, lending, capital
and investment flows with other countries.

2.

The balance of payments contains three accounts:

A. The current account records a countrys net exports and net income.
I.

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 of the
goods and services it imports. This is also known as net exports.

B. The capital account records relatively minor transactions which consist of assets
people take with them when they enter or leave the country, debt forgiveness, and sales
and purchases of non-produced, non-financial assets.
C. 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.
I.

There is a capital outflow from Australia when an investor in Australia buys

a bond issued by a foreign company or government or when an Australian
firm builds a factory in another country.

II.

There is a capital inflow into Australia when a foreign investor buys a bond
issued by an Australian firm or by the government or when a foreign firm
builds a factory in Australia

III.

When firms build or buy facilities in foreign countries, they are engaging in
foreign direct investment.

IV.

When investors buy stock or bonds issued in another country, they are
engaging in foreign portfolio investment.

V.

Net capital flows is the difference between capital inflows and capital
outflows.

VI.

Net foreign investment is the difference between capital outflows from a

country and capital inflows, which is also equal to net foreign direct
investment plus net foreign portfolio investment.

3.

The sum of the current account balance, the capital account balance and the financial

account balance equals the balance of payments.

A. The balance of payments is always zero.
I.

To make the balance on the current account equal the balance on the capital
and financial accounts, the balance of payments includes an entry called the
net errors and omissions.

II.

Changes in foreign holdings of dollars are known as official reserve

transactions.

The Foreign Exchange Market and Exchange Rates

1.

The nominal exchange rate is the value of one countrys currency in terms of another

countrys currency.
2.

There are three sources of foreign currency demand for the Australian dollar:
A. Foreign firms and consumers who want to buy goods and services produced in
Australia.
B. Foreign firms and consumers who want to invest in Australia either through foreign
direct investment buying or building factories or other facilities in Australia, or
through foreign portfolio investment buying shares and bonds issued in Australia.
I.

The factors affecting the supply curve for dollars are similar to those
affecting the demand curve for dollars.

II.

An economic contraction in Australia, (assuming all else remains the same

in the rest of the world), will decrease the demand for a foreign countrys
products and cause the supply curve for dollars to shift to the left.

III.

A decrease in interest rates in a foreign country will make financial

investments in that foreign country less attractive and cause the supply
curve for dollars to shift to the left.

C. Currency traders who believe that the value of the dollar in the future will be greater
than its value today.
I.

Speculators are currency traders who buy and sell foreign exchange in an
attempt to profit by changes in exchange rates.

II.

The exchange rate depends on the direction and size of the shifts in the
demand curve and supply curve.

III.

An increase (decrease) in the supply (demand) of dollars will decrease

(increase) the equilibrium exchange rate.

3.

Some exchange rates are not determined by the market. Some countries have fixed

exchange rates that do not change over long periods.

4.

Movements in the exchange rate affect exports and imports by depreciation and

appreciation of currency. A currency appreciation occurs when the market value of a currency
rises relative to another currency. A currency depreciation occurs when the market value of a
currency falls relative to another currency.
A. A depreciation in the domestic currency will increase exports and decrease imports,
thereby increasing net exports.

B. An appreciation in the domestic currency will decrease exports and increase imports,
which will reduce net exports, aggregate demand and real GDP.
5.

The relative prices of two countries goods are determined by two factors:
A. The relative price levels in the two countries.
B. The nominal exchange rate between the two countries currencies.

6.

The real exchange rate is the price of domestic goods and services in terms of foreign

goods.

The Current Exchange Rate System

1.

The current exchange rate system has three important aspects.

A. Since December 1983 Australia, like the USA and the UK with their currencies, allows
its currency to float against other major currencies, with very occasional intervention by
the Reserve Bank of Australia (RBA).
B. Most countries in Western Europe have adopted a single currency, the euro.
C. Some developing countries have attempted to keep their currencies exchange rates
fixed against the US dollar or another major currency.

2.

The dollar increases in value when it takes more units of foreign currency to buy one

dollar and falls in value when it takes fewer units of foreign currency to buy one dollar.
3.

The two most important causes of exchange rate movements are changes in interest

rates which cause investors to change their views of which countries financial investments
will yield the highest returns and changes in investors expectations about the future values of
currencies.
A. The theory that in the long run exchange rates move to equalise the purchasing power of
different currencies is referred to as the theory of purchasing power of parity.
B. The theory of purchasing power of parity is not a complete explanation of exchange
rates because:

4.

I.

Not all products can be traded internationally.

II.

Products and consumer preferences are different across countries.

III.

Countries impose barriers to trade.

There are four determinants of exchange rates in the long run: (a) relative price levels,

(b) relative rates of productivity growth, (c) preferences for domestic and foreign goods and (d)
tariffs and quotas.