1. The Open Economy &
Exchange rates

2. Pure theory of trade


1. Absolute
advantage: A country is said to have
an absolute advantage in the production of a good
when it is more efficient in the production of that
good
Assume each country has equal amounts of
resources and devotes half to X and half to Y
x
y
Country A
20
100
Country B
10
150

3. 

Country A has an absolute advantage in the
production of X and country B in production of Y.
2. COMPARATIVE ADVANTAGE
:Two countries can
trade with each other if each specializes in the
industry in which it has the lowest opportunity costs.
x
Country A
Country B
20
10
y
200
150

4. 

Country A has a
comparative
advantage in the
production of X and B
in the production of Y
Specialization leads to
increased total
production
A
30
100
B
0
300
Total
30
400
A
35
50
B
0
300
Total
35
350

5. Instruments of trade policy
o
o
o
o
o
Tariffs:
specific tariffs are a fixed charge for
each unit of good produced
Ad valorem: are levied as a fraction of
the value of the imported goods
Quotas
Export subsidies

6. Effects of alternative trade
policies:
tariffs
Exp.sub quota
VER
Producer Rises
s’ surplus
Consume falls
r surplus
Rises
Rises
Rises
Falls
Falls
Falls
Govt rev Rises
Falls
Total
welfare
falls
No
change
Falls
No
change
No
change
Falls

7. 



Adjustable peg- where exchange rates
are fixed for a period of time but may
change
Devaluation: where the Govt re-pegs the
exchange rate at a lower level.
Revaluation – re-pegs at a higher level.
Dirty floating- a system where govt
intervenes to prevent excessive
fluctuations or even to achieve an
unofficial target rate

8. Exchange Rates


Defining Exchange Rate
Measuring Exchange Rate Movements



Appreciation/Depreciation of a currency
Exchange Rate Equilibrium
Factors that influence Exchange Rate
Movements

9. Meaning of Exchange Rate and
Measuring Changes in Exchange
Rates




Value of one currency in units of another
currency
A decline in a currency’s value is referred to
as depreciation and an increase in currency’s
value is called appreciation.
If currency A can buy you more units of
foreign currency, currency A has appreciated
and foreign currency depreciated
If currency A can buy you less units of foreign
currency, currency A has depreciated and
foreign currency appreciated

10. Appreciation/Depreciation

Percentage change in value US $
New Value of Foreign Currency
per unit of $
-
Old value of foreign currency per $
--------------------------------------------------
X 100
Old value of Foreign Currency per $

Percentage change in value of Foreign
Currency
New Value of $ per units of
Foreign Currency
-
Old value of $ per unit of foreign currency
-------------------------------------------------Old value of $ per unit of Foreign Currency
X 100

11. Exchange Rate Equilibrium




Forces of Demand and Supply
Demand for foreign currency negatively
related to the price of foreign currency
Supply of foreign currency positively
related to the price of foreign currency
Forces of demand and supply together
determine the exchange rate

12. Demand for Foreign Currency
Price for Foreign Currency
D
$2.00
$1.50
D
50m
75 m
Units of Foreign Currency (£)

13. 
Demand for pounds:
1.The firms, households and govt who
import UK goods
2. US citizens travelling to UK
3. Holders of $ who want to invest in UK
stocks and shares
4. US companies wanting to invest in
UK
5. Speculators anticipating a fall in
dollar price

14. Supply of Foreign Currency
price of foreign currency
S
$2.00
$1.50
S
50 m
75 m
Units of Foreign Currency (£)

15. 
Supply of pounds:
1. Importers of US goods into UK
2. UK citizens travelling to US.
3. Holders of pounds who want to buy
financial instruments into US
4. UK companies wanting to invest in US
5. Speculators anticipating a rise in the
value of dollars.

16. Equilibrium Exchange Rate
Exchange Rate
D
S
$1.6775
S
D
Units of Foreign
Currency(£)

17. Factors that influence the
Exchange Rate
Relative Inflation Rates
 Relative Interest Rates
 Relative Income Levels
 Expectations of the Market
 Political Events
Exchange rate is the results of an
interaction of these factors


18. Relative Inflation



High inflation relative to a foreign country, decline in
value of currency
Low inflation relative to a foreign country, increase in
value of currency
If inflation rates in one country are higher, there is an
increased demand for imported goods and decrease
in exports. This increases the demand for foreign
currency and reduces demand for local currency –
leading to depreciation

19. Relative Interest Rates



High interest rates in home country relative to a
foreign country may cause domestic currency to
appreciate
If US Interest rates fall then outflow of dollars leading
to increase in demand for pounds and British citizens
will not invest in US leading to a fall in supply of
pounds. This causes dollar to depreciate
An increase in the interest rate paid on deposits of a
currency causes that currency to appreciate against
foreign

20. Relative Income Levels


Increase in domestic income relative to
foreign income may lead to a decline in the
value of domestic currency– Why?
Imports are a function of income . Hence
increasing incomes lead to increase in
imports and hence increase in demand for
foreign currency. This causes domestic
currency to depreciate

21. Market Expectations







Expectations about future exchange rate
changes on the basis of current and future
political and economic conditions
1960s Strong $
Between 1960s and 1970s: weak $
Strong $ in 1999 – 2001
Weak Dollar today 2005 onwards
1995 European Exchange Rate Mechanism
Devaluation of Asian Currencies

22. Political Events





Fall of Berlin Wall and unification of
East and West Germany
Rumors about resignation of Mikhail
Gorbachov
Tiananmen Square
Persian Gulf War
September 11, 2001

23. Fixed vs flexible exchange
rates:

Advantages of flexible exchange rates:






Better adjustment mechanism
Better confidence
No need for central banks to hold money
Gains from freer trade
Increases independence of policy
Disadvantages:



Uncertainty and diminished trade
Instability
speculation

24. 
Fixed exchange rate is maintained by





Use of reserves
Trade policies
Exchange control
Domestic macro-adjustments
Raising interest rates

25. 
Advantages of fixed exchange rates





Certainty
No speculation
Automatic correction of monetary errors
Prevents irresponsible macro policies
Disadvantages:

Makes monetary policy ineffective



Imbalance persists
BOP deficit may hurt the economy
Problems of international liquidity

26. Surplus or a Deficit in the BOP:




A deficit in the BOP can have 2
consequences:
The country can borrow from abroad.
It may sell its assets
To rectify a deficit:



Devaluation/depreciation
Import restrictions
Domestic deflation to reduce aggregate
demand

27. Impact of a Devaluation:

Increase in exports depends on



Price elasticity of demand for the
exportables
Price elasticity of supply in the domestic
market
Decrease in imports depend on


Price elasticity of demand for imports
May result in cost push inflation and hence
a rise in price if exports as well.

28. J curve:


A depreciation leads to at first a
deterioration of the trade balance and
then an improvement
Marshall Lerner condition: The sum of
proportional change in exports plus the
proportional change in imports minus
the percentage change in depreciation
must be positive

29. Balance of Payments



A record of international transactions between
residents of one country and the rest of the world
International transactions include exchanges of
goods, services or assets
“Residents” means businesses, individuals and
government agencies, including citizens
temporarily living abroad but excluding local
subsidiaries of foreign corporations

30. Double-entry Accounting in the BOP


All transactions are either debit or credit
transactions
Credit transactions result in receipt of
payment from foreigners
 Merchandise exports (valued f.o.b.)
 Transportation and travel receipts
 Income received from investments abroad
 Gifts received from foreign residents
 Aid received from foreign governments

31. Double-entry Accounting (Cont’d)

Debit transactions involve payments to
foreigners






Merchandise imports
Transportation and travel expenditures
Income paid on investments of foreigners
Gifts to foreign residents
Aid given by home government
Each credit transaction has a balancing debit
transaction, and vice versa, so the overall
balance of payments is always in balance.

32. Balance of payments:

A. Current Account:
 Balance of Trade in goods
 Balance of Trade in services- travel, insurance
and transportation.
 Balance of trade in goods and services
 Other income flows



Investment income
Transfers, balance( aid, remittances)
GNIE

33. 
B. Capital Account:







1.Foreign investment
FDI and FII
2.Loans and commercial borrowings
3. Banking capital – assets, liabilities and non
resident deposits.
4.Rupee debt service
5. others.
Capital account = 1+2+3+4+5
C. Errors and omissions
D. Overall balances
E. Monetary movements- IMF / foreign
exchange reserves
balance in current account + balance in
capital account + monetary movts =0

34. Real exchange rates:


Relative prices of two currencies after
adjusting for changes in domestic
prices
RER of $ per pound:
= ($/£)(PUK/PUS)
If exchange rate = 3$ per £
RER = 1 if prices in UK and US are 30
and 90 respectively.