Lecture9_OpenEcon

Lecture9_OpenEcon - EC3024 Managerial Macroeconomics The...

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EC3024 Managerial Macroeconomics The open economy and exchange rate regimes
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The Open Economy Openness has three distinct dimensions: 1. Openness in goods markets. The ability of consumers and firms to choose between domestic goods and foreign goods. Free trade restrictions include tariffs and quotas . 2. Openness in financial markets . The ability of financial investors to choose between domestic assets and foreign assets. Capital controls place restrictions on the ownership of foreign assets. 3. Openness in factor markets . The ability of firms to choose where to locate production, and workers to choose where to work. The North American Free Trade Agreement (NAFTA) is an example of this. 2
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The Open Economy We focus on the implications of the openness in financial markets. We will introduce a new equilibrium condition – the interest parity condition – a relation between the nominal exchange rate, both current and expected, and domestic and foreign interest rates. We will discuss the cons and pros of fixed and flexible exchange rate regimes 3
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In this course, the nominal exchange rate E is the price of the domestic currency in terms of the foreign currency . An appreciation of the domestic currency corresponds to an increase in the exchange rate. A depreciation of the domestic currency corresponds to a decrease in the exchange rate. With fixed exchange rates , we use Revaluations , rather than appreciations Devaluations , rather than depreciations. Openness in Financial Markets Nominal Exchange Rates 4
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The purchase and sale of foreign assets implies buying or selling foreign currency—sometimes called foreign exchange . Openness in financial markets allows: Financial investors to diversify—to hold both domestic and foreign assets and speculate on foreign interest rate movements. Countries to run trade surpluses and deficits. A country that buys more than it sells must pay for the difference by borrowing from the rest of the world. How can a country borrow? It borrows by making it attractive for foreign financial investors to increase their holdings of domestic assets – in effect, to lend to the country. Openness in Financial Markets 5
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Openness in Financial Markets New Choices: Domestic currency versus Foreign currency Domestic bonds versus Foreign bonds Assume foreign currency cannot be used for transactions Holding foreign bonds is more desirable than holding foreign currency Actual new choices: domestic versus foreign bonds? 6 The Choice between Domestic and Foreign Assets
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The decision whether to invest abroad or at home depends not only on interest rate differences, but also on your expectation of what will happen to the nominal exchange rate.
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