Macroeconomics - Lecture 5 Notes

The Open Economy

• An open economy engages in trade and financial interactions with other countries.
• To varying degrees, all nations function as open economies.
• The global economy has become increasingly interconnected over time.

Trade Openness

• Trade openness is measured as the sum of exports and imports of goods and services, divided by the gross domestic product (GDP), expressed as a percentage, also known as the "trade openness index."
• The value of exported goods as a share of GDP is also used to measure trade openness.

Balance of Payments

• The balance of payments account records all payments to and receipts from foreign countries for a specific time period, typically a year or a quarter.
• It records all the inflows and outflows of money under various headings.
• Inflows are recorded as credits (+); outflows are recorded as debits (-).
• The balance of payments account consists of three main parts:
  1. The current account
  2. The capital account
  3. The financial account

Current Account

• The current account records a country’s imports and exports of goods and services, plus incomes and transfers of money to and from abroad.
• Balance of trade: exports – imports
  • Exports (credits)
  • Imports (debits)
• Net income flows
  • Wages, interest, and profits flowing into and out of the country.
• Net current transfers
  • Government contributions to (-) and receipts from abroad (+).
  • International transfers of money by private individuals and firms for consumption.
• Current account balance: the overall balance of the above subdivisions.
  • Surplus if credits > debits
  • Deficit if debits < credits

Capital Account

• The capital account records the transfers of capital to and from abroad.
• Records the inflows (credits) and outflows (debits) of funds associated with:
  • Buying or selling fixed assets (land and buildings, intangibles such as patents).
  • Transfer of funds by migrants.
  • Payment of grants by the government for overseas projects.
  • Receipt of money for capital projects.
• The UK’s capital account balance is small compared to that on the current and financial accounts.

Financial Account

• The financial account records the flows of money into and out of the country for the purposes of investment or as deposits in banks and other financial institutions.
• Records cross-border changes in the holding of assets (company shares, property, bank deposits and loans, government securities).
• Direct investment: significant and long-term interest in a business in another country.
  • Credit: foreign company invests from abroad to the UK.
  • Debit: investment abroad by UK company.
• Portfolio investment: transactions in debt and equity securities which do not result in the investor having any significant influence on the operations of a business.
• Other financial flows: various short-term monetary movements between countries.
• Flows to and from reserves:
  • Bank of England sells reserves: inflow (credit) to the Balance of Payments (+).
  • Bank of England builds reserves: outflow (debit) to the Balance of Payments (-).

UK Balance of Payments

• UK Balance of Payments in 2023 (£m and % of GDP):
  • Balance on trade in goods (exports minus imports): -186,719 (£m), -6.9 (% of GDP)
  • Balance on trade in services (exports minus imports): 153,342 (£m), +5.7 (% of GDP)
  • Balance of trade: -33,377 (£m), -1.2 (% of GDP)
  • Net income flows (wages and investment income): -34,866 (£m), -1.3 (% of GDP)
  • Net current transfers (government and private): -20,299 (£m), -0.8 (% of GDP)
  • Balance on current account: -88,542 (£m), -3.3 (% of GDP)
  • Net capital transfers: -5,519 (£m), -0.2 (% of GDP)
  • Balance on capital account: -5,519 (£m), -0.2 (% of GDP)
  • Direct investment: -73,418 (£m), -2.7 (% of GDP)
  • Portfolio investment: -165,885 (£m), -6.2 (% of GDP)
  • Other investment (mainly short-term flows): +298,549 (£m), +11.1 (% of GDP)
  • Financial derivatives (net): +10,621 (£m), +0.4 (% of GDP)
  • Reserves: +3,710 (£m), +0.1 (% of GDP)
  • Balance on financial account: +73,577 (£m), +2.7 (% of GDP)
  • Net errors and omissions: +20,484 (£m), +0.8 (% of GDP)
  • Total: 0 (£m), 0.0 (% of GDP)
  • Total current account: -88,542 (£m), -3.3 (% of GDP)
  • Total capital account: -5,519 (£m), -0.2 (% of GDP)
  • Total financial account: +73,577 (£m), +2.7 (% of GDP)
  • Total current + capital + financial accounts: -20,484 (£m), -0.8 (% of GDP)
  • Net errors and omissions: +20,484 (£m), +0.8 (% of GDP)
  • Overall balance of payments: 0 (£m), 0.0 (% of GDP)

Exchange Rates

• Exchange rate: the rate at which one currency trades for another on the foreign exchange market.
• Floating exchange rate: the exchange rate determined by demand and supply.
  • Depreciation: fall in the free-market exchange rate (for example, £ buys less $).
  • Appreciation: rise in the free-market exchange rate (for example, £ buys more $).
• Exchange rate index: a weighted average exchange rate expressed as an index, where the value of the index is 100 in a given base year.
• Market actors (e.g., banks, firms, individuals) buy and sell foreign exchange on a daily basis.

Implications of Depreciation

• Some impacts of the falling pound:
  • Higher prices: increases the price of imports, as it costs more to buy from abroad.
  • Stronger sales for UK exporters: a weaker pound makes it less expensive for people abroad to buy goods and services from UK firms.
  • More expensive trips abroad: the purchasing power of the pound will fall, as more pounds will be required to pay for goods and services abroad.

Lecture Summary

1. The balance of payments account records all payments to and receipts from foreign countries.
2. The whole account must balance, but surpluses or deficits can be recorded on any specific part of the account.
3. Floating exchange rates are determined by demand and supply in the exchange rate market.