Macroeconomic Principles of Open Economies Study Notes

I. Macroeconomic Principles of Open Economies

1. National Accounting in Open Economies

  • National accounts encompass various sectors, flows, and changes in wealth.

  • Key concepts from national accounts include:   - Sectors: Various economic agents such as firms, households, government, and foreign sector.   - Real and Monetary Flows: Tracking inputs and outputs related to goods and services.   - Change of Wealth: Monitoring wealth shifts within the economy.   - Global Impact: How these factors affect a country's GDP (Gross Domestic Product) and GNI (Gross National Income).

2. Classical Model

  • Describes differences between aggregate expenditures and production in open economies.

3. Exchange Rate

  • The (nominal) exchange rate is the value of one currency compared to another.   - Nominal Exchange Rate Notation: e = €/$ (price notation) or $/€ (quantity notation)   - Appreciation/Depreciation: An appreciation occurs when e ↓ and depreciation when e ↑.   - Real Exchange Rate (ε): Defined as ε = e P*/P, representing the trade rate of goods between countries.

4. Exchange Rate Regimes

  • Variations can be based on supply and demand for currencies.

5. Interest Rate Parities

  • Focuses on the relationship between domestic and foreign interest rates and their impact on currency rates.

6. Purchasing Power Parities (PPP)

  • Explores conditions under which the law of one price (identical goods should have the same price in different markets) holds.   - Absolute PPP: P = e P* where P is the domestic price and P* is the foreign price.   - Relative PPP: Relates the inflation rates to the nominal exchange rates over time.

II. National Accounting in Open Economies

Characteristics of Different Sectors

  • Firm Sector:   - Buys factors of production.   - Produces and sells goods/services.

  • Household Sector:   - Buys goods/services.   - Sells factors of production.

  • Government Sector:   - Generates revenue through taxation.   - Provides public goods at no price.

  • Foreign Sector:   - Individuals residing outside the country in question.

Closed System of Circular Flows

  • The total value of inflows must equal total outflows in all sectors.   - Circular Flow Axiom: Value of inflows = Value of outflows.

  • Example Model:   - Households ⇄ Firms:     - Inflows: Wages, rents, interest, profits → Outflows: Consumption expenditure.     - Identity: Income = Expenditure.

Flows in Change of Wealth Accounts

  • Accounts for various components of the economy:   - Private savings (Sp)   - Government savings (Sg)   - Investments (In = investments - depreciation)   - Net exports (NEX = Exports - Imports)

  • Important Identity:   - S=Sp+Sg=In+NEXS = Sp + Sg = In + NEX and thus, savings finance net investments and positive net exports, transforming into real/financial wealth.

Total Wealth of an Economy

  • Defined as the sum of capital stock and financial wealth:   - Financial Wealth = Financial Assets - Financial Liabilities

  • Change in Total Wealth:   - extChangeintotalwealth=extChangeincapitalstock+extChangeinfinancialwealthext{Change in total wealth} = ext{Change in capital stock} + ext{Change in financial wealth}.

Changes in Net Financial Wealth

  • Current Account Balance Defined:   - extExports−extImports+extIncomereceipts−extIncomepayments+extCurrenttransfersfromabroad−extCurrenttransferstotherestoftheworldext{Exports} - ext{Imports} + ext{Income receipts} - ext{Income payments} + ext{Current transfers from abroad} - ext{Current transfers to the rest of the world} = Current Account Balance

  • Financial wealth changes based on the balance of payments.

III. Classical Model

General Differences Between Open and Closed Economies

  • Aggregate expenditures can deviate from production levels in an open economy (Open economy model where absorption differs from GDP).

  • Absorption (A): A = C + I + G (Domestic expenditures)   - In a closed economy: C+I+G=Y=extGDP<em>extclosedC + I + G = Y = ext{GDP}<em>{ ext{closed}}   - In an open economy: C+I+G+EX−IM=extGDP</em>extopenC + I + G + EX - IM = ext{GDP}</em>{ ext{open}} (absorption can vary)

Relationships Between Net Exports and Capital Flows

  • National accounts relationships:   - Y=C+I+G+NEXY = C + I + G + NEX   - Y−C−G=I+NEXY - C - G = I + NEX   - S=I+NEXS = I + NEX   - S−I=NEXS - I = NEX (net capital export)

  • Interpretations based on NEX relationship indicating savings flows abroad or foreign savings inflow affecting domestic financial wealth positively and negatively.

IV. Empirical Analysis of the Feldstein-Horioka Puzzle

1. Overview of the Study

  • Feldstein and Horioka (1980) analyzed relationships between investment and savings, discovering a significant correlation indicating limited international capital mobility despite expectations of higher mobility.   - Correlation Results: A strong correlation suggests limited mobility.

2. Statistical Methods and Interpretations

  • Investigated through regression analysis, deriving investment ratios from savings ratios with the formula:   - I=βS+exterrortermI = \beta S + ext{error term}

  • Parameters interpreted as:   - Immobile capital if $eta ightarrow 1$.   - Perfect capital mobility if $eta ightarrow 0$.

3. Results and Interpretations

  • The study confirmed the strong correlation between investments and savings.

  • Generally, high correlation is preserved across various datasets, though problems regarding robustness and models arise.

  • Issues include lack of accounting for economic policy's impact on investment and the limiting scope of certain subsamples.

V. Exchange Rate Dynamics

1. Exchange Rate Definition

  • The nominal exchange rate measures one currency's value against another.   - Exchange Rate Notations include:     - Price notation (e = €/$)     - Quantity notation ($/€)

  • Terms of appreciation (decrease in e) or depreciation (increase in e).

2. Real Exchange Rate

  • Defined as ε = e P*/P representing the relative trade rates of goods—an indicator of competitiveness.   - Appreciation of ε (ε ↓) indicates an increase in domestic goods’ competitiveness in foreign markets.

3. Example of Real Exchange Rates

  • Germany example:   - Price per car: €30,000.   - US price per plane: $5,000,000.   - Exchange Rate Calculation and implications.

VI. Interest Rate Parity

1. Covered Interest Rate Parity (CIRP)

  • Investment in domestic returns equals foreign investments, adjusted for expected currency values.   - Basic formula: rac1etimes(1+r)=rac1et+1imes(1+r∗)rac{1}{e_t} imes (1 + r) = rac{1}{e_{t+1}} imes (1 + r^*)

  • Derives the interest arbitrage condition that investment returns must equate across domestic and foreign investments.

2. Uncovered Interest Rate Parity (UIP)

  • Inrisk-neutral scenarios, the expected depreciation of the exchange rate reflects interest rate differentials:   - r−r∗=E(et+1−et)r - r^* = E(e_{t+1} - e_t)

  • Acknowledges expectations affect forward exchange rates through market dynamics—forward bias evidenced in empirical studies.

VII. Conclusion

  • Various factors contribute to the complexity of economic relationships, particularly in open economies where cross-border interactions complicate traditional models.

  • The role of fiscal policy, interest rates, exchange rates, and global economic relationships continue to evolve, making ongoing analysis essential for understanding international finance dynamics.