February, 2025

A Few Notes on International Economics II

Prepared by
Dr. Girma Estiphanos
Department of Economics
(Note: This material does not exhaust all the items in the course outline.
To that effect, missing topics and sub – topics shall be covered in class
lectures. Thus, students are advised to take notes during lecture classes)

I. Introduction

1.1. An Overview of the Subject Matter of International Economics II

(or International Finance Theory and Policy)

To begin with, what is international economics about?

International economics is a sub - branch of economics that deals with
the theory and practice of international trade and finance. In short,
international economics is about economic interdependence between or
among nations. Such interdependence shall take place through the
exchange of goods and services, flow of both physical (or real) capital
and portfolio capital (financial assets such as stocks and bonds), flow of
people, as well as the accompanying spillover effects such as flow of
technology, skill, knowledge, innovation and creativity.
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The components of international economics are: the pure theory of

international trade, the theory of international commercial policy, and
international monetary theory (international finance or the balance of
payments theory). What do mean by each of these components? This
shall be covered in class lecture.
The increasing interdependence among nations has resulted in the loss
of some degree of sovereignty. Some countries have surrendered a good
part of their sovereignty willingly, for example, the European
Community which has now transformed into the European Union (EU).
The EU headquarters is located in Brussels, Belgium. As of 2008 there
were 28 countries in the EU. It originated with the European Coal and
Steel Community (ECSC) of 1951, which became the European
Community (EC) in 1967.

When countries form regional blocs as a community, they are

embracing relatively smaller less developed members and thus put in
place some provisions for compensatory arrangement for loss of
revenue. Other countries, while unwilling to surrender their
sovereignty, are constrained in how they can exercise their autonomy.
In general, each country has to take into account the reactions of other
countries when formulating its economic policies. This is what is
refereed to as international macroeconomic policy coordination.

Some knowledge of international economics is necessary to understand

what goes on in the world of today and to be informed consumers,
citizens, etc.

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1.2. The Foreign Exchange Markets

The foreign exchange market is an organizational framework within

which individuals, firms, and banks buy and sell foreign currencies or
foreign exchange. The major locations for such transactions are London,
Paris, Zurich (Switzerland), Frankfurt, Singapore, Hong Kong, Tokyo,
and New York. These different monetary centers are connected by a
telephone network and video screens and are in constant contact with
one another.

The principal function of a foreign exchange market is the transfer of

funds or purchasing power from one nation and currency to another.
Other functions include the provision of short term credits to finance
trade and the facilities for avoiding foreign exchange risks.

The efficiency of foreign exchange market: A market is said to be

efficient if prices reflect all available information. The Foreign exchange
market is said to be efficient if forward rates accurately predict future
spot rates (to be dealt with in subsequent discussions). Spot exchange
rate refers to the current exchange rate while the forward exchange rate
refers to an exchange rate that is quoted and traded today but for
delivery and payment on a specific future date.

1.3. The Foreign Exchange Rate

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Exchange rate is the price of one currency expressed in terms of another

currency. In other words, it is the price of one country’s currency
expressed in another country’s currency. For example, consider the case
of US dollar ($) and British Pound (£). One can write either $/£ or £/$.
The first representation is the number of dollars that exchanges for one
pound, that is, the price of a British pound in terms of US dollar. The
second representation is the number of pounds that exchanges for one
dollar, that is, the price of a US dollar in terms of the British pound. If
the exchange rate between the dollar and the pound is $2 = 1£, then the
exchange rate $/£ = 2, which means 2 dollars are needed to buy one
pound. The reciprocal will then be £/$ = 0.5, which means half a pound
is needed to buy one dollar.

Let the initial exchange rate be: $/£ = 2 (two dollars are needed to buy
one pound) and let the new exchange rate be: $/£ = 3 (three dollars are
needed to buy one pound). Therefore, the dollar has depreciated (its
value has declined) while the pound has appreciated (its value has
increased). Thus, the higher the exchange rate of one pound in terms of
dollars, the lower the relative value of the dollar.

Foreign exchange rates are usually quoted be dealers. The rate at which
the foreign currency is offered for sale is called the bid price. The rate at
which the foreign currency will be purchased is called the ask price. The
difference between the bid price and the ask price is known as the
spread and is the gross profit margin of the dealer.

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Financing International Trade

One factor that makes international trade different from domestic trade
is the involvement of different national currencies. For example, when a
U. S. firm exports goods to a Mexican firm, the U. S. exporter wants to
be paid in dollars, but the Mexican importer possesses pesos. The
importer must exchange pesos for dollars before the U. S. export
transaction can occur. The problem is resolved in foreign exchange
markets.
EXCHANGE RATES
Recall that one exchange rate is obviously the reciprocal of the other.
Who are the participants in a foreign exchange market? The main
participants in the foreign exchange markets are: commercial banks
(major ones), corporations engaged in international trade, non-bank
financial institutions such as asset management firms, insurance
companies, central banks, foreign exchange brokers and other
authorized dealers.
TYPES OF EXCHANGE RATES
I. A Flexible or floating exchange Rate system:
Demand and supply determine exchange rates and no government
intervention. In other words, if a currency is free-floating, its exchange
rate is allowed to vary against that of other currencies and is
determined by the market forces of supply and demand.
Advantage:

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Proponents of flexible exchange rates say that such rates automatically

adjust and eventually eliminate balance of payments deficits or
surpluses. For example, take the case of the U. S. and the U. K. The shift
in the exchange rate from $2 = £1 to $3 = £1 changes the relative
attractiveness of U. S. imports and exports and restores equilibrium in
the U. S. and U. K. balance of payments. In the above case, the two
adjustments are a decrease in U. S. imports from Britain and an
increase in U. S. exports to Britain. This will correct the U. S. balance of
payments deficit.
In general, under a flexible exchange rate system, a deficit in a nation's
balance of payments is automatically corrected by a devaluation of its
currency, while a surplus if corrected by a revaluation of its currency.
The disadvantages of flexible exchange rate are as follows:
1) Uncertainty and Diminished Trade: The risks and uncertainties
associated with flexible exchange rates may discourage the flow of
trade. For example, a U. S. automobile dealer contracts to
purchase 10 British cars for £150, 000. At the current exchange
rate of, say, $2 = £1, the U. S. importer expects to pay $300,000 for
these automobiles. But, if during the 3- month delivery period, the
rate of exchange shifts to $3 = £1, the £150, 000 payment
contracted by the U. S. importer will be $450,000. The increase in
the dollar price of pounds may thus turn the U. S. importer's
anticipated profit into substantial loss. Aware of the possibility of
an adverse change in the exchange rate, the U. S. importer may
not be willing to assume the risks involved. The U. S. firm may
confine its operations to domestic automobiles and thus
international trade in this product will not occur. The same thing

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can happen with investments. Assume that when the exchange

rate $3 = £1, a U. S. firm invests $30,000 (or £10,000) in a British
enterprise. It estimates a return of 10 percent, that is, it
anticipates annual earnings of $3,000 (10/100 of 30,000) (or £1,000
or 10/100 of 10,000)). Let the expectations prove to be correct in
the first year. Suppose during the second year, the value of the
dollar appreciates to $2 = £1. The return is now $2,000 (or 10/100
of 20,000) rather than $3,000. The rate of return falls from 10
percent to 6.6 percent (that is $2,000/$30, 000 times 100). The
added risk of changing exchange rates may persuade the U. S.
investor not to venture overseas.
2) Terms - of - Trade Changes: A decline in the international value
of its currency will worsen a nation's terms of trade. For example,
an increase in the dollar price of a pound, say from $2 = £1 to $3 =
£1 (that is, dollar depreciates and pound appreciates) will mean
that the United States must export more goods and services to
finance a specific level imports from Britain (because imports
have become expensive and, thus more units of dollars are now
needed to purchase the same basket than before).
3) Instability: Flexible exchange rates may destabilize the domestic
economy because wide fluctuations stimulate and then depress
industries producing exported goods. For example, if the U. S.
economy is operating at full employment and its currency
depreciates, then the results will be inflationary for two reasons:
1) Foreign demand for U. S. goods may rise, increasing total
spending and pulling up U. S. prices. Also, the prices of all U. S.
imports will increase, 2) conversely, appreciation of the dollar will

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lower U. S. exports and increase imports, possibly causing

unemployment. Flexible or floating exchange rates may also
complicate the use of domestic stabilization policies in seeking full
employment and price stability. This is especially true for nations
whose exports and imports are large relative to their total
domestic output.

II. A Fixed Exchange Rate:

Governments are rarely willing to allow complete freedom of movement
in exchange rates, and so intervention in the market. Governments
intervene in order to smooth out fluctuations in the exchange rate. In
general, if there is an excess supply at the target price, then the
government (or its agency) should buy that excess supply on the market,
while if there is an excess demand, then the government should sell.
A fixed or pegged exchange rate system is where governments
determine exchange rates and make necessary adjustments in their
economies to maintain these rates. In other words, governments do not
allow the demand for and supply of its currency against other
currencies to affect a predetermined exchange rate, except within
narrow limits. People who advocate fixed exchange rates claim that this
system eliminates much of the uncertainty for foreign traders, investors,
and citizens who plan to travel abroad. In other words, it establishes
stability in foreign exchange rates.

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Between 1879 and 1934 the major nations of the world adhered to a
fixed-rate system called the gold standard. The gold standard was a
monetary system (to be discussed in another chapter) wherein all forms
of legal tender may be converted, on demand, into fixed quantities fine
gold, as defined by law. Under this system, each nation must: 1) define
its currency in terms of a quantity of gold, 2) maintain a fixed
relationship between its stock of gold and its money supply, and 3) allow
gold to be freely exported and imported. If each nation defines its
currency in terms of gold, then the various national currencies will have
fixed relationships to one another. This is what is refereed to as the mint
- parity (that is a fixed relationship between any two currencies). For
example, if the Unites States defines $1 as worth 25 grains of gold, and
Britain defines £1 as worth 50 grains of gold, then a British pound is
worth 2 times 25 grains or $2.
The first country to go on gold standard was Britain, in 1816. The
United States made the change in 1873, and most other countries
followed suit by 1990. With some exceptions, the prevalence of the gold
standard lasted until the economic crisis of 1929 (that is, the Great
Depression). Between 1931 and 1934, the governments of virtually all
countries found it necessary to abandon the gold standard. This policy
was partly motivated by the belief that the exports of a country could be
stimulated by devaluing its currency in terms of foreign exchange. In

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the Unites States, for example, a policy of devaluation of the currency

was initiated by President Franklin D. Roosevelt.

How do governments maintain a fixed exchange rate?

1. Use of Reserves:
One way to maintain a fixed exchange rate is to manipulate the market
through the use of official reserves. Such manipulations are called
currency interventions. By selling part of its reserves of pounds, the U.
S. government could increase the supply of pounds, shifting the supply
curve to the right.
How do official reserves originate? Perhaps a balance - of - payments
surplus occurred in the past. The U. S. government would have
purchased that surplus. That is, at some earlier time, the U. S.
government may have spent dollars to buy the surplus pounds.

2. Trade Policies
To maintain fixed exchange rates, a nation can try to control the flow of
trade and finance directly. For example, the United States government
could try to maintain the $2 = £1 exchange rate in the face of a shortage
of pounds by discouraging imports (thereby reducing the demand for
pounds) and encouraging exports (thus increasing the supply of
pounds). Imports could be reduced by means of new tariffs or import
quotas; special taxes could be levied on the interest and dividends U. S.
financial investors receive from foreign investments. Also, the U. S.

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government could subsidize certain U. S. exports to increase the supply

of pounds.
The fundamental problem in this regard is that these policies reduce the
volume of world trade. In other words, when nations impose tariffs,
quotas, etc., they lose some of the economic benefits of a free flow of
world trade. Furthermore, trade barriers by one nation could lead to
retaliatory responses from other nations.

3. Exchange Controls and Rationing

Another option in maintaining fixed exchange rates is to adopt exchange
controls and rationing. Under exchange controls, the U. S. government
could handle the problem of a pound shortage by requiring that all
pounds obtained by U. S. exporters be sold to the Federal government.
Then the government would allocate or ration this short supply of
pounds among various U. S. importers. However, there are major
objections to exchange controls: a) Distorted Trade: Like tariffs, quotas,
and export subsidies, exchange controls would distort the pattern of
international trade away from the pattern suggested by comparative
advantage (recall, the effect of tariffs in international trade theory, that
is, the deadweight loss, consumption and production components).
b) Favoritism: The process of rationing scarce foreign exchange might
lead to government favoritism toward selected importers (for example,
big contributors to reelection campaigns). c) Restricted Choice:
Controls would limit freedom of consumers' choice. The U. S.
consumers who prefer Volkswagens might have to buy Chevrolets.
d) Black Markets: A black market is an economic activity in which
merchandise and/or services are bought and sold illegally. Also called

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the "underground market," the black market gets its name due to the
fact that its activity is conducted out of sight and often "in the dark,"
outside the sight of law enforcement. Black markets are phenomena of
times of crisis. When there are exchange controls, importers who want
foreign exchange badly may resort to illegal sellers of foreign exchange.

4. Domestic Macroeconomic Adjustments:

A final way to maintain a fixed exchange rate would be to use domestic
stabilization policies (monetary policy and fiscal policy) to eliminate the
shortage of foreign currency. For example, contractionary policies such
as tax hikes, reduction in government spending, and a high-interest-rate
policy would reduce total spending in the U. S. economy and,
consequently, domestic income. Because the volume of imports varies
directly with domestic income, demand for British goods, and therefore
for pounds, would be restrained.

(You may recall from your macroeconomics that injections constitute

investment, government expenditure, and exports, while leakages or
withdrawals constitute savings, taxation, and imports. Furthermore,
injections are expansionary, while leakages are contractionary).
The Current System: The Managed Float
The current international exchange rate system (1971 - present) is an
almost flexible system called managed floating exchange rates.
Exchange rates among major currencies are free to float to their
equilibrium market levels, but nations occasionally use currency
interventions in the foreign exchange market to stabilize or alter market
exchange rates.

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Devaluation of a Currency
In economics, devaluation is an official act of reducing the value of a
currency.
Causes
The free market value of a currency is determined by the interaction of
supply and demand. If the quantity of the currency demanded is greater
than the quantity supplied, a nation's currency will appreciate, or
increase in value. A nation's currency will depreciate, or decrease in
value, when the quantity of currency supplied is greater than that
demanded.
The demand for a nation's currency depends on the amount of its
exports, domestic investments, and assets held in domestic currency.
For example, the demand for U. S. dollars depends on U. S. exports (the
attractiveness of U. S. goods and services), the need to invest in the U. S.,
etc. A nation's currency supply on world markets depends partly on the
amount of imports, investments abroad, and assets held in foreign
countries. The supply of a currency also depends on national monetary
policy. If a country, for example, prints too much money, causing
inflation domestically, a balance of payments deficit results.

Effects: Expenditure Switching

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Currency devaluation primarily affects a nation's trade balance, which

is the difference between the value of its exports and that of its imports.
Devaluation reduces the value of a nation's currency in terms of other
currencies; thus, following devaluation, a nation will have to exchange
more of its own currency in order to obtain a given amount of foreign
currency. This causes the price of imports to rise and makes domestic
products more attractive to consumers at home. Because it takes less
foreign currency to buy a given amount of the devalued currency, the
price of the nation's exports declines, making them more desirable to
foreign consumers.
Depending on consumer and producer responsiveness to price changes
(known as supply and demand elasticities), an effective devaluation
should reduce a nation's imports and raise world demand for its
exports. The more elastic the demand for imports and exports, the
greater the effect the devaluation will be on the country's trade deficits
and, therefore, on its balance of payments.
Devaluation often is criticized as an inflationary monetary policy
because it raises the domestic price of imports. The underlying cause is
rather excess money creation, rather than devaluation. Devaluation is
unpopular policy, especially in small countries that are extremely
dependent on imports as a source of food and other necessities.

The Law of One Price:

The law of one price is the proposition that states that identical goods
sold in competitive markets should cost the same everywhere when
prices are expressed in terms of the same currency, disregarding
barriers to trade and transportation costs. For example, assume that

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the dollar/pound exchange rate is $2 per pound. If a pair of shoes costs

£200 in the U. K., then the same pair of shoes must cost $400 in the U. S.
The law of one price applies to only an individual good, like shoes.

The Purchasing Power Parity (PPP) Theory: Absolute and Relative PPP
The purchasing power parity is the theory that changes in exchange
rates are related to the changes in relative prices among countries. In
other words, the purchasing power theory extends the law of one price
(which applies to an individual good) to a representative market basket
of goods. Thus, PPP states that an exchange rate between two countries
should equal the ratio of the price level in one country to the price level
in the other country. Absolute PPP is a statement about absolute prices
and exchange rate levels, while relative PPP is a statement about price
and exchange rate changes over time. In other words, relative PPP is the
theory that a percentage change in the exchange rate is equal to the
difference in the percentage change in price levels.
Nominal and Real Exchange Rates
The nominal price of a good is the price posted in the marketplace. Its
real price is the nominal price adjusted for changes in the overall level
of prices. Similarly, the nominal exchange rate (NER) (or the posted
exchange rate) is the amount of the domestic currency that is required
for purchasing a unit of the foreign currency. On the other hand, the
real exchange rate (RER) is the nominal exchange rate adjusted for
changes in domestic prices within the two countries. In other words, it is

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the value of nominal exchange rate corrected by the ratio of domestic

price to the foreign price level.

(You may recall from your macroeconomics that Nominal GDP is the
value of a year's production at that year's prices (also called current -
dollar GDP), while Real GDP is the value of a year's production at the
prices in the base year (also called constant-dollar GDP). In other words
Real GDP is the ratio of Nominal GDP to Price Index).

THE BALANCE OF PAYMENTS

1. What is it?
2. What are the main purposes?
3. Accounting principle
4. Components
A nation's balance of payments is the sum of all the transactions that
take place between its residents and the residents of all foreign nations.
Those transactions include exports and imports of goods, exports and
imports of services, tourist expenditures, interest and dividends received
or paid abroad, and purchases and sales of financial or real assets
abroad. The balance of payments statement shows all the payments a
nation receives from foreign countries and all the payments it makes to
them.
Example:
Consider the following simplified balance of payments statement for the
U. S. in 1999. It is divided into three components: the current account,
the capital account, and the official reserve account.
TABLE 1

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The U. S. Balance of Payments, 1999 (in Billions)

Current account
1. U. S. goods exports $+684
2. U. S. goods imports - 1030
3. Balance on goods $-346
4. U. S. exports of services +272
5. U. S. imports of services - 191
6. Balance on services +81
7. Balance on goods and services - 265
8. Net investment income -18
9. Net transfers -48
10. Balance on current account -331
Capital account:
11. Foreign purchases of assets in the Unites States +760 *
12. U. S. purchases of assets abroad - 438 *
13. Balance on capital account +322
Official reserves account:
14. Official reserves +9
__________
$0
* Includes statistical discrepancy
Source: Survey of Current Business, October 2000, Web Site
Recall that the balance of payments shows all the real and financial
flows between a country and the rest of the world.
The Components of the Balance of Payments:
1. The Current Account

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In the balance of payments accounts, items on the current account are

those that are relating to international trade in merchandise (for
example, airplanes and computer chips) and services (for example,
banking, insurance, transportation, consulting, brokerage), income
from investments, gifts, and other unilateral transfers. The balance of
exports and imports of goods is refereed to as the balance of visible trade
or the balance of merchandise trade. On the other hand, the balance of
exports and imports of services is called the balance of invisible trade.
Unilateral transfers or unrequited transfers can take three forms:
private unrequited transfers or gifts, official unrequited transfers such
as "pure aid" by governments (that is, transactions on which
government expects no return), and reparation payments or indemnities
which are compensation for loss or damage. Specifically, the current
account contains three categories on the receipts side: exports of
merchandise, exports of services, and income receipts on
assets/investments abroad. The three counterparts on the payments side
are: imports of merchandise, imports of services, and income payments on
foreign assets. Unilateral transfers are government and private gifts
abroad.
From Table 1 above, on the U. S. balance of payments, 1999, the United
States incurred a trade deficit on goods of $346 billion (see item 3).
However, as indicated in item 6, the United States registered a trade
surplus on services of $81 billion. Thus, as indicated in item 7, the
balance on goods and services show a deficit of $265 (346 - 81) billion.
For the United Sates, net investment income and net transfers (items 8
and 9) show a deficit of $66 (18+48) billion. Therefore, the balance on

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current account (item 10) for the United States was a deficit of $331
(265+66) billion.
By convention, a surplus is often refereed to as a favorable trade
balance and a deficit is refereed to as an unfavorable trade balance.
These are terms which were carried over from the period of
Mercantilism.
The conventional method is that exports are valued at FOB (Free On
Board) and imports are valued at CIF (cost, insurance, and freight or
charged in full). FOB, is a term which describes a price for or valuation
of a good which is calculated on the basis of the process of manufacture,
and does not include the cost of transporting the good to the consumer.
That is, where a firm prices its goods FOB, we can be sure that the
consumer pays the transport costs. On the other hand, CIF pricing or
valuation includes all the costs of delivering the good to the point of
consumption.
2. The Capital Account
The capital account summarizes the purchase or sale of real assets or
financial assets and the corresponding flows of monetary payments that
accompany them. The real investments may involve land, buildings,
machinery, equipment, tolls, etc. The financial (or portfolio)
investments may involve bonds, stocks, bank deposits, etc. In the
balance of payments model, it is argued that money is not only chasing
goods and services, but to a larger extent, financial assets such as stocks
and bonds. Their flows go into the capital account item of the balance of
payments, thus, balancing the deficit in the current account. The
increase in capital flows has given rise to the asset market model. The
asset market approach views currencies as asset prices traded in an

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efficient financial market. The Mundell - Fleming model, a model

developed independently by two economists, Robert A. Mundell and
Marcus J. Fleming, is used to analyze capital flows, monetary and fiscal
policies. This shall be treated in our subsequent discussions.

The distinguishing feature of financial assets or securities is that they

represent a contractual right to receive future payments if the conditions
stated in the contract are met.
What are bonds? Bonds are a type of fixed - income (or fixed - interest)
assets/securities, in that the repayment stream on the bond is usually
fixed at the time that the bond is issued. The asset is negotiable
(saleable) and contracts to pay the holder a certain fixed money sum at
regular intervals until maturity (that is, until such time as the liability is
discharged and the outstanding sum or the principal is repaid.

Bonds are usually issued by various government bodies or by private

corporations. The issuance of bonds by governments and corporations
represents borrowing by the issuing entities.

There are many different types of bonds. Bonds are distinguished by

their terms of maturity, that is, the time horizon of the loan. We thus find
short-term, medium-term, and long-term bonds. For example, bonds

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issued by the U. S. Treasury Department have different names

depending on their terms of maturity. Treasury bills are short-term
obligations, with maturity of up to 1 year; Treasury notes are
government securities with maturities between 1 to 10 years; and
Treasury bonds are longer-term assets with maturities ranging from 10
years to 30 years. Local governments also issue their own long-term
obligations, commonly called municipal bonds. Bonds that do not have
the backing of the federal government involve the risk of default if the
issuing entity experiences heavy financial strains. Corporate and
municipal bonds fall into this category.

Bonds are debt instruments. They have a face value or maturity value.
For example, a face value of $1000 indicates the amount that will be
paid back to the lender at the end of the life of the bond, and interest
payments (or coupon payments) are usually made each year (for
example, $60 per year or a 6% ($60/$1000).

Other fixed-income assets in addition to the bonds include deposits made

banking institutions. For example, checking accounts (which allow the
privilege of writing checks against them) and saving deposits (which of
course are less liquid and they normally do not involve checking
privileges like the checking accounts). In some cases, depositors are
required to give notice 30 days before a withdrawal.
What are stocks? Stocks are variable - income securities, since the future
dividends are not fixed but rather depend on future profits. Holding of
stocks by individuals and institutions brings with it ownership of the

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company whose stock is held. Hence, there is an element of control

involved with stocks that is absent from bonds.
Primary and Secondary Financial Markets: primary markets are those
that conduct sales of newly issued securities to original buyers. When the
General Motors Corporation wants to finance a project with long-term
bonds, for example, it sells these bonds in a primary market. Secondary
markets, on the other hand, trade previously owned securities. The
distinction is important. When a newly issued share of IBM is sold, the
proceeds of the sale accrue to the IBM, but when a previously issued
share is traded, the proceeds go to the owner of the shares.
The capital account consists of official capital flows, which refers to
governments and central banks. For example, foreign official capital
flows to the United States and foreign official capital outflows from the
United States. Capital flows other than official are foreign private
capital such as foreign private investment (FDI). In the context of
international capital flows, direct investment consists of purchases of
physical assets such as land or factory buildings, or establishment of
wholly owned businesses as foreign branches or foreign subsidiaries.
The automobile production facilities that Japanese auto companies have
established in the United States provide examples of direct investment.
In Table 1, U. S. balance of payments, 1999, items 11 and 12 combined
yield a balance on capital account of +$322 billion for 1999 (line 13).
This capital account surplus brought in +322 billion foreign currencies
to the United States. That is, capital inflows (increased foreign assets in
the U. S.) exceed capital outflows (decreased foreign assets in the U. S.).
3. Official Reserve Account:

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Official reserve assets include gold holdings, foreign currency holdings

of the central bank, and Special Drawing Rights. Special Drawing Rights
(SDRs) is a form of international money created by the IMF (a
multilateral agency). The IMF creates and distributes these reserves
(SDRs) to member countries based on the countries' relative importance
in international trade. Both the IMF and the International Bank for
Reconstruction and Development (IBRD), now the World Bank, were
created at the Bretton Woods (a vacation resort in New Hampshire)
Conference in 1944. The conference was attended by representatives of
44 nations.
Long - term development assistance was to be provided by the World
Bank. Other affiliated institutions of the WB include the International
Finance Corporation (IFC) (established in 1956) and the International
Development Association (IDA) (established in 1960). The IFC aims at
stimulating private investments in developing nations from indigenous
and foreign sources to promote economic development. On the other
hand, the IDA aims at providing long-term, interest-free loans to poor
countries that cannot qualify for loans at market-based interest rates.
4. Statistical Discrepancy
This is also referred to as net errors and omissions or the balancing item.
Some transactions escape the recording and accounting framework
altogether. This applies to smuggling and money laundering, but it also
applies to legal transactions. Thus, the accountant creates a special
category for those items that escape recording due to oversight, secret
capital movements or smuggling, and incorrect entries.
As a concluding remark, in the economist's terminology, note that the
balance of payments is a flow concept rather that a stock concept. In

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other words, it portrays some type of economic activity during a particular

time period. On the other hand, a stock concept examines the value of a
particular economic variable at a point in time.
Deficits and Surpluses in the Balance of Payments
In accounting sense, the balance of payments must balance. That is the
total credits must equal to the total debits. However, economists and
political officials speak of balance of payments deficits and surpluses,
referring to imbalances between the current and capital accounts. Thus,
we speak of balance of payments disequilibria. A deficit in the balance
of payments causes the drawing down of official reserves, while a surplus
causes the building up of official reserves. A balance of payments deficit
is not necessarily bad, nor is a balance of payments surplus necessarily
good. This issue shall be picked up in our subsequent discussions.
From Table 1, on U. S. balance of payments, 1999, the United States had
a large current account deficit of $331 billion (item 10), and a capital
account surplus of $322 (item 13). Large current account deficits have
been the norm for the United States in recent years
Disequilibria in a Nation's Balance of Payments: Causes and Types
The two major reasons for balance of payments disequilibria are:
I. Short - run or cyclical reasons, and
II. Long - run or structural reasons.
I. Short - Run or Cyclical Reasons:

1. A cyclical expansion of national income at home and contraction

abroad will increase the nation's imports (because increased
income is positively related to both domestic and foreign goods);
reduce its exports (because foreign national income has

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contracted). This will lead to a deficit in the home nation. For

example, since 1992, the U. S. economy has grown more rapidly
than the economies of several trading nations. This growth of
income has boosted U. S. purchases of foreign goods (U. S.
imports). In contrast, Japan, some European nations, and Canada
have suffered either recession or slower income growth during this
period. Thus, their purchases of U. S. goods (U. S. exports) have
not kept pace with the rise of U. S. imports. Persistent U. S. trade
imbalances with Japan are particularly noteworthy. What are the
implications of U. S. trade deficits? Most economists see both
benefits and costs to trade deficits. a) Benefit: Increased Current
Consumption - at the time a trade deficit or a current account
deficit is occurring, American consumers benefit. A trade deficit
means that the United States is receiving more goods and services
as imports from abroad than it is sending out as exports.
However, it should be noted that the gain in present consumption
may come at the expense of reduced future consumption (because
the deficit should somehow be corrected in the future). b) Cost:
Increased U. S. indebtedness: A trade deficit is considered as
"unfavorable" because it must be financed by borrowing from the
rest of the world, selling off assets, or dipping into foreign currency
reserves. This will increase United State's debt abroad, resulting
in increased foreign claims against assets in the United States. In
short, U. S. trade deficits are a mixed blessing.

2. Related to number 1 above, a higher rate of inflation at home

than abroad will encourage imports and discourage exports. In

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other words, money supply at home increases, leading to

increased demand for foreign goods (imports).

3. A crop failure or a strike may have the same effect and lead to a
deficit. In other words, if there is a crop failure or a strike,
exports shall reduce, leading to increased imports and, thus
resulting in a deficit.

II. Long - Run or Structural Reasons:

These, in general, refer to conditions of production and supply. Because

the structure of the economy is changing, there are manifestations of
disequilibria in the balance of payments. For example, some economists
argue that a deficit is a sign of dynamism in the economy. At an early
stage of development, essential imports such as raw materials, semi-
finished or intermediate goods, machinery, and equipment are
indispensable to move the economy forward.
In general, differences in the rate of growth at home and abroad (related
to number 1 above, for example in terms of income); changes in tastes
or demand preferences; differences in technological progress and
changing factor endowments; changes in economic and political
framework within which trade and payments are conducted (such as the
type and level of protection, formation of trading blocks, etc.) lead to
disequilibria in the balance of payments.
A deficit nation cannot continue to run deficits indefinitely and a
surplus nation is not willing to continue to run surpluses indefinitely.
Explain.

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1. A deficit nation can finance or settle the deficit in its balance

of payments by drawing on its international reserves, by
borrowing from abroad, or both. However, each nation has
limited reserves and its ability to borrow is also limited by
its ability to repay. Thus, because of limited reserves and
limited ability to repay, the nation cannot continue to run
deficits indefinitely.
2. A surplus means giving up real goods and services in
exchange for sterile (unproductive or idle) gold or foreign
exchange (because part of the surplus is to be kept in official
reserve account). Furthermore, surplus nations are
reluctant to continue lending to deficit nations indefinitely
because of fear of default. Therefore, a surplus nation
cannot continue to run surpluses indefinitely.

3. Finally, it should be noted that it is relatively easier to

remove surpluses than deficits. In other words, the need and
the burden of adjustment is greater for deficit nations than
for surplus nations.

Adjustment Policies:

The most important economic goals or objectives of nations are: 1)

internal balance, 2) External balance. 3) Reasonable rate of growth, and
4) an equitable distribution of income.

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1. Internal balance refers to full employment with stable prices. Full

employment does not mean 100% employment and, thus a rate of
unemployment of, say, 5% per year could be accommodated
because of the so-called frictional unemployment that arises in the
process of changing jobs. In other words, frictional
unemployment is the transitional or temporary unemployment
that arises because unemployed persons may take a few weeks to
find a new job after losing or quitting a job, or after entering or
reentering the labor force following illness, schooling, or some
other reason for being out of the labor force. On the other hand,
when we say stable prices, a rate of inflation of 2 or 3% could be
accommodated.
2. External balance refers to equilibrium in the balance of payments.
In general, nations place priority on internal balance over external
balance. However, they are sometimes forced to switch their
priority when faced with large and persistent external imbalances.
To achieve the objectives stated above, nations have the following policy
instruments:
1. Expenditure-changing or demand policies: refer to fiscal and
monetary policies - expansionary or contractionary (please refer
to our earlier discussions).
2. Expenditure-switching policies: refer to changes in the exchange
rates (that is, devaluation or revaluation of a currency).
Devaluation switches expenditures from foreign to domestic
commodities and can be used to correct a deficit. This is so
because of the theoretical argument that exports become cheaper
while imports become expensive upon devaluation. Revaluation

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switches expenditures from domestic to foreign products and can

be used to correct a surplus. This is so because of the theoretical
argument that exports become expensive while imports become
cheaper upon revaluation. However, experience shows that
nations have often been unwilling to utilize these instruments.
3. Direct controls: consist of tariffs, quotas, and other restrictions on
the flow of international trade and capital. In general, direct
controls are a last resort because these activities are rent-seeking,
unproductive, and involve lobbying and favoritism.
Approaches to Balance of Payments

There are heated debates on the impact of devaluation on trade balance.

To this effect, several theories have been advanced to explain the effect
of devaluation on trade balance. The most common ones are the
elasticity, absorption, and monetary approaches.
I. The Elasticity Approach
The elasticity view of the balance of payments was pioneered by Alfred
Marshall, Abba Lerner and later extended by Joan Robinson (1937)
and Fritz Machlup (1955). This approach states that the elasticity of
demand for exports by foreigners and that of imports by domestic
residents determine trade balance or balance of payments. The
Marshall - Lerner condition upon which the theory is built states that:
1. If the sum of the elasticity of foreign demand for exports and
the elasticity of domestic demand for imports, in absolute
terms, exceeds unity, then devaluation will improve the trade
balance. In other words, the more elastic the demand for imports
and exports, the greater the effect of the devaluation will be on

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the country's trade deficits and, therefore, on its balance of

payments.
2. If the sum of the elasticity of foreign demand for exports and
the elasticity of domestic demand for imports, in absolute
terms, is less than unity, then devaluation will worsen the trade
balance, and
3. If the sum of the elasticity of foreign demand for exports and
the elasticity of domestic demand for imports, in absolute
terms, is equal to unity, then devaluation will neither improve
nor worsen the trade balance.
It should be noted that the elasticity approach to the balance of
payments is based on partial equilibrium analysis, which assumes that
income and prices of other commodities are kept constant.
Furthermore, the approach deals with only the current account and
ignores the capital account of the balance of payments.
There are also critics that higher import prices caused by devaluation
could stimulate increases in domestic prices of non- traded goods. The
consequence is a rise in inflation and this could potentially reduce the
benefits of devaluation. Furthermore, devaluation is an unpopular
policy, especially in small countries that are extremely dependent on
imports as a source of food and necessities.
A general consensus accepted by most economists is that elasticities are
lower in the short run than in the long run, in which case the Marshall -
Lerner condition may only hold in the medium to long-run. In other
words, in the short run it may be difficult to react to price changes by
reallocating factors of production. In the long run, however, it is much
probable that the production pattern will alter according to price changes

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and the demand for imports will therefore be more elastic (i.e., responds
to changes in prices).
In general, less developed agricultural countries have small and poorly
developed import competing sectors. They import necessities and
industrial goods that are needed for their development programs.
Therefore, their demand for imports is on the whole very inelastic. That is,
prices have little effects on imports because these imports are needed for
development.

On the other hand, most well - developed industrial countries have large
and well-developed import competing industries. For these countries the
demand for imports is often very elastic. That is, prices have significant
effect on imports.
The J - Curve Effect:
Most economists and policy makers believe that currency devaluations
bring about competitive advantage in international trade. In other
words, when a country devalues its currency, exports become cheaper
relative to its trading partners, resulting in an increase in the quantity
demanded. Devaluation as a policy prescription is mainly aimed at
improving the trade balance. However, there is a time lag before the
trade balance improves following devaluation. The short run and long
run effects of devaluation on the trade balance are different.
Theoretically, the trade balance deteriorates initially after devaluation
and some time along the way it starts to improve until it reaches its long
run equilibrium. That is, initially devaluation of a currency causes a
current account deficit, and after a period of time the current account

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moves in the direction of a surplus. The time path through which the trade
balance follows is a J-curve.
The J curve is so named since it describes the shape of the time path the
current account figures may follow if time is plotted on the horizontal
axis and the balance of trade on the vertical. A nation's trade balance
may actually worsen soon after a devaluation or depreciation. In
explanation of these events it is usually argued that the volume of
exports and imports respond only slowly to the change in relative prices
that the devaluation has introduced and therefore imports remain high
and exports low in the immediate post-devaluation period. In other
words, there is a tendency that the domestic - currency price of imports
would rise faster than export prices soon after devaluation. To put it
differently, if consumers and producers are unresponsive in the short
run, depreciation actually leads to a short run worsening in the current
account before it ultimately gets better. Only after international
contracts are renewed to reflect the new exchange rate does the quantity
of imports and exports begin to change. That is, imports will begin to
decline and exports will begin to rise. Once this occurs, the country's
current account balance will begin to improve. The classic example of
this phenomenon is the United Kingdom's devaluation of 1967.
Why Time Lag after Devaluation?
The time lag comes about as an impact of several lags such as
recognition, decision, delivery, replacement and production.
i) Recognition Lag: Following a real depreciation, traders
take time to recognize the changes in market
competitiveness. This may take longer in international
markets than in domestic markets before information is

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passed on the stakeholders because of distance and

language problems.
ii) Decision Lag: Some time is spent on deciding on what
business relationships to venture into and for the
placement of new orders.
iii) Delivery Lag: There is a delivery lag that explains the
time taken before new payments are made for orders
that were placed soon after the price shocks.
iv) Replacement Lag: Procurement of new materials may be
delayed to allow inventories of material to be used up.
v) production Lag: There is a production lag before which
producers become certain that the existing market
condition will provide a profitable opportunity.
The Inflationary Impact of Devaluation - Channels
The inflationary impact of devaluation may come through various
channels.
i) Devaluation increases the domestic prices of imports. If these
imports are final goods, then there is an immediate impact on
the price level. If the imports are intermediate goods, then the
increase in their prices will push up the production costs (cost –
push inflation) of those goods in which they are used.
ii) The prices of domestically-produced goods may also rise even if
they do not use imported intermediate goods; this will almost
certainly be the case if they (the domestic goods) are close
substitutes for imports, but may come about through a
reduction in the degree of competition within the economy.

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iii) Devaluation may have a second - stage inflationary impact if

the increase in the price level leads to increased wage demands
(cost-push inflation), and if domestic firms are more willing to
give increases because of the reduction in competitive pressure
from imports. The consequences of such inflation will be that it
erodes the impact of devaluation.

II. The Absorption Approach

One of the major defects of the elasticity approach is that it is based

upon the assumption that all other things are equal (or ceteris paribus).
In other words, the elasticity approach assumes that devaluation is
supposed to work on the balance of payments through the price
(exchange rate) effect. In other words, the absorption approach is a
reaction against the restrictive assumptions underlying the elasticity
approach.
The absorption approach emphasizes the macroeconomic (income)
effects of devaluation. That is, changes in export and import volumes
will have implications for national income and consequently income
effects need to be incorporated in a more comprehensive analysis of the
effects of devaluation. Sidney Alexander (1952) (who named it as the
absorption approach) gave an important evaluation of the income effect,
focusing on the fact that a current account imbalance can be viewed as

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the difference between domestic output and domestic spending (or

absorption).
The model can be explained by using simple mathematical derivation as
follows:
Y = C + I + G + (X - M) -----------(1) Keynesian National Income Identity
And defining domestic absorption as: A = C + I + G ----------- (2)
Rearranging (1), we have
CA = X - M = Y - A ------------ (3)
Where, CA is current account, which is the difference between domestic
output (Y) and domestic absorption (A).
From (3), a current account surplus means (X > M) that domestic
output exceeds domestic spending (Y > A), and current account deficit
(X < M) means that domestic output is less than domestic spending (Y <
A).
Transforming (3) as changes: d CA = d Y - d A ---------- (4)
That is, a change in the current account depends on the difference
between a change in national income and a change in domestic
absorption. Thus, if devaluation raises domestic income relative to
domestic absorption, then the current account improves. If, however,
devaluation raises domestic absorption relative to domestic income, then
the current account deteriorates. Understanding how devaluation affects
both income and absorption is therefore central to the absorption
approach to the balance of payments analysis.
If the economy is at less than full employment, there will be an increase
in net exports following devaluation. This will lead to an increase in
national income and employment via the foreign trade multiplier (the
reciprocal of MPS and MPM or 1/MPS+MPM). Consequently,

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devaluation will become an effective measure in improving the trade

balance.
If, however, the nation was at full employment, then production or real
income (Y) cannot rise, and depreciation or devaluation can be effective
only if domestic absorption /expenditure (A) falls, either automatically
or as a result of contractionary fiscal and monetary policies.
Devaluation has also terms of trade effect. The terms of trade is the ratio
of price of exports to the price of imports. Devaluation tends to make
imports more expensive, resulting in deteriorating terms of trade. The
devaluing country has to export a greater volume in order to import the
same volume as before. This represents a loss of real national income
because more units of exports have to be given up to obtain a unit of
imports.
III. The Monetary Approach - The Impact of Devaluation on the
Purchasing Power (Real Value) of Money Balances
The monetary approach to the balance of payments was started toward
the end of the 1960s by Robert Mundell and Harry Johnson and became
fully developed during the 1970s. The monetary approach represents an
extension of domestic monetarism (stemming from the Chicago School)
to the international economy. It views the balance of payments as an
essentially monetary phenomenon. That is, money plays the crucial role
in the long run both as a disturbance and as an adjustment in the
nation's balance of payments.
The monetary approach to the balance of payments regards the balance
of payments disequilibria as a reflection of disequilibrium in the money
market. According to the monetary approach, the balance of payments
should be analyzed in terms of a country's supply of and demand for

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money. When the quantity supplied of domestic money exceeds the

quantity demanded by the nation's residents, there will be an outflow of
domestic money (a deficit in the nation's balance of payments) under a
fixed exchange rate system or a depreciation of the nation's currency
under flexible exchange rates. On the other hand, when the quantity
demanded of domestic money by the nation's residents exceeds the
quantity supplied, there will be a capital inflow (a balance of payments
surplus) under fixed exchange rates or an appreciation of the domestic
currency under flexible rates. In the international payments context,
attention is principally focused on the capital account.

The monetary approach looks at the implications of devaluation on

capital movements. Devaluation raises domestic prices (because imports
have become expensive and thus reduces the purchasing power (money
balance) of domestic residents because of higher prices. The opposite
holds for foreigners. That is, the purchasing power of their money
balances will rise.
Currency Devaluation in the Ethiopian Context
There are studies that show that, in the long run, real exchange rate
depreciation has a positive impact on Ethiopia's trade balance.
Competitiveness, however, should go beyond currency depreciation.
Export diversification (both horizontal and vertical) should as well be
considered. Horizontal diversification refers to increasing the number of
export items rather than relying on a limited number of primary
commodities. Vertical diversification refers to a movement from primary
exports into manufactured exports.

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Furthermore, Ethiopia should import essential commodities such as raw

materials, semi-finished goods, fuel, capital and consumer goods, which
are crucial for production as well as consumption. These goods have to
be imported at world prices since they are not sufficiently available
domestically. In other words, they are price inelastic. i.e., even when
their prices rise, still they should be imported because they are essential.
The Asset Market or Portfolio Balance Approach
The monetary approach assumes that domestic and foreign bonds are
perfect substitutes. The asset market or portfolio balance approach
differs from the monetary approach in that domestic and foreign bonds
are assumed to be imperfect substitutes.
The asset Market or Portfolio Balance Approach

In the simplest asset market model, individuals and firms hold their
financial wealth in some combination of domestic money, a domestic
bond, and a foreign bond denominated in the foreign currency. The
incentive to hold bonds (domestic and foreign) results from the yield or
interest that they provide. However, they also carry the risk of default
and the risk arising from the variability of their market value over time.
Domestic and foreign bonds are not perfect substitutes. Foreign bonds
denominated in foreign currency carry some additional risk (in that the
foreign currency may depreciate) with respect to domestic bonds.
Holding domestic money, on the other hand, is risk less. Thus, the
opportunity cost of holding domestic money is the yield forgone on
holding domestic bonds. The higher the yield or interest on bonds, the
smaller is the quantity of money that individuals and firms want to
hold. Individuals and firms do want to hold a portion of their wealth in

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the form of money (rather than bonds) to make business payments (that
is, the transactions demand for money).

As has already been stated above, the foreign bond denominated in the
foreign currency carries additional risk that the foreign currency may
depreciate. But, holding foreign bonds allows the individual to spread
his/her risks because disturbances that lower returns in one country are
not likely to occur at the same time in other countries. Thus, a financial

portfolio is likely to hold domestic money (to carry out business

transactions), domestic bond (for the return it yields), and the foreign
bond (for the return and for the spreading of risks).

Thus, given the holder's tastes and preferences, his/her wealth, the level
of domestic and foreign interest rates, his/her expectations as to the future
value of the foreign currency, rates of inflation at home and abroad, etc.
he/she will choose the portfolio that maximizes his/her satisfaction (i.e.,
that best fits his/her tastes). A change in any of the underlying factors
will prompt the holder to reshuffle his/her portfolio. For example, an
increase in the domestic interest rate raises the demand for the domestic
bond but reduces the demand for money and the foreign bond. As
investors sell the foreign bond and exchange the foreign currency for
the domestic currency in order to acquire more of the domestic bond,
the exchange rate falls (i.e., the domestic currency appreciates with
respect to the foreign currency because its demand has increased, while
the foreign currency depreciates because its demand has fallen). On the
other hand, an increase in the foreign interest rate raises the demand for

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foreign bond but reduces the demand for money and the domestic bond.
As investors buy the foreign currency in order to acquire more of the
foreign bond, the exchange rate rises (i.e., the domestic currency
depreciates because its demand has fallen, while the foreign currency
appreciates because its demand has increased). According to the asset
market approach, equilibrium in each financial market occurs when the
quantity demanded of each financial asset equals its supply. Because
investors hold diversified and balanced (from their individual point of
view) portfolios of financial assets, the asset model is also refereed to as
the portfolio balance approach.

Conclusion
Portfolio is a collection of assets both financial (for example, money,
bonds, and stocks) and real (for example, land, gold, paintings). In
general, economic agents (individuals or firms) dislike risk, i.e., they are
risk averse. That is, they care about reducing risks as well as maximizing
expected returns. As a result, they hold a wide portfolio, that is, a
collection of financial assets in order to spread their risks. The essence
of portfolio theory for risk averse investors is "don't put all your eggs in
one basket." In the world of international finance, this translates into
"don't put all your wealth in the financial assets of one country, or even
one currency." When agents care about the expected returns on their
portfolios, but not about risks, we say they are risk neutral.
Some Basic Terms in Financial Assets
1. A Default Risk: is the risk that a borrower will not make
scheduled payments on its outstanding debt.

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2. A Certificate of Deposit (CD): is a bank deposit with a stated

maturity. Ordinarily, a CD cannot be withdrawn before maturity,
but large negotiable (marketable) CDs can be sold to someone
else.
3. Fixed-income Assets: are assets for which the borrower contracts
to make specified dollar (or other currency) payments at specific
times.
4. Bonds: are debt obligations issued by firms and governments,
usually with maturities of 10 - 30 years.
5. Mortgages: are very similar to bonds. They are debt obligations
secured or backed by particular pieces of property.
6. Loans: are debt obligations that differ from other forms of debt
only in that they are not traded in markets.
7. Collateral: is a general term for property offered by a borrower
to assure repayment.
8. Common Stock: is the principal security representing ownership
claims on corporations. The common stockholders (shareholders)
of a corporation are its owners.
9. Excess Reserves: are bank reserves above the amount of required
reserves.
10. The Monetary Base: is the sum of currency in circulation outside
the banking system and in bank reserves.
11. Open-Market Operations: are central bank purchases and sales
government securities in the open (public) market.
12. The Discount Rate: is the interest rate the Fed charges on its
loans to banks.

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13. Reserve Requirement: is a law or regulation requiring that a

bank hold a certain percentage of its deposits in the form of
reserves. The requirement also specifies the assets in which
reserves may be held.
14. M1 Definition of Money (Narrow Money): is defined as the sum
of all currency in the hands of non-bank public, all deposits
subject to check, and all outstanding traveler's checks.
15. M2 Definition of Money: is M1 plus small saving deposits and
small time deposits in banks.
16. M3 Definition of Money: is M2 plus large time deposits (for
example, $100,000 and over) and similar assets held primarily by
wealthy individuals.
17. A Liquid Asset: is one that can be quickly and cheaply converted
into cash, with minimal risk.
18. Money: is defined by the four functions: a medium of exchange
(means of making payments for goods and services); means to
discharge debts (repayment of a loan); a store of value (can be held
for a period of time and at the end of the period can be exchanged
for goods and services); and a unit of account (the standard for
measuring wealth).
Macroeconomic Policy in an Open Economy
Introduction
In order to make policy analysis in the open economy, we begin by
developing a very basic framework that will allow us to examine the
interaction between policies aimed at attaining external balance and those
aimed at other domestic targets such as full employment and price
stability. One of the early models that differentiated the effects of

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monetary and fiscal policy on the open economy was developed by a

Canadian economist Robert Alexander Mundell (1962). Mundell won
the 1999 Nobel Prize in economics for his influential theories on
exchange rates between countries and how they affect monetary
policies. On the assumption of the perfect mobility of capital, Mundell
demonstrated that monetary policy has no impact (i.e., it is ineffective) on
employment under fixed exchange rates, while fiscal policy has no effect
on employment under flexible exchange rates. On the other hand, fiscal
policy has a strong effect (i.e., it is effective) on employment under fixed
exchange rates, while monetary policy has a strong effect on employment
under flexible exchange rates. The Mundell - Fleming (by Robert A.
Mundell and J. Marcus Fleming) model has been the starting point for
most subsequent work on open economy macroeconomics and in
exchange rate determination.
1. What is an open economy?
Open economy is an economy which engages in international trade. The
degree of openness of an economy may be approximated by the size of
its foreign trade sector relative to its Gross Domestic Product (GDP). That
is, the ratio of exports and imports to GDP.

2. What is open - economy macroeconomics?

Open - economy macroeconomics is the study of foreign exchange
markets, the balance of payments, and adjustment to the balance - of -
payments disequilibria.
3. Economics Goals/ Objectives of Nations
The most important economic goals or objectives of nations are:
i) Internal balance,

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ii) External balance,

iii) A reasonable rate of growth, and
iv) An equitable distribution of income.
i) What is internal balance?
Internal balance refers to full employment and price stability. Full
employment does not mean 100 percent employment. Thus, rate
unemployment of no more than, say, 5% per year may be considered as
full employment. This is because of the so-called frictional
unemployment arising in the process of changing jobs. Similarly, when
one refers to price stability, a rate of inflation of no more than 2 or 3
percent per year could be accommodated. The term inflation refers to a
continual increase in the general price level. The general price level is an
average of the prices of all the goods and services in an economy.
In general, there are four types of unemployment.
a) Cyclical unemployment,
b) Frictional unemployment,
c) Structural unemployment, and
d) Seasonal unemployment.

a) Cyclical unemployment is unemployment that arises from the

business cycles. It is short-run demand deficit unemployment. The
implication is that during certain phases of the business cycle there
will be insufficient jobs for the whole of the labor force no matter
how it is trained or deployed.
Business cycles refer to alternating period of expansion and contraction
in economics activity. They are the irregular fluctuations in the general
level of economic activity. Economists have identified four distinct

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phases of business cycles/business fluctuations. These are: i) Peak, ii)

Recession (or Contraction), iii) Trough, and iv) Recovery (or
Expansion).
Peak is a period at which business activity has reached a temporary
maximum. It is a period of high employment, high level of demand, and
high degree of utilization of resources. The price level is likely to rise
during this period. Recession is a period when economic activities slow
down or contract. It is a period of decline in total demand, income,
employment, and trade. Producers become pessimistic about the future
level of demand for their products and hence investment becomes less
attractive. But, because many prices are downwardly inflexible, the price
level is likely to fall if the recession is severe and prolonged, that is, if
depression occurs. In other words, a depression is a large and protracted
recession. Trough is a period of the lowest level of economic activity in
the business cycle. It is the phase in which output and employment
"bottom out" at their lowest levels. Recovery is a period of rising
aggregate demand, expanding output levels, and a falling rate of
unemployment. The rise in production and profits leads to business
optimism. The economy enters the phase of expansion and prosperity.
The cycle is thus complete.
b) Frictional unemployment is the transitional or temporary
unemployment that arises because unemployed persons may take
some time to find a new job after losing or quitting a job, or after
entering or reentering the labor force following illness, schooling
or some other reason for being out of the labor force.
c) Structural unemployment is unemployment that arises from
changes in the geographical or industrial structure of the economy.

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Shifts in the geographical or industrial structure of the economy

cause a certain degree of unemployment because people often take
substantial time to move from declining to expanding regions and
industries. People are often reluctant to move to new areas; they
are concerned about the costs of moving household goods; they
are concerned about the cost of leaving an established home and
friends in a community; they are concerned about the disruption
of their children's education; and so forth. For example, a textile
industry may move to the southern states of the USA because of
lower labor costs, resulting in increased unemployment in the
northern higher labor cost states. Similarly, through time, there
could a shift in the structure of demand, say, away from coal
toward oil and gas, resulting in increased unemployment in the
coal-producing areas. In general, structural unemployment is
unemployment of workers whose skills are not demanded by
employers, who lack sufficient skill to obtain employment, or who
cannot easily move to locations where jobs are available.

d) Seasonal unemployment is unemployment that arises as

employment conditions change over the seasons of the year. For
example, agricultural employment is high during harvest season
and low during other seasons. Christmas shopping boosts
employment in retail stores in the fall. Some teachers are
unemployed in the summer and some construction workers are
unemployed in the winter, etc.
As has been defined earlier, inflation is a sustained rise in the general
price level. It can be classified into two:

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a) Demand - pull inflation, and

b) Cost - push inflation.
a) Demand - pull inflation is a sustainable rise in the general price
level that arises from an excess demand over output at the existing
price level, caused by an increase in aggregate demand. In other
words, an increase in aggregate demand pulls up the price level.
Aggregate demand can be defined as the level of total demand in
the economy for a given level of prices, adding up consumption,
investment, government spending, and net exports in an open
economy.
b) Cost- push inflation: is a sustainable rise in the general price level
that arises from increases in the costs of production. This may
result from either an autonomous decision by employees to
demand higher real wages or by employers to raise their profit
margins or it may result from an autonomous increase in import
prices.
Popular sentiment runs so strongly against inflation that it is usually
taken for granted that the government should do something about it.
But if the government needs to do something about inflation, we need
to know what causes it. How do we explain why some countries have
higher inflation rates than others? If inflation is so disliked, why
don't governments simply get rid of it? The answer is that, normally,
inflation can only be reduced at a cost - only if the unemployment rate
is allowed to increase. In other words, there is a trade-off between
inflation and unemployment. This phenomenon is refereed to as the
Phillips Curve, after A. W. Phillips, a New Zealander who taught
economics in England in the 1950s. The Phillips Curve is the

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statistical observation by A. W. Phillips (1958) that there was an

inverse relationship between the rate of change of money wage rates
and unemployment rate in the U. K. over the period 1861 - 1957.
ii) What is external balance?
External balance refers to equilibrium in the balance of payments. To
achieve equilibrium in the balance of payments, nations employ the
following policy instruments: A) expenditure-changing or demand
policies, B) expenditure-switching policies, and C) direct controls.
A) Expenditure - Changing policies include both fiscal and monetary
policies. Fiscal policy is a macroeconomic policy that uses government
spending and/or taxation to affect the level of economic activity (GDP).
Fiscal policy is expansionary if government expenditures are increased
and/or taxes are reduced. These actions lead to an expansion of
domestic production and income through a multiplier process and
induce a rise in imports, depending on the marginal propensity to
import of the nation. In other words, expanding government spending
and/or reducing taxes will lead to increased income and an increase in
imports (because imports are directly related to income), resulting in a
balance of payments deficit. An expansionary fiscal policy may lead to a
crowding-out effect. Crowding-out effect is an economic outcome that
arises when an increase in government expenditures leads to an
offsetting decrease in private expenditures.
On the other hand, contractionay fiscal policy refers to a reduction in
government spending and/or an increase in taxes, both of which reduce
domestic production and income and induce a fall in imports. A
contractionary fiscal policy may lead to a crowding-in effect. A
crowding-in effect is an economic outcome that arises when a reduction

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in government expenditures leads to an offsetting increase in private

expenditures.

It should be noted that government expenditures (G), just like investment

(I) and exports (X) are injections into the system. On the other hand,
taxes (T), just like savings (S) and imports (M) are leakages/withdrawals
from the system.
Monetary policy is a macroeconomic policy that uses changes in the
money supply and/or changes in interest rates to affect a country's GDP.
Monetary policy is easy if the money supply is increased and interest
rates fall. Easy monetary policy (also refereed to as expansionary
monetary policy) induces an increase in the level of investment and
income in the nation (through the multiplier process), and induces
imports to rise. At the same time, the reduction in the interest rate
induces a short-term capital outflow or reduced inflow. For example, an
increase in the money supply will reduce interest rates, leading to a
reduction in short-term capital inflows or an increase in short-term
capital outflows which results in a balance of payments deficit.
On the other hand, tight monetary policy refers to a reduction in the
nation's money supply and/or a rise in interest rates. Tight monetary
policy (also refereed to as contractionay monetary policy) discourages
investment, income, and imports and leads to a short-term capital
inflow or reduced outflow.
The major tools of monetary policy include: i) Required reserve ratio, ii)
Discount rate, and iii) Open market operations.
i) Required Reserve Ratio:

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In most systems, commercial banks and other financial institutions (for

example, thrift institutions in the U.S.A. such as saving and loan
associations, mutual savings bank, or credit unions) that provide
checkable deposits are required by law to observe specific minimum
reserve ratios. Required reserves are an amount of funds equal to a
specific percentage of the bank's own deposit liabilities. A member bank
must keep these reserves on deposit with the Federal Reserve Bank (that
is, the Central Bank in the context of the United States of America).
Thus, the specific percentage of checkable - deposit liabilities that a
commercial bank must keep as a reserve is known as the reserve ratio.

Commercial bank's required reserves

Thus, reserve ratio = ______________________________________
Commercial bank's checkable-deposit liabilities

For example, if the reserve ratio is 10 percent (1/10 or 0.1), a particular

bank (say, Addis Bank), having accepted $100,000 in deposits from the
public, would have to keep $10,000 as reserves (by applying the above
formula it becomes 0.1 times $100,000 which is $10,000). If the reserve
ratio is 20 percent, then $20,000 of reserves would be required; if the
reserve ratio is 50 percent, then $50,000 would be required, etc.
The Fed has the authority to establish and vary the reserve ration
within limits legislated by Congress. The major purpose of a reserve
ratio is control. Required reserves help the Fed control the lending ability
of commercial banks. The Fed can take certain actions that either
increase or decrease commercial bank reserves and thus can affect the
ability of banks to grant credit. The objective is to prevent from over-

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extending or under-extending bank credit. In the United States of

America there are 12 banks chartered by the U. S. government to
control the money supply and perform other functions.

ii) Discount Rate:

One of the functions of a central bank is to be a "lender of last resort."
Occasionally, commercial banks have unexpected and immediate needs
for additional funds. In such cases, each Federal Reserve Bank will
make short-term loans to commercial banks in its district. When a
commercial bank borrows, it gives the Federal Reserve Bank a
promissory note (IOU) drawn against itself and secured by acceptable
collateral, typically U.S. government securities. Just as commercial
banks charge interest on their loans, so too Federal Reserve Banks
charge interest on loans they grant to commercial banks. The interest
rate that the Federal Reserve Banks charge on loans they make to
commercial banks and thrift institutions is called the discount rate. As a
claim against the commercial bank, the borrowing bank's promissory
note is an asset to the lending Federal Reserve Bank and appears on its
balance sheet as "loans to commercial banks." To the commercial bank
the IOU is a liability, appearing as "Loans from the Federal Reserve
Banks" on the commercial bank's balance sheet. Borrowing from the
Federal Reserve Banks by commercial banks increases the reserves of
the commercial banks and enhances their ability to extend credits.
The Fed has the power to set the discount rate at which commercial
banks borrow from Federal Reserve Banks. A lowering of the discount
rate encourages commercial banks to obtain additional reserves, while

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raising the discount rate discourages commercial banks from obtaining

additional reserves.
Suppose the economy faces recession and unemployment. The Fed
decides that an increase in the supply of money is needed to increase
aggregate demand so as to employ idle resources. To increase the supply
of money, the Fed must increase the excess reserves of commercial
banks. How can it do that? a) By purchasing securities in the open
market and thus injecting money into the economy, b) By lowering the
reserve ratio and thus increasing the size of the money multiplier, and
c) By lowering the discount rate and thus encouraging commercial banks
to borrow. These actions are called easy money policy (or expansionary
monetary policy).
On the other hand, if excessive spending is pushing the economy into an
inflationary spiral, the Fed should try to reduce aggregate demand by
limiting or contracting the supply of money. This is done just in the
opposite way of the actions mentioned above. That is, i) By selling
securities /government bonds in the open market and thus withdrawing
money from the system, ii) By increasing the reserve ration and thus
decreasing the size of the money multiplier, and iii) By raising the
discount rate and thus discouraging commercial banks from borrowing.
These actions are called tight monetary policy (or restrictive monetary
policy).
Of the three instruments of monetary control, buying and selling
securities in the open market is the most important. This technique has
the advantage of flexibility in that government securities can be
purchased or sold in large or small amounts and the impact on bank
reserves is prompt.

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It should be underlined that both fiscal and monetary policies operate

with lags and sometimes unpredictable lags. In general, there are three
types of policy lags. These are a) Recognition lag: time that elapses
between the existence of a problem and its recognition, b) Decision lag:
time that elapses between recognition of a problem and action taken,
and c) Effect (Response) lag: time that elapses between action taken and
the response (or feedback).
The lags of government decision making are avoided through the use of
what is refereed to as automatic stabilizes. Automatic stabilizes are
expenditures that automatically increase or taxes that automatically
decrease when economic conditions worsen. In other words, they have
immediate (automatic) effects on the economy. They may include, for
example, income tax; transfer payments (or entitlement programs) such
as social insurance; unemployment insurance; cash assistance welfare
programs; in-kind assistance programs such as food stamps, medical
care, and housing assistance; Medicare (health insurance for the
elderly/senior citizens and disabled); and Medicaid (health insurance for
the poor).
It is also worth-mentioning that the economy is like a locomotive, that is,
it cannot be expected to stop instantaneously/immediately, nor can it be
expected to accelerate to full speed quickly. Instead, the engineer has to
apply the brakes miles ahead of a planned stop; and acceleration can
take a long time.
iii) Open - Market Operations:
The Fed's Open market operations consist of the buying of bonds
(securities) from, or the selling of bonds (securities) to commercial
banks and the general public. In other words, in the open market, the

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Fed can decide to buy bonds from commercial banks or the general
public or may decide to sell bonds to commercial banks or the general
public. The buying of securities from commercial banks or the general
public would result in increased reserves of commercial banks (to
stimulate the economy), while the selling of securities to commercial
banks of the general public would result in decreased reserves of
commercial banks (to restrain the economy). Thus, the former action is
injection, while the later one is leakage.
B) Expenditure - Switching Policies:
Expenditure - switching policies refer to changes in the exchange rate
(that is, devaluation or revaluation). Devaluation switches expenditures
from foreign to domestic commodities and can be used to correct a deficit
in the nation's balance of payments. Revaluation switches expenditures
from domestic to foreign products and can be used to correct a surplus in
the nation's balance of payments.
C) Direct Controls:
Direct controls that affect the nation's balance of payments can be
subdivided into two: a) trade controls (such as tariffs, subsidies, quotas,
and other quantitative restrictions on the flow of international trade)
and b) financial or exchange controls (such as restrictions on
international capital flows and multiple exchange rates). These are also
expenditure-switching policies, aimed at a specific balance of payments
items. Direct controls can also take the form of price and wage controls
in an attempt to restrain domestic inflation when more general policies
have failed.
a) Trade Controls:

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An import tariff increases the price of imported goods to domestic

consumers and stimulates the domestic production of import
substitutes. On the other hand, export subsidies make domestic goods
cheaper to foreigners and encourage the nation's exports. Export
subsidies are direct payments or the granting of tax relief and subsidized
loans (i.e., loans at lower interest rates) to the nation's exporters or
potential exporters. Export subsidies can also take the form of the
provision of low-interest loans to foreign buyers so as to stimulate the
nation's exports. For example, the major industrial nations give foreign
buyers of the nations' exports low-interest loans to finance the
purchases through such agencies as the U. S. Export-Import Bank.
In general, an import tariff and an export subsidy of a given percentage
applied across the board on all commodities are equivalent to a
devaluation of the nation's currency by the same percentage. However,
import duties and export subsidies are usually applied to specific items
rather than across the board. One can say that an import tariff and an
import quota are equivalent in the sense that both are expenditure-
switching policies (just as devaluation) and both stimulate domestic
production. Trade controls as frequently applied by developing
countries (and some developed countries as well) may also take the form
of advance deposit on imports. As the name implies, advance deposit is a
requirement that the importer make an advance deposit at a
commercial bank of a sum equal to the value of a fraction of the value of
the goods he/she wishes to import, for a period of time of varying
duration and at no interest rate.
b) Exchange Controls:

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Financial or exchange controls refer to the imposition of restrictions on

capital (real and/or portfolio) movements and the use of multiple exchange
rates. As evidences indicate, the imposition of restrictions on capital
flows particularly applies to developed nations, while the use of multiple
exchange rates applies to developing nations.
A nation in balance-of-payments deficit may impose restrictions on
capital exports, while a surplus nation may impose restrictions on capital
imports. For example, in 1963, the United States imposed restrictions on
portfolio capital exports and voluntary (later mandatory) restraints on
direct investments abroad to reduce its balance of payments deficit.
However, while this measure improved the U. S. capital account, it
reduced U. S. exports as well as interest and profit on U. S. foreign
investments. On the other hand, West Germany and Switzerland
discouraged capital imports by allowing lower or no interest on foreign
deposits in the face of large balance-of -payments surpluses and in order
to insulate their economies from worldwide inflationary pressures.

Financial or exchange controls in the context of most developing nations,

on the other hand, took the form of employing multiple exchange rates.
Higher exchange rates were adopted on luxury and nonessential
imports, while lower rates were applied for essential imports. The
higher exchange rate on luxuries and nonessentials makes these foreign
products more expensive to domestic buyers and discourages their
importation. The lower exchange rate on essential imports (such as
capital equipment necessary for development) makes these products
cheaper to domestic users and encourages their importation.

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An extreme form of exchange controls may take the form in which

exporters and other earners of foreign exchange are required to turn in
all their exchange earnings to monetary authorities, who then proceed to
allocate the available supply of foreign exchange to importers through
import licensees and at various rates depending on the importance of
the imported commodities. This, however, encourages black markets,
under-or-over- invoicing, and corruption. A black market is an economic
activity in which merchandise and/or services are bought and sold
illegally. Also called the "underground market," the black market gets
its name due to the fact that its activity is conducted out of sight and
often "in the dark," outside the sight of law enforcement. Black markets
are phenomena of times of crisis. They flourish only when an abnormal
scarcity of essential goods may cause a government to impose rationing
and price controls as a means of ensuring a more equitable distribution
of supplies. As a final remark, for direct controls and other policies to
be effective, international cooperation is often essential.

Faced with multiple objectives and with several policy instruments at its
disposal, the nation must decide which policy to utilize to achieve each
of its objectives. According to Jan Tinbergen (Dutch economist and a
joint winner with Ragnar Frisch (a Norwegian economist) of the first
Nobel Prize for economics in 1969), the nation usually needs as many
effective policy instruments as the number of independent objectives it
has. In his influential work Theory of Economic Policy (1952), Tinbergen
demonstrated the need for as many policy variables (policy instruments)
as there are policy ends (policy objectives). In other words, if the nation

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has two objectives, it usually needs two policy instruments to achieve the
two objectives completely; if it has three objectives, it requires three
policy instruments, and so on. In addition to the theory of economic
policy, Tinbergen has also contributed in such areas as business cycles in
the U. S. A., 1919 - 39, and the concept of "shadow" prices. In fact,
Tinbergen won the Nobel Prize (with Ragnar Frisch) for his pioneering
work in Econometrics. Sweden's Central Bank established the Nobel
Prize in memory of Alfred Nobel, founder of the Nobel Prize.

Economic Policy in the Open Economy - Fixed Exchange Rates

Although the major industrial countries tend to have flexible rate

systems today, many countries still peg their currencies and thus have to
contend with the effects of fixed rates when carrying out monetary and
fiscal policy.
The attainment of the external balance (or balance of payments
equilibrium) target is influenced by both monetary and fiscal policy.
With respect to monetary policy, for example, an increase in the money
supply will reduce interest rates, leading to a reduction in the short-term
capital inflows (i.e., foreign capital is not attracted to lower interest
rates) or an increase in the short - term capital outflows (i.e., capital
flight). This results in a balance of payments deficit. With respect to
fiscal policy, on the other hand, expanding government spending will
lead to increased income (because jobs have been created by the

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government) and an increase in imports (because imports are directly

related to income) and this will also result in a balance of payments
deficit. Thus, expansionary monetary policy and fiscal policy are
assumed to affect the balance of payments in a similar fashion. The
conclusion is that maintaining balance of payments equilibrium for a
given exchange rate requires an opposite use of monetary and fiscal
policy in this model, i.e., expansionary fiscal policy must be
accompanied by contractionary monetary policy and vice versa.
Equilibrium in the Real Sector: The IS Curve
The IS curve shows the various combinations of income and interest
rate that produce equilibrium in the real sector of the economy.

Equilibrium in the Money Market: The LM Curve

The LM curve shows the various combinations of income and interest
rate that produce equilibrium in the monetary sector of the economy.
Equilibrium in the Balance of payments: The BP Curve
The BP curve shows the various combinations of income and interest
rate that produce equilibrium in the balance of payments.

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