Macroeconomıc Theory (ENG) — Ünite 7 Soru-Cevap

In an open economy, openness has three main components; openness in goods markets, openness in factor markets and openness in financial markets.

Openness in goods markets implies the degree by which the consumers and firms are free to choose between domestic goods and foreign goods.

Openness in financial markets is implied by the degree by which financial investors are free to choose between domestic and foreign financial assets.

A small open economy engages in international trade and is open to capital flows, but is small enough not to affect world goods prices, world interest rate or trading partners’ incomes. In other words, small open economies are price takers in world goods and financial markets.

Openness in goods markets is often measured by the ratio of the sum of imports and exports to GDP of a country.

Until the 1980s, the share of the trade volume in the Turkish economy did not exceed 15 percent of GDP, hence we can say that up until the 1980s, the Turkish economy was virtually a closed economy with little trade with the rest of the world. But with the 1980s, particularly after the 1990s, following the general trends elsewhere in the world, the Turkish economy experienced large increases in both exports and imports and started to further integrate into the world markets. Since the 1980s, we see a steady rise in the degree of openness in the Turkish economy. We see that except for short periods of time, imports have consistently exceeded exports, implying that the Turkish economy has consistently run a trade deficit with the rest of the world.

The nominal exchange rate is defined as the price of foreign currency in terms of domestic currency.

The decrease in the value of domestic currency against other currencies is called devaluation.

The increase in the value of domestic currency against other currencies is called revaluation.

Real exchange rate measures the relative price of foreign goods in terms of domestic goods.

The simple multiplier in the open economy is:

1 / 1− c₁ + m₁

The Marshall-Lerner condition foresees that with real depreciation of the domestic currency, volume of exports rise large enough and volume of imports fall large enough to compensate for the rise in the relative price of imports in terms of domestic goods, hence net exports or trade balance improves as a result. This condition holds true when the sum of the price elasticities of export demand (in foreign countries) and import demand (in domestic country) is larger
than one.

Over time as economic agents adapt to the changes in relative prices and change import and export demand behavior, trade balance will start improving, eventually surpassing its initial position. This dynamic effect is depicted by the J-curve. 

Uncovered interest parity (UIP) condition is an equilibrium condition in international financial markets which shows that financial investors make decisions based on the difference in domestic and foreign nominal interest rates in relation to the expected depreciation or appreciation in domestic currency.

Balance of Payments accounts summarize a country’s transactions with the rest of the world, both in terms of trade flows and financial flows. Balance of Payments accounts have two main components: Current Account and Capital & Financial Account.

The Capital & Financial Account:
• Capital Account (Gross acquisitions and disposals of non-produced non-financial assets such as franchising, purchase and sale of trademarks)
• Financial Account
     • Net Foreign Direct Investment (equity capital, other capital and real estate)
     • NetPortfolio Investment(firmsecurities and government’s debt securities)
     • Net Other Investment (commercial loans)

Current Account has three main sub-components:
• Net Exports = Exports-Imports = Trade Balance on Goods and Services (Merchandise trade & services trade - services trade includes patents, property rights and other intellectual property rights)
• Net income received from abroad = Income received on holdings of foreign assets by domestic residents minus income received on holdings of domestic assets by foreigners (Note: This account appears as interest income/primary income in the Turkish Balance of Payments)
• Net current transfers received from abroad (personal transfers including workers remittances & foreign aid. This account appears as Secondary income in the Turkish Balance of Payments)

The Mundell-Fleming Model, which is also known as the IS/LM/BP Model, has been developed by Robert Mundell (1932-2021) and Marcus Fleming (1911-1976), although independently. Mundell Fleming model describes the determination of equilibrium in the shortrun of a small open economy with respect to income, interest rate and exchange rate. The model considers the determination of equilibrium in goods and money markets as well as in balance of payments under varying degrees of capital mobility in a small open economy.

The following factors will tend to shift the IS-curve in an open economy:
• Increases in autonomous I, X, G, or a decrease in net taxes T will shift IS-curve to the right;
• With real depreciation, assuming that Marshall-Lerner condition holds, an improvement in NX shifts the IS-curve to the right;
• Decreases in autonomous I, X, G or an increase in net taxes T will shift IS-curve to the left;
• With real appreciation, assuming that NX worsens, the IS-curve shifts to the left.

Along a given BP-curve, we assume certain factors relating to the balance of payments equilibrium such as the exchange rate (both nominal and real), foreign income level and the world interest rate are held fixed. Whenever there is a change in any one of the factors affecting the equilibrium in balance of payments, the BP-curve will change position or shift.

If the domestic currency loses value against foreign currencies, with an increase in exports and decrease in imports (assuming Marshall-Lerner condition holds), there will be an improvement in the Current Account at the given domestic income level. Therefore, the country’s need for foreign borrowing will be smaller which necessitates a lower interest rate to ensure balance of payments equilibrium. The BP-curve shifts down to the right with domestic currency depreciation. A fall in the nominal exchange rate (a revaluation or nominal appreciation of domestic currency), on the other hand, shifts the BP-curve up to the left. A fall in the exchange rate decreases exports and increases imports, which leads to a deterioration in the Current Account at the given income level.

Suppose there is an increase in the income of the home country’s major trading partner. In that case, the exports of the home country will increase as the country’s major trading partner will start to import more, holding all else the same. With the increase in exports, at the given domestic income level, there will be an improvement in the Current Account, hence the need for foreign borrowing will be reduced, interest rate will be lower at the given domestic income level. With a lower interest rate at the given income level, the BP-curve shifts down to the right. Opposite will be true when foreign income falls: Exports will be lower, leading to a deterioration in the Current Account, which necessitates a higher interest rate to attract higher capital and financial inflows into the country. Thus, the BP-curve shifts up to the left.

Hence, an exogenous change in the foreign or world interest rate will also affect the equilibrium in balance of payments and change the position of the BP-curve. Holding all else constant, an increase in foreign interest rate will cause a net outflow of capital and financial resources from the country, and therefore will necessitate a higher domestic interest rate to reestablish equilibrium in balance of payments, shifting the BP-curve to the left at the given income level. Reversely, a fall in foreign interest rate will make domestic assets more attractive, hence there will be a net inflow of capital and financial resources, which will imply that the same Current Account Balance can now be financed with Capital & Financial Account under a lower domestic interest rate.