Lecture 6

MACROECONOMICS
FOR AN OPEN ECONOMY

References:
N.G. Mankiw, “Principles of Economics”, 8th edition, chapters
31+32
NEU, “Economics”, chapter 27

September 2019
I. Understanding balance of payments
II. How is exchange rate determined?
III. Exchange rate mechanisms

2
Balance of Payments
1. Current Account
2. Capital Account
3. Official transfers Account
Vietnam balance of payments
2008 2009 2010 2011 2012F 2013F
USD million
Current Account -10823 -6608 -4276 236 2973 2569
(% of GDP) -11.9 -6.8 -4 0.2 2.2 1.7
Trade blance
- Export -12.783 -7607 -5136 -450 3691 3269
- Import
Net Services -950 -2421 -2461 -2980 -3616 -4000
Net Investment Income -4401 -3028 -4564 -5019 -5834 -5800
Net transfers 7311 6448 7885 8685 8732 9100
Capital Account 12341 7172 6201 6390 9248 4500
Net FDI 9279 6900 7100 6480 6780 7000
Portfolio Investment -578 -71 2370 1412 3274 1500
Other Investment 3640 343 -3269 -1502 -806 -4000
Errors and Omissions -1044 -9029 -3690 -5475 -1839 0
Reserves + related items 474 -8465 -1765 1151 10382 7069
USD million 2008 2009 2010 2011 2012F 2013F
Current Account -10823 -6608 -4276 236 2973 2569
(% of GDP) -11.9 -6.8 -4 0.2 2.2 1.7
Trade blance -12.783 -7607 -5136 -450 3691 3269

- Export
- Import
Net Services -950 -2421 -2461 -2980 -3616 -4000
Net Investment Income -4401 -3028 -4564 -5019 -5834 -5800
Net transfers 7311 6448 7885 8685 8732 9100

Capital Account 12341 7172 6201 6390 9248 4500

Net FDI 9279 6900 7100 6480 6780 7000
Portfolio Investment -578 -71 2370 1412 3274 1500
Other Investment 3640 343 -3269 -1502 -806 -4000

Official transfers 1518 564 1925 6626 12221 7069

Account

Errors and Omissions -1044 -9029 -3690 -5475 -1839 0

Reserves + related
474 -8465 -1765 1151 10382 7069
items
 Transactions which involve a flow of
payments into our country have a
plus sign (credit items)

 Transactions which involve a flow of

payments out of our country have a
minus sign (debit items)
6
1. Current Account
 Measures flows of payments between countries for
currently produced goods and services

2. Capital Account
 Measures flows of payments between countries for assets
such as stocks, bonds, and real estate

3. Official Transactions Account

 Records amount of foreign currencies that a nation buys or
sells

7
  Merchandise (goods) account
 Services account

 Net investment income account

 Net transfer account

 Inflow of payments – Outflow of payments

= CA balance
Net inflow of payments Net outflow of payments8
  Foreign Direct Investment
 Foreign Indirect Investment
 Porfolio Investment
 Other Investments
 Inflow of payments – Outflow of payments
= KA balance
Net inflow of payments Net outflow of payments9
 1. Current Account Balance
 Net inflow / Net outflow

2. Capital Account Balance

 Net inflow / Net outflow

3. Official Transactions Account / BoP

CA balance + KA balance = BoP

Net inflow of payments Net outflow of payments

10
 Practice:
Explain how each of the following transactions
influence CA, KA and BoP
1. Vietnam students go abroad for university study
2. More foreigners choose Vietnam as a best
destination for tourism
3. Vietnam companies invest more abroad
4. BIDV opens new branch in Laos
5. A new bridge is built using ODA funds from Japan
6. Vietnam government has a support of USD 1
million for Cuba for economic development
 Practice:
Explain how does each of the following
transactions influence CA, KA and BoP?

1. Vietnam students go abroad for university study  CA; net

service (-)
2. More foreigners choose Vietnam as a best destination for
tourists  CA, net service (+)
3. Vietnam companies invest more abroad  KA, net FDI (-)
4. BIDV opens new branch in Laos  KA, net FDI (-)
5. A new bridge is built using ODA funds from Japan  KA,
net Foreign Indirect Investment (+)
6. Vietnam government has a support of USD 1 million for
Cuba for economic development  CA, net transfer (-)
 Homework
 From Vietnam’s Balance of Payments, explains:
1. 2 main accounts
2. Items in each account  examples?
3. Balances of each account
 Plus sign of balance?
 Minus sign of balance?
4. Balance of official transfers account
The relation of Net exports and
Net capital flows
For simplicity, there are 2 main net flows:
Net Exports = Exports – Imports

Net Capital Flow = Inflow – Outflow

If NX > 0  domestic residents hold more foreign

currencies  Net Capital Outflow
If NX < 0  foreign residents hold more domestic

currencies  Net Capital Inflow

NX = NCO
Relationship of Saving and
Investment for open economy

Macroeconomic Identity for open economy:

Total Income = Total Expenditures
 Y
Income = YExpenditure - Te = C + I + G + NX - Te
 T + C + S = C + I + G + NX - T
d e
 S – I + T – G = NX

 SP + SG = I + NX

 SN = I + NX
II. Exchange rate and
Market for foreign exchange
 International transactions require
foreign exchange
 Definition for exchange rate
 Determination of exchange rate
 Changes in exchange rate
 The nominal exchange rate tells us the
price of a foreign currency in terms of
domestic currency
 Exchange rates of several currencies on
July/9/2010
 217.28 VND/JPY

 19095 VND/USD

 24385.1 VND/EUR

17
 Real exchange rate is the nominal
exchange rate adjusted for relative prices
between countries under consideration
P f
 E n
E 
r

Pd
 Real exchange rate tells us which goods,
domestic or foreign, are more competitive
in terms of price
18
 Example
 Suppose that nominal exchange rate
between VND and USD is 20,000 VND/USD
 A jacket’s price is 500,000 VND in Vietnam

 A jacket’s price is 40 USD in US

 Calculate real exchange rate between VN

and US. Briefly explain the meaning of real
exchange rate
Foreign Exchange Market
 From USD to VND
 Supply of USD
 Demand for VND
 From VND to USD
 Supply of VND
 Demand for USD
 For-Ex market
between VND and USD
Exchange rate Exchange rate
(VND/USD) (USD/VND)

SUSD
SVND

E0 e0

DUSD DVND
QUSD QVND
21
 Purchasing Power Parity Theory
 Uncovered Interest Parity

 A simple approach – supply and

demand analysis

22
 Example
 If your family has 500mln VND and the current
exchange rate is 22500 VND/USD, current
interest rate is 6,5%year (for VND saving)
 What do you expect the year-end exchange
rate to get the same return?
 Case 1: your family keeps USD for the whole year
 Case 2: your family lends this amount of USD with
the rate 1.5%/year (for USD saving)
 Purchasing power parity theory (PPP) 1920s–
Gustav Cassell
 Arbitrage forces will lead to the equalization of
goods prices internationally once the price of goods
are measured in the same currency “law of one
price”
 Then, real exchange rate is equal 1, then nominal

exchange rate is equal to the ratio of prices in two

countries
24
 Case study (page 689)
The Hamburger standard
 What is Purchasing-Power-Parity?
 The first step to determine exchange rate
between
 Italian Lira and Japan Yen
 Japan Yen and Russian Rubles
 US Dollars and Britain Pounds
 …
 Exercise 11 (page 390)
Assume that American rice sells for $100 per bushel, Japanese
rice sell for Y16000 per bushel and the nominal exchange rate
is 80 yen per one dollar
a) Explain how you could make a profit from this situation. What
would be your profit per bushel of rice? If other people exploit
the same opportunity, what would happen to the price of rice
in Japan, and the price of rice in US?
b) Suppose that rice is the only one commodity in the world.
What would happen to the real exchange rate between US
and JP?
 d
Exchange rate is defined
P
Er  f
inversely in this diagram. P  En
27
 d
Absolute PPP P

E  f
n

P
 Relative PPP %E  %P  %P
n d f

i.e.

Depreciation rate of  Domestic  Foreign

domestic currency inflation rate inflation rate

28
 Money, Prices, and the Nominal Exchange Rate
During the German Hyperinflation
Indexes
(Jan. 1921 5 100)

1,000,000,000,000,000

Money supply
10,000,000,000

Price level
100,000

Exchange rate
.00001

.0000000001
1921 1922 1923 1924 1925
29
 Uncovered interest parity condition (UIP)
 UIP says that the expected rate of depreciation
of domestic currency is equal to the interest rate
differential between domestic and foreign
bonds
 This condition is to ensure the indifference

between holding domestic and foreign assets,

i.e. the same rate of return.

30
 %(En) = id – if
Interest rate: iusd and ivnd
Prove:
Current exchange rate E0
Expected exchange rate in one year E1

$1 $(1 + iUSD)  1  iusd   E1   1  ivnd   E0

 VND (1 + iUSD)E1  1  ivnd   E1  1  E1  E0  1  %( E )
  1  iusd  E0 E0
VND E0 VND {(1 + ivnd)E0} ln  1  ivnd   ln  1  iusd   ln  1  %( E )
ivnd  iusd  %( E )
 If current exchange rate is E = 20.000
VND/USD; inflation rate in Vietnam is
10%; inflation rate in US is 3%; so what
is the forward exchange rate after one
year according to Relative PPP theory?

32
 If you expect exchange rate in one year will be E = 21.000
VND/USD; interest rate of assets denominated in VND is
12% and that denominated in USD is 4% per year; so what
should current exchange rate be to ensure that UIP holds?
 If UIP does not hold, what would you do, and then what
would happen to current exchange rate?

33
 Supply-demand approach: Exchange rate/price of
foreign currency is determined by the supply of and
demand for foreign currency.
 The demand for foreign currency comes from domestic residents who
want to buy foreign goods or assets
 The supply of foreign currency comes from foreign residents who want
to buy domestic goods or assets

34
 When price of foreign currency goes up
(ex rate increases), the domestic goods
and assets become cheaper in the eye
of foreigners and more foreign currency
is supplied to buy domestic goods and
assets
 The supply curve of foreign currency,

therefore, is upward sloping

35
 When price of foreign currency goes up
(ex rate increases), the foreign goods
and assets become more expensive in
the eye of domestic residents. They don’t
want to buy foreign goods and assets, so
demand for foreign currency decreases.
 The demand curve for foreign currency,

therefore, is downward sloping

36
 Changes in a country’s income
 Changes in a country’s price

 Changes in interest rates

 Changes in risk perception with respect

to currencies
 Changes in trade policy

37
Foreign exchange market
 International transactions require
exchanges for foreign currencies
 Exchanges from foreign currencies into
domestic currency
 Exchanges from domestic currency into
foreign currencies
 For-Ex market
between VND and USD
Exchange rate
(VND/USD)

SUSD: exchange from USD to VND

E0

DUSD: exchange from VND to USD

QUSD 39
 Flexible/floating exchange rate
mechanism
 Fixed exchange rate mechansim

 Partially flexible exchange rate

mechanism (managed floating ex rate)

40
 Flexible/floating exchange rate
mechanism
Exchange rate
(VND/USD)

SUSD: exchange from USD to VND

Exchange
rate
changes
due to the E
0
changes in
supply or
demand

DUSD: exchange from VND to USD

QUSD 41
 Fixed exchange rate mechanism
Exchange rate
(VND/USD)

SUSD: exchange from USD to VND

Central
Banks use Quantity of USD
foreign that CB buy or sell
exchange in forex market
intervention E0
buying or
selling of
foreign
currencies
DUSD: exchange from VND to USD

QUSD 42
 To overvalue Exchange rate
domestic currency, (VND/USD)

Central bank must SUSD

sell foreign S’USD

currency/buy
domestic currency
 Its foreign reserves 19200
can be run out of A B
 Trade balance 18000

deteriorates and low DUSD

economic growth Shortage of USD
 MS reduces
QUSD

43
 To devalue domestic Exchange rate
(VND/USD)
Surplus of USD

currency, Central bank SUSD

must buy foreign
currency/sell domestic
currency 20000
A B Cen tral bank
 Its foreign reserves 19200 buys USD
increase
 Trade balance and
economic growth can D’USD

improve DUSD

 MS increases
QUSD

44
 Disadvantages of Fixed
exchange rate mechanism
Case of Thailand Case of China
 1997  2010-2011
 Capital flight  1990s and 2000s
 Exchange from BTH to  Inflows of FDI and exports
USD  Exchange from USD to CNY (RMB)
 E(BTH/USD) increases  E(CNY/USD) reduces and
 Central Bank sells USD E(USD/CNY) increases
 3/1997  floating  reduces X
 Central bank buys USD
 Advantages:
 Stable exchange rate makes trade and
investment easier
 Allow government to achieve certain

objectives such as trade balance, economic

growth, external debt

46
 Disadvantages
 Government intervention can be harmful for
the economy (inflation, running out of foreign
reserves)
 Limitations on a Central bank’s actions

 Fixed exchange rates can become unfixed

when it is largely deviated from long-run

equilibrium exchange rate, then it can create
enormous monetary instability

47
 Partially flexible exchange rate
mechanism
Exchange rate
(VND/USD)

SUSD: exchange from USD to VND

Exchange
rate
changes
due to the E
0
changes in
supply or
demand

DUSD: exchange from VND to USD

QUSD 48
 If there is a fundamental
misalignment in exchange
rate, policymakers allow
private forces to determine
it – flexible exchange
rate
 If there is speculation on currency
or too large adjustment in
currency’s value in a short time or
adjustments won’t achieve balance
of payments goals, the
policymakers have interventions,
either supporting or pushing down
currency’s value – fixed
exchange rate
49
Excersices
Suppose Vietnam’s trade partners fall in
recession and buy less goods and services
from Vietnam. Answer the following
question
1. Under a flexible exchange rate mechanism,
explain the changes in exchange rate and
the quantity of USD to exchange
2. Under a fixed exchange rate mechanism,
explain how the Central Bank intervenes in
the market to fix exchange rate
 Practice:
Explain the change in exchange rate between VND
and foreign currencies using supply-demand
diagram?
1. Vietnam students go abroad for university study
2. More foreigners choose Vietnam as a best
destination for tourists
3. Vietnam companies invest more abroad
4. BIDV opens new branch in Laos
5. A new bridge is built using ODA funds from Japan
6. Vietnam government has a support of USD 1
million for Cuba for economic development
 For-Ex market
between VND and USD
Exchange rate Exchange rate
(VND/USD) (USD/VND)

SUSD
SVND

E0 e0

DUSD DVND
QUSD QVND
52
 Practice:
Explain how does each of the following
transactions influence foreign exchange market
1. Vietnam students go abroad for university study  from VND to
foreign currencies such as USD,…
2. More foreigners choose Vietnam as a best destination for tourism 
exchange from foreign currencies into VND
3. Vietnam companies invest more abroad  from VND to foreign
currencies such as USD,…
4. BIDV opens new branch in Laos  from VND to foreign currencies
such as USD,…
5. A new bridge is built using ODA funds from Japan  exchange from
JPY to VND
6. Vietnam government has a support of USD 1 million for Cuba for
economic development  exchange from VND to Cuba peso
a. Explain the changes of Exchange rate (VND/USD) in
flexible exchange rate mechanism
b. Explain the intervention by Central Bank in Fixed
exchange rate mechanism
1. Vietnam students go abroad for university study  Demand for
USD  (a) E increases – (b) CB sell USD  Supply of USD
2. More foreigners choose Vietnam as a best destination for tourism
 Supply of USD  (a) E reduces – (b) CB buys USD  Demand for USD
3. Vietnam companies invest more abroad  Demand for USD  (a) E
increases – (b) CB sell USD  Supply of USD
4. BIDV opens new branch in Laos  Demand for USD  (a) E increases
– (b) CB sell USD  Supply of USD
5. A new bridge is built using ODA funds from Japan  Supply of JPY
 (a) E reduces – (b) CB buys JPY  Demand for JPY
6. Vietnam government has a support of USD 1 million for Cuba for
economic development  Demand for USD  (a) E increases – (b) CB
sells USD  Supply of USD
 Conclusion:
 International transactions must be recorded in Balance of
Payment:
 Current Account or Capital Account
 Inflow of payment (+) or Outflow of payment (-)
 International transactions require international payments
 exchange currencies in the market for foreign exchange
(forex market)
 Exchange rate
 1st determination of exchange rate: PPP and UIP
 Changes in exchange rate: supply-demand diagram
Question

1. How is the changes in forex market?

2. What should Fed do in fixed exchange
rate mechanism? Explain changes in
money base, Fed’s foreign reserve?