Macroeconomics of the Open Economy

obligatory courses

Macroeconomics II, Microeconomics

Lecture on Open Economy Macroeconomics focuses on problems of functioning the open economy with respect to international financial markets, capital flows, exchange rate determination, macroeconomic policy and currency union.

Students are expected to have good knowledge of macroeconomics II and basics in microeconomics. Final exam will consist of open questions. Grade will be based on students scores obtained from discussions classes and final exam with weights of 30% and 70%, respectively.

1. Balance of payments (2h)

The structure of the balance of payments, double-entry system, basic identity of the balance of payments. The concept of equilibrium of the balance of payments. Accounting of investment and savings in an open economy, twin deficits hypothesis.

Literature: [KO] Ch. 12; [CFJ] Ch. 16; [G] Ch. 5, 6.

2. Classical model of the open economy

Savings and investment in the classical model of small and large open economy. Impact of the economic policy on the current account and real exchange rate.

Literature: [G] Ch. 18.2.

3. Intertemporal trade and the current account (2h)

Intertemporal approach to balance of payments. Current account and capital flows. Feldstein-Horioka puzzle.

Literature: [M] Ch. 5; [KO] Ch. 7; [G] Ch. 18.2.

4. The exchange rate and interest rates in the short run – interest rates parity (2h)

The exchange rate – concept and various definitions. The foreign exchange market – participants and transactions. Basic instruments. Interest rates parity as a theory explaining short run movements in exchange rates. Covered interest rates parity vs. uncovered interest rates parity. Equilibrium exchange rate. Links between foreign exchange market and money market. Effectiveness of foreign exchange market.

Literature: [KO] Ch. 13, 14; [G] Ch. 4.

5. Long run equilibrium – purchasing power parity (2h)

Law of one price and the concept of purchasing power parity (PPP) – absolute and relative. Verification of the PPP and reasons for deviations from PPP. Importance of productivity driven real appreciation – the Balassa-Samuelson effect.

Literature: [KO] Ch. 15; [CFJ] Ch. 20.2; [G] Ch. 15.1.

6. Long run equilibrium – monetaristic model of the balance of payments and the exchange rate (2h)

Price-specie flow mechanism, money supply and the balance of payments. The effectiveness of devaluation. Monetaristic and generalized model of the exchange rate.

Literature: [KO] Ch. 15; [CFJ] Ch. 20.3, 26.2; [G] Ch. 12, 15.3.1.

7. Dornbusch exchange rate overshooting model (2h)

The role of expectations in the exchange rate movements. Price stickiness vs. price flexibility.

Literature: [KO] Ch. 15; [CFJ] Ch. 26.4; [G] Ch. 15.3.2.

8. Elasticity approach to the balance of payments – Marshall-Lerner condition (2h)

Exchange rate changes and the current account. Marshall-Lerner condition. The “J-curve” effect. Stability of the foreign exchange market.

Literature: [CFJ] Ch. 17; [G] Ch. 7.

9. Macroeconomic policy in the open economy, part I (2h)

Set-up of the Mundell-Flemming model (IS-LM-BP). Mobility of capital and the effectiveness of macroeconomic policy under floating exchange rate system.

Literature: [CFJ] Ch. 23, 24; [G] Ch. 10, 11.

10. Macroeconomic policy in the open economy, part II (2h)

Imperfect asset substitutability and the effectiveness of monetary policy. Fixed exchange rate regime and the effectiveness of macroeconomic policy under various degrees of capital mobility. Impossible trinity of the open economy.

Literature: [KO] Ch. 17; [CFJ] Ch. 23, 24.

11. Currency crises theory (2h)

Capital flows, speculation and currency crises. Krugman model of the first generation. The role of credibility – Krugman model of target zones and exchange rate dynamics. Self-fulfilling currency crises.

Literature: [KO] Ch. 17: Appendix 2; [CFJ] Ch. 26.3; [G] Ch. 16.

12. International monetary system (2h)

Gold standard. Bretton Woods system and International Monetary Fund. The problem of external and internal equilibrium. Collapse of the Bretton Woods system and modern era.

Literature: [KO] Ch. 18, 19; [G] Ch. 17, 22.

13. Architecture of the contemporary financial system (2h)

Contemporary system of floating exchange rates. Eurodollar markets. Debt crises in developing countries. Economic crises of emerging markets 1990-2002, contagiom theory, financial crisis 2007-2010 and reforms of the world financial architecture.

Literature: [KO] R. 21, 22.

14. Monetary union, part I (2h)

Costs and benefits of monetary union. Optimum Currency Areas theory. Economic justification of the convergence criteria.

Literature: [KO] Ch. 20; [dG] Ch. 1-4; [G] Ch. 20, 21.

15. Monetary union, part II (2h)

History and stages of monetary union in Europe. From European Monetary System to European Monetary Union. Is EMU an optimal currency zone?

Literature: [KO] Ch. 20; [dG] Ch. 1-4; [G] Ch. 20, 21.

[CFJ]: Caves R., Frankel J., Jones R., Handel i finanse międzynarodowe, PWE 1998;

[dG]: De Grauwe P., Unia walutowa, PWE 2003;

[G]: Gandolfo G., International Finance and Open-Economy Macroeconomics, Spriger 2002;

[KO]: Krugman P., M. Obstefld, International Economics. Theory and policy. Addison-Wesley, 7ed.

[M]: Mankiw G., Macroeocnomics, Worth Publishers, 5ed 2003.

Expertise:

Upon completion of this course students know:

- how the balance of payments is composed;

- how international flows of capital and goods influence the positions of the balance of payments;

- what are the determinants of exchange rates in the short and long run;

- what are the problems of internal and external macroeconomic equilibrium;

- what are the consequences and constraints of the macroeconomic (fiscal and monetary) policy under different exchange rate regimes;

- what are the mechanisms of the currency union.

Skills:

Upon completion of this course students are able to:

- analyze the balance of payments and changes of its positions over time;

- analyze the functioning of the open economy in the macroeconomic aspect;

- analyze the international economic relations and assess the consequences of internationally transmitted macroeconomic shocks;

- analyze changes of the exchange rates;

- explain the determinants of the exchange rates using interest rates parity and purchasing power parity;

- analyze the consequences and constraints of macroeconomic (fiscal and monetary) policy under different exchange rate regimes;

- analyze costs and benefits of a currency union.

Social skills:

- students understand the role and meaning of empirical verification of theory and theoretical models;

students know how to formulate testable hypotheses and know how to gather relevant data to reject them using quantitative methods;

- students are aware of constant progress in the field and understand that professional approach requires constant learning.

Upon completion of this lecture students will gain deep knowledge and understanding of open economy functioning at the macro level, which will allow them to apply theoretical concepts into real life economic problems.

KK03, KW01, KW02, KU01, KK01, KK02, KK03

The lecture ends up with a written exam in the form of open questions. Sine qua non condition for attempting exam is to have a credit on discussions classes. The exam is passed with the score of 50% or more points available during the exam. The final grade is given upon a weighted average of the score from the exam (with weight of 70%) and the points obtained during discussions classes (with weight of 30%).