Open Economy Monetary Economics

Balance of Payments (BOP) tables are rather detailed and can be summarized by five fundamental variables: "Current account", "capital account", "financial account, "net errors and omissions", and "change in reserve assets".

The current account is the difference between revenues and expenditures stemming from the trade of goods (exports and imports), trade of services (such as tourism and transportation), and primary and secondary income (such as labor income or interest payments). A positive current account indicates that, in that period, there is a current account surplus -revenues exceed expenditures. Conversely, a negative current account means that the current account is in deficit.

The capital account is a small item covering mainly gross acquisition or disposal of non-produced non- financial assets and capital transfers like copyrights, trademarks, and debt forgiveness.

A negative value for the financial account indicates a net capital inflow to a country –a rise in its foreign indebtedness. For example, let us say that the corporate sector of a country receives a loan of 15 billion dollars from abroad. In the same period, if 10 billion dollars of the loans previously taken are overdue and repaid, there is a net capital inflow of 5 billion dollars from that country through the corporate sector. In contrast, a positive value denotes a net capital outflow from a country to the rest of the world. Simply, it indicates that the country in that specific period increased its holding of foreign assets. In other words, the country is a net lender to the rest of the world.

Not every item -such as tourism revenues- in the balance of payments can be measured with 100 percent accuracy. In addition, payments of some goods and services trade can be deferred; consequently, a time difference may occur between payments and physical flows, illustrated by the net errors and omissions item. A positive net errors and omissions entry means that there is a foreign currency entry whose source cannot be determined accurately, which turns into an item that finances foreign exchange expenses. When it gets a negative sign, the opposite is true.

The nominal exchange rate (E) is defined as the domestic currency value of one unit of foreign currency. Name the foreign and local currencies as the dollar and the lira, respectively. When a dollar is 20 liras, we imply that the nominal exchange rate is 20. The increase in the nominal exchange rate indicates that more liras to buy one dollar is needed. An increase in E is called a devaluation in fixed exchange rate regimes, and a decrease in E is called a revaluation. In floating exchange rate regimes, an increase in E signals that the domestic currency  depreciates  in  nominal  terms,  while its decrease specifies that the domestic currency appreciates in nominal terms.

The real exchange rate (Q) denotes the relative prices of goods in two countries when expressed in the same currency. 

Q = EP*/ P

where E is the nominal exchane rate, P is the domestic price index and P* is the foreign price index. An increase in Q indicates that the lira depreciates in real terms against the dollar, while a decrease in Q shows that the lira appreciates in real terms against the dollar. The real exchange rate can also be calculated for a basket of currencies. The real exchange rate index, calculated using more than one exchange rate, is alternatively called the ‘effective real exchange rate index’ or ‘multilateral real exchange rate index.’

Remember nominal exchange rate is E and real exchange rate is  Q = EP/P* where P is the domestic price index and P* is the foreign price index. 

Nominal Exchange rate E=20

Real Exchange rate Q=20x100/1000 Q = 2

According to the ‘law of one price,’ the prices of two goods of the same quality in two countries must be equal when expressed in the same currency if transportation costs and factors such as quotas and customs duties are not considered. This equality is achieved at the nominal exchange rate.

Consider two bonds, one issued abroad and the other domestically. Let them be in euros and liras. They have the same maturities, and both are risk-free and equally liquid. There are no barriers to capital movements. Furthermore, consider risk- neutral economic agents. That is, investors are only concerned with expected returns.

In this case, whichever financial asset has a higher return, the demand for that will increase, leading to a rise in its price and a corresponding drop in its return. Meanwhile, the demand for the second asset will decrease, decreasing its price and thus increasing its return. As a result, the expected return on both financial assets will equalize, and the market will reach equilibrium. This equivalence will give us the uncovered interest rate parity.

Uncovered interest rate parity is where the domestic interest rate (it) to the foreign interest rate (it* ) and the expected rate of change of the nominal exchange rate.

Covered interest rate parity  is 

The only difference between this equations is that the forward exchange rate (Ft+1) appears on the right side instead of the expected nominal exchange rate for the next period.

Risk appetite for a country’s financial assets can alter due to external or internal reasons. Decreased
risk appetite means less demand for that country’s financial assets and an increased desire to sell previously
purchased assets, leading. In this example, the reason for a decrease in risk appetite is the increase in Turkey’s
risk. So, there is an ‘internal’ basis; however, for some external reasons, a country’s risk may also upsurge. For
example, in the spring of 2004, the expectation that the Fed would raise interest rates earlier than expected
became widespread. Moreover, there was a tension that the interest rate hike would be higher than expected. In other words, the idea that the foreign interest rate (i*) in equation (8) would increase prevailed. Foreign investors sold their financial assets in liras, converted the cash they obtained into foreign currency, and left Turkey. The increased demand for foreign currency pushed up the exchange rate. Financial assets sold increased the supply of financial assets: The price of these assets fell, and interest rates increased. Consequently, Turkey and peer countries experienced risk, and interest and exchange rates rose together.

As prices soar, the purchasing power of domestic currency falls. In this case, keeping dollars or euros and converting them into local currency when needed is advantageous because as inflation rises, foreign currencies such as euros and dollars (usually) rise against domestic currencies.

On the other hand, in most cases, there is no need to convert euros or dollars into liras when spending. For example, the seller accepts foreign currencies when buying a television or paying rent. Consequently, the domestic currency  partly loses its medium of exchange property. This phenomenon is called ‘currency substitution.’

Currency substitution is not the only ongoing issue in countries with such high inflation for a long time. At the same time, most goods and services are priced in foreign currencies. “How many dollars is that?” becomes a common question. Therefore, domestic currency also loses its feature as a domestic currency unit of account.

In this environment, the local currency loses its attractiveness as a store of value. This phenomenon is called ‘dollarization.’ 

Public expendtures (G), and foreign income (Y*) increase and vergi oranı (t) decreases at the same domestic interest rate (i0), output increases (Y1). That is, the IS curve shifts to the right. Contrary, when G, and Y* decrease and t increases at the same domestic interest rate, output decreases. That is, the IS curve shifts to the left.

Suppose that the Fed raises its policy rate. In our framework, this is equivalent to a rise in real foreign
interest rates and, eventually, a real depreciation of the domestic currency –an increase in the real exchange
rate. So, exports rise, and imports fall, leading to a rise in aggregate demand represented by the shift of the
AD0 curve to the right: AD1, causing an upsurge in the inflation rate.

Weak economic fundamentals such as weak fiscal stances- high budget deficits, high public debt, a high share of foreign currency-denominated debt in total public debt, monetary financing of large deficits, problems in the banking sector and non-financial corporates reflected in weak balance sheets, and alike make a country susceptible to a crisis either currency or financial or both.

When a crisis breaks out, interest rates and risk spreads jump, and domestic currencies are pressured to depreciate. The panic sales of domestic currency assets and stress accumulation in financial markets underlie heightened interest rates and risk spreads. Generally, financial investors want to convert their domestic currency denominated financial assets into foreign currency
as soon as possible, increasing the depreciation pressure on the domestic currency.

When a crisis breaks out, interest rates and risk spreads jump, and domestic currencies are pressured to depreciate. Banks become more cautious and reluctant to extend new loans, and some loans are called back before their due dates, or additional collateral is requested- from the borrower. The non-financial firms face tremendous issues which force them to cut their activities significantly. Eventually, output contracts, and the unemployment rate jumps.

The basis of the first-generation crisis models is a monetary policy incompatible with the prevailing exchange rate regime. The foremost basis for why monetary policy is mismatched is expansionary fiscal policy and the ensuing monetization of budget deficits. If there is a fiscal and monetary policy combination that is incompatible with the fixed exchange rate regime –or a version of the fixed  rate  regime,  the  collapse  of  the  exchange rate regime is inevitable. Without any speculative attack, the regime is doomed to fail. Let us dub this as the ‘natural time’ of the breakdown. Leading indicators of the eventual collapse are a reduction in official foreign exchange reserves and the widening gap between domestic and foreign interest rates. All in all, the system crashes. Moreover, in some models, the difference between the exchange in the parallel market and the fixed exchange rate gradually increases before the collapse.

The United   Kingdom   faced   a   speculative   attack against the pound in August 1992. To keep the value of its currency within the range allowed by the ERM, the Bank of England sold close to $50 billion to the market in a few weeks. Nevertheless, falling short of meeting the dollar demand rise, the Bank of England finally hiked interest rates in mid-September. Still, the attack on the pound increased demand for converting the British pound to dollars, lasted. The government did not aspire for interest rates to rise further. Ultimately, the United Kingdom was also forced to exit ERM. In the process, the British pound depreciated by 15 percent.

The basis of the first-generation crisis models is a monetary policy incompatible with the prevailing exchange rate regime. The foremost basis for why monetary policy is mismatched is expansionary fiscal policy and the ensuing monetization of budget deficits. The collapse of the exchange rate regime is inevitable. However, the regime collapses before due to speculative attacks.