1. Open-Economy Macroeconomics:
The Balance of Payments and
Exchange Rates
Course: BBA-2
Subject: BE
Unit:4

2. Exchange Rates
• The main difference between an
international transaction and a
domestic transaction concerns
currency exchange.
• International exchange must be
managed in a way that allows each
partner in the transaction to wind
up with his or her own currency.
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3. Exchange Rates
• The exchange rate is the price of
one country’s currency in terms of
another country’s currency; the
ratio at which two currencies are
traded for each other.
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4. The Balance of Payments
• Foreign exchange is simply all
currencies other than the domestic
currency of a given country.
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5. The Balance of Payments
• The balance of payments is the record of a
country’s transactions in goods, services, and
assets with the rest of the world; also the
record of a country’s sources (supply) and
uses (demand) of foreign exchange.
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6. The Current Account
• A country’s current account is the
sum of its:
– net exports (exports minus imports),
– net income received from
investments abroad, and
– net transfer payments from abroad.
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7. The Current Account
• Exports earn foreign exchange and
are a credit (+) item on the current
account. Imports use up foreign
exchange and are a debit (–) item.
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8. The Current Account
• The balance of trade is the difference
between a country’s exports of goods and
services and its imports of goods and services.
• A trade deficit occurs when a country’s
exports are less than its imports.
• Net exports of goods and services (EX – IM),
is the difference between a country’s total
exports and total imports.
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9. The Current Account
• Investment income consists of holdings of
foreign assets that yield dividends, interest,
rent, and profits paid to U.S. asset holders (a
source of foreign exchange).
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10. The Current Account
• Net transfer payments are the difference
between payments from the United States to
foreigners and payments from foreigners to
the United States.
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11. The Current Account
• The balance on current account consists of
net exports of goods, plus net exports of
services, plus net investment income, plus net
transfer payments. It shows how much a
nation has spent relative to how much it has
earned.
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12. The Capital Account
• For each transaction recorded in
the current account, there is an
offsetting transaction recorded in
the capital account.
• The capital account records the
changes in assets and liabilities.
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13. The Capital Account
• The balance on capital account in the United
States is the sum of the following (measured in
a given period):
– the change in private U.S. assets abroad
– the change in foreign private assets in the United
States
– the change in U.S. government assets abroad, and
– the change in foreign government assets in the
United States
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14. The Capital Account
• In the absence of errors, the balance
on capital account would equal the
negative of the balance on current
account.
• If the capital account is positive, the
change in foreign assets in the country
is greater than the change in the
country’s assets abroad, which is a
decrease in the net wealth of the
country.
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15. Imports and Exports and
the Trade Feedback Effect
• The determinants of imports are the same as
the factors that affect consumption and
investment behavior.
• Spending on imports also depends on the
relative prices of domestically produced and
foreign-produced goods.
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16. Imports and Exports and
the Trade Feedback Effect
• The demand for U.S. exports
depends on economic activity in
the rest of the world. If foreign
output increases, U.S. exports tend
to increase.
• Because U.S. imports are
somebody else’s exports, the extra
import demand from the United
States raises the exports of the rest
of the world.
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17. Imports and Exports and
the Trade Feedback Effect
• The trade feedback effect is the
tendency for an increase in the
economic activity of one country to
lead to a worldwide increase in
economic activity, which then
feeds back to that country.
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18. Imports and Export Prices
and the Trade Feedback Effect
• When the export prices of one country rise,
with no change in the exchange rate, the
import prices of another rise.
• If the inflation rate abroad is high, U.S. import
prices are likely to rise.
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19. Imports and Export Prices
and the Trade Feedback Effect
• The price feedback effect is the process by
which a domestic price increase in one
country can “feed back” on itself through
export and import prices.
• Inflation is “exportable.”
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20. The Open Economy with
Flexible Exchange Rates
• Floating, or market-determined, exchange
rates are exchange rates determined by the
unregulated forces of supply and demand.
• Exchange rate movements have important
impacts on imports, exports, and movement
of capital between countries.
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21. The Market for Foreign Exchange
• In a world where there are only
two countries, the United States
and Britain, the demand for
pounds is comprised of holders of
dollars wishing to acquire pounds.
The supply of pounds is comprised
of holders of pounds seeking to
exchange them for dollars.
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22. The Market for Foreign Exchange
• The demand for pounds in the
foreign exchange market shows
a negative relationship between
the price of pounds (dollars per
pound) ($/£) and the quantity of
pounds demanded.
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• When the price of pounds falls, British-made goods and services
appear less expensive to U.S. buyers. If British prices are
constant, U.S. buyers will buy more British goods and services,
and the quantity demanded of pounds will rise.

23. The Market for Foreign Exchange
• The supply of pounds in the
foreign exchange market
shows a positive relationship
between the price of pounds
(dollars per pound) ($/£) and
the quantity of pounds
supplied.
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• When the price of pounds rises, the British can obtain more dollars
for each pound. This means that U.S.-made goods and services
appear less expensive to British buyers. Thus, the quantity of
pounds supplied is likely to rise with the exchange rate.

24. The Equilibrium Exchange Rate
• The equilibrium exchange
rate occurs at the point at
which the quantity demanded
of a foreign currency equals
the quantity of that currency
supplied.
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25. The Equilibrium Exchange Rate
• An excess supply of pounds will cause the
price of pounds to fall—the pound will
depreciate (fall in value) with respect to the
dollar.
• An excess demand for pounds will cause the
price of pounds to rise—the pound will
appreciate (rise in value) with respect to the
dollar.
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26. Factors that Affect Exchange Rates
• Purchasing Power Parity: The Law of
One Price If the costs of
transportation are small, the price of
the same good in different countries
should be roughly the same.
– If the law of one price held for all goods,
and if each country consumed the same
market basket of goods, the exchange
rate between the two currencies would
be determined simply by the relative
price levels in the two countries. 26 of 53

27. Factors that Affect Exchange Rates
• The theory that exchange rates are
set so that the price of similar
goods in different countries is the
same is known as the purchasing-
power parity.
– If it takes ten times as many pesos to
buy a pound of salt in Mexico as it
takes U.S. dollars to buy a pound of
salt in the United States, then the
equilibrium exchange rate should be
10 pesos per dollar.
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28. Factors that Affect Exchange Rates
• A high rate of inflation in one
country relative to another puts
pressure on the exchange rate
between the two countries, and
there is a general tendency for the
currencies of relative high-inflation
countries to depreciate.
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29. Factors that Affect Exchange Rates
• A higher price level in
the United States
increases the demand
for pounds and
decreases the supply
of pounds. The result
is appreciation of the
pound against the
dollar.
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30. Factors that Affect Exchange Rates
• The level of a country’s interest
rate relative to interest rates in
other countries is another
determinant of the exchange rate.
If U.S. interest rates rise relative to
British interest rates, British
citizens may be attracted to U.S.
securities.
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31. Factors that Affect Exchange Rates
• A higher interest rate
in the United States
increases the supply
and decreases the
demand for pounds.
The result is
depreciation of the
pound against the
dollar.
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32. The Effects of Exchange
Rates on the Economy
• When a country’s currency depreciates (falls in
value), its import prices rise and its export
prices (in foreign currencies) fall.
• When the U.S. dollar is cheap, U.S. products
are more competitive in world markets, and
foreign-made goods look expensive to U.S.
citizens.
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33. The Effects of Exchange
Rates on the Economy
• A depreciation of a country’s currency can
serve as a stimulus to the economy:
– Foreign buyers are likely to increase their
spending on U.S. goods
– Buyers substitute U.S.-made goods for imports
– Aggregate expenditure on domestic output will
rise
– Inventories will fall
– GDP (Y) will increase
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34. Exchange Rates and the
Balance of Trade: The J Curve
• The balance of trade is equal to
export revenue minus import costs:
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balance of trade = dollar price of exports x
quantity of exports
 dollar price of imports x quantity of imports
• According to the J-curve effect, the
balance of trade gets worse before it
gets better following a currency
depreciation.

35. Exchange Rates and the
Balance of Trade: The J Curve
• Initially, the negative effect on
the price of imports may
dominate the positive effects
of an increase in exports and a
decrease in imports.
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• But when imports and
exports have had a time to
respond to price changes,
the balance of trade
improves.

36. Exchange Rates and Prices
• Depreciation of a country’s currency tends to
increase the price level.
– Export demand rises.
– Domestic buyers substitute domestic products for
the now more expensive imports.
– If the economy is operating close to capacity, the
increase in aggregate demand is likely to result in
higher prices.
– If import prices rise, costs may rise for business
firms, shifting the AS curve to the left.
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37. Monetary Policy with
Flexible Exchange Rates
• Fed actions to lower interest rates result in a
decrease in the demand for dollars and an
increase in the supply of dollars, causing the
dollar to depreciate.
• If the purpose of the Fed is to stimulate the
economy, dollar depreciation is a good thing.
It increases U.S. exports and decreases
imports.
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38. Fiscal Policy with
Flexible Exchange Rates
• Flexible interest rates may not help
in the attempt by government to
cut taxes in order to stimulate the
economy.
• A tax cut results in increased
household spending, but some of
that spending leaks out as imports,
reducing the multiplier.
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39. Fiscal Policy with
Flexible Exchange Rates
• As income increases, the demand
for money increases. The resulting
higher interest rates cause the
dollar to appreciate. Exports fall,
imports rise, again reducing the
multiplier.
• If interest rates rise, private
investment may be crowed out,
also lowering the multiplier.
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40. Monetary Policy with
Fixed Exchange Rates
• Monetary policy has no role in a country that
has a fixed exchange rate.
• For example, an attempt to lower interest
rates results in currency depreciation and a
lower (not a fixed) exchange rate.
• In the absence of capital controls, the
monetary authority loses its independence.
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41. Appendix: World Monetary
Systems Since 1900
THE GOLD STANDARD
– Early in the century, during the gold
standard era, nearly all currencies
were backed by gold. Their values
were fixed in terms of a specific
number of ounces of gold, which
determined their values in
international trading—exchange
rates.
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42. Appendix: World Monetary
Systems Since 1900
“PURE” FIXED EXCHANGE RATES
– Under this type of system, governments
set a particular fixed rate at which their
currencies will exchange for each other.
– There is no automatic mechanism to
keep exchange rates aligned with each
other, as with the gold standard.
Therefore, governments must at times
intervene to keep currencies aligned at
their established values.
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43. Appendix: World Monetary
Systems Since 1900
Government
Intervention in the
Foreign Exchange
Market
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• If the government has
committed itself to
keeping the value of
the lira at .020, it must
buy up the excess
supply of lira (Qs – Qd).

44. Appendix: World Monetary
Systems Since 1900
• At the end of World War II, economists from
the United States and Europe met to
formulate a new set of rules for exchange
rate determination, known as the Bretton
Woods system:
1. Countries were to maintain fixed exchange rates
with each other. All currencies were fixed in
terms of the U.S. dollar.
2. Countries experiencing a persistent current
account deficit (or fundamental disequilibrium) in
their balance of payments were allowed to
change their exchange rates.
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45. Appendix: World Monetary
Systems Since 1900
• The alternative to a fixed exchange
rate system is a flexible system:
– In a freely floating system,
governments do not intervene at all
in the foreign exchange market.
– In a managed floating system,
governments intervene if markets
are becoming disorderly.
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46. Review Terms and Concepts
appreciation of a currency
balance of payments
balance of trade
balance on capital account
balance on current account
depreciation of a currency
exchange rate
floating, or market-determined,
exchange rates
foreign exchange
J-curve effect
law of one price
marginal propensity to import
(MPM)
net exports of goods and services
(EX – IM)
price feedback effect
purchasing-power-parity theory
trade deficit
trade feedback effect
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47. Source
• Macroeconomics: Theory and Policy-Vanita Agarwal, Pearson Publication
• Macro Economics-D.M. Mithani, Himalaya Publishing House, Mumbai
• Macro Economics-H.L.Ahuja, S. Chand and Company Ltd., Delhi
• Macro Economic theory-M.C.Vaish, Vikas Publishing House, Delhi
• Macro Economic Analysis-Edward Shapiro, Galyotia Publications (P) Ltd
• Macro Economics-M.L. Seth, Lakshmi Narayan Agarwal Publishers