Macroeconomics - Lesson

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CHAPTER 8CHAPTER 8
Open Economy Macroeconomics:
The Balance of Payments and
Exchange Rates

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Exchange Rates
 When people in different countries buy from
and sell to each other, an exchange of
currencies must also take place.
 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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Exchange Rates
 Within a certain range of exchange rates,
trade flows in both directions, each country
specializes in producing the goods in which it
enjoys a comparative advantage, and trade is
mutually beneficial.
 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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Exchange Rates
 Early in the century, 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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Exchange Rates
 At the end of World War II, representatives
of 44 countries met in Bretton Woods, New
Hampshire. One of their agreements
established a system of essentially fixed
exchange rates.
 Each country agreed to intervene by
buying and selling currencies in the foreign
exchange market when necessary to
maintain the agreed-upon value of its
currency.

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Exchange Rates
 In 1971, most countries, including the United
States, gave up trying to fix exchange rates
formally and began allowing them to be
determined essentially by supply and demand.
• Just as with any other commodity, anJust as with any other commodity, an
excess of quantity supplied over quantityexcess of quantity supplied over quantity
demanded will cause the price—in this casedemanded will cause the price—in this case
the exchange rate—to fall.the exchange rate—to fall.

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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.
 Foreign exchange is simply all currencies
other than the domestic currency of a given
country.

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The Balance of Payments
United States Balance of Payments, 1999
CURRENT ACCOUNT
Goods exports 683.0
Goods imports – 1,030.2
(1) Net export of goods – 347.2
Export of services 277.1
Import of services – 197.5
(2) Net export of services 79.6
Income received on investments 273.9
Income payments on investments – 298.6
(3) Net investment income – 24.7
(4) Net transfer payments – 46.6
(5) Balance on current account (1 + 2 + 3 + 4) – 338.9
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –) – 381.0
(7) Change in foreign private assets in the United States 706.2
(8) Change in U.S. government assets abroad (increase is –) 8.3
(9) Change in foreign government assets in the United States 44.5
(10) Balance on capital account (6 + 7 + 8 + 9) 378.0
(11) Statistical discrepancy – 39.1
(12) Balance of payments (5 + 10 + 11) 0

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The Balance of Payments
 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.
 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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The Balance of Payments
 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.

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The Balance of Payments
 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).
 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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The Balance of Payments
 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.
 For each transaction recorded in the current
account, there is an offsetting transaction
recorded in the capital account.

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The Balance of Payments
 The capital account records the changes in assets and
liabilities.
 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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The Balance of Payments
 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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The United States as a Debtor
Nation
 A country’s net wealth is the sum of all its past
current account balances.
 Prior to the mid-1970s, the United States was a
creditor nation. After the mid-1970s, the United
Sates began to have a negative net wealth position
vis-à-vis the rest of the world. This means that the
United States spent much more on foreign goods and
services than it earned through the sales of its goods
and services.

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Equilibrium Output (Income)
in an Open Economy
 Planned aggregate expenditure in an open economy equals:
• In equilibrium:In equilibrium:
m = marginal propensity
to import (MPM)

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Equilibrium Output (Income)
in an Open Economy
 In an open economy, part of the income is spent on imports,
causing domestic income to decline.
a = 75 T= 100 mulltiplier = 2.00
b = 0.75 m = 0.25
I = 120 Aut.= 300
G = 100 Y * = 600
EX = 80
Y C
Closed
Economy
C + I + G
Exports X Imports mY
Net
Exports
(X-M)
Open
Economy
C + I + G
+ (X-M)
0 0 220 80 0 80 300
200 150 370 80 50 30 400
400 300 520 80 100 -20 500
600 450 670 80 150 -70 600
800 600 820 80 200 -120 700
1000 750 970 80 250 -170 800
1200 900 1120 80 300 -220 900

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Imports and Exports and the Trade
Feedback Effect
 The determinants of imports are the same factors
that affect consumption and investment behavior.
 Spending on imports also depends on the relative
prices of domestically produced and foreign-
produced goods.
 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.

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Imports and Exports and the Trade
Feedback Effect
 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.
 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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Import and Export Prices
and the Price 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.
 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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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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The Market for Foreign Exchange
 Assume that 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.
 People exchange currency in order to buy goods
and services, buy stocks or bonds, and for
speculative reasons.

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The Market for Foreign Exchange
Some Private Buyers and Sellers in International Exchange Markets: United
States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1. Firms, households, or governments that import British goods into the United States or wish to buy
British-made goods and services
2. U.S. citizens traveling in Great Britain
3. Holders of dollars who want to buy British stocks, bonds, or other financial instruments
4. U.S. companies that want to invest in Great Britain
5. Speculators who anticipate a decline in the value of the dollar relative to the pound
THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)
1. Firms, households, or governments that export U.S. goods into Great Britain or wish to buy U.S.-made
goods and services
2. British citizens traveling in the United States
3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United States
4. British companies that want to invest in the United States
5. Speculators who anticipate a rise in the value of the dollar relative to the pound

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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.
• 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.

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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.
• 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.

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The Market for Foreign Exchange
 The equilibrium exchange rate
occurs at the point at which the
quantity demanded of a foreign
currency equals the quantity of
that currency supplied.
• An excess supply of pounds will cause the price ofAn excess supply of pounds will cause the price of
pounds to fall—the pound willpounds to fall—the pound will depreciatedepreciate with respect towith respect to
the dollar. An excess demand for pounds will cause thethe dollar. An excess demand for pounds will cause the
price of pounds to rise—the pound willprice of pounds to rise—the pound will appreciateappreciate withwith
respect to the dollar.respect to the dollar.

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Factors that Affect Exchange Rates
 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.

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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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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.
• A higher price level in theA higher price level in the
United States increasesUnited States increases
the demand for poundsthe demand for pounds
and decreases the supplyand decreases the supply
of pounds. The result isof pounds. The result is
appreciation of the poundappreciation of the pound
against the dollar.against the dollar.

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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.
• A higher interest rate inA higher interest rate in
the United Statesthe United States
increases the supply ofincreases the supply of
pounds and decreases thepounds and decreases the
demand for pounds. Thedemand for pounds. The
result is depreciation ofresult is depreciation of
the pound against thethe pound against the
dollar.dollar.

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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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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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Exchange Rates and Prices
 Depreciation of a country’s currency tends to increase the
price level.
 Since the currency is less expensive, 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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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,If the purpose of the Fed is to stimulate the economy,
dollar depreciation is a good thing. It increases U.S.dollar depreciation is a good thing. It increases U.S.
exports and decreases imports. If the purpose of theexports and decreases imports. If the purpose of the
Fed is to fight inflation, dollar appreciation resultingFed is to fight inflation, dollar appreciation resulting
from tight monetary policy also helps in that fight.from tight monetary policy also helps in that fight.

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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.
 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.