International Political Economy

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International Political Economy
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Open Economies and its mechanisms

• Lesson 3
• Section 3.1

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• An Economy has two basic kinds of economic
  interactions with the rest of the world
• Buying and/or Selling
• Goods (e.g. lumber, automobiles, etc.)
• Services (e.g. transportation, tourism, etc.)
• Assets, mainly financial assets (e.g. interest
  and dividend payments)

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Export (Goods, Services, Financial Activities)
Domestic Currency (a)
Rest of the World
A
Foreign Currency (ß)
Import (Goods, Services, Financial Activities)
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• Each international actvities gives rise to a
  situation in which either foreigners wish obtain
  our currency or we wish obtain foreign currency
• The former is viewed as a demand for our currency
  on the foreign exchange market, and the latter is
  viewed as a supply of our currency on this market

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Domestic Currency Supply
Domestic Currency Demand
Rest of the World
A
Foreign Currency Demand
Foreign Currency Supply
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Domestic Currency Supply
Foreign Currency Supply
Country
Rest of the World
Domestic Currency Demand
Foreign Currency Demand
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Supply
Supply
Italy
USA
Demand
Demand
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Exchange rate ()
Supply
Demand
E1 ? QD1gtQS1 E2 ? QD2ltQS2
E2
E1
D and S Foreign Currency ()
QS1
QD2
QD1
QS2
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Exchange rate ()
Supply
Demand
E1 ? QD1gtQS1 E2 ? QD2ltQS2
E2
E1
D and S Foreign Currency ()
QS1
QD2
QD1
QS2
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Exchange rate ()
Supply
Demand
E ? QD QS
E
D and S Foreign Currency ()
Q
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USA good more expensive Price 1 2
Import decrease
Exchange Rate increase (e.g. 1 2)
Export increase
Italy good less expensive Price 1 0,5
Equilibrium Exchange Rate (e.g. 1 1)
Import increase
USA good less expansive Price 1 0,5
Exchange Rate decrease (e.g. 1 0,5)
Italy good more expensive Price 1 2
Export decrease
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What is The balance of payments?

• Lesson 3
• Section 3.2

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• The balance of payments is the difference between
  the sum of all demands for and the supplies of
  domestic currency on the foreign exchange market
• If the total number of domestic currency supplied
  is equal to the total number of domestic currency
  demanded, the result is a zero balance of
  payments
• In this case the international sector of the
  economy is in equilibrium

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• A balance of payments surplus occurs when the
  demand of domestic currency on the foreign
  exchange market exceeds the supply

• A balance of payments deficit is the situation
  where the supply of domestic currency exceeds its
  demand

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• Domestic Currency Supply Domestic Currency
  Demand
• ?
• Balance
• Domestic Currency Supply gt Domestic Currency
  Demand
• ?
• Imbalance (deficit)
• Domestic Currency Supply lt Domestic Currency
  Demand
• ?
• Imbalance (surplus)

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Determinants of foreign exchange market activity

• Lesson 3
• Section 3.3

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• Several variables affect supply and demand
  activity in this market
• Exchange rate
• Income
• Interest rate
• Price level
• Expectations

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• Exchange rate
• The price of domestic currency in terms of
  foreign currency is determined in the foreign
  exchange market
• The exchange rate is a very important determinant
  of international trade in fact
• If exchange rate of domestic currency increase,
  imports is cheaper, so imports increase
• Thus, increasing the supply of domestic currency
  on the foreign exchange market
• Similarly, exports are more expensive to
  foreigners, so exports fall
• Thus, the decreasing the demand of domestic
  currency
• This way the rise in the exchange rate eliminates
  the balance of payments surplus
• The opposite occurs in case of a balance of
  payments deficit
• The exchange rate falls to eliminate the deficit

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Demand/ Supply Foreign Currency Transaction Type Exchange rate Variation Exchange Rate Increase (consequences)
Foreign Currency Demand Import Inverse Exchange Rate ? Currency Demand ? Devaluation Export ? Import ?
Foreign Currency Supply Export Direct Exchange Rate ? Currency Supply ? Revaluation Export ? Import ?
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• Income
• At a higher level of income, imports increase
• The supply of domestic currency on the foreign
  market increases, creating a balance of payments
  deficit and downward pressure on exchange rate

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• Two caveats concerning capital inflows are
  important
• 1. the resul depends on the interest rate
  increase not being part of a worldwide pattern
• 2. the relevant difference in interest rates is
  the difference in real interest rates, and not
  nominal interest rates, because investors are
  concerned with real returns

• Interest rate
• When domestic interes rate is higher, foreigners
  are more interested in buying financial assets
• So, increase the demand of domestic currency on
  the foreign exchange market
• This demand creates
• capital inflows,
• a balance of payments surplus,
• And upward pressure on the exchange rate

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• Price level
• A rise of domestic prices level increase the
  price of exports and the price of
  import-competing goods and services
• So, exports fall and imports rise
• As the result the demand for domestic currency
  decreases, and the supply of domestic currency
  increases creating
• a balance of payments deficit, and
• Downward pressure on the exchange rate
• Again in this case, the effect occur only if
  there is no equivalent price increase in the rest
  of the world

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• Expectations
• If foreigners expets the value of domestic
  currency to rise, they can reap a capital gain by
  buying our bonds and the selling them again after
  the exchange rate has risen
• This speculation creates
• An inflow of capital,
• A balance of payments surplus,
• and upward pressure on the exchange rate
• Speculative activity is indeed the primary
  determinant of exchange rates in the short run

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The international economic accounts

• Lesson 3
• Section 3.4

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• Knowledge of the balance of payments is all that
  is needed for analysis of the economic forces
  that automatically are set in motion whenever
  there is a disequilibrium in the international
  sector of the economy
• Often, however, analysts are interested in the
  source of any disequilibrium in the international
  sector, that is, the relative contributions to an
  equilibrium position of the various components of
  the demand for and supply of domestic currency on
  the foreign exchange market
• Consequently, the balance of payments is broken
  down into several subsidiary measures, which
  together are referred to as the international
  accounts or the balance of payments accounts.

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• At the most general level, the balance of
  payments is broken into two accounts, the current
  and capital accounts
• The current account measures the difference
  between the demand for and the supply of domestic
  currency arising from transactions that affect
  the current level of income here and abroad
• The capital account measures the difference
  between the demand for and the supply of domestic
  currency arising from sales or purchases of
  assets to or from foreigners.
• The capital account measures capital flows
  between a country and the rest of the world. A
  capital account surplus measures a net capital
  inflow, and a capital account deficit measures a
  net capital outflow.

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• The trade balance is the sum of following
• Merchandise trade balance
• Difference between exports and imports of goods
• Services trade balance
• Difference between exports and imports of
  services
• Net investment income from abroad
• Interest and dividend interest
• Net transfer from abroad
• Pension payments, foreign aid, etc.

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The twin deficits

• Lesson 3
• Section 3.5

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• An interesting aspect of the balance of payments
  accounts is that it is quite possible to have an
  economy in international equilibrium while
  simultaneously its subsidiary accounts are
  unbalanced, as long as they offset each other
• The U.S. economy, for example, for several years
  had a current account deficit that was offset by
  a surplus in its capital account.

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• How might this situation come about?
• A prominent explanation is that it is a side
  effect of large government budget deficitshence
  termed the twin deficit problem.
• A large government deficit increases the interest
  rate as the government sells bonds to finance its
  deficit.
• This rise in the interest rate makes domestic
  bonds look very attractive to overseas investors,
  so capital flows into the country, creating a
  balance of payments surplus.
• This bids up the value of the dollar, which in
  turn decreases exports and increases imports,
  creating a balance of trade deficit.

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• How budget deficits cause trade deficits
• G increase and/or T decrease
• This causes
• Budget deficit
• Government sells bonds
• Interest rate increase
• Capital inflows increase
• Exchange rate increase
• Exports decrease and imports increase
• Balance of trade deficit

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Twin deficit USA