ISG international economics course 7 chapter 12

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12
International Economics Open economy
macroeconomics
CHAPTER
The balance of payments and exchange rates
Course 7 Friday, March 24th 2006
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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 countrys
  currency in terms of another countrys 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
  tradingexchange 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, an excess of
  quantity supplied over quantity demanded will
  cause the pricein this case the exchange rateto
  fall.

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The Balance of Payments

• The balance of payments is the record of a
  countrys transactions in goods, services, and
  assets with the rest of the world also the
  record of a countrys 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
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The Balance of Payments

• A countrys 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
  countrys exports of goods and services and its
  imports of goods and services.
• A trade deficit occurs when a countrys 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 countrys 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 countrys 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

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.

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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 elses 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 Pricesand 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 withFlexible 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
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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
  of pounds to fallthe pound will depreciate with
  respect to the dollar. An excess demand for
  pounds will cause the price of pounds to risethe
  pound will appreciate with 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 low 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 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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Factors that Affect Exchange Rates

• The level of a countrys 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 in the United States
  increases the supply of pounds and decreases the
  demand for pounds. The result is depreciation of
  the pound against the dollar.

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The Effects of Exchange Rateson the Economy

• When a countrys 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 Rateson the Economy

• A depreciation of a countrys 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 the Balance of Trade The J
Curve

• According to the J curve, the balance of trade
  gets worse before it gets better following a
  currency depreciation.

• Initially, the negative effect on the price of
  imports may dominate the positive effects of an
  increase in exports and a decrease in imports.

• But when imports and exports have had a time to
  respond to price changes, the balance of trade
  improves.

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Exchange Rates and Prices

• Depreciation of a countrys 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 withFlexible 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. If
  the purpose of the Fed is to fight inflation,
  dollar appreciation resulting from tight monetary
  policy also helps in that fight.

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Fiscal Policy withFlexible 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.

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