THE POWER OF MACROECONOMICS

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THE POWER OF MACROECONOMICS
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Exchange Rates, The Balance of Payments, and
Trade Deficits
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The Purpose Of This Lesson

• Is to explain how exchange rates and our
  international monetary system work and illustrate
  how fiscal and monetary policies may--or may
  not--be used in a global economy.
• We will examine the roots and scope of Americas
  chronic trade deficit problem.

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Lesson 10 Colander McConnell Samuelson
Schiller Brue Nordhaus 3rd Edition 14th
Edition 16th Edition 8th Edition
Complete Textbook (includes both Micro-and
Macroeconomics) Macroeconomics Text Only
15, 16 38 31, 34, 36 18, 36
15, 16 21 15, 18, 20 18, 21
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Mirror, Mirror On the Wall

• Whos the biggest debtor nation in the world?

• The United States of America

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Some History
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Some History

• During those years, the U.S. greatly expanded its
  exports to Europe and, after each war, it lent
  large sums of money to the combatants for
  post-war relief.
• In the course of doing so, the U.S. became the
  worlds largest creditor nation.

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All That Has Changed

• Beginning in the early 1980s, America began
  running huge trade deficits, and, over the years,
  these trade deficits have led to an accumulated
  net foreign debt of over 500 billion dollars.

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Is This A Problem?

• To many observers, Americas chronic trade
  deficits are every bit as dangerous as its
  chronic budget deficits.
• These trade deficit hawks warn that America is
  being forced to sell off its land and its
  factories -- and its future -- to finance these
  deficits.

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The Trade Deficit Doves

• Others, however, see the trade deficits simply as
  an opportunity to buy inexpensive foreign goods
  and enjoy a higher standard of living.
• These trade deficit doves argue that if
  foreign countries sell us cheap goods, we should
  buy and enjoy them and not try to erect
  protectionist trade barriers.

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In This Lesson

• Examine the scope of the trade deficit problem.
• Discuss the economic basis for international
  trade and learn some balance of payments
  accounting.
• Describe how exchange rates work and how the
  international monetary system is structured.

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In This Lesson

• Impacts of domestic fiscal and monetary policies
  on foreign capital markets and the trade deficit.
• Understand the important link between the budget
  and trade deficits and why it is important for
  nations to coordinate their fiscal and monetary
  policies in a global economy.

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Open Economies

• An economy that engages in international trade is
  called an open economy.
• A useful measure of such openness is the trade
  share--the ratio of a countrys exports or
  imports to its GDP.

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Balance of Payments Accounting

• We must distinguish between the current account
  and the capital account in our balance of
  payments.
• If the U.S. runs a trade deficit in its current
  account, it must balance that deficit with
  inflows into its capital account.
• This is the basic trade identity.

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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Tade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account -148 Sum of Current and Capital
Accounts -0-
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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account -148 Sum of Current and Capital
Accounts -0-
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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account -148 Sum of Current and Capital
Accounts -0-
The merchandise trade balance reflects trade in
commodities such as food and fuels and
manufactured goods.
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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account -148 Sum of Current and Capital
Accounts -0-

• Fees for services include shipping, financial
  services, and foreign travel.
• This category has been growing in recent years as
  the U.S. has shifted from a manufacturing economy
  to a more service-orientated economy.

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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account -148 Sum of Current and Capital
Accounts -0-

• The 206 billion represents the amount of income
  earned by Americans holding foreign assets.
• The debit of 203 billion represents the amount
  of income earned by foreigners holding U.S.
  assets.

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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account -148 Sum of Current and Capital
Accounts -0-
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The Capital Account

• One part of the capital account shows
  official-reserve changes.
• When all countries have purely market-determined
  exchange rates, the category equals zero.
• However, when countries intervene in foreign
  exchange markets, they attempt to affect the
  exchange rate by buying and selling foreign
  currencies.

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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
purchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account 148 Sum of Current and Capital
Accounts -0-
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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
purchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account 148 Sum of Current and Capital
Accounts -0-

• Of far greater consequence are the capital
  out-flows and in-flows which track both real
  assets like hotels and factories and financial
  assets such as stocks and bonds.
• Foreign purchases of U.S. assets represent
  capital in-flows and might include the purchase
  of government bonds by a German pension fund, the
  buying of American stock by a Dutch mutual fund,
  or the acquisition of a factory in a Pennsylvania
  by Japanese investors.

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US BALANCE OF PAYMENTS Credit Debits
Net Credits or Debits
Current Account a. Merchandise Trade
Balance -191 U.S Goods Exports 612 U.S.
Goods Imports -803 b. Fees for Services
80 U.S. Exports of Services 237 U.S. Imports
of Services -157 Balance on Goods and
Services -111 c. Net Investment Income
3 Income earned by U.S. 206 Investors
holding foreign assets Income earned by
foreigners holding -203 U.S. assets. d.
Unilateral Transfers -40 Balance on the Current
Account -148 Capital Account a. Foreign
pruchases of assets in 517 the United
States b. U.S. purchases of assets abroad -376
Balance on Foreign/U.S. Purchases 141 c.
Official reserves 7 Balance on Capital
Account 148 Sum of Current and Capital
Accounts -0-

• When U.S. investors purchase assets abroad like
  hotel chains or foreign stocks, this results in
  capital out-flows and a debit such as the 376
  billion in the table.

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Capital Inflow To The United States, 1946-1993

• These were the years when the U.S. trade deficit
  first jumped into the triple digit billions of
  dollars

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America The Worlds Largest Debtor Nation
U.S. is the largest creditor nation
U.S. is the largest debtor nation
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The Potential Problem

• This, in turn, means that the future profits and
  interest payments on these assets go to
  foreigners rather than to U.S. citizens.
• Over time, this leads to a lower level of real
  income for most Americans and a lower rate of
  economic growth.

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The Trade Deficit Hawks

• The obvious policy question is how can the U.S.
  eliminate its chronic trade deficits?
• The answer lies first in understanding how
  exchange rates work to balance trade flows.

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Exchange Rates

• The rate at which one nations currency can be
  traded for another nations currency.

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Foreign Exchange Rates
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Determinant Examples
Change in tastes Change in relative
incomes Change in relative prices Change in
relative real interest rates Speculation
Japanese autos decline in popularity in the
United States (Japanese yen depreciates U.S.
dollar appreciates). German tourists flock to the
United States (U.S. dollar appreciates German
mark depreciates) England encounters a
recession, reducing its imports, while U.S. real
output and real income surge, increasing U.S.
imports (British pound appreciates U.S. dollar
depreciates) Germany experiences a 3 inflation
rate compared to Canadas 10 rate (German mark
appreciates Canadian dollar depreciates) The
Federal Reserve drives up interest rates in the
United States, while the Bank of England takes no
such action (U.S. dollar appreciates British
pound depreciates) Currency traders believe
France will have much more rapid inflation than
Sweden (French franc depreciates Swedish krona
appreciates) Currency traders think German
interest rates will plummet relative to U.S.
rates (German mark depreciates U.S. dollar
appreciates)
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Different Rates Of Growth

• If, for example, the U.S. gross domestic product
  is growing faster than the German GDP, the U.S.
  dollar will depreciate relative to the German
  mark.
• This is precisely what happened in the early
  1990s when the U.S. economy was recovering faster
  than the economies of Europe.

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An Income Effect

• Through an income effect that we shall discuss
  further below, the U.S. recovery attracted
  additional European imports while exports to the
  sluggish European economies stagnated.
• This, in turn, led to a surplus of dollars
  relative to the European currencies and the
  dollars value declined.

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A Change In Relative Interest Rates

• When U.S. interest rates rise relative to British
  interest rates, the dollar will likewise
  appreciate relative to the British pound.
• The reason higher U.S. interest rates will
  attract relatively more British investment.

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In Order To Invest In America

• The British must first buy dollars with their
  pounds.
• This drives the value of the dollar up relative
  to the pound.
• This interest rate effect has played a key role
  in driving U.S. trade deficits.

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Different Rates Of Inflation

• If, for example, the rate of inflation in Canada
  is higher than in Germany, the Canadian dollar
  will depreciate relative to the German mark.
• This is because exchange rates in the currency
  markets reflect real price differences in the
  goods markets.

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Inflation Exchange Rates

• Thus, if inflation raises the actual or nominal
  price of, say, an auto made in Canada relative to
  the nominal price of an identical auto made in
  Germany, there must be a corresponding adjustment
  in the exchange rate so that the real,
  inflation-adjusted prices of the two autos stay
  the same.

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The Law of One Price

• Economists call this the law of one price.
• As we discuss the structure of the international
  monetary system, we shall see how differing rates
  of inflation played a key role in the downfall of
  the so-called gold standard a key linchpin of
  the international monetary system for over sixty
  years.

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• The intersection of the demand for pounds D1 and
  the supply of pounds S1 determine the equilibrium
  exchange rate.
• What is it?

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S1
3
2
Dollar price of 1 pound
1
D1
0
Q1
Q
Quantity of pounds

• Suppose that there were a major recession in the
  United States.
• What would happen to the demand for dollars and
  the exchange rate?

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S1
3
2
Dollar price of 1 pound
The dollar appreciates
1
D1
0
Q1
Q
Quantity of pounds

• Suppose real interest rates rise in the U.S.
• What would happen now in the figure?

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S1
3
2
Dollar price of 1 pound
The dollar appreciates
1
D1
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0
Q1
Q
Quantity of pounds

• A rise in relative real interest rates in the
  U.S. would attract more pounds into currency
  markets.
• British investors will attempt to trade their
  pounds for dollars so they can shift their
  investments to the U.S.

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End of Part 1
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