International Political Economy
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International Political Economy
description
International Political Economy. Lesson 3 Section 3.1. Open Economies and its mechanisms. 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.) - PowerPoint PPT Presentation
Transcript of International Political Economy
International Political Economy
• 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)
A Rest of the World
Export (Goods, Services, Financial Activities)
Import(Goods, Services, Financial Activities)
Domestic Currency (α)
Foreign Currency (β)
• 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
A Rest of the World
Domestic Currency Demand
Domestic Currency Supply
Foreign Currency Demand
Foreign Currency Supply
Country Rest of the World
Domestic Currency
Supply
Domestic Currency Demand
Foreign Currency
Supply
Foreign Currency Demand
Exchange rate(€)
D and S Foreign Currency
($)
$ Supply$ Demand
E1
E2
QS1QD2 QS2QD1
E1 ► QD1>QS1
E2 ► QD2<QS2
Exchange rate(€)
D and S Foreign Currency
($)
$ Supply$ Demand
E1
E2
QS1QD2 QS2QD1
E1 ► QD1>QS1
E2 ► QD2<QS2
Equilibrium Exchange Rate
(e.g. 1$ = 1€)
Exchange Rate decrease
(e.g. 1$ = 0,5€)
Exchange Rate increase
(e.g. 1$ = 2€)
USA good more expensivePrice 1$ = 2€
Importincrease
Exportincrease
Import decrease
USA good less expansivePrice 1$ = 0,5€
Italy good less expensivePrice 1€ = 0,5$
Italy good more expensivePrice 1€ = 2$
Exportdecrease
• 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
• 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
• Domestic Currency Supply = Domestic Currency Demand
▼
Balance
• Domestic Currency Supply > Domestic Currency Demand
▼
Imbalance (deficit)
Domestic Currency Supply < Domestic Currency Demand
▼
Imbalance (surplus)
• Several variables affect supply and demand activity in this market:– Exchange rate– Income– Interest rate– Price level – Expectations
• 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
Demand/ Supply Foreign Currency
Transaction Type Exchange rate VariationExchange Rate
Increase (consequences)
Foreign Currency Demand
Import
Inverse
Exchange Rate ▲ Currency Demand ▼
Devaluation
Export ▲
Import ▼
Foreign Currency Supply
ExportDirect
Exchange Rate ▼ Currency Supply ▲
Revaluation
Export ▼
Import ▲
• 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
• 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
• 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
• 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
• 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
• 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.
• 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.
• 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.
• 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.
• How might this situation come about? – A prominent explanation is that it is a side effect of
large government budget deficits—hence 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.
• 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
-6.000
4.000
14.000
24.000
34.000
44.000
54.000
64.000
74.000
84.000
1980 1985 1990 1995 2000 2005
perc
ent o
f GD
P
General government gross debt Current account balance-6.000
4.000
14.000
24.000
34.000
44.000
54.000
64.000
74.000
84.000
1980 1985 1990 1995 2000 2005
perc
ent o
f GD
P
General government gross debt Current account balance
Twin deficit USA
