Open Economy Macroeconomics the Balance of Payments and Exchange Rates

© 2002 Prentice Hall Business Publishing© 2002 Prentice Hall Business Publishing Principles of Economics, 6/ePrinciples of Economics, 6/e Karl Case, Ray FairKarl Case, Ray Fair

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Prepared by: Fernando Prepared by: Fernando Quijano and Yvonn QuijanoQuijano and Yvonn Quijano

Open Economy Open Economy Macroeconomics: The Macroeconomics: The

Balance of Payments and Balance of Payments and Exchange RatesExchange Rates


Exchange RatesExchange Rates

• When people in different countries buy When people in different countries buy from and sell to each other, an exchange from and sell to each other, an exchange of currencies must also take place.of currencies must also take place.

• The The exchange rateexchange rate is the price of one is the price of one country’s currency in terms of another country’s currency in terms of another country’s currency; the ratio at which two country’s currency; the ratio at which two currencies are traded for each other.currencies are traded for each other.



• Within a certain range of exchange rates, Within a certain range of exchange rates, trade flows in both directions, each trade flows in both directions, each country specializes in producing the country specializes in producing the goods in which it enjoys a comparative goods in which it enjoys a comparative advantage, and trade is mutually advantage, and trade is mutually beneficial.beneficial.

• International exchange must be managed International exchange must be managed in a way that allows each partner in the in a way that allows each partner in the transaction to wind up with his or her own transaction to wind up with his or her own currency.currency.



• Early in the century, nearly all currencies Early in the century, nearly all currencies were backed by gold. Their values were were backed by gold. Their values were fixed in terms of a specific number of fixed in terms of a specific number of ounces of gold, which determined their ounces of gold, which determined their values in international trading—exchange values in international trading—exchange rates.rates.



• At the end of World War II, representatives At the end of World War II, representatives of 44 countries met in Bretton Woods, New of 44 countries met in Bretton Woods, New Hampshire. One of their agreements Hampshire. One of their agreements established a system of essentially fixed established a system of essentially fixed exchange rates.exchange rates.

• Each country agreed to intervene by Each country agreed to intervene by buying and selling currencies in the foreign buying and selling currencies in the foreign exchange market when necessary to exchange market when necessary to maintain the agreed-upon value of its maintain the agreed-upon value of its currency.currency.



• In 1971, most countries, including the United In 1971, most countries, including the United States, gave up trying to fix exchange rates States, gave up trying to fix exchange rates formally and began allowing them to be formally and began allowing them to be determined essentially by supply and demand.determined essentially by supply and demand.

• Just as with any other commodity, an Just as with any other commodity, an excess of quantity supplied over quantity excess of quantity supplied over quantity demanded will cause the price—in this case demanded will cause the price—in this case the exchange rate—to fall. the exchange rate—to fall.


The Balance of PaymentsThe Balance of Payments

• The The balance of paymentsbalance of payments is the record of is the record of a country’s transactions in goods, a country’s transactions in goods, services, and assets with the rest of the services, and assets with the rest of the world; also the record of a country’s world; also the record of a country’s sources (supply) and uses (demand) of sources (supply) and uses (demand) of foreign exchange.foreign exchange.

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



United States Balance of Payments, 1999United States Balance of Payments, 1999CURRENT ACCOUNTCURRENT ACCOUNT

Goods exportsGoods exports 683.0683.0Goods importsGoods imports – – 1,030.21,030.2

(1) Net export of goods(1) Net export of goods – – 347.2347.2

Export of servicesExport of services 277.1277.1Import of servicesImport of services – – 197.5197.5

(2) Net export of services(2) Net export of services 79.679.6

Income received on investmentsIncome received on investments 273.9273.9Income payments on investmentsIncome payments on investments – – 298.6298.6

(3) Net investment income(3) Net investment income – – 24.724.7 (4) Net transfer payments(4) Net transfer payments – – 46.646.6 (5) Balance on current account (1 + 2 + 3 + 4)(5) Balance on current account (1 + 2 + 3 + 4) – – 338.9338.9

CAPITAL ACCOUNTCAPITAL ACCOUNT (6) Change in private U.S. assets abroad (increase is –)(6) Change in private U.S. assets abroad (increase is –) – – 381.0381.0 (7) Change in foreign private assets in the United States(7) Change in foreign private assets in the United States 706.2706.2 (8) Change in U.S. government assets abroad (increase is –)(8) Change in U.S. government assets abroad (increase is –) 8.38.3 (9) Change in foreign government assets in the United States(9) Change in foreign government assets in the United States 44.544.5(10) Balance on capital account (6 + 7 + 8 + 9)(10) Balance on capital account (6 + 7 + 8 + 9) 378.0378.0

(11) Statistical discrepancy(11) Statistical discrepancy – – 39.139.1(12) Balance of payments (5 + 10 + 11)(12) Balance of payments (5 + 10 + 11) 00



• A country’s A country’s current accountcurrent account is the sum of is the sum of its:its:• net exports (exports minus imports),net exports (exports minus imports),• net income received from investments abroad, net income received from investments abroad,

and and • net transfer payments from abroad.net transfer payments from abroad.

• Exports Exports earnearn foreign exchange and are a foreign exchange and are a credit (+) item on the current account. credit (+) item on the current account. Imports Imports use upuse up foreign exchange and are foreign exchange and are a debit (–) item.a debit (–) item.



• The The balance of tradebalance of trade is the difference is the difference between a country’s exports of goods and between a country’s exports of goods and services and its imports of goods and services and its imports of goods and services.services.

• A A trade deficittrade deficit occurs when a country’s occurs when a country’s exports are less than its imports.exports are less than its imports.



• Investment incomeInvestment income consists of holdings of consists of holdings of foreign assets that yield dividends, foreign assets that yield dividends, interest, rent, and profits paid to U.S. interest, rent, and profits paid to U.S. asset holders (a source of foreign asset holders (a source of foreign exchange).exchange).

• Net transfer paymentsNet transfer payments are the difference are the difference between payments from the United States between payments from the United States to foreigners and payments from to foreigners and payments from foreigners to the United States.foreigners to the United States.



• The The balance on current accountbalance on current account consists of net exports of goods, plus net consists of net exports of goods, plus net exports of services, plus net investment exports of services, plus net investment income, plus net transfer payments. It income, plus net transfer payments. It shows how much a nation has spent shows how much a nation has spent relative to how much it has earned.relative to how much it has earned.

• For each transaction recorded in the For each transaction recorded in the current account, there is an offsetting current account, there is an offsetting transaction recorded in the capital transaction recorded in the capital account.account.



• The capital account records the changes in The capital account records the changes in assets and liabilities.assets and liabilities.

• The The balance on capital accountbalance on capital account in the in the United States is the sum of the following United States is the sum of the following (measured in a given period):(measured in a given period):• the change in private U.S. assets abroadthe change in private U.S. assets abroad• the change in foreign private assets in the United the change in foreign private assets in the United

StatesStates• the change in U.S. government assets abroad, andthe change in U.S. government assets abroad, and• the change in foreign government assets in the the change in foreign government assets in the

United StatesUnited States



• In the absence of errors, the balance on In the absence of errors, the balance on capital account would equal the negative of capital account would equal the negative of the balance on current account.the balance on current account.

• If the capital account is positive, the change in If the capital account is positive, the change in foreign assets in the country is greater than foreign assets in the country is greater than the change in the country’s assets abroad, the change in the country’s assets abroad, which is a decrease in the net wealth of the which is a decrease in the net wealth of the country.country.


The United States as a Debtor NationThe United States as a Debtor Nation

• A country’s net wealth is the sum of all its A country’s net wealth is the sum of all its past current account balances.past current account balances.

• Prior to the mid-1970s, the United States Prior to the mid-1970s, the United States was a creditor nation. After the mid-was a creditor nation. After the mid-1970s, the United Sates began to have a 1970s, the United Sates began to have a negative net wealth position vis-à-vis the negative net wealth position vis-à-vis the rest of the world. This means that the rest of the world. This means that the United States spent much more on foreign United States spent much more on foreign goods and services than it earned through goods and services than it earned through the sales of its goods and services.the sales of its goods and services.


Equilibrium Output (Income)Equilibrium Output (Income)in an Open Economyin an Open Economy

• Planned aggregate expenditure in an Planned aggregate expenditure in an open economy equals:open economy equals:

A E C I G E X IM • In equilibrium:In equilibrium:C a bY

I I 0

G G 0

E X E X 0

IM m Y

Y C I G E X IM Y a bY I G E X m Y Y bY m Y a I G E X Y b m a I G E X( )1

Yb m

a I G E X* ( )

1

1multiplier autonomous expenditures

m = marginal propensity to import (MPM)


Equilibrium Output (Income)Equilibrium Output (Income)in an Open Economyin an Open Economy

• In an open economy, part of the income is spent In an open economy, part of the income is spent on imports, causing domestic income to decline.on imports, causing domestic income to decline.

a = 50 mulltiplier = 2.00b = 0.8 m = 0.25I = 100 Aut.= 300G = 100 Y * = 600X = 50

Y CClosed

Economy C + I + G

Exports XImports

mY

Net Exports (X-M)

Open Economy C + I + G + (X-M)

0 50 250 50 0 50 300200 200 400 50 50 0 400400 350 550 50 100 -50 500600 500 700 50 150 -100 600800 650 850 50 200 -150 700

1000 800 1000 50 250 -200 8001200 950 1150 50 300 -250 900

0

200

400

600

800

1000

1200

0 200 400 600 800 1000 1200Aggregate output (income), (Y)

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Imports and Exports and the Trade Imports and Exports and the Trade Feedback EffectFeedback Effect

• The determinants of imports are the same The determinants of imports are the same factors that affect consumption and factors that affect consumption and investment behavior.investment behavior.

• Spending on imports also depends on the Spending on imports also depends on the relative prices of domestically produced relative prices of domestically produced and foreign-produced goods.and foreign-produced goods.

• The demand for U.S. exports depends on The demand for U.S. exports depends on economic activity in the rest of the world. economic activity in the rest of the world. If foreign output increases, U.S. exports If foreign output increases, U.S. exports tend to increase.tend to increase.


Imports and Exports and the Trade Imports and Exports and the Trade Feedback EffectFeedback Effect

• Because U.S. imports are somebody Because U.S. imports are somebody else’s exports, the extra import demand else’s exports, the extra import demand from the United States raises the exports from the United States raises the exports of the rest of the world.of the rest of the world.

• The The trade feedback effecttrade feedback effect is the is the tendency for an increase in the economic tendency for an increase in the economic activity of one country to lead to a activity of one country to lead to a worldwide increase in economic activity, worldwide increase in economic activity, which then feeds back to that country.which then feeds back to that country.


Import and Export PricesImport and Export Pricesand the Price Feedback Effectand the Price Feedback Effect

• When the export prices of one country When the export prices of one country rise, with no change in the exchange rate, rise, with no change in the exchange rate, the import prices of another rise.the import prices of another rise.

• If the inflation rate abroad is high, U.S. If the inflation rate abroad is high, U.S. import prices are likely to rise.import prices are likely to rise.

• The The price feedback effectprice feedback effect is the process is the process by which a domestic price increase in one by which a domestic price increase in one country can “feed back” on itself through country can “feed back” on itself through export and import prices.export and import prices.

• Inflation is “exportable.”Inflation is “exportable.”


The Open Economy withThe Open Economy withFlexible Exchange RatesFlexible Exchange Rates

• FloatingFloating, or , or market-determinedmarket-determined, , exchange ratesexchange rates are exchange rates are exchange rates determined by the unregulated forces of determined by the unregulated forces of supply and demand.supply and demand.

• Exchange rate movements have important Exchange rate movements have important impacts on imports, exports, and impacts on imports, exports, and movement of capital between countries.movement of capital between countries.


The Market for Foreign ExchangeThe Market for Foreign Exchange

• Assume that there are only two countries: Assume that there are only two countries: the United States and Britain.the United States and Britain.

• The demand for pounds is comprised of The demand for pounds is comprised of holders of dollars wishing to acquire pounds. holders of dollars wishing to acquire pounds. The supply of pounds is comprised of The supply of pounds is comprised of holders of pounds seeking to exchange holders of pounds seeking to exchange them for dollars.them for dollars.

• People exchange currency in order to buy People exchange currency in order to buy goods and services, buy stocks or bonds, goods and services, buy stocks or bonds, and for speculative reasons.and for speculative reasons.



Some Private Buyers and Sellers in International Some Private Buyers and Sellers in International Exchange Markets: United States and Great BritainExchange Markets: United States and Great BritainTHE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)

1.1. Firms, households, or governments that import British goods into the United States Firms, households, or governments that import British goods into the United States or wish to buy British-made goods and servicesor wish to buy British-made goods and services

2.2. U.S. citizens traveling in Great BritainU.S. citizens traveling in Great Britain

3.3. Holders of dollars who want to buy British stocks, bonds, or other financial Holders of dollars who want to buy British stocks, bonds, or other financial instrumentsinstruments

4.4. U.S. companies that want to invest in Great BritainU.S. companies that want to invest in Great Britain

5.5. Speculators who anticipate a decline in the value of the dollar relative to the poundSpeculators who anticipate a decline in the value of the dollar relative to the pound

THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)1.1. Firms, households, or governments that import U.S. goods into Great Britain or Firms, households, or governments that import U.S. goods into Great Britain or

wish to buy U.S.-made goods and serviceswish to buy U.S.-made goods and services

2.2. British citizens traveling in the United StatesBritish citizens traveling in the United States

3.3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United Statesthe United States

4.4. British companies that want to invest in the United StatesBritish companies that want to invest in the United States

5.5. Speculators who anticipate a rise in the value of the dollar relative to the poundSpeculators who anticipate a rise in the value of the dollar relative to the pound



• The demand for pounds in The demand for pounds in the foreign exchange the foreign exchange market shows a negative market shows a negative relationship between the relationship between the price of pounds (dollars per price of pounds (dollars per pound) ($/pound) ($/£) and the £) and the quantity of pounds quantity of pounds demanded.demanded.

• When the price of pounds falls, British-made goods and When the price of pounds falls, British-made goods and services appear less expensive to U.S. buyers. If British services appear less expensive to U.S. buyers. If British prices are constant, U.S. buyers will buy more British prices are constant, U.S. buyers will buy more British goods and services, and the quantity demanded of goods and services, and the quantity demanded of pounds will rise.pounds will rise.



• The supply of pounds in the The supply of pounds in the foreign exchange market foreign exchange market shows a positive shows a positive relationship between the relationship between the price of pounds (dollars per price of pounds (dollars per pound) ($/pound) ($/£) and the £) and the quantity of pounds quantity of pounds supplied.supplied.

• When the price of pounds rises, the British can obtain When the price of pounds rises, the British can obtain more dollars for each pound. This means that U.S.-made more dollars for each pound. This means that U.S.-made goods and services appear less expensive to British goods and services appear less expensive to British buyers. Thus, the quantity of pounds supplied is likely to buyers. Thus, the quantity of pounds supplied is likely to rise with the exchange rate.rise with the exchange rate.



• The equilibrium exchange The equilibrium exchange rate occurs at the point at rate occurs at the point at which the quantity which the quantity demanded of a foreign demanded of a foreign currency equals the currency equals the quantity of that currency quantity of that currency supplied.supplied.

• An excess supply of pounds will cause the price of An excess supply of pounds will cause the price of pounds to fall—the pound will pounds to fall—the pound will depreciatedepreciate with respect to with respect to the dollar. An excess demand for pounds will cause the the dollar. An excess demand for pounds will cause the price of pounds to rise—the pound will price of pounds to rise—the pound will appreciateappreciate with with respect to the dollar. respect to the dollar.


Factors that Affect Exchange RatesFactors that Affect Exchange Rates

• The Law of One PriceThe Law of One Price If the costs of If the costs of transportation are small, the price of the transportation are small, the price of the same good in different countries should be same good in different countries should be roughly the same.roughly the same.

• If the low of one price held for all goods, and If the low of one price held for all goods, and if each country consumed the same market if each country consumed the same market basket of goods, the exchange rate between basket of goods, the exchange rate between the two currencies would be determined the two currencies would be determined simply by the relative price levels in the two simply by the relative price levels in the two countries.countries.



• The theory that exchange rates are set so The theory that exchange rates are set so that the price of similar goods in different that the price of similar goods in different countries is the same is known as the countries is the same is known as the purchasing-power paritypurchasing-power parity..

• If it takes ten times as many pesos to buy a If it takes ten times as many pesos to buy a pound of salt in Mexico as it takes U.S. pound of salt in Mexico as it takes U.S. dollars to buy a pound of salt in the United dollars to buy a pound of salt in the United States, then the equilibrium exchange rate States, then the equilibrium exchange rate should be 10 pesos per dollar.should be 10 pesos per dollar.



• A high rate of inflation in one country relative to A high rate of inflation in one country relative to another puts pressure on the exchange rate another puts pressure on the exchange rate between the two countries, and there is a general between the two countries, and there is a general tendency for the currencies of relative high-tendency for the currencies of relative high-inflation countries to depreciate.inflation countries to depreciate.

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



• The level of a country’s interest rate relative to The level of a country’s interest rate relative to interest rates in other countries is another interest rates in other countries is another determinant of the exchange rate. If U.S. interest determinant of the exchange rate. If U.S. interest rates rise relative to British interest rates, British rates rise relative to British interest rates, British citizens may be attracted to U.S. securities.citizens may be attracted to U.S. securities.

• A higher interest rate in A higher interest rate in the United States the United States increases the supply of increases the supply of pounds and decreases the pounds and decreases the demand for pounds. The demand for pounds. The result is depreciation of result is depreciation of the pound against the the pound against the dollar.dollar.


The Effects of Exchange RatesThe Effects of Exchange Rateson the Economyon the Economy

• When a country’s currency depreciates When a country’s currency depreciates (falls in value), its import prices rise and its (falls in value), its import prices rise and its export prices (in foreign currencies) fall.export prices (in foreign currencies) fall.

• When the U.S. dollar is cheap, U.S. When the U.S. dollar is cheap, U.S. products are more competitive in world products are more competitive in world markets, and foreign-made goods look markets, and foreign-made goods look expensive to U.S. citizens. expensive to U.S. citizens.


The Effects of Exchange RatesThe Effects of Exchange Rateson the Economyon the Economy

• A depreciation of a country’s currency can A depreciation of a country’s currency can serve as a stimulus to the economy.serve as a stimulus to the economy.• Foreign buyers are likely to increase their Foreign buyers are likely to increase their

spending on U.S. goodsspending on U.S. goods• Buyers substitute U.S.-made goods for Buyers substitute U.S.-made goods for

importsimports• Aggregate expenditure on domestic output will Aggregate expenditure on domestic output will

riserise• Inventories will fallInventories will fall• GDP (GDP (YY) will increase.) will increase.


Exchange Rates and the Balance of Exchange Rates and the Balance of Trade: The J CurveTrade: The J Curve

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

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

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


Exchange Rates and PricesExchange Rates and Prices

• Depreciation of a country’s currency tends Depreciation of a country’s currency tends to increase the price level.to increase the price level.• Since the currency is less expensive, export Since the currency is less expensive, export

demand rises.demand rises.• Domestic buyers substitute domestic products Domestic buyers substitute domestic products

for the now more expensive imports.for the now more expensive imports.• If the economy is operating close to capacity, If the economy is operating close to capacity,

the increase in aggregate demand is likely to the increase in aggregate demand is likely to result in higher prices.result in higher prices.

• If import prices rise, costs may rise for business If import prices rise, costs may rise for business firms, shifting the AS curve to the left.firms, shifting the AS curve to the left.


Monetary Policy withMonetary Policy withFlexible Exchange RatesFlexible Exchange Rates

• Fed actions to lower Fed actions to lower interest rates result in a interest rates result in a decrease in the demand decrease in the demand for dollars and an increase for dollars and an increase in the supply of dollars, in the supply of dollars, causing the dollar to causing the dollar to depreciate.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 the exports and decreases imports. If the purpose of the Fed is to fight inflation, dollar appreciation resulting Fed 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.


Fiscal Policy withFiscal Policy withFlexible Exchange RatesFlexible Exchange Rates

• Flexible interest rates may not help in the Flexible interest rates may not help in the attempt by government to cut taxes in order attempt by government to cut taxes in order to stimulate the economy.to stimulate the economy.• A tax cut results in increased household A tax cut results in increased household

spending, but some of that spending leaks out as spending, but some of that spending leaks out as imports, reducing the multiplier.imports, reducing the multiplier.

• As income increases, the demand for money As income increases, the demand for money increases. The resulting higher interest rates increases. The resulting higher interest rates cause the dollar to appreciate. Exports fall, cause the dollar to appreciate. Exports fall, imports rise, again reducing the multiplier.imports rise, again reducing the multiplier.

• If interest rates rise, private investment may be If interest rates rise, private investment may be crowed out, also lowering the multiplier.crowed out, also lowering the multiplier.

Open Economy Macroeconomics the Balance of Payments and Exchange Rates

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