Case econ08 ppt_34

© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair

Prepared by:

Fernando & Yvonn Quijano

34Chapter

Open-EconomyMacroeconomics:The Balance of Paymentsand Exchange Rates

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Chapter Outline

34Open-EconomyMacroeconomics:

The Balance of Paymentsand Exchange Rates

The Balance of PaymentsThe Current AccountThe Capital AccountThe United States as a Debtor NationEquilibrium Output (Income) in an Open EconomyThe International Sector and Planned Aggregate ExpenditureImports and Exports and the Trade Feedback EffectImport and Export Prices and the Price Feedback EffectThe Open Economy with Flexible Exchange RatesThe Market for Foreign ExchangeFactors That Affect Exchange RatesThe Effects of Exchange Rates on the EconomyAn Interdependent World EconomyAppendix: World Monetary Systems Since 1900

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Open-Economy Macroeconomics:The Balance of Payments and Exchange Rates

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

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

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THE BALANCE OF PAYMENTS

foreign exchange All currencies other than the domestic currency of a given country.

balance of payments Therecord of a country’stransactions in goods, services,and assets with the rest of theworld; also the record of acountry’s sources (supply) anduses (demand) of foreignexchange.

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balance of trade A country’s exports of goods and services minus its imports of goods and services.

THE CURRENT ACCOUNT

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– 1.5(11) Net capital account transactions

0(12) Balance of payments (5 + 10 + 11)

51.9(11) Statistical discrepancy

615.5(10) Balance on capital account (6 + 7 + 8 + 9)

355.3 (9) Change in foreign government assets in the United States

4.1 (8) Change in U.S. government assets abroad (increase is –)

1077.9 (7) Change in foreign private assets in the United States

– 821.8 (6) Change in private U.S. assets abroad (increase is –)CAPITAL ACCOUNT

– 665.9 (5) Balance on current account (1 + 2 + 3 + 4)

– 72.9 (4) Net transfer payments

24.1 (3) Net investment income

– 344.9Income payments on investments

369.0Income received on investments

48.4 (2) Net export of services

– 291.2Import of services

339.6Export of services

– 665.5 (1) Net export of goods

– 1,473.1Goods imports

807.6Goods exportsCURRENT ACCOUNT

TABLE 21.1 United States Balance of Payments, 2004

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trade deficit Occurs when acountry’s exports of goods andservices are less than its imports of goods and services in a given period.

THE CURRENT ACCOUNT

balance on current account Net exports of goods, plus net exports of services, plus net investment income, plus nettransfer payments.

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balance on capital account In the United States, 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, andthe change in foreign governmentassets in the United States.

THE CAPITAL ACCOUNT

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Prior to the mid-1970s, the United States had generally run current account surpluses. This began to turn around in the mid-1970s, and by the mid-1980s, the United States was running large current account deficits. In other words, the United States changed from a creditor nation to a debtor nation.

THE UNITED STATES AS A DEBTOR NATION

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EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY

THE INTERNATIONAL SECTOR AND PLANNED AGGREGATE EXPENDITURE

Planned aggregate expenditure in an open economy:

AE C + I + G + EX - IM

Determining the Level of Imports

net exports of goods and services (EX - IM) The difference between a country’s total exports and total imports.

marginal propensity toimport (MPM) The change inimports caused by a $1 change in income.

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FIGURE 21.1 Determining Equilibrium Output in an Open Economy

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The Open-Economy Multiplier

open-economy multiplier )(1

1

MPMMPC−−=

The effect of a sustained increase in government spending (or investment) on income—that is, the multiplier—is smaller in an open economy than in a closed economy. The reason: When government spending (or investment) increases and income and consumption rise, some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services.

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IMPORTS AND EXPORTS AND THE TRADE FEEDBACK EFFECT

The Determinants of Imports

The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports.

The Determinants of Exports

The demand for U.S. exports depends on economic activity in the rest of the world—rest-of-the-world real wages, wealth, nonlabor income, interest rates, and so on—as well as on the prices of U.S. goods relative to the price of rest-of-the-world goods. If foreign output increases,

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The Trade Feedback Effect

trade feedback effect 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 thatcountry.

An increase in U.S. imports increases other countries’ exports, which stimulates thosecountries’ economies and increases their imports, which increases U.S. exports, whichstimulates the U.S. economy and increases its imports, and so on. This is the tradefeedback effect. In other words, an increase in U.S. economic activity leads to a worldwide increase in economic activity, which then “feeds back” to the United States.

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The Price Feedback Effect

price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country.

The general rate of inflation abroad is likely to affect U.S. import prices. If the inflationrate abroad is high, U.S. import prices are likely to rise.

Export prices of other countries affect U.S. import prices.

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THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES

THE MARKET FOR FOREIGN EXCHANGE

TABLE 21.2 Some Private Buyers and Sellers in International Exchange Markets: United States and Great Britain

THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)

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

2.U.S. citizens traveling in Great Britain

3.Holders of dollars who want to buy British stocks, bonds, or other financial instruments

4.U.S. companies that want to invest in Great Britain

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

THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)

1. Firms, households, or governments that import U.S. goods into Great Britain or wish to buy U.S.-made goods and services

2. British citizens traveling in the United States

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

4. British companies that want to invest in the United States

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

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floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand.

FIGURE 21.2 The Demand for Pounds in the Foreign Exchange Market

FIGURE 21.3 The Supply of Pounds in the Foreign Exchange Market

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FIGURE 21.4 The Equilibrium Exchange Rate

appreciation of a currency The rise in value of one currency relative to another.

depreciation of a currency The fall in value of one currency relative to another.

The Equilibrium Exchange Rate

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

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FACTORS THAT AFFECT EXCHANGE RATES

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.

purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same.

Purchasing Power Parity: The Law of One Price

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 relatively high-inflation countries to depreciate.

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FIGURE 21.5 Exchange Rates Respond to Changes in Relative Prices

FIGURE 21.6 Exchange Rates Respond to Changes in Relative Interest Rates

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THE EFFECTS OF EXCHANGE RATES ON THE ECONOMY

A depreciation of a country’s currency is likely to increase its GDP.

Exchange Rate Effects on Imports, Exports, and Real GDP

The level of imports and exports depends on exchange rates as well as on income and other factors. When events cause exchange rates to adjust, the levels of imports and exports willchange. Changes in exports and imports can in turn affect the level of real GDP and the price level. Further, exchange rates themselves also adjust to changes in the economy.

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Monetary Policy with Flexible Exchange Rates A cheaper dollar is a good thing if the goal of the monetary expansion is to stimulate the domestic economy.

Fiscal Policy with Flexible Exchange Rates The openness of the economy and flexible exchange rates do not always work to the advantage of policy makers.

Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level.

Monetary Policy with Fixed Exchange Rates There is no role monetary policy can play if a country has a fixed exchange rate.

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AN INTERDEPENDENT WORLD ECONOMY

The increasing interdependence of countries in the world economy has made the problems facing policy makers more difficult.

We used to be able to think of the United States as a relatively self-sufficient region.

Forty years ago, economic events outside U.S. borders had relatively little effect on its economy. This situation is no longer true. The events of the past four decades have taught us that the performance of the U.S. economy is heavily dependent on events outside U.S. borders.

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appreciation of a currencybalance of paymentsbalance of tradebalance on capital accountbalance on current accountdepreciation of a currencyexchange ratefloating, or market- determined, exchange ratesforeign exchange

REVIEW TERMS AND CONCEPTS

J-curve effectlaw of one pricemarginal propensity to import (MPM)net exports of goods and services (EX - IM)price feedback effectpurchasing-power-parity theorytrade deficittrade feedback effectPlanned aggregate expenditure in an open economy: AE C + I + G + EX - IMOpen-economy multiplier:

)(1

1

MPMMPC−−=

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WORLD MONETARY SYSTEMS SINCE 1900

Appendix

THE GOLD STANDARD

FIXED EXCHANGE RATES AND THE BRETTON WOODS SYSTEM

“PURE” FIXED EXCHANGE RATES

PROBLEMS WITH THE BRETTON WOODS SYSTEM

PROBLEMS WITH THE GOLD STANDARD

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Appendix

Bretton Woods The site in New Hampshire where a group of experts from 44 countries met in 1944 and agreed to an international monetary system of fixed exchange rates.

Case econ08 ppt_34

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