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Open Economy Macroeconomics: The Balance of Payments and Exchange Rates
Prepared by: Fernando Quijano and Yvonn Quijano
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.
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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.
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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.
683.0 1,030.2 347.2 277.1 197.5 79.6 273.9 298.6 24.7 46.6 338.9 381.0 706.2 8.3 44.5 378.0 39.1 0
Karl Case, Ray Fair
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
A trade deficit occurs when a countrys exports are less than its imports.
States the change in U.S. government assets abroad, and the change in foreign government assets in the United States
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
AE C I G EX IM In equilibrium: C a bY Y C I G EX IM I I0 Y a bY I G EX mY G G0 Y bY mY a I G EX Y (1 b m) a I G EX EX EX 0 1 Y* (a I G EX ) IM mY 1 b m
m = marginal propensity
to import (MPM)
2002 Prentice Hall Business Publishing
mulltiplier =
1200 1000 800 600 400 200 0 0 200 400 600 800 1000 1200 Aggregate output (income), (Y)
Open Net Closed Imports Economy Exports Economy Exports X mY C+I+G C+I+G (X-M)
+ (X-M)
50 50 50 50 50 50 50
In an open economy, part of the income is spent on imports, causing domestic income to decline.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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.
Exchange rate movements have important impacts on imports, exports, and movement of capital between countries.
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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.
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
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.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
imports
Aggregate expenditure on domestic output will
rise
Inventories will fall
GDP (Y) will increase.
But when imports and exports have had a time to respond to price changes, the balance of trade improves.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
demand rises.
Domestic buyers substitute domestic products
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