CHAPTER

31
Open Economy Macroeconomics: The Balance of Payments and Exchange Rates
Prepared by: Fernando Quijano and Yvonn Quijano

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Balance of Payments

The balance of payments is the record of a countrys transactions in goods, services, and assets with the rest of the world; also the record of a countrys sources (supply) and uses (demand) of foreign exchange. Foreign exchange is simply all currencies other than the domestic currency of a given country.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Balance of Payments

United States Balance of Payments, 1999
CURRENT ACCOUNT Goods exports Goods imports (1) Net export of goods Export of services Import of services (2) Net export of services Income received on investments Income payments on investments (3) Net investment income (4) Net transfer payments (5) Balance on current account (1 + 2 + 3 + 4) CAPITAL ACCOUNT (6) Change in private U.S. assets abroad (increase is ) (7) Change in foreign private assets in the United States (8) Change in U.S. government assets abroad (increase is ) (9) Change in foreign government assets in the United States (10) Balance on capital account (6 + 7 + 8 + 9) (11) Statistical discrepancy (12) Balance of payments (5 + 10 + 11)
2002 Prentice Hall Business Publishing Principles of Economics, 6/e

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

The Balance of Payments

A countrys current account is the sum of its:
net exports (exports minus imports), net income received from investments abroad,

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

The Balance of Payments

The balance of trade is the difference between a countrys exports of goods and services and its imports of goods and services.

A trade deficit occurs when a countrys exports are less than its imports.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Balance of Payments

Investment income consists of holdings of foreign assets that yield dividends, interest, rent, and profits paid to U.S. asset holders (a source of foreign exchange). Net transfer payments are the difference between payments from the United States to foreigners and payments from foreigners to the United States.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Balance of Payments

The balance on current account consists of net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments. It shows how much a nation has spent relative to how much it has earned. For each transaction recorded in the current account, there is an offsetting transaction recorded in the capital account.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Balance of Payments

The capital account records the changes in assets and liabilities. The balance on capital account in the United States is 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, 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

The Balance of Payments

In the absence of errors, the balance on capital account would equal the negative of the balance on current account. If the capital account is positive, the change in foreign assets in the country is greater than the change in the countrys assets abroad, which is a decrease in the net wealth of the country.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The United States as a Debtor Nation

A countrys net wealth is the sum of all its past current account balances. Prior to the mid-1970s, the United States was a creditor nation. After the mid1970s, the United Sates began to have a negative net wealth position vis--vis the rest of the world. This means that the United States spent much more on foreign goods and services than it earned through the sales of its goods and services.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Equilibrium Output (Income) in an Open Economy

Planned aggregate expenditure in an open economy equals:

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

multiplier autonomous expenditures

Karl Case, Ray Fair

Principles of Economics, 6/e

Equilibrium Output (Income) in an Open Economy

m= Aut.= Y* =

Planned aggregate expenditure, AE

a= b= I= G= X= Y 0 200 400 600 800 1000 1200

50 0.8 100 100 50 C 50 200 350 500 650 800 950

mulltiplier =

2.00 0.25 300 600

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)

250 400 550 700 850 1000 1150

50 50 50 50 50 50 50

0 50 100 150 200 250 300

50 0 -50 -100 -150 -200 -250

300 400 500 600 700 800 900

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

Imports and Exports and the Trade Feedback Effect

The determinants of imports are the same factors that affect consumption and investment behavior. Spending on imports also depends on the relative prices of domestically produced and foreign-produced goods. The demand for U.S. exports depends on economic activity in the rest of the world. If foreign output increases, U.S. exports tend to increase.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Imports and Exports and the Trade Feedback Effect

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

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Import and Export Prices and the Price Feedback Effect

When the export prices of one country rise, with no change in the exchange rate, the import prices of another rise. If the inflation rate abroad is high, U.S. import prices are likely to rise. The price feedback effect is the process by which a domestic price increase in one country can feed back on itself through export and import prices. Inflation is exportable.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Open Economy with Flexible Exchange Rates

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

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

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Market for Foreign Exchange

Assume that there are only two countries: the United States and Britain. The demand for pounds is comprised of holders of dollars wishing to acquire pounds. The supply of pounds is comprised of holders of pounds seeking to exchange them for dollars. People exchange currency in order to buy goods and services, buy stocks or bonds, and for speculative reasons.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Market for Foreign Exchange

Some Private Buyers and Sellers in International Exchange Markets: United States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1. 2. 3. 4. 5. Firms, households, or governments that import British goods into the United States or wish to buy British-made goods and services U.S. citizens traveling in Great Britain Holders of dollars who want to buy British stocks, bonds, or other financial instruments U.S. companies that want to invest in Great Britain Speculators who anticipate a decline in the value of the dollar relative to the pound

THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)

1. 2. 3. 4. 5. Firms, households, or governments that import U.S. goods into Great Britain or wish to buy U.S.-made goods and services British citizens traveling in the United States Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United States British companies that want to invest in the United States Speculators who anticipate a rise in the value of the dollar relative to the pound
Principles of Economics, 6/e Karl Case, Ray Fair

2002 Prentice Hall Business Publishing

The Market for Foreign Exchange

The demand for pounds in the foreign exchange market shows a negative relationship between the price of pounds (dollars per pound) ($/) and the quantity of pounds demanded. When the price of pounds falls, British-made goods and services appear less expensive to U.S. buyers. If British prices are constant, U.S. buyers will buy more British goods and services, and the quantity demanded of pounds will rise.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Market for Foreign Exchange

The supply of pounds in the foreign exchange market shows a positive relationship between the price of pounds (dollars per pound) ($/) and the quantity of pounds supplied. When the price of pounds rises, the British can obtain more dollars for each pound. This means that U.S.-made goods and services appear less expensive to British buyers. Thus, the quantity of pounds supplied is likely to rise with the exchange rate.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

The Market for Foreign Exchange

The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied. An excess supply of pounds will cause the price of pounds to fallthe pound will depreciate with respect to the dollar. An excess demand for pounds will cause the price of pounds to risethe pound will appreciate with respect to the dollar.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Factors that Affect Exchange Rates

The 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.

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

Factors that Affect Exchange Rates

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

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.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Factors that Affect Exchange Rates

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 relative highinflation countries to depreciate.

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

Factors that Affect Exchange Rates

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

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

The Effects of Exchange Rates on the Economy

When a countrys currency depreciates (falls in value), its import prices rise and its export prices (in foreign currencies) fall. When the U.S. dollar is cheap, U.S. products are more competitive in world markets, and foreign-made goods look expensive to U.S. citizens.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

The Effects of Exchange Rates on the Economy

A depreciation of a countrys currency can serve as a stimulus to the economy.
Foreign buyers are likely to increase their

spending on U.S. goods

Buyers substitute U.S.-made goods for

imports
Aggregate expenditure on domestic output will

rise
Inventories will fall
GDP (Y) will increase.

2002 Prentice Hall Business Publishing

Principles of Economics, 6/e

Karl Case, Ray Fair

Exchange Rates and the Balance of Trade: The J Curve

According to the J curve, the balance of trade gets worse before it gets better following a currency depreciation. Initially, the negative effect on the price of imports may dominate the positive effects of an increase in exports and a decrease in imports.

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

Exchange Rates and Prices

Depreciation of a countrys currency tends to increase the price level.
Since the currency is less expensive, export

demand rises.
Domestic buyers substitute domestic products

for the now more expensive imports.

If the economy is operating close to capacity,

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

If import prices rise, costs may rise for business

firms, shifting the AS curve to the left.

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

Monetary Policy with Flexible Exchange Rates

Fed actions to lower interest rates result in a decrease in the demand for dollars and an increase in the supply of dollars, causing the dollar to depreciate. If the purpose of the Fed is to stimulate the economy, dollar depreciation is a good thing. It increases U.S. exports and decreases imports. If the purpose of the Fed is to fight inflation, dollar appreciation resulting from tight monetary policy also helps in that fight.
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Fiscal Policy with Flexible Exchange Rates

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

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

crowed out, also lowering the multiplier.

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