Chapter Outline 20 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates The Balance of Payments The Current Account The Capital Account The United States as a Debtor Nation Equilibrium Output (Income) in an Open Economy The International Sector and Planned Aggregate Expenditure Imports and Exports and the Trade Feedback Effect Import and Export Prices and the Price Feedback Effect The Open Economy with Flexible Exchange Rates The Market for Foreign Exchange Factors That Affect Exchange Rates The Effects of Exchange Rates on the Economy

Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates When people in different countries buy from and sell to each other, an exchange of currencies 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.

THE BALANCE OF PAYMENTS foreign exchange All currencies other than the domestic currency of a given country. balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange.

THE BALANCE OF PAYMENTS balance of trade A country’s exports of goods and services minus its imports of goods and services. THE CURRENT ACCOUNT trade deficit Occurs when a country’s exports of goods and services are less than its imports of goods and services in a given period. balance on current account Net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments.

THE BALANCE OF PAYMENTS 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, and the change in foreign government assets in the United States. The capital account records the changes in assets and liabilities. The capital account measures Capital Flows THE CAPITAL ACCOUNT

37.7 (11) Net capital account transactions and financial derivatives 0 (13) Balance of payments ( ) −89.2 (12) Statistical discrepancy (10) Balance on capital account ( ) 211.8(9) Change in foreign government assets in the United States −119.5(8) Change in U.S. government assets abroad (increase is −) 789.2(7) Change in foreign private assets in the United States −364.1(6) Change in private U.S. assets abroad (increase is −) Capital Account −465.9(5) Balance on current account ( ) −133.1(4) Net transfer payments 227.0(3) Net investment income −517.6Income payments on investments 744.6Income received on investments 178.6(2) Net export of services −427.4Imports of services 606.0Exports of services −738.4(1) Net export of goods −2,235.8Goods imports 1,497.4Goods exports Current Account Billions of dollars TABLE 20.1 United States Balance of Payments, 2011 All transactions that bring foreign exchange into the United States are credited (+) to the current account; all transactions that cause the United States to lose foreign exchange are debited (−) to the current account

Prior to the mid-1970s, the United States had generally run current account surpluses, and thus its net wealth position was positive. It was a creditor nation. Sometime between the mid-1970s and the mid-1980s, the United States changed to having a negative net wealth position vis-à-vis the rest of the world. Now it is the largest debtor nation in the world. This reflects the fact that for the past three decades, it has spent much more on foreign goods and services than it has earned through the sales of its goods and services to the rest of the world. The United States as a Debtor Nation

Balance of Payments - Example Say a U.S. resident buys a $30,000 Japanese automobile The Japanese car manufacturer receives $30,000. Has two options: Option 1: The Japanese car manufacturer can buy $30,000 of U.S. goods: Current Account impact: U.S. exports = $30,000 US imports = $30,000 NX = 0 Capital Account impact: Δ Capital Account = 0 Current Account + Capital Account =0

Balance of Payments - Example Option 2: The Japanese car manufacturer can use the $30,000 to buy U.S. assets such as land, stocks, bonds, etc. Current Account impact: US exports = 0. US imports = $30,000 NX = - $30,000 Capital Account impact: Capital inflow = Change in foreign private assets in the United States = + $30,000 Current Account + Capital Account = 0

More on the Capital Account There are many transactions recorded in the capital account that do not pertain to the exports and imports recorded in the current account. US citizen buys German bonds US holding of German bonds - private assets abroad↑ German holdings of USD ↑

The Capital Account 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 (as with the US), the change in foreign assets in the country (the US) is greater than the change in the country’s (US) assets abroad, which is a decrease in the net wealth of the country.

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 to import (MPM) The change in imports caused by a $1 change in income.

EQUILIBRIUM OUTPUT (INCOME) IN AN OPEN ECONOMY

The Open-Economy Multiplier open-economy multiplier 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.

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. Primarily income (Y) The Determinants of Exports The demand for U.S. exports depends on economic activity in the rest of the world as well as on the prices of U.S. goods relative to the price of rest-of-the-world goods. When foreign output increases, U.S. exports tend to increase. U.S. exports also tend to increase when U.S. prices fall relative to those in the rest of the world.

EQUILIBRIUM OUTPUT (INCOME) IN AN OPEN ECONOMY The 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 that country. An increase in U.S. imports increases other countries’ exports, which stimulates those countries’ economies and increases their imports, which increases U.S. exports, which stimulates the U.S. economy and increases its imports, and so on. This is the trade feedback 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.

Equilibrium Output (Income) in an Open Economy The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise. Suppose the US imports radiators from Mexico and Mexico is experiencing rising inflation. The cost of US imports (US import price) goes up. Export prices of other countries affect U.S. import prices ( the cost of US imports). Imports and Exports and prices

Equilibrium Output (Income) in an Open Economy The Price Feedback Effect (we assume exchange rates are constant) 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. Domestic prices in the importing country can increase in one of 2 ways: If imports are an input in production (radiators in cars), the AS curve shifts to the left and the domestic price level rises. If imports are consumer goods, households substitute domestic goods for foreign. The AD curve shifts to the right and the domestic price level rises. This is not the end of the story – this can feedback to the exporting country.

The Open Economy with Flexible Exchange Rates floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. The Market For Foreign Exchange Consider the U.S. and Great Britain: The Supply of and Demand for Pounds Governments, private citizens, banks, and corporations exchange pounds for dollars and dollars for pounds every day. Those who demand pounds are holders of dollars seeking to exchange them for pounds. Those who supply pounds are holders of pounds seeking to exchange them for dollars.

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. 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 (an increase in the value of the pound relative to the dollar). The pound appreciates and the dollar to depreciates.

The Market for Foreign Exchange Some Private Buyers and Sellers in International Exchange Markets: United States and Great Britain 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 (the dollar to appreciate and the pound to depreciate)

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.

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.

THE OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES 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 of a foreign currency equals the quantity of that currency supplied.

The Open Economy with Flexible Exchange Rates 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

Factors that Affect Exchange Rates - Inflation 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 high-inflation countries to depreciate. Next slide looks at the case where inflation in the US is high relative to Great Britain. The Open Economy with Flexible Exchange Rates

Factors that Affect Exchange Rates - Inflation Exchange Rates Respond to Changes in Relative Prices A higher price level in the United States, relative to Great Britain, makes imports relatively less expensive. U.S. citizens are likely to increase their spending on imports from Britain, shifting the demand for pounds to the right, from D to D' At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States. The supply of pounds shifts to the left, from S to S'. The result is an increase in the price of pounds. The pound appreciates, and the dollar is worth less (depreciates). Note: the supply curve and demand curveshift at the same time, which makeexchange rates volatile.

Factors that Affect Exchange Rates – relative interest rates The level of a country’s 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 will be attracted to U.S. securities.

Factors that Affect Exchange Rates – relative interest rates Exchange Rates Respond to Changes in Relative Interest Rates If U.S. interest rates rise relative to British interest rates, British citizens holding pounds will be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S to S'. At the same time, U.S. citizens are less likely to be interested in British securities because interest rates are higher at home. The demand for pounds shifts to the left, from D to D'. The result is a depreciated pound and a stronger dollar.

The Effects of Exchange Rates on the Economy When a country’s currency depreciates (falls in value), exports (EX) increase and imports (IM) decrease. When the U.S. dollar depreciates: U.S. products are more competitive in world markets, and foreign-made goods look expensive to U.S. citizens. A depreciation of a country’s currency is likely to increase NX and increase RGDP.

Exchange Rates and Prices Depreciation of a country’s currency tends to increase the price level. 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. You should draw the AD and AS curves to demonstrate this.

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. As Ms↑=> r↓=> I ↑ => Y↑. (domestic impact) Also, as r↓=> exchange rate depreciates=> NX↑ => Y↑

Fiscal Policy with Open Economy and Flexible Exchange Rates The multiplier is smaller - some of the additional spending leaks out as imports, reducing the multiplier. At the same time – As income increases, the demand for money increases and interest rates increase causing the dollar to appreciate. Exports fall, imports rise, again reducing the multiplier. If interest rates rise, private investment may be crowded out, also lowering the multiplier. Putting it all together – Expansionary fiscal policy => Y ↑ => IM↑=> lower multiplier effect. as Md↑ => r↑=> I ↓ => Y ↓ (crowding-out). (domestic impact) Also, As r↑=>exchange rate appreciates=> NX↓ => Y↓

Most economies in the world operate with flexible exchange rates. One exception among the major trading countries has been China, whose government has acted to keep the value of its currency, the yuan, stable and relatively low. An undervalued yuan increases demand for Chinese goods from abroad, but it also hurts the Chinese population by making foreign goods more expensive. In the late spring of 2010, after much pressure from its trading partners, the Chinese government announced that it would make the yuan more flexible. China’s Increased Flexibility E C O N O M I C S I N P R A C T I C E THINKING PRACTICALLY 1.What mechanisms could the Chinese government use to keep the value of the yuan low?

In 1999 the European Central Bank (ECB) was created and a common currency for much of Europe, the euro, was introduced. Countries across Europe dismantled their own monetary authorities and ceded control over monetary policy to the ECB. In a recent speech, Martin Feldstein, Harvard professor and former advisor to President Reagan, argued the following: “When interest and principal on the British government debt come due, the British Government can always create additional pounds to meet those obligations. By contrast, the French government and the French central bank cannot create euros.… If France cannot borrow to finance that deficit, France will be forced to default.” Losing Monetary Policy Control E C O N O M I C S I N P R A C T I C E THINKING PRACTICALLY 1.With the creation of the ECB some have argued that overspending by the French and Italian governments becomes Germany’s problem. Why?

appreciation of a currency balance of payments balance of trade balance on capital account balance on current account depreciation of a currency exchange rate floating, or market- determined, exchange rates foreign exchange REVIEW TERMS AND CONCEPTS law of one price marginal propensity to import (MPM) net exports of goods and services (EX - IM) price feedback effect purchasing-power-parity theory trade deficit trade feedback effect Planned aggregate expenditure in an open economy: AE  C + I + G + EX - IM Open-economy multiplier: