Chapters 5 and 13 -The Open Economy

Balance of Payments Accounts of the United States, 2011 (Billions of Dollars)

Balance of Payments Accounting Basic Principles Credit item (+) Funds flow into the country Example: exports of goods Debit item (–) Funds flow out of the country Example: imports of goods

Balance of Payments Accounting The current account Net exports of goods and services (NX) Net income from abroad (NFP) Net unilateral transfers (NUT) Net income from abroad (NFP) Income received from abroad is a credit item, since it causes funds to flow into the United States Payment of income to foreigners is a debit item Net income from abroad is part of the current account, and is about equal to NFP, net factor payments Net unilateral transfers (NUT) Payments made from one country to another Negative net unilateral transfers for United States, since United States is a net donor to other countries

Balance of Payments Accounting Sum of net exports of goods and services, net income from abroad, and net unilateral transfers is the current account balance CA = NX + NFP + NUT Positive current account balance implies current account surplus Negative current account balance implies current account deficit

Balance of Payments Accounting The capital and financial account The capital and financial account records trades in existing assets, either real (for example, houses) or financial (for example, stocks and bonds) The capital account records the net flow of unilateral transfers of assets into the country

Balance of Payments Accounting The capital and financial account Most transactions appear in the financial account part of the capital and financial account When home country sells assets to a foreign country, that is a capital inflow for the home country and a credit (+) item in the capital and financial account When assets are purchased from a foreign country, there is a capital outflow from the home country and a debit (–) item in the capital and financial account Financial Account Financial Inflow Credit item (+) Sale of U.S. assets to foreigners Financial Outflow Debit item (–) Purchase of foreign assets by U.S. residents KFA = capital and financial account balance

Balance of Payments Accounting The official settlements balance Transactions in official reserve assets are conducted by central banks of countries Official reserve assets are assets (foreign government securities, bank deposits, and SDRs of the IMF, gold) used in making international payments Central banks buy (or sell) official reserve assets with (or to obtain) their own currencies Also called the balance of payments, it equals the net increase in a country’s official reserve assets For the United States, the net increase in official reserve assets is the rise in U.S. government reserve assets minus foreign central bank holdings of U.S. dollar assets Having a balance of payments surplus means a country is increasing its official reserve assets; a balance of payments deficit is a reduction in official reserve assets

Balance of Payments Accounting The relationship between the current account and the capital and financial account Current account balance (CA) + capital and financial account balance (KFA) = 0 (5.1) CA + KFA = 0 by accounting; every transaction involves offsetting effects http://www.treasury.gov/resource-center/data-chart-center/IR-Position/Pages/04032015.aspx http://www.tradingeconomics.com/united-states/foreign-exchange-reserves

Foreign Holdings of U.S. Treasury Securities The rise in foreign liabilities by the United States since the early 1980s has been very large. The United States has become the world’s largest international debtor http://www.treasury.gov/ticdata/Publish/mfh.txt

Globalization The Impact of Globalization on the U.S. Economy World’s economies are increasingly interdependent—more international trade and investment Should the U.S. reign in globalization?

Exports and imports of goods and services http://www.census.gov/foreign-trade/statistics/highlights/congressional.html

Globalization Costs of globalization: U.S. jobs lost in particular sectors Benefits of globalization: U.S. jobs gained in particular sectors U.S. exports increase Cheaper imported goods means more goods & services at lower prices—gains from trade But loss for jobs from foreign trade is a small fraction of total job loss in U.S.

Globalization Recent years: big changes in business services industry—call centers, etc. Critics: moving jobs abroad Reality: U.S. is world leader in exporting business services—far more is done in U.S. and sold abroad than vice versa So U.S. benefits from such activity far more than it “loses”

Current account balance as a percent of GDP, 1960-2012 Sources: Balance on current account: Bureau of Economic Analysis, available on-line at research.stlouisfed.org/fred2/series/BOPBCA. GDP: Bureau of Economic Analysis, available at research.stlouisfed.org/fred2/series/GDP.

Exchange Rates Nominal exchange rates The nominal exchange rate tells you how much foreign currency you can obtain with one unit of the domestic currency For example, if the nominal exchange rate is 90 yen per dollar, one dollar can be exchanged for 90 yen Transactions between currencies take place in the foreign exchange market Denote the nominal exchange rate (or simply, exchange rate) as enom in units of the foreign currency per unit of domestic currency

Exchange Rates Nominal exchange rates Under a flexible-exchange-rate system or floating-exchange-rate system, exchange rates are determined by supply and demand and may change every day; this is the current system for major currencies

Exchange Rates Nominal exchange rates In the past, many currencies operated under a fixed-exchange-rate system, in which exchange rates were determined by governments The exchange rates were fixed because the central banks in those countries offered to buy or sell the currencies at the fixed exchange rate Examples include the gold standard, which operated in the late 1800s and early 1900s, and the Bretton Woods system, which was in place from 1944 until the early 1970s Even today, though major currencies are in a flexible-exchange-rate system, some smaller countries fix their exchange rates

How Exchange Rates Are Determined In touch with data and research: Exchange rates Trading in currencies occurs around-the-clock, since some market is open in some country any time of day The spot rate is the rate at which one currency can be traded for another immediately The forward rate is the rate at which one currency can be traded for another at a fixed date in the future (for example, 30, 90, or 180 days from now) A pattern of rising forward rates suggests that people expect the spot rate to be rising in the future http://www.xe.com/currencyconverter/

Exchange Rates Real exchange rates The real exchange rate tells you how much of a foreign good you can get in exchange for one unit of a domestic good If the nominal exchange rate is 80 yen per dollar, and it costs 800 yen to buy a hamburger in Tokyo compared to 2 dollars in New York, the price of a U.S. hamburger relative to a Japanese hamburger is 0.2 Japanese hamburgers per U.S. hamburger

Exchange Rates Real exchange rates The real exchange rate is the price of domestic goods relative to foreign goods, or e = enom P/PFor To simplify matters, we’ll assume that each country produces a unique good In reality, countries produce many goods, so we must use price indexes to get P and PFor If a country’s real exchange rate is rising, its goods are becoming more expensive relative to the goods of the other country

Exchange Rates Appreciation and depreciation In a flexible-exchange-rate system, when enom falls, the domestic currency has undergone a nominal depreciation (or it has become weaker); when enom rises, the domestic currency has become stronger and has undergone a nominal appreciation In a fixed-exchange-rate system, a weakening of the currency is called a devaluation, a strengthening is called a revaluation We also use the terms real appreciation and real depreciation to refer to changes in the real exchange rate

Summary

Exchange Rates Purchasing power parity To examine the relationship between the nominal exchange rate and the real exchange rate, think first about a simple case in which all countries produce the same goods, which are freely traded If there were no transportation costs, the real exchange rate would have to be e = 1, or else everyone would buy goods where they were cheaper

Exchange Rates Purchasing power parity Setting e = 1 in Eq. (13.1) gives P = PFor/enom (13.2) This means that similar goods have the same price in terms of the same currency, a concept known as purchasing power parity, or PPP

Exchange Rates Purchasing power parity Empirical evidence PPP holds in the long run but not in the short run Countries produce different goods Some goods aren’t traded Transportation costs Legal barriers to trade

Exchange Rates The real exchange rate and net exports The real exchange rate (also called the terms of trade) is important because it represents the rate at which domestic goods and services can be traded for those produced abroad An increase in the real exchange rate means people in a country can get more foreign goods for a given amount of domestic goods

Exchange Rates The real exchange rate and net exports The real exchange rate also affects a country’s net exports (exports minus imports) Changes in net exports have a direct impact on export and import industries in the country Changes in net exports affect overall economic activity and are a primary channel through which business cycles and macroeconomic policy changes are transmitted internationally

Exchange Rates The real exchange rate and net exports The real exchange rate affects net exports through its effect on the demand for goods A high real exchange rate makes foreign goods cheap relative to domestic goods, so there’s a high demand for foreign goods (in both countries) With demand for foreign goods high, net exports decline Thus the higher the real exchange rate, the lower a country’s net exports

Exchange Rates The real exchange rate and net exports The J curve The effect of a change in the real exchange rate may be weak in the short run and can even go the “wrong” way Although a rise in the real exchange rate will reduce net exports in the long run, in the short run it may be difficult to quickly change imports and exports As a result, a country will import and export the same amount of goods for a time, with lower relative prices on the foreign goods, thus increasing net exports

The J Curve

The Next Step: TPP (Trans - Pacific Partnership)