Slides by Debbie Evercloud Tatiana Nikolaevna Kalashnikova/Getty Images CHAPTER 16 (27): OPEN ECONOMY MACROECONOMICS COREECONOMICS, 3RD EDITION BY ERIC CHIANG Slides by Debbie Evercloud © 2013 Worth Publishers CoreEconomics ▪ Chiang/Stone 1

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone CHAPTER OUTLINE The Balance of Payments Exchange Rates Monetary and Fiscal Policy in an Open Economy © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone LEARNING OBJECTIVES At the end of this chapter, the student will be able to: Define the current account and the capital account in the balance of payments between countries Distinguish between nominal and real exchange rates Illustrate the effects of currency appreciation or depreciation on imports and exports © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone LEARNING OBJECTIVES At the end of this chapter, the student will be able to: Describe the effects of changes in inflation rates, disposable income, and interest rates on exchange rates Compare fixed and flexible exchange rate systems Describe the implications for fiscal and monetary policies of fixed and flexible exchange rate systems © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

EXAMPLE: THE ECONOMIC TOURIST You have experienced a foreign exchange transaction if you have travelled overseas and converted your U.S. dollars into the other country’s domestic currency. Foreign exchange also underlies international trade and investment. This chapter looks at the foreign exchange markets to get a sense of how it affects policymaking in the United States. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

BY THE NUMBERS: FOREIGN EXCHANGE Eric Chiang © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

THE BALANCE OF PAYMENTS The current account includes: Payments for imports and exports of goods and services Incomes flowing into and out of the country Net transfers of money © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

THE BALANCE OF PAYMENTS Imports and exports In 2012, American exports were $2,194.5 billion, with imports totaling $2,734.0 billion. This exchange produced a trade deficit of $539.5 billion. This component of the current account is known as the balance of trade. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

THE BALANCE OF PAYMENTS Income flows include wages, rents, interest, and profits that Americans earn abroad minus the corresponding income foreigners earn in the United States. On balance, foreigners earned $198.6 billion less in the United States than U.S. citizens and corporations earned abroad in 2012. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

THE BALANCE OF PAYMENTS Direct transfers of money also take place between the United States and other countries. These transfers include foreign aid, funds sent to international organizations, and stipends paid to students studying abroad. They also include the money that people working in the United States send back to their families in other countries. Net transfers for 2012 totaled −$134.1 billion. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone THE CAPITAL ACCOUNT The capital account summarizes the flow of money into and out of domestic and foreign assets. This account includes investments by foreign companies in domestic plants or subsidiaries. Because the United States ran a current account deficit in 2012, it must run a capital account surplus. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHECKPOINT: THE BALANCE OF PAYMENTS The balance of payments represents all payments received from foreign countries and all payments made to them. The balance of payments is split into two categories: current and capital accounts. The sum of the current and capital account balances must equal zero. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATES The exchange rate defines the rate at which one currency, such as U.S. dollars, can be exchanged for another, such as British pounds. We can view the exchange rate as the price of one currency in terms of another. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATES A nominal exchange rate is the stated price of one country’s currency in terms of another. The real exchange rate takes the price levels of both countries into account. The real exchange rate is the nominal exchange rate multiplied by the ratio of the price levels of the two countries. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATES The real exchange rate is defined as: er = en × (Pd/Pf) where: er is the real exchange rate en is the nominal exchange rate Pd is the domestic price level Pf is the foreign price level © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

PURCHASING POWER PARITY Purchasing power parity (PPP) is the rate of exchange that allows a specific amount of currency in one country to purchase the same quantity of goods in another country. The Big Mac Index serves as a general approximation of PPP. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

THE MARKET FOR FOREIGN EXCHANGE The foreign exchange market for dollars has an upward-sloping supply and a downward-sloping demand. The supply of dollars to the market reflects the demand for other currencies. With perfectly flexible exchange rates, an equilibrium will be established in which the quantity of currency demanded will equal the quantity supplied. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

THE MARKET FOR FOREIGN EXCHANGE S$ At exchange rate e1, there is an excess demand for dollars, and the dollar will appreciate. At exchange rate e2, there is an excess supply of dollars. The market will settle into equilibrium at rate e0. e2 e Exchange Rate (pounds per dollar) e0 e1 D$ Q1 Q0 Q2 Quantity of Dollars ($) © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

APPRECIATION AND DEPRECIATION Currency appreciation A currency appreciates when its value rises relative to other currencies Currency depreciation A currency depreciates when its value falls relative to other currencies © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CURRENCY DEPRECIATION Consider the market for foreign exchange between U.S. dollars and the British pound. If there is an increase in the demand for dollars, this will result in: An appreciation of the dollar A depreciation of the pound © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATES Determinants of Exchange Rates: Tastes and preferences Income levels Inflation rates Interest rates © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHANGES IN THE CURRENT ACCOUNT As rates of inflation rise in one country, its exports will be relatively more expensive. This will worsen its current account position. As domestic income rises, a country will import more goods. This also serves to worsen its current account position. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHANGES IN THE CAPITAL ACCOUNT Foreign investment possibilities include: Direct investment in projects undertaken by multinational firms Sale and purchase of foreign stocks and bonds Short-term movement of assets in foreign bank accounts © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHANGES IN THE CAPITAL ACCOUNT Because international business ventures involve capital, investors must balance their risks and returns. Two factors essentially incorporate both risk and return for international assets: Interest rates Expected changes in exchange rates © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone INTEREST RATE CHANGES If the exchange rate is assumed to be constant and the assets of two countries are perfectly substitutable, then an interest rate increase in one country will cause a capital inflow. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATE CHANGES Suppose that the exchange rate for American currency is expected to appreciate against the British pound. Investors demand a higher return in Britain to offset the expected depreciation of the pound. Unless interest rates rise in Britain, capital will flow out of Britain and into the United States until American interest rates fall enough to offset the expected appreciation of the dollar. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATE CHANGES If the dollar falls relative to the yen, the euro, and the British pound, this would be a sign that foreign investors are not as enthusiastic about U.S. investments. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATE CHANGES The United States is more dependent on foreign capital than ever before. Today, more than half of Treasury debt held by the public is held by foreigners. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

EXCHANGE RATES AND AS/AD A change in nominal exchange rates will affect imports and exports. When the exchange rate for the dollar depreciates, the dollar is weaker and other currencies buy more dollars. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

EXCHANGE RATES AND AS/AD Effect of the weaker dollar: American products become more attractive in foreign markets, so American exports increase and aggregate demand expands. Yet, because some inputs into the production process may be imported, input costs will rise, causing a leftward shift of aggregate supply. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

EXCHANGE RATES AND POLICY Although it is also possible that a currency depreciation will simply lead to inflation, trade balances usually improve with an exchange rate depreciation. Policymakers can improve the current account balance without inflation by pursuing devaluation first, then imposing a fiscal contraction. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

POLICY IN AN OPEN ECONOMY SRAS1 b SRAS0 P2 Depreciation of the dollar will simultaneously lead to an increase in aggregate demand and a decrease in aggregate supply. a P1 Aggregate Price Level (P) P0 e AD1 LRAS AD0 Q0 Q1 Aggregate Output (Q) © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

ISSUE: THE CHINESE YUAN When the Chinese yuan appreciates, it takes more dollars to obtain the same amount of yuan as before. Therefore, goods made in China become more expensive for Americans. China has been buying and holding U.S. dollars, in order to prevent an appreciation of the yuan. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

ISSUE: THE CHINESE YUAN What are the effects of China’s policy? American consumers benefit. American manufacturers find it harder to compete against imports from China. If American consumers win while American businesses and their workers lose, it can be difficult for policymakers to determine whether to favor China’s policy. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHECKPOINT: EXCHANGE RATES The nominal exchange rates is the rate at which one currency can be exchanged for another. Real exchange rates are the nominal exchange rates multiplied by the ratio of the price levels of the two countries. A currency appreciates when its value rises relative to other currencies. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHECKPOINT: EXCHANGE RATES Currency depreciation causes a currency to lose value relative to others. Inflation and income levels affect the current account. Interest rates and expected exchange rates influence the capital account. Currency appreciation and depreciation affect aggregate supply and demand. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATE SYSTEMS In a fixed exchange rate system, governments determine their exchange rates, then adjust macroeconomic policies to maintain these rates. A flexible or floating exchange rate system relies on currency markets to determine the exchange rates consistent with macroeconomic conditions. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone GOLD STANDARD Before the Great Depression, most countries were on the gold standard. Under the gold standard, each country had to maintain enough gold stocks to keep the value of its currency fixed to that of others. In the 1930s, problems with the gold standard allowed the Great Depression to spread worldwide. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone BRETTON WOODS As World War II came to an end, the Allies met in Bretton Woods, New Hampshire, to design a new and less troublesome international monetary system. Exchange rates were set, and each country agreed to use its monetary authorities to buy and sell its own currency to maintain a fixed exchange rate. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone EXCHANGE RATE SYSTEMS Most currencies now fluctuate in value based on their relative demand and supply on the foreign exchange market. A number of countries, however, use macroeconomic policies to peg their currency to another currency, most commonly the U.S. dollar or the euro. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone DOLLARIZATION Some countries have chosen to abandon their currency altogether by adopting another country’s currency as their own. Panama, Ecuador, and El Salvador all chose to adopt the U.S. dollar as their official currency, a process known as dollarization. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

POLICIES WITH FIXED EXCHANGE RATES Keeping exchange rates fixed and holding the money supply constant, an expansionary fiscal policy will raise the price level. This will cause a decrease in exports and an increase in imports. Together, these changes will worsen the current account. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

POLICIES WITH FIXED EXCHANGE RATES Keeping exchange rates fixed and holding the money supply constant, an expansionary fiscal policy will produce an increase in interest rates. As income rises, there will be a greater transactions demand for money, resulting in higher interest rates. Higher interest rates mean that capital will flow into the United States. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

POLICIES WITH FIXED EXCHANGE RATES Effect of the resulting capital inflow: Interest rates will be reduced, adding to the expansionary impact of the original fiscal policy. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

POLICIES WITH FLEXIBLE EXCHANGE RATES Expansionary monetary policy under a system of flexible exchange rates results in a growing money supply and falling interest rates. Lower interest rates lead to a capital outflow and a balance of payments deficit, or a declining surplus. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

POLICIES WITH FLEXIBLE EXCHANGE RATES Effects of the capital outflow: With flexible exchange rates, consumers and investors will want more foreign currency; thus, the domestic currency will depreciate in the foreign exchange market. As the dollar depreciates, exports increase and output rises. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone OPEN ECONOMY MACRO Several decades ago, presidents and Congress could adopt monetary and fiscal policies without much consideration of the rest of the world. Today, economies of the world are vastly more intertwined. Good macroeconomic policymaking must account for changes in exchange rates and capital flows. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHECKPOINT: MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY A fixed exchange rate system is one in which governments determine their exchange rates and then use macroeconomic policy to maintain them. Flexible exchange rates rely on markets to set the exchange rate given the country’s macroeconomic policies. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

CHECKPOINT: MONETARY AND FISCAL POLICY IN AN OPEN ECONOMY Some countries peg their currency to another to facilitate trade, to promote foreign investment, or to maintain monetary stability. Fixed exchange rate systems hinder monetary policy, but reinforce fiscal policy. Flexible exchange rates hamper fiscal policy, but reinforce monetary policy. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone CHAPTER SUMMARY The current account includes payments for imports and exports of goods and services, incomes flowing into and out of the country, and net transfers of money. The capital account includes flows of money into and out of domestic and foreign assets. A nominal exchange rate is the price of one country’s currency for another. The real exchange rate takes price levels into account. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone CHAPTER SUMMARY The purchasing power parity (PPP) of a currency is the rate of exchange where some currency in one country can purchase the same goods in another country. If exchange rates are fully flexible, markets determine the prevailing exchange rate. Real exchange rates affect the current account. Interest rates and exchange rate expectations affect the capital account. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone CHAPTER SUMMARY A fixed exchange rate system is one in which governments determine their exchange rates, then use macroeconomic adjustments to maintain these rates. A flexible or floating exchange rate system relies on currency markets to determine the exchange rates, given macroeconomic conditions. © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone

© 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone DISCUSSION QUESTIONS How does an economy benefit from importing? From exporting? If you are traveling to another country, which number matters most to you: the nominal exchange rate or the real exchange rate? Who wins and who loses from an appreciation of the U.S. dollar? © 2013 Worth Publishers CoreEconomics ▪ Chiang and Stone