A Primer on the International Connection: Exchange Rates, the Balance of Payments, & Macroeconomic Adjustments

Have you ever been abroad and experienced a dramatic change in exchange rates? WSJ hyperlink

Tricks to reading exchange rates: The price of the dollar in pesos is read as: 9.5 pesos/$US or 1$=9.5 pesos If it takes more pesos to buy a dollar, the dollar has gone up in price. The price of the peso in dollars is read as: .105 $/peso or 1 peso= 10 1/2 cents U.S. If it costs less in dollars to buy a peso, the peso's price has fallen (depreciated)

Tricks to reading a balance of payments table: All sorts of property and rights to property cross borders, so there are many possible balances that can be calculated depending on what kind of property you include. Which way does the money flow? The general accounting principle is an inpayment counts as a plus (+), an outpayment as a minus (-).

Examples of Commonly Used Balances: Balance on Goods (only includes flows of physical commodities- Should Exports be a plus or a minus? Imports? Why?) Balance on Goods and Services (includes physical commodities and provision of services) Where would U.S. tourism abroad show up on the U.S. balance of payments table? How would it count, as a plus or a minus? Foreign travel in the U.S.??

Current Account Balance= Balance on Goods and Services+ Earnings Balance+ Gifts Balance Balance on Current Account- is a country overspending or underspending its budget for the current period? If a household overspends its current income for one year, what are some ways it can finance that deficit? What happens to a country's external wealth position when it runs a current account deficit? A surplus? Result:A country that runs a current account surplus raises its net international wealth position by transferring capital abroad. So the current account is balanced by a corresponding minus on the capital account.

A plus on the current account is balanced by a corresponding minus on the capital account. Balance on the Capital Account- (includes movements in (+) and out (-) of financial capital (bank accounts and loans), portfolio investments (stocks, bonds), and direct investment. How does an increase in foreigners holdings of U.S. treasury securities show up, as a plus or a minus on the capital account? Where would interest payments on that debt show up?? How do foreign purchases of U.S. stocks show up? Where would dividend earnings on their holdings show up? How do U.S. purchases of foreign stocks show up? Sales?

Connection between the Balance of Payments and the Foreign Exchange Market for a Country's Currency Price of peso Supply of pesos-outpayments $/peso .15 .10 .05 Demand for pesos-Mexican inpayments FX Market for Pesos

Try forecasting what will happen to the price of the peso if: The price of oil rises on the world market Interest rates in Mexico rise Portfolio Investors hear a rumor that the Mexican government will be overthrown

First Approximation Macro- Effects of an orderly depreciation of the peso, assuming Mexican Xports rise and Imports fall. The trade balance improves (X-M)rises. A Keynesian Perspective – Which way will Aggregate Demand Move? Under what conditions will there be real economic growth? Inflation? Show on a macro S & D diagram. A Quantity Theory Perspective- how does the improvement of the trade balance influence the Quantity of Money held by the non-bank public in Mexico? Show the effects using the Quantity Equation and an aggregate demand and supply diagram. A Marxist Perspective- what happens to the rate of profit in Mexican export industries? Industries that compete with imports? Show the impact of the rise in the rate of profit on an aggregate demand and supply diagram.

Alternative Scenario: What would happen if portfolio investors expect a further depreciation of the peso, an internal financial crisis or an internal meltdown of another sort? Will the first approximation results happen? Work through this alternative scenario from the three perspectives.

Keynesian First Approximation when X-M rises Supply Price Level D3 D2 D1 Real GDP (D or y)

Quantity Theory First Approximation Xports up, Mports down causes Money Supply to Grow M*V=P*y Supply- based on Say’s Law Price Level D (after the Ms rises and people spend excess cash balances) Demand- Before Real GDP (y or D)

Marxist Theory First Approximation- the rise in export earnings and lowering of competition with imports causes the rate of profit inside the country to rise, demand moves to the right as investors increase purchases of inputs, then supply moves to the right as extra value added yields output increase S S’ Price Level D’ D Real GDP (y or D)

Second Approximation- Capital Flight from fear of future instability Quantity Theory Keynes Marx S’ S S P S P P D D1 D’ D D’ D2 y y y I collapses Capital Investment Collapses Money Supply Collapses