Alexander Núñez Torres, PhD School of Natural and Social Sciences Department of Economics and Business, Lehman College Lecture 11 –The Balance of Payments, Exchange Rates and Aggregate Expenditure "This image" by qimono/pixabay is free of copyright. Alexander Núñez Torres, PhD Assistant Professor, Department of Economics and Business These slides are based on Principles of Macroeconomics by Steven A. Greenlaw and Timothy Taylor - OpenStax (2017). Unless otherwise noted, they are licensed under an Attribution-NonCommercial-ShareAlike 4.0 International.

Schedule Introduction and Concepts Effect of Exports and Imports on the aggregate expenditure and GDP How is it affected? What determines the level of imports? What determines the level of exports? Trade and Price feedback effects on Aggregate Demand How a foreign exchange market works? Concepts Flexible exchange rates Demanders and suppliers of currency Demand and Supply shifts in Foreign Exchange Markets Exchange rate policies

Schedule Effect of Exchange Rates on the Economy Imports, Exports and Real GDP The J-Curve Effect Exchange rates and prices Monetary Policy Fiscal Policy

Introduction and Concepts In this chapter, we explore the ways in which the openness of the economy affects macroeconomic policy making. The economies of the world have become increasingly interdependent over the last four decades. International trade is a major part of today’s world economy. When people in countries with different currencies buy from and sell to each other, an exchange of currencies must also take place. In 1971, most countries, including the United States, began allowing exchange rates to be determined essentially by supply and demand.

Introduction and Concepts 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. Foreign exchange All currencies other than the domestic currency of a given currency 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. In other words, CAPACITY CONSTRAINS At low levels of capacity utilization, Wages are likely to be even stickier upward. At high levels of capacity utilization, additional increases in aggregate demand mainly induce a higher price level with only a small impact of output

Introduction and Concepts Balance of trade A country’s exports of goods and services minus its imports of goods and services. Is the difference between exports and imports. Trade deficit Occurs when a country’s exports of goods and services are less than its imports of goods and services. Balance on current account The sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers. In other words, CAPACITY CONSTRAINS At low levels of capacity utilization, Wages are likely to be even stickier upward. At high levels of capacity utilization, additional increases in aggregate demand mainly induce a higher price level with only a small impact of output

Introduction and Concepts A nation settles its accounts with the rest of the world through its capital account. The capital accounts records the nation’s capital inflows and outflows. Prior to the mid-1970s, the United States had generally run current account surpluses, and thus its net wealth position was positive. In other words, CAPACITY CONSTRAINS At low levels of capacity utilization, Wages are likely to be even stickier upward. At high levels of capacity utilization, additional increases in aggregate demand mainly induce a higher price level with only a small impact of output

Introduction and Concepts 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. In other words, CAPACITY CONSTRAINS At low levels of capacity utilization, Wages are likely to be even stickier upward. At high levels of capacity utilization, additional increases in aggregate demand mainly induce a higher price level with only a small impact of output

Introduction and Concepts Item Value of Exports Value of Imports Balance Goods $ 410.0 $ 595.5 $ -185.3 Services $ 180.4 $ 122.3 $ 58.1 Income Receipts and payments $ 203.0 $ 152.4 $ 50.6 Unilateral transfers $ 27.3 $ 64.4 $ -37.1 Current account balance $ 820.7 $ 2,800 $ -113.7 Components of the U.S. Current Account Balance for 2015 (in billions)

Effect on the aggregate demand: How is it affected? Recall that the Aggregate Demand is: 𝑨𝑫=𝑪+𝑰+𝑮+(𝑿−𝑴) Net exports of goods and services (EX-IM) The difference between a country’s total exports and total imports What happens with the Aggregate demand when exports increases? What happens when imports increases? What about when exports or imports decreases? Give them the document Ask to the class: What's the rate of return on the first bond? What do investors want from investments? If the interest rates rise, old bonds are no longer attractive, why?

Effect on the aggregate demand: How is it affected? Recall that the Aggregate Demand is: 𝑨𝑫=𝑪+𝑰+𝑮+(𝑿−𝑴) Net exports of goods and services (EX-IM) The difference between a country’s total exports and total imports Is then important to determine the level of imports and exports in the economy. Moreover, the dynamics of imports and exports around the globe, as they will affect the aggregate demand of the country. Give them the document Ask to the class: What's the rate of return on the first bond? What do investors want from investments? If the interest rates rise, old bonds are no longer attractive, why?

Effect on the aggregate demand: What determines the level of imports? Determining the Level of Imports When income rises, imports tend to go up. Algebraically: 𝐼𝑀=𝑚𝑌 where 𝑌 is income and 𝑚 is some positive number Marginal propensity to import (MPM) The change in imports caused by a $1 change in income. The marginal propensity to import is 𝑚 in the previous equation Making Imports a function of Y adds another induced leakage to the spending stream (The other two leakages are induced saving and income taxes

Effect on the aggregate demand: What determines the level of imports? The Determinants of Imports The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports because some imported goods are consumption goods and some are investment goods. The relative prices of domestically produced and foreign-produced goods also determine spending on imports.

Effect on the aggregate demand: What determines the level of exports? 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 prices in the rest of the world.

Effect on the aggregate demand: The Trade and Price Feedback effects on aggregate demand 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. Here is how it works: 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. 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.

Effect on the aggregate demand: The Trade and Price Feedback effects on aggregate demand The Trade Feedback effect The trade feedback effect only becomes significant if the economy whose activity is expanding is big enough to affect the world economy Smaller economies are more likely to be heavily influenced by the world economy than to have much impact on it themselves

Effect on the aggregate demand: The Trade and Price Feedback effects on aggregate demand 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. 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. In practice the price feedback effect is likely to be small. To be significant, the economies would have to be about the same size and very open to international trade.

How the foreign exchange market works: Concepts Foreign exchange market A Is the market in which people of firms use one currency to purchase another currency. 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. In other words, CAPACITY CONSTRAINS At low levels of capacity utilization, Wages are likely to be even stickier upward. At high levels of capacity utilization, additional increases in aggregate demand mainly induce a higher price level with only a small impact of output

How the foreign exchange market works: Flexible exchange rates These are determined by the unregulated forces of supply and demand Exchange rates largely determine the domestic price of imported goods and can have significant effect on the quantities of both imports and exports Exchange rates also have a large impact on international financial and capital flows

How the foreign exchange market works: Flexible exchange rates Currency % Daily Share U.S Dollar 87.6% Euro 31.3% Japanese yen 21.6% British pound 12.8% Australian dollar 6.9% Canadian dollar 5.1% Swiss franc 4.8% Chinese yuan 2.6% Currencies Traded most on Foreign Exchange markets as of April, 2016 Talk about how the policies of the U.S. Dollar can affect other currencies and policies around the globe, due to the importance of the U.S. Dollar as a currency

How the foreign exchange market works: Flexible exchange rates These are determined by the unregulated forces of supply and demand Exchange rates largely determine the domestic price of imported goods and can have significant effect on the quantities of both imports and exports Exchange rates also have a large impact on international financial and capital flows

How the foreign exchange market works: Demanders and Suppliers of Currency Governments, private citizens, banks, and corporations exchange foreign currencies for dollars and dollars for foreign currencies every day. Those who demand foreign currencies are holders of dollars seeking to exchange them for foreign currencies. Those who supply foreign currencies are holders of foreign currencies seeking to exchange them for dollars. Demand for domestic currency is created by exports of goods and services, and capital inflows. The supply of domestic currency to the foreign exchange market is created by imports of goods and services, as well as capital outflows.

How the foreign exchange market works: Demanders and Suppliers of Currency Supply A U.S. exporting firm that earned foreign currency and is trying to pay U.S. –based expenses A foreign firm that has sold imported goods in the United States, earned U.S. dollars, and is trying to pay expenses incurred in its home country Foreign tourists visiting the United States U.S. tourist leaving to visit other countries Foreign investors who wish to make direct investment in the U.S. economy U.S. investors who want to make foreign direct investments in other countries Foreign investors who wish to make portfolio investments in the U.S. economy U.S. Investors who want to make portfolio investments in other countries The Demand and Supply line-ups in Foreign Exchange Markets Talk about how the policies of the U.S. Dollar can affect other currencies and policies around the globe, due to the importance of the U.S. Dollar as a currency

How the foreign exchange market works: Demanders and Suppliers of Currency Talk about how the policies of the U.S. Dollar can affect other currencies and policies around the globe, due to the importance of the U.S. Dollar as a currency Exchange rates move up and down substantially. The values in (a) and (b) are mirrors. Any appreciation of one currency must mean depreciation of the other currency, and viceversa.

How the foreign exchange market works: Demanders and Suppliers of Currency Talk about how the policies of the U.S. Dollar can affect other currencies and policies around the globe, due to the importance of the U.S. Dollar as a currency Exchange rate movements affect exporters, tourists, and international investors

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets The foreign exchange market involves firms, households and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets (a) The quantity measured on the horizontal axis is in U.S. dollars, and the exchange rate on the vertical axis is the price of U.S. dollars measured in Mexican pesos

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets (b) The quantity measured on the horizontal axis is in Mexican pesos, while the price on the vertical axis is the prices of pesos measured in U.S. dollars

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets An announcement that the peso exchange rate is likely to strengthen in the future will lead to greater demand for the peso.

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets Similarly, it will make investors less likely to supply pesos to the foreign exchange market.

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets Both the shift of demand to the right and the shift of supply to the left cause an immediate appreciation in the exchange rate.

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets (left) A higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the demand for dollars in the foreign exchange rates shifts to the right. (right) A higher level of inflation for a currency means a reduced buying power, thus the international investors will be less likely to hold that currency

How the foreign exchange market works: Demand and Supply Shifts in Foreign Exchange Markets As a summary: Expectation of a currency appreciation (depreciation) will cause the demand of that currency to increase (decrease). Expectation of a currency appreciation (depreciation) will cause the supply of that currency to decrease (increase). A higher rate of return for U.S. dollars makes holding dollars more attractive. Thus, the demand for dollars in the foreign exchange rates shifts to the right. A higher level of inflation for a currency means a reduced buying power, thus the international investors will be less likely to hold that currency

How the foreign exchange market works: Exchange Rate Policies A nation may adopt one of a variety of exchange rate regimes, from floating rates to a common currency where the nation adopts the currency of another country or group of countries.

How the foreign exchange market works: Exchange Rate Policies Floating exchange rate: When the foreign exchange market sets the exchange rates. Example: U.S. dollar is floating exchange rate and about 40% of the countries in the world economy.

How the foreign exchange market works: Exchange Rate Policies Soft pegs: Is the name for an exchange rate policy where the government usually allows the market to set the exchange rate, but in some cases the central bank intervenes. With a hard peg, the government sets a fixed and unchanging value for the exchange rate

How the foreign exchange market works: Exchange Rate Policies (a) If an exchange rate is pegged below what would otherwise be the equilibrium, then the currency's quantity demanded will exceed the quantity supplied.

How the foreign exchange market works: Exchange Rate Policies (b) If an exchange rate is pegged above what would otherwise be the equilibrium, then the currency's quantity supplied exceeds the quantity demanded.

How the foreign exchange market works: Exchange Rate Policies Merged currency: When a nation to choose a common currency shared with one or more nations. It eliminates foreign exchange risk altogether. It also poses the problem that the nation has given domestic monetary policy, and instead has put its interest rate policies in other hands.

How the foreign exchange market works: Exchange Rate Policies Situation Floating Exchange Rate Soft Peg Hard Peg Merged Currency Large short-run fluctuations in exchange rates? Often considerable in the short term Maybe less in the short run, but still large changes over time None, unless a change in the fixed rate None Large long-term fluctuations in exchange rates? Can often happen Cannot happen unless hard peg changes, in which case substantial volatility can occur Power of central bank to conduct countercyclical monetary policy? Flexible exchange rates make monetary policy stronger Some power, although conflicts may arise between exchange rate policy and countercyclical Policy Very little; central bank must keep fixed None; nation does not have its Own Currency Tradeoffs of Exchange Rate Policies Talk about how the policies of the U.S. Dollar can affect other currencies and policies around the globe, due to the importance of the U.S. Dollar as a currency

How the foreign exchange market works: Exchange Rate Policies Situation Floating Exchange Rate Soft Peg Hard Peg Merged Currency Costs of holding foreign exchange reserves? Do not need to hold Reserves Hold moderate reserves that rise and fall over time Hold large reserves No need to hold Risk of ending up with an exchange rate that causes a large trade imbalance and very high inflows or outflows of financial capital? Adjusts often Adjusts over the medium term, if not the short term May end up over time either far above or below the market level Cannot adjust Tradeoffs of Exchange Rate Policies Talk about how the policies of the U.S. Dollar can affect other currencies and policies around the globe, due to the importance of the U.S. Dollar as a currency

Effect of Exchange Rates on the Economy: Imports, Exports and Real GDP. The level of imports and exports depends on exchange rates as well as on income and other factors. When events cause exchange rates to adjust, the levels of imports and exports will change. Changes in exports and imports can, in turn, affect the level of real GDP and the price level. Further, exchange rates themselves also adjust to changes in the economy.

Effect of Exchange Rates on the Economy: Imports, Exports and Real GDP. When a country’s currency depreciates, its import prices rise and its export prices fall This can serve as a stimulus to the economy. It will likely cause an increase in GDP

Effect of Exchange Rates on the Economy: The J-Curve Effect. J-Curve Effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect. 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = 𝑑𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 − 𝑑𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠

Effect of Exchange Rates on the Economy: The J-Curve Effect. Initially, a depreciation of a country’s currency may worsen its balance of trade. The negative effect on the price of imports may initially dominate the positive effects of an increase in exports and a decrease in imports. The key to the J-curve is the sequence of events following depreciation. Take the dollar-yen market. When the dollar depreciates, the immediate impact is a rise in the dollar price of imports. (Goods will cost the same in yen but it will take more dollars to buy those yen.) Initially, the dollar price of U.S. exports will remain the same, and the quantity of imports and exports will (for some time) respond very little if at all. This is because it takes time for customers to switch from imported goods to domestic alternatives. Firms that are importing inputs, for example, may have established relationships or contracts with foreign suppliers, and they do not want to risk breaking these ties until they are sure that the price change is permanent. After a few months U.S. firms will adjust their behavior, establishing new relationships with domestic suppliers. U.S. tourists, hearing how expensive Japan is for Americans, will plan fewer trips to Japan. Similarly, many Japanese firms and consumers will switch to the (now cheaper) U.S. goods. Thus, U.S. imports from Japan will decrease, and U.S. exports to Japan will increase, shrinking the trade deficit 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝑜𝑓 𝑡𝑟𝑎𝑑𝑒 = 𝑑𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑒𝑥𝑝𝑜𝑟𝑡𝑠 − 𝑑𝑜𝑙𝑙𝑎𝑟 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 × 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑜𝑓 𝑖𝑚𝑝𝑜𝑟𝑡𝑠

Effect of Exchange Rates on the Economy: Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level. This is caused by the increase demand for exports (by the rest of the world) and for domestic production (by domestic residents who react to higher import prices)

Effect of Exchange Rates on the Economy: Monetary Policy Lower interest rates cause a capital outflow. As foreigners purchase fewer U.S. assets the demand for dollar falls. As U.S. residents purchase more foreign assets the supply of dollar rises. A higher interest rate lowers planned investment and consumption spending, thus lowering the price level. This also attracts foreign buyers to U.S. financial markets, driving up the value of the dollar, which reduces the price of imports.

Effect of Exchange Rates on the Economy: Fiscal Policy Fiscal stimulus loses some impact because some of the added income is spent on imports Spending on imports does not increase domestic income

Alexander Núñez Torres, PhD School of Natural and Social Sciences Department of Economics and Business, Lehman College Lecture 11 –The Balance of Payments, Exchange Rates and Aggregate Expenditure "This image" by qimono/pixabay is free of copyright. Alexander Núñez Torres, PhD Assistant Professor, Department of Economics and Business