19 Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE

●International Trade, Exchange Rates, and Aggregate Demand ●Aggregate Supply in an Open Economy ●The Macroeconomic Effects of Exchange Rates ●Fiscal and Monetary Policies in an Open Economy ●International Trade, Exchange Rates, and Aggregate Demand ●Aggregate Supply in an Open Economy ●The Macroeconomic Effects of Exchange Rates ●Fiscal and Monetary Policies in an Open Economy Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

●International Aspects of Deficit Reduction ●Is the Trade Deficit a Problem? ●On Curing the Trade Deficit ●Conclusion: No Nation is an Island ●International Aspects of Deficit Reduction ●Is the Trade Deficit a Problem? ●On Curing the Trade Deficit ●Conclusion: No Nation is an Island Contents (continued) Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  exports and imports  multiplier effects on GDP. ●Booms or recessions in one country affect other countries through international trade. ●  exports and imports  multiplier effects on GDP. ●Booms or recessions in one country affect other countries through international trade. International Trade, Exchange Rates, and AD

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP

FIGURE 1: The Effects of Higher Net Exports Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Price Level Real GDP D 0 D 0 S S D 1 D 1 A B

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ●The Effects of Changes in Exchange Rates ♦A currency depreciation  ■  relative prices of the country’s goods in international trade ■  its net exports and AD ♦A currency appreciation has the opposite effects. ●The Effects of Changes in Exchange Rates ♦A currency depreciation  ■  relative prices of the country’s goods in international trade ■  its net exports and AD ♦A currency appreciation has the opposite effects.

TABLE 1: Exchange Rates and Home Currency Prices Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

FIGURE 2: The Effects of Exchange Rate Changes on AD Copyright © 2006 South-Western/Thomson Learning. All rights reserved. D 2 D 2 D 1 D 1 S S E 1 (depreciation) (appreciation) D 0 D 0 Price Level Real GDP E 0 E 2

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Open Economy: one that trades with other nations in goods and services, and perhaps also in financial assets ●Closed Economy: one that does not trade with other nations in either goods or assets ●Open Economy: one that trades with other nations in goods and services, and perhaps also in financial assets ●Closed Economy: one that does not trade with other nations in either goods or assets Aggregate Supply in an Open Economy

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Aggregate Supply in an Open Economy ●A currency depreciation  ♦  price of foreign goods ♦AS shifts inward ●A currency appreciation has the opposite effects. ●A currency depreciation  ♦  price of foreign goods ♦AS shifts inward ●A currency appreciation has the opposite effects.

FIGURE 3: The Effects of Exchange Rate Changes on AS Copyright © 2006 South-Western/Thomson Learning. All rights reserved. (depreciation) S 0 S 0 (appreciation) D D S 1 S 1 S 2 S 2 E 2 E 0 E 1 Price Level Real GDP

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Currency depreciation  ♦  AD and  AS ♦Net result is inflation ♦Probably also expansionary ■Impact on AD dominates impact on AS ●A currency appreciation has the opposite effects. ●Currency depreciation  ♦  AD and  AS ♦Net result is inflation ♦Probably also expansionary ■Impact on AD dominates impact on AS ●A currency appreciation has the opposite effects. The Macroeconomic Effects of Exchange Rates

FIGURE 4: The Effects of a Currency Depreciation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 E Price Level Real GDP S 1 S 1 D 1 D 1 A

FIGURE 5: The Effects of a Currency Appreciation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 S 2 S 2 D 2 D 2 B D 0 D 0 E Price Level Real GDP

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Macroeconomic Effects of Exchange Rates ●Interest Rates and International Capital Flows ♦  interest rates  ■Attracts foreign capital flows ■Appreciates the currency ■  net exports ■  GDP ♦  interest rates has the opposite effects ●Interest Rates and International Capital Flows ♦  interest rates  ■Attracts foreign capital flows ■Appreciates the currency ■  net exports ■  GDP ♦  interest rates has the opposite effects

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Fiscal Policy Revisited ♦Expansionary fiscal policy  ■  interest rates ■Attracts foreign capital ■Appreciates the currency ■  net exports ●Fiscal Policy Revisited ♦Expansionary fiscal policy  ■  interest rates ■Attracts foreign capital ■Appreciates the currency ■  net exports

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Fiscal Policy Revisited ♦Part of the expansionary effect of fiscal policy is “crowded out.” ♦Thus, international capital flows reduce the power of fiscal policy. ●Fiscal Policy Revisited ♦Part of the expansionary effect of fiscal policy is “crowded out.” ♦Thus, international capital flows reduce the power of fiscal policy.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Fiscal Policy Revisited ♦The evidence indicates that the crowding-out effect of fiscal policy is greater on net exports than on investment. ●Fiscal Policy Revisited ♦The evidence indicates that the crowding-out effect of fiscal policy is greater on net exports than on investment.

FIGURE 6: A Fiscal Expansion in an Open Economy Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP A D 1 D 1 S 2 S 2 D 2 D 2 C B

TABLE 2: Percentage Shares of Real GDP in the U.S Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Monetary Policy Revisited ♦Expansionary monetary policy  ■  interest rates ■Outflow of capital ■Currency depreciation ■  net exports ♦Thus, international capital flows   power of monetary policy ●Monetary Policy Revisited ♦Expansionary monetary policy  ■  interest rates ■Outflow of capital ■Currency depreciation ■  net exports ♦Thus, international capital flows   power of monetary policy

FIGURE 7: A Monetary Contraction in an Open Economy Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP S 2 S 2 D 1 D 1 D 2 D 2 C A B

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●According to theory, success in reducing the federal deficit through a policy mix of fiscal contraction and monetary expansion should: ♦  real interest rates ♦  exchange rate of the dollar ♦  net exports ♦Have an uncertain effect on real GDP and inflation ●According to theory, success in reducing the federal deficit through a policy mix of fiscal contraction and monetary expansion should: ♦  real interest rates ♦  exchange rate of the dollar ♦  net exports ♦Have an uncertain effect on real GDP and inflation International Aspects of Deficit Reduction

TABLE 3: Expected Effects of Policy Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ●What actually happened? ♦Interest rates did fall, just as predicted. ♦The U.S. economy expanded rapidly between 1992 and ■The monetary stimulus overwhelmed the fiscal contraction. ●What actually happened? ♦Interest rates did fall, just as predicted. ♦The U.S. economy expanded rapidly between 1992 and ■The monetary stimulus overwhelmed the fiscal contraction.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ♦Inflation fell despite such rapid growth. ♦The dollar generally declined from 1993 to 1995, as the theory predicted. ♦But then it turned around and rose sharply from 1995 to 1998, just when the budget deficit was turning into a surplus. ♦Inflation fell despite such rapid growth. ♦The dollar generally declined from 1993 to 1995, as the theory predicted. ♦But then it turned around and rose sharply from 1995 to 1998, just when the budget deficit was turning into a surplus.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ♦America’s real net exports sagged from -$30 billion in 1992 to -$238 billion in ♦The effect on the value of the dollar and net exports did not match the theoretical predictions. ♦America’s real net exports sagged from -$30 billion in 1992 to -$238 billion in ♦The effect on the value of the dollar and net exports did not match the theoretical predictions.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦(X - IM) = (S - I) - (G - T) ♦Apply this accounting relationship to actual U.S. events in the 1990s: ■  (G - T) ■  S and  I   (S - I) ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦(X - IM) = (S - I) - (G - T) ♦Apply this accounting relationship to actual U.S. events in the 1990s: ■  (G - T) ■  S and  I   (S - I)

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦Taken by itself:  budget deficit   trade deficit ■But effect offset by  private economic behavior ●  S ●  I ♦Trade deficit depends on private sector behavior as well as public sector behavior. ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦Taken by itself:  budget deficit   trade deficit ■But effect offset by  private economic behavior ●  S ●  I ♦Trade deficit depends on private sector behavior as well as public sector behavior.

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ●Pessimists: trade deficit increases long-term indebtedness to foreigners ●Optimists: trade deficit indicates the attractiveness of the U.S. economy to foreign investors ●Pessimists: trade deficit increases long-term indebtedness to foreigners ●Optimists: trade deficit indicates the attractiveness of the U.S. economy to foreign investors

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ●Each view holds elements of truth. ●But there is a critical question: How long can a trade deficit continue? ●Each view holds elements of truth. ●But there is a critical question: How long can a trade deficit continue?

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ●At some point, foreign investors may conclude that they have acquired about all the American assets they want. ●If and when that happens, the U.S. trade deficit must be eliminated. ●The only question is how? ●At some point, foreign investors may conclude that they have acquired about all the American assets they want. ●If and when that happens, the U.S. trade deficit must be eliminated. ●The only question is how?

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. On Curing the Trade Deficit ●Four basic ways to cure the trade deficit: ♦Tighter fiscal and looser monetary policy ♦  economic growth abroad ♦  savings (good) and/or  investment (bad) ♦Protectionism ■Would be bad for the U.S. and world economies ■Might very well fail to cure the problem ●Four basic ways to cure the trade deficit: ♦Tighter fiscal and looser monetary policy ♦  economic growth abroad ♦  savings (good) and/or  investment (bad) ♦Protectionism ■Would be bad for the U.S. and world economies ■Might very well fail to cure the problem

Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Conclusion: No Nation is an Island ●The fates of nations are intertwined. ●The major trading countries are linked by exports and imports, capital flows, and exchange rates. ●Mutual success may well require mutual coordination. ●The fates of nations are intertwined. ●The major trading countries are linked by exports and imports, capital flows, and exchange rates. ●Mutual success may well require mutual coordination.