Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 1 of 32 The Balance of Payments: Linking the United States to the International Economy Current account The part of the balance of payments that records a country’s net exports, net investment income, and net transfers. Balance of trade The difference between the value of the goods a country exports and the value of the goods a country imports. Balance of payments The record of a country’s trade with other countries in goods, services, and assets.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 32 Trade Flows for the United States, 2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 32

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 32 Net Exports Equals the Sum of the Balance of Trade and the Balance of Services The Balance of Payments of the United States, 2006 (billions of dollars) CURRENT ACCOUNT Exports of goods$1,023 Imports of goods−1,861 Balance of trade−838 Exports of services423 Imports of services−343 Balance of services80 Income received on investments650 Income payments on investments−614 Net income on investments−36 Net transfers−90 Balance on current account−812

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 32 U.S. Imports and Exports, 1970–2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 32 FINANCIAL ACCOUNT Increase in foreign holdings of assets in the United States1,860 Increase in U.S. holdings of assets in foreign countries−1,055 Balance on Financial Account805 BALANCE ON CAPITAL ACCOUNT -4-4 Statistical discrepancy11 Balance of payments0 So how do we pay for the excess of current account payments to foreigners over what they pay to US? We sell them our IOUs and other assets (stocks, real estate deeds, condos…) Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment (in “factories”) plus net foreign portfolio investment (stocks and bonds). The Balance of Payments Is Always Zero (statistical discrepancy makes it so) Don’t Let This Happen to YOU! Don’t Confuse the Balance of Trade, the Current Account Balance, and the Balance of Payments

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 32 Exchange Rates in the Financial Pages EXCHANGE RATE BETWEEN THE DOLLAR AND THE INDICATED CURRENCY CURRENCY UNITS OF FOREIGN CURRENCY PER U.S. DOLLAR U.S. DOLLAR PER UNIT OF FOREIGN CURRENCY Canadian dollar Japanese yen Mexican peso British pound Euro That was then…this is now

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 32 The Foreign Exchange Market and Exchange Rates 1 Foreign firms and households who want to buy goods and services produced in the United States. 2Foreign firms and households who want to invest in the United States either through foreign direct investment — buying or building factories or other facilities in the United States — or through foreign portfolio investment — buying stocks and bonds issued in the United States. 3People doing international business transacted in dollars. 3 Currency traders who believe the value of the dollar will increase. Sources of demand for the U.S. dollar: Sources of supply of the U.S. dollar are analogous: US residents who want to buy foreign stuff or paper or hold foreign currencies

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 32 Equilibrium in the Market for Foreign Exchange Currency appreciation An increase in the market value of one currency relative to another currency. Currency depreciation A decrease in the market value of one currency relative to another currency.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 32 How Do Shifts in Demand and Supply Affect the Exchange Rate? 1 Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign- produced goods and services 2 Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries 3 Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies Factors that cause the demand and supply curves in the foreign exchange market to shift:

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 32 How Do Shifts in Demand and Supply Affect the Exchange Rate? Adjustment to a New Equilibrium Shifts in the Demand and Supply Curve Resulting in a Higher Exchange Rate

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 32 Some Exchange Rates Are Not Determined by the Market Some currencies have fixed exchange rates that do not change … until they are forced to: payments deficit drains Central Bank foreign exchange holdings; M s declines; i rises  capital inflows; Y and P fall  Im decline  Balance of Payments balances at the fixed exchange rate. If the economy is currently below potential GDP, then depreciation/devaluation of the domestic currency should increase net exports, aggregate demand, and real GDP. Appreciation/revaluation of the domestic currency should have the opposite effect: Exports should fall, and imports should rise, which will reduce net exports, aggregate demand, and real GDP. How Movements in the Exchange Rate Affect Exports and Imports The Foreign Exchange Market and Exchange Rates

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 32 Real exchange rate The price of domestic goods in terms of foreign goods.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 32 The International Sector and National Saving and Investment U.S. Imports and Exports, 1970–2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 32 Current Account Balance + Financial Account Balance = 0 or: Current Account Balance = -Financial Account Balance or: Net Exports = Net Foreign Investment … NX = NFI Private Saving = National Income – Consumption - Taxes S private = Y – C – T = (C + I + G + NX) - C - T = I + (G - T) + NX Private saving finances domestic and foreign investment and government deficit Public Saving = Taxes – Gov’t Spending = S public = T – G National Saving = Private Saving + Public Saving S = S private + S public S = [I + (G - T) + NX] + (T - G) = I + NFI - NFI = I - S = I - S private - (T - G) = (I - S private ) + (G - T)

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 32 The Effect of a Government Budget Deficit on Investment The Twin Deficits, 1978–2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 32 Why Is the United States Called the “World’s Largest Debtor”? Making the Connection Large current account deficits have resulted in foreign investors purchasing large amounts of U.S. assets.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 32 An Inside LOOK Can the U.S. Current Account Deficit Be Sustained? Sustaining the Unsustainable U.S. trade-weighted exchange index: Major currencies.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 32 Macro Pictures: Exchange Rate

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 32 Balance of payments Balance of trade Capital account Closed economy Currency appreciation Currency depreciation Current account Financial account K e y T e r m s Net foreign investment Nominal exchange rate Open economy Real exchange rate Saving and investment equation Speculators