International Political Economy

Open Economies and its mechanisms Lesson 3 Section 3.1

An Economy has two basic kinds of economic interactions with the rest of the world: –Buying and/or Selling Goods (e.g. lumber, automobiles, etc.) Services (e.g. transportation, tourism, etc.) Assets, mainly financial assets (e.g. interest and dividend payments)

A Rest of the World Export (Goods, Services, Financial Activities) Import (Goods, Services, Financial Activities) Domestic Currency (α) Foreign Currency (β)

Each international actvities gives rise to a situation in which either foreigners wish obtain our currency or we wish obtain foreign currency The former is viewed as a demand for our currency on the foreign exchange market, and the latter is viewed as a supply of our currency on this market

A Rest of the World Domestic Currency Demand Domestic Currency Supply Foreign Currency Demand Foreign Currency Supply

Country Rest of the World Domestic Currency Supply Domestic Currency Demand Foreign Currency Supply Foreign Currency Demand

Italy € USA $ € Supply € Demand $ Supply $ Demand

Exchange rate (€) D and S Foreign Currency ($) $ Supply $ Demand E1E1 E2E2 QS 1 QD 2 QS 2 QD 1 E 1 ► QD 1 >QS 1 E2 ► QD 2 <QS 2

Exchange rate (€) D and S Foreign Currency ($) $ Supply $ Demand E1E1 E2E2 QS 1 QD 2 QS 2 QD 1 E 1 ► QD 1 >QS 1 E2 ► QD 2 <QS 2

Exchange rate (€) D and S Foreign Currency ($) $ Supply $ Demand E* Q* E* ► QD = QS

Equilibrium Exchange Rate (e.g. 1$ = 1€) Exchange Rate decrease (e.g. 1$ = 0,5€) Exchange Rate increase (e.g. 1$ = 2€) USA good more expensive Price 1$ = 2€ Import increase Export increase Import decrease USA good less expansive Price 1$ = 0,5€ Italy good less expensive Price 1€ = 0,5$ Italy good more expensive Price 1€ = 2$ Export decrease

WHAT IS THE BALANCE OF PAYMENTS? Lesson 3 Section 3.2

The balance of payments is the difference between the sum of all demands for and the supplies of domestic currency on the foreign exchange market If the total number of domestic currency supplied is equal to the total number of domestic currency demanded, the result is a zero balance of payments In this case the international sector of the economy is in equilibrium

A balance of payments surplus occurs when the demand of domestic currency on the foreign exchange market exceeds the supply A balance of payments deficit is the situation where the supply of domestic currency exceeds its demand

Domestic Currency Supply = Domestic Currency Demand ▼ Balance Domestic Currency Supply > Domestic Currency Demand ▼ Imbalance (deficit) Domestic Currency Supply < Domestic Currency Demand ▼ Imbalance (surplus)

DETERMINANTS OF FOREIGN EXCHANGE MARKET ACTIVITY Lesson 3 Section 3.3

Several variables affect supply and demand activity in this market: –Exchange rate –Income –Interest rate –Price level –Expectations

Exchange rate –The price of domestic currency in terms of foreign currency is determined in the foreign exchange market –The exchange rate is a very important determinant of international trade; in fact: If exchange rate of domestic currency increase, imports is cheaper, so imports increase; –Thus, increasing the supply of domestic currency on the foreign exchange market Similarly, exports are more expensive to foreigners, so exports fall; –Thus, the decreasing the demand of domestic currency This way the rise in the exchange rate eliminates the balance of payments surplus The opposite occurs in case of a balance of payments deficit: –The exchange rate falls to eliminate the deficit

Demand/ Supply Foreign Currency Transaction TypeExchange rate Variation Exchange Rate Increase (consequences) Foreign Currency Demand Import Inverse Exchange Rate ▲ Currency Demand ▼ Devaluation Export ▲ Import ▼ Foreign Currency Supply Export Direct Exchange Rate ▼ Currency Supply ▲ Revaluation Export ▼ Import ▲

Income –At a higher level of income, imports increase The supply of domestic currency on the foreign market increases, creating a balance of payments deficit and downward pressure on exchange rate

Interest rate –When domestic interes rate is higher, foreigners are more interested in buying financial assets So, increase the demand of domestic currency on the foreign exchange market This demand creates –capital inflows, –a balance of payments surplus, –And upward pressure on the exchange rate Two caveats concerning capital inflows are important: –1. the resul depends on the interest rate increase not being part of a worldwide pattern –2. the relevant difference in interest rates is the difference in real interest rates, and not nominal interest rates, because investors are concerned with real returns

Price level –A rise of domestic prices level increase the price of exports and the price of import- competing goods and services So, exports fall and imports rise –As the result the demand for domestic currency decreases, and the supply of domestic currency increases creating a balance of payments deficit, and Downward pressure on the exchange rate –Again in this case, the effect occur only if there is no equivalent price increase in the rest of the world

Expectations –If foreigners expets the value of domestic currency to rise, they can reap a capital gain by buying our bonds and the selling them again after the exchange rate has risen This speculation creates –An inflow of capital, –A balance of payments surplus, –and upward pressure on the exchange rate –Speculative activity is indeed the primary determinant of exchange rates in the short run

THE INTERNATIONAL ECONOMIC ACCOUNTS Lesson 3 Section 3.4

Knowledge of the balance of payments is all that is needed for analysis of the economic forces that automatically are set in motion whenever there is a disequilibrium in the international sector of the economy Often, however, analysts are interested in the source of any disequilibrium in the international sector, that is, the relative contributions to an equilibrium position of the various components of the demand for and supply of domestic currency on the foreign exchange market Consequently, the balance of payments is broken down into several subsidiary measures, which together are referred to as the international accounts or the balance of payments accounts.

At the most general level, the balance of payments is broken into two accounts, the current and capital accounts –The current account measures the difference between the demand for and the supply of domestic currency arising from transactions that affect the current level of income here and abroad –The capital account measures the difference between the demand for and the supply of domestic currency arising from sales or purchases of assets to or from foreigners. The capital account measures capital flows between a country and the rest of the world. A capital account surplus measures a net capital inflow, and a capital account deficit measures a net capital outflow.

The trade balance is the sum of following: –Merchandise trade balance Difference between exports and imports of goods –Services trade balance Difference between exports and imports of services Net investment income from abroad –Interest and dividend interest Net transfer from abroad –Pension payments, foreign aid, etc.

THE TWIN DEFICITS Lesson 3 Section 3.5

An interesting aspect of the balance of payments accounts is that it is quite possible to have an economy in international equilibrium while simultaneously its subsidiary accounts are unbalanced, as long as they offset each other The U.S. economy, for example, for several years had a current account deficit that was offset by a surplus in its capital account.

How might this situation come about? –A prominent explanation is that it is a side effect of large government budget deficits—hence termed the twin deficit problem. –A large government deficit increases the interest rate as the government sells bonds to finance its deficit. –This rise in the interest rate makes domestic bonds look very attractive to overseas investors, so capital flows into the country, creating a balance of payments surplus. –This bids up the value of the dollar, which in turn decreases exports and increases imports, creating a balance of trade deficit.

How budget deficits cause trade deficits –G increase and/or T decrease This causes –Budget deficit –Government sells bonds –Interest rate increase –Capital inflows increase –Exchange rate increase –Exports decrease and imports increase Balance of trade deficit

Twin deficit USA