Balance of Accounts and Foreign Exchange Markets Modules 41-44

The Rest of the World US is not a closed economy 2013 Trade in Goods & Services Exports = $2.28 Trillion Imports = $2.74 Trillion

Figure 41.1 The Balance of Payments Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

The Rest of World When foreigners buy our goods or invest in the US, they need to use U.S. dollars We need to account for the dollars that are used to trade with the rest of the world In theory, the total dollars out must equal total dollars in

The Rest of the World Reconciling these flows is what is called the “Balance of Payments” There are two component accounts Current account Capital account (aka Financial Account)

Current Account Value of trade in goods and services that do not produce liabilities Transactions are concluded with no future implications Net Exports Factor (investment) income Transfers

Current Account Net Exports Factor Income Transfers Trade Balance Surplus or deficit Factor Income Wages paid/earned overseas Dividends; Interest Transfers Foreign aid Remittances

Capital Account Value of net change in ownership of assets Things that have implications beyond current year Government sales and purchases of assets Private sales and purchases of assets Financial reserves (currency held)

Capital Account Government sales and purchases of assets e.g., Central banks buy/sell US Treasury Bonds Private sales and purchases of assets e.g., Chinese citizens buy New York real estate Financial reserves Holdings of US dollars abroad

Balance of Payments Because money out + money in must equal 0: Current Account + Capital Account = 0 Current Account = - Capital Account

Balance of Payments Table 41.2 The U.S. Balance of Payments in 2008 (billions of dollars) Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Loanable Funds Market Real Figure 41.2 The Loanable Funds Model Revisited Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Trade and the Loanable Funds Market All things being equal, higher real interest rates will attract foreign investment So countries with higher interest rates will increase supply of loanable funds from foreign investors The source country for those funds will experience a decline in supply

Real Real Figure 41.3 Loanable Funds Markets in Two Countries Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Real Real Figure 41.4 International Capital Flows Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

The Foreign Exchange Market The market that results when currencies are sought by and offered up to those in other countries The “price” of one currency in terms of another is the exchange rate. Expressed as a ratio e.g., euros per dollar (€/$) Currently 0.86 €/$

Exchange rates At 0.86 €/$, each $1 would buy €0.86 To find the number of dollars per euro, just take the inverse: 1/.86 = $1.16 $/€ If the exchange rate increases, we can say that currency in the denominator appreciates, while the currency in the numerator depreciates.

Exchange Rates Since the exchange rate is the price of a currency, it can be used to calculate the prices of goods in one country relative to the other. Suppose 14 pesos/$ What would be the price in pesos of a $2000 computer? 14 pesos/$ x $2,000 = 28,000 pesos What if it were 16 pesos/$? 16 pesos/$ x $2,000 = 32,000 pesos

Exchange Rates In the previous example the dollar appreciated against the peso. As a result the computer became more expensive for the peso-holder If a country’s currency appreciates, its products become relatively more expensive

Bottom-Bottom Rule Figure 42.1 The Foreign Exchange Market Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Changes in Curves These changes will affect the supply of one currency and the demand for the other Changes in the demand for a country’s goods and services Changes in the desire to invest in a country Expectations of speculators

Examples: $US v. ¥ Japanese US consumers demand more Japanese cars Demand for ¥ increases Supply of $ increases US real GDP increases US interest rates increase relative to Japan Demand for $ increases Supply of ¥ increases

Figure 42. 2 An Increase in the Demand for U. S Figure 42.2 An Increase in the Demand for U.S. Dollars Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

Real v. Nominal Exchange Rates The real exchange rate takes into account the difference in price levels of the two countries Real Exchange Rate = Nominal Exchange Rate (A/B) x PB/PA A= currency in country A B= currency in country B PA= price level in country A PB= price level in country B

Real Exchange Rate So, at 14 pesos per dollar, if the price level in the US was 100 and in Mexico was 125… Real Exchange Rate = 14 pesos/$ x (100/125) = 14 x .8 = 11.2 pesos/$

Purchasing Power Parity Related to real exchange rate What nominal exchange rate would result in an identical basket of goods costing the same in each country? So if something costs $100 in the US and 1,000 pesos in Mexico, the rate would be 10