PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE

Macroeconomy Open economy –Trades with other nations in goods and services –And perhaps also trades in financial assets Model – large open economy –Substantial capital flows –Floating exchange rate 2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade International trade, exchange rates, and aggregate demand Increase in net exports (X-IM) –Increase X –Decrease IM –Multiplier effect on economy –Aggregate demand – shifts outward-right Increase real GDP Increase price level 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade Determinants of net exports –Foreign incomes –Relative prices of foreign and domestic goods Booms or recessions in one country –Tend to be transmitted to other countries through international trade in goods and services 4 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 1 The Effects of Higher Net Exports 5 Price Level Real GDP S S D0D0 D0D0 A D1D1 D1D1 B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade Relative prices of a country’s exports –Fall Net exports – increase Real GDP – increase –Rise Net exports – decrease Real GDP – decrease 6 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade Price of foreign products –Rise Net exports – increase Real GDP – increase –Fall Net exports – decrease Real GDP – decrease Currency appreciations or depreciations –Change international relative prices 7 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade Currency depreciation –A unit of currency can buy fewer units of foreign currency Currency appreciation – A unit of currency can buy more units of foreign currency 8 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade Currency depreciation –Raise net exports –Increase aggregate demand Currency appreciation –Reduce net exports –Decrease aggregate demand 9 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 1 Exchange Rates and Home Currency Prices 10 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 2 Effects of exchange rate changes on aggregate demand 11 Price Level Real GDP S S D0D0 D0D0 E0E0 D1D1 D1D1 E1E1 (depreciation) D2D2 D2D2 E2E2 (appreciation) © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Trade Late 1990s & early 2000s –U.S. trade deficit – grew enormously Has fallen a bit recently –1995 – dollar appreciation Boost U.S. imports (40% growth) Damage U.S. exports (7% growth) –1997: $140 billion real net export deficit –2002: $549 billion deficit –2006: $729 billion deficit –2009: $363 billion deficit 12 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Aggregate Supply Aggregate supply in an open economy Depreciation of U.S. dollar –Prices of imported inputs – rise –U.S. aggregate supply curve shifts inward –Prices of domestic goods and services Increase –Additional inflationary effects On consumer prices 13 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Aggregate Supply Appreciation of U.S. dollar –Imported inputs – cheaper –U.S. aggregate supply curve Shifts outward –Prices of domestic goods Decrease 14 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 3 The Effects of Exchange Rate Changes on Aggregate Supply 15 Price Level Real GDP S0S0 S0S0 D D E0E0 (depreciation) (appreciation) S1S1 S1S1 S2S2 S2S2 E2E2 E1E1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Effects The macroeconomic effects of exchange rates Dollar depreciation –Aggregate demand – shift outward –Aggregate supply – shift inward –U.S. price level – increase –GDP – rise or fall If the shift in demand is larger, GDP rises –Inflationary and probably expansionary 16 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 4 The Effects of a Currency Depreciation 17 Price Level Real GDP D0D0 D0D0 D1D1 D1D1 S1S1 S1S1 S0S0 S0S0 E A © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Effects Dollar appreciation –Aggregate demand – shift inward –Aggregate supply – shift outward –U.S. price level – falls –GDP – rise or fall If the shifts in demand is larger, GDP falls –Disinflationary and probably contractionary 18 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 5 The Effects of a Currency Appreciation 19 Price Level Real GDP D0D0 D0D0 D2D2 D2D2 S2S2 S2S2 S0S0 S0S0 E B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Effects International capital flows –Purchases and sales of financial assets –Across national borders Rise in interest rates –Contract the economy International capital inflows Currency – appreciates Net exports – decrease 20 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Macroeconomic Effects Drop in interest rates –Expand the economy International capital outflows Currency – depreciates Net exports – increase 21 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fiscal and Monetary Policies Fiscal and monetary policies in an open economy Fiscal expansion in a closed economy –Aggregate demand increases Closed economy –Does not trade with other nations in either goods or assets 22 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fiscal and Monetary Policies Fiscal expansion in an open economy –Interest rates increase –Exchange rate appreciates –Attract foreign capital Capital account surplus increases –Net exports decrease Current account deficit increases Capital account surplus + Current account deficit = 0 23 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fiscal and Monetary Policies Fiscal expansion in an open economy –Aggregate demand – outward shift –Aggregate supply – outward shift –Aggregate demand – inward shift –Fiscal multiplier – reduced 24 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 6 A fiscal expansion in an open economy 25 Price Level Real GDP D0D0 D0D0 D2D2 D2D2 S2S2 S2S2 S0S0 S0S0 A C D1D1 D1D1 B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 2 Percentage Shares of Real GDP in the United States, 1981 and © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fiscal and Monetary Policies Contractionary monetary policy –Decrease aggregate demand –Interest rates increase –Exchange rates appreciate –Capital inflow Strengthen monetary policy –Aggregate supply – outward shift 27 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Figure 7 A Monetary Contraction in an Open Economy 28 Price Level Real GDP D0D0 D0D0 D2D2 D2D2 S2S2 S2S2 S0S0 S0S0 A C D1D1 D1D1 B © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Aspects International aspects of deficit reduction Policy mix: Fiscal contraction and Monetary expansion –Reduce interest rates strongly –Push down the value of the dollar –Strongly stimulate our foreign trade –Net effects on output and inflation Uncertain 29 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Table 3 Expected Effects of Policy 30 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Aspects Trade deficit –Excess of imports over exports Trade surplus –Excess of exports over imports Accounting relationship between the trade deficit and the budget deficit X – IM = (S – I) – (G – T) 31 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

International Aspects Trade deficit –Negative value for X-IM –Can arise from Government budget deficit G > T Excess investment over saving I > S 32 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Worry about the Trade Deficit? U.S. trade deficits –The nation consumes more then it produces –Forced to borrow the difference from foreigners –Mirror image: required capital inflows 33 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Worry about the Trade Deficit? Capital inflows –Create debts - interest and principal payments must be made in the future –Economic weakness Mortgaging our futures to finance higher consumer spending –Economic strength: foreigners are eager to lend capital Push the value of the dollar up Push our net exports down 34 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Worry about the Trade Deficit? How long can it go on? –As long as the U.S. continues to run large trade deficits –Foreigners will have to continue to accumulate large amounts of U.S. assets 2002, foreign private investors –Acquired about all the American assets they wanted 35 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Worry about the Trade Deficit? Governments of Japan and China –Buy hundreds of billions of dollars of U.S. Treasury securities Sell equivalent amounts of their own currencies Rather than let the yen and the yuan appreciate –Large government capital inflows - allowed the U.S. to continue to run mammoth trade deficits, a few more years 36 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Worry about the Trade Deficit? 2008–2009, financial crisis –Lots of worried investors – eager to buy U.S. dollar assets Especially Treasury securities As the “flight to safety” dissipated –Foreigners decided they did not need quite as many U.S. assets –The dollar declined again 37 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

On Curing the Trade Deficit How can we ameliorate our foreign trade problem and reduce our addiction to foreign borrowing? 1. Change the mix of fiscal and monetary policy 2. More Rapid Economic Growth Abroad 3. Raise Domestic Saving or Reduce Domestic Investment 4. Protectionism 38 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

On Curing the Trade Deficit 1.Change the mix of fiscal and monetary policy –Tightening fiscal policy and loosening monetary policy Done in the 1990s 2. More rapid economic growth abroad –They would buy more American goods –Raising U.S. exports –Reducing our trade deficit 39 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

On Curing the Trade Deficit 3. Raise domestic saving or reduce domestic investment –If Americans would save more We would need to borrow less from abroad –Reducing U.S. domestic investment 2007–2009 recession: –Share of investment in real GDP fell from 17.2% in 2006 to 11.8% in © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

On Curing the Trade Deficit 4. Protectionism –Limit imports by imposing stiff tariffs, quotas, and other protectionist devices –Almost all economists oppose it –It has an undeniable political allure –Might not succeed in reducing our trade deficit Other nations may retaliate Will reduce the supply of dollars on the world market 41 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.