1. © 2015 Pearson Education, Ltd. Chapter 15 Open Economy Macroeconomics

2. 15 Open Economy Macroeconomics Chapter Outline 15.1Exchange Rates 15.2The Foreign Exchange Market EBE How did George Soros make $1 billion? 15.3The Real Exchange Rate and Exports 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

3. 15 Open Economy Macroeconomics Key Ideas 1.The nominal exchange rate is the rate at which one country’s currency can be exchanged for the currency of another country. 2.In a flexible exchange rate system, the nominal exchange rate is determined by supply and demand in the foreign exchange market. © 2015 Pearson Education, Ltd.

4. 15 Open Economy Macroeconomics Key Ideas 3.Fixed or managed exchange rates are controlled by the government. 4.The real exchange rate is the ratio of the prices (for example, all converted to dollars) of a basket of goods and services in two countries and thus influences net exports from one country to the other. © 2015 Pearson Education, Ltd.

5. 15 Open Economy Macroeconomics Key Ideas 5.A decline in net exports reduces labor demand and GDP and might cause unemployment. © 2015 Pearson Education, Ltd.

6. 15.1 Exchange Rates Many countries have their own currencies for use in economic transactions. © 2015 Pearson Education, Ltd.

7. 15.1 Exchange Rates The nominal exchange rate is the price of one (domestic) country’s currency in units of another (foreign) country’s currency: © 2015 Pearson Education, Ltd.

8. 15.1 Exchange Rates When a nominal exchange rate rises, we say that the domestic currency is appreciating. When a nominal exchange rate falls, we say that the domestic currency is depreciating. © 2015 Pearson Education, Ltd.

9. 15.1 Exchange Rates The nominal exchange rate can be rewritten as the price of another (foreign) country’s currency in units of one (domestic) country’s currency. © 2015 Pearson Education, Ltd.

10. 15.1 Exchange Rates There is a nominal exchange rate for each currency pair. Exhibit 15.1 The Nominal Exchange Rates e and 1/e on January 2, 2014 © 2015 Pearson Education, Ltd.

11. 15.1 Exchange Rates A country can adopt one of the following: 1.Flexible exchange rate: The government does not intervene in the foreign exchange market. 2.Fixed exchange rate: The government fixes a value and intervenes to maintain that value. 3.Managed exchange rate: A system between the flexible and fixed exchange rates. © 2015 Pearson Education, Ltd.

12. 15.1 Exchange Rates Exhibit 15.2 Yuan ‒ Dollar and Euro ‒ Dollar Exchange Rates from 1999 to January 2014 © 2015 Pearson Education, Ltd.

13. The foreign exchange market is the global financial market in which currencies are traded and nominal exchange rates are determined. 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

14. The foreign exchange market can be analyzed using the supply and demand model. The price is the exchange rate e (yuan per dollar). The quantity is the amount of dollars traded in the foreign exchange market. 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

15. The demand curve represents traders who are trying to buy dollars in the foreign exchange market with Chinese yuan. Question: Who is part of the demand curve? Air China buying a U.S. Boeing Dreamliner Apple buying parts from Chinese Foxconn Chinese government buying U.S. treasury bonds U.S. investor buying Chinese Alibaba stock 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

16. Question: Who is part of the demand curve? Answer: Air China buying a U.S. Boeing Dreamliner Apple buying parts from Chinese Foxconn Chinese government buying U.S. treasury bonds U.S. investor buying Chinese Alibaba stock 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

17. 15.2 The Foreign Exchange Market Exhibit 15.3, Panel (a) The Foreign Exchange Market Under a Flexible Exchange Rate Regime © 2015 Pearson Education, Ltd.

18. The supply curve represents traders who are trying to obtain Chinese yuan by selling dollars in the foreign exchange market. Question: Who is part of the supply curve? Air China buying a U.S. Boeing Dreamliner Apple buying parts from Chinese Foxconn Chinese government buying U.S. treasury bonds U.S. investor buying Chinese Alibaba stock 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

19. Question: Who is part of the supply curve? Answer: Air China buying a U.S. Boeing Dreamliner Apple buying parts from Chinese Foxconn Chinese government buying U.S. treasury bonds U.S. investor buying Chinese Alibaba stock 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

20. 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd. Exhibit 15.3, Panel (b) The Foreign Exchange Market Under a Flexible Exchange Rate Regime

21. Under a flexible exchange rate regime, the equilibrium exchange market is the exchange rate that equates the quantity supplied and the quantity demanded. 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

22. 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd. Exhibit 15.3, Panel (c) The Foreign Exchange Market Under a Flexible Exchange Rate Regime

23. Question: What happens to the yuan–dollar exchange rate if Air China unexpectedly faces a higher demand for air travel in China? 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

24. 15.2 The Foreign Exchange Market Exhibit 15.4 The Foreign Exchange Market After a Rightward Shift in the Dollar Demand Curve © 2015 Pearson Education, Ltd.

25. Under a managed or fixed exchange rate regime, the government announces a target, or “pegged” exchange. However, the government must be prepared to sell or buy its currency whenever the pegged exchange rate e Pegged is above or below the equilibrium exchange rate e*. 15.2 The Foreign Exchange Market © 2015 Pearson Education, Ltd.

26. 15.2 The Foreign Exchange Market Exhibit 15.5 The Foreign Exchange Market Under a Pegged Exchange Rate That Overvalues the Dollar Relative to the Yuan © 2015 Pearson Education, Ltd.

27. 15.2 The Foreign Exchange Market Exhibit 15.6 The Foreign Exchange Market Under a Pegged Exchange Rate That Undervalues the Dollar Relative to the Peso © 2015 Pearson Education, Ltd.

28. Question: How did George Soros make $1 billion? Data: Exchange rate and reserves data for the United Kingdom from 1991 to 1992. © 2015 Pearson Education, Ltd. 15 Open Economy Macroeconomics

29. From 1990 to 1992, the British pound had an exchange rate that was pegged against the German mark. In the summer of 1992, changing market forces led the British pound to become overvalued; the British government spent about $24 million of foreign currency reserves to defend the pegged rate. © 2015 Pearson Education, Ltd. 15 Open Economy Macroeconomics

30. Exhibit 15.7 The Mark–Pound Exchange Rate (Marks per Pound) from January 1991 to December 1992 © 2015 Pearson Education, Ltd. 15 Open Economy Macroeconomics

31. Question: How did George Soros make $1 billion? © 2015 Pearson Education, Ltd. 15 Open Economy Macroeconomics Answer: George Soros bet against the British pound just before the depreciation of the pound. How did he do it?

32. Throughout 1992, Soros borrowed $10 billion worth of pounds to buy German marks. On Black Wednesday, the British pound depreciated by 12%, so Soros’s marks were worth more in terms of pounds. Soros paid off his pound debt and had $1 billion left in profits. © 2015 Pearson Education, Ltd. 15 Open Economy Macroeconomics

33. U.S. importers like Walmart compare the cost of a good from China and from the United States in the same currency: 15.3 The Real Exchange Rate and Exports © 2015 Pearson Education, Ltd.

34. U.S. importers like Walmart compare the cost of a good from China and from the United States in the same currency: 15.3 The Real Exchange Rate and Exports © 2015 Pearson Education, Ltd.

35. The real exchange rate is the ratio of the dollar price of a basket of goods and services in the United States divided by the dollar price of the same basket of goods and services in a foreign country: 15.3 The Real Exchange Rate and Exports © 2015 Pearson Education, Ltd.

36. Question: Does the real exchange rate follow the nominal exchange rate? Data: The nominal and the real pound ‒ dollar exchange rates from 1950 to 2010 15.3 The Real Exchange Rate and Exports © 2015 Pearson Education, Ltd.

37. 15.3 The Real Exchange Rate and Exports Exhibit 15.8 The Nominal and the Real Pound-Dollar Exchange Rates from 1950 to 2010 © 2015 Pearson Education, Ltd.

38. Question: Does the real exchange rate follow the nominal exchange rate? Answer: Not always. In our example, the real exchange rate fell from 1950 to 1966, when the nominal exchange rate was fixed. After 1967, the real and nominal exchange rates moved together, although the real exchange rate keeps falling further behind. 15.3 The Real Exchange Rate and Exports © 2015 Pearson Education, Ltd.

39. Question: What happens to U.S. exports to China and Chinese exports to the United States when the real exchange rate goes up? Question: What happens to U.S. exports to China and Chinese exports to the United States when the real exchange rate goes down? 15.3 The Real Exchange Rate and Exports © 2015 Pearson Education, Ltd.

40. 15.3 The Real Exchange Rate and Exports Exhibit 15.9 The Relationship Between the Real Exchange Rate and Trade Flows © 2015 Pearson Education, Ltd.

41. 15.3 The Real Exchange Rate and Exports Exhibit 15.10 The Real Exchange Rate (E) and Net Exports © 2015 Pearson Education, Ltd.

42. National income accounting identity: Question: Why has the Chinese government kept the yuan undervalued? 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

43. Answer: A weaker yuan leads to an overvalued yuan ‒ dollar real exchange rate E. An increase in E leads to a trade deficit in the United States (X U.S. M China ). 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

44. Exhibit 15.11 U.S. Trade Balance with China 1999 to 2013 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

45. Question: What is the impact of a U.S. trade deficit for U.S. employment? 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

46. 15.4 GDP in the Open Economy Exhibit 15.12 Employment Falls When the Real Exchange Rate Appreciates © 2015 Pearson Education, Ltd.

47. Question: Can U.S. monetary policy respond to the appreciation of the real exchange rate? Answer: The U.S. Fed can pursue an expansionary monetary policy to decrease the real exchange rate. How? 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

48. An expansionary monetary policy lowers U.S. interest rates. Chinese investors reduce their holdings of U.S. assets, which decreases the demand for U.S. dollars in the foreign exchange market. This will cause the real yuan–dollar exchange rate E to fall and thus U.S. net exports to increase. 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.

49. Question: What is the implication for the depreciation of the pound on Black Wednesday? Answer: The sharp depreciation of the pound led to a decline in the pound’s real exchange rate, an expansion of British net exports, and a corresponding increase in economic activity. 15.4 GDP in the Open Economy © 2015 Pearson Education, Ltd.