1. 9 OPEN ECONOMY THE EXCHANGE RATE AND THE BALANCE OF PAYMENTS
Notes and teaching tips: 4, 5, 8, 35, 37, 38, 39, 51, 52, 53, 65, and 68.
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Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action.
(1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining.
(2) Once or twice a semester, set an assignment, for credit, with the following instructions:
(a) Find a news article about an economic topic that you find interesting.
(b) Make a short bullet-list summary of the article.
(c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article.
Use the Economics in the News features in your textbook as models.

2. In this chapter:
Define the foreign exchange rate and explain how the exchange rate is determined
Explain the alternative exchange rate policies and explain their effects
Describe the balance of payments accounts and explain what causes an international deficit

3. The Foreign Exchange Market
To buy goods and services produced in another country we need money of that country.
Foreign bank notes (cash), coins, and bank deposits are called foreign currency.
The foreign exchange market is the market in which the currency of one country is exchanged for the currency of another.
Exchange rates: Exchange rates are always somewhat confusing. The problem is that there are two ways to express an exchange rate: It can be expressed as the units of foreign currency per U.S. dollar (120 yen per U.S. dollar) or as U.S. dollars per unit of foreign currency (1.28 U.S. dollars per Euro). Tell this fact to the students. But, because the textbook is consistent in using the exchange rate as the units of foreign currency per U.S. dollar, stick to the “120 yen per dollar” format in your lectures.

4. The Foreign Exchange Market
Exchange Rates
The price at which one currency exchanges for another is called the exchange rate.
A fall in the value of one currency in terms of another currency is called currency depreciation
e.g., the value of the US dollar falls from 2 euros/dollar to
1 euro/ dollar – the dollar depreciates.
A rise in value of one currency in terms of another currency is called currency appreciation
e.g., the value of the US dollar rises from 1 euro/dollar to
2 euros/ dollar – the dollar appreciates.

5. May 2, 2017.
Euro Depreciation

6. The Foreign Exchange Market
Questions we want to answer
How is the exchange rate determined?
Why does the U.S. dollar (or currencies in general) appreciate and sometimes depreciate?
How does the Fed operate in the foreign exchange market?
How is macro policy affected?
How do exchange rate fluctuations influence the balance of trade and the balance of payments of a country?

7. The Foreign Exchange Market
An Exchange Rate Is a Price
Like all prices, an exchange rate is determined in a market by supply and demand.
The U.S. dollar is demanded and supplied by thousands of traders every hour of every day.
With many traders and no restrictions, the foreign exchange market is a competitive market.
Classroom activity
Check out Economics in Action: The U.S. Dollar More Down than Up

8. The Foreign Exchange Market
Demand for US Dollars in the Foreign Exchange Market
The quantity of U.S. dollars that traders plan to buy in the foreign exchange market during a given period depends in general on
World demand for U.S. exports
Interest rates in the United States and other countries
The expected future exchange rate

9. The Foreign Exchange Market
The Law of Demand Applies for Foreign Exchange
People demand U.S. dollars so that they can buy US -produced goods and services or assets.
Other things remaining the same, the lower the exchange rate, the larger is the quantity of U.S. dollars demanded in the foreign exchange market.
2 euros/dollar to falls to 1 euro/ dollar

10. The Foreign Exchange Market
The demand for US dollars in the foreign exchange market shows a negative relationship between the price of dollars (yen per dollar, (¥/$) and the quantity of dollars demanded.
When the price of the dollar falls (the exchange rate falls), US - made goods and services appear less expensive to Japanese buyers. If US domestic prices are constant, Japanese buyers will buy more US goods and services, and the quantity demanded of dollars will increase.

12. The Demand for US Dollars
THE DEMAND FOR US DOLLARS (SUPPLY OF JAPANESE YEN)
1. Firms and households that import US goods into Japan or wish to buy US - made goods and services
2. Japanese citizens traveling in the US
3. Holders of Japanese yen who want to buy US stocks, bonds, or other financial instruments
4. Japanese companies that want to invest in the US
5. Speculators who anticipate an increase in the value of the dollar (relative to the yen). They expect the dollar to appreciate and the yen to depreciate (buy at 100 yen/dollar expecting to sell at 125 yen/dollar)
If you think the U.S. dollar is going to decline in value relative to the pound, you may want to hold some of your wealth in the form of pounds.

13. The Foreign Exchange Market
Supply of US Dollars in the Foreign Exchange Market
The quantity of U.S. dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate.
This quantity depends on many factors but the main ones are
U.S. demand for imported goods and services
Interest rates in the United States and other countries
The expected future exchange rate. They expect the dollar to depreciate (sell at 100 yen/dollar expecting to buy back at 80 yen/dollar)

14. The Foreign Exchange Market
The Law of Supply Applies for Foreign Exchange
People supply U.S. dollars so that they can buy foreign-produced goods and services or foreign assets.
Other things remaining the same, the higher the exchange rate, the larger is the quantity of U.S. dollars supplied in the foreign exchange market.

15. The Foreign Exchange Market
The supply of dollars in the foreign exchange market shows a positive relationship between the price of dollars (Yen per dollar (¥/$) and the quantity of dollars supplied.
When the price of dollars rises, US buyers can obtain more yen for each dollar. This means that Japanese products are less expensive to US buyers. If prices of Japanese products are constant , the quantity of dollars supplied will rise with the exchange rate.

17. The Market for Foreign Exchange
THE SUPPLY OF US DOLLARS (DEMAND FOR JAPANESE YEN)
Firms and households that import Japanese goods into the US or wish to buy Japanese-made goods and services
US citizens traveling in the Japan
Holders of dollars who want to buy stocks, bonds, or other financial instruments in Japan
US companies that want to invest in Japan
Speculators who anticipate the yen to appreciate and the dollar to depreciate
If you think the U.S. dollar is going to decline in value relative to the pound, you may want to hold some of your wealth in the form of pounds.

18. The Foreign Exchange Market
Market Equilibrium
Demand and supply in the foreign exchange market determine the exchange rate.

19. Exchange Rate Fluctuations
Changes in the Demand for U.S. Dollars
A change in any influence on the quantity of U.S. dollars that people plan to buy, other than the exchange rate, brings a change in the demand for U.S. dollars.
These other influences are
World demand for U.S. exports
U.S. interest rate relative to the foreign interest rate
The expected future exchange rate

20. Exchange Rate Fluctuations
World Demand for U.S. Exports At a given exchange rate, if world demand for U.S. exports increases, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate If interest rates in the US rise relative to foreign interest rates, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward.

21. Exchange Rate Fluctuations
The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, the demand for U.S. dollars increases and the demand curve for dollars shifts rightward.

22. Exchange Rate Fluctuations
How the demand curve for U.S. dollars shifts in response to changes in
Demand for U.S. exports
U.S. interest rates differential
Expected future exchange rate.

24. Exchange Rate Fluctuations
Changes in the Supply of U.S. Dollars
A change in any influence on the quantity of U.S. dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars.
These other influences are
U.S. demand for imports (want more French wine)
U.S. interest rates relative to the foreign interest rate
The expected future exchange rate

25. Exchange Rate Fluctuations
U.S. Demand for Imports At a given exchange rate, if the U.S. demand for imports increases, the supply of U.S. dollars on the foreign exchange market increases and the supply curve of U.S. dollars shifts rightward. U.S. Interest Rate Relative to the Foreign Interest Rate If the U.S. interest rates fall relative to foreign interest rates the supply of U.S. dollars increases and the supply curve of U.S. dollars shifts rightward. If the U.S. interest rates rise relative to foreign interest rates the supply of U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward.

26. Exchange Rate Fluctuations
The Expected Future Exchange Rate At a given current exchange rate, if the expected future exchange rate for U.S. dollars rises, … the supply of U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward.

27. Exchange Rate Fluctuations
How the supply curve of U.S. dollars shifts in response to changes in
U.S. demand for imports
The U.S. interest rate differential
The expected future exchange rate

29. Exchange Rate Fluctuations
Changes in the Exchange Rate
If demand for U.S. dollars increases and supply does not change, the exchange rate rises - the dollar appreciates.
French demand for California wine increases (change in taste)
or Great Britain is booming, YGB is increasing => IM = mxY increases.
or US stocks become more attractive to Japanese investors ….
on and on……….
Euro/$ S0
1.10
0.95 D1
Classroom activity
Check out Economics in Action: The Dollar on a Roller Coaster
Check out Economics in the News: The Rising U.S. Dollar D0
Quantity of Dollars

30. Exchange Rate Fluctuations
Changes in the Exchange Rate
If demand for U.S. dollars decreases and supply does not change, the exchange rate falls – the dollar depreciates.
European demand for California wine decreases (change in taste)
or Great Britain in recession, YGB is decreasing => IM = mxY decreases.
or US stocks become less attractive to Japanese investors ….
on and on……….
$/Euro
Euro/$ S0
1.10
0.90 D0
Classroom activity
Check out Economics in Action: The Dollar on a Roller Coaster
Check out Economics in the News: The Rising U.S. Dollar D1
Quantity of Dollars

31. Exchange Rate Fluctuations
Changes in the Exchange Rate
If supply of U.S. dollars increases and demand does not change, the exchange rate falls - the dollar depreciates.
US demand for French wine increases (change in taste)
or US is booming, YUS is increasing => IM = mxY increases.
or Japanese stocks become more attractive to US investors ….
on and on……….
Euro/$ S0 S1
1.10
0.95
Classroom activity
Check out Economics in Action: The Dollar on a Roller Coaster
Check out Economics in the News: The Rising U.S. Dollar D0
Quantity of Dollars

32. Exchange Rate Fluctuations
Changes in the Exchange Rate
If supply of U.S. dollars decreases and demand does not change, the exchange rate rises - the dollar appreciates.
US demand for French wine decreases (change in taste)
or US is in a recession, YUS is decreasing => IM = mxY decreases.
or Japanese stocks become less attractive to US investors ….
on and on……….
Euro/$ S1 S0
1.10
0.95
Classroom activity
Check out Economics in Action: The Dollar on a Roller Coaster
Check out Economics in the News: The Rising U.S. Dollar D0
Quantity of Dollars

33. The Open Economy with Flexible Exchange Rates
Purchasing Power Parity: The Law of One Price
law of one price If the costs of transportation are small, the price of the same good in different countries should be roughly the same.
purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same.
Arbitrage is the practice of seeking to profit by buying in one market and selling for a higher price in another related market.

34. Purchasing Power Parity: The Law of One Price
Arbitrage example: Price of basket balls in Toronto and Buffalo.
Say a basket ball cost $15(cad) in Toronto and $13(usd) in Buffalo and the exchange rate is $0.75usd/$1cad.
I can buy a basket ball in Toronto for $11.25usd (15 x .75) and sell in Buffalo for $13usd => profit = $1.75.
Holding the basket ball price constant, demand for Canadian dollar increases and the exchange rate will increase to $0.867usd/$1cad (15cad x .867 = $13us) .
-In actuality, the price of basket balls will also change, increase in Toronto and decrease in Buffalo.

35. Arbitrage and Speculation
Speculation is trading on the expectation of making a profit. This is different from arbitrage.
Arbitrage is trading on the certainty of making a profit.
Most foreign exchange transactions are based on speculation.
The expected future exchange rate influences both supply and demand, so it influences the current equilibrium exchange rate.

36. How Inflation Affects Exchange Rates
The Open Economy with Flexible Exchange Rates
How Inflation Affects Exchange Rates
A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries
General tendency is for the currency of relative high-inflation countries to depreciate and currency of low-inflation countries to appreciate.
Next slide looks at the case where inflation in the US is high relative to Great Britain.

37. Factors that Affect Exchange Rates - Inflation
A higher price level in the United States, relative to Great Britain, makes British imports more attractive.
The demand for pounds increases from D to D'
At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States.
The supply of pounds decreases from S to S'.
The result is an increase in the price of the pound from $1.89 to $2.25.
The pound appreciates, and the dollar is worth less (depreciates).
Note: the supply curve and demand curve shift at the same time, which make exchange rates volatile.

38. How Relative Interest Rates Affect Exchange Rates
The Open Economy with Flexible Exchange Rates
How Relative Interest Rates Affect Exchange Rates
The level of a country’s interest rate relative to interest rates in other countries is another determinant of the exchange rate.
If U.S. interest rates rise relative to British interest rates, British citizens will be attracted to U.S. securities.
To buy bonds in the United States, British buyers must exchange pounds for dollars (or supply their pounds in exchange for dollars). With higher interest rates in the United States, U.S. citizens are less likely to be interested in British securities, so they demand less pounds.

39. Factors that Affect Exchange Rates – relative interest rates
Exchange Rates Respond to Changes in Relative Interest Rates
If U.S. interest rates rise relative to British interest rates, British citizens holding pounds will be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S to S'.
At the same time, U.S. citizens are less likely to be interested in British securities because interest rates are higher at home. The demand for pounds shifts to the left, from D to D'.
The result is a depreciated pound and a stronger dollar (dollar appreciates).
To buy bonds in the United States, British buyers must exchange pounds for dollars (or supply their pounds in exchange for dollars). With higher interest rates in the United States, U.S. citizens are less likely to be interested in British securities, so they demand less pounds.

40. The Effects of Exchange Rates on the Economy
When the U.S. dollar depreciates: U.S. products are more competitive in world markets, and foreign-made goods look expensive to U.S. citizens. Exports increase and imports decrease.
A depreciation of a country’s currency is likely to increase NX and increase RGDP.
If the economy is operating close to capacity, the increase in aggregate demand is likely to result in higher prices.
Also, if import prices rise, costs may rise for business firms, shifting the AS curve to the left.

41. Open Economy - Monetary Policy with Flexible Exchange Rates
Fed actions to lower interest rates result in a decrease in the demand for dollars and an increase in the supply of dollars, causing the dollar to depreciate.
If the purpose of the Fed is to stimulate the economy, dollar depreciation is a good thing. It increases U.S. exports and decreases imports.
As Ms↑=> r↓=> I↑ => Y↑. (domestic market impact)
Also, as r↓=> exchange rate depreciates=> NX↑ => Y↑ (international market impact)

42. Open Economy - Fiscal Policy Flexible Exchange Rates
We know from earlier discussion, the multiplier is smaller with imports - some of the additional spending leaks out as imports, reducing the multiplier.
At the same time –
As income increases, the demand for money increases and interest rates increase causing the dollar to appreciate.
Exports fall, imports rise, again reducing the multiplier.
If interest rates rise, private investment may be crowded out, also lowering the multiplier.
Putting it all together –
Expansionary fiscal policy => Y ↑ => IM↑=> lower multiplier effect.
as Y ↑ => Md↑ => r↑=> I↓ => Y ↓ (crowding-out). (domestic market impact)
Also, as r↑=>exchange rate appreciates=> NX↓ => Y↓ (international market impact)

43. STOP HERE Arbitrage, Speculation, and Market Fundamentals
The Expected Future Exchange Rate
An expectation is a forecast.
Exchange rate forecasts, like weather forecasts, are made over horizons that run from a few hours to many months and perhaps y
But exchange rate forecasts are hedged with a lot of uncertainty, there are many divergent forecasts, and the forecasts influence the outcome.
The dependence of today’s exchange rate on forecasts of tomorrow’s exchange rate can give rise to exchange rate volatility in the short run.

44. Exchange Rate Policy Three possible exchange rate policies are
Flexible exchange rate
Fixed exchange rate
Crawling peg
Flexible Exchange Rate
A flexible exchange rate policy is one that permits the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.

45. Exchange Rate Policy
Fixed Exchange Rate A fixed exchange rate policy is one that pegs the exchange rate at a value decided by the government or central bank and is achieved by direct intervention in the foreign exchange market to block unregulated forces of demand and supply. A fixed exchange rate requires active intervention in the foreign exchange market.

46. Fixed Exchange Rate Policy
This figure shows how the Fed, as an example, could intervene in the foreign exchange market to keep the exchange rate close to a target rate. Suppose that the target is 100 yen per U.S. dollar. If the demand for U.S. dollars increases, the Fed sells U.S. dollars to increase supply.

48. Exchange Rate Policy
If demand for the U.S. dollar decreases, the Fed buys U.S. dollars to decrease supply. Persistent intervention on one side of the foreign exchange market cannot be sustained. The US follows a policy of flexible exchange rates.

49. Exchange Rate Policy
Crawling Peg A crawling peg works like a fixed exchange rate except that the target value changes periodically by small amounts. China is a country that operates a crawling peg. The idea to avoid wild swings in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.
Classroom activity
Check out Economics in Action: The People’s Bank of China in the Foreign Exchange Market

50. Pegging the Yuan
The People’s Bank of China needs to buy $460usd billion to maintain the exchange rate at 6.0 D
Yuan per US Dollar S A B
China’s Target Exchange Rate 6 5 E
Quantity of Dollars
1000
1460

51. Balance of Payments Accounts
A country’s balance of payments accounts records its international trading, borrowing, and lending. There are three balance of payments accounts: 1. Current account 2. Capital and financial account 3. Official settlements account
Classroom activity
Check out Economics in Action: Three Decades of Deficits

52. Financing International Trade
The current account records flows of goods and services
receipts from exports of goods and services sold abroad,
payments for imports of goods and services from abroad,
net investment income (interest),
income received on investments less
Income paid on investments
net transfers (such as foreign aid payments).
The current accounts balance = exports - imports + net investment income + net transfers.

53. Financing International Trade
The capital and financial account records foreign investment in the United States minus U.S. investment abroad. Records flows of capital investment.
The sum of the following (measured in a given period):
the change in private U.S. investments abroad,
the change in foreign private investments in the
United States,
the change in U.S. government assets abroad,
and the change in foreign government assets in the
United States.

54. Balance of Payments - Example
Say a U.S. resident buys a $30,000 Japanese automobile
The Japanese car manufacturer receives $30,000.
Has two options:
Option 1: The Japanese car manufacturer can buy $30,000 of U.S. goods:
Current Account impact:
U.S. exports = $30,000
US imports = $30,000
NX = 0
Capital Account impact:
Δ Capital Account = 0
Current Account + Capital Account =0

55. Balance of Payments - Example
Option 2: The Japanese car manufacturer can use the $30,000 to buy U.S. assets such as land, stocks, bonds, etc.
Current Account impact:
US exports = 0.
US imports = $30,000
NX = - $30,000
Capital Account impact:
Capital inflow = Change in foreign private assets in the
United States
= + $30,000
Current Account + Capital Account = 0

56. More on the Capital Account
There are many transactions recorded in the capital account that do not pertain to the exports and imports recorded in the current account.
US citizen buys German bonds
US holding of German bonds - private assets abroad↑
German holdings of USD ↑

57. Financing International Trade
The official settlements account records the change in U.S. official reserves. U.S. official reserves are the government’s holdings of foreign currency. If U.S. official reserves decrease, the official settlements account is positive. The sum of the balances of the three accounts always equals zero.

58. US Balance of Payments 2013 Balance of Payments Current Account
Billions of Dollars
Exports of G & S
+2,280
Imports of G & S
-2,757
Net Investment Income
+209
Net Transfers
-132
(1) Current Account Balance
-400
Capital and Financial Account
Foreign Investment in US
+1,017
US Investment Abroad
-650
Statistical Discrepancy
+30
(2) Capital and Financial Account Balance
+397
(3) Official Settlements Account +3
(1) + (2) +(3)

59. Financing International Trade
Borrowers and Lenders
A country that is borrowing more from the rest of the world than it is lending to it is called a net borrower.
A country that is lending more to the rest of the world than it is borrowing from it is called a net lender.
Since the early 1980s, except for 1991, the United States has been a net borrower from the rest of the world.
In 2010, the United States borrowed more than $400 billion from the rest of the world, mostly from China.

60. Financing International Trade
The Global Loanable Funds Market The loanable funds market is global, not national. Financial capital is mobile: It moves to the best advantage of lenders and borrowers. Funds flow into the country in which the real interest rate is highest and out of the country in which the real interest rate is lowest.

61. Financing International Trade
A country’s loanable funds market connects with the global market through net exports. If a country’s net exports are negative, the rest of the world supplies funds to that country and the quantity of loanable funds in that country is greater than national saving. If a country’s net exports are positive, the country is a net supplier of funds to the rest of the world and the quantity of loanable funds in that country is less than national saving.

62. Financing International Trade
Figure 9.7(a) illustrates the global market. The world equilibrium real interest rate is 5 percent a year.

64. Financing International Trade
In part (b), at the world real interest rate, borrowers want more funds than the quantity supplied by domestic lenders. The shortage of funds is made up by international borrowing.

65. Financing International Trade
In part (c), at the world real interest rate, the quantity supplied by domestic lenders exceeds what domestic borrowers want. The excess quantity supplied goes to foreign borrowers.

66. Financing International Trade
Debtors and Creditors A debtor nation is a country that during its entire history has borrowed more from the rest of the world than it has lent to it. Since 1986, the United States has been a debtor nation. A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it. The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.

67. Financing International Trade
Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income. Being a net borrower is a problem if the borrowed funds are used to finance consumption.
The analogy of a country being like an individual in being a borrower or lender is revealing. When Polonius tells Laertes to “neither a lender nor a borrower be” in Hamlet, he is the voice of prudence. But, perhaps, it is too much prudence. Much economic activity and development would be impossible without borrowing and lending. This is true at the individual level and for countries. The United States financed its industrialization and railroads in the nineteenth century by being a debtor nation.

68. From Chapter 7-The Loanable Funds Market
In the market for loanable funds. The market for funds that finance investment. Y = national income Y is either consumed (C), saved (S) or taxed (T): Y = C + S + T We know from Chapter 4: Y = C + I + G + X – M We get: C + S + T = C + I + G + X – M Solve for I: I = S + (T - G) + (M - X)

69. The Loanable Funds Market
Funds that Finance Investment come from three sources:
1. Household saving (S), called private saving.
2. Government budget surplus (T – G), called public saving.
NOTE: S + (T- G) is called national saving.
3. Borrowing from the rest of the world (M – X)
4. Domestic Investment (I) is financed by national saving plus foreign borrowing:
I = S + (T - G) + (M - X)