1. 20
Open Macroeconomics
CHAPTER

2. Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates21
Chapter Outline
The Balance of Payments The Current Account The Capital Account The United States as a Debtor Nation Equilibrium Output (Income) in an Open Economy The International Sector and Planned Aggregate Expenditure Imports and Exports and the Trade Feedback Effect Import and Export Prices and the Price Feedback Effect The Open Economy with Flexible Exchange Rates The Market for Foreign Exchange Factors That Affect Exchange Rates The Effects of Exchange Rates on the Economy An Interdependent World Economy Appendix: World Monetary Systems Since 1900

4. The link between trade & capital outflows
Y = C + I + G + NX
NX = Y – (C + I + G )
NX = (Y – C – G ) – I
NX = (Y – C – T) + ( T – G) – I
NX = (private Saving) + (public
Saving) - I
NX = S – I
Net outflow of goods and services = Net capital outflow
trade balance = net capital outflow
Starting from the equation derived on slides 6 and 7, we can derive another important identity: NX = S – I
This equation says that Net exports (the net outflow of goods) = net capital outflow (the net outflow of loanable funds)
While the identity and its derivation are very simple, we learn a very important lesson from it:
A country (such as the U.S.) with persistent, large trade deficits (NX < 0) also has low saving, relative to its investment, and is a net borrower of assets.

5. Open- Economy Macroeconomics
When people in different countries buy from and sell to each other, an exchange of
currencies must also take place.
Exchange rate The price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other.
     USD     GBP      CAD      EUR      AUD      
                         0.6546   
    Friday, November 28, 2008

6. Floating & fixed exchange rates
In a system of floating exchange rates (flexible) , exchange rate is allowed to fluctuate in response to changing economic conditions.
In contrast, under fixed exchange rates, the central bank trades domestic for foreign currency at a predetermined price.

7. Data on the SE Asian crisis
exchange rate % change from 7/97 to 1/98
stock market % change from 7/97 to 1/98
nominal GDP % change
Indonesia
-59.4%
-32.6%
-16.2%
Japan
-12.0%
-18.2%
-4.3%
Malaysia
-36.4%
-43.8%
-6.8%
Singapore
-15.6%
-36.0%
-0.1%
S. Korea
-47.5%
-21.9%
-7.3%
Taiwan
-14.6%
-19.7%
n.a.
Thailand
-48.3%
-25.6%
-1.2%
U.S.
2.7%
2.3%

8. Balance of Payment Accounts
Balance of payments are the accounts in which a nation records its international trading, borrowing, and lending.
It is divided into three main accounts:
Current account records exports minus imports, plus the net interest and net transfers received from and paid to other countries.
Capital account records foreign investment in the United States minus U.S. investment abroad.
Official settlements account records the change in U.S. official reserves. U.S. official reserves are government’s holdings of foreign currency.

9. The U.S. balance of payments in 2006.

10. THE BALANCE OF PAYMENTS
– 2.2
(11) Net capital account transactions
(12) Balance of payments ( )
83.6
(11) Statistical discrepancy
657.4
(10) Balance on capital account ( )
412.7
(9) Change in foreign government assets in the United States
- 23.0
(8) Change in U.S. government assets abroad (increase is –)
1,451.0
(7) Change in foreign private assets in the United States
– 1,183.3
(6) Change in private U.S. assets abroad (increase is –)
CAPITAL ACCOUNT
– 738.6
(5) Balance on current account ( )
– 104.4
(4) Net transfer payments
74.3
(3) Net investment income
– 707.9
Income payments on investments
782.2
Income received on investments
106.9
(2) Net export of services
– 372.3
Import of services
479.2
Export of services
– 815.4
(1) Net export of goods
– 1,964.6
Goods imports
1,149.2
Goods exports
CURRENT ACCOUNT
TABLE 21.1 United States Balance of Payments, 2007

11. Balance of Payments Accounts
Figure shows the balance of payments (as a percentage of GDP) over the period 1983 to 2003.

12. The national income identity in an open economy
Y = C + I + G + NX
or, NX = Y – (C + I + G )
net exports
output
domestic spending
Solving this identity for NX yields the second equation, which says:
A country’s net exports---its net outflow of goods---equals the difference between its output and its expenditure.
Example: If we produce $500b worth of goods, and only buy $400b worth, then we export the remainder.
Of course, NX can be a negative number, which would occur if our spending exceeds our income/output.
Spending need not equal output
Saving need not equal investment

13. Trade surpluses and deficits
NX = EX – IM = Y – (C + I + G )
trade surplus: output > spending ======= exports > imports Size of the trade surplus = NX
trade deficit: spending > output ======= imports > exports Size of the trade deficit = –NX

14. FINANCING INTERNATIONAL TRADE
Net Exports
Private sector balance is saving minus investment.
Government sector balance is equal to net taxes minus government expenditure on goods and services.
Current account balance is equal to (S – I) + (NT – G). To end a current account deficit, some combination of an increase in saving and taxes and a decrease in investment and government expenditures must occur.
Drive home the point that the current account balance is (S − I) + (NT − G)
To end a current account deficit, some combination of an increase in saving and taxes and a decrease in investment and government expenditures must occur.
There is no alternative!
What combination will the United States eventually go for?

15. Borrowers and Lenders, Debtors and Creditors
Net borrower is a country that is borrowing more from the rest of the world than it is lending to the rest of the world.
Net lender is a country that is lending more to the rest of the world than it is borrowing from the rest of the world.
Thus, a country with a trade deficit (NX < 0) is a net borrower (S < I ).

16. Borrowers and Lenders, Debtors and Creditors
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.
A debtor nation has a stock of outstanding debt to the rest of the world that exceeds the stock of its own claims on the rest of the world.
Creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.

17. THE UNITED STATES AS A DEBTOR NATION
Prior to the mid-1970s, the United States had generally run current account surpluses.
This began to turn around in the mid-1970s, and by the mid-1980s, the United States was running large current account deficits.
In other words, the United States changed from a creditor nation to a debtor nation.

18. The State of the Economy (BEA)
% change % change
Year in NGDP in RGDP
2007q
2007q
2008q
2008q
2008q
2008q
2009q

19. Current Account Balance 2006

20. THE INTERNATIONAL SECTOR AND PLANNED AGGREGATE EXPENDITURE
Planned aggregate expenditure in an open economy:
AE  C + I + G + EX - IM
Marginal propensity to import (MPM) The change in imports caused by a $1 change in income.
Let us define imports as a function of income

21. Equilibrium Output (Income) in an Open Economy
Equilibrium Income
The open economy multiplier

22. EQUILIBRIUM OUTPUT (INCOME) IN AN OPEN ECONOMY
The Open-Economy Multiplier
open-economy multiplier
The effect of a sustained increase in government spending (or investment) on income—that is, the multiplier—is smaller in an open economy than in a closed economy.
The reason: When government spending (or investment) increases and income and consumption rise, some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services.

23. EQUILIBRIUM OUTPUT (INCOME) IN AN OPEN ECONOMY
FIGURE Determining Equilibrium Output in an Open Economy

24. IMPORTS AND EXPORTS AND THE TRADE FEEDBACK EFFECT
The Determinants of Imports
The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports.
The Determinants of Exports
The demand for U.S. exports depends on economic activity in the rest of the world—rest-of-the-world real wages, wealth, nonlabor income, interest rates, and so on—as well as on the prices of U.S. goods relative to the price of rest-of-the-world goods.

25. The Trade Feedback Effect
Trade feedback effect The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country.
An increase in U.S. imports increases other countries’ exports, which stimulates those countries’ economies and increases their imports, which increases U.S. exports, which stimulates the U.S. economy and increases its imports, and so on. This is the trade feedback effect. In other words, an increase in U.S. economic activity leads to a worldwide increase in economic activity, which then “feeds back” to the United States.

26. The Price Feedback Effect
Price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country.
The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise.

27. THE EXCHANGE RATE
Foreign exchange market is the market in which the currency of one country is exchanged for the currency of another.
The foreign exchange market that is made up of importers and exporters, banks, and specialist dealers who buy and sell currencies.
A lot of silly ideas about the exchange rate find their way into the popular media. The most notable one is that the strength of a nation’s currency on the foreign exchange market is somehow a sign of the nation’s overall strength. Explain that the exchange rate is just a price. And it is the relative price of two currencies that ultimately depends on the price levels in two countries. A downward trend in an exchange rate means that a country is experiencing more rapid inflation that another country. That is all. The exchange rate trend tells us nothing—absolutely nothing—about productivity and real income growth in the two countries.

28. THE EXCHANGE RATE
Foreign exchange rate is the price at which one currency exchanges for another.
For example, in December 5th of 2008, one U.S. dollar bought Mexican Pesos. The exchange rate was Peso per U.S. dollar.
This exchange rate can be expressed in terms of dollars per Peso. The exchange rate was per Peso.  

29. THE EXCHANGE RATE
Currency appreciation is the rise in the value of one currency in terms of another currency.
For example, when the dollar rose from 86 euro cents in 1999 to 1.18 euros in 2001, the dollar appreciated by 37 percent.
Currency depreciation is the fall in the value of one currency in terms of another currency.
For example, when the dollar fell from 1.18 euros in 2001 to 0.70 euros in 2007, the dollar depreciated by 40 percent.

30. THE EXCHANGE RATE Changes in the Supply and Demand for Dollars
Changes in the supply and demand for U.S. dollars and shifts the supply and demand curves for dollars are influenced by the following factors
Interest rates in the United States and other countries
Expected future exchange rate

31. THE EXCHANGE RATE
Interest Rates in the United States and Other Countries
U.S. interest rate differential is the U.S. interest rate minus the foreign interest rate.
Other things remaining the same, the larger the U.S. interest rate differential, the greater is the demand for U.S. assets and the greater is the demand for dollars on the foreign exchange market.

32. THE EXCHANGE RATE The Expected Future Exchange Rate
Other things remaining the same, the higher the expected future exchange rate, the greater is the demand for dollars.
The higher the expected future exchange rate, the larger is the expected profit from holding dollars, so the larger is the quantity of dollars that people plan to buy on the foreign exchange market.

35. THE EXCHANGE RATE An Appreciating Dollar: 1999–2001
Between 1999 and 2001, the dollar appreciated against the euro. The exchange rate rose from 0.86 euros to 1.18 euros per dollar.
A Depreciating Dollar: 2001–2007
Between 2001 and 2007, the dollar depreciated against the euro. The exchange rate fell from 1.18 euros to 0.70 euros per dollar.

36. THE EXCHANGE RATE
Figure shows why the dollar appreciated between 1999 and 2001.
1.Traders expected the dollar to appreciate— the demand for U.S. dollars increased and the supply of U.S. dollars decreased.
2. The dollar appreciated.

37. THE EXCHANGE RATE
Figure shows why the dollar depreciated between 2001 and 2007.
1.Traders expected the dollar to depreciate— the demand for U.S. dollars decreased and the supply of U.S. dollars increased.
2. The dollar depreciated.

38. THE EXCHANGE RATE Why the Exchange Rate Is Volatile
Sometimes the dollar appreciates and sometimes it depreciates, but the quantity of dollars traded each day barely changes.
Why?
The main reason is that demand and supply are not independent in the foreign exchange market.

39. THE EXCHANGE RATE
Exchange Rate Expectations
Why do exchange rate expectations change?
There are two forces:
Purchasing power parity
Interest rate parity
Purchasing power parity means equal value of money—a situation in which money buys the same amount of goods and services in different currencies.
Use the Big Mac PPP to explain further the forces of purchasing power parity and deviations from purchasing power parity (PPP). Each year, The Economist calculates a Big Mac PPP exchange rate for a number of developed and developing economies. The Economist uses this to show which currencies are “overvalued” and which are “undervalued.” You can also use this, however, to show deviations from PPP in Big Mac prices. You may want to hand out the table or use it as an overhead in class to show the different prices of Big Macs across the globe. This can be a useful way to get the students to explain PPP before giving a formal economic definition. Describe how an individual can arbitrage away the Big Mac price difference by trading a Big Mac across countries (by buying a Big Mac in a low-price country and selling it in a high-price country). Students will immediately see that the Big Mac is not a tradable good…at least, it is likely none of them will want to eat a Big Mac that has spent hours if not days in transit! Now ask them to think about the components of the Big Mac. Will PPP hold for the tradable components such as onions, beef, buns, and pickles that make up the Big Mac? What about the other non-tradable components such as the labor and the rent on the building? This exercise can help to solidify the basic idea of PPP while allowing students to see why PPP will not hold at all times.

40. Purchasing Power Parity
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.

41. THE EXCHANGE RATE
Suppose that a Big Mac costs $4 (Canadian) in Toronto and $3 (U.S.) in New York.
If the exchange rate is $1.33 Canadian per U.S. dollar, then the two monies have the same value—you can buy a Big Mac in Toronto or New York for either $4 (Canadian) or $3 (U.S.).
But if a Big Mac in New York rises to $4 and the exchange rate remains at $1.33 Canadian per U.S. dollar, then money buys more in Canada than in the United States.
Money does not have equal value.

42. The Big Mac Index (the economist)
Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries.
The "basket" is a McDonald's Big Mac, which is produced in about 120 countries.
The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad.

43. ~ McZample ~
one good: Big Mac
price in Japan: P* = 200 Yen
price in USA: P = $2.50
nominal exchange rate e = 120 Yen/$
To buy a U.S. Big Mac, someone from Japan would have to pay an amount that could buy 1.5 Japanese Big Macs. ε

45. THE EXCHANGE RATE The value of money is determined by the price level.
If prices in the United States rise faster than those of other countries, people will generally expect the foreign exchange value of the U.S. dollar to fall.
Demand for U.S. dollars will decrease, and supply of U.S. dollars will increase. The U.S. dollar exchange rate will fall. The U.S. dollar depreciates.

46. THE OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES
FIGURE Exchange Rates Respond to Changes in Relative Prices (the case of higher price level in the U.S.)
FIGURE Exchange Rates Respond to Changes in Relative Interest Rates (U.S interest rates rise relative to British)

47. THE EXCHANGE RATE
Exchange Rate Expectations
Why do exchange rate expectations change?
There are two forces:
Purchasing power parity
Interest rate parity
Purchasing power parity means equal value of money—a situation in which money buys the same amount of goods and services in different currencies.
Use the Big Mac PPP to explain further the forces of purchasing power parity and deviations from purchasing power parity (PPP). Each year, The Economist calculates a Big Mac PPP exchange rate for a number of developed and developing economies. The Economist uses this to show which currencies are “overvalued” and which are “undervalued.” You can also use this, however, to show deviations from PPP in Big Mac prices. You may want to hand out the table or use it as an overhead in class to show the different prices of Big Macs across the globe. This can be a useful way to get the students to explain PPP before giving a formal economic definition. Describe how an individual can arbitrage away the Big Mac price difference by trading a Big Mac across countries (by buying a Big Mac in a low-price country and selling it in a high-price country). Students will immediately see that the Big Mac is not a tradable good…at least, it is likely none of them will want to eat a Big Mac that has spent hours if not days in transit! Now ask them to think about the components of the Big Mac. Will PPP hold for the tradable components such as onions, beef, buns, and pickles that make up the Big Mac? What about the other non-tradable components such as the labor and the rent on the building? This exercise can help to solidify the basic idea of PPP while allowing students to see why PPP will not hold at all times.

48. Interest Rate Parity
Interest rate parity means equal interest rates—a situation in which the interest rate in one currency equals the interest rate in another currency when exchange rate changes are taken into account.
Suppose a Canadian dollar deposit in a Toronto bank earns 5 percent a year and the U.S. dollar deposit in New York earns 3 percent a year.
If people expect the Canadian dollar to depreciate by 2 percent in a year, then the expected fall in the value of the Canadian dollar must be subtracted to calculate the net return on the Canadian dollar deposit
Be sure that your students appreciate interest rate parity. There are many horror stories of people losing their shirts by misunderstanding interest rate parity. One story concerns the once wealthy Catholic Church of Australia that decided to borrow in Japan at a low interest rate and lend the proceeds of its borrowing in Australia at a higher interest rate. When the Australian dollar nosedived against the Japanese yen, the church struggled to repay its loans. Interest rate parity always holds. Interest rates might look unequal, but the market expectation of the change in the exchange rate equals the gap between interest rates. It is a foolish person or organization that acts as if it can beat the market.

49. Interest Rate Parity
The net return on the Canadian dollar deposit is 3 percent (5 percent minus 2 percent) a year. Interest rate parity holds.
Adjusted for risk, interest rate parity always holds.
Traders in the foreign exchange market move their funds into the currencies that earn the highest return.
This action of buying and selling currencies brings about interest rate parity.

50. THE FIXED EXCHANGE RATE
Figure shows foreign market intervention.
Suppose that the Fed’s target exchange rate is 100 yen per dollar.
Pegging the Exchange Rate
But the Fed can intervene directly in the foreign exchange market to influence the exchange rate.
The Fed can try to smooth out fluctuations in the exchange rate by changing the supply of U.S. dollars.
The Fed changes the supply of U.S. dollars on the foreign exchange market by buying or selling U.S. dollars.
1. If demand increases from D0 to D1, the Fed sells U.S. dollars to increase the supply of dollars.

51. THE EXCHANGE RATE
2. If demand decreases from D0 to D2, the Fed buys U.S. dollars to decrease the supply of dollars.

52. THE EXCHANGE RATE
People’s Bank of China in the Foreign Exchange Market
The People’s Bank of China has been piling up reserves of U.S. dollars since 2000.
The China situation will always provide a source of news for lively classroom discussion.

53. THE EXCHANGE RATE
Figure shows the market for U.S. dollars in terms of the Chinese yuan.
1. The equilibrium exchange rate is 5 yuan per U.S. dollar.
2. The People’s Bank has a target exchange rate of 7.50 yuan per U.S. dollar.

54. THE EXCHANGE RATE
At the target exchange rate, the yuan is undervalued.
3. To keep the exchange rate pegged at its target, the People's Bank of China must buy U.S. dollars in exchange for yuan.
China’s reserves of U.S. dollars piles up.
Only by allowing the yuan to appreciate can China stop piling up U.S. dollars

55. THE OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES
THE EFFECTS OF EXCHANGE RATES ON THE ECONOMY
The level of imports and exports depends on exchange rates as well as on income and other factors. When events cause exchange rates to adjust, the levels of imports and exports will change. Changes in exports and imports can in turn affect the level of real GDP and the price level. Further, exchange rates themselves also adjust to changes in the economy.
Exchange Rate Effects on Imports, Exports, and Real GDP
A depreciation of a country’s currency is likely to increase its GDP.

56. THE OPEN ECONOMY WITH FLEXIBLE EXCHANGE RATES
Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level and likely to increase its GDP.
Monetary Policy with Flexible Exchange Rates A cheaper dollar is a good thing if the goal of the monetary expansion is to stimulate the domestic economy.
Fiscal Policy with Flexible Exchange Rates The openness of the economy and flexible exchange rates do not always work to the advantage of policy makers.
Monetary Policy with Fixed Exchange Rates There is no role monetary policy can play if a country has a fixed exchange rate.

57. AN INTERDEPENDENT WORLD ECONOMY
Forty years ago, economic events outside U.S. borders had relatively little effect on its economy. This situation is no longer true. The events of the past four decades have taught us that the performance of the U.S. economy is heavily dependent on events outside U.S. borders.
We used to be able to think of the United States as a relatively self-sufficient region.
The increasing interdependence of countries in the world economy has made the problems facing policy makers more difficult.

58. THE EXCHANGE RATE Monetary & Fiscal Policies and the Exchange Rate
Monetary policy influence the U.S. interest rate, so the Fed’s actions influence the U.S. dollar exchange rate.
If the U.S. interest rate rises relative to those in other countries, the value of the U.S. dollar rises on the foreign exchange market.
So the exchange rate responds to monetary policy.

59. The link between trade & capital outflows
Y = C + I + G + NX
NX = Y – (C + I + G )
NX = (Y – C – G ) – I
NX = (Y – C – T) + ( T – G) – I
NX = (private Saving) + (public
Saving) - I
NX = S – I
Net outflow of goods and services = Net capital outflow
trade balance = net capital outflow
Starting from the equation derived on slides 6 and 7, we can derive another important identity: NX = S – I
This equation says that Net exports (the net outflow of goods) = net capital outflow (the net outflow of loanable funds)
While the identity and its derivation are very simple, we learn a very important lesson from it:
A country (such as the U.S.) with persistent, large trade deficits (NX < 0) also has low saving, relative to its investment, and is a net borrower of assets.

60. The NX curve for the U.S. ε2
At high enough values of ε, U.S. goods become so expensive that NX ε
NX (ε)
NX(ε2)
we export less than we import

61. How ε is determined ε 1 NX(ε ) NX 1 ε NX
Neither S nor I depend on ε, so the net capital outflow curve is vertical. ε NX
NX(ε )
ε 1
ε adjusts to equate NX with net capital outflow, S - I.
*** Note ***
At the lower left corner (origin) of this graph, NX does NOT NECESSARILY EQUAL ZERO!!!
NX 1

62. Interpretation: Supply and demand in the foreign exchange market
Foreigners need dollars to buy U.S. net exports. e NX
NX(e)
supply:
Net capital outflow (S - I ) is the supply of dollars to be invested abroad. e1
WARNING: Don’t let your students confuse the demand for dollars in the foreign exchange market with demand for real money balances (chapter 11), or the supply of dollars in the foreign exchange market with the supply of money (chapter 11).
If you and your students are into details:
NX is actually the net demand for dollars: foreign demand for dollars to purchase our exports minus our supply of dollars to purchase imports. Net capital outflow is the net supply of dollars: The supply of dollars from U.S. residents investing abroad minus the demand for dollars from foreigners buying U.S. assets.
NX 1

63. Trade policy to restrict imports (Tariffs)
At any given value of ε, an import quota
 IM  NX
 demand for dollars shifts right ε NX
NX (ε )1
NX1
ε 1
NX (ε )2
ε 2
Trade policy doesn’t affect S or I , so capital flows and the supply of dollars remain fixed.
The analysis here applies for import restrictions (tariffs, quotas) as well as export subsidies. It also applies for exogenous changes in preferences regarding domestic vs. foreign goods.

64. 1. Fiscal policy at home (Expansionary)
A fiscal expansion reduces national saving, net capital outflow, and the supply of dollars in the foreign exchange market…
NX 2
ε 2 ε NX
NX(ε )
ε 1
NX 1
…causing the real exchange rate to rise and NX to fall.

65. Increase in investment demand
An increase in investment reduces net capital outflow and the supply of dollars in the foreign exchange market…
NX 2
ε 2 ε NX
NX 1
NX(ε )
ε 1
Suggestion: Have your students do this experiment as an in-class exercise. Have them take out a piece of paper, draw the graph, then show what happens when there’s an increase in the country’s investment demand (perhaps in response to an investment tax credit).
…causing the real exchange rate to rise and NX to fall.

66. THE END

67. REVIEW TERMS AND CONCEPTS
appreciation of a currency balance of payments
balance of trade
balance on capital account
balance on current account
depreciation of a currency
exchange rate
floating, or market- determined, exchange rates
foreign exchange
J-curve effect
law of one price
marginal propensity to import (MPM)
net exports of goods and services (EX - IM)
price feedback effect
purchasing-power-parity theory
trade deficit
trade feedback effect
Planned aggregate expenditure in an open economy:
AE  C + I + G + EX - IM
Open-economy multiplier: