1. 19 Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE

2. ●International Trade, Exchange Rates, and Aggregate Demand ●Aggregate Supply in an Open Economy ●The Macroeconomic Effects of Exchange Rates ●Fiscal and Monetary Policies in an Open Economy ●International Trade, Exchange Rates, and Aggregate Demand ●Aggregate Supply in an Open Economy ●The Macroeconomic Effects of Exchange Rates ●Fiscal and Monetary Policies in an Open Economy Contents Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

3. ●International Aspects of Deficit Reduction ●Is the Trade Deficit a Problem? ●On Curing the Trade Deficit ●Conclusion: No Nation is an Island ●International Aspects of Deficit Reduction ●Is the Trade Deficit a Problem? ●On Curing the Trade Deficit ●Conclusion: No Nation is an Island Contents (continued) Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

4. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●  exports and imports  multiplier effects on GDP. ●Booms or recessions in one country affect other countries through international trade. ●  exports and imports  multiplier effects on GDP. ●Booms or recessions in one country affect other countries through international trade. International Trade, Exchange Rates, and AD

5. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP

6. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP ●Relative Prices, Exports, and Imports ♦  relative prices of a country’s exports  ■  that country’s net exports ■  its real GDP

7. FIGURE 1: The Effects of Higher Net Exports Copyright © 2006 South-Western/Thomson Learning. All rights reserved. Price Level Real GDP D 0 D 0 S S D 1 D 1 A B

8. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ●The Effects of Changes in Exchange Rates ♦A currency depreciation  ■  relative prices of the country’s goods in international trade ■  its net exports and AD ♦A currency appreciation has the opposite effects. ●The Effects of Changes in Exchange Rates ♦A currency depreciation  ■  relative prices of the country’s goods in international trade ■  its net exports and AD ♦A currency appreciation has the opposite effects.

9. TABLE 1: Exchange Rates and Home Currency Prices Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

10. FIGURE 2: The Effects of Exchange Rate Changes on AD Copyright © 2006 South-Western/Thomson Learning. All rights reserved. D 2 D 2 D 1 D 1 S S E 1 (depreciation) (appreciation) D 0 D 0 Price Level Real GDP E 0 E 2

11. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Open Economy: one that trades with other nations in goods and services, and perhaps also in financial assets ●Closed Economy: one that does not trade with other nations in either goods or assets ●Open Economy: one that trades with other nations in goods and services, and perhaps also in financial assets ●Closed Economy: one that does not trade with other nations in either goods or assets Aggregate Supply in an Open Economy

12. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Aggregate Supply in an Open Economy ●A currency depreciation  ♦  price of foreign goods ♦AS shifts inward ●A currency appreciation has the opposite effects. ●A currency depreciation  ♦  price of foreign goods ♦AS shifts inward ●A currency appreciation has the opposite effects.

13. FIGURE 3: The Effects of Exchange Rate Changes on AS Copyright © 2006 South-Western/Thomson Learning. All rights reserved. (depreciation) S 0 S 0 (appreciation) D D S 1 S 1 S 2 S 2 E 2 E 0 E 1 Price Level Real GDP

14. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●Currency depreciation  ♦  AD and  AS ♦Net result is inflation ♦Probably also expansionary ■Impact on AD dominates impact on AS ●A currency appreciation has the opposite effects. ●Currency depreciation  ♦  AD and  AS ♦Net result is inflation ♦Probably also expansionary ■Impact on AD dominates impact on AS ●A currency appreciation has the opposite effects. The Macroeconomic Effects of Exchange Rates

15. FIGURE 4: The Effects of a Currency Depreciation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 E Price Level Real GDP S 1 S 1 D 1 D 1 A

16. FIGURE 5: The Effects of a Currency Appreciation Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 S 2 S 2 D 2 D 2 B D 0 D 0 E Price Level Real GDP

17. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. The Macroeconomic Effects of Exchange Rates ●Interest Rates and International Capital Flows ♦  interest rates  ■Attracts foreign capital flows ■Appreciates the currency ■  net exports ■  GDP ♦  interest rates has the opposite effects ●Interest Rates and International Capital Flows ♦  interest rates  ■Attracts foreign capital flows ■Appreciates the currency ■  net exports ■  GDP ♦  interest rates has the opposite effects

18. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Fiscal Policy Revisited ♦Expansionary fiscal policy  ■  interest rates ■Attracts foreign capital ■Appreciates the currency ■  net exports ●Fiscal Policy Revisited ♦Expansionary fiscal policy  ■  interest rates ■Attracts foreign capital ■Appreciates the currency ■  net exports

19. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Fiscal Policy Revisited ♦Part of the expansionary effect of fiscal policy is “crowded out.” ♦Thus, international capital flows reduce the power of fiscal policy. ●Fiscal Policy Revisited ♦Part of the expansionary effect of fiscal policy is “crowded out.” ♦Thus, international capital flows reduce the power of fiscal policy.

20. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Fiscal Policy Revisited ♦The evidence indicates that the crowding-out effect of fiscal policy is greater on net exports than on investment. ●Fiscal Policy Revisited ♦The evidence indicates that the crowding-out effect of fiscal policy is greater on net exports than on investment.

21. FIGURE 6: A Fiscal Expansion in an Open Economy Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP A D 1 D 1 S 2 S 2 D 2 D 2 C B

22. TABLE 2: Percentage Shares of Real GDP in the U.S Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

23. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ●Monetary Policy Revisited ♦Expansionary monetary policy  ■  interest rates ■Outflow of capital ■Currency depreciation ■  net exports ♦Thus, international capital flows   power of monetary policy ●Monetary Policy Revisited ♦Expansionary monetary policy  ■  interest rates ■Outflow of capital ■Currency depreciation ■  net exports ♦Thus, international capital flows   power of monetary policy

24. FIGURE 7: A Monetary Contraction in an Open Economy Copyright © 2006 South-Western/Thomson Learning. All rights reserved. S 0 S 0 D 0 D 0 Price Level Real GDP S 2 S 2 D 1 D 1 D 2 D 2 C A B

25. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. ●According to theory, success in reducing the federal deficit through a policy mix of fiscal contraction and monetary expansion should: ♦  real interest rates ♦  exchange rate of the dollar ♦  net exports ♦Have an uncertain effect on real GDP and inflation ●According to theory, success in reducing the federal deficit through a policy mix of fiscal contraction and monetary expansion should: ♦  real interest rates ♦  exchange rate of the dollar ♦  net exports ♦Have an uncertain effect on real GDP and inflation International Aspects of Deficit Reduction

26. TABLE 3: Expected Effects of Policy Copyright © 2006 South-Western/Thomson Learning. All rights reserved.

27. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ●What actually happened? ♦Interest rates did fall, just as predicted. ♦The U.S. economy expanded rapidly between 1992 and 1998. ■The monetary stimulus overwhelmed the fiscal contraction. ●What actually happened? ♦Interest rates did fall, just as predicted. ♦The U.S. economy expanded rapidly between 1992 and 1998. ■The monetary stimulus overwhelmed the fiscal contraction.

28. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ♦Inflation fell despite such rapid growth. ♦The dollar generally declined from 1993 to 1995, as the theory predicted. ♦But then it turned around and rose sharply from 1995 to 1998, just when the budget deficit was turning into a surplus. ♦Inflation fell despite such rapid growth. ♦The dollar generally declined from 1993 to 1995, as the theory predicted. ♦But then it turned around and rose sharply from 1995 to 1998, just when the budget deficit was turning into a surplus.

29. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ♦America’s real net exports sagged from -$30 billion in 1992 to -$238 billion in 1998. ♦The effect on the value of the dollar and net exports did not match the theoretical predictions. ♦America’s real net exports sagged from -$30 billion in 1992 to -$238 billion in 1998. ♦The effect on the value of the dollar and net exports did not match the theoretical predictions.

30. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦(X - IM) = (S - I) - (G - T) ♦Apply this accounting relationship to actual U.S. events in the 1990s: ■  (G - T) ■  S and  I   (S - I) ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦(X - IM) = (S - I) - (G - T) ♦Apply this accounting relationship to actual U.S. events in the 1990s: ■  (G - T) ■  S and  I   (S - I)

31. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦Taken by itself:  budget deficit   trade deficit ■But effect offset by  private economic behavior ●  S ●  I ♦Trade deficit depends on private sector behavior as well as public sector behavior. ●The Loose Link Between The Budget Deficit and the Trade Deficit ♦Taken by itself:  budget deficit   trade deficit ■But effect offset by  private economic behavior ●  S ●  I ♦Trade deficit depends on private sector behavior as well as public sector behavior.

32. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ●Pessimists: trade deficit increases long-term indebtedness to foreigners ●Optimists: trade deficit indicates the attractiveness of the U.S. economy to foreign investors ●Pessimists: trade deficit increases long-term indebtedness to foreigners ●Optimists: trade deficit indicates the attractiveness of the U.S. economy to foreign investors

33. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ●Each view holds elements of truth. ●But there is a critical question: How long can a trade deficit continue? ●Each view holds elements of truth. ●But there is a critical question: How long can a trade deficit continue?

34. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ●At some point, foreign investors may conclude that they have acquired about all the American assets they want. ●If and when that happens, the U.S. trade deficit must be eliminated. ●The only question is how? ●At some point, foreign investors may conclude that they have acquired about all the American assets they want. ●If and when that happens, the U.S. trade deficit must be eliminated. ●The only question is how?

35. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. On Curing the Trade Deficit ●Four basic ways to cure the trade deficit: ♦Tighter fiscal and looser monetary policy ♦  economic growth abroad ♦  savings (good) and/or  investment (bad) ♦Protectionism ■Would be bad for the U.S. and world economies ■Might very well fail to cure the problem ●Four basic ways to cure the trade deficit: ♦Tighter fiscal and looser monetary policy ♦  economic growth abroad ♦  savings (good) and/or  investment (bad) ♦Protectionism ■Would be bad for the U.S. and world economies ■Might very well fail to cure the problem

36. Copyright© 2006 Southwestern/Thomson Learning All rights reserved. Conclusion: No Nation is an Island ●The fates of nations are intertwined. ●The major trading countries are linked by exports and imports, capital flows, and exchange rates. ●Mutual success may well require mutual coordination. ●The fates of nations are intertwined. ●The major trading countries are linked by exports and imports, capital flows, and exchange rates. ●Mutual success may well require mutual coordination.