1. Balance of Accounts and Foreign Exchange Markets
Modules 41-44

2. The Rest of the World US is not a closed economy
2013 Trade in Goods & Services
Exports = $2.28 Trillion
Imports = $2.74 Trillion

3. Figure The Balance of Payments Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

4. The Rest of World
When foreigners buy our goods or invest in the US, they need to use U.S. dollars
We need to account for the dollars that are used to trade with the rest of the world
In theory, the total dollars out must equal total dollars in

5. The Rest of the World
Reconciling these flows is what is called the “Balance of Payments”
There are two component accounts
Current account
Capital account (aka Financial Account)

6. Current Account
Value of trade in goods and services that do not produce liabilities
Transactions are concluded with no future implications
Net Exports
Factor (investment) income
Transfers

7. Current Account Net Exports Factor Income Transfers Trade Balance
Surplus or deficit
Factor Income
Wages paid/earned overseas
Dividends; Interest
Transfers
Foreign aid
Remittances

8. Capital Account Value of net change in ownership of assets
Things that have implications beyond current year
Government sales and purchases of assets
Private sales and purchases of assets
Financial reserves (currency held)

9. Capital Account Government sales and purchases of assets
e.g., Central banks buy/sell US Treasury Bonds
Private sales and purchases of assets
e.g., Chinese citizens buy New York real estate
Financial reserves
Holdings of US dollars abroad

10. Balance of Payments
Because money out + money in must equal 0: Current Account + Capital Account = 0 Current Account = - Capital Account

11. Balance of Payments
Table The U.S. Balance of Payments in 2008 (billions of dollars) Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

12. Loanable Funds Market Real
Figure The Loanable Funds Model Revisited Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

13. Trade and the Loanable Funds Market
All things being equal, higher real interest rates will attract foreign investment
So countries with higher interest rates will increase supply of loanable funds from foreign investors
The source country for those funds will experience a decline in supply

14. Real
Real
Figure Loanable Funds Markets in Two Countries Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

15. Real
Real
Figure International Capital Flows Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

16. The Foreign Exchange Market
The market that results when currencies are sought by and offered up to those in other countries
The “price” of one currency in terms of another is the exchange rate.
Expressed as a ratio
e.g., euros per dollar (€/$)
Currently 0.86 €/$

17. Exchange rates At 0.86 €/$, each $1 would buy €0.86
To find the number of dollars per euro, just take the inverse:
1/.86 = $1.16 $/€
If the exchange rate increases, we can say that currency in the denominator appreciates, while the currency in the numerator depreciates.

18. Exchange Rates
Since the exchange rate is the price of a currency, it can be used to calculate the prices of goods in one country relative to the other.
Suppose 14 pesos/$
What would be the price in pesos of a $2000 computer?
14 pesos/$ x $2,000 = 28,000 pesos
What if it were 16 pesos/$?
16 pesos/$ x $2,000 = 32,000 pesos

19. Exchange Rates
In the previous example the dollar appreciated against the peso.
As a result the computer became more expensive for the peso-holder
If a country’s currency appreciates, its products become relatively more expensive

20. Bottom-Bottom Rule
Figure The Foreign Exchange Market Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

21. Changes in Curves
These changes will affect the supply of one currency and the demand for the other
Changes in the demand for a country’s goods and services
Changes in the desire to invest in a country
Expectations of speculators

22. Examples: $US v. ¥ Japanese
US consumers demand more Japanese cars
Demand for ¥ increases
Supply of $ increases
US real GDP increases
US interest rates increase relative to Japan
Demand for $ increases
Supply of ¥ increases

23. Figure 42. 2 An Increase in the Demand for U. S
Figure An Increase in the Demand for U.S. Dollars Ray and Anderson: Krugman’s Macroeconomics for AP, First Edition Copyright © 2011 by Worth Publishers

24. Real v. Nominal Exchange Rates
The real exchange rate takes into account the difference in price levels of the two countries
Real Exchange Rate =
Nominal Exchange Rate (A/B) x PB/PA
A= currency in country A
B= currency in country B
PA= price level in country A
PB= price level in country B

25. Real Exchange Rate
So, at 14 pesos per dollar, if the price level in the US was 100 and in Mexico was 125…
Real Exchange Rate =
14 pesos/$ x (100/125) =
14 x .8 =
11.2 pesos/$

26. Purchasing Power Parity
Related to real exchange rate
What nominal exchange rate would result in an identical basket of goods costing the same in each country?
So if something costs $100 in the US and 1,000 pesos in Mexico, the rate would be 10