Open Economy Macroeconomics: The Balance of Payments and Exchange Rates

CHAPTER 31
Open Economy
Macroeconomics: The
Balance of Payments and
Exchange Rates
Prepared by: Fernando

Quijano and Yvonn Quijano
2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair
Exchange Rates
When people in different countries buy

from and sell to each other, an exchange
of currencies must also take place.
The exchange rate is the price of one
countrys currency in terms of another
countrys currency; the ratio at which two
currencies are traded for each other.
Exchange Rates
Within a certain range of exchange rates,

trade flows in both directions, each
country specializes in producing the goods
in which it enjoys a comparative
advantage, and trade is mutually
beneficial.
International exchange must be managed
in a way that allows each partner in the
transaction to wind up with his or her own
currency.
Exchange Rates
Early in the century, nearly all currencies

were backed by gold. Their values were
fixed in terms of a specific number of
ounces of gold, which determined their
values in international tradingexchange
rates.
Exchange Rates
At the end of World War II, representatives

of 44 countries met in Bretton Woods, New
Hampshire. One of their agreements
established a system of essentially fixed
exchange rates.
Each country agreed to intervene by
buying and selling currencies in the foreign
exchange market when necessary to
maintain the agreed-upon value of its
currency.
Exchange Rates
In 1971, most countries, including the United

States, gave up trying to fix exchange rates
formally and began allowing them to be
determined essentially by supply and demand.
Just as with any other commodity, an
excess of quantity supplied over quantity
demanded will cause the pricein this case
the exchange rateto fall.
The Balance of Payments
The balance of payments is the record of

a countrys transactions in goods,
services, and assets with the rest of the
world; also the record of a countrys
sources (supply) and uses (demand) of
foreign exchange.
Foreign exchange is simply all currencies
other than the domestic currency of a
given country.
United States Balance of Payments, 1999
CURRENT ACCOUNT
Goods exports 683.0
Goods imports 1,030.2
(1) Net export of goods 347.2
Export of services 277.1
Import of services 197.5
(2) Net export of services 79.6
Income received on investments 273.9
Income payments on investments 298.6
(3) Net investment income 24.7
(4) Net transfer payments 46.6
(5) Balance on current account (1 + 2 + 3 + 4) 338.9
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is ) 381.0
(7) Change in foreign private assets in the United States 706.2
(8) Change in U.S. government assets abroad (increase is ) 8.3
(9) Change in foreign government assets in the United States 44.5
(10) Balance on capital account (6 + 7 + 8 + 9) 378.0
(11) Statistical discrepancy 39.1
(12) Balance of payments (5 + 10 + 11) 0
A countrys current account is the sum of

its:
net exports (exports minus imports),
net income received from investments abroad,
and
net transfer payments from abroad.
Exports earn foreign exchange and are a
credit (+) item on the current account.
Imports use up foreign exchange and are
a debit () item.
The balance of trade is the difference

between a countrys exports of goods and
services and its imports of goods and
services.
A trade deficit occurs when a countrys
exports are less than its imports.
Investment income consists of holdings of

foreign assets that yield dividends,
interest, rent, and profits paid to U.S.
asset holders (a source of foreign
exchange).
Net transfer payments are the difference
between payments from the United States
to foreigners and payments from
foreigners to the United States.
The balance on current account

consists of net exports of goods, plus net
exports of services, plus net investment
income, plus net transfer payments. It
shows how much a nation has spent
relative to how much it has earned.
For each transaction recorded in the
current account, there is an offsetting
transaction recorded in the capital
account.
The capital account records the changes in

assets and liabilities.
The balance on capital account in the
United States is the sum of the following
(measured in a given period):
the change in private U.S. assets abroad
the change in foreign private assets in the United
States
the change in U.S. government assets abroad, and
the change in foreign government assets in the
United States
In the absence of errors, the balance on

capital account would equal the negative of
the balance on current account.
If the capital account is positive, the change in
foreign assets in the country is greater than
the change in the countrys assets abroad,
which is a decrease in the net wealth of the
country.
The United States as a Debtor Nation
A countrys net wealth is the sum of all its

past current account balances.
Prior to the mid-1970s, the United States
was a creditor nation. After the mid-
1970s, the United Sates began to have a
negative net wealth position vis--vis the
rest of the world. This means that the
United States spent much more on foreign
goods and services than it earned through
the sales of its goods and services.
Equilibrium Output (Income)
in an Open Economy
Planned aggregate expenditure in an
open economy equals:
A E C I G E X IM
C a bY In equilibrium:
Y C I G EX IM
I I0
Y a bY I G EX m Y
G G 0 Y bY m Y a I G EX
Y (1 b m ) a I G E X
EX EX 0
1
IM m Y Y*
1 b m
(a I G E X )
m = marginal propensity
multiplier autonomous expenditures
to import (MPM)
Equilibrium Output (Income)
in an Open Economy
a= 50 mulltiplier = 2.00
1200
b= 0.8 m= 0.25
Planned aggregate expenditure, AE

I= 100 Aut.= 300
1000
G= 100 Y* = 600
X= 50
Open 800
Closed Net
Imports Economy
Y C Economy Exports X
mY
Exports
C+I+G
C+I+G (X-M)
+ (X-M)
600
0 50 250 50 0 50 300
200 200 400 50 50 0 400 400
400 350 550 50 100 -50 500
600 500 700 50 150 -100 600 200
800 650 850 50 200 -150 700
1000 800 1000 50 250 -200 800 0
1200 950 1150 50 300 -250 900 0 200 400 600 800 1000 1200
Aggregate output (income), (Y)
In an open economy, part of the income is spent

on imports, causing domestic income to decline.
Imports and Exports and the Trade
Feedback Effect
The determinants of imports are the same
factors that affect consumption and
investment behavior.
Spending on imports also depends on the
relative prices of domestically produced
and foreign-produced goods.
The demand for U.S. exports depends on
economic activity in the rest of the world.
If foreign output increases, U.S. exports
tend to increase.
Imports and Exports and the Trade
Feedback Effect
Because U.S. imports are somebody
elses exports, the extra import demand
from the United States raises the exports
of the rest of the world.
The trade feedback effect is 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.
Import and Export Prices
and the Price Feedback Effect
When the export prices of one country
rise, with no change in the exchange rate,
the import prices of another rise.
If the inflation rate abroad is high, U.S.
import prices are likely to rise.
The price feedback effect is the process
by which a domestic price increase in one
country can feed back on itself through
export and import prices.
Inflation is exportable.
The Open Economy with
Flexible Exchange Rates
Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated forces of
supply and demand.
Exchange rate movements have important
impacts on imports, exports, and
movement of capital between countries.
The Market for Foreign Exchange
Assume that there are only two countries:

the United States and Britain.
The demand for pounds is comprised of
holders of dollars wishing to acquire pounds.
The supply of pounds is comprised of
holders of pounds seeking to exchange
them for dollars.
People exchange currency in order to buy
goods and services, buy stocks or bonds,
and for speculative reasons.
Some Private Buyers and Sellers in International
Exchange Markets: United States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1. Firms, households, or governments that import British goods into the United States
or wish to buy British-made goods and services
2. U.S. citizens traveling in Great Britain
3. Holders of dollars who want to buy British stocks, bonds, or other financial
instruments
4. U.S. companies that want to invest in Great Britain
5. Speculators who anticipate a decline in the value of the dollar relative to the pound
THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)

1. Firms, households, or governments that import U.S. goods into Great Britain or
wish to buy U.S.-made goods and services
2. British citizens traveling in the United States
3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in
the United States
4. British companies that want to invest in the United States
5. Speculators who anticipate a rise in the value of the dollar relative to the pound
The demand for pounds in

the foreign exchange
market shows a negative
relationship between the
price of pounds (dollars per
pound) ($/) and the
quantity of pounds
demanded.
When the price of pounds falls, British-made goods and
services appear less expensive to U.S. buyers. If British
prices are constant, U.S. buyers will buy more British
goods and services, and the quantity demanded of
pounds will rise.
The supply of pounds in the

foreign exchange market
shows a positive
relationship between the
price of pounds (dollars per
pound) ($/) and the
quantity of pounds
supplied.
When the price of pounds rises, the British can obtain
more dollars for each pound. This means that U.S.-made
goods and services appear less expensive to British
buyers. Thus, the quantity of pounds supplied is likely to
rise with the exchange rate.
The equilibrium exchange

rate occurs at the point at
which the quantity
demanded of a foreign
currency equals the
quantity of that currency
supplied.
An excess supply of pounds will cause the price of

pounds to fallthe pound will depreciate with respect to
the dollar. An excess demand for pounds will cause the
price of pounds to risethe pound will appreciate with
respect to the dollar.
Factors that Affect Exchange Rates
The 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.
If the low of one price held for all goods, and
if each country consumed the same market
basket of goods, the exchange rate between
the two currencies would be determined
simply by the relative price levels in the two
countries.
The theory that exchange rates are set so

that the price of similar goods in different
countries is the same is known as the
purchasing-power parity.
If it takes ten times as many pesos to buy a
pound of salt in Mexico as it takes U.S.
dollars to buy a pound of salt in the United
States, then the equilibrium exchange rate
should be 10 pesos per dollar.
A high rate of inflation in one country relative to

another puts pressure on the exchange rate
between the two countries, and there is a general
tendency for the currencies of relative high-
inflation countries to depreciate.
A higher price level in the
United States increases
the demand for pounds
and decreases the supply
of pounds. The result is
appreciation of the pound
against the dollar.
The level of a countrys 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 may be attracted to U.S. securities.
A higher interest rate in
the United States
increases the supply of
pounds and decreases the
demand for pounds. The
result is depreciation of
the pound against the
dollar.
The Effects of Exchange Rates
on the Economy
When a countrys currency depreciates
(falls in value), its import prices rise and
its export prices (in foreign currencies) fall.
When the U.S. dollar is cheap, U.S.
products are more competitive in world
markets, and foreign-made goods look
expensive to U.S. citizens.
The Effects of Exchange Rates
on the Economy
A depreciation of a countrys currency can
serve as a stimulus to the economy.
Foreign buyers are likely to increase their
spending on U.S. goods
Buyers substitute U.S.-made goods for
imports
Aggregate expenditure on domestic output will
rise
Inventories will fall
GDP (Y) will increase.
Exchange Rates and the Balance of
Trade: The J Curve
According to the J curve, the balance of trade
gets worse before it gets better following a
currency depreciation.
Initially, the negative effect
on the price of imports may
dominate the positive effects
of an increase in exports
and a decrease in imports.
But when imports and exports
have had a time to respond to
price changes, the balance of
trade improves.
Exchange Rates and Prices
Depreciation of a countrys currency tends

to increase the price level.
Since the currency is less expensive, export
demand rises.
Domestic buyers substitute domestic products
for the now more expensive imports.
If the economy is operating close to capacity,
the increase in aggregate demand is likely to
result in higher prices.
If import prices rise, costs may rise for business
firms, shifting the AS curve to the left.
Monetary Policy with
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. If the purpose of the
Fed is to fight inflation, dollar appreciation resulting
from tight monetary policy also helps in that fight.
Fiscal Policy with
Flexible interest rates may not help in the
attempt by government to cut taxes in order
to stimulate the economy.
A tax cut results in increased household
spending, but some of that spending leaks out as
imports, reducing the multiplier.
As income increases, the demand for money
increases. The resulting higher interest rates
cause the dollar to appreciate. Exports fall,
imports rise, again reducing the multiplier.
If interest rates rise, private investment may be
crowed out, also lowering the multiplier.

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CHAPTER 31

Prepared by: Fernando

When people in different countries buy

Within a certain range of exchange rates,

Early in the century, nearly all currencies

At the end of World War II, representatives

In 1971, most countries, including the United

The balance of payments is the record of

A countrys current account is the sum of

The balance of trade is the difference

Investment income consists of holdings of

The balance on current account

The capital account records the changes in

In the absence of errors, the balance on

A countrys net wealth is the sum of all its

Planned aggregate expenditure, AE

In an open economy, part of the income is spent

Assume that there are only two countries:

THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)

The demand for pounds in

The supply of pounds in the

The equilibrium exchange

An excess supply of pounds will cause the price of

The Law of One Price If the costs of

The theory that exchange rates are set so

A high rate of inflation in one country relative to

The level of a countrys interest rate relative to

Depreciation of a countrys currency tends

If the purpose of the Fed is to stimulate the economy,

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