Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates

CHAPTER 21
Open-Economy
Macroeconomics: The
Balance of Payments and
Exchange Rates
Appendix: World Monetary Systems Since 1900
Prepared by: Fernando Quijano

and Yvonn Quijano
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair
Open-Economy Macroeconomics: The Balance of Payments
Exchange Rates
• The main difference between an

international transaction and a
domestic transaction concerns
and Exchange Rates
currency exchange.
• International exchange must be

managed in a way that allows each
partner in the transaction to wind up
C H A P T E R 21:
with his or her own currency.
© 2004 Prentice Hall Business Publishing Principles of Economics, 7/e Karl Case, Ray Fair 2 of 53
Exchange Rates
• The exchange rate is the price of

one country’s currency in terms of
another country’s currency; the ratio
and Exchange Rates
at which two currencies are traded

for each other.
C H A P T E R 21:
The Balance of Payments
• Foreign exchange is simply all

currencies other than the domestic
currency of a given country.
and Exchange Rates
C H A P T E R 21:
The Balance of Payments
• The balance of payments is the

record of a country’s transactions in
goods, services, and assets with the
and Exchange Rates
rest of the world; also the record of a

country’s sources (supply) and uses
(demand) of foreign exchange.
C H A P T E R 21:
The Current Account

United States Balance of Payments, 2002
CURRENT ACCOUNT
Goods exports 682.6
Goods imports – 1,166.9
(1) Net export of goods – 484.3
Export of services 289.3
Import of services – 240.5
and Exchange Rates
(2) Net export of services 48.8

Income received on investments 244.6
Income payments on investments – 256.5
(3) Net investment income – 11.9
(4) Net transfer payments – 56.0
(5) Balance on current account (1 + 2 + 3 + 4) – 503.4
CAPITAL ACCOUNT
C H A P T E R 21:
(6) Change in private U.S. assets abroad (increase is –) – 152.9

(7) Change in foreign private assets in the United States 533.7
(8) Change in U.S. government assets abroad (increase is –) – 3.3
(9) Change in foreign government assets in the United States 46.6
(10) Balance on capital account (6 + 7 + 8 + 9) 474.1
(11) Statistical discrepancy 29.3
(12) Balance of payments (5 + 10 + 11) 0
The Current Account
• A country’s current account is the

sum of its:
• net exports (exports minus imports),
and Exchange Rates
• net income received from investments

abroad, and
• net transfer payments from abroad.
C H A P T E R 21:
The Current Account
• Exports earn foreign exchange and

are a credit (+) item on the current
account. Imports use up foreign
and Exchange Rates
exchange and are a debit (–) item.

C H A P T E R 21:
The Current Account
• The balance of trade is the

difference between a country’s
exports of goods and services and
its imports of goods and services.
and Exchange Rates
• A trade deficit occurs when a

country’s exports are less than its
imports.
C H A P T E R 21:
• Net exports of goods and services

(EX – IM), is the difference between
a country’s total exports and total
imports.
The Current Account
• Investment income consists of

holdings of foreign assets that yield
dividends, interest, rent, and profits
and Exchange Rates
paid to U.S. asset holders (a source

of foreign exchange).
C H A P T E R 21:
The Current Account
• Net transfer payments are the

difference between payments from
the United States to foreigners and
and Exchange Rates
payments from foreigners to the

United States.
C H A P T E R 21:
The Current Account
• The balance on current account

consists of net exports of goods, plus
net exports of services, plus net
and Exchange Rates
investment income, plus net transfer

payments. It shows how much a
nation has spent relative to how
much it has earned.
C H A P T E R 21:
The Capital Account
• For each transaction recorded in the

current account, there is an offsetting
transaction recorded in the capital
account.
and Exchange Rates
• The capital account records the

changes in assets and liabilities.
C H A P T E R 21:
The Capital Account
• The balance on capital account in the

United States is the sum of the following
(measured in a given period):
and Exchange Rates
• 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
C H A P T E R 21:
• the change in foreign government assets in the

United States
The Capital Account
• In the absence of errors, the balance on

capital account would equal the negative
of the balance on current account.
and Exchange Rates
• If the capital account is positive, the

change in foreign assets in the country is
greater than the change in the country’s
assets abroad, which is a decrease in the
C H A P T E R 21:
net wealth of the country.
The United States as a Debtor Nation
• A country’s net wealth is the sum of

all its past current account balances.
• Prior to the mid-1970s, the United

and Exchange Rates
States was a creditor nation. After

the mid-1970s, the United Sates
began to have a negative net wealth
position vis-à-vis the rest of the
C H A P T E R 21:
world.
The United States as a Debtor Nation
• A negative net wealth position vis-à-

vis the rest of the world reflects the
fact that the United States spent
and Exchange Rates
much more on foreign goods and

services than it earned through the
sales of its goods and services.
C H A P T E R 21:
Equilibrium Output (Income)
in an Open Economy
Planned aggregate expenditure (AE) in an open economy:
A E  C  I  G  E X  IM
C  a  bY • In equilibrium:
and Exchange Rates
I  I0 Y  C  I  G  EX  IM
Y  a  bY  I  G  EX  m Y
G  G 0 Y  bY  m Y  a  I  G  EX
EX  EX Y (1  b  m )  a  I  G  E X
C H A P T E R 21:
0
1
IM  m Y Y*  (a  I  G  E X )
1 b  m
m = marginal propensity multiplier autonomous expenditures
to import (or MPM)
Equilibrium Output (Income)
in an Open Economy
and Exchange Rates
C H A P T E R 21:
• Exports contribute to an • Imports affect the value of the

increase in autonomous multiplier. After imports are
expenditures and cause the included, the aggregate
planned aggregate expenditure expenditure function rotates and
function to shift upward. equilibrium income decreases.
Imports and Exports and
the Trade Feedback Effect
• The determinants of imports are the

same as the factors that affect
consumption and investment
and Exchange Rates
behavior.
• Spending on imports also depends

on the relative prices of domestically
produced and foreign-produced
C H A P T E R 21:
goods.
• The demand for U.S. exports

depends on economic activity in the
rest of the world. If foreign output
and Exchange Rates
increases, U.S. exports tend to

increase.
• Because U.S. imports are somebody

else’s exports, the extra import
C H A P T E R 21:
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
and Exchange Rates
lead to a worldwide increase in

economic activity, which then feeds
back to that country.
C H A P T E R 21:
Imports and Export Prices
and the Trade Feedback Effect
• When the export prices of one

country rise, with no change in the
exchange rate, the import prices of
and Exchange Rates
another rise.
• If the inflation rate abroad is high,

U.S. import prices are likely to rise.
C H A P T E R 21:
Imports and Export Prices
and the Trade Feedback Effect
• The price feedback effect is the

process by which a domestic price
increase in one country can “feed
and Exchange Rates
back” on itself through export and

import prices.
• Inflation is “exportable.”
C H A P T E R 21:
The Open Economy with
Flexible Exchange Rates
• Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated
and Exchange Rates
forces of supply and demand.
• Exchange rate movements have

important impacts on imports,
exports, and movement of capital
C H A P T E R 21:
between countries.
The Market for Foreign Exchange
• In a world where there are only two

countries, the United States and
Britain, the demand for pounds is
and Exchange Rates
comprised of holders of dollars

wishing to acquire pounds. The
supply of pounds is comprised of
holders of pounds seeking to
C H A P T E R 21:
exchange them for dollars.
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
and Exchange Rates
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

C H A P T E R 21:
5. Speculators who anticipate a decline in the value of the dollar relative to the pound
Some Private Buyers and Sellers in International

Exchange Markets: United States and Great Britain
THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)
1. Firms, households, or governments that import U.S. goods into Great Britain or
and Exchange Rates
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

C H A P T E R 21:
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
and Exchange Rates
(dollars per pound) ($/£) and

the quantity of pounds
demanded.
C H A P T E R 21:
• 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
and Exchange Rates
price of pounds (dollars per

pound) ($/£) and the
quantity of pounds
supplied.
C H A P T E R 21:
• 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
• The equilibrium exchange

rate occurs at the point at
which the quantity
demanded of a foreign
and Exchange Rates
currency equals the

quantity of that currency
supplied.
C H A P T E R 21:
The Equilibrium Exchange Rate
• An excess supply of pounds will

cause the price of pounds to fall—
the pound will depreciate (fall in
and Exchange Rates
value) with respect to the dollar.

• An excess demand for pounds will
cause the price of pounds to rise—
the pound will appreciate (rise in
C H A P T E R 21:
value) with respect to the dollar.
Factors that Affect Exchange Rates
• Purchasing Power Parity: The

Law of One Price If the costs of
transportation are small, the price of
and Exchange Rates
the same good in different countries

should be roughly the same.
• If the law of one price held for all goods,
and if each country consumed the same
C H A P T E R 21:
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
and Exchange Rates
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
C H A P T E R 21:
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
and Exchange Rates
countries, and there is a general

tendency for the currencies of
relative high-inflation countries to
depreciate.
C H A P T E R 21:
• A higher price level in

the United States
increases the demand
and Exchange Rates
for pounds and

decreases the supply
of pounds. The result
is appreciation of the
C H A P T E R 21:
pound against the

dollar.
• The level of a country’s interest rate

relative to interest rates in other
countries is another determinant of
and Exchange Rates
the exchange rate. If U.S. interest

rates rise relative to British interest
rates, British citizens may be
attracted to U.S. securities.
C H A P T E R 21:
• A higher interest rate in

the United States
increases the supply
and Exchange Rates
and decreases the

demand for pounds.
The result is
depreciation of the
C H A P T E R 21:
pound against the

dollar.
The Effects of Exchange
Rates on the Economy
• When a country’s currency

depreciates (falls in value), its import
prices rise and its export prices (in
and Exchange Rates
foreign currencies) fall.
• When the U.S. dollar is cheap, U.S.

products are more competitive in
world markets, and foreign-made
C H A P T E R 21:
goods look expensive to U.S.

citizens.
The Effects of Exchange
Rates on the Economy
• A depreciation of a country’s
currency can serve as a stimulus to
the economy:
and Exchange Rates
• Foreign buyers are likely to increase

their spending on U.S. goods
• Buyers substitute U.S.-made goods for
imports
C H A P T E R 21:
• Aggregate expenditure on domestic

output will rise
• Inventories will fall
• GDP (Y) will increase
Exchange Rates and the
Balance of Trade: The J Curve
• The balance of trade is equal to

export revenue minus import costs:
balance of trade = dollar price of exports x
and Exchange Rates
quantity of exports
 dollar price of imports x quantity of imports
• According to the J-curve effect, the
balance of trade gets worse before it
C H A P T E R 21:
gets better following a currency

depreciation.
Exchange Rates and the
Balance of Trade: The J Curve
• Initially, the negative effect

on the price of imports may
dominate the positive effects
of an increase in exports
and Exchange Rates
and a decrease in imports.

• But when imports and
exports have had a time to
respond to price changes,
C H A P T E R 21:
the balance of trade

improves.
Exchange Rates and Prices
• Depreciation of a country’s currency tends

to increase the price level.
• Export demand rises.
and Exchange Rates
• 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.
C H A P T E R 21:
• 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
and Exchange Rates
supply of dollars, causing the dollar

to depreciate.
• If the purpose of the Fed is to
stimulate the economy, dollar
C H A P T E R 21:
depreciation is a good thing. It

increases U.S. exports and
decreases imports.
Fiscal Policy with
• Flexible interest rates may not help

in the attempt by government to cut
taxes in order to stimulate the
and Exchange Rates
economy.
• A tax cut results in increased
household spending, but some of
that spending leaks out as imports,
C H A P T E R 21:
reducing the multiplier.
Fiscal Policy with
• As income increases, the demand

for money increases. The resulting
higher interest rates cause the dollar
and Exchange Rates
to appreciate. Exports fall, imports

rise, again reducing the multiplier.
• If interest rates rise, private
investment may be crowed out, also
C H A P T E R 21:
lowering the multiplier.
Monetary Policy with
Fixed Exchange Rates
• Monetary policy has no role in a

country that has a fixed exchange
rate.
and Exchange Rates
• For example, an attempt to lower

interest rates results in currency
depreciation and a lower (not a fixed)
exchange rate.
C H A P T E R 21:
• In the absence of capital controls,

the monetary authority loses its
independence.
Appendix: World Monetary
Systems Since 1900
THE GOLD STANDARD

• Early in the century, during the gold
standard era, nearly all currencies were
and Exchange Rates
backed by gold. Their values were

fixed in terms of a specific number of
ounces of gold, which determined their
values in international trading—
exchange rates.
C H A P T E R 21:
Systems Since 1900
“PURE” FIXED EXCHANGE RATES

• Under this type of system,
governments set a particular fixed rate
and Exchange Rates
at which their currencies will exchange

for each other.
• There is no automatic mechanism to
keep exchange rates aligned with each
C H A P T E R 21:
other, as with the gold standard.

Therefore, governments must at times
intervene to keep currencies aligned at
their established values.
Systems Since 1900
Government Intervention
in the Foreign Exchange
Market
and Exchange Rates
• If the government has

committed itself to
keeping the value of
the lira at .020, it must
C H A P T E R 21:
buy up the excess

supply of lira (Qs – Qd).
Systems Since 1900
• At the end of World War II, economists

from the United States and Europe met to
formulate a new set of rules for exchange
rate determination, known as the Bretton
and Exchange Rates
Woods system:
1. Countries were to maintain fixed exchange
rates with each other. All currencies were
fixed in terms of the U.S. dollar.
C H A P T E R 21:
2. Countries experiencing a persistent current

account deficit (or fundamental
disequilibrium) in their balance of payments
were allowed to change their exchange rates.
Systems Since 1900
• The alternative to a fixed exchange

rate system is a flexible system:
• In a freely floating system,
and Exchange Rates
governments do not intervene at

all in the foreign exchange
market.
C H A P T E R 21:
• In a managed floating system,

governments intervene if markets
are becoming disorderly.
Review Terms and Concepts
appreciation of a currency foreign exchange

balance of payments J-curve effect
balance of trade law of one price

marginal propensity to import
and Exchange Rates
balance on capital account

(MPM)
balance on current account net exports of goods and
depreciation of a currency services (EX – IM)
exchange rate price feedback effect
C H A P T E R 21:
floating, or market-determined, purchasing-power-parity theory

exchange rates trade deficit
trade feedback effect

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CHAPTER 21

Prepared by: Fernando Quijano

• The main difference between an

• International exchange must be

with his or her own currency.

• The exchange rate is the price of

at which two currencies are traded

The Balance of Payments

• Foreign exchange is simply all

The Balance of Payments

• The balance of payments is the

rest of the world; also the record of a

The Current Account

(2) Net export of services 48.8

(6) Change in private U.S. assets abroad (increase is –) – 152.9

The Current Account

• A country’s current account is the

• net income received from investments

The Current Account

• Exports earn foreign exchange and

exchange and are a debit (–) item.

The Current Account

• The balance of trade is the

• A trade deficit occurs when a

• Net exports of goods and services

The Current Account

• Investment income consists of

paid to U.S. asset holders (a source

The Current Account

• Net transfer payments are the

payments from foreigners to the

The Current Account

• The balance on current account

investment income, plus net transfer

The Capital Account

• For each transaction recorded in the

• The capital account records the

The Capital Account

• The balance on capital account in the

• the change in private U.S. assets abroad

• the change in foreign private assets in the

• the change in foreign government assets in the

The Capital Account

• In the absence of errors, the balance on

• If the capital account is positive, the

net wealth of the country.

The United States as a Debtor Nation

• A country’s net wealth is the sum of

• Prior to the mid-1970s, the United

States was a creditor nation. After

The United States as a Debtor Nation

• A negative net wealth position vis-à-

much more on foreign goods and

Planned aggregate expenditure (AE) in an open economy:

• Exports contribute to an • Imports affect the value of the

the Trade Feedback Effect

• The determinants of imports are the

• Spending on imports also depends

the Trade Feedback Effect

• The demand for U.S. exports

increases, U.S. exports tend to

• Because U.S. imports are somebody

demand from the United States