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Open Macroeconomics

20. Open Macroeconomics. CHAPTER. Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates. 21. Chapter Outline.

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Open Macroeconomics

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  1. 20 Open Macroeconomics CHAPTER

  2. Open-EconomyMacroeconomics:The Balance of Paymentsand Exchange Rates 21 Chapter Outline The Balance of PaymentsThe Current AccountThe Capital AccountThe United States as a Debtor NationEquilibrium Output (Income) in an Open EconomyThe International Sector and Planned Aggregate ExpenditureImports and Exports and the Trade Feedback EffectImport and Export Prices and the Price Feedback EffectThe Open Economy with Flexible Exchange RatesThe Market for Foreign ExchangeFactors That Affect Exchange RatesThe Effects of Exchange Rates on the EconomyAn Interdependent World EconomyAppendix: World Monetary Systems Since 1900

  3. 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

  4. 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 1.534790.8090611.269390.6546 1 0.6516 1.23600 0.7878 1.5276 Friday, November 28, 2008

  5. 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.

  6. Data on the SE Asian crisis

  7. Balance of Payment Accounts • Balance of paymentsare the accounts in which a nation records its international trading, borrowing, and lending. • It is divided into three main accounts: • Current accountrecords exports minus imports, plus the netinterest and net transfersreceived from and paid to othercountries. Capital accountrecords foreign investment in the United States minus U.S. investment abroad. Official settlements accountrecords the change in U.S. official reserves. U.S. official reserves are government’s holdings of foreign currency.

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

  9. THE BALANCE OF PAYMENTS TABLE 21.1 United States Balance of Payments, 2007 CURRENT ACCOUNT Goods exports 1,149.2 Goods imports – 1,964.6 (1) Net export of goods – 815.4 Export of services 479.2 Import of services – 372.3 (2) Net export of services 106.9 Income received on investments 782.2 Income payments on investments – 707.9 (3) Net investment income 74.3 (4) Net transfer payments – 104.4 (5) Balance on current account (1 + 2 + 3 + 4) – 738.6 CAPITAL ACCOUNT (6) Change in private U.S. assets abroad (increase is –) – 1,183.3 (7) Change in foreign private assets in the United States 1,451.0 (8) Change in U.S. government assets abroad (increase is –) - 23.0 (9) Change in foreign government assets in the United States 412.7 (10) Balance on capital account (6 + 7 + 8 + 9) 657.4 (11) Net capital account transactions – 2.2 (11) Statistical discrepancy 83.6 (12) Balance of payments (5 + 10 + 11) 0

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

  11. Y = C + I + G + NX net exports domestic spending output The national income identity in an open economy or, NX= Y– (C+ I + G) • Spending need not equal output • Saving need not equal investment

  12. 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

  13. 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.

  14. Borrowers and Lenders, Debtors and Creditors • Net borroweris a country that is borrowing more from the rest of the world than it is lending to the rest of the world. • Net lenderis 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 ).

  15. Borrowers and Lenders, Debtors and Creditors • Debtor nationis 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 nationis a country that has invested more in the rest of the world than other countries have invested in it.

  16. 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.

  17. The State of the Economy (BEA) • % change % change • Year in NGDP in RGDP • 2007q3 6.3 4.8 • 2007q4 2.3 -0.2 • 2008q1 3.5 0.9 • 2008q2 4.1 2.8 • 2008q3 3.4 -0.5 • 2008q4 -5.8 -6.3 • 2009q1 -3.5 -6.1

  18. Current Account Balance 2006

  19. 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

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

  21. open-economy multiplier EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY The 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.

  22. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY FIGURE 21.1 Determining Equilibrium Output in an Open Economy

  23. 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.

  24. 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.

  25. 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.

  26. THE EXCHANGE RATE • Foreign exchange marketis 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.

  27. THE EXCHANGE RATE • Foreign exchange rateis the price at which one currency exchanges for another. • For example, in December 5th of 2008, one U.S. dollar bought 13.80 Mexican Pesos. The exchange rate was 13.80 Peso per U.S. dollar. • This exchange rate can be expressed in terms of dollars per Peso. The exchange rate was 0.0724 per Peso.

  28. THE EXCHANGE RATE • Currency appreciationis 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 depreciationis 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.

  29. 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

  30. THE EXCHANGE RATE • Interest Rates in the United States and Other Countries • U.S. interest rate differentialis 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.

  31. 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.

  32. 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.

  33. 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.

  34. 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.

  35. 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.

  36. THE EXCHANGE RATE • Exchange Rate Expectations • Why do exchange rate expectations change? • There are two forces: • Purchasing power parity • Interest rate parity • Purchasing power paritymeans equal value of money—a situation in which money buys the same amount of goods and services in different currencies.

  37. 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.

  38. 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.

  39. 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.

  40. ε ~ 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.

  41. 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.

  42. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES FIGURE 21.5 Exchange Rates Respond to Changes in Relative Prices (the case of higher price level in the U.S.) FIGURE 21.6 Exchange Rates Respond to Changes in Relative Interest Rates (U.S interest rates rise relative to British)

  43. THE EXCHANGE RATE • Exchange Rate Expectations • Why do exchange rate expectations change? • There are two forces: • Purchasing power parity • Interest rate parity • Purchasing power paritymeans equal value of money—a situation in which money buys the same amount of goods and services in different currencies.

  44. Interest Rate Parity • Interest rate paritymeans 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

  45. 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.

  46. THE FIXED EXCHANGE RATE Figure shows foreign market intervention. Suppose that the Fed’s target exchange rate is 100 yen per dollar. 1. If demand increases from D0 to D1, the Fed sells U.S. dollars to increase the supply of dollars.

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