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

Chapter
34
Open-Economy
Macroeconomics:
The Balance of Payments
and Exchange Rates
Prepared by:
Fernando & Yvonn Quijano
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair
Open-Economy
Macroeconomics:
34
Chapter Outline
and Exchange Rates The Current Account
The Capital Account
The United States as a Debtor Nation
Equilibrium Output (Income)
in an Open Economy
The International Sector
and Planned Aggregate Expenditure
Imports and Exports
and the Trade Feedback Effect
Import and Export Prices
and the Price Feedback Effect
Cy mo noc E- ne p: O
The Open Economy

with Flexible Exchange Rates
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The Market for Foreign Exchange

Factors That Affect Exchange Rates
The Effects of Exchange Rates
on the Economy
An Interdependent World Economy
Appendix: World Monetary
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Systems Since 1900
© 2007 Prentice Hall Business Publishing Principles of Economics 8e by Case and Fair 2 of 26
Open-Economy Macroeconomics:
The Balance of Payments and Exchange Rates
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.
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THE BALANCE OF PAYMENTS
foreign exchange All currencies

other than the domestic currency
of a given country.
balance of payments The

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

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country’s sources (supply) and

uses (demand) of foreign
exchange.
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THE CURRENT ACCOUNT

balance of trade A country’s exports
of goods and services minus its
imports of goods and services.
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TABLE 21.1 United States Balance of Payments, 2004
CURRENT ACCOUNT
Goods exports 807.6
Goods imports – 1,473.1
(1) Net export of goods – 665.5
Export of services 339.6
Import of services – 291.2
(2) Net export of services 48.4
Income received on investments 369.0
Income payments on investments – 344.9
(3) Net investment income 24.1
(4) Net transfer payments – 72.9
(5) Balance on current account (1 + 2 + 3 + 4) – 665.9
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –) – 821.8
(7) Change in foreign private assets in the United States 1077.9

(8) Change in U.S. government assets abroad (increase is –) 4.1
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(9) Change in foreign government assets in the United States 355.3

(10) Balance on capital account (6 + 7 + 8 + 9) 615.5
(11) Net capital account transactions
– 1.5
(11) Statistical discrepancy
51.9
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(12) Balance of payments (5 + 10 + 11) 0
THE CURRENT ACCOUNT
trade deficit Occurs when a

country’s exports of goods and
services are less than its imports
of goods and services in a given
period.
balance on current account
Net exports of goods, plus net
exports of services, plus net
investment income, plus net

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transfer payments.
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THE CAPITAL ACCOUNT
balance on capital account In

the United States, 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

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assets in the United States.

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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.
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EQUILIBRIUM OUTPUT (INCOME)
IN AN OPEN ECONOMY
THE INTERNATIONAL SECTOR AND PLANNED
AGGREGATE EXPENDITURE
Planned aggregate expenditure in an open economy:
AE ≡ C + I + G + EX - IM
net exports of goods and

services (EX - IM) The
difference between a country’s
total exports and total imports.
Determining the Level of Imports

marginal propensity to
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import (MPM) The change in

imports caused by a $1
change in income.
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IN AN OPEN ECONOMY
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FIGURE 21.1 Determining Equilibrium Output in an Open Economy

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IN AN OPEN ECONOMY
The Open-Economy Multiplier
1
open-economy multiplier =
1 − ( MPC − MPM )
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.
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IN AN OPEN ECONOMY
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,

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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. If foreign output increases,
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IN AN OPEN ECONOMY
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.
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An increase in U.S. imports increases other countries’ exports, which stimulates those
countries’ economies and increases their imports, which increases U.S. exports, which
stimulates the U.S. economy and increases its imports, and so on. This is the trade
feedback effect. In other words, an increase in U.S. economic activity leads to a
worldwide increase in economic activity, which then “feeds back” to the United States.
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IN AN OPEN ECONOMY
Export prices of other countries affect U.S. import prices.
The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation
rate abroad is high, U.S. import prices are likely to rise.
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

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up prices in other countries. This in turn

further increases the price level in the
first country.
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THE OPEN ECONOMY WITH FLEXIBLE
EXCHANGE RATES
THE MARKET FOR FOREIGN EXCHANGE
TABLE 21.2 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
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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
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EXCHANGE RATES
floating, or market-determined, exchange rates

Exchange rates that are determined by the
unregulated forces of supply and demand.
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FIGURE 21.2 The Demand for Pounds FIGURE 21.3 The Supply of Pounds in
in the Foreign Exchange Market the Foreign Exchange Market
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EXCHANGE RATES
The Equilibrium 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.
appreciation of a
currency The rise in value
of one currency relative to
another.
depreciation of a
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currency The fall in value

of one currency relative to
FIGURE 21.4 The Equilibrium Exchange Rate another.
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EXCHANGE RATES
FACTORS THAT AFFECT EXCHANGE RATES
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

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is the same.
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
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relatively high-inflation countries to depreciate.

EXCHANGE RATES
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FIGURE 21.5 Exchange Rates Respond FIGURE 21.6 Exchange Rates Respond
to Changes in Relative Prices to Changes in Relative Interest Rates
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EXCHANGE RATES
THE EFFECTS OF EXCHANGE RATES ON THE
ECONOMY
The level of imports and exports depends on exchange rates as

well as on income and other factors. When events cause
exchange rates to adjust, the levels of imports and exports will
change. Changes in exports and imports can in turn affect the
level of real GDP and the price level. Further, exchange rates
themselves also adjust to changes in the economy.
Exchange Rate Effects on Imports, Exports, and

Real GDP
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A depreciation of a country’s currency is likely to increase its GDP.

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EXCHANGE RATES
Exchange Rates and Prices The depreciation of a

country’s currency tends to increase its price level.
Monetary Policy with Flexible Exchange Rates A

cheaper dollar is a good thing if the goal of the monetary
expansion is to stimulate the domestic economy.
Fiscal Policy with Flexible Exchange Rates The

openness of the economy and flexible exchange rates do not
always work to the advantage of policy makers.
Monetary Policy with Fixed Exchange Rates

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There is no role monetary policy can play if a country has a

fixed exchange rate.
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AN INTERDEPENDENT WORLD ECONOMY
The increasing interdependence of countries in the

world economy has made the problems facing policy
makers more difficult.
We used to be able to think of the United States as a

relatively self-sufficient region.
Forty years ago, economic events outside U.S. borders

had relatively little effect on its economy. This situation
is no longer true. The events of the past four decades
have taught us that the performance of the U.S.
economy is heavily dependent on events outside U.S.

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borders.
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REVIEW TERMS AND CONCEPTS
appreciation of a currency J-curve effect

balance of payments law of one price
balance of trade marginal propensity to import (MPM)
balance on capital account net exports of goods and services
balance on current account (EX - IM)
depreciation of a currency price feedback effect
exchange rate purchasing-power-parity theory
floating, or market- trade deficit
determined, exchange rates trade feedback effect
foreign exchange Planned aggregate expenditure in
an open economy:
AE ≡ C + I + G + EX - IM
Open-economy multiplier:
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1
=
1 − ( MPC − MPM )
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Appendix
WORLD MONETARY SYSTEMS SINCE 1900
THE GOLD STANDARD
PROBLEMS WITH THE GOLD

STANDARD
FIXED EXCHANGE RATES AND

THE BRETTON WOODS
SYSTEM
“PURE” FIXED EXCHANGE

RATES
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PROBLEMS WITH THE

BRETTON WOODS SYSTEM
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Appendix
Bretton Woods The site in New

Hampshire where a group of experts
from 44 countries met in 1944 and
agreed to an international monetary
system of fixed exchange rates.
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Chapter

Fernando & Yvonn Quijano

The Open Economy

The Market for Foreign Exchange

Systems Since 1900

exchange rate The price of one

foreign exchange All currencies

balance of payments The

world; also the record of a

country’s sources (supply) and

THE CURRENT ACCOUNT

(7) Change in foreign private assets in the United States 1077.9

(9) Change in foreign government assets in the United States 355.3

(12) Balance of payments (5 + 10 + 11) 0

THE CURRENT ACCOUNT

trade deficit Occurs when a

investment income, plus net

THE CAPITAL ACCOUNT

balance on capital account In

the change in foreign government

assets in the United States.

THE UNITED STATES AS A DEBTOR NATION

Prior to the mid-1970s, the United States had

net exports of goods and

Determining the Level of Imports

import (MPM) The change in

FIGURE 21.1 Determining Equilibrium Output in an Open Economy

The Open-Economy Multiplier

The effect of a sustained increase in government spending (or investment) on income—

IMPORTS AND EXPORTS AND THE TRADE

The Determinants of Exports

the rest of the world—rest-of-the-world real wages, wealth,

nonlabor income, interest rates, and so on—as well as on the

The Trade Feedback Effect

trade feedback effect The tendency

Export prices of other countries affect U.S. import prices.

The Price Feedback Effect

the price level in one country can drive

up prices in other countries. This in turn

THE MARKET FOR FOREIGN EXCHANGE

TABLE 21.2 Some Private Buyers and Sellers in International Exchange

THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)

2. British citizens traveling in the United States

floating, or market-determined, exchange rates

The Equilibrium Exchange Rate

currency The fall in value

price of similar goods in different countries

relatively high-inflation countries to depreciate.

The level of imports and exports depends on exchange rates as

Exchange Rate Effects on Imports, Exports, and

A depreciation of a country’s currency is likely to increase its GDP.

Exchange Rates and Prices The depreciation of a

Monetary Policy with Flexible Exchange Rates A

Fiscal Policy with Flexible Exchange Rates The

Monetary Policy with Fixed Exchange Rates

There is no role monetary policy can play if a country has a

The increasing interdependence of countries in the

We used to be able to think of the United States as a

Forty years ago, economic events outside U.S. borders

economy is heavily dependent on events outside U.S.

appreciation of a currency J-curve effect

WORLD MONETARY SYSTEMS SINCE 1900