Openeconomy Macroeconomics: The Balance of Payments

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Open-economy Macroeconomics The Balance of
Payments Exchange Rates

• Chapter 21

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Introduction

• The economies of the world have become
  increasingly interdependent over the last two
  decades.
• International trade is a major part of todays
  world economy.
• From a macroeconomic point of view, the main
  difference between an international transaction
  and a domestic transaction concerns currency
  exchange.

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• The price of one countrys currency in terms of
  anothers is the exchange rate.
• Since 1971 these exchange rates are no longer
  fixed but are determined essentially by supply
  and demand.

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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.
• It is also the record of a countrys sources
  (supply) and uses (demand) of foreign exchange,
  meaning all currencies other than the domestic
  currency of a given country.

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A. Current Account

• The current account includes trade in
  merchandise, services, investment income, and net
  transfer payments and other.
• The balance of trade is the difference between
  exports and imports. The balance on current
  account is the sum of the balances of these
  components.

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• It shows how much a nation has spent on foreign
  goods, services, and transfers relative to how
  much it has earned from other countries.
• A nation settles its accounts with the rest of
  the world through its capital account.

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B. Capital Account

• The capital account records the nations inflows
  and outflows. The balance on capital account
  records the changes in asset holdings.

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Equilibrium Output International Sector
Planned Aggregate Expenditure

• Planned aggregate expenditure becomes C I G
  EX - IM
• where EX - IM represents the countrys net export
  of goods and services.
• We assume exports are given and imports are a
  function of Y.

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• We can also calculate the open economy
  multiplier, which indicates that some of the
  increased income is used to purchase imports and
  thus there is less of an impact on the domestic
  economy.
• The Determinants of Imports Exports Imports
  depend on income as well as on those factors that
  affect consumption and investment.

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• An additional factor is the relative prices of
  import as compared to domestically produced
  goods.
• Exports depend on the same factors but in the
  country doing the buying.
• 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.

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• The prices of imports to the United States depend
  on the prices of goods abroad and the rate of
  inflation abroad.
• 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.
• It can drive up prices in other countries and so
  increase its own price level.

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Open Economy with Flexible Exchange Rates

• The open economy with flexible exchange rates is
  more complicated than when we assume rates are
  fixed.
• Exchange rates determine the price of imported
  goods and can have significant effects on the
  levels of imports and exports, as well as the
  movement of capital between countries.

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The Market For Foreign Exchange

• People want foreign exchange to buy goods
  produced in other countries, or the assets of
  other countries.
• Other people and institutions hold currency
  balances for speculative reasons.
• When exchange rates are allowed to float they are
  determined by supply and demand.
• An excess demand causes a currency to appreciate
  and an excess supply causes it to depreciate.

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Factors That Affect Exchange Rates

• 1. Purchasing Power Parity The Law of One
  Price The price of the same good in two
  countries should be the same, otherwise there is
  a profit potential in the price differential.
• In practice significant transportation costs
  account for price differences.

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• 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 relatively high
  inflation countries to depreciate.
• 2. Relative interest rates this affects peoples
  demand for securities of different countries
  funds will move to the highest yielding
  securities and affects the demand for currencies.

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The Effects of Exchange Rates on the Economy

• The level of imports and exports depends on
  exchange rates, and this affects GDP and the
  price level.
• Policy which affects interest rates also affect
  exchange rates.
• 1. Exchange rate effects on imports, exports, and
  GDP when a countrys currency depreciates its
  import prices rise and its export prices fall,
  and this can serve as a stimulus to the economy.

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• 2. Exchange rates Price
• the depreciation of a countrys currency tends to
  increase its price level. This is due to the
  greater demand for exports and domestic
  production as well as because of the increased
  price of imports.

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Monetary Fiscal Policies with Flexible Exchange
rates

• Monetary Policy with Flexible Ex. Rates
• Lower interest rates lower the value of the
  dollar which affects the balance of trade adding
  to the stimulus.
• Higher rates drive up the value of the dollar and
  the reduction in the price of imports helps to
  fight the inflation.

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• Fiscal Policy with Flex. Exchange rates
• fiscal stimulus by cutting taxes loses some
  impact as some of the added income is spent on
  imports and therefore leaks out of the economy.