Chapter 16: Open Economy Macroeconomics

Lecture 16

I. The Balance of Payments

The current account balance and the capital account balance must sum to $0.

A. The Current Account

Includes the balance of trade, the balance on income, and net transfers

Balance of trade: exports minus imports Balance on income: income received minus income payments Net transfers of money: money sent abroad less money sent into the U.S.

B. The Capital Account

Summarizes the flow of money into and out of domestic and foreign assets

Net increase in foreign-owned holdings: increase in foreign-owned assets in the U.S. minus increase in U.S.-owned assets abroad Statistical discrepancy

II. Exchange Rates

A. Nominal Exchange Rates

From Chapter 9: Why a change in the value of the dollar affects net exports: Go to http://finance.yahoo.com/currency-converter?u to see exchange rates.

I’ve added a trend line to show that the value of the dollar has fallen.

In late 2008 you could get about 80 euro cents for $1. In late 2009 you could get about 68 euro cents for $1. Since you don’t get as many euros per dollar, we say that the value of the US dollar fell. © 2010 Jane Himarios, Ph.D. 3

B. Real Exchange Rates

The real exchange rate is the price of one country’s currency for another when the price levels of both countries are taken into account. The real exchange rate is important when inflation is an issue in one country. er = en X (Pd/Pf) where er = the real exchange rate en = the nominal exchange rate Pd = the domestic price level Pf = the foreign price level

Land Rover example from the text: If Britain suffers inflation then Pf climbs, including the price of Land Rovers, while U.S. auto prices remain unchanged. Fewer Land Rovers will be bought, leading to lower demand for the British pound, reducing its exchange value and restoring some competitiveness. © 2010 Jane Himarios, Ph.D. 4

C. Purchasing Power Parity

The rate of exchange that allows a specific amount of currency in one country to purchase the same quantity of goods in another country.

This implies that, given this chart, something that cost $1 in the U.S. would cost . 67 euros:

D. Exchange Rate Determination

How Foreign Exchange Markets Work Pounds and kilograms are both units of measurement for measuring weight. They aren't compatible, as the peso and the dollar aren't compatible. But they can be compared (1kg = 2.2 pounds), just like the peso and the dollar can be compared.

1. Why do Americans want to buy foreign currencies? a. In order to buy foreign-made products b. In order to make investments in foreign firms or foreign government bonds c. As an investment if they believe the domestic currency will lose value relative to the foreign currency

2. Why are foreigners willing to sell their currency to Americans? a. In order to buy American-made products b. In order to make investments in American firms or US government bonds c. As an investment if they believe their currency will lose value relative to the US dollar

3. Graphically, what does a foreign exchange market look like?

One way to look at the market for currency looks is to consider that it looks just like the market for refrigerators or watches. The demand curve shows how many units of a given currency are demanded at each and every price per unit. The supply curve shows how many units of a given currency are supplied at each and every price.

The following graph shows the market for Japanese yen. The price per yen is denoted in dollars, just like in the market for refrigerators or watches. The demand curve for yen is negatively sloped because people will want to buy more yen at lower prices. The supply curve for yen is positively sloped because people will be willing to supply more at higher prices.

Price per yen Syen (Denoted in US dollars)

A second way to look at the foreign exchange market is to consider the “product” that is traded in the market to be U.S. dollars. In this case, the price is measured in terms of the foreign currency, that is, how many units of the foreign currency it takes to buy one U.S. dollar. This is the exchange rate.

Price (denoted in S$ pounds) per dollar

Number of dollars traded

An appreciation of the dollar is shown by sliding up the horizontal axis. Notice that a dollar appreciation would cause the quantity of dollars demanded to fall and the quantity of dollars supplied to rise.

A depreciation of the dollar is shown by sliding down the horizontal axis. Notice that a dollar depreciation would cause the quantity of dollars demanded to rise and the quantity of dollars supplied to fall.

Here is an example of a dollar depreciation (and an appreciation of the euro):

Initially, it cost $1.33 to buy a euro, but after the demand curve shifts it costs $1.50 to buy a euro.

Price per euro Seuros (Denoted in U.S. dollars)

D’euros

Deuros # of euros traded

To find the initial price of a US dollar (denoted in euros), we would divide 1 by 1.33. The initial price per US dollar (denoted in euros) was .75 euro cents. After the depreciation of the dollar it only cost 0.66 euro cents to buy a dollar.

Price per US SUS dollars dollar (denoted in euros)

DUS dollars

Determinants of Exchange Rates

Dollar appreciation Dollar depreciation Decrease in American tastes and Increase in American tastes and preferences for foreign goods and preferences for foreign goods and services services Foreign incomes rise faster than American incomes rise faster than American incomes (so that our demand foreign incomes (so that our demand for imports is exceeded by foreign for imports exceeds foreign demand for demand for our exports) our exports) Inflation rises faster in foreign countries Inflation rises faster in the U.S. than in than in the U.S. (so that our exports are foreign countries (so that foreign goods relatively better deals) are relatively better deals) U.S. interest rates increase (so that U.S. interest rates decrease (so that people across the globe are more likely people across the globe are more likely to want to put their money in American to want to put their money in foreign financial institutions) financial institutions)

E. Exchange Rates and Aggregate Supply and Demand

We know this much from Chapter 9: When the dollar appreciates, net exports fall, shifting AD leftward. When the dollar depreciates, net exports rise, shifting AD rightward.

We can now consider that, since some inputs are imported, the change in the dollar will also shift the AS curve: When the dollar appreciates, imported inputs become less expensive, shifting AS rightward. When the dollar depreciates, imported inputs become more expensive, shifting AS leftward.

We also know this from Chapter 9: Along with these reasons for AS shifts, the AD shift put us into a “danger zone,” so wage rates will also change, shifting the AS curve to get us back to NAIRU.

III. Monetary and Fiscal Policy in an Open Economy

Monetary Policy in an Open Economy

Easy Money Policy If the Fed increases the money supply, interest rates will fall, and then we will see two things happen: 1. Initial effect: I↑ → AD↑ → real GDP and the price level↑ 2. Feedback effect: the dollar depreciates → (EX – IM)↑ → AD↑ → real GDP and the price level↑

Tight Money Policy If the Fed decreases the money supply, interest rates will rise, and then we will see two things happen: 1. Initial effect: I↓ → AD↓ → real GDP and the price level↓ 2. Feedback effect: the dollar appreciates → (EX – IM)↓ → AD↓ → real GDP and the price level↓

Principle of economics: Feedback effects magnify the effects of monetary policy. Monetary policy is stronger in an open economy than in a closed economy.

Fiscal Policy in an Open Economy

Expansionary Fiscal Policy If the government practices expansionary fiscal policy by spending more than it collects in taxes, and if it borrows to cover the resulting deficit, two things happen: 1. Initial effect: G↑ → AD↑ → real GDP and the price level↑ 2. Crowding out effect: interest rates↑ → the dollar appreciates → (EX – IM)↓ → AD↓ → real GDP and the price level↓

Contractionary Fiscal Policy If the government practices contractionary fiscal policy by spending less than it collects in taxes, government borrowing falls and two things happen: 1. Initial effect: G↓ → AD↓ → real GDP and the price level↓ 2. Crowding out effect: interest rates↓ → the dollar depreciates → (EX – IM)↑ → AD↑ → real GDP and the price level↑

Principle of economics: Crowding out effects reduce the effects of fiscal policy. Fiscal policy is weaker in an open economy than in a closed economy.