Economics of Exchange Rates and Net Exports

Page 1: Figure and Section 6-1

• Figure 6-1 displays imports and exports as a percentage of output for various countries in 2012.
• Section 6-1 discusses international capital and goods flows in open economies.
• An open economy's spending doesn't necessarily equal its output.
• Borrowing from or lending to other countries is possible.

Page 2: The Role of Net Exports

• Expenditure in a closed economy consists of consumption (Cd), investment (Id), and government purchases (Gd).
• In an open economy, exports (X) are added to the components.
• Y = Cd + Id + Gd + X represents the identity of spending.
• The sum of Cd, Id, and Gd is domestic spending on domestic goods and services.
• The sum of domestic spending = domestic spending on domestic goods & services + domestic spending on foreign goods & services.
• The identity can be re-written as Y = C + I + G + X − IM.
• IM represents imports.

Page 3: International Capital Flows and the Trade Balance

• In open economies, financial and goods markets are related.
• National saving (S) equals the sum of private saving (Y − T − C) and public saving (T − G).
• S=I+NX
• NX, or net exports, is the difference between exports and imports.
• The trade balance represents the difference between a country’s imports and exports of goods and services
• Net capital outflow equals the difference between domestic saving and domestic investment.

Page 4: International Flows of Goods and Capital: An Example

• A U.S. resident selling software to a Japanese consumer is an export.
• The seller's choice of what to do with the foreign currency impacts the net capital outflow.
• Net exports equal to net capital outflow form an identity, this must hold.

Page 5: The Irrelevance of Bilateral Trade Balances

• A nation's overall trade balance (exports minus imports) with the rest of the world is important, not bilateral balances.
• Bilateral, or country-to-country, balances may be politically relevant, but aren't significant in macro-economic sense. Exchanged goods and services from different countries do eventually balance out across all the nations.

Page 6: Saving and Investment in a Small Open Economy

• A country's spending in a given year need not equal its output of goods and services in an open economy.
• Countries can spend more than they produce (by borrowing abroad) or less than they produce (by lending abroad).
• Net exports must equal the difference between saving and investment.

Page 7: Capital Mobility and the World Interest Rate

• A small open economy has perfect access to world financial markets and the domestic interest rate equals the world interest rate.
• Residents of the economy can always borrow or lend at the world rate.
• The world interest rate is determined by the equilibrium of world saving and world investment.
• A small open economy's effect on the world interest rate is negligible.

Page 8: The Model

• Output (Y) is fixed by factors of production and the production function.
• Consumption (C) is positively related to disposable income (Y-T).
• Investment (I) is negatively related to the real interest rate (r).

Page 9: Saving and Investment in a Small Open Economy; How Policies Influence the Trade Balance

• The trade balance depends on variables that determine national saving (S) and investment (I)
• Policies affecting national saving (fiscal policy changes) will affect the trade balance.
• Changes in foreign saving (fiscal policy in another country) will impact the world interest rate, which then influences domestic investment and the trade balance in a small open economy.

Page 10: Fiscal Policy at Home; Fiscal Policy Abroad

• Fiscal policy changes that affect national saving (like tax cuts) will cause a trade deficit.
• Fiscal policy changes in other countries can affect the world interest rate.
• Changes in the world interest rate then influence investment and, consequently, the trade balance.

Page 11:International Flows of Goods and Capital: Summary

• A summary of trade surplus, balance, and deficit.
• Net Exports relate to net capital outflow based on international flows.

Page 12: Evaluating Economic Policy

• Whether trade deficits are problems depends on their underlying reasons.
• Trade deficits might be due to low saving, high consumption.
• They might reflect economic development rather than a problem.

Page 13: The U.S. Trade Deficit

• U.S. trade deficits fluctuated during the 1980s, 1990s, and 2000s. This was due to changes in fiscal policy (tax cuts, government spending).
• The period saw shifts from being a creditor nation to a debtor nation.
• 2013, the trade deficit was $497 billion or 3 percent of GDP.

Page 14: The Trade Balance, Saving, and Investment: The U.S. Experience

• Figure demonstrates U.S. trade balance, saving, and investment from 1960 to 2013.

Page 15: Why Doesn't Capital Flow to Poor Countries?

• Factors such as differences in technology, institutions, and property rights affect capital flows.
• Capital may not flow to poorer nations even if it would yield a higher return there according to simplistic models.

Page 16: Exchange Rates

• Exchange rates are prices at which one currency can be traded for another.
• Nominal exchange rates describe the relative prices of the currencies.
• Real exchange rates describe the relative prices of goods, considering the exchange rate

Page 17: Nominal and Real Exchange Rates

• Nominal exchange rate is the relative price of the currencies of the two countries.
• Example: price of 1 US Dollar in Japanese Yen.
• Real exchange rate is the relative price of goods of two countries (terms of trade).
• Example: comparing the price of a car in the US to the price of a similar car in Japan.

Page 18: The Real Exchange Rate and the Trade Balance

• The real exchange rate determines the relative price of domestic and foreign goods, which then affect the demand for imports and exports; hence the trade balance.
• The trade balance is negatively related to the real exchange rate.

Page 19: The Determinants of the Real Exchange Rate

• Real exchange rate depends on net exports, saving, investment, and the world interest rate.
• The real exchange rate is determined the net exports schedule and the saving minus investment schedule.

Page 20: Policies in the Large Open Economy

• Fiscal policy impacts both the domestic interest rates and net exports.
• Expansionary fiscal policy (tax cuts, increased government spending) reduces national saving, raises the interest rate, leads to a trade deficit, and an appreciation of the domestic currency.

Pages 21 - 22 : Effects of Trade Policies

• Trade Policies (tariffs or quotas) do not directly change the trade balance, instead they alter net exports by affecting the real exchange rate.
• A trade restriction increases net exports in the short run, while increasing costs in the long run for consumers

Page 23: The Determinants of the Nominal Exchange Rate

• The nominal exchange rate depends on the real exchange rate and price levels in the two countries (domestic and foreign).
• The formula demonstrates how changes in the real exchange rate and price levels impact the nominal exchange rate.

Page 24: Inflation and Nominal Exchange Rates

• Inflation in a country causes depreciation or devaluation of that country's currency.
• High inflation countries frequently have depreciating currencies.
• Conversely, countries with low inflation experiences appreciating currencies.

Page 25: The Special Case of Purchasing-Power Parity

• The law of one price states that the same commodity should cost the same in different markets, at the same time.
• The law of one price is known as the purchasing power parity (PPP), which shows how different currency values affect a single commodity price in two different markets.

Page 26: Conclusion: The United States as a Large Open Economy

• The U.S. is considered a large open economy.
• Policies influence both domestic interest rates and net exports. Differences in responses between small and large open economies stem in part from the effect of policies on world interest rates.

Page 27-28: Appendix and Summary; The Large Open Economy

• In large open economies, net capital outflow affects the interest rate.
• The net capital outflow depends on domestic real interest rates.
• Net capital outflow is a function of real interest rates (CF=CF(r)).

Pages 29-30: Appendix; The Large Open Economy

• The large open economy model considers how different countries, as part of the world economy, interact in the market for loanable funds and foreign currency.

Page 31-37: Policies in the Large Open Economy

• Policies can influence the equilibrium interest rate and the real exchange rate or net exports in both small and large open economies.
• Policies that increase saving or decrease investment tend to cause trade surpluses.
• Policies that decrease saving or increase investment tend toward trade deficits.
• Trade policies affect the real exchange rate without changing the trade balance.

This quiz examines the impacts of real exchange rates on domestic purchasing behavior and explores the relationship between net exports and the real exchange rate. Additionally, it discusses factors influencing foreign demand for U.S. goods and key concepts related to small open economies. Test your understanding of these economic principles!