Principles of Economics Chapter 34 PDF

Principles of Economics Thirteenth Edition Chapter 34 Open-Economy Macroeconomics: The Balance of Payments and Exchange...

Principles of Economics Thirteenth Edition Chapter 34 Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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 country’s sources (supply) and uses (demand) of foreign exchange. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Current Account balance of trade A country’s exports of goods and services minus its imports of goods and services. trade deficit Occurs when a country’s exports of goods and services are less than its imports of goods and services. balance on current account The sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Capital Account Prior to the mid-1970s, the United States had generally run current account surpluses, and thus its net wealth position was positive. Sometime between the mid-1970s and the mid-1980s, the United States changed to having a negative net wealth position vis-à-vis the rest of the world. Now it is the largest debtor nation in the world. This reflects the fact that for the past three decades, it has spent much more on foreign goods and services than it has earned through the sales of its goods and services to the rest of the world. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Equilibrium Output (Income) in an Open Economy The International Sector and Planned Aggregate Expenditure Planned aggregate expenditure in an open economy: AE º C + I + G + EX - IM net exports of goods and services (EX − IM) The difference between a country’s total exports and total imports. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The International Sector and Planned Aggregate Expenditure (1 of 2) Determining the Level of Imports When income rises, imports tend to go up. Algebraically, IM = mY where Y is income and m is some positive number. marginal propensity to import (MPM) The change in imports caused by a $1 change in income. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Solving for Equilibrium Figure 34.1 Determining Equilibrium Output in an Open Economy In panel (a), planned investment spending (I), government spending (G), and total exports (EX) are added to consumption (C) to arrive at planned aggregate expenditure. However, C + I + G + EX includes spending on imports. In panel (b), the amount imported at every level of income is subtracted from planned aggregate expenditure. Equilibrium output occurs at Y* = 200, the point at which planned domestic aggregate expenditure crosses the 45-degree line. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The International Sector and Planned Aggregate Expenditure (2 of 2) The Open-Economy Multiplier 1 open - economy multipler = 1- ( MPC - MPM ) The multiplier is smaller in an open economy than in a closed economy. 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Imports, Exports, and the Trade Feedback Effect (1 of 4) The Determinants of Imports The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports because some imported goods are consumption goods and some are investment goods. The relative prices of domestically produced and foreign- produced goods also determine spending on imports. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Imports, Exports, and the Trade Feedback Effect (2 of 4) The Determinants of Exports The demand for U.S. exports depends on economic activity in the rest of the world as well as on the prices of U.S. goods relative to the price of rest-of-the-world goods. When foreign output increases, U.S. exports tend to increase. U.S. exports also tend to increase when U.S. prices fall relative to prices in the rest of the world. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Imports, Exports, and the Trade Feedback Effect (3 of 4) 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. 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. 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Imports, Exports, and the Trade Feedback Effect (4 of 4) Export prices of other countries affect import prices, and a country’s export prices tend to move fairly closely with the general price level in that country. 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Import and Export Prices and the Price Feedback Effect 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Open Economy with Flexible Exchange Rates floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Market for Foreign Exchange (1 of 2) The Supply of and Demand for Pounds Governments, private citizens, banks, and corporations exchange pounds for dollars and dollars for pounds every day. Those who demand pounds are holders of dollars seeking to exchange them for pounds. Those who supply pounds are holders of pounds seeking to exchange them for dollars. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 34.2 The Demand for Pounds in the Foreign Exchange Market When the price of pounds falls, British-made goods and services appear less expensive to U.S. buyers. If British prices are constant, U.S. buyers will buy more British goods and services, and the quantity of pounds demanded will rise. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 34.3 The Supply of Pounds in the Foreign Exchange Market When the price of pounds rises, the British can obtain more dollars for each pound. This means that U.S.-made goods and services appear less expensive to British buyers. Thus, the quantity of pounds supplied is likely to rise with the exchange rate. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Market for Foreign Exchange (2 of 2) 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 currency The fall in value of one currency relative to another. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 34.4 The Equilibrium Exchange Rate When exchange rates are allowed to float, they are determined by the forces of supply and demand. An excess demand for pounds will cause the pound to appreciate against the dollar. An excess supply of pounds will lead to a depreciating pound. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved 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 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 so the currencies of relatively high-inflation countries tend to depreciate. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 34.5 Exchange Rates Respond to Changes in Relative Prices The higher price level in the United States makes imports relatively less expensive. U.S. citizens are likely to increase their spending on imports from Britain, shifting the demand for pounds to the right, from D0 to D1. At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States. The supply of pounds shifts to the left, from S0 to S1. The result is an increase in the price of pounds. The pound appreciates, and the dollar is worth less. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Relative Interest Rates Figure 34.6 Exchange Rates Respond to Changes in Relative Interest Rate If U.S. interest rates rise relative to British interest rates, British citizens holding pounds may be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S0 to S. However, U.S. citizens are less likely to be 1 interested in British securities because interest rates are higher at home. The demand for pounds shifts to the left, from D0 to D1. The result is the pound depreciates vis-a-vis the dollar and the dollar (naturally) appreciates vis-a-vis the pound. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (1 of 7) 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. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (2 of 7) Exchange Rate Effects on Imports, Exports, and Real GDP A depreciation of a country’s currency is likely to increase its GDP. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (3 of 7) Exchange Rates and the Balance of Trade: The J Curve J-curve effect Following a currency depreciation, a country’s balance of trade may get worse before it gets better. The graph showing this effect is shaped like the letter J, hence the name J-curve effect. balanceof trade = dollar priceof exports ´ quantity of exports - dollar price of imports ´ quantity of imports Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Figure 34.7 The Effect of a Depreciation on the Balance of Trade (the J Curve) Initially, a depreciation of a country’s currency may worsen its balance of trade. The negative effect on the price of imports may initially dominate the positive effects of an increase in exports and a decrease in imports. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (4 of 7) Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (5 of 7) Monetary Policy with Flexible Exchange Rates A cheaper dollar means more U.S. exports and fewer imports. If consumers substitute U.S.-made goods for imports, they will spend more on domestic products, so the multiplier increases. A higher interest rate lowers planned investment and consumption spending, thus lowering the price level. This also attracts foreign buyers to U.S. financial markets, driving up the value of the dollar, which reduces the price of imports. The reduction in the price of imports causes a shift of the aggregate supply curve to the right, which helps fight inflation. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (6 of 7) Fiscal Policy with Flexible Exchange Rates Flexible exchange rates hurt the fiscal authorities if they want to contract the economy to fight inflation. If the Fed does not change the interest rate in response to the fiscal policy change, there is no change in the currency value and thus no offset to what the fiscal authorities are trying to do. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved The Effects of Exchange Rates on the Economy (7 of 7) Monetary Policy with Fixed Exchange Rates The one case in which a country can change its interest rate and keep its exchange rate fixed is if it imposes capital controls. Imposing capital controls means that the country limits or prevents people from buying or selling its currency in the foreign exchange markets. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved An Interdependent World Economy We used to be able to think of the United States as a relatively self-sufficient region. 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. borders. This chapter and the previous chapter have provided only the bare bones of open-economy macroeconomics. The next chapter concludes with a discussion of the problems of developing countries. Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts (1 of 2) appreciation of a currency law of one price balance of payments marginal propensity to balance of trade import (MPM) balance on current account net exports of goods and depreciation of a currency services (EX - IM ) exchange rate floating, or market- price feedback effect determined, exchange rates purchasing-power-parity foreign exchange theory J-curve effect trade deficit trade feedback effect Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved Review Terms and Concepts (2 of 2) Equations: planned aggregate expenditure in an open economy: AE º C + I + G + EX - IM open − economy multiplier = 1 ÷ 1 - (MPC - MPM ) Copyright © 2020, 2016, 2011 Pearson Education, Inc. All Rights Reserved