BOP and Exchange Rates Fall 2024: ECO 6716 PowerPoint 3.0 PDF

1 Balance of trade deficit 2016: $502 billion 2019: $617 billion 2023: $773 billion 2 Return to National Income Accounting We know that GDP = C + I + G + (EX – IM) Here is something new: GDP = GNI. But what is GNI? GNI = Gross National In...

1 Balance of trade deficit 2016: $502 billion 2019: $617 billion 2023: $773 billion 2 Return to National Income Accounting We know that GDP = C + I + G + (EX – IM) Here is something new: GDP = GNI. But what is GNI? GNI = Gross National Income And why does GNI equal GDP? Hint: Think about a firm’s income statement: Profit = Revenue – Cost or Cost + Profit = Revenue  Simplest case: The economy has 1 final goods firm Final Goods firm: Produces using only labor Gross National Income is the sum of income received by labor and the firm’s owner, its profit. Gross Domestic Product is the total revenue received by the firm, P x Q. Total Cost is the amount paid as wages, W Profit = Total Revenue – Total Cost Total Cost + Profit = Total Revenue GNI = GDP More complicated case: The economy has 1 final goods firm and 1 intermediate goods firm Final Goods firm: Produces using labor and intermediate good Intermediate Goods firm: Produces using labor and land Gross National Income is the sum of income received by labor and landowners plus the owners’ profits. Gross Domestic Product is the total revenue received by the final goods firm, P x Q. The economy has 1 final goods firm … Total Revenue = Total Cost + Profit (W × L) + (Cost of Intermediate Goods) + Profit (W × L) + Profit + (Cost of Intermediate Goods) P × Q = Income + (Cost of Intermediate Goods) and one intermediate goods firm: Cost of Intermediate Goods = P × Q = Total Revenue = Total Cost + Profit Income GDP = P × Q = Income + Income = GNI Think of how consumers can use GNI: GNI = C + S + TX So … using GDP = GNI … C + I + G + (EX – IM) = C + S +TX I + G + (EX – IM) = S +TX (EX – IM) = S +TX – I – G (EX – IM) = (S – I) + (TX – G) EX − IM is also called the balance of trade, say TB. TB = (S – I) + (TX – G) You might say “So what!” Well, next slide has some more algebra …  TB = (S – I) + (TX – G) An insight about the causes of a balance of trade deficit: TB = S + (TX – G) – I TB = S – (G – TX) – I TB = S – (Government Budget Deficit) – I TB = S – (Government Budget Deficit + I) Balance of trade deficit 2016: $502 billion 2019: $617 billion 2023: $773 billion 9 10 BOP records trade in goods and services as well as trade in financial assets. Three general rules Rule 1 A transaction resulting in a payment TO foreigners is a “debit” and is entered with a NEGATIVE sign. (Intuitively, money flowing out has a negative sign) A transaction resulting in a receipt FROM foreigners is a “credit” and is entered with a POSITIVE sign. (Intuitively, money flowing in has a positive sign) Rule 2 Transactions go into 1 of 3 categories: 1. Current Account (CA): Largely imports and exports of goods and services. Imports of goods (payment to foreigners, money flowing out) have a NEGATIVE sign; exports of goods (payment from foreigners, money flowing in) have a POSITIVE sign. 2. Financial Account (FA): We are loaning funds [or repaying our debts] to foreigners = payment to foreigners, money flowing out have a NEGATIVE sign (intuitively, imports of assets); Foreigners loaning funds [or repaying their debts] to us = payment from foreigners, money flowing in have a POSITIVE sign (intuitively, exports of assets). 3. Capital Account (KA): Nonmarket transactions, such as forgiven debt. Rule 3 Every international transaction must be financed, which will ultimately imply two equal BOP entries, one as a credit and one as a debit. US buys $100 of wine from France and pays by borrowing $100 from French vineyard US sells $100 of rice to Japan and uses the funds to buy $100 of oil from Norway Turkish resident buys (OR BUILDS) a US factory for $100 and US uses the funds to buy $100 of services from Turkish shipping firm Rule 3 means that CA + KA + FA = 0. The current account consists of transactions between U.S. residents and foreigners in goods, services, primary income, and secondary income. } Goods and services are the trade balance. } Primary income is mainly investment income. } Secondary income includes gifts. Current Account (CA) (2024-I) In billions Goods $−277.7 Services $73.1 Primary + $−33.0 Secondary CURRENT $−237.6 ACCOUNT RULE 1: The current account balance of $−237.6B means the U.S. paid foreigners more than we received from them; in particular we spent $237.6B more (foreign currency) abroad more than we received. Money flowed out. The capital account consists things such as debt forgiveness, leases and licenses. Capital Account (KA) (2024-I) In billions CAPITAL ACCOUNT $0.0 The financial account consists of transactions between U.S. residents and foreigners for direct investment, portfolio investment, other investment, reserve assets, and statistical discrepancy. 5 Components in detail 1. Direct investment is cross-border investment with a resident in one country controlling the management of a firm in another country. 2. Portfolio investment consist of cross-border transactions involving equity and investment fund shares and debt securities. 3. Other investment is a miscellaneous residual category. 4. Reserve assets are those assets that are controlled by monetary authorities for meeting balance of payments financing needs or for intervention in exchange markets. 5. Statistical discrepancy is what the name implies.  Financial Account (FA) (2024-I) In billions Investment $194.4 Reserves $2.5 Statistical Discrepancy $40.7 FINANCIAL ACCOUNT $237.6 RULE 1: The positive $237.6B means that the United States received more from foreigners than we paid to them. Money flowed in. In other words, the financial account balance of $237.6B means the US borrowed $237.7B from foreigners. Alternatively, the financial account balance of $237.6B means that foreigners invested $237.6B in the United States. Due to borrowing from foreigners, the United States is a net debtor nation  CA + KA + FA = $0 => $−237.6B + $0.0 +$237.6B = $0.0 The current account deficit is financed by an exactly equal financial account surplus. Remember: TB = S – (Government Deficit + I) We asked WHY we worked to get this… If we now combine BOP accounting and National Income accounting, we will see why! Combine BOP and National Income accounting: 1. TB = S – (Government Deficit + I) 2. CA + KA + FA = 0 CA ≈ TB and KA ≈ $0 so … 3. TB + FA = 0 so TB = - FA so - FA = S – (Government Deficit + I) (Government Deficit + I) = S + FA Again, you may say “So what?” Again, I say wait for the next slide.  INSIGHT: (Government Deficit + I) = S + FA Our government deficit plus our investment are financed by: 1. Our saving (S) 2. Plus foreign saving (FA) $438T + $5.021T ≈ $5.542T + $0.238T $5.459T ≈ $5.780T Data from 2024-I We know TB = ─FA … but what does this tell us? If foreigners invest in the United States, FA is positive. Hence TB is negative. As usual, we ask why? To invest in the United States, foreigners need dollars. The only way they can acquire dollars is by selling goods to the United States. These goods are U.S. imports. Balance of trade deficit 2016: $502 billion 2019: $617 billion 2023: $773 billion 24  Are trade deficits good or bad? 1. Thinking of TB = Exports ─ Imports might make it seem BAD. 2. Thinking of TB = ─FA and FA is positive because foreigners want to invest in the United States might make it seem GOOD. As an economist, I cannot say “bad” or “good,” I can just say here are two ways of thinking about the trade deficit. 26  Hint: The first currency in the quote is the currency being bought The exchange rate is the price of a country’s currency in terms of another currency. The exchange rate can be quoted two ways: Indirect Quote The foreign currency as the base currency (the first in the pair) and home currency the quote currency (the second in the pair) 25.00 Turkish lira per dollar Direct Quote The home currency as the base currency (the first in the pair) and foreign currency the quote currency (the second in the pair) 0.04 dollar per Turkish lira Hint: You can ‘flip’ the quote to see how much of the first currency must be used to buy a unit of the second 1. The indirect quote for the dollar—25 liras per dollar—is the direct quote for the lira. 2. The exchange rate for the dollar and the exchange rate for the lira are reciprocals. When the U.S. exchange rate is 25 liras per dollar the lira exchange rate is 1/(25 liras per dollar) = 0.04 dollars per lira Suppose the price of a U.S. produced pair of New Balance shoes is $100 and the exchange rate is 25 liras per dollar: P = $100/shoe ε = 25 liras per dollar What is the price of the shoes in Turkey? P* = ($100/shoe) × (25 ե/$) = ե 2,500/shoe Depreciation A decrease in the value of a given currency relative to another. Depreciation of the dollar means a decrease in the value of the dollar. ◦ DIRECT QUOTE: The exchange rate goes from 0.04 dollars per lira to 0.05 dollars per lira. From 0.04 dollars to buy one lira it now takes 0.05 dollars to buy one lira. The dollar has depreciated but it has risen in this price. ◦ INDIRECT QUOTE: The exchange rate goes from 25 lira per dollar to 20 lira per dollar. From one dollar buying 25 liras now one dollar buys only 20 liras. The dollar has depreciated and fallen in this price. Appreciation An increase in the value of a given currency relative to another. Appreciation of the dollar means an increase in the value of the dollar. ◦ DIRECT QUOTE: The exchange rate goes from 0.04 dollars per lira to 0.03 dollars per lira. From 0.04 dollars to buy one lira it now takes only 0.03 dollars to buy one lira. The dollar has appreciated but it has fallen in this price. ◦ INDIRECT QUOTE: The exchange rate goes from 25 liras per dollar to 33 liras per dollar. From one dollar buying 25 liras now one dollar buys 33 liras. The dollar has appreciated and has risen in this price. DIRECT QUOTE (dollars per euro): This the direct quote, so: when the exchange rate rises, the dollar depreciates. when the exchange rate falls, the dollar appreciates We use indirect quotes (because this is more intuitive). Remember When the U.S. exchange rate is 25 liras per dollar … The lira exchange rate is 1/(25 liras per dollar) = 0.04 dollars per lira Dollar Appreciates: From 25 lira per dollar to 33 lira per dollar Lira Depreciates: From 0.04 dollars per lira to 0.03 dollars per lira Suppose the price of a U.S. produced pair of New Balance shoes is $100 and the exchange rate is 25 liras per dollar: P = $100/shoe ε = 25 liras per dollar P* = ($100/shoe) × (25 ե /$) = ե 2,500/shoe Dollar Appreciates DOLLAR APPRECIATES P = $100/shoe ε = 30 lira per dollar P* = ($100/shoe) × (30 ե /$) = ե 3,000/shoe The shoes are more expensive in Turkey. Dollar Depreciates P = $100/shoe ε = 20 liras per dollar DOLLAR DEPRECIATES P* = ($100/shoe) × (20 ե /$) = ե 2,000/shoe The shoes are less expensive in Turkey. 35  The U.S. exchange rate depends on the demand for and the supply of dollars. Demanders of dollars: Foreigners who want dollars to buy U.S. goods and services. Foreigners who want dollars to buy U.S. assets. Federal Reserve and other central banks which want to influence the U.S. exchange rate. Anyone demanding dollars is supplying foreign currency. Demand: (Use the indirect quote, euros per dollar.) When the exchange rate rises (the dollar appreciates), say from 0.90€/$ to 0.95€/S, then … the price of U.S. goods and services abroad rises… the quantity demanded of U.S. goods and services abroad decreases … the quantity of U.S. dollars demanded decreases. Shifts of the Demand Curve: What factors shift the demand curve for dollars? I’ll list just three … ◦ Foreign demand for U.S. goods ◦ The U.S. interest rate ◦ The foreign interest rate We see the effect of these factors in the market for foreign exchange in detail later. Suppliers of dollars: U.S. residents who want foreign exchange to buy foreign goods and services. U.S. residents who want to buy foreign assets. Federal Reserve and other central banks which want to influence U.S. exchange rate. Anyone supplying dollars is demanding foreign currency. Supply: When the exchange rate rises (the dollar appreciates), say from 0.90€/$ to 0.95€/S, then … the price of foreign goods and services in the U.S. falls… the quantity demanded of foreign goods and services in the U.S. increases … the quantity of U.S. dollars supplied increases. Shifts of the Supply Curve: What factors shift the supply of dollars curve? I’ll list just three … ◦ U.S. demand for foreign goods ◦ The U.S. interest rate ◦ The foreign interest rate Again, we return to the effect of these factors in the foreign exchange market in detail later. Foreign exchange market: 43 1. Fixed (pegged) exchange rate The exchange rate is not allowed to change 2. Flexible exchange rate The exchange rate is allowed to freely respond to changes in supply and demand Gold standard: Each nation fixed its currency to a certain amount of gold. US: $20.67 per 90% troy ounce of gold UK: ₤4.24 per 90% troy ounce of gold The price of an ounce of gold must be the same in both nations. Let’s look at the price in pounds in the UK and the US: ₤4.24 must equal ε × $20.67 ₤4.24 = ε × $20.67 ₤4.24 ε= = 0.205 pounds per dollar $20.67 (4.87 dollars per pound) Gold flows (or foreign reserve flows) were supposed to maintain the exchange rate and balance of trade equilibrium. Foreign reserves are assets that central banks can use to finance current account deficits. (We’ll return to these in the next slide.) Example … AD P PEXPORTS PIMPORTS Exports Imports Trade deficit Gold Exports M AD P Some of my work … J Gold standard irretrievably broke during the Depression After WWII 1. Nations pegged their exchange rate to the dollar. 2. The US pegged the dollar to gold. But there is a problem… 3. Central banks were now supposed to intervene in the foreign exchange market to maintain the What is it? Let’s see! fixed exchange rate. Foreign reserves include: 1. Gold 2. US dollars (actually US government bills) 3. Other reserve currencies (actually foreign government bills)  Suppose the EU pegged to the dollar at 0.90 euros per 1 dollar, ε = 0.90 €/$. The Fed (and ECB) was supposed to intervene to maintain the exchange rate at 0.90 euro/dollar. The Fed must buy or sell dollars to maintain this exchange rate. This commitment effectively means that the supply curve of dollars on the foreign exchange market is now horizontal. Suppose at this exchange rate, importers and exporters are buying and selling $5 billion dollars per year. Suppose the demand for dollars increases. If the Fed does nothing, the exchange rate appreciates to 1.00. BUT THE EXCHANGE RATE IS FIXED. So the Fed offsets the increase in demand by selling more dollars and thereby increasing the supply of dollars. The Fed increases the supply of dollars by purchasing foreign reserves. Let’s suppose it buys gold and pays with dollars, this is, the Fed sells dollars: Fed Assets Liabilities & NW Gold FRN Government Banks’ reserves securities After the Fed’s action: Fed Assets Liabilities & NW Gold ↑ FRN ↑ Government Banks’ reserves securities The US starts to accumulate gold, or more generally, starts to accumulate foreign reserves. NO PROBLEM (so far). Suppose the demand for dollars decreases. If the Fed does nothing, the exchange rate depreciates to 0.80. BUT THE EXCHANGE RATE IS FIXED. So again the Fed offsets the decrease in demand by buying more dollars and thereby decreasing the supply of dollars. The Fed decreases the supply of dollars by selling foreign reserves. Let’s suppose it sells gold and takes dollars as payment, this is, the Fed buys dollars: Fed Assets Liabilities & NW Gold FRN Government Banks’ reserves securities After the Fed’s action: Fed Assets Liabilities & NW Gold ↓ FRN ↓ Government Banks’ reserves securities The US starts to lose gold, or more generally, starts to lose foreign reserves. THE PROBLEM! If the Fed runs out of foreign reserves (gold) it must devalue (depreciate) the exchange rate. A Role Played by Speculators Suppose the exchange rate will fall from 0.90 euros per dollar to 0.80 euros per dollar and speculators anticipate this outcome. What can they do? ◦ Before the Fed devalues, go to the Fed with $1 and get 0.90 euros. ◦ After the Fed devalues, go back and exchange 0.80 euros for $1. The speculator has made a profit of 0.10 euros. But the first step decreased the Fed’s foreign reserves and thereby increased the likelihood of devaluation. ◦ This sort of “speculative attack” occurred with frequency when there was a “one-way bet” on the direction of the exchange rate. History } After WWII, most exchange rates were pegged to the US dollar and the dollar was pegged (somewhat) to gold. } In the late 1960s/early 1970s the demand for dollars started to persistently decrease. } In 1971 President Nixon declared that the US would no longer stand ready to sell gold to foreign central banks at the then-price of $35 per ounce. } The dollar was devalued to $38 per ounce then to $42.22 per ounce. This still wasn’t enough, so … The world moved to flexible exchange rates 56  Two theories of a flexible exchange rate The asset approach: This approach looks at demand and supply used to buy US and foreign assets. It assumes that a dollar used to buy a domestic asset gives the same return as a dollar used to buy a foreign asset so a dollar has equal returns in domestic and foreign assets. Two theories of a flexible exchange rate The monetary approach: This approach looks at demand and supply used to buy US and foreign goods and services. It assumes that a dollar used to buy a domestic good or service can buy the same quantity as a dollar used to buy a foreign good or service so a dollar has equal purchasing power in domestic and foreign goods and services. Interest Rate Parity: Using a dollar to buy a US asset or a foreign asset gives the same return. Let’s measure the return in US dollars: Return from US asset: Call the US interest rate RUS $1 × (1 + RUS) = (1 + RUS) Return from foreign asset: Step 1) Buy euros. How many Euros do you get? Call the exchange rate ε ($1 x ε) = (ε) Step 2) Buy European assets and get the return. What’s the return from using the euros to buy a European assets? Call the EU interest rate REU (ε) × (1 + REU) Step 3) In the future, change the euros back to dollars. How many dollars will you get? That depends on the future exchange rate. Call the future exchange rate εFUT [(ε) × (1 + REU )] / [εFUT ] Step 4) Now equate the returns. Interest rate parity requires (1 + RUS) = [(ε) × (1 + REU)] / [εFUT ]  (1 + RUS) = [(ε) × (1 + REU)] / (εFUT ) Which gives 1 + R US = εε 1 + R EU FUT As a theory of the exchange rate: 1 + RUS ε= EU × εFUT 1+R  1 + RUS ε= EU × εFUT 1+R Three implications for the exchange rate: 1. Suppose the Fed raises the U.S. interest rate. Then the U.S. exchange rate rises—the U.S. exchange rate appreciates. 2. Suppose the EU interest rate rises. Then the U.S. exchange rate falls—the U.S. exchange rate depreciates. 3. Finally, suppose the future exchange rate rises. Then the U.S. exchange rate rises—the U.S. exchange rate appreciates.  Changes in the U.S. or foreign interest rate immediately change the exchange rate. Changes in the future exchange rate immediately change the exchange rate. Let’s use the supply and demand model to see the effects. Say the U.S. interest rate rises. Then the: demand for dollars increases. supply of dollars decreases.  1 + RUS ε= × εFUT 1 + REU Another implication for the exchange rate: 1. Expectations about the future exchange rate matter. 2. It is possible to buy a forward contract that fixes the future exchange rate (called the forward rate). We might be interested in how well the forward exchange rate matches the actual future exchange rate … at least I was… Fiscal policy: An expansionary fiscal policy raises the interest rate. Appreciates the dollar exchange rate, making US exports more expensive abroad and US imports less expensive in the US. Exports decrease and imports increase. Offsets (somewhat) the expansionary part of the fiscal policy. Let’s check out the effect on the exchange rate: ◦ https://www.youtube.com/watch?v=ra57ClA4gtc Monetary policy: An expansionary monetary policy lowers the interest rate. Depreciates the dollar exchange rate, making US exports less expensive abroad and US imports more expensive in the US. Exports increase and imports decrease. Reinforces the expansionary effect of the policy. Purchasing Power Parity (PPP): The purchasing power of a dollar (how many dollars it takes to buy a basket of goods) is the same for domestic and foreign markets. Example In the United States the basket’s price is $50 and in the EU the price is €40. The PPP exchange rate will make the purchasing power of a dollar the same in both areas. ($50 × ε) = €40 ε = €40/$50 Þ 0.80 euros per dollar. With this exchange rate, $50 buys the basket in the United States and the same $50, exchanged into €40, buys the basket in the EU.  ε = €40/$50 More generally, ε = (Price of basket in EU)/(Price of basket in US) An increase in the EU price of the basket appreciates the US dollar. Even more generally, Price levels are the price of a basket of goods. So … ε = (Price level in EU)/(Price level in US) An increase in the EU price level appreciates the US dollar. Suppose the US has 10% inflation and the EU has 0%. After a year the US market basket costs $55. After a year the EU basket (still) costs €40. The new PPP exchange rate is: ($55 × ε) = €40 Þ ε = €40/$55 Þ 0.727 euros per dollar. The US exchange rate has depreciated from 0.80 euros per dollar to 0.727 euros per dollar, approximately 10%. More generally, if one country’s inflation rate is X% higher than another country, the first country’s exchange rate depreciates by approximately X%. How about the exchange rate?  Empirically, the models economists have of exchange rates are lousy. Short run (asset approach): Exchange rates follow close to a random walk. Long run (monetary approach): Exchange rates reflect differences in inflation rates. Return to Milton Friedman and allow him to sum up for us by tying together microeconomic reasons for trade and the macroeconomic issue of the exchange rate. https://www.youtube.com/watch?v=c9STBcacDIM 72 In Chapter 15, our book lists 7 factors that change exchange rates: 1. Price level 2. (Real) interest rates 3. Expectations (profit and future exchange rate) 4. Central bank actions 5. Real GDP 6. Tax rates 7. Risk 1. Price level: A higher price level depreciates the exchange rate P↑ = ε ↓ Monetary approach and purchasing power parity 2. (Real) interest rate: A higher interest rate appreciates the exchange rate R↑ = ε ↑ Asset approach and interest rate parity 3. Expectations: Higher expected profit from domestic investment appreciates the exchange rate E(Profit)↑ = ε ↑ Higher expected future exchange rate increases the return from domestic investment and decreases the return from foreign investment, which appreciate the exchange rate E(Future ε)↑ = ε ↑ Asset approach and interest rate parity 4. Central bank actions: Central bank sale of domestic currency (and purchase of foreign reserves) depreciates the exchange rate Sale of domestic currency↑ = ε ↓ Basic supply and demand 5. Real GDP: An increase in real GDP increases the demand for imports and depreciates the exchange rate GDP↑ = ε ↓ Basic supply and demand 6. Tax rates: A decrease in domestic tax rates increases the expected profit from domestic investment and appreciates the exchange rate E(Profit)↑ = ε ↑ Asset approach and interest rate parity 7. Risk: An increase in domestic risk decreases the desirability of domestic investment and depreciates the exchange rate Risk↑ = ε ↓ Asset approach and interest rate parity