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CHAPTER 16 (27): OPEN
ECONOMY MACROECONOMICS
COREECONOMICS, 3RD EDITION BY ERIC CHIANG
Slides by Debbie Evercloud
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CHAPTER OUTLINE
• The Balance of Payments
• Exchange Rates
• Monetary and Fiscal Policy in an Open
Economy
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LEARNING OBJECTIVES
• At the end of this chapter, the student will be
able to:
– Define the current account and the capital
account in the balance of payments between
countries
– Distinguish between nominal and real
exchange rates
– Illustrate the effects of currency appreciation
or depreciation on imports and exports
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LEARNING OBJECTIVES
• At the end of this chapter, the student will be
able to:
– Describe the effects of changes in inflation
rates, disposable income, and interest rates
on exchange rates
– Compare fixed and flexible exchange rate
systems
– Describe the implications for fiscal and
monetary policies of fixed and flexible
exchange rate systems
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EXAMPLE: THE ECONOMIC
TOURIST
• You have experienced a foreign exchange
transaction if you have travelled overseas
and converted your U.S. dollars into the
other country’s domestic currency.
• Foreign exchange also underlies
international trade and investment.
• This chapter looks at the foreign exchange
markets to get a sense of how it affects
policymaking in the United States.
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Eric Chiang
BY THE NUMBERS:
FOREIGN EXCHANGE
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THE BALANCE OF PAYMENTS
• The current account includes:
– Payments for imports and exports of goods and
services
– Incomes flowing into and out of the country
– Net transfers of money
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THE BALANCE OF PAYMENTS
• Imports and exports
– In 2012, American exports were $2,194.5
billion, with imports totaling $2,734.0 billion.
– This exchange produced a trade deficit of
$539.5 billion.
– This component of the current account is
known as the balance of trade.
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THE BALANCE OF PAYMENTS
• Income flows include wages, rents,
interest, and profits that Americans earn
abroad minus the corresponding income
foreigners earn in the United States.
• On balance, foreigners earned $198.6 billion less
in the United States than U.S. citizens and
corporations earned abroad in 2012.
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THE BALANCE OF PAYMENTS
• Direct transfers of money also take place
between the United States and other
countries.
– These transfers include foreign aid, funds
sent to international organizations, and
stipends paid to students studying abroad.
– They also include the money that people
working in the United States send back to
their families in other countries.
– Net transfers for 2012 totaled −$134.1 billion.
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THE CAPITAL ACCOUNT
• The capital account summarizes the flow
of money into and out of domestic and
foreign assets.
– This account includes investments by foreign
companies in domestic plants or subsidiaries.
• Because the United States ran a current
account deficit in 2012, it must run a
capital account surplus.
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CHECKPOINT:
THE BALANCE OF PAYMENTS
• The balance of payments represents all
payments received from foreign countries
and all payments made to them.
• The balance of payments is split into two
categories: current and capital accounts.
• The sum of the current and capital account
balances must equal zero.
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EXCHANGE RATES
• The exchange rate defines the rate at which
one currency, such as U.S. dollars, can be
exchanged for another, such as British pounds.
• We can view the exchange rate as the price of
one currency in terms of another.
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EXCHANGE RATES
• A nominal exchange rate is the stated
price of one country’s currency in terms of
another.
• The real exchange rate takes the price
levels of both countries into account.
– The real exchange rate is the nominal
exchange rate multiplied by the ratio of the
price levels of the two countries.
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EXCHANGE RATES
• The real exchange rate is defined as:
er = en × (Pd/Pf)
where:
er is the real exchange rate
en is the nominal exchange rate
Pd is the domestic price level
Pf is the foreign price level
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PURCHASING POWER PARITY
• Purchasing power parity (PPP) is the
rate of exchange that allows a specific
amount of currency in one country to
purchase the same quantity of goods in
another country.
• The Big Mac Index serves as a general
approximation of PPP.
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THE MARKET FOR
FOREIGN EXCHANGE
• The foreign exchange market for dollars
has an upward-sloping supply and a
downward-sloping demand.
– The supply of dollars to the market reflects
the demand for other currencies.
• With perfectly flexible exchange rates, an
equilibrium will be established in which the
quantity of currency demanded will equal
the quantity supplied.
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THE MARKET FOR
FOREIGN EXCHANGE
Exchange Rate
(pounds per dollar)
S$
e2
e
e0
e1
At exchange rate e1, there is
an excess demand for dollars,
and the dollar will appreciate.
At exchange rate e2, there is an
excess supply of dollars.
The market will settle into
equilibrium at rate e0.
D$
Q1 Q0 Q2
Quantity of Dollars ($)
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APPRECIATION AND
DEPRECIATION
• Currency appreciation
– A currency appreciates when its value rises
relative to other currencies
• Currency depreciation
– A currency depreciates when its value falls
relative to other currencies
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CURRENCY DEPRECIATION
• Consider the market for foreign exchange
between U.S. dollars and the British
pound. If there is an increase in the
demand for dollars, this will result in:
– An appreciation of the dollar
– A depreciation of the pound
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EXCHANGE RATES
• Determinants of Exchange Rates:
– Tastes and preferences
– Income levels
– Inflation rates
– Interest rates
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CHANGES IN THE CURRENT
ACCOUNT
• As rates of inflation rise in one country, its
exports will be relatively more expensive.
– This will worsen its current account position.
• As domestic income rises, a country will
import more goods.
– This also serves to worsen its current account
position.
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CHANGES IN THE CAPITAL
ACCOUNT
• Foreign investment possibilities include:
– Direct investment in projects undertaken by
multinational firms
– Sale and purchase of foreign stocks and
bonds
– Short-term movement of assets in foreign
bank accounts
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CHANGES IN THE CAPITAL
ACCOUNT
• Because international business ventures
involve capital, investors must balance
their risks and returns.
• Two factors essentially incorporate both
risk and return for international assets:
– Interest rates
– Expected changes in exchange rates
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INTEREST RATE CHANGES
• If the exchange rate is assumed to be
constant and the assets of two countries
are perfectly substitutable, then an interest
rate increase in one country will cause a
capital inflow.
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EXCHANGE RATE CHANGES
• Suppose that the exchange rate for
American currency is expected to
appreciate against the British pound.
– Investors demand a higher return in Britain to
offset the expected depreciation of the pound.
– Unless interest rates rise in Britain, capital will
flow out of Britain and into the United States
until American interest rates fall enough to
offset the expected appreciation of the dollar.
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EXCHANGE RATE CHANGES
• If the dollar falls relative to the yen, the euro,
and the British pound, this would be a sign
that foreign investors are not as enthusiastic
about U.S. investments.
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EXCHANGE RATE CHANGES
• The United States is more dependent on
foreign capital than ever before.
• Today, more than half of Treasury debt
held by the public is held by foreigners.
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EXCHANGE RATES AND
AS/AD
• A change in nominal exchange rates will
affect imports and exports.
• When the exchange rate for the dollar
depreciates, the dollar is weaker and other
currencies buy more dollars.
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EXCHANGE RATES AND
AS/AD
• Effect of the weaker dollar:
– American products become more attractive in
foreign markets, so American exports
increase and aggregate demand expands.
– Yet, because some inputs into the production
process may be imported, input costs will rise,
causing a leftward shift of aggregate supply.
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EXCHANGE RATES AND
POLICY
• Although it is also possible that a currency
depreciation will simply lead to inflation,
trade balances usually improve with an
exchange rate depreciation.
• Policymakers can improve the current
account balance without inflation by
pursuing devaluation first, then imposing a
fiscal contraction.
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POLICY IN AN OPEN
ECONOMY
SRAS1
Aggregate Price Level (P)
b
SRAS0
P2
a
P1
P0
e
Depreciation of the dollar will
simultaneously lead to an
increase in aggregate demand and
a decrease in aggregate supply.
AD1
LRAS
Q0 Q1
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AD0
Aggregate Output (Q)
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ISSUE: THE CHINESE YUAN
• When the Chinese yuan appreciates, it
takes more dollars to obtain the same
amount of yuan as before.
– Therefore, goods made in China become
more expensive for Americans.
• China has been buying and holding U.S.
dollars, in order to prevent an appreciation
of the yuan.
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ISSUE: THE CHINESE YUAN
• What are the effects of China’s policy?
– American consumers benefit.
– American manufacturers find it harder to
compete against imports from China.
• If American consumers win while American
businesses and their workers lose, it can
be difficult for policymakers to determine
whether to favor China’s policy.
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CHECKPOINT: EXCHANGE
RATES
• The nominal exchange rates is the rate at
which one currency can be exchanged for
another.
– Real exchange rates are the nominal
exchange rates multiplied by the ratio of the
price levels of the two countries.
• A currency appreciates when its value
rises relative to other currencies.
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CHECKPOINT: EXCHANGE
RATES
• Currency depreciation causes a currency
to lose value relative to others.
• Inflation and income levels affect the
current account.
• Interest rates and expected exchange
rates influence the capital account.
• Currency appreciation and depreciation
affect aggregate supply and demand.
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EXCHANGE RATE SYSTEMS
• In a fixed exchange rate system,
governments determine their exchange
rates, then adjust macroeconomic policies
to maintain these rates.
• A flexible or floating exchange rate
system relies on currency markets to
determine the exchange rates consistent
with macroeconomic conditions.
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GOLD STANDARD
• Before the Great Depression, most
countries were on the gold standard.
– Under the gold standard, each country had to
maintain enough gold stocks to keep the
value of its currency fixed to that of others.
In the 1930s, problems with the
gold standard allowed the Great
Depression to spread worldwide.
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BRETTON WOODS
• As World War II came to an end, the Allies
met in Bretton Woods, New Hampshire, to
design a new and less troublesome
international monetary system.
• Exchange rates were set, and each
country agreed to use its monetary
authorities to buy and sell its own currency
to maintain a fixed exchange rate.
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EXCHANGE RATE SYSTEMS
• Most currencies now fluctuate in value
based on their relative demand and supply
on the foreign exchange market.
• A number of countries, however, use
macroeconomic policies to peg their
currency to another currency, most
commonly the U.S. dollar or the euro.
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DOLLARIZATION
• Some countries have chosen to abandon
their currency altogether by adopting
another country’s currency as their own.
• Panama, Ecuador, and El Salvador all
chose to adopt the U.S. dollar as their
official currency, a process known as
dollarization.
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POLICIES WITH
FIXED EXCHANGE RATES
• Keeping exchange rates fixed and holding
the money supply constant, an
expansionary fiscal policy will raise the
price level.
• This will cause a decrease in exports and
an increase in imports.
• Together, these changes will worsen the
current account.
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POLICIES WITH
FIXED EXCHANGE RATES
• Keeping exchange rates fixed and holding
the money supply constant, an
expansionary fiscal policy will produce an
increase in interest rates.
– As income rises, there will be a greater
transactions demand for money, resulting in
higher interest rates.
– Higher interest rates mean that capital will
flow into the United States.
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POLICIES WITH
FIXED EXCHANGE RATES
• Effect of the resulting capital inflow:
– Interest rates will be reduced, adding to the
expansionary impact of the original fiscal
policy.
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POLICIES WITH
FLEXIBLE EXCHANGE RATES
• Expansionary monetary policy under a
system of flexible exchange rates results
in a growing money supply and falling
interest rates.
• Lower interest rates lead to a capital
outflow and a balance of payments deficit,
or a declining surplus.
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POLICIES WITH
FLEXIBLE EXCHANGE RATES
• Effects of the capital outflow:
– With flexible exchange rates, consumers and
investors will want more foreign currency;
thus, the domestic currency will depreciate in
the foreign exchange market.
– As the dollar depreciates, exports increase
and output rises.
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OPEN ECONOMY MACRO
• Several decades ago, presidents and
Congress could adopt monetary and fiscal
policies without much consideration of the
rest of the world.
– Today, economies of the world are vastly
more intertwined.
• Good macroeconomic policymaking must
account for changes in exchange rates
and capital flows.
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CHECKPOINT: MONETARY AND FISCAL
POLICY IN AN OPEN ECONOMY
• A fixed exchange rate system is one in
which governments determine their
exchange rates and then use
macroeconomic policy to maintain them.
• Flexible exchange rates rely on markets to
set the exchange rate given the country’s
macroeconomic policies.
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CHECKPOINT: MONETARY AND FISCAL
POLICY IN AN OPEN ECONOMY
• Some countries peg their currency to
another to facilitate trade, to promote
foreign investment, or to maintain
monetary stability.
• Fixed exchange rate systems hinder
monetary policy, but reinforce fiscal policy.
• Flexible exchange rates hamper fiscal
policy, but reinforce monetary policy.
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CHAPTER SUMMARY
• The current account includes payments for
imports and exports of goods and services,
incomes flowing into and out of the country, and
net transfers of money.
• The capital account includes flows of money into
and out of domestic and foreign assets.
• A nominal exchange rate is the price of one
country’s currency for another. The real
exchange rate takes price levels into account.
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CHAPTER SUMMARY
• The purchasing power parity (PPP) of a currency
is the rate of exchange where some currency in
one country can purchase the same goods in
another country.
• If exchange rates are fully flexible, markets
determine the prevailing exchange rate.
• Real exchange rates affect the current account.
• Interest rates and exchange rate expectations
affect the capital account.
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CHAPTER SUMMARY
• A fixed exchange rate system is one in
which governments determine their
exchange rates, then use macroeconomic
adjustments to maintain these rates.
• A flexible or floating exchange rate system
relies on currency markets to determine
the exchange rates, given macroeconomic
conditions.
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DISCUSSION QUESTIONS
• How does an economy benefit from
importing? From exporting?
• If you are traveling to another country,
which number matters most to you:
the nominal exchange rate or the real
exchange rate?
• Who wins and who loses from an
appreciation of the U.S. dollar?
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