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International Political Economy Lesson 3 Section 3.1 Open Economies and its mechanisms [email protected] • An Economy has two basic kinds of economic interactions with the rest of the world: – Buying and/or Selling • Goods (e.g. lumber, automobiles, etc.) • Services (e.g. transportation, tourism, etc.) • Assets, mainly financial assets (e.g. interest and dividend payments) [email protected] Export (Goods, Services, Financial Activities) Domestic Currency (α) Rest of the World A Foreign Currency (β) Import (Goods, Services, Financial Activities) [email protected] • Each international actvities gives rise to a situation in which either foreigners wish obtain our currency or we wish obtain foreign currency • The former is viewed as a demand for our currency on the foreign exchange market, and the latter is viewed as a supply of our currency on this market [email protected] Domestic Currency Supply Domestic Currency Demand Rest of the World A Foreign Currency Demand Foreign Currency Supply [email protected] Domestic Currency Supply Foreign Currency Supply Country Rest of the World Foreign Currency Demand Domestic Currency Demand [email protected] € Supply $ Supply Italy € USA $ $ Demand € Demand [email protected] Exchange rate (€) $ Supply $ Demand E1 ► QD1>QS1 E2 ► QD2<QS2 E2 E1 QD2 QS1 QD1 QS2 [email protected] D and S Foreign Currency ($) Exchange rate (€) $ Supply $ Demand E1 ► QD1>QS1 E2 ► QD2<QS2 E2 E1 QD2 QS1 QD1 QS2 [email protected] D and S Foreign Currency ($) Exchange rate (€) $ Supply $ Demand E* ► QD = QS E* Q* [email protected] D and S Foreign Currency ($) USA good more expensive Price 1$ = 2€ Import decrease Italy good less expensive Price 1€ = 0,5$ Export increase USA good less expansive Price 1$ = 0,5€ Import increase Italy good more expensive Price 1€ = 2$ [email protected] Export decrease Exchange Rate increase (e.g. 1$ = 2€) Equilibrium Exchange Rate (e.g. 1$ = 1€) Exchange Rate decrease (e.g. 1$ = 0,5€) Lesson 3 Section 3.2 WHAT IS THE BALANCE OF PAYMENTS? [email protected] • The balance of payments is the difference between the sum of all demands for and the supplies of domestic currency on the foreign exchange market • If the total number of domestic currency supplied is equal to the total number of domestic currency demanded, the result is a zero balance of payments • In this case the international sector of the [email protected] economy is in equilibrium • A balance of payments surplus • A balance occursofwhen the demand of domestic currency payments on the deficit foreignis exchange market exceeds the the situation supply where the supply of domestic currency exceeds its demand [email protected] • Domestic Currency Supply = Domestic Currency Demand ▼ Balance • Domestic Currency Supply > Domestic Currency Demand ▼ Imbalance (deficit) Domestic Currency Supply < Domestic Currency Demand ▼ Imbalance (surplus) [email protected] Lesson 3 Section 3.3 DETERMINANTS OF FOREIGN EXCHANGE MARKET ACTIVITY [email protected] • Several variables affect supply and demand activity in this market: – Exchange rate – Income – Interest rate – Price level – Expectations [email protected] • Exchange rate – The price of domestic currency in terms of foreign currency is determined in the foreign exchange market – The exchange rate is a very important determinant of international trade; in fact: • If exchange rate of domestic currency increase, imports is cheaper, so imports increase; – Thus, increasing the supply of domestic currency on the foreign exchange market • Similarly, exports are more expensive to foreigners, so exports fall; – Thus, the decreasing the demand of domestic currency • This way the rise in the exchange rate eliminates the balance of payments surplus • The opposite occurs in case of a balance of payments deficit: – The exchange rate falls to eliminate the deficit [email protected] Demand/ Supply Foreign Currency Foreign Currency Demand Foreign Currency Supply Transaction Type Import Export Exchange rate Variation Inverse Exchange Rate ▲ Currency Demand ▼ Direct Exchange Rate ▼ Currency Supply ▲ [email protected] Exchange Rate Increase (consequences) Devaluation Export ▲ Import ▼ Revaluation Export ▼ Import ▲ • Income – At a higher level of income, imports increase • The supply of domestic currency on the foreign market increases, creating a balance of payments deficit and downward pressure on exchange rate [email protected] • Interest rate • Two caveats concerning capital inflows are important: – 1. the resul depends on the interest rate increaseare not – When domestic interes rate is higher, foreigners beingassets part of a worldwide more interested in buying financial pattern • So, increase the demand of domestic currency on the foreign – 2. the relevant difference in exchange market interest rates is the • This demand creates difference in real interest – capital inflows, – a balance of payments surplus, rates, and not nominal interest rates, because – And upward pressure on the exchange rate investors are concerned with real returns [email protected] • Price level – A rise of domestic prices level increase the price of exports and the price of importcompeting goods and services • So, exports fall and imports rise – As the result the demand for domestic currency decreases, and the supply of domestic currency increases creating • a balance of payments deficit, and • Downward pressure on the exchange rate – Again in this case, the effect occur only if [email protected] there is no equivalent price increase in the • Expectations – If foreigners expets the value of domestic currency to rise, they can reap a capital gain by buying our bonds and the selling them again after the exchange rate has risen • This speculation creates – An inflow of capital, – A balance of payments surplus, – and upward pressure on the exchange rate – Speculative activity is indeed the primary determinant of exchange rates in the short run [email protected] Lesson 3 Section 3.4 THE INTERNATIONAL ECONOMIC ACCOUNTS [email protected] • Knowledge of the balance of payments is all that is needed for analysis of the economic forces that automatically are set in motion whenever there is a disequilibrium in the international sector of the economy • Often, however, analysts are interested in the source of any disequilibrium in the international sector, that is, the relative contributions to an equilibrium position of the various components of the demand for and supply of domestic currency on the foreign exchange market • Consequently, the balance of payments is broken down into several subsidiary measures, which together are referred to as the international accounts or the balance of payments accounts. [email protected] [email protected] • At the most general level, the balance of payments is broken into two accounts, the current and capital accounts – The current account measures the difference between the demand for and the supply of domestic currency arising from transactions that affect the current level of income here and abroad – The capital account measures the difference between the demand for and the supply of domestic currency arising from sales or purchases of assets to or from foreigners. • The capital account measures capital flows between a country and the rest of the world. A capital account surplus measures a net capital inflow, and a capital account deficit measures a net capital outflow. [email protected] • The trade balance is the sum of following: – Merchandise trade balance • Difference between exports and imports of goods – Services trade balance • Difference between exports and imports of services • Net investment income from abroad – Interest and dividend interest • Net transfer from abroad – Pension payments, foreign aid, etc. [email protected] Lesson 3 Section 3.5 THE TWIN DEFICITS [email protected] • An interesting aspect of the balance of payments accounts is that it is quite possible to have an economy in international equilibrium while simultaneously its subsidiary accounts are unbalanced, as long as they offset each other • The U.S. economy, for example, for several years had a current account deficit that was offset by a surplus in its capital account. [email protected] • How might this situation come about? – A prominent explanation is that it is a side effect of large government budget deficits—hence termed the twin deficit problem. – A large government deficit increases the interest rate as the government sells bonds to finance its deficit. – This rise in the interest rate makes domestic bonds look very attractive to overseas investors, so capital flows into the country, creating a balance of payments surplus. – This bids up the value of the dollar, which in turn decreases exports and increases imports, creating a balance of trade deficit. [email protected] • How budget deficits cause trade deficits – G increase and/or T decrease • This causes – Budget deficit – Government sells bonds – Interest rate increase – Capital inflows increase – Exchange rate increase – Exports decrease and imports increase [email protected] Twin deficit USA 84.000 74.000 64.000 percent of GDP 54.000 44.000 34.000 24.000 14.000 4.000 -6.0001980 1985 1990 General government gross debt 1995 2000 Current account balance 2005