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PART V THE WORLD ECONOMY
Open-Economy
Macroeconomics: The
Balance of Payments
and Exchange Rates
20
CHAPTER OUTLINE
The Balance of Payments
Equilibrium Output (Income)
in an Open Economy
The Open Economy with Flexible
Exchange Rates
Adapted from:
Fernando & Yvonn Quijano
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CHAPTER 20 Open-Economy Macroeconomics: The Balance of Payments and
Exchange Rates
20.1 Introduction
International trade is a major part of today’s world economy.
When people in different countries buy from and sell to each other, an
exchange of currencies must also take place.
The main difference between a domestic transaction and an
international transaction concerns currency exchange. The former uses
a single currency while the latter uses several difference currencies.
For instance, when Malaysia imports machinery from the U.S., the
standard currency is the U.S. dollars (U$).
In the above case, the exchange rate of MYR/U$ will determine the
costs of imported goods. If the rate goes up from MYR3/U$ to
MYR4/U$, the Malaysian importer will have to pay MYR4000 for a
U$1000 machine (compared with MYR3000 before the rate increases).
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Early in the century, during the gold standard era, nearly all currencies
were backed by gold. The values were fixed in terms of a specific
number of ounces of gold.
At the end of World War II, the Bretton Woods system came into force
before its demise in 1971. Under this system, countries were to
maintain fixed exchange rates with each other. Governments must at
times intervene to keep currencies aligned at their established values.
After 1971, exchange rates are determined essentially by supply and
demand, either under a freely floating system (no government
intervention) or managed floating system (limited intervention).
foreign exchange All currencies other than the domestic currency of a
given country.
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20.2 The Balance of Payments
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.
The balance of payments is divided into 2 major accounts:
(1) The current account
(1) The capital account
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CHAPTER 20 Open-Economy Macroeconomics: The Balance of Payments and
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TABLE 20.1 United States Balance of Payments, 2007
Current Account
Goods exports
Goods imports
(1) Net export of goods
Billions of dollars
1,149.2
 1,964.6
 815.4
Export of services
Import of services
(2) Net export of services
479.2
 372.3
106.9
Income received on investments
Income payments on investments
782.2
 707.9
(3) Net investment income
(4) Net transfer payments
(5) Balance on current account (1 + 2 + 3 + 4)
Capital Account
(6) Change in private U.S. assets abroad (increase is –)
(7) Change in foreign private assets in the United States
(8) Change in U.S. government assets abroad (increase is –)
74.3
 104.4
 738.6
(9) Change in foreign government assets in the United States
(10) Balance on capital account (6 + 7 + 8 + 9)
(11) Net capital account transactions
(12) Statistical discrepancy
(13) Balance of payments (5 + 10 + 11 + 12)
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 1,183.3
1,451.0
23.0
412.7
657.4
 2.2
83.6
0
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CHAPTER 20 Open-Economy Macroeconomics: The Balance of Payments and
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(1) The Current Account
(a) The first item in the current account is a country trade in goods, i.e.
exports (+, credit, earn foreign exchange) and imports (-, debit, use up
foreign exchange) of goods.
(b) The second item is a country trade in services, i.e. exports (+) and
imports (-) of services.
balance of trade A country’s exports of goods and services minus its
imports of goods and services.
If exports > imports  trade surplus
If exports < imports  trade deficit
(c) The third item is investment income, i.e. holdings of foreign assets
that yield dividends, interest, rent and profits.
(d) The final item is transfer payments, such as funds for relief agency
or remittances by foreign workers.
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balance on current account Net exports of goods, plus net exports of
services, plus net investment income, plus net transfer payments.
If C/A is negative, a country uses up more foreign exchange than it earns.
If C/A is positive, a country earns more foreign exchange than it uses up.
(2) The Capital Account
A nation settles its accounts with the rest of the world through its capital
account.
The capital account records the changes in assets and liabilities.
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The capital account records the nation’s capital inflows and outflows.
When a foreigner purchases a domestic asset, the transaction creates a
capital inflow.
 When a domestic resident purchases a foreign asset, the transaction
creates a capital outflow.
For each transaction recorded in the current account, there is an offsetting
transaction recorded in the capital account.
 U.S. imports  (current account), foreign assets in the U.S.  (capital
account), because U.S. must pay for the imports.
 U.S. exports  (current account), U.S. assets abroad  (capital
account), because foreigners must pay for the U.S. exports).
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Foreign assets in the U.S. are divided into:
a) Foreign private holdings (line 7)
b) Foreign government holdings, such as accumulation of dollars by Japan
and China (line 9)
U.S. assets abroad are divided into:
a) Private holdings (line 6)
b) Government holdings (line 8)
Balance on capital account: The sum of lines 6, 7, 8 and 9.
If balance on capital account:
+  change in foreign assets in U.S. > change in U.S. assets abroad
(current account negative as imports > exports)
(decrease in U.S. net wealth position)
-  change in foreign assets in U.S. < change in U.S. assets abroad
(current account positive as imports < exports)
(increase in U.S. net wealth position)
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Balance on current account = Balance on capital account (with opposite
signs, if no errors of measurement in the data correction).
However, there is a measurement error of $83.6 billion in Table 20.1,
causing the balance on current account ≠ balance on capital account (line
5 versus line 10).
By construction, the balance of payments is always zero.
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The United States as a Debtor Nation
Prior to the mid-1970s, the United States had generally run current account
surpluses, and net wealth position was positive. Hence U.S. was a creditor
nation during this period.
This began to turn around in the mid-1970s, and by the mid-1980s, the
United States was running large current account deficits, with negative net
wealth position. In other words, the United States changed from a creditor
nation to a debtor nation.
A negative net wealth position reflects the fact that the U.S. spent much
more on foreign goods and services than it earned through the sales of its
goods and services.
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20.3 Equilibrium Output (Income) in an Open Economy
In 2-sector economy,
AE  C + I
In 3-sector economy,
AE  C + I + G
In an open economy,
AE  C + I + G + EX  IM
Exports (EX) are assumed to be completely autonomous (fixed).
Imports (IM), on the other hand, are a constant fraction of income (Y).
IM = mY,
where m = IM/ Y = MPM
marginal propensity to import (MPM) The change in imports caused
by a $1 change in income.
If MPM= 0.2, and Y = 1000, then IM = 0.2 * 1000 = 200
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Deriving the multipliers
In a 4-sector economy,
C = a + bYd
IM = mY
C  a  b(Y  T )
At equilibrium,
Y  C  I  G  EX  IM
Y  a  bY  bT  I  G  EX  mY
Y  bY  mY  a  bT  I  G  EX
Y (1  b  m)  a  bT  I  G  EX
Y
a
b
1
1
1

T
I
G
EX
1 b  m 1 b  m 1 b  m
1 b  m
1 b  m
where b = MPC and m = MPM
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Solving for Equilibrium
Figure 20.1 Equilibrium output occurs at Y* = 200, the point at which planned domestic aggregate
expenditure crosses the 45-degree line.
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The slope for the planned domestic aggregate expenditure function
Planned domestic aggregate expenditure = C + I + G + EX – IM
Since I, G and EX are assumed to be fixed, we focus only on C – IM.
C – IM = (a + bY – bT) – mY
= (a – bT) + (b – m)Y
The slope of the planned domestic AE function = b – m
From Figure 20.1, we can determine that MPC (or b) = 0.75, and m = 0.25
So, the slope of the planned domestic AE = 0.75 – 0.25 = 0.50
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Suppose MPC = 0.75, MPM = 0.25, compare the government spending
multiplier in a closed versus open economy.
Closed-economy, Y/ G = 1/ (1-MPC) = 1/0.25 = 4 times
Open economy, Y/ G = 1/ (1-MPC+MPM) = 1/0.50 = 2 times.
The multiplier is smaller in an open economy than in a closed economy.
Why??
The reason: When government spending (or investment) increases,
some of the increased income is used to purchase imports, and thus
there is less of an impact on the domestic economy.
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Exports and Imports Functions
The Determinants of Imports
We have thus far assumed that imports depends only on income.
Imports also depend on those factors that affect consumption and
investment.
Other determinants are:
• after-tax real wage
• after-tax non-labor income
• interest rate
• relative prices of domestically produced and foreign-produced
goods
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The Determinants of Exports
We have thus far assumed that the level of exports is fixed.
The demand for exports depends on economic activity in the rest of
the world—rest-of-the-world real wages, wealth, non-labor income,
interest rates, and so on—as well as on the prices of domestic
goods relative to the price of rest-of-the-world goods.
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CHAPTER 20 Open-Economy Macroeconomics: The Balance of Payments and
Exchange Rates
20.4 The Market for Foreign Exchange
After 1971, most countries decided to abandon the fixed exchange rate
system, in favor of floating exchange rates, in which the rates are
determined by unregulated forces of supply and demand.
Exchange rate movements have important impacts on imports, exports,
and the movement of capital between countries.
The Supply of and Demand for Pounds (£)
Governments, private citizens, banks, and corporations exchange
pounds for dollars and dollars for pounds every day.
In our two-country case (U.S. and U.K.), 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.
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TABLE 20.2 Some Private Buyers and Sellers in International Exchange Markets:
United States and Great Britain
The Demand for Pounds
1.
2.
3.
4.
5.
Firms, households, or governments that import British goods into the United States or wish to buy
British-made goods
and services
U.S. citizens traveling in Great Britain
Holders of dollars who want to buy British stocks, bonds, or other financial instruments
U.S. companies that want to invest in Great Britain
Speculators who anticipate a decline in the value of the dollar relative to the pound
The Supply of Pounds
1. Firms, households, or governments that import U.S. goods into Great Britain or wish to buy U.S.made goods and
services
2. British citizens traveling in the United States
3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United
States
4. British companies that want to invest in the United States
5. Speculators who anticipate a rise in the value of the dollar relative to the pound
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CHAPTER 20 Open-Economy Macroeconomics: The Balance of Payments and
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 FIGURE 20.2 The Demand for £ in the
Foreign Exchange Market
When the price of £ 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 £ demanded will rise .
Hence, the demand-for-pounds curve has a
negative slope.
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 FIGURE 20.3 The Supply of £ in the
Foreign Exchange Market
When the price of £ falls, the British obtain less
dollars for each pound. This means that U.S.made goods and services appear more
expensive to British buyers. A decrease in
British demand for U.S. goods and services is
likely to cause a fall in the quantity of £ supplied.
Thus, the supply-of-pounds curve has a positive
slope.
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The Equilibrium Exchange Rate
 FIGURE 20.4
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 £ will cause
the price of £ to rise- the £ will
appreciate with respect to the dollar
(£1 will buy more dollars) .
An excess supply of £ will cause the
price of £ to fall- the pound will
depreciate with respect to the dollar
(£1 will buy less dollars).
The equilibrium exchange rate
occurs at the point at which the
quantity demanded for £ equals the
quantity of £ supplied.
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20.5 Factors that Affect Exchange Rates
(1) Relative Price Levels
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.
For instance, if the price of a basketball were U$12 in the U.S. and £10 in
the U.K., the exchange rate between the U.S. and the U.K. would have to
be U$1.2/£.
What if the exchange rate were U$1/ £? (From the perspective of
DD/SS of £)
If would be wise to buy basketballs in the U.K. for £10, and sell them in the
U.S. for U$12. This would increase the demand for £ in the U.S., thereby
driving up their price to U$1.2/£.
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What if the exchange rate were U$2/£? (From the perspective of DD/SS
of £)
It would be wise to buy basketballs in the U.S. for U$12, which costs a
British about £6 per basketball. Selling them later in the U.K. at £10 would
earn a profit of £4. This would increase the supply of £, and its price would
fall from U$2 until it reached U$1.2.
A good example of the application of the law of one price is the Big Mac
Index, which looks at the prices of a Big Mac burger in Macdonald’s
restaurants in about 120 different countries. If a Big Mac costs U$3 in the
U.S. and £4 in the U.K., then the exchange rate would be U$0.75/£.
For more details on the Big Mac Index, see
http://www.economist.com/markets/bigmac/
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If the law of one price held for all goods, then the purchasing power parity
(PPP) is said to hold. In other words, the PPP is an aggregate application
of the law of one price.
The PPP asserts that if the law of one price held for all goods, and if each
country consumed the same market basket of goods, the exchange rate
between the two currencies would be determined simply by the relative
price levels in the two countries (i.e. the ratio of the two countries’ price
levels).
In practice, the PPP might not hold due to significant transportation costs,
insurance, storage, and/or tariffs.
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 FIGURE 20.5
Exchange Rates Respond to Changes in
Relative Prices (from the perspective of
SS and DD of £)
Assume that the U.S. price level increases
relative to the price level in U.K.
The higher prices in the U.S. make imports
relatively less expensive. U.S. citizens are
likely to increase their spending on imports
from U.K., shifting the demand for £ 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 £ shifts to the left,
from S0 to S1. The result is an increase in
the price of £.
The pound appreciates against the dollar,
from U$1.89 to U$2.25 per pound.
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(2) Relative Interest Rates
 FIGURE 20.6
Exchange Rates Respond to Changes in
Relative Interest Rates (from the
perspective of SS and DD of £)
If U.S. interest rates rise relative to British
interest rates, British citizens holding £ may
be attracted into the U.S. securities market.
To buy bonds in the United States, British
buyers must exchange £ for dollars. This
implies an increase in the supply of £, shifting
the supply curve to the right, from S0 to S1.
However, U.S. citizens are less likely to be
interested in British securities because
interest rates are higher at home. The
demand for £ drops and shifts to the left, from
D0 to D1 (at the same time the supply of £
increases).
The result is depreciation of the £ against the
dollar, falling from U$1.89 to U$1.25 per
pound.
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20.6 The Effects of Exchange Rates on the Economy
(1) Imports, Exports and Real GDP
When MYR depreciates against the dollar, the direct effects are:
(1) a rise in the ringgit price of imports (a U$1000 machine now needs more
MYR to buy);
(2) and a fall in the dollar price of Malaysian exports, though its ringgit price
is fixed (a U.S. importer now needs less dollars to buy one tonne of
palm oil, price at MYR3000).
The depreciation of MYR tends to bring about an increase in Malaysian
exports (more competitive abroad) and a decrease in her imports
(expensive imports encourage consumers to switch to domestically
produced goods and services). This will cause a rise in Malaysia’s real
GDP.
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(2) The Balance of Trade
Balance of trade = Export Revenue – Import Costs
(BOT)
= (ringgit price of exports * quantity of exports) –
(ringgit price of imports * quantity of imports)
According to the J-curve effect, when a currency starts to depreciate, the
balance of trade is likely to worsen for the first few quarters. After that, it
gets better.
For instance, when MYR depreciates against the dollar:
(1) ringgit price of exports fixed;
(2) quantity of exports  (not instantaneously);
(3) ringgit price of imports  (instantaneously);
(4) quantity of imports  (not instantaneously);
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BOT unchanged
BOT 
BOT 
BOT 
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 FIGURE 20.7 The Effect of a Depreciation on the Balance of Trade
The negative effect on the price of imports is generally felt quickly; while it takes
time for export and import quantities to respond.
In the short run, the value of imports increases more than the value of exports, so
BOT worsens. But after exports and imports have had time to respond, the BOT
turns positive.
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(3) The Price Level (Inflation)
When a country’s currency depreciates, its price level will rise:
i)
Currency depreciation increases planned AE (EX , IM), and AD curve
will shift to the right. If the economy is close to capacity, the result is
likely to be higher prices;
ii) Currency depreciation makes imported inputs more expensive, shifting
the AS curve to the left. If AD curve remains unchanged, the price level
will increase.
(4) Monetary Policy
i.
Exchange rate is fixed: There is no role monetary policy can play.
Suppose the Malaysian ringgit is fixed to USD, the central bank has no
independent way of changing its interest rate. Lowering the interest rate
to stimulate output will cause MYR to depreciate.
The only way to change its interest rate while keeping a fixed exchange
rate is to impose capital controls (limiting the trading of MYR).
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ii.
Exchange rate is flexible:
A cheaper MYR is a good thing if the goal of the expansionary
monetary policy is to stimulate the domestic economy. When MS, r.
A lower interest rate means a lower demand for MYR, and hence push
down its value. A cheaper MYR means more exports and fewer imports,
and hence Y .
Floating exchange rates also help if the central bank wants to fight
inflation via contractionary monetary policy. When MS, r. The
higher interest rate will push up the demand for MYR and hence its
value. When MYR appreciates, the price of imports falls, shifting the AS
curve to the right. If AD curve remains unchanged, the price level will
drop.
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