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AP Macroeconomics
Mr. Graham
AP Exam Review
Unit 7:
Open Economy:
International Trade and Finance
(10-15%)
2
Capital Flows and the
Balance of Payments
3
Capital Flows and the Balance of Payments
• We learned that economists keep track of the
domestic economy using the national income
and product accounts (i.e. GDP)
• Economists keep track of international
transactions using a different but related set of
numbers—the balance of payment accounts
Balance of Payment Accounts
• A country’s balance of payment accounts are a
summary of the country’s transactions with other
countries.
• Current Account
– Represents the purchases and sales of goods and
services with other countries (i.e. net exports)
– Also includes factor income and international transfers
• Financial Account
– Represents the purchases and sales of assets with
other countries
Current Account
 Sales and Purchases of Goods and Services
 U.S. wheat exports or U.S. oil imports, for example.
 Factor Income: Payments for the use of factors of
production owned by residents of other countries.
 The profits earned by Disneyland Paris or the profits earned
by U.S. operations of Japanese auto companies, for example.
 International Transfers: Funds sent by residents of
one country to those of another (i.e. foreign aid, gifts).

Remittances that immigrants (i.e. millions of Mexican-born workers employed in U.S.) send
to their families, for example.
Balance of Payment Accounts
Financial Account
 Sales and purchases of assets between governments
or government agencies, mainly central banks
 In 2008, for example, most of the U.S. sales in this category
involved the accumulation of foreign exchange reserves by
the central banks of China and oil-exporting countries.
 Private sales and purchases of assets.
 The 2008 purchase of Budweiser by the Belgian corporation
InBev or the purchase of European stocks by U.S. investors,
for example
Balance of Payment Accounts
Balance of Payment Accounts
 Any nation experiencing a current account deficit
must also be running a financial account surplus.
 In Table 41.2, the U.S. current account deficit and
financial account surplus almost offset each other—
the $167 billion difference was just a statistical error,
reflecting the imperfection of official data.
 In fact, there is a basic rule of BOP accounting:
Current account (CA)  Financial account (FA)  0
Balance of Payment Accounts
• To explain the equation, we again use a circular-flow
model to explain the flow of money between economies.
Balance of Payment Accounts
Why do the accounts balance?
 When the current account is negative, it means we
have been spending more abroad than foreigners
have been spending here.
 This excess spending puts dollars in foreign hands…
 The financial account will be positive because it
accounts for those dollars put in foreign hands.
 These dollars are most commonly used to buy assets in the
United States.
 If foreigners decided to hold onto them, it is still an
investment—in U.S. currency, which is also an “asset”.
The Foreign Exchange Market
14
Understanding Exchange Rates
 In general, goods, services, and assets produced in a
country must be paid for in that country’s currency.
 Foreign Exchange Market
 International transactions require a market in which
currencies can be exchanged for each other.
 Exchange Rates
 The prices at which currencies trade, as determined by
the foreign exchange market.
Understanding Exchange Rates
 Exchange rates are expressed in two different ways:
U.S. Dollars
Yen
Euros
One U.S. dollar
exchanged for
1
88.75
0.7509
One yen
exchanged for
0.0113
1
0.0085
One euro
exchanged for
1.3317
118.1880
1
The Equilibrium Exchange Rate
• The exchange rate for any currency is determined by
the supply of that currency and the demand for that
currency (in the foreign exchange market model).
The Equilibrium Exchange Rate
• How does a shift in demand for U.S. dollars affect equilibrium?
 Changes in real interest rates
 Changes in product preferences
 Changes in productivity
 Perceptions of economic stability
The Equilibrium Exchange Rate
• Appreciation
– An increase in the exchange value of one nation’s
currency in terms of the currency of another nation
• Depreciation
– An decrease in the exchange value of one nation’s
currency in terms of the currency of another nation
The Equilibrium Exchange Rate
• When the Japanese demand for Dollars increases, the
supply of Yen increases in foreign exchange market.
• The dollar appreciates, while the yen depreciates.
The Role of the Exchange Rate
 The capital account reflects the international
movement of goods and services.
 The financial account reflects the international
movement of capital.
 So what ensures that the balance of payments really
does balance (i.e. offset each other)?
 The Exchange Rate!
The Role of the Exchange Rate
The Role of the Exchange Rate
 Increase in real interest rates in the United States
causes an increase capital inflow into the U.S.
 Appreciation of the dollar makes U.S. exports
relatively more expensive.
The Role of the Exchange Rate
• The increased capital inflow to the United States
(financial account) must be matched by a decline in
the balance of payments on the current account.
Caused
by the
appreciation
of the dollar
The Equilibrium Exchange Rate
• So any change in the U.S. balance of payments
on the financial account generates an equal
and opposite reaction in the balance of
payments on the current account.
• Movements in the exchange rate ensure that
changes in the financial account and in the
current account offset each other!
Inflation and Real Exchange Rates
• Real Exchange Rates
– Exchange rates adjusted for international
differences in aggregate price levels
• As an example, we’ll look at the number of Mexican
pesos per U.S. dollar. Let PUS and PMex be indexes of
the aggregate price levels in the United States and
Mexico, respectively.
• Then the real exchange rate between the Mexican
peso and the U.S. dollar is defined as:
Real Exchange Rate = Mexican pesos per U.S. dollar x PUS/PMex
Inflation and Real Exchange Rates
• To understand the significance of the difference between
the real and nominal exchange rates, let’s consider:
– The Mexican peso depreciates against the U.S. dollar,
with the exchange rate going from 10 pesos per U.S.
dollar to 15 pesos per U.S. dollar.
– At the same time the price of everything in Mexico,
measured in pesos, increases by 50%, so that the
Mexican price index rises from 100 to 150.
– We’ll assume that there is no change in U.S. prices, so
that the U.S. price index remains at 100. The initial
real exchange rate is:
Real Exchange Rate = Mexican pesos per U.S. dollar x PUS/PMex
Inflation and Real Exchange Rates
• The current account responds only to changes in the
real exchange rate, not the nominal exchange rate.
Exchange Rate Policy
29
Exchange Rate Regimes
How Can an Exchange Rate be Fixed?
1. Exchange Market Intervention
– Government purchases or sales of currency in the foreign
exchange market to make up the differences above.
– Stocks of foreign currency (usually U.S. dollars or euros) that
they can use to buy their own currency to support its price
How Can an Exchange Rate be Fixed?
2. Governments can shift the supply/demand curves in
the foreign exchange market
–
Government conducts monetary policy to raise/lower the
interest rate to decrease/increase capital flows from abroad
How Can an Exchange Rate be Fixed?
3. Foreign Exchange Controls
– Government-imposed licensing systems that limit the right of
individuals to buy foreign currency.
– Reduces the supply of a currency by limiting the number of
licenses to people engaged in government-approved actions
Exchange Rate Regimes
• Fixed Exchange Rate Benefits
– Certainty about the future value of a currency.
– Commits a country to not engaging in inflationary
policies, which would destabilize the exchange rate
• Fixed Exchange Rate Costs
– A country must keep large quantities of foreigncurrency on hand for stabilization needs.
– Monetary policy used to stabilize the exchange rate
is diverted from other policy goals.
– Foreign exchange controls distort incentives for
importing and exporting goods and services.