Download Macro2

An Economic Barometer
• What exactly is GDP?
• How do we use GDP to tell us whether our
economy is in a recession or how rapidly our
economy is expanding?
• How do we take the effects of inflation out of
GDP to reveal the rate of growth of our
economic well-being?
• And how to we compare economic well-being
across countries?
Gross Domestic Product
• GDP Defined
– GDP or gross domestic product is the market
value of all final goods and services produced in a
country in a given time period.
– This definition has four parts:
 Market value
 Final goods and services
 Produced within a country
 In a given time period
Gross Domestic Product
– Market Value
– GDP is a market value—goods and services are
valued at their market prices.
– To add apples and oranges, computers and
popcorn, we add the market values so we have a
total value of output in dollars.
Gross Domestic Product
– Final Goods and Services
– GDP is the value of the final goods and services
produced.
– A final good (or service) is an item bought by its final
user during a specified time period.
– A final good contrasts with an intermediate good,
which is an item that is produced by one firm, bought
by another firm, and used as a component of a final
good or service.
– Excluding intermediate goods and services avoids
double counting.
Gross Domestic Product
– Produced Within a Country
– GDP measures production within a country—
domestic production.
– In a Given Time Period
– GDP measures production during a specific time
period, normally a year or a quarter of a year.
Gross Domestic Product
• GDP and the Circular Flow of Expenditure and
Income
– GDP measures the value of production, which also
equals total expenditure on final goods and total
income.
– The equality of income and output shows the link
between productivity and living standards.
– The circular flow diagram illustrates the equality
of income, expenditure, and the value of
production.
Gross Domestic Product
– The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world.
Gross Domestic Product
– These transactions take place in factor markets, goods
markets, and financial markets.
Gross Domestic Product
– Firms hire factors of production from households. The blue
flow, Y, shows total income paid by firms to households.
Gross Domestic Product
– Households buy consumer goods and services. The
red flow, C, shows consumption expenditure.
Gross Domestic Product
– Households save, S, and pay net taxes, T. Firms borrow
some of what households save to finance their investment.
Gross Domestic Product
– Firms buy capital goods from other firms. The red flow
I represents this investment by firms.
Gross Domestic Product
– Governments buy goods and services, G, and borrow or
repay debt if spending exceeds or is less than net taxes.
Gross Domestic Product
– The rest of the world buys goods and services from us, X,
and sells us goods and services, M. Net exports are X – M.
Gross Domestic Product
– And the rest of the world borrows from us or lends to us
depending on whether net exports are positive or negative.
Gross Domestic Product
– The blue and red flows are the circular flow of expenditure
and income. The green flows are financial flows.
Gross Domestic Product
– The sum of the red flows equals the blue flow.
Gross Domestic Product
– That is: Y = C + I + G + X – M
Gross Domestic Product
– The circular flow demonstrates how GDP can be
measured in two ways.
– Aggregate expenditure
– Total expenditure on final goods and services,
equals the value of output of final goods and
services, which is GDP.
– Total expenditure = C + I + G + (X – M).
Gross Domestic Product
– Aggregate income
– Aggregate income equals the total amount paid
for the use of factors of production: wages,
interest, rent, and profit.
– Firms pay out all their receipts from the sale of
final goods, so income equals expenditure,
– Y = C + I + G + (X – M).
Gross Domestic Product
– If G exceeds T, the government has a budget deficit
(G –T) and the government borrows from the financial
markets.
– If T exceeds G, the government has a budget surplus
(T – G) and this surplus flows to the financial markets.
– If U.S. imports exceed U.S. exports, the United States
borrows an amount equal to (M – X) from the rest of
the world. Rest of world saving finances some
investment in the United States.
– If U.S. exports exceed U.S. imports, the United States
lends an amount equal to (X – M) to the rest of the
world. U.S. saving finances some investment in other
countries.
Gross Domestic Product
• How Investment Is Financed
– Investment is financed from three sources:
– 1. Private saving, S
– 2. Government budget surplus, (T – G)
– 3. Borrowing from the rest of the world (M – X).
Gross Domestic Product
• Gross and Net Domestic Product
– “Gross” means before deducting the depreciation
of capital. The opposite of gross is net.
– To understand this distinction, we need to
distinguish between flows and stocks.
– Flows and Stocks in Macroeconomics
– A flow is a quantity per unit of time.
– A stock is the quantity that exists at a point in
time.
Gross Domestic Product
– Wealth and Saving
– Wealth, the value of all the things that people
own, is a stock.
– Saving is the flow that changes the stock of
wealth.
– Wealth at the start of this year equals wealth at
the start of last year plus saving during last year.
Gross Domestic Product
– Capital and Investment
– Capital is the plant, equipment, and inventories of
raw and semi-finished materials that are used to
produce other goods.
– Capital is a stock.
– Investment is the flow that changes the stock of
capital.
Gross Domestic Product
– Depreciation is the decrease in the capital stock
that results from wear and tear and obsolescence.
– Gross investment is the total amount spent on
purchases of new capital and on replacing
depreciated capital.
– Net investment is the change in the capital stock.
– Net investment = Gross investment 
Depreciation.
Gross Domestic Product
– Figure illustrates
the relationships
among the capital
stock, gross
investment,
depreciation, and
net investment.
Gross Domestic Product
– The Short Run Meets the Long Run
– Capital and investment play a central role in the
understanding the growth and fluctuations in real
GDP.
– Investment adds to the capital stock, so
investment is one source of real GDP growth.
– Investment fluctuates, so investment is one source
of fluctuations in real GDP.
Measuring U.S. GDP
– The Bureau of Economic Analysis uses two
approaches to measure GDP:
 The expenditure approach
 The income approach
Measuring U.S. GDP
• The Expenditure Approach
– The expenditure approach measures GDP as the sum
of consumption expenditure, investment, government
expenditure on goods and services, and net exports.
– GDP = C + I + G + (X  M)
– Table in the textbook shows the expenditure
approach with data for 2006.
–
GDP = $9,079 + $2,215 + $2,479  $765
–
= $13,008
Measuring U.S. GDP
• The Income Approach
– The income approach measures GDP by summing
the incomes that firms pay households for the
factors of production they hire.
Measuring U.S. GDP
– The National Income and Expenditure Accounts
divide incomes into five categories:
1. Compensation of employees
2. Net interest
3. Rental income
4. Corporate profits
5. Proprietors’ income
– These five income components sum to net
domestic income at factor cost.
Real GDP and the Price Level
– Real GDP is the value of final goods and services
produced in a given year when valued at constant
prices.
• Calculating Real GDP
– The first step in calculating real GDP is to calculate
nominal GDP.
– Nominal GDP is the value of goods and services
produced during a given year valued at the prices
that prevailed in that same year.
Real GDP and the Price Level
– Nominal GDP
Calculations
– The table provides data
for 2005 and 2006.
– In 2005,
– Expenditure on balls =
$100
– Expenditure on bats =
$100
– Nominal GDP = $200
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– In 2006,
– Expenditure on balls
= $80
– Expenditure on bats
= $495
– Nominal GDP = $575
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– Base-Year Prices Value
of Real GDP
– This method of
calculating real GDP is
to value each year’s
output at the prices of
a base year.
– In the base year, real
GDP equals nominal
GDP.
– Suppose 2005 is the
base year, then real
GDP in 2005 is $200.
– This method is the
traditional method.
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– Using the traditional
base-year prices
method to calculate
real GDP in 2006:
– Expenditure on balls in
2006 valued at 2005
prices is $160.
– Expenditure on bats in
2006 valued at 2005
prices is $110.
– So real GDP in 2006
would be recorded as
$270.
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– The new method of calculating real GDP, which is
called the chain-weighted output index.
– The chain-weighted output index method, uses
the prices of two adjacent years to calculate the
real GDP growth rate.
– This calculation has four steps described on the
next slide.
Real GDP and the Price Level
– Step 1: Value last year’s production and this year’s
production at last year’s prices and then calculate the
growth rate of this number from last year to this year.
– Step 2: Value last year’s production and this year’s
production at this year’s prices and then calculate the
growth rate of this number from last year to this year.
– Step 3: Calculate the average of the two growth rates.
This average growth rate is the growth rate of real
GDP from last year to this year.
– Step 4: Apply the growth rate this year to last year’s
real GDP to calculate this year’s real GDP.
Real GDP and the Price Level
– We’ve done step 1.
– Value of 2005
quantities at 2005
prices (GDP in 2005) is
$200.
– Value of 2006
quantities at 2005
prices is $270.
– At 2005 prices, the
value of production
increased from $200 to
$270—an increase of
35 percent.
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– Step 2.
– Value of 2005
quantities at 2006
prices is $500.
– Value of 2006
quantities at 2006
prices (GDP in 2006) is
$575.
– At 2006 prices, the
value of production
increased from $500 to
$575—an increase of
15 percent.
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– Step 3.
– At 2005 prices, the
2006 growth rate is
35 percent.
– At 2006 prices, the
2006 growth rate is
15 percent.
– The average of these
two growth rates is
25 percent.
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
– Step 4.
– So with 2005 as the
base year, real GDP
in 2006 is $250—25
percent more that
$200 in 2005.
– Real GDP in 2005 is
$200
– Real GDP in 2006 is
$250
Item
Quantity
Price
2005
Balls
100
$1.00
Bats
20
$5.00
Balls
160
$0.50
Bats
22
$22.50
2006
Real GDP and the Price Level
• Calculating the Price Level
– The average level of prices is called the price level.
– One measure of the price level is the GDP
deflator, which is an average of the prices of the
goods and services in GDP in the current year
expressed as a percentage of the base-year prices.
– The GDP deflator is calculated in the table on the
next slide.
Real GDP and the Price Level
– Nominal GDP and real GDP are calculated in the way that
you’ve just seen.
– GDP Deflator = (Nominal GDP ÷ Real GDP)  100.
– In 2005, the GDP deflator is ($200 ÷ $200)  100 = 100.
– In 2006, the GDP deflator is ($575 ÷ $250)  100 = 230.
Year
Nominal
GDP
Real
GDP
GDP
deflator
2005
$200
$200
100
2006
$575
$250
230
Real GDP and the Price Level
• Deflating the GDP Balloon
– Nominal GDP increases because production—real
GDP– increases.
Real GDP and the Price Level
– Nominal GDP also increases because prices rise.
Real GDP and the Price Level
– We use the GDP deflator to let the inflation air out
of the nominal GDP balloon and reveal real GDP.
The Uses and Limitations of Real GDP
– We use real GDP to calculate the economic growth
rate.
– The economic growth rate is the percentage
change in the quantity of goods and services
produced from one year to the next.
– We measure economic growth so we can make
 Economic welfare comparisons across time
 International comparisons across countries
 Business cycle forecasts
The Uses and Limitations of Real GDP
• Economic Welfare Comparisons Over Time
– Economic welfare measures the nation’s overall
state of economic well-being.
– Real GDP is not a perfect measure of economic
welfare for seven reasons:
– 1. Inflation rate tends to be overestimated because
quality improvements are neglected, so real GDP is
underestimated.
– 2. Real GDP does not include household
production— productive activities done in and
around the house by members of the household.
The Uses and Limitations of Real GDP
– 3. Real GDP, as measured, omits the underground
economy, which is illegal economic activity or legal
economic activity that goes unreported for tax
avoidance reasons.
– 4. Health and life expectancy are not directly
included in real GDP.
– 5. Leisure time, a valuable component of an
individual’s welfare, is not included in real GDP.
– 6. Environmental damage is not deducted from real
GDP.
– 7. Political freedom and social justice are not
included in real GDP.
The Uses and Limitations of Real GDP
• Economic Welfare Comparisons Across Countries
– Real GDP is used to compare economic welfare in one
country with that in another.
– Two special problems arise in making these
comparisons.
– Real GDP of one country must be converted into the
same currency units as the real GDP of the other
country, so an exchange rate must be used.
– The same prices should be used to value the goods
and services in the countries being compared, but
often are not.
The Uses and Limitations of Real GDP
– Using the exchange rate to compare GDP in one
country with GDP in another country is
problematic because prices of particular products
in one country may be much less or much more
than in the other country.
– For example, using the market exchange rate to
value Chinese GDP in dollars leads to an estimate
that in 2006, U.S. real GDP per person was 28
times Chinese real GDP per person.
The Uses and Limitations of Real GDP
– Figure illustrates
the problem.
– Using the market
exchange rate and
domestic prices
leads to an
estimate that
China is very poor.
– U.S. GDP per
person is 28 times
that in China.
The Uses and Limitations of Real GDP
– Using
purchasing
power parity
prices leads to
an estimate
that U.S. GDP
per person is
(only) 12 times
that in China.
The Uses and Limitations of Real GDP
• Business Cycle Forecasts
– Real GDP is used to measure business cycle
fluctuations.
– These fluctuations are probably accurately timed,
but the changes in real GDP probably overstate
the changes in total production and people’s
welfare caused by business cycles.
Unemployment and Full Employment
• Full Employment
– Full employment occurs when there is no cyclical
unemployment or, equivalently, when all
unemployment is frictional and structural.
– The unemployment rate at full employment is
called the natural unemployment rate.
– The natural unemployment rate was high during
the early 1980s but has gradually decreased.
Unemployment and Full Employment
• Real GDP and Unemployment Over the Cycle
– Potential GDP is the quantity of real GDP produced at
full employment.
– Potential GDP corresponds to the capacity of the
economy to produce output on a sustained basis.
– Over the business cycle, actual real GDP fluctuates
around potential GDP and the unemployment rate
fluctuates around the natural rate of unemployment.
Unemployment and
Full Employment
• Real GDP and Unemployment
Over the Cycle
– Figure 6.10 shows real GDP, and
the unemployment rate...
…and estimates of potential
GDP and the natural
unemployment rate.
The Consumer Price Index
– The BLS calculates the Consumer Price Index every
month.
– The Consumer Price Index, or CPI, measures the
average of the prices paid by urban consumers for
a “fixed” basket of consumer goods and services.
The Consumer Price Index
• Reading the CPI Numbers
– The CPI is defined to equal 100 for the reference base
period.
– Currently, the reference base period is 19821984.
– That is, for the average of the 36 months from January
1982 through December 1984, the CPI equals 100.
– In June 2006, the CPI was 202.9.
– This number tells us that the average of the prices
paid by urban consumers for a fixed basket of goods
was 102.9 percent higher in 2006 than it was during
19821984.
The Consumer Price Index
• Constructing the CPI
– Constructing the CPI involves three stages:
 Selecting the CPI basket
 Conducting a monthly price survey
 Calculating the CPI
The Consumer Price Index
– The CPI Basket
– The CPI basket is based on a Consumer
Expenditure Survey, which is undertaken
infrequently.
– The CPI basket today is based on data collected in
the Consumer Expenditure Survey of 20012002.
– The CPI basket contains 80,000 goods.
The Consumer Price Index
– Figure 6.11 illustrates the CPI basket.
– Housing is the largest component.
– Transportation and food and beverages are the
next largest components.
– The remaining components account for 25
percent of the basket.
The Consumer Price Index
– The Monthly Price Survey
– Every month, BLS employees check the prices of
80,000 goods on 30 metropolitan areas.
– Calculating the CPI
– 1. Find the cost of the CPI basket at base-period
prices.
– 2. Find the cost of the CPI basket at current-period
prices.
– 3. Calculate the CPI for the current period.
The Consumer Price Index
– Let’s work an example of the CPI calculation.
– In a simple economy, people consume only oranges
and haircuts. The CPI basket is 10 oranges and 5
haircuts.
– The table also shows the prices in the base period.
Item
Quantity
Price
Oranges
10
$1.00
Haircuts
5
$8.00
The Consumer Price Index
– The cost of the CPI basket in the base period was
$50.
Item
Quantity
Price
Cost of CPI
basket
Oranges
10
$1.00
$10
Haircuts
5
$8.00
$40
Cost of CPI basket at base period prices
$50
The Consumer Price Index
– This table shows the prices in the current period.
– The cost of the CPI basket at current-period prices is
$70.
Item
Quantity
Price
Cost of CPI
basket
Oranges
10
$2.00
$20
Haircuts
5
$10.00
$50
Cost of CPI basket at current-period
prices
$70
The Consumer Price Index
– The CPI is calculated using the formula:
– CPI = (Cost of basket at current-period prices ÷
Cost of basket at base-period prices)  100.
– Using the numbers for the simple example,
– CPI = ($70 ÷ $50)  100 = 140.
– The CPI is 40 percent higher in the current period
than it was in the base period.
The Consumer Price Index
• Measuring Inflation
– The major purpose of the CPI is to measure inflation.
– The inflation rate is the percentage change in the
price level from one year to the next.
– The inflation formula is:
– Inflation rate = [(CPI this year – CPI last year) ÷ CPI last
year]  100.
The Consumer Price Index
– Figure shows the relationship between the price
level and inflation.
– Figure (a) shows the CPI from1971 to 2006.
The Consumer Price Index
– Figure (b) shows that the inflation rate is
 High when the price level is rising rapidly and
 Low when the price level is rising slowly.
The Consumer Price Index
• The Biased CPI
– The CPI might overstate the true inflation for four
reasons:
 New goods bias
 Quality change bias
 Commodity substitution bias
 Outlet substitution bias
The Consumer Price Index
– New Goods Bias
– New goods that were not available in the base
year appear and, if they are more expensive than
the goods they replace, they put an upward bias
into the CPI.
– Quality Change Bias
– Quality improvements occur every year. Part of
the rise in the price is payment for improved
quality and is not inflation.
– The CPI counts all the price rise as inflation.
The Consumer Price Index
– Commodity Substitution Bias
– The market basket of goods used in calculating the
CPI is fixed and does not take into account
consumers’ substitutions away from goods whose
relative prices increase.
– Outlet Substitution Bias
– As the structure of retailing changes, people
switch to buying from cheaper sources, but the
CPI, as measured, does not take account of this
outlet substitution.
The Consumer Price Index
• Some Consequences of the Bias
– The bias in the CPI
 Distorts private contracts.
 Increases government outlays (close to a third of
federal government outlays are linked to the CPI).
 Biases estimates of real earnings.
– Reducing the Bias
–
The BLS now undertakes consumer spending
surveys at more frequent intervals and is
experimenting with a chained CPI.
What is Money?
• Official Measures of Money
– The two main official measures of money in the
United States are M1 and M2.
– M1 consists of currency and traveler’s checks and
checking deposits owned by individuals and
businesses.
– M2 consists of M1 plus time, saving deposits,
money market mutual funds, and other deposits.
What is Money?
– Figure 9.1
illustrates the
composition of M1
and M2 in June
2005 and shows
the relative
magnitudes of
their components.
What is Money?
– Are M1 and M2 Really Money?
– All the items in M1 are means of payment.
– Some saving deposits in M2 are not means of
payments—they are called liquid assets.
– Liquidity is the property of being instantly
convertible into a means of payment with little
loss of value.
– Deposits are money, but checks are not–a check is
an instruction to a bank to transfer money.
– Credit cards are not money. A credit card enables
the holder to obtain a loan quickly, but the loan
must be repaid with money.
Depository Institutions
– A depository institution is a firm that takes deposits
from households and firms and makes loans to other
households and firms.
– The institutions in the banking system divide into
 Commercial banks
 Thrift institutions
 Money market mutual funds
Many Monies!
• The dollar, the yen, and the euro are three of the
world’s monies. But they are among more than 100
different monies that circulate in the global economy.
• The dollar and the yen have been around for a long
time. The euro was created in the 1990s.
• In August 2002, 1 dollar bought 1.02 euros. In August
2006, 1 dollar bought 0.78 euros. Why do currency
exchange rates fluctuate?
• The U.S. economy has become attractive to foreign
investors.
• What determines the amount of international
borrowing and lending?
Currencies and Exchange Rates
– To buy goods and services produced in another
country we need money of that country.
– Foreign bank notes, coins, and bank deposits are
called foreign currency.
– We get foreign currency in the foreign exchange
market.
Currencies and Exchange Rates
– The Foreign Exchange Market
– We get foreign currency and foreigners get U.S
dollars in the foreign exchange market.
– The foreign exchange market is the market in
which the currency of one country is exchanged
for the currency of another.
Currencies and Exchange Rates
– Foreign Exchange Rates
– The price at which one currency exchanges for
another is called a foreign exchange rate.
– A fall in the value of one currency in terms of
another currency is called currency depreciation.
– A rise in value of one currency in terms of another
currency is called currency appreciation.
Currencies and Exchange Rates
– Figure 10.1
shows how
the U.S. dollar
has moved
against other
currencies
from 1995 to
2005.
Currencies and Exchange Rates
– Nominal and Real Exchange Rates
– The nominal exchange rate is the value of the U.S.
dollar expressed in units of foreign currency per
U.S. dollar.
– It is a measure of how much of one money
exchanges for a unit of another currency.
– The real exchange rate is the relative price of
foreign-produced goods and services.
– It is a measure of the quantity of real GDP of other
countries that we get for a unit of U.S. real GDP.
Currencies and Exchange Rates
– Trade-Weighted Index
– The trade-weighted index is the average exchange
rate of the U.S. dollar against other currencies,
with individual currencies weighted by their
importance in U.S. international trade.
The Foreign Exchange Market
• The Demand for One Money Is the Supply of
Another Money
– When people who are holding one money want to
exchange it for U.S. dollars, they demand U.S. dollars
and they supply that other country’s money.
– So the factors that influence the demand for U.S.
dollars also influence the supply of Canadian dollars,
E.U. euros, U.K. pounds, and Japanese yen.
– And the factors that influence the demand for another
country’s money also influence the supply of U.S.
dollars.
The Foreign Exchange Market
• Demand in the Foreign Exchange Market
– The quantity of U.S. dollars that traders plan to
buy in the foreign exchange market during a given
period depends on
– 1. The exchange rate
– 2. World demand for U.S. exports
– 3. Interest rates in the United States and other
countries
– 4. The expected future exchange rate
The Foreign Exchange Market
• The Law of Demand for Foreign Exchange
– The demand for dollars is a derived demand.
– People buy U.S. dollars so that they can buy U.S.produced goods and services or U.S. assets.
– Other things remaining the same, the higher the
exchange rate, the smaller is the quantity of U.S.
dollars demanded in the foreign exchange market.
The Foreign Exchange Market
– The exchange rate influences the quantity of U.S.
dollars demanded for two reasons:
 Exports effect
 Expected profit effect
– Exports Effect
– The larger the value of U.S. exports, the greater is
the quantity of U.S. dollars demanded on the
foreign exchange market.
– And the lower the exchange rate, the greater is
the value of U.S. exports, so the greater is the
quantity of U.S. dollars demanded.
The Foreign Exchange Market
– Expected Profit Effect
– The larger the expected profit from holding U.S.
dollars, the greater is the quantity of U.S. dollars
demanded today.
– But expected profit depends on the exchange rate.
– The lower today’s exchange rate, other things
remaining the same, the larger is the expected
profit from buying U.S. dollars and the greater is
the quantity of U.S. dollars demanded today.
The Foreign Exchange Market
• Supply in the Foreign Exchange Market
– The quantity of U.S. dollars supplied in the foreign
exchange market is the amount that traders plan to
sell during a given time period at a given exchange
rate.
– This quantity depends on many factors but the main
ones are
– 1. The exchange rate
– 2. U.S. demand for imports
– 3. Interest rates in the United States and other
countries
– 4. The expected future exchange rate
The Foreign Exchange Market
• The Law of Supply of Foreign Exchange
– Other things remaining the same, the higher the
exchange rate, the greater is the quantity of U.S.
dollars supplied in the foreign exchange market.
– The exchange rate influences the quantity of
U.S.dollars supplied for two reasons:
 Imports effect
 Expected profit effect
The Foreign Exchange Market
– Imports Effect
– The larger the value of U.S. imports, the larger is
the quantity of U.S. dollars supplied on the foreign
exchange market.
– And the higher the exchange rate, the greater is the
value of U.S. imports, so the greater is the quantity
of U.S. dollars supplied.
The Foreign Exchange Market
– Expected Profit Effect
– For a given expected future U.S. dollar exchange
rate, the lower the exchange rate, the greater is the
expected profit from holding U.S. dollars, and the
smaller is the quantity of U.S. dollars supplied on
the foreign exchange market.
Exchange Rate Fluctuations
• Changes in the Demand for U.S. Dollars
– A change in any influence on the quantity of
U.S.dollars that people plan to buy, other than the
exchange rate, brings a change in the demand for U.S.
dollars and a shift in the demand curve for U.S.
dollars.
– These other influences are
 World demand for U.S. exports
 U.S. interest rate relative to the foreign interest rate
 The expected future interest rate
Exchange Rate Fluctuations
– World Demand for U.S. Exports Increases
– At a given exchange rate, if world demand for U.S.
exports increases, the demand for U.S. dollars
increases and the demand curve for U.S. dollars shifts
rightward.
– U.S. Interest Rate Relative to the Foreign Interest
Rate
– The U.S. interest rate minus the foreign interest rate is
called the U.S. interest rate differential.
– If the U.S. interest differential rises, the demand for
U.S. dollars increases and the demand curve for U.S.
dollars shifts rightward.
Exchange Rate Fluctuations
– The Expected Future Exchange Rate
– At a given exchange rate, if the expected future
exchange rate for U.S. dollars rises, the demand
for U.S. dollars increases and the demand curve
for dollars shifts rightward.
Exchange Rate Fluctuations
• Changes in the Supply of Dollars
– A change in any influence on the quantity of U.S.
dollars that people plan to sell, other than the
exchange rate, brings a change in the supply of dollars
and a shift in the supply curve of dollars.
– These other influences are
 U.S. demand for imports
 U.S. interest rates relative to the foreign interest rate
 The expected future exchange rate
Exchange Rate Fluctuations
– U.S. Demand for Imports
– At a given exchange rate, if the U.S. demand for
imports increases, the supply of U.S. dollars on
the foreign exchange market increases and the
supply curve of U.S. dollars shifts rightward.
– U.S. Interest Rates Relative to the Foreign
Interest Rate
– If the U.S. interest differential rises, the supply for
U.S. dollars decreases and the supply curve of U.S.
dollars shifts leftward.
Exchange Rate Fluctuations
– The Expected Future Exchange Rate
– At a given exchange rate, if the expected future
exchange rate for U.S. dollars rises, the supply of
U.S. dollars decreases and the demand curve for
dollars shifts leftward.
Exchange Rate Fluctuations
• Changes in the Exchange Rate
– Changes in demand and supply in the foreign
exchange market change the exchange rate (just
like they change the price in any market).
 If demand for U.S. dollars increases and supply
does not change, the exchange rate rises.
 If demand for U.S. dollars decreases and supply
does not change, the exchange rate falls.
 If supply of U.S. dollars increases and demand
does not change, the exchange rate falls.
 If supply of U.S. dollars decreases and demand
does not change, the exchange rate rises.
Exchange Rate Fluctuations
• An Appreciating U.S. Dollar: 20002002
– Between 2000 and 2002, the U.S. dollar
appreciated against the yen.
– Investors expected higher profits in the United
States than in Japan and the demand for U.S.
dollars increased.
– Currency traders expected the U.S. dollar to
appreciate and the supply of U.S. dollars
decreased.
– The exchange rate rose from 108 yen per U.S.
dollar to 127 yen per U.S. dollar.
Exchange Rate Fluctuations
• A Depreciating Dollar: 20022004
– Between 2000 and 2002, the U.S. dollar
depreciated against the yen.
– Investors began to expect higher profits in Japan
and the demand for U.S. dollars increased.
– Currency traders expected the U.S. dollar to
depreciate and the supply of U.S. dollars
increased.
– The exchange rate fell from 127 yen per U.S. dollar
to 109 yen per U.S. dollar.
Exchange Rate Fluctuations
• Exchange Rate Expectations
– The exchange rate changes when it is expected to
change.
– But expectations about the exchange rate are
driven by deeper forces. Two such forces are
 Interest rate parity
 Purchasing power parity
Exchange Rate Fluctuations
– Interest Rate Parity
– A currency is worth what it can earn.
– The return on a currency is the interest rate on that
currency plus the expected rate of appreciation over a
given period.
– When the rates of returns on two currencies are
equal, interest rate parity prevails.
– Interest rate parity means equal interest rates when
exchange rate changes are taken into account.
– Market forces achieve interest rate parity very quickly.
Exchange Rate Fluctuations
– Purchasing Power Parity
– A currency is worth the value of goods and
services that it will buy.
– The quantity of goods and services that one unit
of a particular currency will buy differs from the
quantity of goods and services that one unit of
another currency will buy.
– When two quantities of money can buy the same
quantity of goods and services, the situation is
called purchasing power parity, which means
equal value of money.
Exchange Rate Fluctuations
– Instant Exchange Rate Response
– The exchange rate responds instantly to news
about changes in the variables that influence
demand and supply in the foreign exchange
market.
– Suppose that the Bank of Japan is considering
raising the interest rate next week.
– With this news, currency traders expect the
demand for yen to increase and the demand for
dollars to decrease—they expect the U.S. dollar to
depreciate.
Exchange Rate Fluctuations
– But to benefit from a yen appreciation, yen must be
bought and dollars must be sold before the exchange
rate changes.
– Each trader knows that all the other traders share the
same information and have similar expectations.
– Each trader knows that when people begin to sell
dollars and buy yen, the exchange rate will change.
– To transact before the exchange rate changes means
transacting right away, as soon as the news is
received.
Exchange Rate Fluctuations
– Nominal and Real Exchange Rates in Short Run
and the Long Run
– The equation that links the nominal exchange rate
(E) and real exchange rate (RER) is
– RER = E x (P/P*)
– where P is the U.S. price level and P* is the
Japanese price level.
– In the short run, this equation determines RER.
– In the short run, (P/P*) doesn’t change and a
change in E brings an equivalent change in RER.
Exchange Rate Fluctuations
– In the long run, RER is determined by the real
forces of demand and supply in markets for goods
and services.
– So in the long run E determined by RER and the
price levels. That is
– E = RER x (P*/P)
– A rise in the Japanese price level P* brings an
appreciation of the U.S. dollar in the long run.
– A rise in the U.S. price level P brings a depreciation
of the U.S. dollar in the long run.
Financing International Trade
– We’ve seen how the exchange rate is determined,
but what is the effect of the exchange rate?
– How does currency appreciation or appreciation
influence U.S. international trade?
– We record international transactions in the
balance of payments accounts.
• Balance of Payments Accounts
– A country’s balance of payments accounts
records its international trading, borrowing, and
lending.
Financing International Trade
–
–
–
–
–
There are three balance of payments accounts:
1. Current account
2. Capital account
3. Official settlements account
The current account records receipts from exports of
goods and services sold abroad, payments for imports
of goods and services from abroad, net interest paid
abroad, and net transfers (such as foreign aid
payments).
– The current accounts balance equals the sum of:
exports minus imports, net interest income, and net
transfers.
Financing International Trade
– The capital account records foreign investment in
the United States minus U.S. investment abroad.
– The official settlements account records the
change in U.S. official reserves.
– U.S. official reserves are the government’s
holdings of foreign currency.
– If U.S. official reserves increase, the official
settlements account is negative.
– The sum of the balances of the three accounts
always equals zero.
Financing International Trade
– Figure 10.9 shows the balance of payments (as a
percentage of GDP) over the period 1980 to 2005.
Financing International Trade
• Borrowers and Lenders
– A country that is borrowing more from the rest of
the world than it is lending to it is called a net
borrower.
– A country that is lending more to the rest of the
world than it is borrowing from it is called a net
lender.
– The United States is currently a net borrower but
during the 1960s and 1970s, the United States
was a net lender.
Financing International Trade
– Debtors and Creditors
– A debtor nation is a country that during its entire
history has borrowed more from the rest of the world
than it has lent to it.
– Since 1986, the United States has been a debtor
nation.
– A creditor nation is a country that has invested more
in the rest of the world than other countries have
invested in it.
– The difference between being a borrower/lender
nation and being a creditor/debtor nation is the
difference between stocks and flows of financial
capital.
Financing International Trade
– Being a net borrower is not a problem provided
the borrowed funds are used to finance capital
accumulation that increases income.
– Being a net borrower is a problem if the borrowed
funds are used to finance consumption.
Financing International Trade
• Current Account Balance
– The current account balance (CAB) is
– CAB = NX + Net interest income + Net transfers
– The main item in the current account balance is
net exports (NX).
– The other two items are much smaller and don’t
fluctuate much.
Financing International Trade
– The government sector surplus or deficit is equal
to net taxes, T, minus government expenditures
on goods and services G.
– The private sector surplus or deficit is saving, S,
minus investment, I.
– Net exports is equal to the sum of government
sector balance and private sector balance:
– NX = (T – G) + (S – I)
Financing International Trade
– For the United States in 2006,
– Net exports is a deficit of $784 billion, which
equals the sum of the government sector deficit
of $313 billion and the private sector deficit of
$471 billion.
Financing International Trade
• The Three Sector
Balances
– Figure 10.10 shows
these three balances
from 1980 through
2005.
– The private sector
balance and the
government sector
balance tend to move
in opposite
directions.
Financing International Trade
– Where is the Exchange Rate?
– In the short run, a fall in the nominal exchange
rate lowers the real exchange rate, which makes
our imports more costly and our exports more
competitive.
– So in the short run, fall in the nominal exchange
rate decreases the current account deficit.
– But in the long run, a change in the nominal
exchange rate leaves the real exchange rate
unchanged.
– So in the long run, the nominal exchange rate
plays no role in influencing the current account
Exchange Rate Policy
•



Three possible exchange rate policies are
Flexible exchange rate
Fixed exchange rate
Crawling peg
• Flexible Exchange Rate
• A flexible exchange rate policy is one that
permits the exchange rate to be determined
by demand and supply with no direct
intervention in the foreign exchange market
Exchange Rate Policy
• Fixed Exchange Rate
• A fixed exchange rate policy is one that pegs
the exchange rate at a value decided by the
government or central bank and that blocks
the unregulated forces of demand and supply
by direct intervention in the foreign exchange
market.
• A fixed exchange rate requires active
intervention in the foreign exchange market.
Exchange Rate Policy
– Figure shows how the
central bank can
intervene in the foreign
exchange market to
keep the exchange rate
close to a target rate.
– Suppose that the target
is 100 yen per U.S.
dollar.
– If demand increases,
the central bank sells
U.S. dollars to increase
supply.
Exchange Rate Policy
– If demand decreases,
the central bank buys
U.S. dollars to
decrease supply.
– Persistent
intervention on one
side of the foreign
exchange market
cannot be sustained.
Exchange Rate Policy
• Crawling Peg
• A crawling peg exchange rate policy is one that selects
a target path for the exchange rate with intervention in
the foreign exchange market to achieve that path.
• China is a country that operates a crawling peg.
• A crawling peg works like a fixed exchange rate except
that the target value changes.
• The idea behind a crawling peg is to avoid wild swings
in the exchange rate that might happen if expectations
became volatile and to avoid the problem of running
out of reserves, which can happen with a fixed
exchange rate.
Exchange Rate Policy
• People’s Bank of
China in the Foreign
exchange Market
• Figure 10.12(a) shows
the immediate effect
of the fixed yuan
exchange rate.
• China’s official foreign
currency reserves are
piling up.
Exchange Rate Policy
• Figure (b) illustrates
what is happening in
the market for U.S.
dollars priced in
terms of the yuan.
• The People’s bank
buy U.S. dollars to
maintain the target
exchange rate.
• China’s official foreign
reserves increase.