Download The Balance of Payments and Exchange Rates

CHAPTER
21
International Trade , Balance
of Payments and Exchange
Rates
Appendix: World Monetary Systems Since 1900
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
International Trade
• All economies, regardless of their
size, depend to some extent on other
economies and are affected by
events outside their borders.
• The “internationalization” or
“globalization” of the U.S. economy
has occurred in the private and
public sectors, in input and output
markets, and in business firms and
households.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Trade Surpluses and Deficits
• When a country exports more than it
imports, it runs a trade surplus.
• A trade deficit is the situation when
a country imports more than it
exports.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Economic Basis for Trade:
Comparative Advantage
• Corn Laws were the tariffs, subsidies, and
restrictions enacted by the British
Parliament in the early nineteenth century
to discourage imports and encourage
exports of grain.
•
David Ricardo’s theory of comparative
advantage, which he used to argue
against the corn laws, states that
specialization and free trade will benefit all
trading partners (real wages will rise), even
those that may be absolutely less efficient
producers.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Absolute Advantage
versus Comparative Advantage
• A country enjoys an absolute
advantage over another country in
the production of a product when it
uses fewer resources to produce that
product than the other country does.
• A country enjoys a comparative
advantage in the production of a
good when that good can be
produced at a lower cost in terms of
other goods.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Terms of Trade
• The ratio at which a country can
trade domestic products for imported
products is the terms of trade.
• The terms of trade determine how
the gains from trade are distributed
among trading partners.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Heckscher-Ohlin Theorem
• The Heckscher-Ohlin theorem is a
theory that explains the existence of
a country’s comparative advantage
by its factor endowments.
• According to the theorem, a country
has a comparative advantage in the
production of a product if that
country is relatively well endowed
with inputs used intensively in the
production of that product
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Other Explanations for
Observed Trade Flows
• Product differentiation is a natural
response to diverse preferences
within an economy, and across
economies.
• Some economists also distinguish
between gains from acquired
comparative advantage and gains
from natural comparative
advantages.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Trade Barriers: Tariffs,
Export Subsidies, and Quotas
• Protection is the practice of shielding a
sector of the economy from foreign
competition.
• A tariff is a tax on imports.
• A quota is a limit on the quantity of
imports.
• Export subsidies are government
payments made to domestic firms to
encourage exports.
• Dumping refers to a firm or industry that
sells products on the world market at prices
below the cost of production.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Balance of Payments
• Foreign exchange is simply all
currencies other than the domestic
currency of a given country
• The balance of payments is 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.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
United States Balance of Payments, 2002
CURRENT ACCOUNT
Goods exports
Goods imports
(1) Net export of goods
682.6
– 1,166.9
– 484.3
Export of services
Import of services
(2) Net export of services
289.3
– 240.5
48.8
Income received on investments
Income payments on investments
244.6
– 256.5
(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 –)
(9) Change in foreign government assets in the United States
(10) Balance on capital account (6 + 7 + 8 + 9)
(11) Statistical discrepancy
(12) Balance of payments (5 + 10 + 11)
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– 11.9
– 56.0
– 503.4
– 152.9
533.7
– 3.3
46.6
474.1
29.3
0
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• A country’s current account is the
sum of its:
• net exports (exports minus imports),
• net income received from investments
abroad, and
• net transfer payments from abroad.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• Exports earn foreign exchange and
are a credit (+) item on the current
account. Imports use up foreign
exchange and are a debit (–) item.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• The balance of trade is the
difference between a country’s
exports of goods and services and
its imports of goods and services.
• A trade deficit occurs when a
country’s exports are less than its
imports.
• Net exports of goods and services
(EX – IM), is the difference between
a country’s total exports and total
imports.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• Investment income consists of
holdings of foreign assets that yield
dividends, interest, rent, and profits
paid to U.S. asset holders (a source
of foreign exchange).
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• Net transfer payments are the
difference between payments from
the United States to foreigners and
payments from foreigners to the
United States.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• The balance on current account
consists of net exports of goods, plus
net exports of services, plus net
investment income, plus net transfer
payments. It shows how much a
nation has spent relative to how
much it has earned.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Capital Account
• For each transaction recorded in the
current account, there is an offsetting
transaction recorded in the capital
account.
• The capital account records the
changes in assets and liabilities.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Capital Account
• The balance on capital account in the United
States is the sum of the following (measured in a
given period):
• the change in private U.S. assets abroad
• the change in foreign private assets in the United
States
• the change in U.S. government assets abroad, and
• the change in foreign government assets in the United
States
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Capital Account
• In the absence of errors, the balance on
capital account would equal the negative
of the balance on current account.
• If the capital account is positive, the
change in foreign assets in the country is
greater than the change in the country’s
assets abroad, which is a decrease in the
net wealth of the country.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates
• The main difference between an international
transaction and a domestic transaction concerns
currency exchange.
• International exchange must be managed in a
way that allows each partner in the transaction to
wind up with his or her own currency.
• The exchange rate is the price of one country’s
currency in terms of another country’s currency;
the ratio at which two currencies are traded for
each other.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Open Economy with
Flexible Exchange Rates
• Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated
forces of supply and demand.
• Exchange rate movements have
important impacts on imports,
exports, and movement of capital
between countries.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
• In a world where there are only two
countries, the United States and
Britain, the demand for pounds is
comprised of holders of dollars
wishing to acquire pounds. The
supply of pounds is comprised of
holders of pounds seeking to
exchange them for dollars.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
Some Private Buyers and Sellers in International
Exchange Markets: United States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1.
Firms, households, or governments that import British goods into the United States
or wish to buy British-made goods and services
2.
U.S. citizens traveling in Great Britain
3.
Holders of dollars who want to buy British stocks, bonds, or other financial
instruments
4.
U.S. companies that want to invest in Great Britain
5.
Speculators who anticipate a decline in the value of the dollar relative to the pound
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
Some Private Buyers and Sellers in International
Exchange Markets: United States and Great Britain
THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)
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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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
• The demand for pounds in
the foreign exchange market
shows a negative relationship
between the price of pounds
(dollars per pound) ($/£) and
the quantity of pounds
demanded.
• When the price of pounds falls, British-made goods and services
appear less expensive to U.S. buyers. If British prices are
constant, U.S. buyers will buy more British goods and services,
and the quantity demanded of pounds will rise.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
• The supply of pounds in
the foreign exchange
market shows a positive
relationship between the
price of pounds (dollars per
pound) ($/£) and the
quantity of pounds
supplied.
• When the price of pounds rises, the British can obtain more dollars
for each pound. This means that U.S.-made goods and services
appear less expensive to British buyers. Thus, the quantity of
pounds supplied is likely to rise with the exchange rate.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Equilibrium Exchange Rate
© 2004 Prentice Hall Business Publishing
• The equilibrium exchange
rate occurs at the point at
which the quantity
demanded of a foreign
currency equals the
quantity of that currency
supplied.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Equilibrium Exchange Rate
• An excess supply of pounds will
cause the price of pounds to fall—
the pound will depreciate (fall in
value) with respect to the dollar.
• An excess demand for pounds will
cause the price of pounds to rise—
the pound will appreciate (rise in
value) with respect to the dollar.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• Purchasing Power Parity: The
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.
• 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.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• The theory that exchange rates are
set so that the price of similar goods
in different countries is the same is
known as the purchasing-power
parity.
• If it takes ten times as many pesos to
buy a pound of salt in Mexico as it takes
U.S. dollars to buy a pound of salt in the
United States, then the equilibrium
exchange rate should be 10 pesos per
dollar.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• A high rate of inflation in one country
relative to another puts pressure on
the exchange rate between the two
countries, and there is a general
tendency for the currencies of
relative high-inflation countries to
depreciate.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
© 2004 Prentice Hall Business Publishing
• A higher price level in
the United States
increases the demand
for pounds and
decreases the supply
of pounds. The result
is appreciation of the
pound against the
dollar.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• The level of a country’s interest rate
relative to interest rates in other
countries is another determinant of
the exchange rate. If U.S. interest
rates rise relative to British interest
rates, British citizens may be
attracted to U.S. securities.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
© 2004 Prentice Hall Business Publishing
• A higher interest rate in
the United States
increases the supply
and decreases the
demand for pounds.
The result is
depreciation of the
pound against the
dollar.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Effects of Exchange
Rates on the Economy
• When a country’s currency
depreciates (falls in value), its import
prices rise and its export prices (in
foreign currencies) fall.
• When the U.S. dollar is cheap, U.S.
products are more competitive in
world markets, and foreign-made
goods look expensive to U.S.
citizens.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Effects of Exchange
Rates on the Economy
• A depreciation of a country’s
currency can serve as a stimulus to
the economy:
• Foreign buyers are likely to increase
their spending on U.S. goods
• Buyers substitute U.S.-made goods for
imports
• Aggregate expenditure on domestic
output will rise
• Inventories will fall
• GDP (Y) will increase
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates and the
Balance of Trade: The J Curve
• The balance of trade is equal to
export revenue minus import costs:
balance of trade = dollar price of exports x
quantity of exports
 dollar price of imports x quantity of imports
• According to the J-curve effect, the
balance of trade gets worse before it
gets better following a currency
depreciation.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates and the
Balance of Trade: The J Curve
© 2004 Prentice Hall Business Publishing
• Initially, the negative effect
on the price of imports may
dominate the positive effects
of an increase in exports
and a decrease in imports.
• But when imports and
exports have had a time to
respond to price changes,
the balance of trade
improves.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates and Prices
• Depreciation of a country’s currency tends
to increase the price level.
• Export demand rises.
• Domestic buyers substitute domestic products
for the now more expensive imports.
• If the economy is operating close to capacity, the
increase in aggregate demand is likely to result
in higher prices.
• If import prices rise, costs may rise for business
firms, shifting the AS curve to the left.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Monetary Policy with
Flexible Exchange Rates
• Fed actions to lower interest rates
result in a decrease in the demand
for dollars and an increase in the
supply of dollars, causing the dollar
to depreciate.
• If the purpose of the Fed is to
stimulate the economy, dollar
depreciation is a good thing. It
increases U.S. exports and
decreases imports.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Fiscal Policy with
Flexible Exchange Rates
• Flexible interest rates may not help
in the attempt by government to cut
taxes in order to stimulate the
economy.
• A tax cut results in increased
household spending, but some of
that spending leaks out as imports,
reducing the multiplier.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Fiscal Policy with
Flexible Exchange Rates
• As income increases, the demand
for money increases. The resulting
higher interest rates cause the dollar
to appreciate. Exports fall, imports
rise, again reducing the multiplier.
• If interest rates rise, private
investment may be crowed out, also
lowering the multiplier.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Monetary Policy with
Fixed Exchange Rates
• Monetary policy has no role in a
country that has a fixed exchange
rate.
• For example, an attempt to lower
interest rates results in currency
depreciation and a lower (not a fixed)
exchange rate.
• In the absence of capital controls,
the monetary authority loses its
independence.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
THE GOLD STANDARD
• Early in the century, during the gold
standard era, nearly all currencies were
backed by gold. Their values were
fixed in terms of a specific number of
ounces of gold, which determined their
values in international trading—
exchange rates.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
“PURE” FIXED EXCHANGE RATES
• Under this type of system,
governments set a particular fixed rate
at which their currencies will exchange
for each other.
• There is no automatic mechanism to
keep exchange rates aligned with each
other, as with the gold standard.
Therefore, governments must at times
intervene to keep currencies aligned at
their established values.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
© 2004 Prentice Hall Business Publishing
Government Intervention
in the Foreign Exchange
Market
• If the government has
committed itself to
keeping the value of
the lira at .020, it must
buy up the excess
supply of lira (Qs – Qd).
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
•
At the end of World War II, economists
from the United States and Europe met to
formulate a new set of rules for exchange
rate determination, known as the Bretton
Woods system:
1. Countries were to maintain fixed exchange
rates with each other. All currencies were
fixed in terms of the U.S. dollar.
2. Countries experiencing a persistent current
account deficit (or fundamental disequilibrium)
in their balance of payments were allowed to
change their exchange rates.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
• The alternative to a fixed exchange
rate system is a flexible system:
• In a freely floating system,
governments do not intervene at
all in the foreign exchange
market.
• In a managed floating system,
governments intervene if markets
are becoming disorderly.
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C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Review Terms and Concepts
appreciation of a currency
foreign exchange
balance of payments
J-curve effect
balance of trade
law of one price
balance on capital account
marginal propensity to import
(MPM)
balance on current account
depreciation of a currency
net exports of goods and
services (EX – IM)
exchange rate
price feedback effect
floating, or market-determined,
exchange rates
purchasing-power-parity theory
© 2004 Prentice Hall Business Publishing
trade deficit
trade feedback effect
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