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Exchange Rates and the
Macroeconomy
No man is an island, entire of itself.
JOHN DONNE
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1
Macroeconomy
• Open economy
– Trades with other nations in goods and
services
– And perhaps also trades in financial
assets
• Model – large open economy
– Substantial capital flows
– Floating exchange rate
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2
International Trade
• International trade, exchange rates, and
aggregate demand
• Increase in net exports (X-IM)
– Increase X
– Decrease IM
– Multiplier effect on economy
– Aggregate demand – shifts outward-right
• Increase real GDP
• Increase price level
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
3
International Trade
• Determinants of net exports
– Foreign incomes
– Relative prices of foreign and domestic
goods
• Booms or recessions in one country
– Tend to be transmitted to other countries
through international trade in goods and
services
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4
Figure 1
The Effects of Higher Net Exports
D1
S
D0
Price Level
B
A
S
D0
D1
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5
International Trade
• Relative prices of a country’s exports
– Fall
• Net exports – increase
• Real GDP – increase
– Rise
• Net exports – decrease
• Real GDP – decrease
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6
International Trade
• Price of foreign products
– Rise
• Net exports – increase
• Real GDP – increase
– Fall
• Net exports – decrease
• Real GDP – decrease
• Currency appreciations or depreciations
– Change international relative prices
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
7
International Trade
• Currency depreciation
– A unit of currency can buy fewer units of
foreign currency
• Currency appreciation
– A unit of currency can buy more units of
foreign currency
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
International Trade
• Currency depreciation
– Raise net exports
– Increase aggregate demand
• Currency appreciation
– Reduce net exports
– Decrease aggregate demand
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
9
Table 1
Exchange Rates and Home Currency Prices
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
10
Figure 2
Effects of exchange rate changes on aggregate demand
D1
S
Price Level
D0
D2
E1
(depreciation)
E2
E0
(appreciation)
D1
S
D2
D0
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
11
International Trade
• Late 1990s & early 2000s
– U.S. trade deficit – grew enormously
• Has fallen a bit recently
– 1995 – dollar appreciation
• Boost U.S. imports (40% growth)
• Damage U.S. exports (7% growth)
– 1997: $140 billion real net export deficit
– 2002: $549 billion deficit
– 2006: $729 billion deficit
– 2009: $363 billion deficit
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
Aggregate Supply
• Aggregate supply in an open economy
• Depreciation of U.S. dollar
– Prices of imported inputs – rise
– U.S. aggregate supply curve shifts inward
– Prices of domestic goods and services
• Increase
– Additional inflationary effects
• On consumer prices
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
13
Aggregate Supply
• Appreciation of U.S. dollar
– Imported inputs – cheaper
– U.S. aggregate supply curve
• Shifts outward
– Prices of domestic goods
• Decrease
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
14
Figure 3
The Effects of Exchange Rate Changes on Aggregate
Supply
(depreciation)
D
S1
S0
S2
Price Level
E1
(appreciation)
E0
E2
S1
S0
D
S2
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
15
Macroeconomic Effects
• The macroeconomic effects of exchange
rates
• Dollar depreciation
– Aggregate demand – shift outward
– Aggregate supply – shift inward
– U.S. price level – increase
– GDP – rise or fall
• If the shift in demand is larger, GDP rises
– Inflationary and probably expansionary
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
Figure 4
The Effects of a Currency Depreciation
S1
D1
D0
S0
Price Level
A
E
S1
D1
S0
D0
Real GDP
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
17
Macroeconomic Effects
• Dollar appreciation
– Aggregate demand – shift inward
– Aggregate supply – shift outward
– U.S. price level – falls
– GDP – rise or fall
• If the shifts in demand is larger, GDP falls
– Disinflationary and probably
contractionary
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
18
Figure 5
The Effects of a Currency Appreciation
S0
D0
Price Level
D2
S2
E
B
S0
S2
D2
D0
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
19
Macroeconomic Effects
• International capital flows
– Purchases and sales of financial assets
– Across national borders
• Rise in interest rates
– Contract the economy
• International capital inflows
• Currency – appreciates
• Net exports – decrease
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
20
Macroeconomic Effects
• Drop in interest rates
– Expand the economy
• International capital outflows
• Currency – depreciates
• Net exports – increase
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
21
Fiscal and Monetary Policies
• Fiscal and monetary policies in an open
economy
• Fiscal expansion in a closed economy
– Aggregate demand increases
• Closed economy
– Does not trade with other nations in either
goods or assets
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
22
Fiscal and Monetary Policies
• Fiscal expansion in an open economy
– Interest rates increase
– Exchange rate appreciates
– Attract foreign capital
• Capital account surplus increases
– Net exports decrease
• Current account deficit increases
Capital account surplus + Current account
deficit = 0
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
23
Fiscal and Monetary Policies
• Fiscal expansion in an open economy
– Aggregate demand – outward shift
– Aggregate supply – outward shift
– Aggregate demand – inward shift
– Fiscal multiplier – reduced
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
24
Figure 6
A fiscal expansion in an open economy
D1
D2
S0
D0
S2
Price Level
B
A
C
D1
S0
D2
S2
D0
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
25
Table 2
Percentage Shares of Real GDP in the United States, 1981
and 1986
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
26
Fiscal and Monetary Policies
• Contractionary monetary policy
– Decrease aggregate demand
– Interest rates increase
– Exchange rates appreciate
– Capital inflow
• Strengthen monetary policy
– Aggregate supply – outward shift
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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Figure 7
A Monetary Contraction in an Open Economy
D0
Price Level
D1
S0
D2
S2
A
B
C
S0
S2
D0
D2
D1
Real GDP
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
28
International Aspects
• International aspects of deficit reduction
• Policy mix: Fiscal contraction and
Monetary expansion
– Reduce interest rates strongly
– Push down the value of the dollar
– Strongly stimulate our foreign trade
– Net effects on output and inflation
• Uncertain
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
Table 3
Expected Effects of Policy
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
30
International Aspects
• Trade deficit
– Excess of imports over exports
• Trade surplus
– Excess of exports over imports
• Accounting relationship between the
trade deficit and the budget deficit
X – IM = (S – I) – (G – T)
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
31
International Aspects
• Trade deficit
– Negative value for X-IM
– Can arise from
• Government budget deficit G > T
• Excess investment over saving I > S
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32
Worry about the Trade Deficit?
• U.S. trade deficits
– The nation consumes more then it
produces
– Forced to borrow the difference from
foreigners
– Mirror image: required capital inflows
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33
Worry about the Trade Deficit?
• Capital inflows
– Create debts - interest and principal
payments must be made in the future
– Economic weakness
• Mortgaging our futures to finance higher
consumer spending
– Economic strength: foreigners are eager
to lend capital
• Push the value of the dollar up
• Push our net exports down
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
34
Worry about the Trade Deficit?
• How long can it go on?
– As long as the U.S. continues to run large
trade deficits
– Foreigners will have to continue to
accumulate large amounts of U.S. assets
• 2002, foreign private investors
– Acquired about all the American assets
they wanted
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35
Worry about the Trade Deficit?
• Governments of Japan and China
– Buy hundreds of billions of dollars of U.S.
Treasury securities
• Sell equivalent amounts of their own
currencies
• Rather than let the yen and the yuan
appreciate
– Large government capital inflows allowed the U.S. to continue to run
mammoth trade deficits, a few more years
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36
Worry about the Trade Deficit?
• 2008–2009, financial crisis
– Lots of worried investors – eager to buy
U.S. dollar assets
• Especially Treasury securities
• As the “flight to safety” dissipated
– Foreigners decided they did not need
quite as many U.S. assets
– The dollar declined again
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
On Curing the Trade Deficit
• How can we ameliorate our foreign trade
problem and reduce our addiction to
foreign borrowing?
1. Change the mix of fiscal and monetary
policy
2. More Rapid Economic Growth Abroad
3. Raise Domestic Saving or Reduce
Domestic Investment
4. Protectionism
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38
On Curing the Trade Deficit
1. Change the mix of fiscal and monetary
policy
– Tightening fiscal policy and loosening
monetary policy
• Done in the 1990s
2. More rapid economic growth abroad
– They would buy more American goods
– Raising U.S. exports
– Reducing our trade deficit
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39
On Curing the Trade Deficit
3. Raise domestic saving or reduce
domestic investment
– If Americans would save more
• We would need to borrow less from abroad
– Reducing U.S. domestic investment
• 2007–2009 recession:
– Share of investment in real GDP fell from 17.2%
in 2006 to 11.8% in 2009
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40
On Curing the Trade Deficit
4. Protectionism
– Limit imports by imposing stiff tariffs,
quotas, and other protectionist devices
– Almost all economists oppose it
– It has an undeniable political allure
– Might not succeed in reducing our trade
deficit
• Other nations may retaliate
• Will reduce the supply of dollars on the world
market
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41