Download Lecture 10 - UTA Economics

© 2010 Jane Himarios, Ph.D.
Lecture 16
Chapter 16: Open Economy Macroeconomics
I.
The Balance of Payments
The current account balance and the capital account balance must sum to $0.
A.
The Current Account
Includes the balance of trade, the balance on income, and net transfers
Balance of trade: exports minus imports
Balance on income: income received minus income payments
Net transfers of money: money sent abroad less money sent into the U.S.
B.
The Capital Account
Summarizes the flow of money into and out of domestic and foreign assets
Net increase in foreign-owned holdings: increase in foreign-owned assets
in the U.S. minus increase in U.S.-owned assets abroad
Statistical discrepancy
See Table 1: In 2006 the current account balance was -$811.5 billion so the
capital account balance had to be $811.5 billion.
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© 2010 Jane Himarios, Ph.D.
II.
Exchange Rates
A.
Nominal Exchange Rates
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From Chapter 9:
Why a change in the value of the dollar affects net exports: Go to
http://finance.yahoo.com/currency-converter?u to see exchange rates.
I’ve added a trend line to show that the value of the dollar has fallen.
In late 2008 you could get about 80 euro cents for $1. In late 2009 you could get
about 68 euro cents for $1. Since you don’t get as many euros per dollar, we say
that the value of the US dollar fell.
© 2010 Jane Himarios, Ph.D.
B.
Real Exchange Rates
The real exchange rate is the price of one country’s currency for another when
the price levels of both countries are taken into account. The real exchange rate
is important when inflation is an issue in one country.
er = en X (Pd/Pf)
where
er = the real exchange rate
en = the nominal exchange rate
Pd = the domestic price level
Pf = the foreign price level
Land Rover example from the text: If Britain suffers inflation then Pf climbs,
including the price of Land Rovers, while U.S. auto prices remain unchanged.
Fewer Land Rovers will be bought, leading to lower demand for the British
pound, reducing its exchange value and restoring some competitiveness.
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© 2010 Jane Himarios, Ph.D.
C.
Purchasing Power Parity
The rate of exchange that allows a specific amount of currency in one country to
purchase the same quantity of goods in another country.
This implies that, given this chart, something that cost $1 in the U.S. would cost
.67 euros:
Think about why purchasing power parity should hold in the long run: it should
hold because ____________________________________________________.
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© 2010 Jane Himarios, Ph.D.
D.
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Exchange Rate Determination
How Foreign Exchange Markets Work
Pounds and kilograms are both units of measurement for measuring weight. They aren't compatible, as the
peso and the dollar aren't compatible. But they can be compared (1kg = 2.2 pounds), just like the peso and
the dollar can be compared.
1.
Why do Americans want to buy foreign currencies?
a.
In order to buy foreign-made products
b.
In order to make investments in foreign firms or foreign government bonds
c.
As an investment if they believe the domestic currency will lose value
relative to the foreign currency
2.
Why are foreigners willing to sell their currency to Americans?
a.
In order to buy American-made products
b.
In order to make investments in American firms or US government bonds
c.
As an investment if they believe their currency will lose value relative to
the US dollar
3.
Graphically, what does a foreign exchange market look like?
One way to look at the market for currency looks is to consider that it looks just
like the market for refrigerators or watches. The demand curve shows how many
units of a given currency are demanded at each and every price per unit. The
supply curve shows how many units of a given currency are supplied at each and
every price.
The following graph shows the market for Japanese yen. The price per yen is
denoted in dollars, just like in the market for refrigerators or watches. The
demand curve for yen is negatively sloped because people will want to buy more
yen at lower prices. The supply curve for yen is positively sloped because people
will be willing to supply more at higher prices.
Price per yen
(Denoted in
US dollars)
Syen
Dyen
Number of yen traded
© 2010 Jane Himarios, Ph.D.
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A second way to look at the foreign exchange market is to consider the “product”
that is traded in the market to be U.S. dollars. In this case, the price is measured
in terms of the foreign currency, that is, how many units of the foreign currency it
takes to buy one U.S. dollar. This is the exchange rate.
Price (denoted in
pounds) per dollar
S$
D$
Number of dollars traded
An appreciation of the dollar is shown by sliding up the horizontal axis. Notice
that a dollar appreciation would cause the quantity of dollars demanded to fall
and the quantity of dollars supplied to rise.
A depreciation of the dollar is shown by sliding down the horizontal axis. Notice
that a dollar depreciation would cause the quantity of dollars demanded to rise
and the quantity of dollars supplied to fall.
See Figure 3 on page 389, which shows a dollar appreciation (and a depreciation
of the pound).
© 2010 Jane Himarios, Ph.D.
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Here is an example of a dollar depreciation (and an appreciation of the euro):
Initially, it cost $1.33 to buy a euro, but after the demand curve shifts it costs
$1.50 to buy a euro.
Price per euro
(Denoted in U.S. dollars)
Seuros
$1.50
$1.33
D’euros
Deuros
# of euros traded
To find the initial price of a US dollar (denoted in euros), we would divide 1 by
1.33. The initial price per US dollar (denoted in euros) was .75 euro cents. After
the depreciation of the dollar it only cost 0.66 euro cents to buy a dollar.
Price per US
dollar (denoted
in euros)
SUS dollars
0.75
0.66
DUS dollars
# of US dollars traded
© 2010 Jane Himarios, Ph.D.
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Determinants of Exchange Rates
Dollar appreciation
Decrease in American tastes and
preferences for foreign goods and
services
Foreign incomes rise faster than
American incomes (so that our demand
for imports is exceeded by foreign
demand for our exports)
Inflation rises faster in foreign countries
than in the U.S. (so that our exports are
relatively better deals)
U.S. interest rates increase (so that
people across the globe are more likely
to want to put their money in American
financial institutions)
E.
Dollar depreciation
Increase in American tastes and
preferences for foreign goods and
services
American incomes rise faster than
foreign incomes (so that our demand
for imports exceeds foreign demand for
our exports)
Inflation rises faster in the U.S. than in
foreign countries (so that foreign goods
are relatively better deals)
U.S. interest rates decrease (so that
people across the globe are more likely
to want to put their money in foreign
financial institutions)
Exchange Rates and Aggregate Supply and Demand
We know this much from Chapter 9:
When the dollar appreciates, net exports fall, shifting AD leftward.
When the dollar depreciates, net exports rise, shifting AD rightward.
We can now consider that, since some inputs are imported, the change in the
dollar will also shift the AS curve:
When the dollar appreciates, imported inputs become less expensive, shifting AS
rightward.
When the dollar depreciates, imported inputs become more expensive, shifting
AS leftward.
We also know this from Chapter 9:
Along with these reasons for AS shifts, the AD shift put us into a “danger zone,”
so wage rates will also change, shifting the AS curve to get us back to NAIRU.
(Notice that the text box accompanying Figure 4 on page 392 isn’t fully
accurate—you must also read the text above the figure and below it.)
© 2010 Jane Himarios, Ph.D.
III.
9
Monetary and Fiscal Policy in an Open Economy
Monetary Policy in an Open Economy
Easy Money Policy
If the Fed increases the money supply, interest rates will fall, and then we will
see two things happen:
1. Initial effect: I↑ → AD↑ → real GDP and the price level↑
2. Feedback effect: the dollar depreciates → (EX – IM)↑ → AD↑ → real GDP and
the price level↑
Tight Money Policy
If the Fed decreases the money supply, interest rates will rise, and then we will
see two things happen:
1. Initial effect: I↓ → AD↓ → real GDP and the price level↓
2. Feedback effect: the dollar appreciates → (EX – IM)↓ → AD↓ → real GDP and
the price level↓
Principle of economics:
Feedback effects magnify the effects of monetary policy. Monetary policy is
stronger in an open economy than in a closed economy.
Fiscal Policy in an Open Economy
Expansionary Fiscal Policy
If the government practices expansionary fiscal policy by spending more than it
collects in taxes, and if it borrows to cover the resulting deficit, two things
happen:
1. Initial effect: G↑ → AD↑ → real GDP and the price level↑
2. Crowding out effect: interest rates↑ → the dollar appreciates → (EX – IM)↓ →
AD↓ → real GDP and the price level↓
Contractionary Fiscal Policy
If the government practices contractionary fiscal policy by spending less than it
collects in taxes, government borrowing falls and two things happen:
1. Initial effect: G↓ → AD↓ → real GDP and the price level↓
2. Crowding out effect: interest rates↓ → the dollar depreciates → (EX – IM)↑ →
AD↑ → real GDP and the price level↑
Principle of economics:
Crowding out effects reduce the effects of fiscal policy. Fiscal policy is weaker in
an open economy than in a closed economy.