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ECN 253---Macroeconomics in an Open Economy

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Yuanyuan Chen

on 29 November 2012

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Transcript of ECN 253---Macroeconomics in an Open Economy

The Balance of Payments: Linking the United States to the International Economy The Foreign Exchange Market and Exchange Rates The International Sector and National Saving and Investment Net Exports Equal Net Foreign Investment Catherine Chen, Ph.D. Macroeconomics in an Open Economy What We Do in this Chapter Expand Our Knowledge Worldwide The Balance of Payments: Linking the United States to the International Economy The Foreign Exchange Market and Exchange Rates The International Sector and National Saving and Investment The Effect of a Government Budget Deficit on Investment Monetary Policy and Fiscal Policy in an Open Economy Open economy An economy that has interactions in trade or finance with other countries. Closed economy An economy that has no interactions in trade or finance with other countries. Balance of payments The record of a country’s trade with other countries in goods, services, and assets. The Current Account Current account The part of the balance of payments that records a country’s net exports, net income on investments, and net transfers. The current account records current, or short-term, flows of funds. The difference between exports and imports of goods and services is called net exports; the difference between investment income received and investment income paid is called net income on investments; and the difference between transfers made and transfers received is called net transfers. The Balance of Trade Balance of trade The difference between the value of the goods a country exports and the value of the goods a country imports. If a country exports more goods than it imports, it has a trade surplus. If a country exports less than it imports, it has a trade deficit. Net Exports Equals the Sum of the Balance of Trade and the Balance of Services The balance of services is the difference between the value of the services a country exports and the value of the services a country imports. Notice that, technically, net exports is not equal to the current account balance because this account also includes net income on investments and net transfers. But these other two items are relatively small, so it is often a convenient simplification to think of net exports as being equal to the current account balance. The Financial Account Financial account The part of the balance of payments that records purchases of assets a country has made abroad and foreign purchases of assets in the country. We use the word capital here to apply not just to physical assets, such as factories, but also to financial assets, such as shares of stock. When firms build or buy facilities in foreign countries, they are engaging in foreign direct investment. When investors buy stock or bonds issued in another country, they are engaging in foreign portfolio investment. Another way of thinking of the balance on the financial account is as a measure of net capital flows, or the difference between capital inflows and capital outflows. Net foreign investment The difference between capital outflows from a country and capital inflows, also equal to net foreign direct investment plus net foreign portfolio investment. Net capital flows and net foreign investment are always equal but have opposite signs: When net capital flows are positive, net foreign investment is negative, and when net capital flows are negative, net foreign investment is positive. Net foreign investment is also equal to net foreign direct investment plus net foreign portfolio investment. The Capital Account Capital account The part of the balance of payments that records relatively minor transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets. This is a less important part of the balance of payments. A nonproduced, nonfinancial asset is a copyright, patent, trademark, or right to natural resources. Why Is the Balance of Payments Always Zero? The sum of the current account balance, the financial account balance, and the capital account balance equals the balance of payments. To make the balance on the current account equal the balance on the financial account, we include an entry called the statistical discrepancy. Changes in foreign holdings of dollars are known as official reserve transactions. A current account deficit must be exactly offset by a financial account surplus, leaving the balance of payments equal to zero. Nominal exchange rate The value of one country’s currency in terms of another country’s currency. Economists also calculate the real exchange rate, which corrects the nominal exchange rate for changes in prices of goods and services. There are three sources of foreign currency demand for the U.S. dollar:
Foreign firms and households that want to buy goods and services produced in the United States.
Foreign firms and households that want to invest in the United States either through foreign direct investment—buying or building factories or other facilities in the United States—or through foreign portfolio investment—buying stocks and bonds issued in the United States.
Currency traders who believe that the value of the dollar in the future will be greater than its value today. Equilibrium in the Market for Foreign Exchange Currency appreciation An increase in the market value of one currency relative to another currency. Currency depreciation A decrease in the market value of one currency relative to another currency. How Do Shifts in Demand and Supply Affect the Exchange Rate? Three main factors cause the demand and supply curves in the foreign exchange market to shift:
Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign-produced goods and services.
Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries.
Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies. Shifts in the Demand for Foreign Exchange Speculators Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates. The demand curve for dollars shifts to the right when incomes in Japan rise, when interest rates in the United States rise, or when speculators decide that the value of the dollar will rise relative to the value of the yen. Shifts in the Supply of Foreign Exchange The factors that affect the supply curve for dollars are similar to those that affect the demand curve for dollars. Adjustment to a New Equilibrium Some Exchange Rates Are Not Determined by the Market How Movements in the Exchange Rate Affect Exports and Imports Some currencies have fixed exchange rates that do not change over long periods. A country’s central bank has to intervene in the foreign exchange market to buy and sell its currency to keep the exchange rate fixed. If the economy is currently below potential GDP, then, holding all other factors constant, a depreciation in the domestic currency should increase net exports, aggregate demand, and real GDP.
An appreciation in the domestic currency should have the opposite effect: Exports should fall, and imports should rise, which will reduce net exports, aggregate demand, and real GDP. The Real Exchange Rate Real exchange rate The price of domestic goods in terms of foreign goods. If the exchange rate between the U.S. dollar and the British pound is $1 =£1, the price level in the United States is 100, and the price level in the United Kingdom is also 100. Then the real exchange rate between the dollar and the pound is If the nominal exchange rate increases to 1.1 pounds per dollar, while the price level in the United States rises to 105 and the price level in the United Kingdom remains 100, the real exchange rate will be Current account balance + Financial account balance = 0
or:
Current account balance = – Financial account balance
or:
Net exports = Net foreign investment Domestic Saving, Domestic Investment, and Net Foreign Investment National saving = Private saving + Public saving
or S = Sprivate + Spublic
Private saving = National income – Consumption – Taxes
or Sprivate = Y – C – T
Government saving = Taxes – Government spending
or Spublic = T – G Saving and investment equation An equation that shows that national saving is equal to domestic investment plus net foreign investment. One more basic: National saving = Domestic investment + Net foreign investment S = I + NFI This equation is an identity because it must always be true, given the definitions we have used.
A country’s saving will be invested either domestically or overseas. If you save $1,000 and use the funds to buy a bond issued by General Motors, GM may use the $1,000 to renovate a factory in the United States (I) or to build a factory in China (NFI) as a joint venture with a Chinese firm. A country such as the United States that has negative net foreign investment must be saving less than it is investing domestically. S – I = NFI. The Effect of a Government Budget Deficit on Investment When the government runs a budget deficit, national saving will decline unless private saving increases by the amount of the budget deficit, which is unlikely. S = I + NFI The result of a decline in national saving must be a decline in either domestic investment or net foreign investment. To attract investors, the Treasury may have to raise the interest rates on its bonds. Higher interest rates will discourage some firms from borrowing funds to build new factories or to buy new equipment or computers. When a government budget deficit leads to a decline in net exports, the result is sometimes referred to as the twin deficits. A government budget deficit will also lead to a current account deficit. Monetary Policy and Fiscal Policy in an Open Economy Monetary Policy in an Open Economy When the Federal Reserve engages in an expansionary monetary policy, it buys Treasury securities to lower interest rates and stimulate aggregate demand.
In a closed economy, the main effect of lower interest rates is on domestic investment spending and purchases of consumer durables.

In an open economy, lower interest rates will also affect the exchange rate between the dollar and foreign currencies. The switch from U.S. financial assets to foreign financial assets will lower the demand and value of the dollar. A lower exchange rate will decrease the price of U.S. products in foreign markets and cause net exports to increase. This additional policy channel will increase the ability of an expansionary monetary policy to affect aggregate demand.

To summarize: Monetary policy has a greater effect on aggregate demand in an open economy than in a closed economy. Fiscal Policy in an Open Economy To engage in an expansionary fiscal policy, the federal government increases its purchases or cuts taxes.
An expansionary fiscal policy may result in higher interest rates. In a closed economy, the main effect of higher interest rates is to reduce domestic investment spending and purchases of consumer durables.
In an open economy, higher interest rates will also lead to an increase in the foreign exchange value of the dollar and a decrease in net exports. Therefore, in an open economy, an expansionary fiscal policy may be less effective because the crowding out effect may be larger. In a closed economy, only consumption and investment are crowded out by an expansionary fiscal policy. In an open economy, net exports may also be crowded out.
In summary: Fiscal policy has a smaller effect on aggregate demand in an open economy than in a closed economy. http://www.bloomberg.com/markets/currencies/currency-converter/ Example SELL BUY BUY SELL Use different exchange rates (£/$) to explain:
1. who demand more, who demand less;
2. who want to sell more, who want to sell less;
3. extend it to equilibrium market, when demand more $, when demand more £; when supply more $, when supply more £.
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