Week 8 - Pacing Guide and Lesson Plans Unit 7 – Open Economy: International Trade and Finance

Unit 710-15% of AP Open Economy: International Trade and Finance

I. Open Economy: International Trade and Finance *A. Balance of Payments accounts

1. Balance of trade2. Current account3. Capital account

B. Foreign exchange market1. Demand for and supply of foreign exchange2. Exchange rate determination3. Currency appreciation and depreciation

C. Net exports and capital flowsD. Links to financial and goods markets

* Taken from the AP Economics Course Description 2010II. Student objectives

A. Explain how the balance of payments accounts are recordedB. Explain the effect of trade restrictionsC. List the factors that influence equilibrium foreign exchange ratesD. Using demand/supply analysis, show how market forces and public policy

affect currency demand and currency supplyE. Define currency appreciation and depreciation and relate to graphical

analysisF. State the effects of appreciation and depreciation on a country’s net exportsG. Understand how changes in net exports and capital flows affect financial

and goods marketsIII. Graphs and Diagrams to be mastered

A. Balance of Payments AccountsB. International Capital FlowsC. Foreign Exchange MarketsD. Fixed Exchange Markets and Market InterventionE. Monetary Policy Effects and the Exchange Rate

IV. Key Terms Section 8 p. 453 (Textbook)V. Key Concepts: The United States and world trade, comparative advantage, the foreign

exchange market, government and trade agreements, exchange ratesVI. Supplemental Activities

A. Economics by Example: David AndersonChapter 27: Is Globalization A Bad Word?

B. Strive for a 5: Ray and MayerModule 41 Activities p. 284-286Module 42 Activities p. 287-289Module 43 Activities p. 290-292Module 44 Activities p. 293-294Module 45 Activities p. 295-296Section 8 Before You Take the Test

Featured Graph: Foreign Exchange Model p. 296-297Problems p. 297-305 Review Questions p. 305-309

C. Favorite Ways to Learn Economics: Anderson and ChaseyChapter 12 International Economics

Class Room Experiments 12A and 12 BProblem Set 12.1-12.6

Section 8 Textbook pages

Opening Section 8 p. 409Module 41: Capital Flows and the Balance of Payments p. 410-420Module 42: The Foreign Exchange Market p. 421-430Module 43: Exchange Rate Policy p. 437-442Module 44: Exchange Rates and Macroeconomic Policy p. 443-451Module 45: Putting it All Together p. 443-451Section 8 Summary p. 452-455

MODULE 41: CAPITAL FLOWS AND THE BALANCE OFPAYMENTS

The purpose of this module is to show students how economists keep track of the flow of money from one nation to another and to examine what factors determine whether the flow of money between nations speeds up or slows down.

Student learning objectives:• The meaning of the balance of payments accounts. • The determinants of international capital flows.

Key Economic Concepts For This Module:• A country’s balance of payments accounts are a summary of the country’s transactions

with other countries. • Transactions that don’t create future liabilities are recorded in the current account. • Transactions that do create future liabilities are recorded in the financial account. • The balance on the current account plus the balance on the financial account must

sum to zero. Why? In total the sources of cash must equal the uses of cash. • CA = - FA • If one nation has a higher real interest rate than another nation, it will attract an inflow

of financial capital. The nation with the lower interest rate will experience an outflow of financial capital.

Common Student Difficulties:• Students do get confused with how certain transactions get entered into the balance of

payments accounts. Keep it simple with just a few examples and problems from the chapter and released AP Macro exams.

• Stress to students that there are financial assets (like buying a bond, a share of stock, or a certificate of deposit) and there are physical assets (like buying a factory, a shopping mall, or a piece of production equipment). When discussing the flow of financial capital, students must understand that differences in real interest rates drive the flow of financial capital not physical capital.

In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be covered in two one-hour class sessions.

I. Capital Flows and the Balance of Payments

A. Balance of Payments Accounts B. Modeling the Financial Account C. Underlying Determinants of International Capital Flows D. Two-way Capital Flows

I. Capital Flows and the Balance of Payments Every year Americans buy trillions of dollars of “stuff” from firms in foreign countries. Consumers in foreign countries buy nearly the same amount of “stuff” from America.

Economists keep track of international transactions using the balance of payments accounts.

A. Balance of Payments Accounts Note: The textbook has an excellent example of a family farm that, at a micro level, prepares the student to examine the balance of payments account at the macro level. It is suggested that the instructor walk the class through this example. Or the instructor can use this as an additional example.

Example• The Santa Cruz family runs an auto repair and body shop. Over the course of the

year, the shop earned $450,000 in sales. • The family spent $400,000 for living expenses and to run the shop, including

purchasing equipment, supplies, materials and utilities. • The family earned $5000 in interest on savings and other investments. • The family paid $20,000 in interest on the mortgage for the building. • After paying all of the bills, the family took the remaining cash and deposited it into the

bank.

The table below shows the net inflow of cash for the Santa Cruz family business.

Sources of cash Uses of Cash NetPurchases or Auto repair sales:

Shop operationsand living +$50,0001 sales of goods $450,000 expenses:

and services $400,000Interest income Interest received from Interest paid on

2 mortgage: -$20,000and payments investments: $5000 $25,000

3Loans and Funds received from Funds deposited in

-$30,000deposits new loans: $0 bank: $30,000Total $455,000 $455,000 $0

Explanations:• Row 1: Summarizes the sale of goods and services to customers, and the

payments made to outside firms for the purchase of goods and services. • Row 2: Summarizes interest income received from past savings and interest

paid for past borrowing. • Row 3: Summarizes money received from new borrowing and money used for new

saving.

It is important to stress that the sum of cash coming in from all sources and the sum of all cash used are equal, by definition: every dollar has a source, and every dollar received gets used somewhere.

Note: the instructor can now hand out or project a table like 41-2 to show a simplified version of the U.S. balance of payments accounts. A table such as this can be used to explain where various transactions might appear in the table.

Row 1 of Table 41-2 shows payments that arise from sales and purchases of goods and services.• The U.S. exports cars to be sold in Canada. This is a payment from foreigners for

goods and services. • The U.S. imports oil from Venezuela. This is a payment to foreigners for goods and

services.

Row 2 shows factor income—payments for the use of factors of production owned by residents of other countries. This can be interest on loans from overseas, profits of foreign-owned corporations or labor income from native-born workers who work overseas.

• Wal-mart, an American company, earns profit from stores in Europe. This is a factor income payment from foreigners.

• Honda, a Japanese company, produces and sells cars in Indiana and other U.S. states. This is a factory income payment to foreigners.

Row 3 shows international transfers —funds sent by residents of one country to residents of another. The main element here is the remittances that immigrants, such as the millions of Mexican - born workers employed in the United States, send to their families in their country of origin.Notice that Table 41-2 only shows the net value of transfers. That’s because the U.S. government only provides an estimate of the net, not a breakdown between payments to foreigners and payments from foreigners.

The next two rows of Table 41-2 show payments resulting from sales and purchases of assets, broken down by who is doing the buying and selling.

Row 4 shows transactions that involve governments or government agencies, mainly central banks.

• When the central bank of China purchases a U.S. Treasury, cash flows from China to the U.S.

Row 5 shows private sales and purchases of assets.• When Coca-Cola buys a factory in Mexico, this is an asset purchase and payment to

foreigners. • If a Brazilian company buys an apartment building in Boston, this is an asset sale, and

payment to foreigners.

In laying out Table 41-2, we have separated rows 1, 2, and 3 into one group and rows 4 and 5 into another. This reflects a fundamental difference in how these two groups of transactions affect the future.

Note: a great way to help the students see how the table is separated is to point out that the balance of payments accounts distinguish between transactions that don’t create liabilities (like when an American buys a jacket produced in Honduras) and those that do (like when a

Honduran banker buys a U.S. Treasury).

• Transactions that don’t create liabilities are considered part of the balance of payments on current account, often referred to simply as the current account: the balance of payments on goods and services plus factor income and net international transfer payments.

• The most important part of the current account: the balance of payments on goods and services, the difference between the value of exports and the value of imports during a given period.

• The merchandise trade balance, (or simply trade balance) is the difference between a country’s exports and imports of goods alone—not including services.

The current account, as we’ve just learned, consists of international transactions that don’t create liabilities. Transactions that involve the sale or purchase of assets, and therefore do create future liabilities, are considered part of the balance of payments on financial account, or the financial account for short.

Note: Until a few years ago, economists often referred to the financial account as the capital account. We’ll use the modern term, but point out to students that they may run across the older term on the AP Macro exam.

Note: the instructor should point out that in Table 41-2 the total balance is not zero, it is $44 billion. This is just a statistical error, reflecting the imperfection of official data. (And a $44 billion error when you’re measuring inflows and outflows of $4.5 trillion isn’t bad!) In fact, it’s a basic rule of balance of payments accounting that the current account and the financial account must sum to zero:

Current account (CA) + Financial account (FA) = 0 orCA = −FA

Why must this be true?In total, the sources of cash must equal the uses of cash.

Note: it would likely be productive if the instructor walked the students through the circular flow diagram Figure 41-1that describes the flow of money between national economies.

Two other equivalent ways to see the equation above:Positive entries on current account + Positive entries on financial account = Negative entries on current account + Negative entries on financial account

Positive entries on current account - Negative entries on current account = Positive entries on financial account - Negative entries on financial account = 0

B. Modeling the Financial Account What determines whether money flows into a nation’s financial account?The financial account is a measure of capital inflows, of foreign savings that are available to finance domestic investment spending.

The basic model of the loanable funds market is used to model the flow of financial capital from one nation to another.

In using this model, we make two important simplifications:• We simplify the reality of international capital flows by assuming that all flows

are in the form of loans. In reality, capital flows take many forms, including purchases of shares of stock in foreign companies and foreign real estate as well as direct foreign investment, in which companies build factories or acquire other productive assets abroad.

• We also ignore the effects of expected changes in exchange rates, the relative values of different national currencies. We analyze the determination of exchange rates later.

Note: the instructor can pick any two nations to use as an example. And this example can also be used as the in-class activity below.

Suppose that the real interest rate in the U.S. is 3% and the real interest rate in Japan is 7%.

Note: this is a good opportunity for students to review the LF market. Ask them to draw two side-by-side markets and show how the real interest rate in Japan is significantly higher.

When two nations have differing real interest rates in their domestic loanable funds markets, savers in the U.S. begin to look for countries like Japan where the return on a financial asset is higher.Individuals and firms in the U.S. begin to purchase financial assets in Japan, sending dollars as payment to Japan.Another way to think about it is that the U.S. is exporting dollars and importing financial assets. Japan is exporting the financial assets and importing dollars.

Note: stress to the students that recent AP Macro exams have been very strict on this point. It is important that students understand that U.S. investors are seeking financial assets in Japan, not physical assets (like factories) in Japan.

These dollars serve as capital inflow in Japan, and capital outflow from the U.S. The flow of dollars ends when the interest rate disparity is gone, perhaps at a level of about 5%.

C. Underlying Determinants of International Capital Flows But what underlies differences across countries in the supply and demand for funds?

International differences in the demand for funds reflect underlying differences in investment opportunities.

• A country with a rapidly growing economy, other things equal, tends to offer more investment opportunities than a country with a slowly growing economy. So a rapidly growing economy typically—though not always—has a higher demand for capital and offers higher returns to investors than a slowly growing economy in the absence of capital flows. As a result, capital tends to flow from slowly growing to rapidly growing economies.

• International differences in the supply of funds reflect differences in savings across countries. These may be the result of differences in private savings rates, which vary widely among countries.

• They may also reflect differences in savings by governments. In particular, government budget deficits, which reduce overall national savings, can lead to capital inflows.

D. Two-way Capital Flows The flow of financial capital is a two-way street.Financial investors in the U.S. are sending money to Japan because interest rates might be higher, but Japanese investors are sending money to the U.S. stock market because they believe the U.S. economy has a brighter future.Corporations diversify financial risk by both selling shares of their own stock to foreign investors, but also by purchasing foreign shares of stocks or foreign bonds

In-Class Activities and Demonstrations

Recent AP Macro exams have tested the balance of payments accounts in both multiple choice and free-response questions.

1. How would the following transactions be categorized in the U.S. balance of payments accounts? How will the balance of payments on the current and financial accounts change?

• An American college student decides to spend a year studying (and paying tuition) at a university in Australia.

• A German telecommunications firm purchases microprocessors from an American firm. • An American bank purchases shares of stock in Japanese firms traded on the

Tokyo stock exchange.

Answers:• The college student is essentially buying a service from Australia. This would be an

import of services into the U.S., so this is recorded as a payment to foreigners, and the

current account balance would decrease. • The German firm is buying products from America. This is an American export,

so this is recorded as a payment from foreigners, and the current account balance in the U.S. would increase.

The American bank has purchased a foreign asset so dollars are sent to foreigners. Thus the balance on the financial account would decrease.

MODULE 42: THE FOREIGN EXCHANGE MARKET

The purpose of this module is to adapt the model of supply and demand to the market for a nation’s currency. The foreign exchange market shows us how the value of a particular currency, like the U.S. dollar, rises and falls with global economic forces and economic policies.

Student learning objectives:• The role of the foreign exchange market and the exchange rate. • The importance of real exchange rates and their role in the current account.

Key Economic Concepts For This Module:• Foreign currencies are exchanged because foreign goods and services are exchanged.

The market for a currency (like the U.S. dollar) operates with the forces of supply and demand.

• When the dollar can buy more of a foreign currency (like the euro), it is said that the dollar has appreciated in value, or it has become “stronger” against the euro.

• When the dollar can buy less of a foreign currency (like the euro), it is said that the dollar has depreciated in value, or it has become “weaker” against the euro.

• Movements in the exchange rate ensure that changes in the financial account and in the current account offset each other.

• The real exchange rate is the nominal exchange rate adjusted for international differences in aggregate price levels.

Common Student Difficulties:• It is confusing for many students to think of “buying” a dollar. But if you are a Mexican

or Canadian or Brazilian tourist to America, how are you going to get a hotel room, pay for a taxi or buy a meal in downtown Los Angeles? You need dollars, and you can buy them by supplying the currency from your nation. Try to get the students to think of buying (demand) and selling (supply) a currency in much the same way that they are familiar with buying and selling a pizza.

• Has the dollar appreciated or depreciated? Do a few simple mathematical conversions, or use the currency calculator website provided below. If the dollar can buy more of a foreign currency, it has appreciated. The other currency must have depreciated against the dollar because those consumers must supply more of their currency to buy a dollar.

In-Class Presentation of Module and Sample Lecture

Suggested time: This module should be covered in two hour-long class sessions. Leave plenty of time to practice at least one released FRQ.

Note: there are many websites that offer currency calculators. Students might find this interesting. http://www.x-rates.com/calculator.html#

I. The Role of the Exchange Rate A. Understanding Exchange Rates B. The Equilibrium Exchange Rate

C. Inflation and Real Exchange Rates D. Purchasing Power Parity

I. The Role of the Exchange Rate In the previous module we saw that the market for loanable funds shows us how financial capital flows into or out of a nation’s capital account.Goods and services also flow, but this flow is tracked as balance of payments into and out of the current account.

So given that the financial account reflects the movement of capital and the current account reflects the movement of goods and services, what ensures that the balance of payments really does balance? That is, what ensures that the two accounts actually offset each other?

The answer lies in the role of the exchange rate, which is determined in the foreign exchange market.

A. Understanding Exchange Rates Suppose you are traveling to Mexico and you wish to buy a t-shirt at a market and the price is 187.5 Mexican pesos. You have U.S. dollars in your pocket, but you must pay the Mexican shirt manufacturer in the currency most useful to her, the peso.

How does an American get his hands on some pesos? He must exchange his dollars for pesos in the foreign exchange market.How many Mexican pesos does one U.S. dollar fetch at the foreign exchange counter? It depends upon the exchange rate. In mid-June 2010, one U.S. dollar could buy about 12.5 pesos. Or, if you were in Mexico and you wanted some dollars, it would take 12.5 of your pesos to buy one dollar. If you only had one peso, you could buy 1/12.5 = $.08.

So how much does the shirt cost in June 2010? (187.5 pesos)/(12.5 pesos per dollar) = $15

The exchange rate is just a price. In this case, 12.5 pesos is the price of a U.S. dollar. And we know from many previous modules that prices change based upon the forces of supply and demand.

For example, in late April 2010, it took 12.1 pesos to buy 1 U.S. dollar. This means that if you were in Mexico that month, your dollar would have been able to purchase fewer pesos. How much would the shirt cost in April 2010? (187.5 pesos)/(12.1 pesos per dollar) = $15.50.In other words, the dollar was more expensive (measured in pesos per dollar) in June 2010 than it was two months earlier. Economists would say that the dollar has appreciated in value against the peso because it has become more expensive.

Another way to think about it is to look at what happens to the price of the shirt. From April to June 2010, the price of the shirt, measured in U.S. dollars, drops by $.50. Your dollar would have been stronger in Mexico because it would have been able to buy more of everything priced in pesos.

What happened to the value of the peso?June 2010: 187.5 pesos would have bought $15April 2010 187.5 pesos would have bought $15.50

In other words, in the span of two months, the same amount of pesos bought fewer dollars.

Economists would say that the peso had depreciated against the dollar. The price of a peso, measured in dollars, has fallen.

B. The Equilibrium Exchange Rate The price of a currency, or exchange rate, is determined in the market with the forces of supply and demand. If I want pesos, I demand them. And in order to acquire pesos, I must supply dollars to the exchange market. So when Americans demand more pesos, they must supply more dollars.

The graph below shows the market for the U.S. dollar.• The unit on the x-axis is the quantity of U.S. dollars supplied and demanded. • The unit on the y-axis is the price of U.S. dollars, measured in pesos per dollar.

Note: If students are graphing the market for the U.S. dollar, an easy way to remember how to label the y-axis is to think of the notation typically used: (foreign currency)/dollar. The dollar goes in the denominator or “below” the “/”. The dollars are also the unit on the x-axis, which is “below” the graph. Tell the students that “what goes below goes below”. If it’s the market for dollars, dollars are on the x-axis and in the denominator.

The equilibrium exchange rate is 12.5 Mexican pesos per U.S. dollar.

Why does the Demand for dollars slope downward?• As the price of a dollar falls (its value depreciates) it takes fewer pesos to buy one dollar. • Consumers in Mexico will find U.S. goods to be less expensive. • U.S. exports to Mexico will rise, and more dollars will be demanded to pay for those

goods.

Why does the Supply of Dollars slope upward?• As the price of a dollar rises (its value appreciates) one dollar buys more pesos. • Consumers in the U.S. will find Mexican-made goods to be less expensive. • U.S. imports from Mexico will rise, and more dollars will be supplied to pay for those

goods.

At the equilibrium exchange rate of 12.5 pesos/dollar, the quantity of dollars demanded is equal to the quantity of dollars supplied.

Suppose the demand for U.S. dollars increases. Maybe Mexican consumers have more money to spend and some of that additional income is being spent on financial investments in America. The payments from those Mexican citizens will flow into the U.S. financial account.

As the demand for dollars shifts to the right, the equilibrium price of dollars rises and the dollar appreciates. It will now cost more than 12.5 pesos to buy one U.S. dollar. Because the U.S. dollar has appreciated against the peso, American consumers will increase purchases of goods and services from Mexico. More U.S. dollars will be supplied and will flow out of the U.S. current account. Because the quantity of dollars demanded and supplied is the same at the equilibrium exchange rate, the increased quantity of dollars demanded must be equal to the increased quantity of dollars supplied.

This tells us that any increase in the U.S. balance of payments on the financial account is exactly offset by a decrease in the U.S. balance of payments on the current account.

Summary:• An increase in capital flows into the U.S. leads to a stronger dollar, which then creates a

decrease in U.S. net exports. • A decrease in capital flows into the U.S. leads to a weaker dollar, which then creates an

increase in U.S. net exports.

C. Inflation and Real Exchange Rates The price of imported goods depends on the exchange rate for foreign currencies, but also on the aggregate price level in those nations.

To take account of the effects of differences in inflation rates, economists calculate real exchange rates, exchange rates adjusted for international differences in aggregate price levels.

Example Suppose that the exchange rate we are looking at is the number of Mexican pesos per U.S. dollar.

Let PUS and PMex be indexes of the aggregate price levels in the United States and Mexico, respectively. Then the real exchange rate between the Mexican peso and the U.S. dollar is defined as:

Real exchange rate = Mexican pesos per U.S. dollar *(PUS/PMex)

To distinguish it from the real exchange rate, the exchange rate unadjusted for aggregate price levels is sometimes called the nominal exchange rate.

Example 1: There is no difference in aggregate price levels between the U.S. and Mexico in the base year.

Real exchange rate = 12.5*(100/100) = 12.5 pesos per dollar

Example 2: Suppose the Mexican economy has suffered 10% aggregate inflation and PMex=110.

Real exchange rate = 12.5*(100/110) = 11.4 pesos per dollar.So in real terms, even though the exchange rate hasn’t changed, inflation in Mexico means that each U.S. dollar will buy fewer pesos and thus fewer Mexican goods.

D. Purchasing Power Parity The purchasing power parity between two countries’ currencies is the nominal exchange rate at which a given basket of goods and services would cost the same amount in each country.

Suppose, for example, that a basket of goods and services that costs $100 in the United States costs 1,000 pesos in Mexico. Then the purchasing power parity is 10 pesos per U.S. dollar: at that exchange rate, 1,000 pesos = $100, so the market basket costs the same amount in both countries.

In-Class Activities and Demonstrations

A Token ExampleStudents who have traveled abroad tend to have an easier time understanding the foreign exchange market. To simplify for students who have not traveled, I often talk about currencies as tokens. I reference an establishment that uses tokens for playing games (Chuck-E-Cheese for example).In order to play at Chuck-E-Cheese, you have to have the right tokens. Dollars do not work in the machines. If you have a dollar, you must exchange it into tokens in order to play.As students are relating this experience, I point out that other countries also require tokens; they just call them Yen, Euros, Pounds, etc.Now the question is, why do people want Chuck-E-Cheese tokens? To play their games. Why do people want Yen? To buy Japanese goods and services, or to invest in Japanese markets. Many times, connecting experiences that students have had (obtaining tokens to play a game, or tickets to ride a ride) helps them to understand experiences they have not had yet.Tell the students that the current exchange rate is $1=4 tokens.What would happen if the token machine changed such that $1=10 tokens? Would demand for games increase? Absolutely! The dollar has appreciated in value and more of these foreign “games” will be purchased. This is what happens when the dollar appreciates; imports rise so net exports rise.What would happen if the token machine changed such that $1 = 2 tokens? Obviously fewer dollars would be converted (supplied) and demand for the games would decrease. This is what happens when the dollar depreciates; imports fall so net exports rises.

A Practice FRQNote: in some way or another, foreign exchange will be tested on the AP Macro exam. Use released FRQs from the College Board.

MODULE 43: EXCHANGE RATE POLICY

The purpose of this module is to show how a nation can influence the exchange rate for its own currency. Both fixed and floating exchange rate regimes have advantages and disadvantages.

Student learning objectives:• The difference between fixed exchange rates and floating exchange rates. • Considerations that lead countries to choose different exchange rate regimes.

Key Economic Concepts For This Module:• The exchange rate for a nation’s currency can be influenced by government policy. • If the fixed rate is above the market equilibrium rate, there is a surplus of that nation’s

currency in the foreign exchange market. There are typically three ways in which the government can reduce the price to reach the target exchange rate.

• Likewise, if the fixed rate is below the market equilibrium rate, there is a shortage of that nation’s currency in the foreign exchange market. There are typically three ways in which the government can increase the price to reach the target exchange rate.

• There are some advantages to a fixed exchange rate regime, but there are also disadvantages. Nations like the U.S. and Canada have determined that a floating exchange rate policy is superior to the fixed exchange rate policy.

Common Student Difficulties:• If the students have been exposed to price ceilings and price floors, this section on fixed

exchange rates will be familiar. If not, it might be necessary to explain how a shortage or surplus of anything (in this case a currency) can be eliminated through market forces.

• This module includes some important connections between monetary policy, balance of payments accounts, and foreign exchange markets. It can provide an opportune time to review how monetary policy affects interest rates, which in turn affects the flow of money into financial markets.

In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be covered in one hour-long class session.

I. Exchange Rate Policy A. Exchange Rate Regimes B. How Can an Exchange Rate Be Held Fixed? C. The Exchange Rate Regime Dilemma

I. Exchange Rate Policy As we have seen in the previous module, the nominal exchange rate is a price that is determined by supply and demand in a market. This is very similar to how the price of apples or soybeans might be set by market forces.However, a nation can deliberately manipulate the exchange rate of its own currency to achieve certain economic goals.

Why? Because the exchange rate has a great deal of influence on net exports. If your nation’s

currency is inexpensive, foreigners will find your goods to be inexpensive and your net exports will rise.

A. Exchange Rate Regimes An exchange rate regime is a rule governing policy toward the exchange rate.

There are two main kinds of exchange rate regimes:A country has a fixed exchange rate when the government keeps the exchange rate against some other currency at or near a particular target. For example, Hong Kong has an official policy of setting an exchange rate of HK$7.80 per US$1.A country has a floating exchange rate when the government lets the exchange rate go wherever the market takes it. This is the policy followed by Britain, Canada, and the United States.

But if the exchange rate is determined by market forces of supply and demand, how can it be held fixed?

B. How Can an Exchange Rate Be Held Fixed? Note: the text uses an example of a hypothetical nation of Genovia. It might be interesting if the instructor modified the example by creating a nation that sounds suspiciously similar to a local town or high school.

Suppose the small nation of El Tigardo decides to fix their currency, the tigre, at a rate of $2 US for every 1 tigre.

If the tigre is exchanged in a free market, the equilibrium exchange rate may be higher, or lower, than the target rate of $2.

Scenario 1: the equilibrium exchange rate is below $2.

As we know, at the target of $2, there is now a surplus of tigres in the foreign exchange market which would normally push the exchange rate down to $1 per tigre.

The government of El Tigardo can:• Buy up the surplus of tigres in the foreign exchange market. This is called exchange

market intervention. The government must have dollars for this purchase, which is why governments keep foreign exchange reserves, or stocks of foreign currencies, so that they can engage in these types of price supports.

• The government can try to shift either the demand or supply curves so that the price rises to the target of $2. Maybe the central bank of El Tigardo increases interest rates. This will attract foreign capital investment, increasing the demand for the tigre. This will also reduce the capital outflow from El Tigardo, reducing the supply of tigres. The price of the tigre will begin to rise.

• The government can limit the right of individuals to but foreign currency. The government might require citizens to acquire a license to purchase dollars, thus reducing the supply of the tigre. The price will begin to rise,

Scenario 2: the equilibrium exchange rate is above $2.

As we know, at the target of $2, there is now a shortage of tigres in the foreign exchange market which would normally push the exchange rate up to $3 per tigre.

The government of El Tigardo can:• Sell tigres in the foreign exchange market. • The central bank of El Tigardo decreases interest rates. This will deter foreign capital

investment, decreasing the demand for the tigre. This will also increase the capital outflow from El Tigardo, increasing the supply of tigres. The price of the tigre will begin to fall.

• The government can limit the ability of foreigners to buy the tigre. The price will begin to fall.

But is it actually a good idea to fix the exchange rate?

C. The Exchange Rate Regime Dilemma There are advantages and disadvantages of both the fixed and floating exchange rate regimes.

Advantages in StabilityA fixed exchange rate provides stability in foreign transactions in much the same way we experience transactions across state lines. If you take your dollars from Indiana to Kentucky, you know that the value of your dollars is unchanged. But if you take your dollars from Indiana to Europe, the value of those dollars can change daily. A fixed exchange rate avoids this uncertainty.

The fixed exchange rate also commits the central bank to monetary policies that would not upset the exchange rate. For example, if the bank adhered to the exchange rate regime, the bank could not dramatically increase the money supply. This would cause inflation and reduce the value of the currency. More stability.

Disadvantages in CostsTo stabilize an exchange rate through intervention, a country must keep large quantities of foreign currency on hand, and that currency is usually a low-return investment. Even large reserves can be quickly exhausted when there are large capital flows out of a country. If a country chooses to stabilize an exchange rate by adjusting monetary policy rather than through intervention, it must divert monetary policy from other goals, notably stabilizing the economy and managing the inflation rate.

Finally, foreign exchange controls, like import quotas and tariffs, distort incentives for importing and exporting goods and services. They can also create substantial costs in terms of red tape and corruption.

In-Class Activities and Demonstrations

Practice, practice, practice.Late in the semester is a good time to tackle as many problems as possible in preparation for the AP Macro exam.

Suppose the United States and China were the only two countries in the world.a. Draw a correctly labeled graph of the foreign exchange market for U.S. dollars showing the equilibrium in the market. The currency in China is the yuan. b. On your graph, indicate a fixed exchange rate set below the equilibrium exchange rate. Does the fixed exchange rate lead to a surplus or shortage of U.S. dollars? Explain and show the amount of the surplus/shortage on your graph. c. To bring the foreign exchange market back to an equilibrium at the fixed exchange rate, would the U.S. government need to buy or sell dollars? On your graph, illustrate how the government buying or selling dollars would bring the equilibrium exchange rate back to the desired fixed rate. d. Suppose that instead of buying or selling dollars, the Federal Reserve was going to engage in monetary policy to bring the foreign exchange market back to an equilibrium at the fixed exchange rate. Should the Fed buy or sell Treasury securities in an open-market operation?

Explain.

Answer (11 points)(1 point) The vertical axis is labeled “Exchange rate (Chinese yuan per U.S. dollar)” and the horizontal axis is labeled “Quantity of U.S. dollars.”(1 point) Demand is downward sloping and labeled, supply is upward sloping and labeled.(1 point) The equilibrium exchange rate and the quantity of dollars are labeled on the axes at the point where the supply and demand curves intersect.(1 point) The fixed exchange rate level is depicted below the equilibrium exchange rate. (1 point) Shortage(1 point) The quantity demanded exceeds the quantity supplied at the higher fixed exchange rate.(1 point) The shortage is labeled as the horizontal distance between the supply and demand curves at the fixed exchange rate.(1 point) Sell(1 point) The new supply curve is shown to the right of the old supply curve, crossing the demand curve at the fixed exchange rate.(1 point) Buy Treasuries(1 point) Expansion of the money supply decreases interest rates in the U.S. This will reduce the demand for the dollar and increase the supply of the dollar. The price of the dollar will begin to fall.

MODULE 44: EXCHANGE RATES AND MACROECONOMICPOLICY

The purpose of this module is to make the connections between macroeconomic policy, particularly monetary policy, and the foreign exchange market. These connections have appeared on most of the recent AP Macro exams.

Student learning objectives:• The meaning and purpose of devaluation and revaluation of a currency under a fixed exchange

rate regime. • Why open-economy considerations affect macroeconomic policy under floating exchange rates.

Key Economic Concepts For This Module:• A nation can intentionally devalue the currency through expansionary monetary policy. A

decrease in interest rates causes a decrease in the demand, and an increase in the supply, of the currency, thus making the currency depreciate. This can have the effect of increasing net exports and increasing real GDP.

• A nation can intentionally revalue the currency through contractionary monetary policy. An increase in interest rates causes an increase in the demand, and a decrease in the supply, of the currency, thus making the currency appreciate. This can have the effect of decreasing net exports and decreasing inflation.

• A floating exchange rate can insulate a nation from recessions that begin overseas.

Common Student Difficulties:• Students have studied so many macroeconomic models that it now can become difficult to see the

connections. More and more the AP Macro exams have stressed connections between, for example, monetary policy and the value of a nation’s currency. This is a good opportunity for the instructor to review past models and stress the connections to foreign exchange.

In-Class Presentation of Module and Sample Lecture

Suggested time: This module can be covered in one hour-long class session.

I. Exchange Rates and Macroeconomic Policy A. Devaluation and Revaluation of Fixed Exchange Rates B. Monetary Policy under a Floating Exchange Rate Regime C. International Business Cycles

I. Exchange Rates and Macroeconomic Policy In 1999, while most of Europe adopted the euro, Britain did not. Why?There are economic arguments for and against adoption of a common currency.

British economists who favored adoption of the euro argued that if Britain used the same currency as its neighbors, the country’s international trade would expand and its economy would become more productive. But other economists pointed out that adopting the euro would take away Britain’s ability to have an independent monetary policy and might lead to macroeconomic problems.

In a global economy, there are conflicts between more open trade and stronger domestic concerns.

A. Devaluation and Revaluation of Fixed Exchange Rates In the hypothetical nation of El Tigardo, the previous module described a fixed exchange rate regime where the tigre was valued at $2.Suppose the central bank of El Tigardo decided to revise the fixed exchange rate such that 1 tigre = $1.50. This depreciation of the tigre would be called a devaluation.

Why would a nation want to devalue its own currency? Maybe El Tigardo has a recessionary gap.• It now takes fewer U.S. dollars to buy 1 tigre, so goods produced in El Tigardo would be less

expensive for American consumers. • This devaluation would also make American goods more expensive to consumers in El Tigardo,

thus reducing imports from America. • El Tigardo would experience an increase in net exports to America; aggregate demand would

shift to the right, boosting GDP.

What would happen if the nation revalued the tigre so that it took $3 to buy one tigre? Not surprisingly, just the opposite.

Why would a nation want to revalue its own currency? Maybe El Tigardo has an inflationary gap.• It now takes more U.S. dollars to buy 1 tigre, so goods produced in El Tigardo would be more

expensive for American consumers. • This revaluation would also make American goods less expensive to consumers in El Tigardo,

thus increasing imports from America. • El Tigardo would experience a decrease in net exports to America; aggregate demand would shift

to the left, reducing inflation.

B. Monetary Policy under a Floating Exchange Rate Regime Monetary policy is used to stabilize the economy, but it can also have an impact on the foreign exchange market.

Suppose the market for the tigre is competitive and the exchange rate with the dollar is floating.

What would happen if the central bank of El Tigardo increased the money supply?• Interest rates would fall with expansionary monetary policy, domestic investment would

increase, and aggregate demand would increase. • Foreign investors would seek alternative nations in which to invest in financial assets, so the

demand for the tigre would decrease. • Citizens of El Tigardo would also seek nations with higher returns on financial investments so

the supply of tigres would increase. • With both an increased supply and decreased demand, the value of the tigre will depreciate

against the dollar. • A depreciated currency will make products made in El Tigardo less expensive to American

consumers, thus there would be an increase in net exports and another increase in aggregate demand.

C. International Business Cycles A recession in Canada, the biggest trading partner with the U.S., will likely cause a decrease in real GDP in the U.S.

Why?

Canadians buy many goods made in America, so a recession in Canada means American firms will shift fewer products to Canadian customers. Exports will fall and aggregate demand will fall with it.

But this straightforward chain of events is also affected by the exchange rate regime in the U.S.

A recession hits the Canadian economy.• Canadians decrease demand for goods made in America. • This amounts to a decrease in the demand for the U.S. dollar, and the U.S. dollar depreciates. • A depreciating U.S. dollar means that goods made in America become more affordable to

Canadian consumers. • Thus the depreciating U.S. dollar puts the brakes on the diminished exports to Canada and the

negative impact on the U.S. economy is lessened.

So in theory a free-floating exchange rate allows a nation some insulation from recessions that begin in other nations.

In-Class Activities and Demonstrations

The instructor might find a worksheet such as the one below to be useful in stressing connections between monetary policy and foreign exchange rates. The first row is completed to give the instructor an idea of what the students should be able to complete.

The Central Interest Domestic AD Value Why? Net Real PriceBank Rates Investment of Exports GDP Level

DomesticCurrency

Increases fall rises rises depreciates Foreign rise rise riseMS investors

seek nationswith higherinterest rateson financialassets, thusdecreasingthe demandfor thecurrency.Domesticinvestorsseek nationswith higherinterest rateson financialassets, thusincreasingthe supply ofthe currency.

DecreasesMS

MODULE 45: PUTTING IT ALL TOGETHER

The purpose of this module is to show students how to tackle long free-response questions that combine elements of multiple macroeconomic models. The instructor can use this framework to greatly assist students in their preparation.

An additional FRQ is provided below. The instructor is encouraged to follow the “Structure for Macroeconomic Analysis” provided in the textbook.Assume that the United States economy is in a long-run equilibrium.(a) Draw a correctly labeled long run graph of aggregate demand and aggregate supply

and show each of the following for the United States. (i) The current equilibrium output level, labeled Ye, and the current equilibrium

price level, labeled PLe.

(b) Suppose that consumer confidence in the United States experiences a significant downturn. In the graph drawn in part (a), show the impact of weakened consumer confidence. In the graph, show any changes to the equilibrium price level and the equilibrium output level.

(c) Assume that the central bank of the United States is prepared to take action to reverse the economic impacts shown in part (b). (i) Should the central bank buy or sell bonds in an open market operation? (ii) How does the central bank’s action in part (c)(i) affect the nominal interest rate?

Explain.

(d) The United States and Mexico are major trading partners. How would the weak consumer confidence in the United States affect the balance of payments current account with Mexico? Explain.

(e) Consider the foreign exchange market for the United States dollar. Based only upon your response to part (d), how are each of the following affected? (i) The supply of the United States dollar relative to the Mexican peso. (ii) The value of the dollar relative to the peso.

The Starting Point(a) Every question such as this gives the student a starting point. The student must demonstrate that he/she can understand, and usually graph, the situation that is given. In this case, the economy is in long-run equilibrium. If necessary, the instructor should review the implications of long-run equilibrium in the AD/AS model. The student must be aware that, given this starting point, there is neither an inflationary or a recessionary gap. Equilibrium output is current at full-employment output.

1 point: A correctly labeled graph with the AD, SRAS, and LRAS curves all intersecting. 1 point: The equilibrium output level is shown at LRAS.1 point: The equilibrium price level is shown at the intersection of AD and SRAS.

PLe

The Pivotal Event(b) In this part of the problem, consumer confidence has significantly fallen. Students should know the factors that shift AD, SRAS , and LRAS and that weaker consumer confidence causes a decrease in AD. This is a great opportunity for the instructor to review all of these “shifters” in the AD/AS model.1 point: The graph shows a leftward shift of the AD curve.1 point: The graph indicates a decrease in both the price level and real GDP.

PLe

Secondary and Long-Run Effects

(c) The central bank, given the weakened demand shown in part (b), should be pursuing expansionary monetary policy. The instructor should take this time to review the tools of the Fed. In the case of this question, the student is asked to focus on open market operations. To expand the money supply, the central bank should buy bonds.(i) 1 point: Buy bonds

The student who understands monetary policy in the face of a recessionary gap also knows why buying bonds is the correct policy prescription.(ii) 1 point: The nominal interest rate decreases.1 point: Buying bonds shifts the money supply curve to the right. In the money market, this causes the interest rate to fall.

(d) This part of the problem tests the student’s understanding of the balance of payments accounts and how international business cycles begin to affect the international flow of goods and money. 1 point: The current account balance in the U.S. will begin to rise. 1 point: A recession in the U.S. (caused by the weak consumer confidence) will decrease imports from Mexico. As fewer U.S. dollars are flowing to Mexico, the balance of payments in the current account rises.

(e) Finally, the question requires the student to demonstrate understanding of foreign exchange markets. The question has led the students to the conclusion that American consumers are buying fewer Mexican-made products. As the demand for Mexican products is falling, the demand for the peso would be falling, thus the supply of the dollar should also be falling. 1 point: Supply of the dollar is decreasing. 1 point: The dollar is appreciating relative to the peso.

Toward the end of the semester, as the instructor begins to intensively review for the AP Macro exam by using released Macro FRQs, it is suggested that this approach be followed. It will help the students to review critical material presented in earlier modules, and it will help the students acquire a straightforward approach to taking the test itself.

Best of luck!