chap17pp

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e.

Fernando & Yvonn Quijano

Prepared by:

Chapter

17

Macroeconomics in an Open Economy

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 31

NewPage Paper versus China

17.1 Explain how the balance of payments is calculated.

17.2 Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports.

17.3 Explain the saving and investment

equation.

17.4 Explain the effect of a government budget deficit on investment in an open economy.

17.5 Discuss the difference between the effectiveness of monetary and fiscal policy in an open economy and in a closed economy.

Learning Objectives

Under existing international trade agreements, governments are not allowed to subsidize firms that export to other countries…

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The Balance of Payments: Linking theUnited States to the International Economy

Learning Objective 17.1

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.

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Current account The part of the balance of payments that records a country’s net exports, net investment income, and net transfers.

The Current Account

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.

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The Current AccountFIGURE 17.1

Trade Flows for the United States and Japan, 2006

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Net Exports Equals the Sum of the Balance of Trade and the Balance of Services

Table 17-1

The Balance of Payments of the United States, 2006 (billions of dollars)

CURRENT ACCOUNT

Exports of goods $1,023

Imports of goods −1,861

Balance of trade −838

Exports of services 423

Imports of services −343

Balance of services 80

Income received on investments 650

Income payments on investments −614

Net income on investments −36

Net transfers −90

Balance on current account −812

The Current Account

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Net Exports Equals the Sum of the Balance of Trade and the Balance of Services

FINANCIAL ACCOUNT

Increase in foreign holdings of assets in the United States 1,860

Increase in U.S. holdings of assets in foreign countries −1,055

Balance on Financial Account 805

BALANCE ON CAPITAL ACCOUNT -4

Statistical discrepancy 11

Balance of payments 0

The Current Account

Table 17-1

The Balance of Payments of the United States, 2006 (billions of dollars) (continued)

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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.

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.

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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.

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Why Is the Balance of Payments Always Zero?

Don’t Let This Happen to YOU!Don’t Confuse the Balance of Trade, the Current Account Balance, and the Balance of Payments

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, the balance of payments includes an entry called the statistical discrepancy.

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Solved Problem 17-1Understanding the Arithmetic of Open Economies


Test your understanding of the relationship between the current account and the financial account by evaluating the following assertion by a political commentator:

“The industrial countries are committing economic suicide. Every year, they invest more and more in developing countries. Every year, more U.S., Japanese, and European manufacturing firms move their factories to developing countries. With extensive new factories and low wages, developing countries now export far more to the industrial countries than they import.”

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The Foreign Exchange Market and Exchange Rates


Nominal exchange rate The value of one country’s currency in terms of another country’s currency.

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Exchange Rates in the Financial Pages

Makingthe

Connection

The financial pages of most newspapers provide information on exchange rates.

EXCHANGE RATE BETWEEN THE DOLLAR AND THE INDICATED CURRENCY

CURRENCY

UNITS OF FOREIGN CURRENCY

PER U.S. DOLLARU.S. DOLLAR PER UNIT OF FOREIGN CURRENCY

Canadian dollar 1.067 0.937

Japanese yen 122.650 0.008

Mexican peso 10.919 0.092

British pound 0.507 1.972

Euro 0.752 1.330

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1 Foreign firms and households who want to buy goods and services produced in the United States.

2 Foreign firms and households who 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.

3 Currency traders who believe that the value of the dollar in the future will be greater than its value today.

There are three sources of foreign currency demand for the U.S. dollar:

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Equilibrium in the Market for Foreign Exchange

FIGURE 17.2

Equilibrium in the Foreign Exchange Market

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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.

Equilibrium in the Market for Foreign Exchange

Don’t Let This Happen to YOU!Remember That Modern Currencies Are Fiat Money

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How Do Shifts in Demand and Supply Affect the Exchange Rate?

1 Changes in the demand for U.S.-produced goods and services and changes in the demand for foreign-produced goods and services

2 Changes in the desire to invest in the United States and changes in the desire to invest in foreign countries

3 Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies

Three main factors cause the demand and supply curves in the foreign exchange market to shift:

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Speculators Currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates.

Shifts in the Demand for Foreign Exchange

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.

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Adjustment to a New Equilibrium

FIGURE 17.3

Shifts in the Demand and Supply Curve Resulting in a Higher Exchange Rate


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Some Exchange Rates Are Not Determined by the Market

Some currencies have fixed exchange rates that do not change over long periods.

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.

How Movements in the Exchange Rate Affect Exports and Imports


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Solved Problem 17-2The Effect of Changing Exchange Rates on the Prices of Imports and Exports


In March 2001, the average price of goods imported into the United States from Canada fell 3.3 percent. This decline was the largest since the federal government began gathering such statistics in 1992. Is it likely that the value of the U.S. dollar appreciated or depreciated versus the Canadian dollar during this period? Is it likely that the average price in Canadian dollars of goods exported from the United States to Canada during March 2001 rose or fell?

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The Real Exchange Rate

Real exchange rate The price of domestic goods in terms of foreign goods.

Domestic price levelReal exchange rate = Nominal exchange rate ×

Foreign price level


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The International Sector and NationalSaving and Investment


FIGURE 17.4

U.S. Imports and Exports, 1970–2006

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Net Exports Equal Net Foreign Investment

Current Account Balance + Financial Account Balance = 0

or:

Current Account Balance = -Financial Account Balance

or:

Net Exports = Net Foreign Investment

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Domestic Saving, Domestic Investment, and Net Foreign Investment

National Saving = Private Saving + Public SavingS = Sprivate + Spublic

Private Saving = National Income – Consumption - Taxes

Sprivate = Y – C – T

Government Saving = Taxes – Government Spending

Spublic = T – G

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Domestic Saving, Domestic Investment, and Net Foreign Investment

Saving and investment equation An equation that shows that national saving is equal to domestic investment plus net foreign investment.

Remember the basic macroeconomic equation for GDP or national income:

Y = C + I + G + NX

National Saving = Domestic Investment + Net Foreign Investment

S = I + NFI

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Solved Problem 17-3Arriving at the Saving and Investment Equation


S = Sprivate + Spublic = (Y − C − T) + (T − G) = Y − C − G

S = (C + I + G + NX) − C − G

S = I + NX

S = I + NFI

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The Effect of a Government Budget Deficit on Investment


FIGURE 17.5

The Twin Deficits, 1978–2006

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Why Is the United States Called the “World’s Largest Debtor”?

Makingthe

Connection

Large current account deficits have resulted in foreign investors purchasing large amounts of U.S. assets.

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Monetary Policy and Fiscal Policyin 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.

Monetary Policy in an Open Economy

To engage in an expansionary fiscal policy, the federal government increases its purchases or cuts taxes. Increases in government purchases directly increase aggregate demand.

Fiscal Policy in an Open Economy

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An Inside LOOK Can the U.S. Current Account Deficit Be Sustained?

Sustaining the Unsustainable

U.S. trade-weighted exchange index: Major currencies.

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Balance of payments

Balance of trade

Capital account

Closed economy

Currency appreciation

Currency depreciation

Current account

Financial account

K e y T e r m s

Net foreign investment

Nominal exchange rate

Open economy

Real exchange rate

Saving and investment equation

Speculators

chap17pp

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