1. 1 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy CHAPTER 17 The value of the dollar had increased relative to most other currencies. So, converting pounds, euros, and yen into dollars yielded fewer dollars for McDonald’s. Macroeconomics in an Open Economy

2. 2 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy CHAPTER 17 17.1 The Balance of Payments: Linking the United States to the International Economy Explain how the balance of payments is calculated. 17.2 The Foreign Exchange Market and Exchange Rates Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.3 The International Sector and National Saving and Investment Explain the saving and investment equation. 17.4 The Effect of a Government Budget Deficit on Investment Explain the effect of a government budget deficit on investment in an open economy. 17.5 Monetary Policy and Fiscal Policy in an Open Economy Discuss the difference between the effectiveness of monetary and fiscal policy in an open economy and in a closed economy. Chapter Outline and Learning Objectives Macroeconomics in an Open Economy

3. 3 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International 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. Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

4. 4 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International Economy 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 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. Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

5. 5 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International Economy Table 17-1 The Balance of Payments of the United States, 2008 (billions of dollars) The Current Account Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

6. 6 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International Economy Net Exports Equals the Sum of the Balance of Trade and the Balance of Services The Current Account Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE 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 the current account balance also includes net income on investments and net transfers. But these other two items are relatively small.

7. 7 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Current Account Figure 17-1 Trade Flows for the United States and Japan, 2008 Panel (a) shows that in 2008, the United States ran a trade deficit with all its major trading partners and with every region of the world. Panel (b) shows that Japan ran trade deficits with China, the Middle East, and Africa, and it ran trade surpluses with other regions. In each panel, the green arrows represent exports from the United States or Japan, and the red arrows represent imports. The Balance of Payments: Linking the domestic nation to the International Economy Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

8. 8 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International Economy 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. Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

9. 9 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International Economy 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. Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

10. 10 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Balance of Payments: Linking the domestic nation to the International Economy 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. YOUR TURN: Test your understanding by doing related problem 1.6 at the end of this chapter. Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

11. 11 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy Solved Problem 17-1 Understanding 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.” YOUR TURN: For more practice, do related problems 1.7, 1.8 and 1.9 at the end of this chapter. Explain how the balance of payments is calculated. 17.1 LEARNING OBJECTIVE

12. 12 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates Nominal exchange rate The value of one country’s currency in terms of another country’s currency. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

13. 13 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy Exchange Rates Listings EXCHANGE RATE BETWEEN THE DOLLAR AND THE INDICATED CURRENCY CURRENCY UNITS OF FOREIGN CURRENCY PER U.S. DOLLAR U.S. DOLLAR PER UNIT OF FOREIGN CURRENCY Canadian dollar1.1160.896 Japanese yen94.3600.011 Mexican peso13.3580.075 British pound0.6121.634 Euro0.7091.410 Making the Connection Many online sites that report economic news and the financial pages of most newspapers provide information on exchange rates. YOUR TURN: Test your understanding by doing related problem 2.5 at the end of this chapter. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

14. 14 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates 1.Foreign firms and households that want to buy goods and services produced in the domestic market. 2.Foreign firms and households that want to invest in the domestic market either through foreign direct investment—buying or building factories or other facilities locally — or through foreign portfolio investment—buying stocks and bonds issued in the domestic market. 3.Currency traders who believe that the value of the domestic currency in the future will be greater than its value today. There are three sources of foreign currency demand for the domestic currency: Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

15. 15 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates Equilibrium in the Market for Foreign Exchange Figure 17-2 Equilibrium in the Foreign Exchange Market When the exchange rate is ¥150 to the dollar, it is above its equilibrium level, and there will be a surplus of dollars. When the exchange rate is ¥100 to the dollar, it is below its equilibrium level, and there will be a shortage of dollars. At an exchange rate of ¥120 to the dollar, the foreign exchange market is in equilibrium. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

16. 16 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates 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 Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

17. 17 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates How Do Shifts in Demand and Supply Affect the Exchange Rate? 1.Changes in the demand for local-produced goods and services and changes in the demand for foreign- produced goods and services 2.Changes in the desire to invest locally 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 domestic currency and the likely future value of foreign currencies Three main factors cause the demand and supply curves in the foreign exchange market to shift: Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

18. 18 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates How Do Shifts in Demand and Supply Affect the Exchange Rate? 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. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

19. 19 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Foreign Exchange Market and Exchange Rates How Do Shifts in Demand and Supply Affect the Exchange Rate? Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE The factors that affect the demand and supply for currencies are constantly changing. Whether the exchange rate increases or decreases depends on the direction and size of the shifts in the demand curve and supply curve. Adjustment to a New Equilibrium

20. 20 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy How Do Shifts in Demand and Supply Affect the Exchange Rate? Adjustment to a New Equilibrium Figure 17-3 Shifts in the Demand and Supply Curve Resulting in a Higher Exchange Rate The Foreign Exchange Market and Exchange Rates Holding other factors constant, an increase in the supply of dollars will decrease the equilibrium exchange rate. An increase in the demand for dollars will increase the equilibrium exchange rate. In the case shown in this figure, the demand curve and the supply curve have both shifted to the right. Because the demand curve has shifted to the right by more than the supply curve, the equilibrium exchange rate has increased from ¥120 to $1 at point A to ¥130 to $1 at point B. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

21. 21 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy What Explains the Fall and Rise and Fall of the Dollar? Making the Connection YOUR TURN: Test your understanding by doing related problems 2.12 and 2.13 at the end of this chapter. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE Low U.S. interest rates have played a role in the declining value of the dollar. Second, many investors and some central banks became convinced that the value of the dollar was too high in 2002 and that it was likely to decline in the future.

22. 22 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy 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 The Foreign Exchange Market and Exchange Rates Don’t Let This Happen to YOU! Don’t Confuse What Happens When a Currency Appreciates with What Happens When It Depreciates YOUR TURN: Test your understanding by doing related problem 2.4 at the end of this chapter. Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

23. 23 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The Real Exchange Rate Real exchange rate The price of domestic goods in terms of foreign goods. The Foreign Exchange Market and Exchange Rates Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.2 LEARNING OBJECTIVE

24. 24 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The International Sector and National Saving and Investment 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 Explain the saving and investment equation. 17.3 LEARNING OBJECTIVE

25. 25 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The International Sector and National Saving and Investment Domestic Saving, Domestic Investment, and Net Foreign Investment National saving = Private saving + Public saving S = S private + S public Private saving = National income – Consumption - Taxes S private = Y – C – T Government saving = Taxes – Government spending S public = T – G Explain the saving and investment equation. 17.3 LEARNING OBJECTIVE

26. 26 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy The International Sector and National Saving and 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 Explain the saving and investment equation. 17.3 LEARNING OBJECTIVE Domestic Saving, Domestic Investment, and Net Foreign Investment

27. 27 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy Solved Problem 17-3 Arriving at the Saving and Investment Equation S = S private + S public = (Y − C − T) + (T − G) = Y − C − G S = (C + I + G + NX) − C − G S = I + NX S = I + NFI YOUR TURN: For more practice, do related problem 3.8 at the end of this chapter. Explain the saving and investment equation. 17.3 LEARNING OBJECTIVE

28. 28 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy Monetary Policy and Fiscal 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 consumption and investment spending (C & I) In an open economy, lower interest rates also affect the exchange rate between domestic currency and foreign currencies. Lower interest rates cause some local investors to prefer investing in other foreign financial assets. This will lower the demand for the local currency and lower its value. This, in turn, will reduce the price of local goods and attract more exports from abroad. (NX increases) Monetary Policy in an Open Economy Discuss the difference between the effectiveness of monetary and fiscal policy in an open economy and in a closed economy. 17.5 LEARNING OBJECTIVE

29. 29 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy Fiscal Policy in an Open Economy Fiscal policy: Changes in government increases or taxes. Expansionary Fiscal policy: When government increases its purchases, real GDP increases, which may increase money demand. Interest rates will therefore rise, increasing the exchange rate. Net exports will thus decline. Net exports will ‘crowd out’ more in an open economy. Contractionary Fiscal Policy: Government reduces purchases. Real GDP declines, interest rate drops, reducing the exchange rate, and increasing net exports. So, the impact of a fiscal policy is smaller in an open economy than in a closed economy. Monetary Policy and Fiscal Policy in an Open Economy

30. 30 of 36 Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Macroeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. Chapter 17: Macroeconomics in an Open Economy Tutorial questions Question 1.2, 2.1, 2.2, 2.3, 2.8, 5.1, 5.2