1 Sect. 8 - The Open Economy: International Trade & Finance Module 41 - Capital Flows & the Balance of Payments What you will learn: The meaning of the balance of payments accounts The determinants of international capital flows

2 Sect. 8 - The Open Economy: International Trade & Finance Module 41 - Capital Flows & the Balance of Payments Balance of Payment Accounts - A summary of a country’s transactions with other countries

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4 Sect. 8 - The Open Economy: International Trade & Finance Module 41 - Capital Flows & the Balance of Payments Balance of Payment Accounts - A summary of a country’s transactions with other countries Balance of Payments on Goods & Services - The difference between the value of exports and the value of imports Merchandise Trade Balance - The difference between the value of exports and the value of imports for goods only, not services

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6 Balance of Payments on the Financial Account - The difference between a country’s sales of assets to a foreign country and its purchases of assets from a foreign country *Current Account (Goods & Services, Factor Income, Transfers) + Financial Account = 0

7 The Sum of the RED arrows = the sum of the GREEN arrows

8 Balance of Payments on the Financial Account - The difference between a country’s sales of assets to a foreign country and its purchases of assets from a foreign country Modeling the Financial Account - Using the loanable funds model for an open economy (trade between nations) to illustrate the flow of capital funds - these funds become available for domestic investment spending

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10 Balance of Payments on the Financial Account - The difference between a country’s sales of assets to a foreign country and its purchases of assets from a foreign country Modeling the Financial Account - Using the loanable funds model for an open economy (trade between nations) to illustrate the flow of capital funds - these funds become available for domestic investment spending International Capital Flows - Will equalize interest rates between nations - Countries with rapidly growing economies have more investment opportunities and higher demand for capital

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13 Balance of Payments on the Financial Account - The difference between a country’s sales of assets to a foreign country and its purchases of assets from a foreign country Modeling the Financial Account - Using the loanable funds model for an open economy (trade between nations) to illustrate the flow of capital funds - these funds become available for domestic investment spending International Capital Flows - Will equalize interest rates between nations - Countries with rapidly growing economies have more investment opportunities and higher demand for capital

Two-way Capital Flows - Many investors and firms will diversify by buying stocks in other countries or expanding their business to other countries creating both capital inflows and outflows

15 Module 42 - The Foreign Exchange Market What you will learn The role of the foreign exchange market and the exchange rate The importance of real exchange rates and their role in the current account

16 Module 42 - The Foreign Exchange Market Foreign Exchange Rates - As countries trade, products must be paid for in that country’s own currency - creates a “foreign exchange” market where currencies can be exchanged for each other

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Module 42 - The Foreign Exchange Market Foreign Exchange Rates - As countries trade, products must be paid for in that country’s own currency - creates a “foreign exchange” market where currencies can be exchanged for each other Exchange Rates - The prices at which currencies trade - when a currency becomes more valuable relative to other currencies it appreciates - when it becomes less valuable it depreciates

Ex: (Exchange rate is 12.5 Pesos = 1 Dollar) How much does a shirt cost in US dollars if it costs pesos in Mexico / 12.5 = $15 US dollars

21 Module 42 - The Foreign Exchange Market Foreign Exchange Rates - As countries trade, products must be paid for in that country’s own currency - creates a “foreign exchange” market where currencies can be exchanged for each other Exchange Rates - The prices at which currencies trade - when a currency becomes more valuable relative to other currencies it appreciates - When it becomes less valuable it depreciates

22 The Equilibrium Exchange Rate - When quantity of a currency demanded (foreigners who want to buy U.S. goods) is equal to the quantity supplied (U.S. residents who want to buy foreign goods)

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The Equilibrium Exchange Rate - When quantity of a currency demanded (foreigners who want to buy U.S. goods) is equal to the quantity supplied (U.S. residents who want to buy foreign goods) Real Exchange Rates - To compensate for different levels of inflation - adjusted for differing aggregate price levels world wide Real Exchange Rate = Foreign currency per U.S. dollar X Ex: 10 X = 10 But if 10 X = 8 P in U.S. P in foreign nation

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28 The Equilibrium Exchange Rate - When quantity of a currency demanded (foreigners who want to buy U.S. goods) is equal to the quantity supplied (U.S. residents who want to buy foreign goods) Real Exchange Rates - To compensate for different levels of inflation - adjusted for differing aggregate price levels world wide Real Exchange Rate = Foreign currency per U.S. dollar X P in U.S. P in foreign nation

29 Purchasing Power Parity - Nominal exchange rates between two countries at which a given basket of goods would cost the same in each country

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31 Purchasing Power Parity - Nominal exchange rates between two countries at which a given basket of goods would cost the same in each country

32 Module 43 - Exchange Rate Policy What you will learn The difference between fixed exchange rates and floating exchange rates Considerations that lead countries to choose different exchange rate regimes

33 Module 43 - Exchange Rate Policy Exchange Rate Regime - The exchange rate policy that a government adopts Fixed Exchange Rate - The government keeps the exchange rate against another currency at a particular target - ease of trade Ex: Hong Kong keeps HK$ at fixed rate of $7.80 to $1 US - If the fixed exchange rate is not at equilibrium a govt. will take action to bring the rate towards equilibrium

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35 Module 43 - Exchange Rate Policy Exchange Rate Regime - The exchange rate policy that a government adopts Fixed Exchange Rate - The government keeps the exchange rate against another currency at a particular target - certainty of future currency value Ex: Hong Kong keeps HK$ at fixed rate of $7.80 to $1 US - If the fixed exchange rate is not at equilibrium a govt. will take action to bring the rate towards equilibrium

36 Floating Exchange Rate - The government lets the exchange rate go wherever the market takes it - current policy of Unites States, Canada, Great Britain - allows monetary policy to stabilize currency value but leaves uncertainty in trade

37 Module 44 - Exchange Rates & Macroeconomic Policy What you will learn 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

38 Module 44 - Exchange Rates & Macroeconomic Policy Devaluation - (under a fixed exchange rate) Readjusting a fixed exchange rate toward equilibrium which reduces the value of a currency - increases exports / reduces imports which can eliminate a recessionary gap by increasing AG demand

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40 Module 44 - Exchange Rates & Macroeconomic Policy Devaluation - (under a fixed exchange rate) Readjusting a fixed exchange rate toward equilibrium which reduces the value of a currency - increases exports / reduces imports which can eliminate a recessionary gap by increasing AG demand Revaluation - (under a fixed exchange rate) Readjusting a fixed exchange rate toward equilibrium which increases the value of a currency - decreases exports / increases imports which can eliminate an inflationary gap by decreasing AG demand

41 Monetary Policy Under Floating Exchange Rate - Raising or lowering interest rates effects the foreign exchange market: - lowering interest rate lowers demand and increases supply of a nations currency - the currency depreciates - raising interest rate raises demand and decreases supply of a nations currency - the currency appreciates

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Monetary Policy Under Floating Exchange Rate - Raising or lowering interest rates effects the foreign exchange market: - lowering interest rate lowers demand and increases supply of a nations currency - the currency depreciates - raising interest rate raises demand and decreases supply of a nations currency - the currency appreciates International Business Cycles - Business cycles in one nation effect the business cycle in other nations - one nation’s exports are another’s imports - affect is more significant in countries with fixed rate regimes

44 Module 45 - Putting It All Together What you will learn How to use macroeconomic models to conduct policy analysis How to approach free-response macroeconomics questions

45 Module 45 - Putting It All Together Macroeconomic Analysis - We can now use our economic models to analyze and evaluate economic policies - most macroeconomic problems have the following components 1) A Starting Point - Using “Aggregate Demand / Aggregate Supply Model - three possible starting points 1. long-run equilibrium 2. a recessionary gap 3. an inflationary gap

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47 Module 45 - Putting It All Together Macroeconomic Analysis - We can now use our economic models to analyze and evaluate economic policies - most macroeconomic problems have the following components 1) A Starting Point - Using “Aggregate Demand / Aggregate Supply Model - three possible starting points 1. long-run equilibrium 2. a recessionary gap 3. an inflationary gap

48 2) The Pivotal Event - While the possibilities are many, the following table groups events into the main factors that influence macroeconomics

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50 2) The Pivotal Event - While the possibilities are many, the following table groups events into the main factors that influence macroeconomics 3) The Initial Effect of the Event - Fiscal and monetary policy will shift demand curve - affects aggregate price level and aggregate output

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52 2) The Pivotal Event - While the possibilities are many, the following table groups events into the main factors that influence macroeconomics 3) The Initial Effect of the Event - Fiscal and monetary policy will shift demand curve - affects aggregate price level and aggregate output 4) Secondary & Long-Run Effects of the Event - The economy will move to its long-run equilibrium after short-run effects run their course

53 2) The Pivotal Event - While the possibilities are many, the following table groups events into the main factors that influence macroeconomics 3) The Initial Effect of the Event - Fiscal and monetary policy will shift demand curve - affects aggregate price level and aggregate output 4) Secondary & Long-Run Effects of the Event - The economy will move to its long-run equilibrium after short-run effects run their course

54 The End