Open-Economy Macroeconomics: Basic Concepts 31

International Flows of Goods & Capital Closed economy - does not interact with other economies in the world Open economy - interacts freely with other economies around the world

Flow of goods: exports, imports,& net exports Exports – domestically produced goods and services that are sold abroad Imports - goods and services produced abroad sold domestically

Flow of goods: exports, imports,& net exports Net exports - value of a nation’s exports minus the value of its imports Trade balance (balance of trade) - value of a nation’s exports minus the value of its imports Current Account - the difference between a nation's total exports of goods, services and its total imports of them. Current account balance calculations exclude transactions in financial assets and liabilities.

Flow of goods: exports, imports,& net exports Trade surplus - excess of exports over imports Exports > Imports Trade deficit - excess of imports over exports Exports < Imports Balanced trade - exports equal imports Exports = Imports

International Flow of Goods and Capital Foreign direct investment – investment of capital in a foreign nation Domestic physical investment in a foreign economy such as factories, buildings, machinery, firms etc. Disney World in Europe Foreign portfolio investment – investment in an financial asset (bond) by a foreign nation Domestic financial investment in foreign assets, such as bonds, stocks or other financial instruments

Flow of financial resources: net capital outflow Financial Capital - can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services Capital Account - reflects net change in national ownership of assets

Flow of financial resources: net capital outflow Net capital outflow – refers to the difference between the purchase of foreign assets by domestic residents and the purchase of domestic assets by foreigners Can be positive or negative Positive – domestic residents are buying more foreign assets than foreigners are buying domestic assets Capital is flowing out of the nation Negative – domestic residents are buying less foreign assets than foreigners are buying domestic assets Capital is flowing into the nation

London Olympics

London Olympics

International Flows of Goods & Capital Factors - influence a country’s exports, imports, and net exports: Tastes of consumers for domestic & foreign goods Prices of goods at home and abroad Exchange rates People use domestic currency to buy foreign currencies Incomes of consumers at home and abroad Cost of transporting goods from country to country Government policies toward international trade

Foreign Exchange Market FOREX (Foreign Exchange Market) - is a form of exchange for the global decentralized trading of international currencies (video)

International Flows of Goods & Capital Variables that influence demand for foreign money Interest Rates Travel abroad Trade

Prices for International Transactions Exchange rate - rate at which a person can trade currency of one country for currency of another Fixed (Pegged), Floating Appreciation (strengthen) - increase in the value of a currency; amount of foreign currency it can buy Depreciation (weaken) - decrease in the value of a currency; amount of foreign currency it can buy

Measuring Trade Exchange Rate – the value of one foreign nation’s currency in relation to another nation’s currency Determining the Rate of Exchange 1 Dollar = 12 Mexican Pesos 1/12 = .083 Hotel room costs 500 Pesos per night .083 x 500 = $41.66 500/12 = $41.66 Insert a map of your country. 15

Foreign Exchange Market Graph Exchange Rate Supply of currency Demand for currency Equilibrium exchange rate Equilibrium quantity Quantity of Dollars Exchanged into Foreign Currency An increase in the demand for U.S. dollars appreciates the value of the currency to other currencies A decrease in demand for U.S. dollars depreciates the value of the currency to other currencies An increase supply of U.S. dollars depreciates the value of the U.S. currency A decrease in supply of U.S. dollars appreciates the value of the U.S. currency

Foreign Exchange Market Graph US citizens travel to the England for the 2012 Olympics $/GBP Market British Pounds Market for US Dollars GBP/$ S1 S2 S e1 e2 e1 e2 D2 D1 D1 Qe1 Qe2 Qe1 Qe2 Q of Pounds Q of Dollars An increase demand of the Pound caused an appreciation of the Pound Increased supply of US Dollars caused a depreciation of the US Dollar

Foreign Exchange Market Graph French citizens travel to the United States to shop Market for Dollars Market for Euros e/$ $/e S1 S2 S e2 e1 e1 e2 D2 D1 D1 Qe1 Qe2 Q of Dollars Qe1 Qe2 Q of Euros Increased supply of Euros caused a depreciation of the Euro to the dollar An increase demand of the U.S. dollar caused an appreciation of the U.S. dollar

Foreign Exchange Market Graph Japan suffers a recession after the tsunami Yen Market Yen/$ $/Yen S2 S S1 e2 e e e2 D1 D D2 Q of Dollars Qe2 Qe1 Qe2 Qe1 Q of Yen Decreased supply of Yen caused an appreciation of the Yen to the dollar An decrease demand of the U.S. dollar caused a depreciation of the U.S. dollar

(ii) One point is earned for stating that the decrease in the real interest rate caused interest-sensitive spending to increase. • One point is earned for stating that the increase in aggregate demand increases output, which causes an increase in employment.

MARKET FOR CANADIAN DOLLAR ii. One point is earned for stating that Canadian exports to Mexico will decrease because the appreciation of the Canadian dollar makes Canadian products more expensive for Mexican consumers.

2011 MACROECONOMICS FREE RESPONSE QUESTIONS (FORM B) • One point is earned for stating that aggregate demand in Singapore will increase and for explaining that the depreciating Singaporean dollar increases Singapore’s exports to European Union countries because the price of those exports — in terms of euros — decreases. • One point is earned for stating that employment in Singapore will increase because Singapore’s real GDP increases and it takes more labor to produce more goods and services. • One point is earned for stating that the Singaporean central bank should sell euros. • One point is earned for stating that the Singaporean central bank should sell government bonds. • One point is earned for explaining that the sale of government bonds raises the interest rate in Singapore and increases the demand for Singaporean dollars for financial investment purposes.

One point is earned for stating that Argentina’s aggregate demand will fall because the purchase results in increased imports decreased net exports, which are components of aggregate demand. One point is earned for stating that the United States current account will be in surplus or increases because exports are recorded as a credit in the current account.

d. One point is earned for stating that the peso will depreciate against the dollar. • One point is earned for explaining that the higher inflation rate in Argentina makes U.S. goods less expensive (or more attractive) than Argentinean goods. MARKET FOR US DOLLAR

Foreign Market Exchange Rate Application A United States firm sells $10 million worth of goods to a firm in Argentina, where the currency is the peso. (a) How will the transaction above affect Argentina’s aggregate demand? Explain. (b) Assume that the United States current account balance with Argentina is initially zero. How will the transaction above affect the United States current account balance? Explain. (c) Using a correctly labeled graph of the foreign exchange market for the United States dollar, show how a decrease in the United States financial investment in Argentina affects each of the following. (i) The supply of United States dollars (ii) The value of the United States dollar relative to the peso (d) Suppose that the inflation rate is 3 percent in the United States and 5 percent in Argentina. What will happen to the value of the peso relative to the United States dollar as a result of the difference in inflation rates? Explain.

Foreign Market Exchange Rate Application One point is earned for stating that Argentina’s aggregate demand will fall because the purchase results in increased imports decreased net exports, which are components of aggregate demand. One point is earned for stating that the United States current account will be in surplus or increases because exports are recorded as a credit in the current account.

Foreign Market Exchange Rate Application One point is earned for a correctly labeled graph of the dollar market. One point is earned for showing a leftward shift of the supply curve and indicating that the value of the dollar against the peso increases, using arrows, labels or dotted lines. One point is earned for stating that the peso will depreciate against the dollar. • One point is earned for explaining that the higher inflation rate in Argentina makes U.S. goods less expensive (or more attractive) than Argentinean goods.

Foreign Market Exchange Rate Application 2. Balance of payments accounts record all of a country’s international transactions during a year. (a) Two major subaccounts in the balance of payments accounts are the current account and the capital account. In which of these subaccounts will each of the following transactions be recorded? (i) A United States resident buys chocolate from Belgium. (ii) A United States manufacturer buys computer equipment from Japan. (b) How would an increase in the real income in the United States affect the United States current account balance? Explain. (c) Using a correctly labeled graph of the foreign exchange market for the United States dollar, show how an increase in United States firms’ direct investment in India will affect the value of the United States dollar relative to the Indian currency (the rupee).

Binder Check Due 4-27-12 Free Responses Exchange Rate Webquest Mankiw Practice Worksheet FOREX Practice Questions Application Worksheet Chapter 31-32 Notes Daily Tens Terms

Extra Credit Draw foreign currency markets for the US dollar and the European zone euro. Show on each model the impact of European exports of wheat to the US. Determine the impact on the international value of the US dollar and of the euro. The US and Mexico are trading partners. Imagine that the US is experiencing a recession. Draw a LRAS model to show the recession. Then show how this recession will most likely impact the foreign exchange market for the Mexican Peso. Refer to Question #2. Draw a Phillips curve to show the impact of the recession on unemployment in the United States.

Balance of Payments Simulation Current Account East Exports of goods Imports of goods Exports of Services Imports of Services Balance of Trade Current Account West Exports of goods Imports of goods Exports of Services Imports of Services Balance of Trade Capital Account East Capital Going Abroad Capital coming in Balance of CA Capital Account West Capital Going Abroad Capital coming in Balance of CA