© 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 17.1Explain how the balance of payments is calculated. 17.2Explain how exchange rates are determined and how changes in exchange rates affect the prices of imports and exports. 17.3Explain the saving and investment equation. 17.4Explain the effect of a government budget deficit on investment in an open economy. 17.5Discuss 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…

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 32 The Balance of Payments: Linking the United 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.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 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.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 The Current Account FIGURE 17.1 Trade Flows for the United States and Japan, 2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 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 services423 Imports of services−343 Balance of services80 Income received on investments650 Income payments on investments−614 Net income on investments−36 Net transfers−90 Balance on current account−812 The Current Account

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 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 States1,860 Increase in U.S. holdings of assets in foreign countries−1,055 Balance on Financial Account805 BALANCE ON CAPITAL ACCOUNT -4-4 Statistical discrepancy11 Balance of payments0 The Current Account Table 17-1 The Balance of Payments of the United States, 2006 (billions of dollars) (continued)

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 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.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 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.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 32 The Balance of Payments: Linking the United States to the International Economy Learning Objective 17.1 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.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 32 Solved Problem 17-1 Understanding the Arithmetic of Open Economies Learning Objective 17.1 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.”

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 32 The Foreign Exchange Market and Exchange Rates Learning Objective 17.2 Nominal exchange rate The value of one country’s currency in terms of another country’s currency.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 32 Learning Objective 17.2 Exchange Rates in the Financial Pages Making the 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. DOLLAR U.S. DOLLAR PER UNIT OF FOREIGN CURRENCY Canadian dollar Japanese yen Mexican peso British pound Euro

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 32 The Foreign Exchange Market and Exchange Rates Learning Objective 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:

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 32 The Foreign Exchange Market and Exchange Rates Learning Objective 17.2 Equilibrium in the Market for Foreign Exchange FIGURE 17.2 Equilibrium in the Foreign Exchange Market

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 32 The Foreign Exchange Market and Exchange Rates Learning Objective 17.2 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 32 The Foreign Exchange Market and Exchange Rates Learning Objective 17.2 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:

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 32 The Foreign Exchange Market and Exchange Rates Learning Objective 17.2 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.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 32 Learning Objective 17.2 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 32 Learning Objective 17.2 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 32 Solved Problem 17-2 The Effect of Changing Exchange Rates on the Prices of Imports and Exports Learning Objective 17.2 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 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?

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 32 Learning Objective 17.2 The Real Exchange Rate Real exchange rate The price of domestic goods in terms of foreign goods. The Foreign Exchange Market and Exchange Rates

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 32 The International Sector and National Saving and Investment Learning Objective 17.3 FIGURE 17.4 U.S. Imports and Exports, 1970–2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 32 The International Sector and National Saving and Investment Learning Objective 17.3 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 32 The International Sector and National Saving and Investment Learning Objective 17.3 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 32 The International Sector and National Saving and Investment Learning Objective 17.3 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 32 Solved Problem 17-3 Arriving at the Saving and Investment Equation Learning Objective 17.3 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 32 The Effect of a Government Budget Deficit on Investment Learning Objective 17.4 FIGURE 17.5 The Twin Deficits, 1978–2006

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 32 Learning Objective 17.4 Why Is the United States Called the “World’s Largest Debtor”? Making the Connection Large current account deficits have resulted in foreign investors purchasing large amounts of U.S. assets.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 32 Monetary Policy and Fiscal Policy in an Open Economy Learning Objective 17.5 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

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 32 An Inside LOOK Can the U.S. Current Account Deficit Be Sustained? Sustaining the Unsustainable U.S. trade-weighted exchange index: Major currencies.

Chapter 17: Macroeconomics in an Open Economy © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 32 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