Chapter 12 International Linkages

12-2 Introduction National economies are becoming more closely interrelated Economic influences from abroad have effects on the U.S. economy Economic developments and policies in the U.S. affect economies abroad  When the U.S. moves into a recession, it tends to pull down other economies  When the U.S. is in an expansion, it tends to stimulate other economies In this chapter we present the key linkages among open economies and introduce some first pieces of analysis

12-3 Introduction Economies are linked through two broad channels 1. Trade in goods and services Some of a country’s production is exported to foreign countries  increase demand for domestically produced goods Some goods that are consumed or invested at home are produced abroad and imported  a leakage from the circular flow of income 2. Finance U.S. residents can hold U.S. assets OR assets in foreign countries As international investors shift their assets around the world, they link assets markets here and abroad  affect income, exchange rates, and the ability of monetary policy to affect interest rates

12-4 The Balance of Payments and Exchange Rates Balance of payments: the record of the transactions of the residents of a country with the rest of the world Two main accounts:  Current account: records trade in goods and services, as well as transfer payments  Capital account: records purchases and sales of assets, such as stocks, bonds, and land Current account + Capital account = Balance of Payments [Insert Table 12-1 here]

12-5 Exchange Rates Exchange rate is the price of one currency in terms of another Two different exchange rate systems: Fixed exchange rate system Floating exchange rate system

12-6 Fixed Exchange Rates The central bank stands ready to buy and sell its currency at a fixed price Central banks hold reserves to sell when have to intervene in the foreign exchange market Intervention: CB buys or sells foreign exchange If a country persistently runs deficits in the balance of payments: CB eventually will run out of reserves on of foreign exchange Before this occurs, CB will likely devalue the currency

12-7 Flexible Exchange Rates The central bank allows the exchange rate to adjust to equate the supply and demand for its currency