AP Macro Unit 6: Open Economy- International Trade and Finance

Balance of payment (BOP)

an accounting system to keep track of transactions between countries over a period of time

made up of current account and capital and financial account

Current account (CA)

-Net exports

-Money transfers

-Investment income

-Net unilateral transfers

-Not always balanced

Net exports= trade balance= exports -imports

Exports = credit; imports = debit

Exports > imports =surplus; Imports > exports= deficit (if a country has a trade deficit it does not necessarily have a deficit in the current account)

Ex:

-purchase or sale of goods between countries

-earning income from assets owned in another country

-sending or receiving income from another country

Capital and financial account (CFA)

-Balance of payments for assets between countries

-Financial capital transfers

-Real estate

-Not always balanced

-Financial capital inflow: Financial capital going into an economy is a surplus

-Financial capital outflow: financial capital going out of an economy is a deficit

Ex:

-Purchase/sale of CD's, bonds, other interest-bearing assets

-Foreign exchange market transactions

-Purchase/sale physical assets

-Foreign direct investment

Debit or credit

-Credit: money in (receiving $)

-Debit: money out (paying $)

-Sum of all credit entries should match the sum of all debit entries

-Increase in the CA balance must be offset by a decrease in the CFA balance (vice versa)

Balance of payments: CA + CFA=0

Exchange Rate

-The price of one currency in terms of another

-In the foreign exchange market, one currency is exchanged for another; the price of the currency is the exchange rate

-In order for any transaction to occur between different countries, currencies must be exchanged

Currency appreciation/depreciation

-Currency appreciation: when a currency becomes more valuable in terms of other countries

-Currency depreciation: when a currency becomes less valuable in terms of other currencies.

-If one currency appreciates, then the other has to depreciate

Foreign exchange market

-The interaction of buyers and sellers exchanging the currency of one country for the currency of another.

-This determines the equilibrium exchange rate in a flexible exchange market and influences the flow of goods, services, and financial capital between countries

Determinants of currency demand

-Demand for a country's exports: if the demand for a country's exports increase, the demand for the currency also increases (will cause the currency to appreciate) (vice versa)

-Interest rates: if the US interest rate increases relative to another country, the demand for US dollars will increase (will cause the currency to appreciate) (vice versa)

-Expected future exchange: higher future exchange rates increase demand and lower expected future exchange rates decrease demand

Determinants of currency supply

-Demand for imports within the country: more imports leads importers to sell dollars to purchase the foreign currency needed to pay for the imports; a higher supply of US dollars in the foreign exchange market will cause the currency to depreciate

- Interest rates: if the US interest rate decreases relative to another country's interest rate, the supply of dollars increases (causes currency to depreciate) (will also cause a decrease in the supply of the other country's currency and an appreciation in that country's currency)

-Expected future exchange rates: higher expected future exchange rates decrease supply and lower expected future exchanges rates increase supply

Foreign exchange market graph

-Y axis: ratio of currency

-X axis: quantity of currency

-If demand increases it goes right and if it decreases it goes left (same with supply)

-There is equilibrium when the supply and the demand are equal.

-Surplus: when the quantity supplied is greater than demand; above where the lines intersect

-Shortage: when the demand is greater than the supply; below where the lines intersect

What causes the demand curve to change for the foreign exchange market graph

1. Foreign demand for the country's goods and services

2. Foreign demand for the country's assets

3. Fiscal Policy

4. Monetary Policy

What causes the supply curve to change for the foreign exchange market graph

1. Domestic demand for other country's goods and services

2. Domestic demand for other country's assets

3. Protectionist policies (tariffs, quotas) imposed on other country's goods and services

Exchange rates

-Exchange rates are relative values so one currency will appreciate and the other will depreciate

-If US citizens need Yen to buy a popular product, the demand for Yen will increase (causing an appreciation) and there will be an increase in the supply of dollars (causing a depreciation)

-If interest rates go up in Europe, the demand for assets in Europe will increase, which will cause the demand for Euros to increase (causing appreciation) and the supply of Rands to increase (causing depreciation)

Shifting AD

Shifters: C, I, G, NX)

- Y axis: PL; X axis: GDPr; LRAS; SRAS; AD

-Changes in the relative price of goods cause changes in net exports

-Fluctuating currency values cause changes in the relative price of goods

-If the US$ appreciates, US goods are more expensive so exports fall and imports rise.

-If exports decrease, aggregate demand goes left

Effects of appreciated and depreciated currency

-Appreciated currency: more expensive exports and a decrease in AD

-Depreciated currency: less expensive exports and an increase in AD