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

Balance of Payments Accounts

• Measure all international transactions in a year

• Include 2 accounts: the Current Account, and the Capital Account

Current Account balance + Capital Account balance =

0

Current Account

• Includes:

  • Net exports

  • Net investments

    • Any interest or dividend paid to or from domestic investors

  • Net transfers

    • Any aid or grants paid to and from the domestic economy

• If the US sent more USD abroad than receiving foreign currency, the balance of the account would be negative

• If the US received more foreign currency than sent USD abroad, the balance of the account would be positive

Trade surplus

* Country has more exports than imports - got more money than lost

Trade deficit

* Country has more imports than exports - lost more money than gained

Capital Account

• Includes:

  • Financial investments

    • Purchase of foreign and domestic financial assets

  • Real investments

    • Purchase of foreign and domestic land and business

• If there was more investment in the US than American investments abroad, then the balance of the account would be positive

• If there was more American investments abroad than investment in the US, then the balance of the account would be negative

Surplus balance

* The balance of the account is positive

Official Reserve Account

* The foreign currency the Federal Reserve holds and how it is balanced by the amount of USD sent out

Balance of Payments Deficit

• When the current and capital accounts added together are negative because the US sent more dollars out than received foreign currency

• When this happens, the Federal Reserve will use some of the foreign currency it holds to balance the account and make it 0

Balance of Payments Surplus

• When the current and capital accounts added together are positive because the US received more foreign currency than sent out dollars

• When this happens, the Federal Reserve will take the surplus currency and save it as official reserves (foreign currency) until it is needed

Circular Flow of Dollars

• Like the circular flow the economy in AP Micro!

• The imports/goods the US receives from abroad should be equal to the amount of USD sent out

• Essentially, any money sent out would eventually find its way back to its original nation

Exchange Rates

* The price at which one international currency can be exchanged for another

Appreciation

• Occurs when the value of a country’s currency increases relative to a foreign currency

• The country’s currency is stronger in relation to other currencies

Consequences of Appreciation

• Overall decrease in net exports

  • Increases the cost of exports, which can decrease demand for these exports

  • Decreases the cost of imports, which can increase the demand for these imports

• Decrease in net exports decreases AD, decreasing output and increasing unemployment

Depreciation

• Occurs when the value of a country’s currency falls relative to a foreign currency

• The country’s currency is weaker in relation to other currencies

Consequences of Depreciation

• Overall increase in net exports

  • Decreases the cost of exports, which can increase the demand for these exports

  • Increases the cost of imports, which can decrease the demand for these imports

• Increase in net exports increases AD, increasing output and decreasing unemployment

Gold Standard

• Before the Great Depression, many economies were on the gold standard, meaning exchange rates were always fixed

• No longer is used in the US

Factors that Change Exchange Rates

• Consumer tastes

  • If Americans have a demand for a foreign good, that will cause the demand for that foreign currency to increase to the right, leading the value of USD to depreciate

  • If foreigners have a demand for a US good, that will cause the demand for the USD to increase to the right, leading the value of USD to appreciate

• Relative income

  • If one nation’s GDP is increasing and their population’s income is increasing, they will demand more goods and products, including international ones

  • Say a country was in a recession. Another country in an economic boom would buy products from that country because they have more money to spend, increasing the demand for that country’s currency and appreciating its value

• Relative inflation

  • If a country is experiencing high inflation, they will demand goods from other countries where it is cheaper, increasing demand for other country’s currency

• Speculation

  • Investors will try to make profit by buying currency at low rates and selling them at high rates

Foreign Exchange Demand

• The quantity of an international currency that all domestic and foreign currencies are willing and able to purchase at various rates of exchange

• About how much one currency is needed for one of this currency

Foreign Exchange Supply

• The quantity of an international currency that all domestic and foreign sellers are willing and able to sell at various rates of exchange

• About how much currency is gained when selling one of this currency

FOREX Market

* The market where foreign currency is bought and sold

FOREX Market Equilibrium

* When the quantity supplied of the currency equals the quantity demanded of the currency at a specific exchange rate

FOREX and Monetary Policy

• When the money supply increases, interest rates on US assets decrease, making the US a place that is not as ideal to gain profit on investments. Demand for the dollar will fall and the dollar will depreciate.

  • LONG RUN: A depreciating dollar makes American goods cheaper to foreign consumers, increasing net exports, shifting AD to the right, and the dollar will appreciate again

  • Expansionary Monetary Policy → Depreciation

• When the money supply decreases, interest rates on US assets increase, making the US an ideal place to gain profit on investments. Demand for the dollar will increase and the dollar will appreciate.

  • LONG RUN: An appreciating dollar makes American goods more expensive to foreign consumers, decreasing net exports, shifting AD to the left, and the dollar will depreciate again

  • Contractionary Monetary Policy → Appreciation

Determinants of Supply and Demand in the FOREX Market

• Foreign Tastes

  • Less consumers/tourists are attracted to visiting a country, decreasing the demand for its currency, depreciating

  • More consumers/tourists are attracted to visiting a country, increasing the demand for its currency, appreciating

• Trade Prices

  • Price of exports increase, causing the demand for US goods (and its currency) to decrease, depreciating

  • Price of exports decrease, causing the demand for US goods (and its currency) to increase, appreciating

• Income Levels

  • A foreign country’s general income decreases, decreasing demand for international goods (and their currencies), depreciating

  • A foreign country’s general income increases, increasing demand for international goods (and their currencies), appreciating

• Real Interest Rates

  • A foreign country’s interest rates are lower than interest rates in the US, the demand for that country’s currency will decrease, depreciating

  • A foreign country’s interest rates are higher than interest rates in the US, the demand for that country’s currency will increase, appreciating

Fiscal Policy and Exchange Rates

• Expansionary Fiscal Policy

  • AD increases, increasing RGDP and PL, making US goods more expensive and other countries will not buy as much, leading a decrease in demand for the USD, depreciating

  • Expansionary Fiscal Policy → Depreciation

• Contractionary Fiscal Policy

  • AD decreases, decreasing RGDP and PL, making US goods less expensive and other countries will buy more, leading an increase in demand for the USD, appreciating

  • Contractionary Fiscal Policy → Appreciation

Monetary Policy and Exchange Rates

• Expansionary Monetary Policy

  • Increase in money supply lowers the interest rate, increasing investment spending which increases AD, raising the PL, making exports more expensive, decreasing demand for the USD, depreciating

  • Expansionary Monetary Policy → Depreciation

• Contractionary Monetary Policy

  • Decrease in money supply raises the interest rate, decreasing investment spending which decreases AD, lowering the PL, making exports less expensive, increasing demand for the USD, appreciating

  • Contractionary Monetary Policy → Appreciation

Trade Barriers

* Trade barriers protect domestic jobs in a high-wage paying country

Revenue Tariffs

• Taxes imposed on goods that were not produced domestically

• No domestic jobs to protect, but instead to raise government revenue

Protective Tariffs

• Taxes imposed on goods that are produced domestically

• Protect domestic jobs that produce the goods being imported from another country

Economic Effects of Tariffs

• Consumers pay higher prices while consuming less products

• Consumer surplus is lost

• Domestic producers increase productivity and output

• Imports decline

• The government makes revenue off of tariffs

• Inefficiency - we are not working a market equilibrium

Import Quota

• Sets a maximum amount of goods that can be imported

• The government does NOT make revenue from this, but this has a similar effect to tariffs

Interest Rates and the Loanable Funds Market

• When interest rates are high in the US, assets are more attractive to foreign investors, so more funds are injected into the economy due to foreign investors purchasing domestic assets

  • Higher interest rates → more loanable funds

• When interest rates are low in the US, assets are less attractive to foreign investors, so less funds are injected into the economy due to foreign investors not purchasing domestic assets

  • Also, domestic investors will seek to invest elsewhere, leading to a decrease in funds available in the US

  • Lower interest rates → less loanable funds

Capital Flow

* The movement of money for the purpose of investment, trade, or business production

Inbound Capital Flow

* The injection of funds into a domestic economy that occurs through the purchase of domestic assets by foreign investors

Outbound Capital Flow

* The extraction of funds from a domestic economy that occurs through the purchase of foreign assets by domestic investors

Interest Rates and Net Exports

• Higher interest rates in one country will make it more attractive to foreign investors to invest there, leading to appreciation of its currency, making exports more expensive and less foreign consumers will buy domestic products, decreasing net exports

  • Higher interest rates → decrease in net exports

• Lower interest rates in one country will make it less attractive to foreign investors to invest there, leading to depreciation of its currency, making exports less expensive and more foreign consumers will buy domestic products, increasing net exports

  • Lower interest rates → increase in net exports

Central Banks and Changing Domestic Interest Rates

• Adjusting the interest rates they charge on loans

  • Raising interest rates on loans → higher interest rates domestically

  • Lowering interest rates on loans → lower interest rates domestically

• Adjusting the interest rates they charge on deposits

  • Raising interest rates on deposits → higher interest rates domestically

    • Less will spend, more will save

  • Lowering interest rates on deposits → lower interest rates domestically