Ch 20: Exchange Rates and the Macroeconomy

Change in exports and imports

Leads to

Multiplier effects on GDP

International capital flows

are purchases and sales of financial assets across national borders.

A country's trade deficit is the

excess of its imports over its exports. If, instead, exports exceed imports, the country has a trade surplus.

Booms or Recessions

....in one country affect other countries through international trade.

Decrease in Relative Price of a Country's Exports

Leads to

Increase of that country's net exports

Increase its real GDP

Increase in Relative Price of a Country's Exports

Leads to

Decrease that country's net exports

Decrease its real GDP

A currency depreciation

Leads to

Decrease in relative prices of the country's goods in international trade

Increase its net exports and AD

A currency appreciation has the opposite effects.

Open Economy

One that trades with other nations in goods and services, and perhaps also in financial assets

Closed Economy

One that does not trade with other nations in either goods or assets

A Currency Depreciation

Leads to

Increase in price of foreign goods

AS shifts inward

A currency appreciation has the opposite effects.

Increase in AD

Decrease in AS

Net result is inflation

Probably also expansionary

Impact on AD dominates impact on AS

A current appreciation has the opposite effects.

Interest Rates and International Capital Flows

Increase in Interest Rates ->

1. Attracts foreign capital flows

2. Appreciates the currency

3. Decrease in net exports

4. Decrease in GDP

Decrease in Interest Rates has the opposite effects

Expansionary Fiscal Policy

Leads to

Increase in Interest Rates

Attracts foreign capital

Appreciates the currency

Decrease in Net Exports

Fiscal Policy Revisited

Part of the expansionary effect of fiscal policy is "crowded out."

Thus, international capital flows reduce the power of fiscal policy.

The evidence indicates that the crowding out effect of fiscal policy is greater on net exports than on investment.

Expansionary Monetary Policy

Leads to:

Decrease in interest rates

Outflow of capital

Currency depreciation

Increase in net exports

Thus, international capital flows -> Increase in power of monetary policy

International Aspects of Deficit Reduction

According to theory, success in reducing the federal deficit through a policy mix of fiscal contraction and monetary expansion should:

Decrease in real interest rates

Decrease in exchange rate of the dollar

Increase in net exports

Have an uncertain effect on real GDP and inflation

Inflation fell despite such rapid growth.

The dollar generally declined from 1993 to 1995 as the theory predicted.

But then it turned around and rose sharply from 1995 to 1998 just when the budget deficit was turning into a surplus.

America's real net exports sagged from -$30 billion in 1992 to -$238 billion in 1998.

The effect on the value of the dollar and net exports did not match the theoretical predictions.

What Actually Happened?

Interest rates did fall, just as predicted.

The U.S. economy expanded rapidly between 1992 and 1998.

The monetary stimulus overwhelmed the fiscal contraction.

The Loose Link Between the Budget Deficit and the Trade Deficit

(X - IM) = (S - I) - (G - T)

Apply this accounting relationship to actual U.S. events in the 1990s:

Decrease (G - T)

Decrease in S and Increase in I -> Decrease (S - I)

Taken by itself: Decrease in budget deficit -> Decrease in trade deficit

But effect offset by change in private economic behavior

Decrease in S

Increase in I

Trade Deficit

Depends on private sector behavior as well as public sector behavior.

Pessimists

Trade Deficit increases long term indebtedness to foreigners

Optimists

Trade deficit indicates the attractiveness of the U.S. economy to foreign investors.

Is the Trade Deficit a Problem?

Each view holds elements of truth.

But there is a critical question: How long can a trade deficit continue?

At some point, foreign investors may conclude that they have acquired about all the American assets they want.

If and when that happens, the U.S. trade deficit must be eliminated.

The only question is how?

Four Basic Ways to Cure the Trade Deficit:

1. Tighter fiscal and looser monetary policy

2. Increase in economic growth abroad

3. Increase in savings (good) and/or Decrease in investment (bad)

4. Protectionism

Protectionism

1. Would be bad for the U.S. and world economics

2. Might very well fail to cure the problem

Conclusion: No Nation is an Island

The fates of nations are intertwined.

The major trading countries are linked by exports and imports, capital flows, and exchange rates.

Mutual success may well require mutual coordination.