Unit 6: Open Economy—International Trade and Finance

Unit 6: Open Economy— International Trade and Finance

6.1 Balance of Payment Accounts

  • Balance of Payments Statement: A summary of payments received by the U.S. from foreign countries versus payments sent to them.

Current Account

  • Definition: Reflects current import and export payments of both goods and services, as well as investment income.

  • Example: If a Canadian receives dividends from an American corporation, this results in dollars sent out of the U.S.

  • Deficit Balance: Indicates that more U.S. dollars are sent abroad than foreign currency received.

6.2 Capital (or Financial) Account

  • Definition: Captures investments in real or financial assets by foreigners in the U.S. and vice versa.

  • Example: A Swedish firm purchasing a facility in Idaho counts as inflow.

  • Surplus Balance: More foreign capital investment in the U.S. than U.S. investment abroad.

Official Reserves Account

  • Definition: Adjusts deficits or surpluses in the current and capital accounts with foreign currencies to keep the balance of payments at zero.

  • Balance of Payments Deficit: More dollars sent out than foreign currency received.

  • Balance of Payments Surplus: More foreign currency received than dollars sent out.

A Circular Flow of Dollars

  • U.S. dollars sent to foreigners equal those received from foreigners, influenced by imports and exports.

6.3 Exchange Rates

Currency Markets

  • Exchange Rate: Price of one currency in terms of another (e.g., 2 dollars = 1 euro).

Determinants of Exchange Rates

  • Consumer Tastes: Increased demand for foreign goods leads to dollar depreciation.

  • Relative Incomes: Stronger national income increases demand for imports, affecting currency value.

  • Speculation: Currency traded as assets; speculators' decisions can drive appreciation or depreciation.

6.4 Foreign Exchange Market

Demand and Supply

  • Demand: Quantity of currency that can be purchased at various exchange rates; inversely related to exchange rates.

  • Supply: Quantity of currency sellers offer at various exchange rates; directly related to exchange rates.

6.5 FOREX Market Equilibrium

  • Equilibrium: Achieved when supply equals demand at a specific exchange rate. Influences of Fed’s monetary policy on exchange rates and net exports are significant.

6.6 Effects of Policy Changes on Foreign Exchange Market

Fiscal Policy

  • Expansionary Fiscal Policy: Increased spending/decreased taxes leads to higher aggregate demand, affecting exchange rates.

  • Contractionary Fiscal Policy: Decreased spending/increased taxes leads to lower aggregate demand.

Monetary Policy

  • Expansionary: Increasing money supply lowers interest rates, increasing investment and demand.

  • Contractionary: Decreasing money supply raises interest rates, leading to decreased investment and demand.

6.7 Tariffs

Types of Tariffs

  • Revenue Tariff: Tax on imported goods not produced domestically to generate government revenue.

  • Protective Tariff: Protects domestic industries from foreign competition by taxing imports.

Economic Effects of Tariffs

  • Higher consumer prices and reduced consumption of protected goods.

  • Domestic producers benefit from reduced competition.

  • Government collects tariff revenue, but overall efficiency suffers.

Quotas

  • Import Quota: Limits the quantity of goods imported, affecting prices and resource allocation.

6.8 Changes in Currency Value

Appreciating vs. Depreciating Currency

  • Appreciating Currency: Strengthening value relative to another currency.

  • Depreciating Currency: Weakening value relative to another currency.

6.9 Impact on Net Exports

  • Changes in net exports significantly affect aggregate demand, production, employment, and economic output.

6.10 Real Interest Rates and International Capital Flows

Capital Flows

  • Inbound Capital Flow: Investment from foreign investors in domestic assets when interest rates are high.

  • Outbound Capital Flow: Domestic investors purchasing foreign assets when domestic interest rates are low.

Conclusion

  • The relationship between real interest rates and currency values significantly impacts net exports. Therefore, central banks influence domestic interest rates through monetary policies to stabilize economic conditions.