Chapter 19

19.1 The Balance of Payments
- Explain how the balance of payments is calculated.
19.2 Equilibrium Output (Income) in an Open Economy
- Discuss how equilibrium output is determined in an open economy, and describe the trade feedback effect and the price feedback effect.
19.3 The Open Economy with Flexible Exchange Rates
- Discuss factors that affect exchange rates in an open economy with a floating system.
19.4 An Interdependent World Economy
- Appendix: World Monetary Systems since 1900
- Explain what the Bretton Woods system is.

Discusses the impact of economic openness on macroeconomic policy.
Exchange of currencies occurs when countries buy from and sell to each other.
- Exchange rate: The price of one country’s currency in terms of another; the ratio at which two currencies are traded.
In 1971, a significant shift occurred as most countries allowed exchange rates to be determined by supply and demand.

Foreign exchange: Currencies other than the domestic currency of a given country.
Balance of payments: Record of a country’s transactions in goods, services, and assets with the world; includes sources (supply) and uses (demand) of foreign exchange.

Balance of trade: Exports of goods and services minus imports.
Trade deficit: Occurs when exports < imports.
Balance on current account: Income from exports and investments minus payments for imports and transfers.

Shift from a net wealth position to a negative net wealth position for the U.S. from mid-1970s to mid-1980s.
- U.S. identified as the largest debtor nation reflecting higher spending on foreign goods than earnings from exports.

Current Account (Billions of dollars):
1. Goods exports: $1,550.7
2. Goods imports: $2,361.9
3. Exports of services: $780.9
4. Imports of services: $538.1
5. Balance of trade: (1) − (2) + (3) − (4): −$568.4
6. Investment income: $926.9
7. Investment payments: $709.0
8. Transfer income: $149.7
9. Transfer payments: $264.5
10. Balance on current account: (5) + (6) − (7) + (8) − (9): −$466.2
Financial Account:
1. Net capital transfer receipts: $24.8
2. Change in net U.S. liabilities: $375.5
3. Net receipts from financial derivatives: −$26.4
4. Statistical discrepancy: $92.2
5. Balance of payments: (10) + (11) + (12) + (13) + (14): $0.0

The U.S. is the largest debtor nation, followed by Spain and Brazil.
Largest creditor nations include Japan and China.
Some European countries are classified as debtor nations (Spain, Italy), while others are creditors (Germany, Switzerland).
Critical Thinking: Consider long-term costs of being a large debtor nation.

Planned aggregate expenditure components in an open economy include net exports (EX − IM).
When income (Y) rises, imports increase, and this relationship is expressed as:
- Marginal propensity to import (MPM): Change in imports due to a change in income.

Figure 19.1 illustrates determining equilibrium output, where equilibrium occurs when planned domestic aggregate expenditure crosses the 45-degree line.
Planned investment (I), government spending (G), and total exports (EX) contribute to aggregate expenditure; import spending is subtracted for equilibrium calculation.

The multiplier in an open economy is smaller than that in a closed economy because increased income results in higher consumption of foreign products.

Factors influencing imports include household consumption behavior, firm investment behavior, and relative prices of domestic vs. foreign goods.
Demand for U.S. exports correlates with global economic activity and relative prices.

Trade feedback effect: Economic activity increase in one country leads to global activity rise, enhancing exports and stimulating the U.S. economy.

Price feedback effect: A domestic price rise can increase prices in other countries, further driving domestic prices upward through import prices.

Floating or market-determined exchange rates: Determined through unregulated supply and demand forces.
Supply and demand for currencies is influenced by numerous entities exchanging currencies daily.

Achieved when the quantity of demand for a currency matches the quantity of supply.
Changes in demand or supply directly impact currency appreciation or depreciation.

Law of One Price: Prices of similar goods across countries should equate, with minimal transport costs.
Purchasing-power-parity theory: Determines exchange rates based on equal prices for similar goods internationally.

Higher U.S. interest rates can lead to higher demand for dollars, causing pound depreciation.

Import and export levels are contingent on exchange rates, with fluctuations impacting GDP and price levels.
Currency depreciation can initially worsen balance of trade due to the price of imports.

Cheaper dollars bolster exports, potentially increasing GDP.
Fiscal policy efficacy may be undermined by exchange rate non-responsiveness if the Federal Reserve maintains interest rates.

Gold Standard: Prior to 1914, currencies were valued in terms of gold; limited money supply control.
Bretton Woods System: Countries maintained fixed rates in U.S. dollar terms; allowed adjustments during fundamental disequilibrium.

Limited devaluation options and resulted in a “managed floating” system post-1971.

Key terms include appreciation/depreciation of currency, balance of payments, floating exchange rates, foreign exchange, J-curve effect, marginal propensity to import, and purchasing-power-parity.