ECO3200 Chap 13

Introduction

• National economies are becoming more closely interrelated

  • Economic influences abroad have effects on the U.S economy

  • Economic occurrences and policies in the U.S affect economies abroad

    • When the U.S moves into a recession, it tens to pull down other economies

    • When the U.S is in an expansion, it stimulates other economies

• Economies are linked through 2 channels

  • Trade in goods and services

    • Some of a country's production is exported to foreign countries => increase demand for domestically produced goods

    • Some goods that are consumed or invested at home are produces abroad and imported

  • Finance

    • Investment managers shop the world for the most attractive yields

    • U.S residents can hold U.S assets or assets in foreign countries

The balance of payments and exchange rates

• Balance of payments: the records of the transactions of residents of a country with the rest of the world

• 2 main accounts

  • Current account: trade in goods and services and transfer payments

  • Capital account: purchases and sales of assets (bonds and stocks)

External accounts must balance

• The central point of international payments is very simple: individuals and firms have to pay for what they buy abroad

• If a person spends more than her income her deficit needs to be financed b selling assets or borrowing

• If a country runs deficit in current account the deficit need to be financed by selling asses or borrowing abroad

• Any current account deficit t must be finances by an offsetting capital inflow

  • Current account +capital account=0

Exchange rates

• Exchange rate: price of one currency int terms of another

• Ex) in August 1999 you could buy 1 Irish punt for $1.38 in U.S currency => nominal exchange rate was e = 1.39

• If a sandwich costs 2.39 punts, how much U.S current is that equivalent to?

  • 1.39*2.39=$3.3221

• 2 different exchange rate systems

  • Fixed exchange rate system

  • Floating exchange rate system

Fixed Exchange Rates

• In a fixed exchange rate system foreign central banks buy and sell currencies at fixed price in terms of dollars

• Ensures that market prices equal to fixed rates

  • No one will buy dollars for more than one fixed rate since know that they can get them for fixed rate

  • No one will sell dollars for less then fixed rate since know can sell for the fixed rate

• Foreign central banks hold reserves to sell when they have to intervene in the foreign exchange market

  • Intervention: the buying/selling of foreign exchange by the central bank

• What determines the level of intervention of a central bank in a fixed exchange rate system?

  • The balance of payments measures the amount to foreign exchange intervention needed from central banks

  • Under a fixed exchange rate, a policy maker who wants to fix the price must make up the excess demand or take up the excess supply of home currency

  • The central bank can continue to intervene in foreign exchange markets to keep the exchange rate constant

Flexible Exchange rates

• In a flexible/floating exchange rate system, central banks allow the exchange rate to adjust to make the supply for foreign currency equal to and demand for foreign currency

• Ex) exchange rate of the dollar against the yen is .86 cents per yen

  • If bank of Japan allows the exchange rate to adjust

    • Exchange rate could increase to .9 cents per yen

    • Japanese goods more expensive in terms of dollars

    • Demand for Japanese goods by American declines

The exchange rate in the long run

• In long run, exchange rate between pair of countries is determined by relative purchasing power of currency within each country

• 2 currencies are at purchasing power parity (PPP) when a unit of domestic currency can buy the same basket of goods at home or abroad

• The relative purchasing power of 2 currencies is measured by the real exchange rate

• The real exchange rate, R, is defined as R=eP_f/P where P_f and P are the price levels abroad and domestically, respectively

• e:  nominal exchange rate. Ex: 1 USD = 1.30 CAD.

  • *price level : Consumer Price Index (CPI). The CPI represent the average level of prices for goods and services in a given country. It reflects changes in the cost of living over time by tracking the prices of a basket of goods and services that are commonly consumed by households.

    • price levels abroad : ex: CPI of Canada

    • price levels domestically: ex: CPI of USA

• If R=1, currencies are at PPP

• If R>1, goods abroad are more expensive than at home

• If 1< goods abroad are cheaper than those at home

Net Exports

• Net exports (X-Q) is the excess of exports over imports

• NX depends on domestic income, foreign income, and real exchange rate, R: NX=X (Y_f, R)-Q(Y,R)=NX(Y,Y_f,R)

• A rise in foreign income improves the home country's trade balances and raises their AD

• A real depreciation by the home country improves the trade balance and increases AD

• A rise in home income raise import spending and worsens the trade balance, decreasing AD

Goods Market Equilibrium

• Marginal propensity to import= fraction of an extra dollar of income spent on imports

  • IS curve will be steeper in an open economy compared to a closed economy

  • For a given reduction in interest rates it takes a smaller increase output and income to restore equilibrium in the goods market

• IS curve now includes NX as a component of AD

• A real depreciation of the domestic currency increases the demand for domestic goods => shifts IS to right

• An increase in GDP of foreign country results in an increase in foreign spending on domestic goods => shifts IS right

Discussion

• A real depreciation of domestic currency increases the demand for domestic goods => shifts IS right

  • x

• An increase in GDP of the foreign country results in an increase inf foreign spending on domestic goods => shifts IS right

  • X

Goods Market Equilibrium

• Higher foreign spending on out goods raises AD and thus higher output

  • Rightward shift of IS

Capital Mobility

• Start our analysis with the assumption of perfect capital mobility

  • Capital is perfectly mobile internationally when investors can purchase in any country, quickly, with low transaction costs, and in unlimited amounts

  • Asset holders willing and bale to move large amounts of funds across borders in search of the highest return or lowest borrowing cost

Adjustment to a change in the money stock

• Suppose there's an increase in the nominal money supply

  • The reals stock of money, M/P, increases since P is fixed

  • At E there will be an excess supply of real money balances

  • Interest rates will have to fall => LM shifts right

  • At point E', goods market is in equilibrium but i is below the world level => capital outflows to foreign countries, leading to home currency depreciation

  • Imports prices increase, domestic goods more competitive and demand for home goods expands

  • IS shifts right to E" where i=i_f

Expansionary Monetary Policy

• During recessions expansionary monetary policy decreases the interest rate

• Cheaper to borrow and less rewarding to save money

• Aggregate demand curve shifts out

• Price and output increase

Contractionary Monetary Policy

• During overheating, contractionary monetary policy increases the interest rate

• More expensive to borrow and encourages saving

• Aggregate demand curve shifts in

• Prices and output decrease

•