Open-Economy Macroeconomics Notes

Open-Economy Macroeconomics: The Balance of Payments and Exchange Rates

Key difference between international and domestic transactions: currency exchange.
Exchange rate: The price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other.
- Impacts trade patterns significantly by influencing price competitiveness.
- Expensive yen (cheap dollar) encourages buying from U.S. producers.
- Cheap yen (expensive dollar) encourages buying from Japanese producers.

Foreign exchange: All currencies other than the domestic currency of a given country.
Balance of payments: The record of a country’s transactions in goods, services, and assets with the rest of the world.
- Also a record of a country’s sources (supply) and uses (demand) of foreign exchange.
- U.S. demand for foreign exchange stems from buying foreign goods, services, or investments.
- Supply of foreign exchange comes from U.S. citizens or firms selling to other countries.

Balance of trade: A country’s exports of goods and services minus its imports of goods and services.
Trade deficit: Occurs when a country’s exports of goods and services are less than its imports of goods and services in a given period.
Trade surplus: Occurs when a country’s exports of goods and services are more than its imports of goods and services in a given period.
Balance on current account: Net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments.
- Calculated by the sum of net export of goods, net export of services, net investment income, and net transfer payments.

Balance on capital account: In the United States, the sum of:
- The change in private U.S. assets abroad (e.g., Americans buying foreign stocks, real estate).
- The change in foreign private assets in the United States (e.g., foreigners investing in U.S. companies).
- The change in U.S. government assets abroad (e.g., lending to other countries).
- The change in foreign government assets in the United States (foreign central banks buying U.S. Treasury bonds).
Positive Balance:
- More capital flowing into the U.S. than leaving.
- Foreign investors putting money into U.S. assets (stocks, bonds, real estate).
- Indicates strong foreign interest and investment in the U.S. economy.
Negative Balance:
- More capital flowing out of the U.S. than coming in.
- U.S. investors putting money into foreign assets or businesses.
- Signals that U.S. capital is being invested abroad.
Reflects financial flows rather than trade in goods and services.
Shows how a country finances its current account deficits or surpluses.
- Current account deficit financed by a positive capital account balance.
- Current account surplus results in capital outflows.

Prior to the mid-1970s, the United States generally had current account surpluses.
By the mid-1980s, the United States was running large current account deficits.
The United States changed from a creditor nation to a debtor nation.

Planned aggregate expenditure in an open economy: AE = C + I + G + EX - IM
Net exports of goods and services (EX - IM):
- The difference between a country’s total exports and total imports.
Marginal propensity to import (MPM):
- The change in imports caused by a $1 change in income.
- Example: If m = 0.2, and income is $1,000, then imports, IM = 0.2 * $1,000 = $200. If income rises by $100 to $1,100, the change in imports will equal m * (the change in income) = 0.2 * $100 = $20.
Equilibrium output occurs when planned domestic aggregate expenditure crosses the 45-degree line.
To get spending on domestically produced goods, we must subtract the amount that is imported at each level of income.

Open-economy multiplier:
- The effect of a sustained increase in government spending (or investment) on income is smaller in an open economy than in a closed economy.
- Some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services.
Domestic consumption portion is determined by the marginal propensity to consume domestic goods, which is the MPC minus the marginal propensity to import (MPM).
If the MPC is 0.75 and the MPM is 0.25, then the multiplier is 1/0.5, or 2.
- This multiplier is smaller than the multiplier in which imports are not taken into account, which is 1/0.25, or 4.
One country’s government spending increases affects other countries as it increases demand for their exports.
When income rises: People buy both domestic and foreign goods.
The leakage of spending on imports means that some of the money does not circulate within the domestic economy.

Determinants of Imports:
- Factors that affect households’ consumption behavior and firms’ investment behavior (after-tax income, interest rates, and the prices of foreign goods).
Determinants of Exports:
- Economic activity in the rest of the world (real wages, wealth, nonlabor income, interest rates, etc.).
- Prices of U.S. goods relative to the price of rest-of-the-world goods.
- When foreign output increases, U.S. exports tend to increase because of Higher Income Abroad and Increased Global Demand.
Trade feedback effect:
- The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country.
- Rising exports lead to an increase in U.S. output (income), which leads to an increase in U.S. imports.
- U.S. imports are somebody else’s exports. Extra import demand from the U.S. raises the exports of the rest of the world.

Price feedback effect:
- The process by which a domestic price increase in one country can “feed back” on itself through export and import prices.
- An increase in the price level in one country can drive up prices in other countries, which in turn further increases the price level in the first country.
- Example: U.S. inflation leads to higher prices for American-made goods. European countries importing from the U.S. now pay more, which raises inflation in Europe. Then, if the U.S. imports European machinery or goods, it now pays more—thus, U.S. prices rise further.