Macroeconomics Study Notes: The Balance of Payments and Exchange Rates
Introduction to Open-Economy Macroeconomics
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.
Transition to Supply and Demand: In 1971, most countries, including the United States, began allowing exchange rates to be determined essentially by the forces of supply and demand.
Openness and Policy: The openness of an economy significantly affects macroeconomic policy making, as transactions between countries with different currencies necessitate an exchange of those currencies.
The Balance of Payments
Foreign Exchange: Refers to 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; it is also the record of a country’s sources (supply) and uses (demand) of foreign exchange.
Balance of Trade: A country’s exports of goods and services minus its imports of goods and services.
Trade Deficit: This occurs when a country’s exports of goods and services are less than its imports of goods and services.
Balance on Current Account: The sum of income from exports of goods and services and income from investments and transfers minus payments for imports of goods and services and payments for investments and transfers.
U.S. Current Account Detailed Statistics (2023)
Goods Exports (1): billion dollars
Goods Imports (2): billion dollars
Exports of Services (3): billion dollars
Imports of Services (4): billion dollars
Balance of Trade (5): billion dollars
Investment Income (6): billion dollars
Investment Payments (7): billion dollars
Transfer Income (8): billion dollars
Transfer Payments (9): billion dollars
Balance on Current Account (10): billion dollars
The U.S. Financial Position and International Interdependence
Net Wealth Evolution: Prior to the mid-1970s, the United States generally ran current account surpluses, maintaining a positive net wealth position. Sometime between the mid-1970s and mid-1980s, the U.S. transitioned to a negative net wealth position relative to the rest of the world.
Debtor Nation Status: Currently, the United States is the largest debtor nation in the world. This status reflects three decades of spending more on foreign goods and services than has been earned through domestic sales to the rest of the world.
Federal Reserve Influence: Monetary authorities worldwide observe Federal Reserve actions due to international spillover effects. Many countries in Latin America, Asia, and Eastern Europe peg their exchange rates to the U.S. dollar. During the COVID-19 pandemic, global reactions to the Fed’s actions allowed financial markets to remain liquid.
Equilibrium Output (Income) in an Open Economy
Net Exports of Goods and Services: The difference between a country’s total exports and total imports.
Marginal Propensity to Import (MPM): The change in imports caused by a dollar change in income.
Import Function: When income rises, imports tend to increase. This is expressed algebraically as: * * Where is income and is the MPM (a positive number).
The Open-Economy Multiplier: The multiplier is smaller in an open economy compared to a closed economy. When government spending or investment increases, income and consumption rise; however, some of this extra consumption is leaked into spending on foreign products rather than domestically produced goods.
Determining Equilibrium Output: * Aggregate Expenditure: Planned investment spending (), government spending (), and total exports () are added to consumption (). This total includes spending on imports. * Domestic Adjustment: To find equilibrium output, the amount imported at every level of income is subtracted from the planned aggregate expenditure. Equilibrium occurs where planned domestic aggregate expenditure crosses the 45-degree line.
The Trade and Price Feedback Effects
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. * Process: Increased U.S. imports lead to increased foreign exports $\rightarrow$ stimulating foreign economies $\rightarrow$ increasing foreign imports $\rightarrow$ increasing U.S. exports $\rightarrow$ stimulating the U.S. economy.
Determinants of Imports: These include the same factors affecting household consumption and firm investment, as well as the relative prices of domestic vs. foreign-produced goods.
Determinants of Exports: Demand for exports depends on economic activity in the rest of the world and the relative price of domestic goods to foreign goods. Higher foreign output or lower domestic prices lead to increased U.S. exports.
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 drives up prices in other countries, which in turn further increases the price level in the original country.
Inflation Dynamics: Foreign inflation rates affect domestic import prices. If inflation abroad is high, U.S. import prices are likely to rise.
The Market for Foreign Exchange
Floating (Market-Determined) Exchange Rates: Rates determined by unregulated forces of supply and demand.
The Demand for Pounds (Supply of Dollars): Driven by U.S. entities importing British goods, U.S. travelers in Britain, buyers of British financial instruments, U.S. companies investing in Britain, and speculators anticipating a dollar decline.
The Supply of Pounds (Demand for Dollars): Driven by British entities importing U.S. goods, British travelers in the U.S., buyers of U.S. stocks/bonds, British companies investing in the U.S., and speculators anticipating a dollar rise.
Law of Demand for Currency: When the price of pounds falls, British goods appear cheaper. If British prices are constant, U.S. buyers demand more pounds to purchase more goods.
Law of Supply for Currency: When the price of pounds rises, the British can obtain more dollars per pound, making U.S. goods cheaper. This increases the quantity of pounds supplied.
Equilibrium: Occurs where quantity demanded equals quantity supplied. * Appreciation: The rise in value of one currency relative to another. * Depreciation: The fall in value of one currency relative to another.
Factors Affecting Exchange Rates
Purchasing-Power-Parity (PPP) Theory: A theory holding that exchange rates are set so that the price of similar goods in different countries is the same.
Law of One Price: If transportation costs are small, the price of the same good in different countries should be roughly the same.
Relative Prices: Higher inflation in the U.S. relative to Britain makes imports from Britain cheaper (demand for pounds shifts right) and U.S. exports more expensive (supply of pounds shifts left), leading to an appreciation of the pound and depreciation of the dollar.
Relative Interest Rates: If U.S. interest rates rise relative to British rates, British citizens sell pounds to buy U.S. dollars for investment (supply of pounds shifts right). Simultaneously, U.S. citizens are less interested in British securities (demand for pounds shifts left). The result is a depreciating pound and an appreciating dollar.
Macroeconomic Effects of Exchange Rates
GDP Impacts: A depreciation of a country's currency is likely to increase its real GDP by making exports cheaper and imports more expensive.
Price Level Impacts: Currency depreciation tends to increase a country's price level (inflationary pressure).
The J-Curve Effect: Following a currency depreciation, a country’s balance of trade may get worse before it gets better. This occurs because the negative effect on the price of imports may initially dominate the positive effects of increased export volume and decreased import volume.
Monetary Policy with Flexible Rates: A cheaper dollar increases exports and decreases imports. If consumers switch to domestic goods, the multiplier increases. Higher interest rates lower investment/consumption but also attract foreign capital, driving up the dollar and reducing import prices, which shifts aggregate supply to the right to help fight inflation.
Fiscal Policy with Flexible Rates: Flexible rates can hinder fiscal authorities attempting to contract the economy to fight inflation. If the Fed does not change interest rates in response to fiscal policy, there is no currency value change to offset the fiscal action.
Fixed Exchange Rates and Capital Controls: To change interest rates while keeping an exchange rate fixed, a country must impose capital controls to limit or prevent the buying or selling of its currency in foreign exchange markets.
World Monetary Systems since 1900
The Gold Standard: The primary system before 1914. All currencies were priced in terms of gold. A major problem was that countries had little control over their money supply, which fluctuated based on new gold discoveries.
The Bretton Woods System: Established a system of fixed exchange rates where currencies were pegged to the U.S. dollar rather than gold. It established the International Monetary Fund (IMF) and allowed for currency changes only in cases of "fundamental disequilibrium" or "chronic" current account deficits.
Pure Fixed Exchange Rates: A system where governments set a specific rate and commit to maintaining it. If the market value of a currency drops below the fixed rate, the government must intervene by buying up the excess supply of its own currency.
Managed Floating: The system in place since 1971, where exchange rates are primarily market-determined but subject to occasional government intervention.