chapter 18 Macroeconomics in an Open Economy - Study Notes

Chapter 18: Macroeconomics in an Open Economy

Introduction to Open and Closed Economies

• Open Economy: An economy that has interactions in trade or finance with other countries.

• Closed Economy: An economy that has no interactions in trade or finance with other countries.

The Balance of Payments

• Definition: The record of a country’s trade with other countries in goods, services, and assets.

• Components:

  • Current Account: Records a country’s net exports, net investment income, and net transfers.

  • Financial Account: Records purchases of assets abroad and foreign purchases of domestic assets.

  • Capital Account: Records relatively minor transactions, such as migrants’ transfers and sales/purchases of nonproduced, nonfinancial assets.

1. The Current Account

• Definition: The part of the balance of payments that records economic transactions involving goods, services, income, and current transfers.

• Balance of Trade: The difference between the value of the goods a country exports and the value of the goods a country imports.

• Net Exports: The sum of the Balance of Trade and the Balance of Services.

  • Example (US Balance of Payments 2010):

  • Exports of goods: $1,289 billion

  • Imports of goods: -$1,935 billion

  • Balance of trade: -$646 billion

  • Exports of services: $549 billion

  • Imports of services: -$403 billion

  • Balance of services: $146 billion

  • Income received on investments: $663 billion

  • Income payments on investments: -$498 billion

  • Net income on investments: $165 billion

  • Net transfers: -$136 billion

  • Balance on current account: -$471 billion

2. The Financial Account

• Definition: The part of the balance of payments that records purchases and sales of assets.

• Net Foreign Investment: The difference between capital outflows and capital inflows, including net foreign direct investment and net foreign portfolio investment.

• Example (US Financial Account 2010):

  • Increase in foreign holdings of U.S. assets: $1,259 billion

  • Increase in U.S. holdings of foreign assets: -$1,005 billion

  • Balance on Financial Account: $254 billion

3. The Capital Account

• Definition: The part of the balance of payments that records relatively minor transactions.

  • Examples: Transactions like migrants’ transfers, and sales and purchases of nonproduced, nonfinancial assets.

Key Concept: Why Is the Balance of Payments Always Zero?

• Accounting Identity: The sum of the current account balance, financial account balance, and capital account balance equals the balance of payments, which is always zero.

• Statistical Discrepancy: An entry included in the balance of payments to ensure these balances remain equal.

Foreign Exchange Market and Exchange Rates

• Nominal Exchange Rate: The value of one country’s currency in terms of another country’s currency.

• Influences on Exchange Rates:

  • Demand for U.S.-produced goods and services

  • Desire to invest in the United States vs. foreign countries

  • Expectations of currency traders about future values of currencies

Examples of Exchange Rates From Financial Pages

• Exchange Rate Between the Dollar and Indicated Currency:

  • Canadian Dollar: 1.023 units of foreign currency per U.S. dollar; 0.978 U.S. dollars per unit of foreign currency.

  • Japanese Yen: 76.870 units of foreign currency per U.S. dollar; 0.013 U.S. dollars per unit of foreign currency.

  • Mexican Peso: 13.449 units of foreign currency per U.S. dollar; 0.074 U.S. dollars per unit of foreign currency.

  • British Pound: 0.635 units of foreign currency per U.S. dollar; 1.574 U.S. dollars per unit of foreign currency.

  • Euro: 0.727 units of foreign currency per U.S. dollar; 1.375 U.S. dollars per unit of foreign currency.

Currency Appreciation and Depreciation

• Currency Appreciation: An increase in the market value of one currency relative to another.

• Currency Depreciation: A decrease in the market value of one currency relative to another.

Adjustments to New Equilibrium

• Impacts of Currency Value Changes:

  • A depreciation in the domestic currency increases net exports, aggregate demand, and real GDP when the economy is below potential GDP.

  • Conversely, an appreciation in the domestic currency decreases net exports, aggregate demand, and real GDP.

The Real Exchange Rate

• Definition: The price of domestic goods in terms of foreign goods, considering nominal exchange rates and relative inflation rates.