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 The Balance of Payments Foreign exchange all currencies other than the domestic currency of a given country The u s earns foreign exchange when it sells products services or assets to another country Balance of payments the record of a country s transactions in goods services and assets with the rest of the world also the record of a country s sources supply and uses demand of foreign exchange The current account The balance of payments is divided into 2 accounts Current account First item is u s trade in goods u s exports earn foreign exchange for the u s and are a credit item on the current account U s imports use up foreign exchange and are a debit item Services ex U s rm shipping wheat to England might purchase insurance from british insurance company A Dutch ower grower may y its owers to the u s aboard an American airliner In rst case the u s is importing services therefore using up foreign exchange in second case it s selling services to foreigners and earning foreign exchange Balance of trade a country s exports of goods and services minus it s imports of goods and services Trade de cit when a country s exports of goods and services are less than its imports of goods and services Third item in current account concerns investment income U s citizens hold foreign assets Dividends interest rent and pro ts paid to u s asset holders are a source of foreign exchange Conversely when foreigners earn dividends interest and pro ts on assets held in the u s foreign exchange is used up Fourth item in current account is net transfer payments Transfer payments from u s to foreigner are another use of foreign exchange Net refers to difference between payments from u s to foreigners and payments from foreigners to u s Balance on current account net exports of goods plus net exports of The Capital Account services plus net investment income plus net transfer payments Shows how much a nation has spent on foreign goods services investment income payments and transfers relative to how much it has earned from other countries Negative nation has spent more on foreign goods and services than it has earned through sales of its goods and services to the rest of the world Net wealth nations assets abroad its liabilities to the rest of the world For each transaction recorded in current account there is offsetting transaction in capital account Purchase of Japanese car by u s citizen Yen dollar exchange rate is 100 yen to a dollar and yen price of the car is 2 0 million yen which is 20 000 U s citizen takes 20 000 and buys 2 0 million yen and then buys the car In this case u s imports are increased by 20 000 in current account and foreign assets in u s are increased by 20 000 in capital account Realize increase in u s import results in increase in foreign assets in u s U s must pay for imports and whatever it pays with is an increase in foreign assets in u s Conversely an increase in u s exports results in increase u s assets abroad because foreigners must pay for u s exports U s assets are divided into private holdings and u s govt holdings Foreign assets are divided into foreign private and foreign govt Balance on capital account in the u s the sum of the following measured in a given period the change in private u s assets abroad the change in foreign private assets in the u s the change in u s govt assets abroad and the change in foreign govt assets in u s Net capital account transactions includes things such as u s govt debt forgiveness do not affect current account When balance on capital account is positive the change in foreign assets in country is greater than change in country s assets abroad which is decrease in net wealth position of the country Balance of payments is sum of balance on current account balance on capital account net capital account transactions and statistical discrepancy always 0 Many transactions get recorded in capital account that do not pertain to current account Consider purchase of a u k Security by u s resident This is done by the u s resident s selling dollars for pounds and using the pounds to buy the u k Security After this transaction u s assets abroad have increased and foreign assets in u s have increased The purchase if u k Security is recorded as a minus item and increase in foreign holdings of dollars is recorded as plus item The U S as a Debtor Nation If a country has positive net wealth position compared to the rest of the world it can be said to be a creditor nation Conversely if it has a negative net wealth position it can be said to be a debtor nation A country s net wealth position increases if it has a positive current account balance and decreases if it has a negative current account balance The only way a country s net wealth position can change is if it s current account balance is nonzero Equilibrium Output income in an Open Economy The International Sector and Planned Aggregate Expenditure To analyze international sector include goods and services a country exports to the rest of the world as well as what it imports Imports are not a part of domestic output Planned aggregate expenditure in open economy C I G EX IM Net exports of good and services EX IM Determining Level of Imports Level of imports is a function of income Y IM mY Y is income and m is some positive number less than 1 m MPM or marginal propensity to import which is the change in imports caused by a 1 change in income If m 2 or 20 and income is 1 000 imports will be 2 x 1 000 200 If income rises by 100 to 1 100 the change in imports 2 x 100 20 Solving for Equilibrium Equilibrium is reached when planned domestic aggregate expenditure equals domestic aggregate output income The Open Economy Multiplier 1 1 MPC MPM Imports and Exports and the Trade Feedback Effect The Determinants of Imports Anything that increases consumption spending is likely to increase the demand for imports Anything that increases investment spending is likely to increase demand for imports Ex Decrease in interest rates should encourage spending on both domestically produced goods and foreign produced goods The relative prices of domestically produced goods and foreign produced goods If prices of foreign goods fall relative to prices of domestic goods people will consume more foreign goods relative to domestic goods Determinants of Exports Demand for u s exports
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