Chapter 20 Open Economy Macroeconomics The Balance of Payments and Exchange Rates The main difference between an international transaction and a domestic transaction concerns currency exchange Exchange rates 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 determine the flow of international trade if Japanese yen is cheap making the US dollar expensive both Japanese and Americans would buy from Japanese producers The Balance of Payments given country Foreign exchange all currencies other than the domestic currency of a Where does the supply of foreign exchange come from the US earns foreign exchange when it sells products services or assets to another country like as Mexico earns foreign exchange when US tourists visit Cancun 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 sum of the balance on current account the balance on capital account net capital account transactions and the statistical discrepancy o Divided into 2 major accounts current account capital account o Current account US trade in goods Exports for example computer chips earn foreign exchange and are a credit item Imports for example scotch whisky use up foreign exchange and are a debit item Services Exports A Dutch flower grower flies flowers to the US aboard an American ship US earning foreign exchange by selling a service Imports US firm is shipping wheat to England and purchases insurance from a British insurance company US using up foreign exchange by buying a service Investment income US citizens hold foreign assets like stocks and bonds in other countries source of foreign exchange Foreigners earn dividends interest profits on assets in US foreign exchange is used up Net transfer payments Payments from the US to foreigners and payments from foreigners to the US Balance on current account net exports of goods net exports of services net investment income net transfer o Capital account 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 a nation has spent more on foreign goods and services than it has earned if this happens then its net wealth position in the world decreases by net we mean a nation s assets abroad liabilities to the world capital account records the changes in these assets and liabilities For each transaction recorded in the current account there is an offsetting transaction recorded in the capital account An increase in US exports results in an increase in US assets abroad bc foreigners must pay for US exports US assets abroad are divided into private holding and US Foreign assets in the US are divided into foreign private and government holdings foreign government Balance on capital account in the US the sum of the following measured in a given period the change in private US assets abroad the change in foreign private assets in the US the change in US government assets abroad and the change in foreign government assets in the US Net capital account transactions affect capital account but not current account small things like US government debt forgiveness When the balance on capital account is positive this means the change in foreign assets in the country is greater than the change in the country s assets abroad which is a decrease in the net wealth position of the country Balance of trade a country s exports of goods and services minus its imports of goods and services o Trade deficit occurs when a country s exports of goods and services are less than its imports of goods and services Positive net wealth position creditor nation Negative net wealth position 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 its current account balance is NOT 0 Equilibrium Output Income in an Open Economy Imports are not a part of domestic output Planned aggregate expenditure in an open economy C I G EX IM Net exports of goods and services the difference between a country s total exports and total imports When income rises imports tend to go up Americans have more money not only to buy US products but also products from abroad Marginal propensity to import MPM the change in imports caused by a Equilibrium planned domestic aggregate expenditure domestic aggregate 1 change in income output at Y o If Y were beneath Y planned expenditure would exceed output inventories would be lower than planned and output would rise o AT levels above Y output would exceed planned expenditure inventories would be larger than planned and output would fall Equilibrium output rises by a multiple of the initial increase in government purchases multiplier o In an open economy some of the increase in income brought about by increase in G is spent on imports instead of domestically produced goods and services the part of income spent on imports does not increase domestic income Y bc imports are produced by foreigners o To compute the multiplier we need to know how much of the increased income is used to increase domestic consumption we need to know the marginal propensity to consume domestic goods o Domestic consumption is C IM o Open economy multiplier 1 1 MPC MPM Determinants of imports factors that increase household consumption or investment spending should increase the demand for imports also relative prices of domestically produced and foreign produced goods Determinants of exports depends on the economic activity in the rest of the world rest of the world real wages wealth non labor income interest rates prices of US goods relative to the price of the rest of the world goods foreign output increases then US exports increase 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 Export prices of other countries affect US import prices when Mexico s export prices rise with no change in the dollar peso exchange rate US import prices rise A country s export prices tend to move fairly closely with the general price level in that country Increase in the price of imported inputs will
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