Chapter 18 Section 1 2 Macroeconomics in an Open Economy Countries are linked by trade in goods and services and by flows of financial investment Balance of payments linking the US to the International Economy Open economy an economy that has interactions in trade or finance with other countries Done so by making investments in each other s economies Closed economy an economy that has no interactions in trade or finance with other countries No country is completely closed Some countries have very limited economic interactions with other countries Balance of payments the record of a country s trade with other countries in goods services and assets The Current account Current account the part of the balance of payments that records a country s net exports net income on investments and net transfers Export and imports of goods and services Difference between transfers made to residents of other countries and Income received by US residents from investments in other countries Income paid on investments in the US owned by residents of other countries transfers received by US residents from other countries Any payment received by US residents are positive numbers in the current account Any payment made by US residents are negative numbers in the current account Balance of Trade the difference between the value of the goods a country exports and the value of the goods a country imports Largest item in the current account Exports imports trade surplus Exports imports trade deficit Net exports balance of trade balance of services Balance of services value of the services a country exports the value of the services a country imports Net exports DOES NOT equal the current account balance o Account includes net income on investments and net transfers Financial account Financial account the part of the balance of payments that records purchase of assets a country has made abroad and foreign purchases of assets in the country Capital outflow o When an investor in the US buys a bond issued by a foreign company or government o When a US firm builds a factory in another country Capital inflow government o When a foreign investor buys a bond issued by a US firm of by the o When a foreign firm builds a factory in the US Foreign direct investment o When firms build or buy facilities in foreign countries Foreign portfolio investment o When investors buy stock or bonds issued in another country Net capital flows capital inflows capital outflow Net foreign investment capital outflows capital inflows net foreign direct investment net foreign portfolio investment o Net capital flows are positive net foreign investment is negative o Net capital flows are negative net foreign investment is positive Capital account Capital account the part of the balance of payments that records relatively minor transactions such as migrants transfers and sales and purchases on nonproduced nonfinancial assets The balance of payments is always zero Current account balance fiscal account balance capital account balance 0 To make the balance eon the current account equal to the balance on the financial account the balance of payments includes an entry called the statistical discrepancy o Some imports or exports of goods and services or some capital inflows or outflows were not measured accurately Dollars that aren t spent are added to foreign holdings of dollars Official reserve transactions changes in foreign holdings of dollars Foreign investment in the US and additions to foreign holdings of dollars both show up as positive entries in the US financial account o Current account deficit must be exactly offset by a financial account surplus leaving the balance of payments equal to 0 The Foreign Exchange Market and Exchange rates Nominal exchange rate the value of one country s currency in terms of another country s currency The real exchange rate corrects the nominal exchange rate for changes in prices of goods and services The market exchange rate is determined by the interaction of demand and supply Three sources of foreign currency demand for the US dollar 1 Foreign firms and households that want to buy goods and services produced in the US 2 Foreign firms and households that want to invest in the US either through foreign direct investment or through foreign portfolio investment 3 Currency traders who believe that the value of the dollar in the future will be greater than its value today Equilibrium in the Market for Foreign Exchange Quantity Demand Quantity Supplied Demand curve normal downward slope o When value of the dollar is high the quantity of dollars demanded will be low Supply curve normal upward slope o When value of the dollar is high the quantity of dollars supplied in exchange will be high Surpluses and shortages in the foreign exchange market are eliminated very quickly because the volume of trading in major currencies is very large and currency traders are linked by computer Currency appreciation an increase in the market value of one currency relative to another currency Currency depreciation a decrease in the market value of one currency relative to another currency Shifts in the demand and supply curves cause the equilibrium exchange rate to change 1 Changes in the demand for US produced goods and services and changes in the demand for foreign produced goods and services 2 Changes in the desire to invest in the US and changes in the desire to invest in foreign countries 3 Changes in the expectations of currency traders about the likely future value of the dollar and the likely future value of foreign currencies Shift in the Demand of Foreign exchange Speculators currency traders who buy and sell foreign exchange in an attempt to profit from changes in exchange rates Shifts to the right when incomes rise interest rates rise or when speculators decide that the value of the dollar will rise relative Expansion Shift in the Supply of Foreign exchange Shifts to the right when consumers and firms increase spending increase in interest rates or when speculators are convinced that the future value of the dollar will be higher relative to the dollar than it is today Expansion Some exchange rates are not determined by the market Some currencies have fixed exchange rates that do not change over long periods of time A country s central bank has to intervene in the foreign exchange market to buy and sell its currency to keep the exchange rate fixed How movements in the exchange rate affect exports and imports When