Introduction
• Economies are linked through two broad channels
1. Trade in goods and services
• Some of a country’s production is exported to foreign countries
increase demand for domestically produced goods
• Some goods that are consumed or invested at home are produced
abroad and imported a leakage from the circular flow of income
2. Finance
• Portfolio managers shop the world for the most attractive yields
• As international investors shift their assets around the world, they link
assets markets here and abroad affect income, exchange rates, and
the ability of monetary policy to affect interest rates
• U.S. residents can hold U.S. assets OR assets in foreign countries
13-1
The Balance of Payments and
Exchange Rates
• Balance of payments: the record of the transactions of the residents
of a country with the rest of the world
• Two main accounts:
Current account: records trade in goods and services, as well as transfer
payments
Capital account: records purchases and sales of assets, such as stocks,
bonds, and land
13-2
External Accounts Must Balance
• The central point of international payments is very simple:
Individuals and firms have to pay for what they buy abroad
– If a person spends more than her income, her deficit needs to be
financed by selling assets or by borrowing
– Similarly, if a country runs a deficit in its current account the
deficit needs to be financed by selling assets or by borrowing
abroad
• Selling/borrowing implies the country is running a capital account
surplus any current account deficit is of necessity financed by an
offsetting capital inflow
Current account + Capital account = 0 (1)
13-3
Exchange Rates
• Exchange rate is the price of one currency in terms of another
– Ex. In august 1999 you could buy 1 Irish punt for $1.38 in U.S.
currency nominal exchange rate was e = 1.38
If a sandwich cost 2.39 punts, that is equivalent to
$
1.39 2.39 punt $3.30
punt
• We will discuss two different exchange rate systems:
1. Fixed exchange rate system
2. Floating exchange rate system
13-4
Fixed Exchange Rates
• In a fixed exchange rate system foreign central banks buy
and sell their currencies at a fixed price in terms of dollars
– Ensures that market prices equal to the fixed rates
No one will buy dollars for more than fixed rate since know that
they can get them for the fixed rate
No one will sell dollars for less than fixed rate since know can sell
them for the fixed rate
• Foreign central banks hold reserves to sell when they have to
intervene in the foreign exchange market
– Intervention: the buying or selling of foreign exchange by the
central bank
13-5
Fixed Exchange Rates
• What determines the level of intervention of a central bank in a
fixed exchange rate system?
– The balance of payments measures the amount of foreign
exchange intervention needed from the central banks
• Ex. If the U.S. were running a current account deficit vis-à-vis Japan,
the demand for yen in exchange for dollars exceeded the supply of
yen in exchange for dollars, the Bank of Japan would buy the excess
dollars, paying for them with yen
Under a fixed exchange rate, price fixers must make up the excess
demand or take up the excess supply
Makes it necessary to hold an inventory for foreign currencies that
can be provided in exchange for the domestic currency
13-6
Fixed Exchange Rates
• What determines the level of intervention of a central bank in a
fixed exchange rate system?
– With necessary reserves, Federal Reserve can continue to
intervene in foreign exchange markets to keep the exchange rate
constant
– If a country persistently runs deficits in the balance of
payments:
• The central bank eventually will run out of reserves on of foreign
exchange
• Will be unable to continue its intervention
• Before this occurs, the central bank will likely devalue the currency
13-7
Flexible Exchange Rates
• In a flexible (floating) exchange rate system, central banks
allow the exchange rate to adjust to equate the supply and
demand for foreign currency
– Suppose the following:
• Exchange rate of the dollar against the yen is 0.86 cents per yen
Japanese exports to the U.S. increase
Americans must pay more yen to Japanese exporters
• Bank of Japan stands aside and allows the exchange rate to adjust
Exchange rate could increase to 0.90 cents per yen
Japanese goods more expensive in terms of dollars
Demand for Japanese goods by Americans declines
13-8
The Exchange Rate in the Long
Run
• In long run, exchange rate between pair of countries is
determined by relative purchasing power of currency within
each country
– Two currencies are at purchasing power parity (PPP) when a
unit of domestic currency can buy the same basket of goods at
home or abroad
• The relative purchasing power of two currencies is measured by the
real exchange rate eP
R f
• The real exchange rate, R, is defined as P (3), where P f and P
are the price levels abroad and domestically, respectively
If R =1, currencies are at PPP
If R > 1, goods abroad are more expensive than at home
If R < 1, goods abroad are cheaper than those at home
13-9
The Exchange Rate in the Long
Run
ePf
R
P
If R =1, currencies are at PPP
If R > 1, goods abroad are more expensive
than at home
If R < 1, goods abroad are cheaper than
those at home
13-10
Trade in Goods, Market Equilibrium,
and the Balance of Trade
• Need to incorporate foreign trade into the IS-LM model
– Assume the price level is given, and output demanded will be
supplied (flat AS curve)
• With foreign trade, domestic spending no longer solely
determines domestic output spending on domestic goods
determines domestic output
Spending by domestic residents is DS C I G (4)
Spending on domestic goods is DS NX (C I G ) ( X Q )
(C I G ) NX (5)
Assume DS depends on the interest rate and income:
DS DS (Y , i ) (6)
13-11
Net Exports
• Net exports, (X-Q), is the excess of exports over imports
• NX depends on:
domestic income
NX X (Y f , R ) Q (Y , R ) NX (Y , Y f , R )
foreign income, Yf (7)
R
A rise in foreign income improves the home country’s trade balance
and raises their AD
A real depreciation by the home country improves the trade balance
and increases AD
A rise in home income raises import spending and worsens the
trade balance, decreasing AD
13-12