Principles of Economics
Global Edition
Chapter 34
Open-Economy
Macroeconomics: The
Balance of Payments and
Exchange Rates
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Outline
The Balance of Payments
Equilibrium Output (Income) in an Open Economy
The Open Economy with Flexible Exchange Rates
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Chapter 34 Open-Economy
Macroeconomics: The Balance of
Payments and Exchange Rates
• In this chapter, we explore the ways in which the openness
of the economy affects macroeconomic policy making.
• When people in countries with different currencies buy
from and sell to each other, an exchange of currencies
must also take place.
• 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.
• In 1971, most countries, including the United States,
began allowing exchange rates to be determined
essentially by supply and demand.
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The Balance of Payments
• foreign exchange All currencies other than the domestic
currency of a given 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.
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The Current Account
• balance of trade A country’s exports of goods and
services minus its imports of goods and services.
• trade deficit Occurs when a country’s exports of goods
and services are less than its imports of goods and
services.
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Balance of Payments
• The balance of payments consists of 5
accounts:
– current account: accounts for flows of goods and
services (imports and exports) as well as primary and
secondary income accounts.
– financial account: accounts for flows of financial assets
(financial capital).
– capital account: flows of special categories of assets
(capital): typically nonmarket, non-produced, or intangible
assets like debt forgiveness, copyrights and trademarks.
– Net errors and omissions
– Reserves
Copyright 2020 A.Yasemin Yalta, Hacettepe
University
Balance of Payments
Current account:
1. merchandise
2. services (payments for tourism, transportation,
legal services, financial services etc.)
3. income receipts (interest and dividend payments,
earnings of firms and workers operating in foreign
countries)
a) Primary Income Account
b) Secondary Income Account
Copyright 2020 A.Yasemin Yalta, Hacettepe
University
Current Account Balance
Current account balance = Balance on goods and services
(trade balance) + primary income balance + secondary
income balance
• If CA > 0, current account surplus
• If CA< 0, current account deficit
• Note that trade deficit and current account deficit are not
the same. Current account is broader than trade
balance.
Copyright 2020 A.Yasemin Yalta, Hacettepe
University
Balance of Payments
Financial Account
• Shows the change in assets owned by Turkish residents
abroad and assets owned by foreignors in Turkey.
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University
Balance of Payments
Financial Account
• Foreign Direct Investment
• Portfolio Investment
• Other Investment
a) Foreign Direct Investment (FDI): Foreignors hold at
least 10 per cent of ownership.
b) It has two types: Mergers and acquisitons
c) FDI brings certain benefits to countries such as transfer
of know-how, technology, managerial skills.
d) It is relatively a stable source of financial flows.
Copyright 2020 A.Yasemin Yalta, Hacettepe
University
Net Financial Account= Net Foreign Direct Investment Balance + net portfolio
balance + net other investment balance
Net Financial Account= Acquistion of assets – incurrence of liabilities
IF NFA<0, liabilities > assets, capital inflow to the country (i.e. Foreign
investment in the country is rising)
If NFA>0, liabilities< assets, capital outflow from the country
Copyright 2020 A.Yasemin Yalta, Hacettepe
University
Errors and Omissions
4) Errors and Omissions
• It is used to correct discrepencies between the accounts.
• It includes compilation errors, calculation errors as well.
• It also indicates unrecorded capital flows.
5) Reserves
Central Bank reserves
Special drawing rights
Reserves are important because if there is a deficit in the total of other
accounts, central bank uses its reserves to finance the deficit.
Copyright 2020 A.Yasemin Yalta, Hacettepe
University
Equilibrium Output (Income) in an
Open Economy
The International Sector and Planned Aggregate
Expenditure
• Planned aggregate expenditure in an open economy:
AE C I G EX IM
• net exports of goods and services (EX − IM) The
difference between a country’s total exports and total
imports.
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The International Sector and Planned
Aggregate Expenditure (1 of 2)
Determining the Level of Imports
• When income rises, imports tend to go up. Algebraically,
IM mY
where Y is income and m is some positive number.
• marginal propensity to import (MPM) The change in
imports caused by a $1 change in income.
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Solving for Equilibrium
Figure 34.1 Determining Equilibrium
Output in an Open Economy
• In panel (a), planned investment spending (I), government spending (G), and total
exports (EX) are added to consumption (C) to arrive at planned aggregate expenditure.
However, C + I + G + EX includes spending on imports.
• In panel (b), the amount imported at every level of income is subtracted from planned
aggregate expenditure. Equilibrium output occurs at Y* = 200, the point at which planned
domestic aggregate expenditure crosses the 45-degree line.
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The International Sector and Planned
Aggregate Expenditure (2 of 2)
The Open-Economy Multiplier
1
open-economy multipler
1 MPC MPM
• The multiplier is smaller in an open economy than in a
closed economy.
• Reason: When government spending (or investment)
increases and income and consumption rise, some of the
extra consumption spending that results is on foreign
products and not on domestically produced goods and
services.
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Imports, Exports, and the Trade
Feedback Effect (1 of 4)
The Determinants of Imports
• The same factors that affect households’ consumption
behavior and firms’ investment behavior are likely to affect
the demand for imports because some imported goods are
consumption goods and some are investment goods.
• The relative prices of domestically produced and foreign-
produced goods also determine spending on imports.
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Imports, Exports, and the Trade
Feedback Effect (2 of 4)
The Determinants of Exports
• The demand for our exports depends on economic activity
in the rest of the world as well as on the prices of goods in
Turkey relative to the price of rest-of-the-world goods.
• When foreign output increases, exports from Turkey tend
to increase. Exports of Turkey also tend to increase when
domestic prices fall relative to prices in the rest of the
world.
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Imports, Exports, and the Trade
Feedback Effect (3 of 4)
The Trade Feedback Effect
• 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.
• An increase in U.S. imports increases other countries’ exports,
which stimulates those countries’ economies and increases their
imports, which increases U.S. exports, which stimulates the
U.S. economy and increases its imports, and so on.
• In other words, an increase in U.S. economic activity leads to a
worldwide increase in economic activity, which then “feeds
back” to the United States.
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The Open Economy with Flexible
Exchange Rates
• floating, or market-determined, exchange rates
Exchange rates that are determined by the unregulated
forces of supply and demand.
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The Market for Foreign Exchange
(1 of 2)
The Supply of and Demand for Pounds
• Governments, private citizens, banks, and corporations
exchange pounds for dollars and dollars for pounds every
day.
• Those who demand pounds are holders of dollars seeking
to exchange them for pounds.
• Those who supply pounds are holders of pounds seeking
to exchange them for dollars.
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Table 34.2 Some Buyers and Sellers
in International Exchange Markets:
United States and Great Britain
The Demand for Pounds (Supply of Dollars)
1. Firms, households, or governments that import British goods into the United States or
want to buy British-made goods and services
2. U.S. citizens traveling in Great Britain
3. Holders of dollars who want to buy British stocks, bonds, or other financial instruments
4. U.S. companies that want to invest in Great Britain
5. Speculators who anticipate a decline in the value of the dollar relative to the pound
The Supply of Pounds (Demand for Dollars)
1. Firms, households, or governments that import U.S. goods into Great Britain or want to
buy U.S.-made goods and services
2. British citizens traveling in the United States
3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the
United States
4. British companies that want to invest in the United States
5. Speculators who anticipate a rise in the value of the dollar relative to the pound
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Figure 34.2 The Demand for Pounds
in the Foreign Exchange Market
• When the price of pounds falls, British-made goods and services
appear less expensive to U.S. buyers.
• If British prices are constant, U.S. buyers will buy more British goods
and services, and the quantity of pounds demanded will rise.
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Figure 34.3 The Supply of Pounds in
the Foreign Exchange Market
• When the price of pounds rises, the British can obtain more dollars for each
pound.
• This means that U.S.-made goods and services appear less expensive to
British buyers.
• Thus, the quantity of pounds supplied is likely to rise with the exchange rate.
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The Market for Foreign Exchange
(2 of 2)
The Equilibrium Exchange Rate
• The equilibrium exchange rate occurs at the point at which
the quantity demanded of a foreign currency equals the
quantity of that currency supplied.
• appreciation of a currency The rise in value of one
currency relative to another.
• depreciation of a currency The fall in value of one
currency relative to another.
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Figure 34.4 The Equilibrium
Exchange Rate
• When exchange rates are allowed to float, they are determined by the forces
of supply and demand.
• An excess demand for pounds will cause the pound to appreciate against the
dollar.
• An excess supply of pounds will lead to a depreciating pound.
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Factors That Affect Exchange
Rates
Purchasing Power Parity: The Law of One Price
• law of one price If the costs of transportation are small,
the price of the same good in different countries should be
roughly the same.
• purchasing-power-parity theory A theory of international
exchange holding that exchange rates are set so that the
price of similar goods in different countries is the same.
• A high rate of inflation in one country relative to another
puts pressure on the exchange rate between the two
countries, and so the currencies of relatively high-inflation
countries tend to depreciate.
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Figure 34.5 Exchange Rates Respond
to Changes in Relative Prices
• The higher price level in the United States makes imports relatively less expensive. U.S. citizens are
likely to increase their spending on imports from Britain, shifting the demand for pounds to the right,
from D0 to D1.
• At the same time, the British see U.S. goods getting more expensive and reduce their demand for
exports from the United States. The supply of pounds shifts to the left, from S0 to S1.
• The result is an increase in the price of pounds. The pound appreciates, and the dollar is worth less.
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Relative Interest Rates Figure 34.6
Exchange Rates Respond to
Changes in Relative Interest Rate
• If U.S. interest rates rise relative to British interest rates, British citizens holding pounds may be
attracted into the U.S. securities market. To buy bonds in the United States, British buyers must
exchange pounds for dollars.
• The supply of pounds shifts to the right, from S0 to S1. However, U.S. citizens are less likely to be
interested in British securities because interest rates are higher at home. The demand for pounds
shifts to the left, from D0 to D1. The result is the pound depreciates vis-a-vis the dollar and the dollar
(naturally) appreciates vis-a-vis the pound.
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The Effects of Exchange Rates on
the Economy (1 of 7)
• The level of imports and exports depends on exchange
rates as well as on income and other factors.
• When events cause exchange rates to adjust, the levels of
imports and exports will change.
• Changes in exports and imports can, in turn, affect the
level of real GDP and the price level.
• Further, exchange rates themselves also adjust to
changes in the economy.
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The Effects of Exchange Rates on
the Economy (2 of 7)
Exchange Rate Effects on Imports, Exports, and Real
GDP
• A depreciation of a country’s currency is likely to increase
its GDP.
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The Effects of Exchange Rates on
the Economy (3 of 7)
Exchange Rates and the Balance of Trade: The J Curve
• J-curve effect Following a currency depreciation, a
country’s balance of trade may get worse before it gets
better. The graph showing this effect is shaped like the
letter J, hence the name J-curve effect.
balance of trade dollar price of exports quantity of exports
dollar price of imports quantity of imports
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Figure 34.7 The Effect of a
Depreciation on the Balance of Trade
(the J Curve)
• Initially, a depreciation of a country’s currency may worsen its balance of
trade.
• The negative effect on the price of imports may initially dominate the positive
effects of an increase in exports and a decrease in imports.
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The Effects of Exchange Rates on
the Economy (4 of 7)
Exchange Rates and Prices
• The depreciation of a country’s currency tends to increase
its price level.
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