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Chapter 34 - Open-market macroeconomics. After studying this chapter you will be able to understand: How to define balance of trade, portfolio investment, and foreign direct investment? What the relationship is between balance of trade and net capital outflow? What the determinants of international capital flows are?...
Chapter 34 Open-Market Economics © 2014 by McGraw-Hill Education What will you learn in this chapter? • How to define balance of trade, portfolio investment, and foreign direct investment • What the relationship is between balance of trade and net capital outflow • What the determinants of international capital flows are • How to define the international market for loanable funds • What determinants and types of exchange rates exists • How exchange rates affect trade • How monetary policy affects currency value © 2014 by McGraw-Hill Education International flows of goods and capital • International trade can be analyzed by studying the flow of goods and capital in and out of a country • The balance of trade measures the flow of the value of goods and is calculated as: Balance of Trade = Exports - Imports • A trade deficit is a negative balance of trade • A trade surplus is a positive balance of trade © 2014 by McGraw-Hill Education Active Learning: Imports and exports For each of the following situations, indicate whether there is a trade deficit or surplus and calculate the balance of trade Imports (millions of $) Exports (millions of $) 15 10 37 47 75.5 110.5 54 27 Trade deficit or trade surplus? Balance of trade (millions of $) © 2014 by McGraw-Hill Education International flows of goods and capital • Until 1975, U.S trade was relatively balanced • After 1975, imports grew faster than exports, causing a trade deficit Billions of dollars 2,500 Imports 2,000 Exports 1,500 Balance of trade (Exports _ imports) 1,000 500 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 -500 -1,000 -1,500 • Currently the trade deficit is approximately $600 billion © 2014 by McGraw-Hill Education International flows of goods and capital Much of U.S trade occurs with its closest neighbors Even though it is far away, the biggest importer of goods into the U.S is China Trade in billions of dollars 700 600 500 Imports 400 Exports 300 200 100 Canada China Mexico © 2014 by McGraw-Hill Education Japan Germany United S.Korea Brazil Kingdom France Taiwan Venezuela Singapore International flows of goods and capital • The U.S is a big importer of consumer goods, capital goods, and industrial supplies • The U.S is also a big exporter of capital goods and industrial supplies Trade in billions of dollars 600 Imports 500 Exports 400 300 200 100 Consumer goods Capital goods Industrial supplies Automotive Foods, feeds, vehicles, etc & beverages Other goods © 2014 by McGraw-Hill Education Foreign investment • Imports and exports are the most visible and straightforward aspects of international economics • Countries interact in other ways as well, including through investment – Foreign direct investment (FDI) refers to when a firm runs part of its operation abroad or invests in another company abroad – Foreign portfolio investment is investment funded by foreign sources that is operated domestically • Net capital outflow refers to the net flow of funds invested outside of a country © 2014 by McGraw-Hill Education Foreign investment • For many years, portfolio and direct investment flows were small • Portfolio investment dramatically increased during the tech bubble • The housing bubble resulted in a significant decrease in portfolio investment Net capital flows for the United States Trillions of dollars 1.6 Portfolio investment 1.2 Direct investment 0.8 0.4 1980 1984 1988 1992 1996 2000 2004 2008 -0.4 © 2014 by McGraw-Hill Education Balance of payments • A country can sustain large deficits by sending out more capital than it receives • The balance-of-payments identity shows that NX = NCO • The gap between savings and investment is equal to the trade balance • The U.S has higher investment than savings, since it has a negative trade balance Percent of GDP (%) 25 Investment Savings Trade balance 20 15 10 1980 -5 1985 1990 1995 2000 2005 2010 -10 © 2014 by McGraw-Hill Education 10 Active Learning: Balance of payments Use the balance-of-payments identity to fill in the missing values in the table below Imports (millions of $) Exports (millions of $) 5,000 10,000 1,000 4,000 Net exports (millions of $) Net capital outflow (millions of $) 5,000 750 3,000 7,000 -3,000 © 2014 by McGraw-Hill Education 11 International capital flows The flow of savings and investment can be analyzed using an open economy model of loanable funds Expanded market for loanable funds Interest rate Savings r* I + NCO • Demand is equal to domestic investment and net capital outflows • Savings consists of public and private savings • The equilibrium occurs at the intersection of S = I + NCO Q* Quantity of U.S dollars © 2014 by McGraw-Hill Education 12 How does foreign investment work? • The open economy model of loanable funds can examine the impact of foreign investment • A preview of the economic benefits are: – Increase the GDP of the host country by giving it access to additional resources – Increase the GDP of the investing country by providing it with ways to earn higher returns on its capital – Improve the global economy’s efficiency © 2014 by McGraw-Hill Education 13 How does foreign investment work? Suppose there is an increase in confidence by foreigners and domestic residents in the U.S economy • NCO decreases because: Interest rate Savings r1 r2 I + NCO1 I + NCO2 Q2 Q1 Quantity of U.S dollars – Foreigners want to invest in the U.S – U.S residents want to invest less abroad • The demand curve (I + NCO) curve shifts inward • At the new equilibrium: – The interest rate is lower – There is a lower quantity of loanable funds traded © 2014 by McGraw-Hill Education 14 How does foreign investment work? • Suppose a country increases its budget deficit – When a government continually spends more than it collects, it has to borrow to make up the difference Interest rate S2 S1 r2 r1 I + NCO • As borrowing increases, the supply curve shifts inward • At the new equilibrium: – The interest rate is higher – There is a lower quantity of loanable funds traded Q2 Q1 Quantity of U.S dollars © 2014 by McGraw-Hill Education 15 Can a country save too much? • It is possible for a country to save too much – Occurs in extremes conditions • Too much savings leads to a trade imbalance – Low interest rates encourage capital to flow abroad • High domestic savings can keep demand for local products low as people consume less © 2014 by McGraw-Hill Education 16 Exchange rates • The foreign exchange market is where foreign currencies are bought and sold • The exchange rate is the value of one currency expressed in terms of another currency – Exchange rates can be expressed in terms of either the domestic or foreign currency – The exchange rates between two nations’ currencies will be reciprocals of one another © 2014 by McGraw-Hill Education 17 Active Learning: Exchange rates • Suppose you travel to Mexico and exchange $100 USD at a Mexican bank for 1,250 Mexican pesos • Calculate the exchange rate for each country’s currency © 2014 by McGraw-Hill Education 18 Exchange rates • Exchange-rate appreciation is an increase in the value of a currency relative to the value of another currency • When the U.S currency appreciates, U.S residents can buy more foreign currency and foreigners can buy less U.S currency – Foreign goods are less expensive for U.S residents – U.S goods are more expensive for foreign residents • Net exports decreases, because foreigners are buying less domestic goods (imports) than domestic residents are selling to foreigners (exports) © 2014 by McGraw-Hill Education 19 Exchange rates • Exchange-rate depreciation is a decrease in the value of a currency relative to other currencies • When the U.S currency depreciates, U.S residents can buy fewer foreign currency and foreigners can buy more U.S currency – Foreign goods are more expensive for U.S residents – U.S goods are less expensive for foreign residents • Net exports increases, because foreigners are buying more domestic goods (imports) than domestic residents are selling to foreigners (exports) © 2014 by McGraw-Hill Education 20 Exchange rates There is a positive relationship between the U.S exchange rate and its trade deficit This effect operates on a lag Exchange rate index 160 U.S Real effective exchange rate index (2005 = 100) U.S Trade deficit (% of GDP) 150 % of U.S GDP 140 130 120 110 100 90 1975 21 1980 1985 1990 1995 2000 2005 22 • When the exchange rate increases, exports fall while imports rise – The trade deficit expands • When the exchange rate decreases, exports rise while imports fall – The trade deficit shrinks © 2014 by McGraw-Hill Education 21 9/25/2014 A model of the exchange‐rate market The foreign‐exchange market can be analyzed using a supply and demand model Foreign-exchange market • Factors affecting demand: Exchange rate Supply of dollars – Interest rates: domestic and foreign – Perceived riskiness of investing in another country • Factors affecting supply: XR* Demand for dollars Q* Quantity of dollars – Interest rates: domestic and foreign – Investors’ confidence in foreign economies. – Consumer preferences • Equilibrium exchange rate and quantity of dollars bought and sold is found at the intersection of supply and demand © 2014 by McGraw‐Hill Education 22 A model of the exchange‐rate market The equilibrium exchange rate in turn determines the level of net exports Exchange rate and net exports Exchange rate XR* Net exports Q* Quality of net exports • When the price of dollars is high, foreigners will buy fewer goods from the U.S., and Americans will buy more goods fromoverseas ã Asaresult,netexportsarelow ã Astheexchangeratedecreases, thequantityofnetexports decreases â2014byMcGrawHillEducation 23 Amodeloftheexchangeratemarket When U.S. suppliers of imports want to increase inventories, they must first exchange U.S. dollars for foreign currency to buy the import Foreign-exchange market Exchange rate and net exports Exchange rate (yen per dollar) Exchange rate (yen per dollar) S1 S2 XR1 XR2 XR1 XR2 Net exports D1 Net exports Q1 Q2 Quantity of dollars • • Thesupplyofdollarsincreases Theexchangeratedecreases â2014byMcGrawHillEducation Q* Quantity of net exports ã • Increase in imports causes net exports to decreases The exchange rate decreases 24 9/25/2014 A model of the exchange‐rate market Consider a situation where the U.S. Fed decides to tighten monetary policy by increasing the interest rate. Decrease in quantity demanded for net exports Foreign-exchange market Exchange rate Exchange rate S2 S1 XR XR2 XR XR1 D2 Net exports D1 Q2 Q1,2 Quantity of U.S dollars • • Q1 Quantity of net exports The supply and demand for dollars increases Theexchangerateincreases â2014byMcGrawHillEducation ã ã Netexportsdonotshift Anincreaseintheexchangeratecausesa decrease inthequantityofnetexports(a 25 movement) Exchange‐rate regimes • There are benefits to multiple countries using the same currency – Tourists do not have to go through the hassle of exchanging money. – Neighboring trade countries don’t have to worry about exchange‐rate fluctuations • There are also costs to such regimes – Countries give up the ability to conduct independent macroeconomic policy © 2014 by McGraw‐Hill Education 26 Fixed and floating rates Exchange rates can be categorized by whether they float or are fixed Fixed exchange rate Floating exchange rate Exchange rate (yen per dollar) Exchange rate (yen per dollar) S S XR* XR* Shortage of dollars Fixed exchange rate D D Q* Quantity • A floating exchange rate is determined by the market © 2014 by McGraw‐Hill Education QS QD Quantity • A fixed exchange rate is set by the government • This causes either a shortage or a 27 surplus Fixed and floating rates • Why would a government decide to fix its exchange rate? – It allows for more predictability and stability • It takes government intervention in the foreign-exchange market to maintain a fixed exchange rate – The government must either buy or sell foreign currency © 2014 by McGraw-Hill Education 28 Fixed and floating rates • Maintaining a fixed exchange rate has its challenges • Speculators can sell currency when it has a high value and buy it when it has cheapened, called a speculative attack • Exchange rate (baht per dollar) Amount of currency the government must buy initially to maintain an overvalued exchange rate S1 S2 • Fixed exchange rate When under speculative attack, the amount of currency the government must buy increases D Quantity • When a country suffers from a speculative attack, the supply of currency shifts to the right The government must buy its own currency using foreign reserves to maintain the fixed exchange rate If the government abandons the fixed rate regime, then the equilibrium exchange rate prevails © 2014 by McGraw-Hill Education 29 Macroeconomic policy and exchange rates • Monetary policy is more effective under a flexible exchange rate than a fixed rate – If the exchange rate is flexible, monetary policy can affect investment and net exports – If the exchange rate is fixed, monetary policy can only affect investment © 2014 by McGraw-Hill Education 30 10 Macroeconomic policy and exchange rates Consider a country with a fixed exchange rate entering a recession Exchange rate S1 S2 Fixed exchange rate XR1 ,3 XR2 D Q1,3 Q2 Quantity • The central bank expands the money supply to help the economy recover • The exchange rate falls • The government is forced to buy back the local currency • The exchange rate is restored • It is impossible to enact monetary policy and maintain a fixed exchange rate © 2014 by McGraw-Hill Education 31 Macroeconomic policy and exchange rates • Analysis of monetary policy and exchange rates leads to an explanation for the large trade deficit between China and the United States • During China’s great economic expansion, China maintained a fixed exchange rate – The Chinese government keeps the yuan’s value low by selling piles of yuan in the foreign-exchange market • If the Chinese yuan appreciated, Chinese exports would become more expensive and imports would become less expensive, and so the Chinese trade balance would fall © 2014 by McGraw-Hill Education 32 The real exchange rate • The nominal exchange rate is the stated rate at which one country’s currency can be traded for another country’s currency – Up to this point, only the nominal exchange rate has been analyzed • The real exchange rate is the value of goods in one country expressed in terms of the same goods in another country Real exchange rate = Nominal exchange rate ì â 2014 by McGraw-Hill Education Domestic price level Foreign price level 33 11 The real exchange rate • The real exchange rate accounts for prices in two different countries • This aids in better understanding international trade • The real exchange rate is another way of saying “the exchange rate adjusted for purchasing power parity.” — The same factors that influence PPP calculations impact real exchange rate calculations © 2014 by McGraw-Hill Education 34 Global financial crises • The international financial system works well most of the time, but occasionally it falls out of order • These crises can be labeled as one of two types: – Debt crises – Exchange-rate crises • The International Monetary Fund (IMF) is the institution responsible for keeping the global financial system together – Steps in as lender of last resort when countries run into trouble maintaining their currencies – Provides loans to help stabilize economies © 2014 by McGraw-Hill Education 35 Global financial crises: Debt crises • Investors worry about a country’s ability to repay when it takes on too much debt • When a government defaults, everyone who invested in the debt stands to lose The Argentine debt crisis Interest rate Savings2 Savings1 r3 r2 r1 I + NCO2 I + NCO1 Q1,3 Q2 Quantity of Argentine pesos © 2014 by McGraw-Hill Education • Investors in Argentina lost confidence in Argentina’s ability to repay debt in 2001 – Investors pulled their investments out of the country, causing higher interest rates • Higher interest rates caused government debt to increase, reducing public savings 36 12 Global financial crises: Exchange-rate crises • Investors can lose confidence in a government’s ability to defend an exchange rate • When a government devalues an exchange rate, everyone holding investments in that country suffers a loss • Historically, countries have abandoned fixed exchange rates for flexible ones when currency loses value © 2014 by McGraw-Hill Education 37 Summary • The balance of trade (net exports) is the value of exports minus the value of imports • Exchange rates influence net exports • The balance-of-payments-identity states that net exports equals net capital outflow • Net capital outflows are determined by the market for net capital outflow © 2014 by McGraw-Hill Education 38 Summary • The international market for loanable funds is influenced by confidence in an economy and government deficits • Exchange rates indicate the value of one currency in terms of another currency • Exchange rates can be expressed in terms of both the domestic and foreign currency • A country’s exchange rate is determined by demand and supply for domestic currency © 2014 by McGraw-Hill Education 39 13 Summary • A fixed exchange rate is set by the government, not the market • A floating exchange rate is determined by the market • Monetary policy cannot have any effect when there is a fixed exchange rate • Floating exchange rates allow monetary policy to influence the economy • The real exchange rate is the nominal exchange rate adjusted for price levels between countries © 2014 by McGraw-Hill Education 40 14 ... Savings Trade balance 20 15 10 1980 -5 1985 1990 1995 2000 2005 2010 -1 0 © 2014 by McGraw-Hill Education 10 Active Learning: Balance of payments Use the balance-of-payments identity to fill in the... 1996 2000 2004 2008 -0 .4 © 2014 by McGraw-Hill Education Balance of payments • A country can sustain large deficits by sending out more capital than it receives • The balance-of-payments identity... 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 -5 00 -1 ,000 -1 ,500 • Currently the trade deficit is approximately $600 billion © 2014 by McGraw-Hill Education International flows of goods and