Chapter 34: Open-Market Economics

11© 2014 by McGraw-Hill Education Chapter 34 Open-Market Economics 2© 2014 by McGraw-Hill Education • 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. What will you learn in this chapter? 3© 2014 by McGraw-Hill Education • 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. International flows of goods and capital 24© 2014 by McGraw-Hill Education For each of the following situations, indicate whether there is a trade deficit or surplus and calculate the balance of trade. Active Learning: Imports and exports Imports (millions of $) Exports (millions of $) Trade deficit or trade surplus? Balance of trade (millions of $) 15 10 37 47 75.5 110.5 54 27 5© 2014 by McGraw-Hill Education • Until 1975, U.S. trade was relatively balanced. • After 1975, imports grew faster than exports, causing a trade deficit. International flows of goods and capital Imports Exports Balance of trade (Exports _ imports) -1,500 -1,000 -500 0 500 1,000 1,500 2,000 2,500 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 Billions of dollars 1960 • Currently the trade deficit is approximately $600 billion. 6© 2014 by McGraw-Hill Education International flows of goods and capital 0 100 Canada China Mexico Japan Germany United Kingdom S.Korea Brazil France Taiwan Venezuela Singapore 200 300 400 500 600 700 Trade in billions of dollars Imports Exports 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. 37© 2014 by McGraw-Hill Education • 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. International flows of goods and capital 0 100 200 300 400 500 600 Consumer goods Capital goods Industrial supplies Automotive vehicles, etc. Foods, feeds, & beverages Other goods Trade in billions of dollars Imports Exports 8© 2014 by McGraw-Hill Education • 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. Foreign investment 9© 2014 by McGraw-Hill Education • 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. Foreign investment Portfolio investment Direct investment Trillions of dollars -0.4 0 0.4 0.8 1.2 1.6 1984 1988 1992 1996 2000 2004 20081980 Net capital flows for the United States 410© 2014 by McGraw-Hill Education • 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. Balance of payments Investment Savings Trade balance -10 -5 0 5 10 15 20 25 1985 1990 1995 2000 2005 2010 Percent of GDP (%) 1980 11© 2014 by McGraw-Hill Education Use the balance-of-payments identity to fill in the missing values in the table below. Active Learning: Balance of payments Imports (millions of $) Exports (millions of $) Net exports (millions of $) Net capital outflow (millions of $) 5,000 10,000 5,000 1,000 750 4,000 3,000 7,000 -3,000 12© 2014 by McGraw-Hill Education The flow of savings and investment can be analyzed using an open economy model of loanable funds. International capital flows Quantity of U.S. dollars r* Q* Interest rate I + NCO Savings Expanded market for loanable funds • 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. 513© 2014 by McGraw-Hill Education • 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. How does foreign investment work? 14© 2014 by McGraw-Hill Education Suppose there is an increase in confidence by foreigners and domestic residents in the U.S. economy. How does foreign investment work? 1 r Q I + NCO2 2 I + NCO1 r Q12 Interest rate Quantity of U.S. dollars Savings • NCO decreases because: – 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. 15© 2014 by McGraw-Hill Education • 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. How does foreign investment work? • 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. r S2 r2 Q2 Interest rate Quantity of U.S. dollars I + NCO S1 1 Q1 616© 2014 by McGraw-Hill Education • 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. Can a country save too much? 17© 2014 by McGraw-Hill Education • 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. Exchange rates 18© 2014 by McGraw-Hill Education • 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. Active Learning: Exchange rates 719© 2014 by McGraw-Hill Education • 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). Exchange rates 20© 2014 by McGraw-Hill Education • 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). Exchange rates 21© 2014 by McGraw-Hill Education There is a positive relationship between the U.S. exchange rate and its trade deficit. This effect operates on a lag. Exchange rates U.S. Real effective exchange rate index (2005 = 100) U.S. Trade deficit (% of GDP) 22 21 0 1 2 3 4 5 6 7 90 100 110 120 130 140 150 160 1975 1980 1985 1990 1995 2000 2005 Exchange rate index % of U.S. GDP • 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. 9/25/2014 1 22© 2014 by McGraw‐Hill Education The foreign‐exchange market can be analyzed using a  supply and demand model. A model of the exchange‐rate market • Factors affecting demand: – Interest rates: domestic and foreign. – Perceived riskiness of investing in  another country. • Factors affecting supply: – 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. Demand for dollars Supply of dollars XR* Q* Exchange rate Quantity of dollars Foreign-exchange market 23© 2014 by McGraw‐Hill Education The equilibrium exchange rate in turn determines the  level of net exports. A model of the exchange‐rate market Net exports Quality of net exports Exchange rate Exchange rate and net exports 0 XR* Q* • When the price of dollars is  high, foreigners will buy fewer  goods from the U.S., and  Americans will buy more goods  from overseas. • As a result, net exports are low. • As the exchange rate decreases,  the quantity of net exports  decreases. 24© 2014 by McGraw‐Hill Education When U.S. suppliers of imports want to increase inventories, they  must first exchange U.S. dollars for foreign currency to buy the  import. A model of the exchange‐rate market 1 XR2 S2 D1 S1 Q1 XR1 Q2 XR2 XR Quantity of net exports Exchange rate (yen per dollar) Net exports1 Q* Exchange rate and net exports 0 Exchange rate (yen per dollar) Quantity of dollars Foreign-exchange market • Increase in imports causes net  exports to decreases. • The exchange rate decreases. Net exports2 • The supply of dollars increases. • The exchange rate decreases. 9/25/2014 2 25© 2014 by McGraw‐Hill Education Consider a situation where the U.S. Fed decides to tighten  monetary policy by increasing the interest rate.  A model of the exchange‐rate market XR2 Q2 Exchange rate Net exports XR1 Q1 Quantity of net exports Decrease in quantity demanded for net exports 0 D2 S2 XR2 Exchange rate Quantity of U.S. dollars D1 S1 XR1 Q1,2 Foreign-exchange market • Net exports do not shift. • An increase in the exchange rate causes a  decrease in the quantity of net exports (a  movement). • The supply and demand for dollars increases. • The exchange rate increases. 26© 2014 by McGraw‐Hill Education • 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. Exchange‐rate regimes 27© 2014 by McGraw‐Hill Education Exchange rates can be categorized by whether they float or are  fixed. Fixed and floating rates D S Q* XR* S D XR* Fixed exchange rate Q S Q D Exchange rate (yen per dollar) Quantity Floating exchange rate Quantity Exchange rate (yen per dollar) Fixed exchange rate Shortage of dollars • A fixed exchange rate is set by the  government. • This causes either a shortage or a  surplus. • A floating exchange rate is  determined by the market. 10 28© 2014 by McGraw-Hill Education • 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. Fixed and floating rates 29© 2014 by McGraw-Hill Education • 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. Fixed and floating rates Fixed exchange rate Amount of currency the government must buy initially to maintain an overvalued exchange rate. S2 When under speculative attack, the amount of currency the government must buy increases. D Exchange rate (baht per dollar) Quantity S1 • 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. 30© 2014 by McGraw-Hill Education • 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. Macroeconomic policy and exchange rates 11 31© 2014 by McGraw-Hill Education Consider a country with a fixed exchange rate entering a recession. Macroeconomic policy and exchange rates Fixed exchange rate 1 S2 XR2 Q2 S1 D Q Exchange rate Quantity XR • 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. ,3 ,3 1 32© 2014 by McGraw-Hill Education • 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. Macroeconomic policy and exchange rates 33© 2014 by McGraw-Hill Education • 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 × Domestic price levelForeign price level The real exchange rate 12 34© 2014 by McGraw-Hill Education • 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. The real exchange rate 35© 2014 by McGraw-Hill Education • 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. Global financial crises 36© 2014 by McGraw-Hill Education • 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. Global financial crises: Debt crises r1 2 Q1 Interest rate Quantity of Argentine pesos Savings1 I + NCO1 The Argentine debt crisis • 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. Savings2 r3 ,3 I + NCO2 Q2 r 13 37© 2014 by McGraw-Hill Education • 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. Global financial crises: Exchange-rate crises 38© 2014 by McGraw-Hill Education • 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. Summary 39© 2014 by McGraw-Hill Education • 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. Summary 14 40© 2014 by McGraw-Hill Education • 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. Summary