Chapter 17 Notes

Chapter 17 Notes - There are two types of economies a Open...

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Unformatted text preview: There are two types of economies: a Open economies interact by trading goods and services and by making Investments in each other’s economies. UX % O o A closed economy has no interactions in trade or finance with other countries. tinged? 0 The balance of payments is‘ a record of e country‘strade with other countries in goods, services, and asSets. a The befance of payments contains three accounts: the current account, the financial account, and the capital account. exportgwamwt‘tfi ‘mcome {EC-ENEd -' it‘iCOW'EE. Witt _. - l a The current account recordsa country’s net exports, net investment income, and net transfers. a The balance of trade is the difference between the vaiue of the goods a country exports and the value of the goods a country imports. Net exports equal the. sum of the balance of trade and the balance of services. nor {Xportc comes-me boos gorse; wt ere—more -. % gwflwm m . eflmfimiw K! / The financial account records purchases of assets a country has made abroad and foreign purchases of assets in the country. There is a capital outflow from the United States when an investor in the United States buys a bond issued by a foreign company or government or when a US. firm builds a factory in another country‘ There is a capital inflow into the United States when a foreign investor buys a bond issued by a US. firm or by the government or when a foreign firm builds a factory in the United States. When firms buiicl or buy facilities in foreign countries, they are engaging in foreign direct investment. _ When investors buy stock or bonds issued in another country, they are engaging in foreign portfolio investment. '- Net capitoiflOWS is the difference between capitai inflows and capital outflows. Net foreign investment is the difference between capital outflows from a country and capitai inflows also equal to net foreign direct investment plus net foreign portfolio investment. The capital account records‘relatively minor transactions, such as migrants’ transfers and sales and purchases of nonproduced, nonfinancial assets. The sum of the current account balance, financial account balance, and the capitai account balance equals the balance of payments- The balance of nayments is always zero. J ': :-‘ w ._ a“! 'e «nu ‘ a i g ”5M" ",_- flag E w?" 5’" WIDE iii 4 ' g E W . a ‘ f” g , if! ‘ n _ ‘ a _ '2 r_- 3‘: ,_ ) L.u 1 5 ‘ 1' e 1 = __ __‘ w E ‘” n: 33 m, a»; - . H h i .. __ i \W/ Emmi-$53; awn , ._......«._..; .1 5 w; 5, E a...» _ g: 459 mi}? givmgmvfi m g; MM 06% w’xliflgkif mafia a}? fiéaxéé‘fiififi QM V“ f% J g :3)“ 3 ”3‘ M _ ‘ “a ‘u i P \ fl fiflwmfi a; 5““ h a: - LUWEW Whigs? jrafim‘im J l a.» ‘ 3"} fl g \3) I “‘” 3L "‘2“ i“? is"? ~— ~'””“"’"W'M r E Qfifigr fixtwwé 0 To make the baiance on the current account equai the baiance on the financial account, the balance of payments inciudes an entry called the statistical discrepancy. - if the balance on the capital account was included, the statistical discrepancy takes on a value equal to the difference between the current account balance and the sum ofthe balance on the financial account and the balance on the capital account. o if it does not equal zero, a measurement error must have occurred. Some imports or exports of goods and services or some capital inflows or capitai outflows must not have been measured accurately. - Changes in foreign holdings of dollars are known as ofiicioi reserve transactions. ’i‘he foreign Exchange Market and Exchange Rates 0 The nominal exchange rate is the value of one country’s currency in terms of another country’s currency. 0 Economists also calculate the real exchange rate, which corrects the nominai exchange rate for changes in prices of goods and services. c There are three sources of foreign currency demand for the US. dollar: 1. Foreign firms and consumers who want to buy goods and services produced in the U.S. 2. Foreign firms and consumers who want to invest in the U.S. either through foreign direct investment—buying or building factories or other facilities in the U.S.———or through foreign portfolio investmentmbuying stocks and bonds issued in the US. 3. Currency traders who believe that the value of the dollar in the future will be greater than its value today. \N WW5 Cafi: 1:15:23: 5., mum”; {53,}, ’ -52r‘age CFC 4133? {Wu I‘gg‘fgwfsg \‘39 6 0 {Jr ’6 O 454. H #3 ”\a ‘ I r - A: \ T ’- i337 5‘3 fifflbtf» 3:3“? 33"” if?“ ; s ‘ w...» 5 ; 3,» 1930 3/53 ha: 3% dfi afigarflg CH” fiagk’émff‘ffgw? i 3‘ i “9333 bugs; 520 5' _ $1; bUL% We?” a: ‘ V ‘ J 5 1-: (105 jegrec; ma: ‘ APPW 3‘33 1“ 3G“ 3333 33' ’QOV‘KQV“ QOOCL§ CW5, fiai Ox’r'sve‘: L) (in: 5-3pm” =9 buxj V'Y-Qféfi 33).": 53.15;?“ 399‘ {F‘E $2335 {3}“ {gaming} - A350 dow‘fiéfrtc “051%.; 0%»? 35-33233“? ’3 mom EKDm‘ {3+0 If . ““5 4N4 {axDQr-‘r ) ' 3 l 2:} 3.5] “ ' 3 3,, _ .5 . . . ,95 4...; .ammtrwg-a 1-,; .9. 1,. . ,5 4 ;_ ; _ R: X 3 EL:,‘}'M.4 33.15:! 93(355; "q“ 1 {‘3QYAE, 333113;???“ ,1 L: a . -‘.—r5 inmafig e, = 3OOY/gg (”(330333 - 3 S '33 335%wa (30.51:; c303; “ Q0953 W3 mfi‘xm Q; - r} ,_ 5 ' ' I H: :3: - , a . _ Pg“: M Ta :52 a 335:}? if; “MM“: 51:? J” ,5 ,5} 9““ “‘~‘“r”-.;:‘-;V“§; $.51“: 3'1 5 ‘1’ L), 3—33 I] 3 .. If {302-}: ' f f“ I «3" "0 $35136? 3‘9“" 3‘ 30-5.} .5; “3‘13"“. JES?’”J1€€2-M 6.53533‘éau5‘mgr—g F‘P‘éfléfiu 1% mp5 Wore: {30533.1 QVPOIFR 30.933“ ”MW . fl ‘ A {if} MAE} :j 33 N3 3333 3‘3 33 4 31 3W5 ‘50?” +55% {5‘31 SOPQ‘fanE SKA/fin Hi. :15 ”333.4153 E3333; ‘2’: 31; 10V Amfiwci‘ f w—v“- A. Egatiihrium in the Market for ¥ereiga Exchange 0 The demand curve for doilars in exchange for yen has downward slope while the supply curve has upward slope. o The foreign exchange market is in equilibrium at the exchange rate where the quantity supplied equals the quantity demanded. 0 Currency appreciation occurs when the market value of a country’s currency increases relative to the value of another country's currency. 0 Currency depreciation occurs when the market value of a country’s currency decreases relative to the value of another country’s currency. 3. Raw Bo Shifts in Semand and Sepyiy Affect the Exchange Rate? - Speculators are currency traders who buy and sell foreign exchange in an attempt to profit by changes in exchange rates. 0 Shifts in the demand and suppiy curves cause the equilibrium exchange rate to change. 0 Three main factors cause the demand and supply curves in the foreign exchange market to shift: 1. Changes in the demand for U.S.—produced goods and services and changes in the demand for foreign—produced goods and services. 2. Changes in the desire to invest in the U.S. 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. “a #- DDr‘nEQ-hc Pam-fig (ELK-emf: {.0} 52) saw/153k Cgcz’l‘igflfié baiiavé US ”Mama avg ‘37:}; “"*:C - : W L: ' ‘. -- 1- “if 1"?‘1‘1'dfif'as “u 2’?“ if; The demand curve for dollars shifts to the right when incomes in a foreign country rise, when interest rates in the US. rise, or when speculators decide that the vaiue of the dollar will rise relative to the value ofthe foreign currenCy. The factors affecting the supply curve for dollars are simiiar to those affecting the demand curve for dollars. A recession in the US. wiii decrease the demand for a foreign country’s products and cause the supply curve for dollars to shift to the left. A decrease in interest rates in a foreign country will make financial investments in that foreign country less attractive and cause the supply curve of dollars to shift to the ieft. The exchange rate depends on the direction and size of the shifts in the demand curve and supply curve. An increase (decrease) in the supply (demand) of doiiars wiil decrease (increase) the equilibrium exchange rate. Some Exchange Rates Are Not Betet‘mined 'ioy the Market Some exchange rates are not determined by the market. They have fixed exchange’rotes that do not change over long periods. For example, for more than 10 years, the value of the Chinese yuan was fixed against the US. dollar at a rate of 8.28 yuan to the dollar. A country’s central bank has to intervene in the foreign exchange market to buy and seii its currency to keep the exchange rate fixed. How Movements in the Exchange Rate Affect Experts and imports Movements in the exchange rate affect exports and imports by depreciation and appreciation of currency. The depreciation in the domestic currency will increase exports and decrease imports, thereby increasing net exports. 1 {‘37: g: .3 3‘ , 7:22 5:33:53 $333133,“ £51313 ‘xflfififi .33 OFormcm WU? 3* 03333 353263553514326 33‘: m D 522‘} daweéflc‘. i331: 333+ 3:2 333; i“ 232 {Urura 3:02:23 <23. 5:2 «Wj @333 0-4333 3:23 'J ,1 1)”? m 335$ng :33:- :3 23,. ' :> ‘3‘ m D To"! 2322523235222 (Sp-3‘65“? 53:3 "13: “”5534: 3-3“ a *5; 2}“ 1 3 .-' 5 V: k ' )— Illa ‘. £19556} mK‘ I632! ' M 520.5 4132;223:322 332:3 33$ fifty: \:33re, 312’ 4,. 931591252} 335233 $55 3 "M’F‘thdr C"iv --‘:‘: 91:53 55"1-33 =‘ 3 5 3M 53"“ m ' 52393)"; 33242.3?) a The appreciation in the domestic currency wiil decrease exports and increase imports, which wiii reduce net exports, aggregate demand, and reai GDP. a The relative prices oftwo countries” goods are determined by two factors: 1. The relative price levels in the two countries 2. The nominal exchange rate between the two countries’ currencies a Economists combine these two factors in the real exchange rate. a The real exchange rate is the price of domestic goods in terms of foreign goods. Reai exchange rates are reported as index numbers with one year chosen as the base year. a We can caiculate the real exchange rate between two currencies as: Domestic price level) Reai exchange rate = Nominal exchange rate x _ _ Foreign pnce levei ' 1763-9.” r ff)" a“; j r a} ‘31 n . [ \alosueli . £11.... Pom 55w Ii 3 .1 “EM 0 4 ‘fl39'ii.€ lfl Of}; +0 "the international Sector and Nationat Saving and investment At etet Exnorts Betta} Net Foreign investment 0 For any country, a current account deficit must be exactly offset by a financial account surplus. - When a country sells more assets to foreigners than it buys from foreigners, or borrows more from foreigners than it lends to foreigners, the country experiences a net capital inflow and a financial account surplus. - When imports are greater than exports, net exports are negative and there will be net capital inflow as people in the U.S. sell assets and borrow to pay for the surplus of imports over exports. - Therefore, net capital flows will be equal to net exports (but with the opposite sign), and net foreign investment will also be equal to net exports (and with the same Sign). In summary, the following equations must be always true: Current account balance + Financial account balance 2 0 or Current account balance = ~ Financial account balance or Net exports = — Net foreign investment. 0:: co "‘ pi 1"” ‘t iiifi’fiéfiafifi Lcepi val emote» c E. Bemestfic Saving, Domestic investment, and Net saggy; §nvestmem o The total saving in any economy is equal to saving by'the private sector plus saving by the government sector, which is called public saving (difference between government spending and taxes). I When the government runs a budget surplus by spending less than it receives in taxes, it is saving. a When the government runs a budget deficit, public saving is negative, which is also known as dissaving. - Nationai saving is equal to private saving plus public saving. Private saving is equal to what households have left of their income after spending on consumption goods and paying taxes. 0 Public saving is equal to the difference between government spending and taxes. 0 The saving and investment equation shows that the national saving is equal to domestic investment plus net foreign investment: National saving = Domestic investment + Net foreign investment Or, S=I+NFI o This equation is an identity because it must always be true. 0 The saving and investment equation telis us that a country’s saving will be invested either domestically or overseas. If net foreign investment is negative,domestic investment: must be greater than national saving. the fittest of a Government Budget Beficit on investment 0 When the government runs a budget deficit, national saving will decline unless private saving increases by the amount ofthe budget deficit, which is unlikely. - If the federal government runs a budget deficit, the U.S. Treasury must raise an amount equal to the deficit by selling bonds. 0 In order to attract investors, the U.S. Treasury may have to raise the interest rates on its bonds. 0 As interest rates on Treasury bonds rise, other interest rates, including those on corporate bonds and bank loans, will aiso rise. Higher interest rates on financial assets in the United States will attract foreign investors, causing a greater demand for dollars. As the value of the dollar rises, exports from the United States wili fall, and imports to the United States wiii rise, causing net exports and net foreign investment to fall. Menatary i3eiicy and Fiscai Pniicy in an Gpen Ecenemy ”a more exit"? 53%.; we E i {Stag Economists refer to the ways in which monetary and fiscal policy affect the domestic economy as policy channels. An open economy has more policy channels than does a closed economy. Manetary i’niicy in an Open Econemy When the Federal Reserve engages in an expansionary monetary policy, it buys Treasury securities to lower interest rates and stimulate aggregate demand. In an open economy, lower interest rates will also affect the exchange rate between the doliar and foreign currencies. Lower interest rates will cause some investors in the United States and abroad to switch from investing in US. financial assets to investing in foreign financial assets. This wiii cause the dollar to depreciate and net exports to increase. This additional policy channei will increase the abiiity of an expansionary monetary policy to affect aggregate demand. Monetary policy has a greater impact on aggregate demand in an open economy than in a closed economy. 3. Fiscal 9niicy in an Span Ecenemy a When the federal government engages in an expansionary fiscal policy, it increases its purchases or cuts taxes. 0 Increases in government purchases directly increase aggregate demand. 0 Tax cuts increase aggregate demand by increasing household disposable income and business income, which results in increased consumption spending and investment spending. 0 An expansionary fiscal policy may result in higher interest rates. In an open economy, higher interest rates will aiso lead to an increase in the foreign exchange value of the dollar and a decrease in net exports. 0 Therefore, in an open economy, an expansionary fiscal policy may be less effective because the crowding out effect may be larger. 0 In an open economy, net exports may also be crowded out. Fiscal policy has a smaller impact on aggregate demand in an open economy than in a closed economy. Extra Snivad fiablem 29—5 Monetary and Fiscai i3niicy in a Recessian Assume that the United States, an open economy, has slipped into a recession. Policymakers consider two different strategies for increasing aggregate demand. First, the Federai Reserve can use open market operations to lower the federal funds rate by 1/2 point (50 basis points). Second, Congress and the president can pass iegislation to cut income taxes. a. if the United States were a closed economy, would the Federal Reserve have to lower the federal funds rate by more or less than 50 basis points in order to have the same impact on aggregate demand as in an open economy? Expiain your answer. b. In an open economy, as national income or GDP increases, so will spending on imports. Let’s define the marginal propensity to import (WI) as the increase in imports divided by the increase in GDP. Assume two different values for the MP] for the United States: MP] = 0.10 and MP1r = 020. For which value of the M’PI would an income tax out have a greater impact on aggregate demand? Explain your answer. SOLVING THE PROBLEM: Step 1 : Step 2: Step 3: Review the chapter material. This problem concerns the impact of fiscal policy and monetary policy, so you may want to review the section “Monetary Policy and Fiscal Policy in an Open Economy,” which begins on page 1024 in the textbook. Answer question (a) by explaining whether, it the United States had a closed economy, the Federal Reserve would have to lower the federal funds rate by more or less than 50 basis points in order to have the some impact on aggregate demand as in an open economy. Because the United States has an open economy, open market operations that reduce the federal funds rate will cause some investors to switch from investing in US. financial assets to foreign assets that have higher yields. As investors sell dollars to buy foreign currencies, the value of the dollar will fall relative to other currencies. The depreciation of the dollar will eventually cause U.S. exports to rise. If the United States had a closed economy, lowering the federal funds rate would have no effect on the exchange rate or exports. Therefore, the Federal Reserve would have to lower the federal funds rate by more than 50 basis points to have the same impact on aggregate demand. Answer question (b) by explaining for which value of the MPI an income tax cut would have the greater impact on aggregate demand. The multiplier effect of a given change in taxes or government spending would be greater in a closed economy than in an open economy. The MP] in a closed economy would equal zero because there would be no increase in imports as GDP increases. In an open economy, the larger the value of the WI, the larger the increase in imports as GDP increases, and, therefore, the larger the decline in net exports and aggregate demand. We can conclude that a given size tax cut will have a larger impact on aggregate demand when the MP1 equals 0.10 than when the MP1r equals 0.20, because with the smaller MPI there will be a smaller decrease in net exports. ...
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