Chapter 36

1. Chapter 36 Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE

2. Macroeconomy • Open economy • Trades with other nations • Goods and services • Financial assets • Model – large open economy • Substantial capital flows • Floating exchange rate

3. International Trade, Exchange Rates, AD • Increase in net exports (X-IM) • Increase X; decrease IM • Multiplier effect on economy • Aggregate demand – shifts outward-right • Increase real GDP • Increase price level • Determinants of net exports • Foreign incomes • Relative prices of foreign & domestic goods

4. Figure 1 The effects of higher net exports D0 D1 S B Price Level A D0 D1 S Real GDP

5. International Trade, Exchange Rates, AD • Relative prices of a country’s exports • Fall • Net exports – increase • Real GDP – increase • Rise • Net exports – decrease • Real GDP – decrease

6. International Trade, Exchange Rates, AD • Price of foreign products • Rise • Net exports – increase • Real GDP – increase • Fall • Net exports – decrease • Real GDP – decrease • Currency appreciations or depreciations • Change international relative prices

7. International Trade, Exchange Rates, AD • Currency depreciation • Raise net exports • Increase aggregate demand • Currency appreciation • Reduce net exports • Decrease aggregate demand

8. Table 1 Exchange rates and home currency prices

9. Figure 2 D1 Effects of exchange rate changes on aggregate demand D0 D2 S (depreciation) (appreciation) E2 E1 Price Level E0 D1 D2 D0 S Real GDP

10. International Trade, Exchange Rates, AD • Late 1990s & early 2000s • U.S. trade deficit – grew enormously • 1995 – dollar appreciation • Boost U.S. imports (40% growth) • Damage U.S. exports (7% growth) • 1997: $105 billion real net export deficit • 2002: $471 billion deficit

11. Aggregate Supply in an Open Economy • Depreciation of U.S. dollar • Prices of imported inputs – rise • U.S. aggregate supply curve • Shifts inward • Prices of domestic goods & services • Increase • Additional inflationary effects • On consumer prices

12. Aggregate Supply in an Open Economy • Appreciation of U.S. dollar • Imported inputs – cheaper • U.S. aggregate supply curve • Shifts outward • Prices of domestic goods • Decrease

13. (depreciation) Figure 3 Effects of exchange rate changes on aggregate supply D S0 S2 S1 (appreciation) E1 Price Level E0 E2 D S0 S2 S1 Real GDP

14. Macroeconomic Effects of Exchange Rates • Dollar depreciation • Aggregate demand – shift outward • Aggregate supply – shift inward • U.S. price level – increase • GDP – rise or fall • Shifts in demand – larger • GDP – rises • Currency depreciation • Inflationary • Probably expansionary

15. Figure 4 D1 The effects of a currency depreciation D0 S0 S1 A Price Level E D1 D0 S0 S1 Real GDP

16. Macroeconomic Effects of Exchange Rates • Dollar appreciation • Aggregate demand – shift inward • Aggregate supply – shift outward • U.S. price level – falls • GDP – rise or fall • Shifts in demand – larger • GDP – falls • Currency appreciation • Disinflationary • Probably contractionary

17. Figure 5 D2 The effects of a currency appreciation D0 S0 S2 E Price Level B D2 D0 S0 S2 Real GDP

18. Macroeconomic Effects of Exchange Rates • International capital flows • Purchases & sales of financial assets • Across national borders • Rise in interest rates • Contract the economy • International capital inflows • Currency – appreciates • Net exports – decrease

19. Macroeconomic Effects of Exchange Rates • Drop in interest rates • Expand the economy • International capital outflows • Currency – depreciates • Net exports – increase

20. Fiscal & Monetary Policies - Open Economy • Fiscal expansion - Closed economy • Aggregate demand – increase • Closed economy • Does not trade with other nations • Goods • Assets

21. Fiscal & Monetary Policies - Open Economy • Fiscal expansion - Open economy • Interest rates – increase • Exchange rate – appreciate • Attract foreign capital • Capital account surplus – increase • Net exports – decrease • Current account deficit – increase Capital account surplus + Current account deficit = 0

22. Fiscal & Monetary Policies - Open Economy • Fiscal expansion - Open economy • Aggregate demand – outward shift • Aggregate supply – outward shift • Aggregate demand – inward shift • Fiscal multiplier – reduced

23. Figure 6 D1 D2 A fiscal expansion in an open economy D0 S0 S2 B A Price Level C D2 D1 D0 S0 S2 Real GDP

24. Table 2 Percentage shares of real GDP in U.S.; 1981 & 1986

25. Fiscal & Monetary Policies - Open Economy • Contractionary monetary policy • Decrease aggregate demand • Interest rates – increase • Exchange rates – appreciate • Capital inflow • Strengthen monetary policy • Aggregate supply – outward shift

26. Figure 7 D1 D2 A monetary contraction in an open economy D0 S0 S2 B A Price Level C D2 D1 D0 S0 S2 Real GDP

27. International Aspects: Deficit Reduction • Policy mix • Fiscal contraction & Monetary expansion • Reduce interest rates strongly • Push down the value of the dollar • Strongly stimulate our foreign trade • Net effects on output and inflation • Uncertain

28. Table 3 Expected effects of policy

29. International Aspects: Deficit Reduction • Trade deficit • Excess of imports over exports • Trade surplus • Excess of exports over imports • Accounting relationship • X – IM = (S – I) – (G – T) • Trade deficit – can arise • Government budget deficit G > T • Excess investment over saving I > S

30. Should we Worry about the Trade Deficit? • U.S. trade deficits • The nation • Consumes more then it produces • Mirror image: required capital inflows • Economic weakness • Mortgage our futures • To finance higher consumer spending • Economic strength • Foreigners – eager to lend capital

31. On Curing the Trade Deficit • X-IM = (S-I) – (G-T) • Reduce trade deficit • Decrease budget deficit G-T • Tightening fiscal policy • Loosening monetary policy • More rapid economic growth abroad • Raise domestic saving • Reduce domestic investment • Protectionism