International Political Economy

1. International Political Economy

2. Lesson 3 Section 3.1 Open Economies and its mechanisms roberto.fini@univr.it

3. An Economy hastwobasickinds of economicinteractions with the rest of the world: • Buying and/or Selling • Goods (e.g. lumber, automobiles, etc.) • Services (e.g. transportation, tourism, etc.) • Assets, mainlyfinancialassets(e.g. interest and dividendpayments) roberto.fini@univr.it

4. Export (Goods, Services, Financial Activities) Domestic Currency (α) Rest of the World A Foreign Currency (β) Import (Goods, Services, Financial Activities) roberto.fini@univr.it

5. Eachinternationalactvitiesgives rise to a situation in whicheitherforeignerswishobtainourcurrency or wewishobtainforeigncurrency • The formerisviewedas a demand for ourcurrency on the foreignexchange market, and the latterisviewedas a supply of ourcurrency on this market roberto.fini@univr.it

6. Domestic Currency Supply Domestic Currency Demand Rest of the World A Foreign Currency Demand Foreign Currency Supply roberto.fini@univr.it

7. Domestic Currency Supply Foreign Currency Supply Country Rest of the World Foreign Currency Demand Domestic Currency Demand roberto.fini@univr.it

8. € Supply $ Supply Italy € USA $ $ Demand € Demand roberto.fini@univr.it

9. Exchange rate (€) $ Supply $ Demand E1► QD1>QS1 E2 ► QD2<QS2 E2 E1 D and S Foreign Currency ($) QD2 QS1 QD1 QS2 roberto.fini@univr.it

10. Exchange rate (€) $ Supply $ Demand E1► QD1>QS1 E2 ► QD2<QS2 E2 E1 D and S Foreign Currency ($) QD2 QS1 QD1 QS2 roberto.fini@univr.it

11. Exchange rate (€) $ Supply $ Demand E* ► QD = QS E* D and S Foreign Currency ($) Q* roberto.fini@univr.it

12. USA good more expensive Price 1$ = 2€ Import decrease Exchange Rate increase (e.g. 1$ = 2€) Export increase Italy good less expensive Price 1€ = 0,5$ Equilibrium Exchange Rate (e.g. 1$ = 1€) USA good less expansive Price 1$ = 0,5€ Import increase Exchange Rate decrease (e.g. 1$ = 0,5€) Italy good more expensive Price 1€ = 2$ Export decrease roberto.fini@univr.it

13. Lesson 3 Section 3.2 Whatis The balance of payments? roberto.fini@univr.it

14. The balance of paymentsis the differencebetween the sum of alldemands for and the supplies of domesticcurrency on the foreignexchange market • If the totalnumber of domesticcurrencysuppliedisequal to the totalnumber of domesticcurrencydemanded, the resultis a zero balance of payments • In this case the internationalsector of the economy is in equilibrium roberto.fini@univr.it

15. A balance of payments deficit is the situation where the supply of domestic currency exceeds its demand • A balance of payments surplus occurs when the demand of domestic currency on the foreign exchange market exceeds the supply roberto.fini@univr.it

16. Domestic Currency Supply = Domestic Currency Demand ▼ Balance • Domestic Currency Supply > Domestic Currency Demand ▼ Imbalance (deficit) Domestic Currency Supply < Domestic Currency Demand ▼ Imbalance (surplus) roberto.fini@univr.it

17. Lesson 3 Section 3.3 Determinants of foreignexchange market activity roberto.fini@univr.it

18. Several variables affect supply and demand activity in this market: • Exchange rate • Income • Interest rate • Price level • Expectations roberto.fini@univr.it

19. Exchange rate • The price of domestic currency in terms of foreign currency is determined in the foreign exchange market • The exchange rate is a very important determinant of international trade; in fact: • If exchange rate of domestic currency increase, imports is cheaper, so imports increase; • Thus, increasing the supply of domestic currency on the foreign exchange market • Similarly, exports are more expensive to foreigners, so exports fall; • Thus, the decreasing the demand of domestic currency • This way the rise in the exchange rate eliminates the balance of payments surplus • The opposite occurs in case of a balance of payments deficit: • The exchange rate falls to eliminate the deficit roberto.fini@univr.it

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21. Income • At a higher level of income, imports increase • The supply of domestic currency on the foreign market increases, creating a balance of payments deficit and downward pressure on exchange rate roberto.fini@univr.it

22. Two caveats concerning capital inflows are important: 1. the resul depends on the interest rate increase not being part of a worldwide pattern 2. the relevant difference in interest rates is the difference in real interest rates, and not nominal interest rates, because investors are concerned with real returns • Interest rate • When domestic interes rate is higher, foreigners are more interested in buying financial assets • So, increase the demand of domestic currency on the foreign exchange market • This demand creates • capital inflows, • a balance of payments surplus, • And upward pressure on the exchange rate roberto.fini@univr.it

23. Price level • A rise of domestic prices level increase the price of exports and the price of import-competing goods and services • So, exports fall and imports rise • As the result the demand for domestic currency decreases, and the supply of domestic currency increases creating • a balance of payments deficit, and • Downward pressure on the exchange rate • Again in this case, the effect occur only if there is no equivalent price increase in the rest of the world roberto.fini@univr.it

24. Expectations • If foreigners expets the value of domestic currency to rise, they can reap a capital gain by buying our bonds and the selling them again after the exchange rate has risen • This speculation creates • An inflow of capital, • A balance of payments surplus, • and upward pressure on the exchange rate • Speculative activity is indeed the primary determinant of exchange rates in the short run roberto.fini@univr.it

25. Lesson 3 Section 3.4 The internationaleconomic accounts roberto.fini@univr.it

26. Knowledge of the balance of payments is all that is needed for analysis of the economic forces that automatically are set in motion whenever there is a disequilibrium in the international sector of the economy • Often, however, analysts are interested in the source of any disequilibrium in the international sector, that is, the relative contributions to an equilibrium position of the various components of the demand for and supply of domestic currency on the foreign exchange market • Consequently, the balance of payments is broken down into several subsidiary measures, which together are referred to as the international accounts or the balance of payments accounts. roberto.fini@univr.it

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28. At the most general level, the balance of payments is broken into two accounts, the current and capital accounts • The current account measures the difference between the demand for and the supply of domestic currency arising from transactions that affect the current level of income here and abroad • The capital account measures the difference between the demand for and the supply of domestic currency arising from sales or purchases of assets to or from foreigners. • The capital account measures capital flows between a country and the rest of the world. A capital account surplus measures a net capital inflow, and a capital account deficit measures a net capital outflow. roberto.fini@univr.it

29. The trade balance is the sum of following: • Merchandisetrade balance • Differencebetweenexports and imports of goods • Services trade balance • Differencebetweenexports and imports of services • Net investmentincome from abroad • Interest and dividendinterest • Net transfer from abroad • Pensionpayments, foreignaid, etc. roberto.fini@univr.it

30. Lesson 3 Section 3.5 The twin deficits roberto.fini@univr.it

31. An interesting aspect of the balance of payments accounts is that it is quite possible to have an economy in international equilibrium while simultaneously its subsidiary accounts are unbalanced, as long as they offset each other • The U.S. economy, for example, for several years had a current account deficit that was offset by a surplus in its capital account. roberto.fini@univr.it

32. How might this situation come about? • A prominent explanation is that it is a side effect of large government budget deficits—hence termed the twin deficit problem. • A large government deficit increases the interest rate as the government sells bonds to finance its deficit. • This rise in the interest rate makes domestic bonds look very attractive to overseas investors, so capital flows into the country, creating a balance of payments surplus. • This bids up the value of the dollar, which in turn decreases exports and increases imports, creating a balance of trade deficit. roberto.fini@univr.it

33. How budget deficits cause trade deficits • G increase and/or T decrease • This causes • Budget deficit • Government sells bonds • Interest rate increase • Capital inflows increase • Exchange rate increase • Exports decrease and imports increase • Balance of trade deficit roberto.fini@univr.it

34. Twin deficit USA