Understanding GDP and Balance of Payments Accounts

1. Do Now. • Explain GDP and what it is used for • Define the following: • Balance of payment accounts • Current account • Financial account (capital account)

2. AP Macroeconomics MR. Graham Unit Eight The Open Economy: International Trade and Finance

3. Module 41: Capital Flows and the Balance of Payments 3

4. We learned that economists keep track of the domestic economy using the national income and product accounts (i.e. GDP) Economists keep track of international transactions using a different but related set of numbers—the balance of payment accounts Capital Flows and the Balance of Payments

5. A country’s balance of payment accounts are a summary of the country’s transactions with other countries. Current Account Represents the purchases and sales of goods and services with other countries (i.e. net exports) Also includes factor income and international transfers Financial Account Represents the purchases and sales of assets with other countries Balance of Payment Accounts

6. Current Account • Sales and Purchases of Goods and Services • U.S. wheat exports or U.S. oil imports, for example. • Factor Income: Payments for the use of factors of production owned by residents of other countries. • The profits earned by Disneyland Paris or the profits earned by U.S. operations of Japanese auto companies, for example. • International Transfers: Funds sent by residents of one country to those of another (i.e. foreign aid, gifts). • Remittances that immigrants (i.e. millions of Mexican-born workers employed in U.S.) send to their families, for example.

7. Balance of Payment Accounts $167 billion error isn’t bad when measuring inflows and outflows of $3.5 trillion.

8. Financial Account • Sales and purchases of assets between governments or government agencies, mainly central banks • In 2008, for example, most of the U.S. sales in this category involved the accumulation of foreign exchange reserves by the central banks of China and oil-exporting countries. • Private sales and purchases of assets. • The 2008 purchase of Budweiser by the Belgian corporation InBev or the purchase of European stocks by U.S. investors, for example

9. Balance of Payment Accounts

10. Current account (CA)  Financial account (FA)  0 Balance of Payment Accounts • Any nation experiencing a current account deficit must also be running a financial account surplus. • In Table 41.2, the U.S. current account deficit and financial account surplus almost offset each other—the $167 billion difference was just a statistical error, reflecting the imperfection of official data. • In fact, there is a basic rule of BOP accounting:

11. To explain the equation, we again use a circular-flow model to explain the flow of money between economies. Balance of Payment Accounts

12. Balance of Payment Accounts

13. Why do the accounts balance? • When the current account is negative, it means we have been spending more abroad than foreigners have been spending here. • This excess spending puts dollars in foreign hands… • The financial account will be positive because it accounts for those dollars put in foreign hands. • These dollars are most commonly used to buy assets in the United States. • If foreigners decided to hold onto them, it is still an investment—in U.S. currency, which is also an “asset”.

14. Why do the accounts balance? • What would happen if both accounts were positive? • The price of dollars would rise in the Foreign Exchange Market, making U.S. goods relatively expensive. • Current account would go down… • The U.S. would have more dollars, but not more “stuff,” so inflation would occur, making U.S. goods relatively expensive • Current account would go down…

15. Modeling the Financial Account • So, in reality, the financial account is what guides the current account. • In other words, the amount of capital inflow we experience determines the amount of net exports we experience…

16. Modeling the Financial Account • A country’s financial account measures its net sales of assets, such as currencies, securities, and factories, to foreigners. • Those assets are exchanged for a type of capital called financial capital, which is funds from savings that are available for investment spending. • We can thus think of the financial account as a measure of capital inflows in the form of foreign savings that become available to finance domestic investment spending.

17. Modeling the Financial Account • We can gain insight into the motivations for capital inflows that are the result of private decisions by revisiting the loanable funds model.

18. Modeling the Financial Account • When we “open” the loanable funds market to include a second country, we see the determinants of international capital flows.

19. Modeling the Financial Account • In short, international flows of capital are like international flows of goods and services. Capital moves from places where it would be cheap in the absence of international capital flows to places where it would be expensive in absence of such flows.

20. Do Now. • List everything you know about exchange rates.

21. Module 42: The Foreign Exchange Market 21

22. The Role of the Exchange Rate • The current account reflects the international movement of goods and services. • The financial account reflects the international movement of capital (inflows and outflows). • So what ensures that the balance of payments really does balance (i.e. offset each other)? • The Exchange Rate-(prices at which currencies are traded) • Foreign exchange market—global electronic market around the world where traders buy/sell currency.

23. The Role of the Exchange Rate

24. The Role of the Exchange Rate • Increase in real interest rates in the United States causes an increase capital inflow into the U.S. • Appreciation of the dollar makes U.S. exports relatively more expensive.

25. The increased capital inflow to the United States (financial account) must be matched by a decline in the balance of payments on the current account. The Role of the Exchange Rate Caused by the appreciation of the dollar

26. So any change in the U.S. balance of payments on the financial account generates an equal and opposite reaction in the balance of payments on the current account. Movements in the exchange rate ensure that changes in the financial account and in the current account offset each other! Dollar appreciates=financial account increases Europeans buy less American goods (current account decreases) Dollar depreciates=current account (net exports) increase Europeans buy more American goods (current account increases) The Equilibrium Exchange Rate

27. Understanding Exchange Rates • In general, goods, services, and assets produced in a country must be paid for in that country’s currency. • Foreign Exchange Market • International transactions require a market in which currencies can be exchanged for each other. • Exchange Rates • The prices at which currencies trade, as determined by the foreign exchange market.

28. Understanding Exchange Rates Updated 1/15/2014 • Exchange rates are expressed in two different ways:

29. The exchange rate for any currency is determined by the supply of that currency and the demand for that currency (in the foreign exchange market model). The Equilibrium Exchange Rate

30. How does a shift in demand for U.S. dollars affect equilibrium? The Equilibrium Exchange Rate • Changes in real interest rates • Changes in relative prices of goods • Changes in product preferences • Changes in disposable income • Trade restrictions • Perceptions of economic stability

31. Appreciation An increase in the exchange value of one nation’s currency in terms of the currency of another nation Depreciation An decrease in the exchange value of one nation’s currency in terms of the currency of another nation The Equilibrium Exchange Rate

32. Exchange Rate Interactive

33. Real Exchange Rates Exchange rates adjusted for international differences in aggregate price levels As an example, we’ll look at the number of Mexican pesos per U.S. dollar. Let PUS and PMex be indexes of the aggregate price levels in the United States and Mexico, respectively. Then the real exchange rate between the Mexican peso and the U.S. dollar is defined as: Real Exchange Rate = Mexican pesos per U.S. dollar x PUS/PMex Inflation and Real Exchange Rates

34. To understand the significance of the difference between the real and nominal exchange rates, let’s consider: The Mexican peso depreciates against the U.S. dollar, with the exchange rate going from 10 pesos per U.S. dollar to 15 pesos per U.S. dollar. At the same time the price of everything in Mexico, measured in pesos, increases by 50%, so that the Mexican price index rises from 100 to 150. We’ll assume that there is no change in U.S. prices, so that the U.S. price index remains at 100. The initial real exchange rate is: 10 X 100/100 =10 15 X 150/100 = 10 Inflation and Real Exchange Rates

35. The current account responds only to changes in the real exchange rate, not the nominal exchange rate. Inflation and Real Exchange Rates

36. A useful tool for analyzing exchange rates, closely connected to the concept of the real exchange rate, is known as purchasing power parity Between two countries’ currencies, it is the nominal exchange rate at which a given basket of goods and services would cost same amount in each country. Purchasing Power Parity

37. Do Now. • Define: • Exchange rate • Fixed exchange rate • Floating exchange rate • In your opinion, is it better to have a fixed or floating exchange rate? Why/why not?

38. Module 43: Exchange Rate Policy 38

39. Exchange Rate Regime A rule governing policy toward the exchange rate. There are two main kinds of exchange rate regimes: Fixed Exchange Rates When government keeps the exchange rate against some other currency at or near a particular target. Floating Exchange Rates When government lets the exchange rate go wherever the market takes it. Exchange Rate Regimes

40. Exchange Rate Regimes

41. Exchange Market Intervention Government purchases or sales of currency in the foreign exchange market to make up the differences above. Stocks of foreign currency (usually U.S. dollars or euros) that they can use to buy their own currency to support its price Panel a (buy genos and sell US dollars, panel b sell genos and buy US dollars How Can an Exchange Rate be Fixed?

42. Governments can shift the supply/demand curves in the foreign exchange market Government conducts monetary policy to raise/lower the interest rate to decrease/increase capital flows from abroad Raise interest rate=support geno, lower interest rate= lower geno How Can an Exchange Rate be Fixed?

43. Foreign Exchange Controls Government-imposed licensing systems that limit the right of individuals to buy foreign currency. Reduces the supply of a currency by limiting the number of licenses to people engaged in government-approved actions All things equal this increases the value of currency How Can an Exchange Rate be Fixed?

44. Fixed Exchange Rate Benefits Certainty about the future value of a currency. This can encourage trade between countries. Commits a country to not engaging in inflationary policies, which would destabilize the exchange rate Fixed Exchange Rate Costs A country must keep large quantities of foreign-currency on hand for stabilization needs. Monetary policy used to stabilize the exchange rate is diverted from other policy goals. Foreign exchange controls distort incentives for importing and exporting goods and services. Exchange Rate Regimes

45. Mini-Poster Assignment • Create a chart detailing your countries balance of payment accounts. Your financial account or current can be larger but make sure they equal zero when added together. • Draw 2 graphs displaying the equilibrium interest rate in the loanable funds market. One graph will use date from your country other will use date from one of your trading partners. • Create a chart comparing your countries currency’s value to 4 other countries • Your currency has either appreciated or depreciated in terms of another currency. Display that in the supply and demand model. • Design an example of currency from your country. What does your countries “dollar bill” look like?

46. Do Now. • Watch this video: • http://www.youtube.com./watch?v=xwtgByffoUw

47. Module 44: Exchange Rates and Macroeconomic Policy 47

48. Devaluation and Revaluation of Fixed Exchange Rates • Sometimes countries with a fixed exchange rate switch to a floating rate. • Argentina, which maintained a fixed exchange rate against the dollar from 1991 to 2001, switched to a floating exchange rate at the end of 2001. • In other cases, they retain a fixed exchange rate regime but change the target exchange rate. • In 1967 Britain changed the target exchange rate from $2.80 per £1 to $2.40 per £1.

49. Devaluation and Revaluation of Fixed Exchange Rates • Devaluation: A reduction in the value of a currency that is set under a fixed exchange rate regime . • Depreciation that is due to a revision in a fixed exchange rate target. • Leads to higher exports (domestic goods cheaper in foreign currency) and lower imports (foreign goods more expensive in domestic currency) • The effect is to increase the balance of payments on the current account.

50. Devaluation and Revaluation of Fixed Exchange Rates • Revaluation: An increase in the value of a currency that is set under a fixed exchange rate regime • Appreciation that is due to a revision in a fixed exchange rate target. • Leads to lower exports (domestic goods more expensive in foreign currency) and higher imports (foreign goods cheaper in domestic currency) • The effect is to reduce the balance of payments on the current account.