Understanding Open Economy Macroeconomics

2. 21 Open-EconomyMacroeconomics:The Balance of Paymentsand Exchange Rates Chapter Outline The Balance of PaymentsThe Current AccountThe Capital AccountThe United States as a Debtor NationEquilibrium Output (Income) in an Open EconomyThe International Sector and Planned Aggregate ExpenditureImports and Exports and the Trade Feedback EffectImport and Export Prices and the Price Feedback EffectThe Open Economy with Flexible Exchange RatesThe Market for Foreign ExchangeFactors That Affect Exchange RatesThe Effects of Exchange Rates on the EconomyAn Interdependent World EconomyAppendix: World Monetary Systems Since 1900

3. The study of exchange rates is very important because: a. Exchange rates determine the course of monetary policy. b. Exchange rates strongly influence interest rates. c. Exchange rates are a factor in determining the flow of international trade. d. All of the above.

4. The study of exchange rates is very important because: a. Exchange rates determine the course of monetary policy. b. Exchange rates strongly influence interest rates. c. Exchange rates are a factor in determining the flow of international trade. d. All of the above.

5. Open-Economy Macroeconomics:The Balance of Payments and Exchange Rates When people in different countries buy from and sell to each other, an exchange of currencies must also take place. exchange rate The price of one country’s currency in terms of another country’s currency; the ratio at which two currencies are traded for each other.

6. THE BALANCE OF PAYMENTS foreign exchange All currencies other than the domestic currency of a given country. balance of payments The record of a country’s transactions in goods, services, and assets with the rest of the world; also the record of a country’s sources (supply) and uses (demand) of foreign exchange.

7. Colombian purchases of real estate in Miami: a. Increase the U.S. supply of foreign exchange. b. Increase the U.S. demand for foreign exchange. c. Decrease the U.S. supply of foreign exchange. d. Decrease the U.S. demand for foreign exchange.

8. Colombian purchases of real estate in Miami: a. Increase the U.S. supply of foreign exchange. b. Increase the U.S. demand for foreign exchange. c. Decrease the U.S. supply of foreign exchange. d. Decrease the U.S. demand for foreign exchange.

9. THE BALANCE OF PAYMENTS THE CURRENT ACCOUNT balance of trade A country’s exports of goods and services minus its imports of goods and services.

10. THE BALANCE OF PAYMENTS TABLE 21.1 United States Balance of Payments, 2004 CURRENT ACCOUNT Goods exports 807.6 Goods imports – 1,473.1 (1) Net export of goods – 665.5 Export of services 339.6 Import of services – 291.2 (2) Net export of services 48.4 Income received on investments 369.0 Income payments on investments – 344.9 (3) Net investment income 24.1 (4) Net transfer payments – 72.9 (5) Balance on current account (1 + 2 + 3 + 4) – 665.9 CAPITAL ACCOUNT (6) Change in private U.S. assets abroad (increase is –) – 821.8 (7) Change in foreign private assets in the United States 1077.9 (8) Change in U.S. government assets abroad (increase is –) 4.1 (9) Change in foreign government assets in the United States 355.3 (10) Balance on capital account (6 + 7 + 8 + 9) 615.5 (11) Net capital account transactions – 1.5 (11) Statistical discrepancy 51.9 (12) Balance of payments (5 + 10 + 11) 0

11. When a nation has spent more on foreign goods and services than it has earned through the sales of its goods and services to the rest of the world, its net wealth position vis-à-vis the rest of the world must have: a. Increased. b. Decreased. c. Remained the same. d. Either increased or decreased, depending on changes in the capital account.

12. When a nation has spent more on foreign goods and services than it has earned through the sales of its goods and services to the rest of the world, its net wealth position vis-à-vis the rest of the world must have: a. Increased. b. Decreased. c. Remained the same. d. Either increased or decreased, depending on changes in the capital account.

13. THE BALANCE OF PAYMENTS THE CURRENT ACCOUNT trade deficit Occurs when a country’s exports of goods and services are less than its imports of goods and services in a given period. balance on current account Net exports of goods, plus net exports of services, plus net investment income, plus net transfer payments.

14. THE BALANCE OF PAYMENTS THE CAPITAL ACCOUNT balance on capital account In the United States, the sum of the following (measured in a given period): the change in private U.S. assets abroad, the change in foreign private assets in the United States, the change in U.S. government assets abroad, and the change in foreign government assets in the United States.

15. If the balance on capital account is positive, the net wealth position of a country has: a. Increased. b. Decreased. c. Remained the same. d. Either increased or decreased, depending on other changes in the balance of payments account.

16. If the balance on capital account is positive, the net wealth position of a country has: a. Increased. b. Decreased. c. Remained the same. d. Either increased or decreased, depending on other changes in the balance of payments account.

17. THE BALANCE OF PAYMENTS THE UNITED STATES AS A DEBTOR NATION Prior to the mid-1970s, the United States had generally run current account surpluses. This began to turn around in the mid-1970s, and by the mid-1980s, the United States was running large current account deficits. In other words, the United States changed from a creditor nation to a debtor nation.

18. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY THE INTERNATIONAL SECTOR AND PLANNED AGGREGATE EXPENDITURE Planned aggregate expenditure in an open economy: AEC + I + G + EX - IM net exports of goods and services (EX - IM) The difference between a country’s total exports and total imports. Determining the Level of Imports marginal propensity to import (MPM) The change in imports caused by a $1 change in income.

19. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY FIGURE 21.1 Determining Equilibrium Output in an Open Economy

20. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY open-economy multiplier The Open-Economy Multiplier The effect of a sustained increase in government spending (or investment) on income—that is, the multiplier—is smaller in an open economy than in a closed economy. The reason: When government spending (or investment) increases and income and consumption rise, some of the extra consumption spending that results is on foreign products and not on domestically produced goods and services.

21. The open-economy multiplier is: a. Larger than the closed-economy multiplier. b. Smaller than the closed-economy multiplier. c. The same as the closed-economy multiplier. d. Zero because imports and exports cancel each other out.

22. The open-economy multiplier is: a. Larger than the closed-economy multiplier. b. Smaller than the closed-economy multiplier. c. The same as the closed-economy multiplier. d. Zero because imports and exports cancel each other out.

23. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY IMPORTS AND EXPORTS AND THE TRADE FEEDBACK EFFECT The Determinants of Imports The same factors that affect households’ consumption behavior and firms’ investment behavior are likely to affect the demand for imports. The Determinants of Exports The demand for U.S. exports depends on economic activity in the rest of the world—rest-of-the-world real wages, wealth, nonlabor income, interest rates, and so on—as well as on the prices of U.S. goods relative to the price of rest-of-the-world goods. If foreign output increases,

24. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY The Trade Feedback Effect trade feedback effect The tendency for an increase in the economic activity of one country to lead to a worldwide increase in economic activity, which then feeds back to that country. An increase in U.S. imports increases other countries’ exports, which stimulates those countries’ economies and increases their imports, which increases U.S. exports, which stimulates the U.S. economy and increases its imports, and so on. This is the trade feedback effect. In other words, an increase in U.S. economic activity leads to a worldwide increase in economic activity, which then “feeds back” to the United States.

25. EQUILIBRIUM OUTPUT (INCOME)IN AN OPEN ECONOMY Export prices of other countries affect U.S. import prices. The general rate of inflation abroad is likely to affect U.S. import prices. If the inflation rate abroad is high, U.S. import prices are likely to rise. The Price Feedback Effect price feedback effect The process by which a domestic price increase in one country can “feed back” on itself through export and import prices. An increase in the price level in one country can drive up prices in other countries. This in turn further increases the price level in the first country.

26. If the inflation rate in Colombia is high, the prices of Colombian exports will ___________, and U.S import prices are likely to _________. a. increase; rise b. increase; fall c. decrease; rise d. decrease; fall

27. If the inflation rate in Colombia is high, the prices of Colombian exports will ___________, and U.S import prices are likely to _________. a. increase; rise b. increase; fall c. decrease; rise d. decrease; fall

28. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES THE MARKET FOR FOREIGN EXCHANGE

29. A drop in the value of the dollar against the Colombian peso will: a. Make U.S. goods more attractive to Colombians. b. Make U.S. goods more attractive to U.S. residents. c. Dollars buy fewer pesos and pesos buy more dollars. d. All of the above.

30. A drop in the value of the dollar against the Colombian peso will: a. Make U.S. goods more attractive to Colombians. b. Make U.S. goods more attractive to U.S. residents. c. Dollars buy fewer pesos and pesos buy more dollars. d. All of the above.

31. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES floating, or market-determined, exchange rates Exchange rates that are determined by the unregulated forces of supply and demand. FIGURE 21.2 The Demand for Pounds in the Foreign Exchange Market FIGURE 21.3 The Supply of Pounds in the Foreign Exchange Market

32. In the foreign exchange market for Colombian pesos, who constitutes supply and demand? a. Supply is the central bank of Colombia (or Banco de la República), and demand is any foreigner who wants to buy Colombian goods, services and assets. b. Supply is comprised of those who hold pesos and would like to acquire foreign currency, and demand is comprised of those who hold foreign exchange and would like to acquire pesos. c. Supply is comprised of those who have Colombian goods, and demand is comprised of those who wish to buy Colombian goods. d. Supply is the central bank of Colombia (or Banco de la República), and demand is comprised of Colombians wishing to buy foreign currency.

33. In the foreign exchange market for Colombian pesos, who constitutes supply and demand? a. Supply is the central bank of Colombia (or Banco de la República), and demand is any foreigner who wants to buy Colombian goods, services and assets. b. Supply is comprised of those who hold pesos and would like to acquire foreign currency, and demand is comprised of those who hold foreign exchange and would like to acquire pesos. c. Supply is comprised of those who have Colombian goods, and demand is comprised of those who wish to buy Colombian goods. d. Supply is the central bank of Colombia (or Banco de la República), and demand is comprised of Colombians wishing to buy foreign currency.

34. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES The Equilibrium Exchange Rate The equilibrium exchange rate occurs at the point at which the quantity demanded of a foreign currency equals the quantity of that currency supplied. appreciation of a currency The rise in value of one currency relative to another. depreciation of a currency The fall in value of one currency relative to another. FIGURE 21.4 The Equilibrium Exchange Rate

35. Which of the following groups have an interest in participating in foreign exchange markets? a. Firms, households, or governments. b. Travelers. c. Investors and speculators. d. All of the above.

36. Which of the following groups have an interest in participating in foreign exchange markets? a. Firms, households, or governments. b. Travelers. c. Investors and speculators. d. All of the above.

37. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES FACTORS THAT AFFECT EXCHANGE RATES Purchasing Power Parity: The Law of One Price law of one price If the costs of transportation are small, the price of the same good in different countries should be roughly the same. purchasing-power-parity theory A theory of international exchange holding that exchange rates are set so that the price of similar goods in different countries is the same. A high rate of inflation in one country relative to another puts pressure on the exchange rate between the two countries, and there is a general tendency for the currencies of relatively high-inflation countries to depreciate.

38. According to the purchasing-power-parity theory, a 10% increase in the rate of inflation in Colombia would lead to: a. 10% appreciation of the dollar against the peso. b. 10% depreciation of the dollar against the peso. c. No change in the value of the dollar relative to the peso. d. A decrease in prices in the United States by 10%.

39. According to the purchasing-power-parity theory, a 10% increase in the rate of inflation in Colombia would lead to: a. 10% appreciation of the dollar against the peso. b. 10% depreciation of the dollar against the peso. c. No change in the value of the dollar relative to the peso. d. A decrease in prices in the United States by 10%.

40. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES FIGURE 21.5 Exchange Rates Respond to Changes in Relative Prices FIGURE 21.6 Exchange Rates Respond to Changes in Relative Interest Rates

41. When domestic prices in the United States are rising, in the foreign exchange market for dollars: a. The supply of dollars will rise, and the demand for dollars will fall. b. The supply of dollars will fall and the demand for dollars will rise. c. Both the supply and the demand for dollars will fall. d. Both the supply and the demand for dollars will rise.

42. When domestic prices in the United States are rising, in the foreign exchange market for dollars: a. The supply of dollars will rise, and the demand for dollars will fall. b. The supply of dollars will fall and the demand for dollars will rise. c. Both the supply and the demand for dollars will fall. d. Both the supply and the demand for dollars will rise.

43. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES THE EFFECTS OF EXCHANGE RATES ON THE ECONOMY The level of imports and exports depends on exchange rates as well as on income and other factors. When events cause exchange rates to adjust, the levels of imports and exports will change. Changes in exports and imports can in turn affect the level of real GDP and the price level. Further, exchange rates themselves also adjust to changes in the economy. Exchange Rate Effects on Imports, Exports, and Real GDP A depreciation of a country’s currency is likely to increase its GDP.

44. THE OPEN ECONOMY WITH FLEXIBLEEXCHANGE RATES Exchange Rates and Prices The depreciation of a country’s currency tends to increase its price level. Monetary Policy with Flexible Exchange Rates A cheaper dollar is a good thing if the goal of the monetary expansion is to stimulate the domestic economy. Fiscal Policy with Flexible Exchange Rates The openness of the economy and flexible exchange rates do not always work to the advantage of policy makers. Monetary Policy with Fixed Exchange Rates There is no role monetary policy can play if a country has a fixed exchange rate.

45. An open economy with flexible exchange rates works to the advantage of: a. Fiscal policy used to stimulate the economy. b. Monetary policy to stimulate the economy. c. Both fiscal and monetary policies to stimulate the economy. d. Neither fiscal nor monetary policies to stimulate the economy.

46. An open economy with flexible exchange rates works to the advantage of: a. Fiscal policy used to stimulate the economy. b. Monetary policy to stimulate the economy. c. Both fiscal and monetary policies to stimulate the economy. d. Neither fiscal nor monetary policies to stimulate the economy.

47. AN INTERDEPENDENT WORLD ECONOMY The increasing interdependence of countries in the world economy has made the problems facing policy makers more difficult. We used to be able to think of the United States as a relatively self-sufficient region. Forty years ago, economic events outside U.S. borders had relatively little effect on its economy. This situation is no longer true. The events of the past four decades have taught us that the performance of the U.S. economy is heavily dependent on events outside U.S. borders.

48. What is the impact of the exchange rate on the economy following a tax cut designed to stimulate the economy, all else the same? a. The exchange rate moves in such a way as to enhance the effectiveness of the tax cut. b. The exchange rate moves in such a way as to diminish the effectiveness of the tax cut. c. The exchange rate contributes to stimulating the economy, only as long as the Fed does not accommodate increases in money demand. d. There is no relationship between tax cuts and exchange rates; therefore, the foreign exchange market has no impact on the economy following a tax cut.

49. What is the impact of the exchange rate on the economy following a tax cut designed to stimulate the economy, all else the same? a. The exchange rate moves in such a way as to enhance the effectiveness of the tax cut. b. The exchange rate moves in such a way as to diminish the effectiveness of the tax cut. c. The exchange rate contributes to stimulating the economy, only as long as the Fed does not accommodate increases in money demand. d. There is no relationship between tax cuts and exchange rates; therefore, the foreign exchange market has no impact on the economy following a tax cut.

50. REVIEW TERMS AND CONCEPTS J-curve effect law of one price marginal propensity to import (MPM) net exports of goods and services (EX - IM) price feedback effect purchasing-power-parity theory trade deficit trade feedback effect Planned aggregate expenditure in an open economy: AEC + I + G + EX - IM Open-economy multiplier: • appreciation of a currencybalance of payments • balance of trade • balance on capital account • balance on current account • depreciation of a currency • exchange rate • floating, or market- determined, exchange rates • foreign exchange