Open-Economy

Macroeconomics: The
Balance of Payments
 The Balance of Payments

• Foreign exchange is simply all

currencies other than the domestic
currency of a given country.

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 The Balance of Payments

• The balance of payments is 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.

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 The Current Account
United States Balance of Payments, 2002
CURRENT ACCOUNT
Goods exports 682.6
Goods imports – 1,166.9
(1) Net export of goods – 484.3
Export of services 289.3
Import of services – 240.5
(2) Net export of services 48.8
Income received on investments 244.6
Income payments on investments – 256.5
(3) Net investment income – 11.9
(4) Net transfer payments – 56.0
(5) Balance on current account (1 + 2 + 3 + 4) – 503.4
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –) – 152.9
(7) Change in foreign private assets in the United States 533.7
(8) Change in U.S. government assets abroad (increase is –) – 3.3
(9) Change in foreign government assets in the United States 46.6
(10) Balance on capital account (6 + 7 + 8 + 9) 474.1
(11) Statistical discrepancy 29.3
(12) Balance of payments (5 + 10 + 11) 0
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 The Current Account

• A country’s current account is the

sum of its:
• net exports (exports minus imports),

• net income received from investments

abroad, and
• net transfer payments from abroad.

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 The Current Account

• Exports earn foreign exchange and

are a credit (+) item on the current
account. Imports use up foreign
exchange and are a debit (–) item.

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 The Current Account

• The balance of trade is the

difference between a country’s
exports of goods and services and
its imports of goods and services.
• A trade deficit occurs when a
country’s exports are less than its
imports.
• Net exports of goods and services
(EX – IM), is the difference between
a country’s total exports and total
imports.
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 The Current Account

• Investment income consists of

holdings of foreign assets that yield
dividends, interest, rent, and profits
paid to U.S. asset holders (a source
of foreign exchange).

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 The Current Account

• Net transfer payments are the

difference between payments from
the United States to foreigners and
payments from foreigners to the
United States.

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 The Current Account

• The balance on current account

consists of net exports of goods, plus
net exports of services, plus net
investment income, plus net transfer
payments. It shows how much a
nation has spent relative to how
much it has earned.

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 The Capital Account

• For each transaction recorded in the

current account, there is an offsetting
transaction recorded in the capital
account.
• The capital account records the
changes in assets and liabilities.

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 The Capital Account

• The balance on capital account in the

United States is 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

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 The Capital Account

• In the absence of errors, the balance on

capital account would equal the negative
of the balance on current account.

• If the capital account is positive, the

change in foreign assets in the country is
greater than the change in the country’s
assets abroad, which is a decrease in the
net wealth of the country.

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The United States as a Debtor Nation

• A country’s net wealth is the sum of

all its past current account balances.

• Prior to the mid-1970s, the United

States was a creditor nation. After
the mid-1970s, the United Sates
began to have a negative net wealth
position vis-à-vis the rest of the
world.

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The United States as a Debtor Nation

• A negative net wealth position vis-à-

vis the rest of the world reflects the
fact that the United States spent
much more on foreign goods and
services than it earned through the
sales of its goods and services.

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 Imports and Exports and
the Trade Feedback Effect

• The determinants of imports are the

same as the factors that affect
consumption and investment
behavior.

• Spending on imports also depends

on the relative prices of domestically
produced and foreign-produced
goods.

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 Imports and Exports and
the Trade Feedback Effect

• The demand for U.S. exports

depends on economic activity in the
rest of the world. If foreign output
increases, U.S. exports tend to
increase.

• Because U.S. imports are somebody

else’s exports, the extra import
demand from the United States
raises the exports of the rest of the
world.
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 Imports and Exports and
the Trade Feedback Effect

• The trade feedback effect is 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.

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 Imports and Export Prices
and the Trade Feedback Effect

• When the export prices of one

country rise, with no change in the
exchange rate, the import prices of
another rise.

• If the inflation rate abroad is high,

U.S. import prices are likely to rise.

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 Imports and Export Prices
and the Trade Feedback Effect

• The price feedback effect is the

process by which a domestic price
increase in one country can “feed
back” on itself through export and
import prices.

• Inflation is “exportable.”

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 The Open Economy with
Flexible Exchange Rates

• Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated
forces of supply and demand.

• Exchange rate movements have

important impacts on imports,
exports, and movement of capital
between countries.

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The Market for Foreign Exchange

• In a world where there are only two

countries, the United States and
Britain, the demand for pounds is
comprised of holders of dollars
wishing to acquire pounds. The
supply of pounds is comprised of
holders of pounds seeking to
exchange them for dollars.

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The Market for Foreign Exchange

Some Private Buyers and Sellers in International

Exchange Markets: United States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1. Firms, households, or governments that import British goods into the United States
or wish to buy British-made goods and services

2. U.S. citizens traveling in Great Britain

3. Holders of dollars who want to buy British stocks, bonds, or other financial
instruments

4. U.S. companies that want to invest in Great Britain

5. Speculators who anticipate a decline in the value of the dollar relative to the pound

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The Market for Foreign Exchange

Some Private Buyers and Sellers in International

Exchange Markets: United States and Great Britain
THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)
1. Firms, households, or governments that import U.S. goods into Great Britain or wish
to buy U.S.-made goods and services

2. British citizens traveling in the United States

3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in
the United States

4. British companies that want to invest in the United States

5. Speculators who anticipate a rise in the value of the dollar relative to the pound

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 The Market for Foreign Exchange

• The demand for pounds in

the foreign exchange market
shows a negative relationship
between the price of pounds
(dollars per pound) ($/£) and
the quantity of pounds
demanded.

• When the price of pounds falls, British-made goods and services

appear less expensive to U.S. buyers. If British prices are
constant, U.S. buyers will buy more British goods and services,
and the quantity demanded of pounds will rise.
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 The Market for Foreign Exchange

• The supply of pounds in

the foreign exchange
market shows a positive
relationship between the
price of pounds (dollars per
pound) ($/£) and the
quantity of pounds
supplied.

• When the price of pounds rises, the British can obtain more dollars
for each pound. This means that U.S.-made goods and services
appear less expensive to British buyers. Thus, the quantity of
pounds supplied is likely to rise with the exchange rate.
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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.

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The Equilibrium Exchange Rate

• An excess supply of pounds will

cause the price of pounds to fall—
the pound will depreciate (fall in
value) with respect to the dollar.
• An excess demand for pounds will
cause the price of pounds to rise—
the pound will appreciate (rise in
value) with respect to the dollar.

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Factors that Affect Exchange Rates

• Purchasing Power Parity: The

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.
• If the law of one price held for all goods,
and if each country consumed the same
market basket of goods, the exchange
rate between the two currencies would
be determined simply by the relative
price levels in the two countries.
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Factors that Affect Exchange Rates

• The theory that exchange rates are

set so that the price of similar goods
in different countries is the same is
known as the purchasing-power
parity.
• If it takes ten times as many pesos to
buy a pound of salt in Mexico as it takes
U.S. dollars to buy a pound of salt in the
United States, then the equilibrium
exchange rate should be 10 pesos per
dollar.
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Factors that Affect Exchange Rates

• 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
relative high-inflation countries to
depreciate.

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Factors that Affect Exchange Rates

• A higher price level in

the United States
increases the demand
for pounds and
decreases the supply
of pounds. The result
is appreciation of the
pound against the
dollar.

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Factors that Affect Exchange Rates

• The level of a country’s interest rate

relative to interest rates in other
countries is another determinant of
the exchange rate. If U.S. interest
rates rise relative to British interest
rates, British citizens may be
attracted to U.S. securities.

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Factors that Affect Exchange Rates

• A higher interest rate in

the United States
increases the supply
and decreases the
demand for pounds.
The result is
depreciation of the
pound against the
dollar.

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 The Effects of Exchange
Rates on the Economy

• When a country’s currency

depreciates (falls in value), its import
prices rise and its export prices (in
foreign currencies) fall.

• When the U.S. dollar is cheap, U.S.

products are more competitive in
world markets, and foreign-made
goods look expensive to U.S.
citizens.

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 The Effects of Exchange
Rates on the Economy

• A depreciation of a country’s
currency can serve as a stimulus to
the economy:
• Foreign buyers are likely to increase
their spending on U.S. goods
• Buyers substitute U.S.-made goods for
imports
• Aggregate expenditure on domestic
output will rise
• Inventories will fall
• GDP (Y) will increase
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 Exchange Rates and Prices

• Depreciation of a country’s currency tends

to increase the price level.
• Export demand rises.
• Domestic buyers substitute domestic products
for the now more expensive imports.
• If the economy is operating close to capacity,
the increase in aggregate demand is likely to
result in higher prices.
• If import prices rise, costs may rise for business
firms, shifting the AS curve to the left.

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