Unit 6

Open Economy: International Trade and Finance: the one-page sheet

6.1 Balance of Payments Accounts

The balance of payments has two halves. The current account records trade in goods and services, income and transfers; the capital and financial account records purchases and sales of assets. Because every purchase from abroad is paid for somehow, the two balances sum to zero: a current account deficit comes with a capital and financial account surplus of the same size. And a budget deficit is a different thing altogether.

The balance of payments records every transaction between a country's residents and the rest of the world over a period. Money coming in is a credit (+); money going out is a debit (-).
The current account holds the balance of trade in goods and services (net exports), net income from abroad (interest, dividends, wages) and net transfers (gifts, aid, money sent home).
The capital and financial account records purchases and sales of assets: bonds, stocks, bank deposits, real estate and whole firms. A foreigner buying a domestic asset is a credit; a resident buying a foreign asset is a debit.
Current account + capital and financial account = 0. A current account deficit is matched by a capital and financial account surplus of the same size.
A government budget deficit (outlays above revenue) is not a trade deficit or a current account deficit.

its current account balance is negative, a current account deficit the country sells assets (bonds, stocks, land, firms) to foreigners or borrows from them its capital and financial account is in surplus by exactly the size of the current account deficit current account + capital and financial account = 0

balance of payments: The record of every transaction between a country's residents and the rest of the world over a period, such as a year. It has two parts, the current account and the capital and financial account, which sum to zero.
current account: The part of the balance of payments that records the balance of trade in goods and services, net income from abroad (interest, dividends, wages) and net transfers. A negative balance is a current account deficit.
balance of trade: Exports of goods and services minus imports of goods and services: net exports. It is the largest part of the current account; a negative balance is a trade deficit.
capital and financial account: The part of the balance of payments that records purchases and sales of assets, such as bonds, stocks, real estate and firms. A foreign purchase of a domestic asset is a credit; a resident's purchase of a foreign asset is a debit.

6.2 Exchange Rates

An exchange rate is the price of one currency in another, and it can be written two ways that are reciprocals of each other. When one unit of a currency buys more of the other currency, it has appreciated, and the other has depreciated by the same change. Read the units before you compare two rates or convert a price: the units tell you which currency the number is the price of.

An exchange rate is the price of one currency in units of another: "1.25 dollars per euro" is the price of one euro.
The same rate can be written either way; one quote is the reciprocal of the other: 1.25 dollars per euro is $\frac{1}{1.25} = 0.80$ euro per dollar.
A currency appreciates when one unit buys more of the other currency, and depreciates when it buys less. When one currency appreciates, the other depreciates.
To convert a price, multiply it by a rate whose units cancel: euros times dollars per euro gives dollars.

each euro buys more dollars: the euro appreciates each dollar buys fewer euros (0.80 to about 0.67): the dollar depreciates goods priced in euros cost Americans more dollars, and goods priced in dollars cost Europeans fewer euros

exchange rate: The price of one currency in units of another, such as 1.25 dollars per euro. The same rate written the other way is its reciprocal: 0.80 euro per dollar.
appreciation: A rise in the value of a currency: one unit buys more of another currency than before. Its opposite, depreciation, is a fall in value; when one currency appreciates against another, the other depreciates.

6.3 The Foreign Exchange Market

The foreign exchange market is a supply and demand market for a currency. Draw it with the quantity of the currency across the bottom and its price in the other currency per unit up the side. Foreigners buying the country's goods and assets demand its currency; its own residents buying foreign goods and assets supply it. The same trades show up as the mirror change in the market for the other currency, so when one currency appreciates, the other depreciates.

In the foreign exchange market for a currency, the horizontal axis is the quantity of that currency and the vertical axis is its price in the other currency per unit: dollars per euro in the market for euros.
Demand for a currency comes from people abroad who want the country's goods, services and assets. Supply comes from the currency's own holders who want foreign goods, services and assets.
Demand slopes down: a cheaper euro makes European goods cheaper for Americans, so they want more euros. Supply slopes up: a dearer euro makes American goods cheaper for Europeans, so they offer more euros.
One set of trades shows in both markets as mirror changes: more demand for euros is more supply of dollars.

they need more euros, so the demand for euros shifts right the price of the euro in dollars rises: the euro appreciates the supply of dollars shifts right in the market for dollars, so the dollar depreciates

foreign exchange market: The market where currencies are bought and sold. In the market for one currency, demand comes from people abroad buying the country's goods, services and assets, supply comes from its residents buying foreign ones, and the equilibrium price is the exchange rate.

6.4 Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market

A currency's value moves when its demand or supply shifts, and four shifters do most of the work: tastes, relative incomes, relative price levels and relative real interest rates, plus expectations. Higher real interest rates at home raise demand for the home currency, so it appreciates; higher inflation or faster income growth at home push it down. Policy acts through these: anything that raises a country's interest rates, such as contractionary monetary policy or more government borrowing, tends to make its currency appreciate. Always name the curve that shifts and say which way.

Four shifters to know: tastes for a country's goods; relative incomes (higher income at home raises imports, so the supply of the home currency rises); relative price levels (higher inflation at home lowers demand for the home currency and raises its supply); relative interest rates (a higher real rate at home raises demand for the home currency).
Expectations matter too: if traders expect a currency to appreciate, they buy it now, and it appreciates now.
Policy works through these shifters. Contractionary monetary policy (raising administered rates with ample reserves, or selling bonds with limited reserves) and borrowing to fund a budget deficit both raise interest rates, so the currency appreciates.
When demand and supply both shift, say what is certain (the price) and call the other indeterminate.

its bonds and other assets pay savers more than those abroad they need its currency, so the demand for its currency shifts right its price in other currencies rises: the currency appreciates the supply of the other currency rises in its own market, so the other currency depreciates: the mirror change

determinant of exchange rates: Something other than the exchange rate itself that shifts the demand for or supply of a currency: tastes, relative incomes, relative price levels, relative real interest rates and expectations. Changes in policy work through them.

6.5 Changes in the Foreign Exchange Market and Net Exports

When a currency appreciates, everything the country sells costs foreign buyers more and everything it buys from abroad costs its residents less. Exports fall, imports rise and net exports fall, so aggregate demand shifts left and output and the price level fall in the short run. A depreciation works the other way round. Always state the link through net exports and AD, and remember that the trading partner sees the mirror change.

Appreciation makes a country's exports dearer abroad and its imports cheaper at home, so net exports fall and AD shifts left, other things equal.
Depreciation does the opposite: exports get cheaper abroad, imports dearer at home, net exports rise and AD shifts right.
In a two-country story, one country's exports are the other's imports: when Arland's net exports fall, Belvia's rise.
Net exports are in the current account, so a fall in net exports lowers the current account balance and raises the capital and financial account balance by the same amount.
Higher domestic income raises imports, so net exports fall; income is not the same as competitiveness.

US goods cost foreign buyers more of their currency, and foreign goods cost Americans fewer dollars US exports fall and US imports rise net exports (X - M) fall AD shifts left, so real GDP and the price level fall and unemployment rises in the short run

exchange rate effect on net exports: How a change in a currency's value changes net exports. Appreciation makes exports dearer abroad and imports cheaper at home, so net exports and AD fall; depreciation raises net exports and AD, other things equal.

6.6 Real Interest Rates and International Capital Flows

Relative real interest rates steer financial capital between countries. When one country's real rate rises above others', savers abroad buy its assets: financial capital flows in, its capital and financial account balance rises, the demand for its currency rises and the currency appreciates, so its net exports and current account balance fall. The inflow also adds to its supply of loanable funds. Write the whole chain, link by link, and use the real interest rate.

Financial capital flows toward the country with the higher real interest rate, other things equal: savers compare returns after expected inflation.
A capital inflow raises the capital and financial account balance and the demand for the currency, so the currency appreciates and net exports fall. The current account balance falls by the same amount, keeping the sum at zero.
The inflow also adds to the supply of loanable funds in the receiving country, which holds down its real interest rate; in the sending country, the supply of loanable funds falls.
Lower relative real rates, as after expansionary monetary policy, send capital out: the currency depreciates and net exports rise.

its assets pay savers a higher real return than assets abroad financial capital flows in, and the capital and financial account balance rises the demand for its currency rises, so the currency appreciates exports cost more abroad and imports cost less at home, so net exports and the current account balance fall

international capital flows: Movements of financial capital between countries as savers buy and sell assets abroad. Financial capital tends to flow toward the country with the higher real interest rate; an inflow is a capital and financial account credit and raises demand for the currency.