Chapter 33 lecture Outline

Much of this chapter consists of learning jargon -- what particular terms mean, and the circumstances in which they are used. The analytic bits are applications of supply and demand, some identities from national income accounting and the balance of payments accounts, and remembering what aggregate demand is and how changes in it affect output etc.

The foreign exchange rate is just the price of one currency in terms of another -- e.g. $1 = 120 Yen, you can buy 120 Yen for a dollar, or a dollar for 120 Yen.

Under floating or flexible exchange rates [current system for major currencies] the price of a currency, i.e. the foreign exchange rate, depends solely on Supply and Demand for it in the foreign exchange market.

If the value of a currency in terms of foreign currencies goes up, the currency is said to have appreciated; if it goes down, to have depreciated. E.g. if 1 DM [Deutschmark] was 3 FF [French Franc], but now 1 DM is 4 FF, the DM has appreciated [and the FF depreciated].

A currency is supplied to the market when agents with that currency want other ones, e.g. to import goods and services; so they can travel abroad; to make investment abroad [i.e. in general to make payments to foreigners, buy things abroad]. The same currency is demanded in the market by agents who have foreign currency but want that one, e.g. to buy goods and services with it (i.e. buy exports from that country); to invest in that country; to travel in it; etc.

Supply and Demand will be shifted by:

-- Changes in GDP [GDP up, Import demand up, currency tends to depreciate]

-- Differences in inflation rates between countries (faster inflation at home --> home goods more expensive relative to foreign, M demand up, X demand down, currency tends to depreciate)

-- Differences in interest rates [higher interest rates pulls in foreign capital, currency tends to appreciate]

-- Political and other events that change expectations about the future

[It is important to understand that there are very large amounts of highly liquid assets that can move between currencies very quickly (worldwide, the volume of foreign exchange transactions is always billions of dollars a day, at times tens of billions a day; most day-to-day fluctuations in exchange rates have nothing to do with underlying economic conditions, but are the results of movements of "short-term capital," these liquid funds, that move in response to small changes in market conditions and expectations.)]

If a country wanted to appreciate its currency, i.e. increase its value in terms of foreign exchange, it could:

Slow GDP growth (reduces iMports)

Lower inflation (reduces M, increases eXports)

Raise real interest rates (pulls in foreign capital)

i.e., follow a restrictionary monetary policy

If a country wanted to depreciate its currency, i.e. lower its value in terms of other currencies, it could:

Increase GDP growth (increases M)

Increase inflation (increases M, reduces X)

Lower real interest rates (drives foreign capital out).

i.e., follow an expansionary monetary policy

[Another way of looking at that is to think, if we want each unit of money to be worth more, we should have less of it, i.e. restrictionary monetary policy; if we want it to be worth less, we need more of it, i.e. expansionary monetary policy]

In the past, countries have tried to have fixed exchange rates. This requires the country to maintain reserves of foreign currency, to deal with periods when the market is not in balance at the fixed rate. If there is a persistent deficit, i.e. foreign payments exceed foreign receipts continuously, eventually the reserves would run out, so countries had to either:

1. "Devalue" -- make a change to a lower fixed rate [e.g. in July 1997 the Thai Baht went from 25 to the dollar to 40 to the dollar]; this makes domestic goods cheaper when priced in foreign currency, so tends to increase exports; and foreign goods more expensive when priced in domestic currency, so tends to reduce imports -- reducing or eliminating the deficit.

2. Reduce foreign payments via protection or controls -- causes inefficiency and difficulties (e.g. international agreements like GATT -- now WTO -- forbid this).

3. Reduce GDP via restrictive macro policy.

For major countries, the size of the pool of liquid assets that can move in or out of their currency is now so large that fixed rates are not tenable for longer than short periods, and therefore not worthwhile trying to maintain.

The balance of payments is simply an accounting of payments that cross borders. To decide which "side" a particular kind of payment goes, one asks who gets the payment.

If a local resident gets it, it is a credit in the Balance of Payments; if a foreign resident gets it, it is a debit. There are three sections: the current account (transactions that are now only); the capital account (where assets are acquired or debts paid); and the official reserves (because even with floating rates the authorities need some reserves to ensure payments can always be made, like a balance in a checking account).

                                            Credit [payment in]                             Debit [payment out]

                                                    [+ve]                                                         [-ve]

Current:                                     Exports                                                 Imports         [goods and non-factor services]

                                                    Investment income                             Investment income
                                                    from abroad                                        to foreigners

                                                                                                                    "Unilateral transfers" (net)
                                                                                                                    (e.g. gifts to foreigners, foreign aid)

Capital:                                     Foreign Direct Investment                     US Foreign Direct Investment
                                                    into the US                                                 abroad

                                                    Loans into the US                                 Loans from US to foreigners

Offical Reserves: {which offset balance to this point; see below}

                                                                                                                    Changes in US Official Reserve Assets
                                                                                                                    (an increase counts as -ve in the B of P because                                                                                                     it offsets a surplus on current and capital                                                                                                         accounts);

                Changes in Foreign official assets held in US
            (an increase counts as +ve because it offsets
            a deficit on current and capital accounts).
 

Overall, "Current balance + capital balance + official reserve balance = zero" -- i.e. overall everything must balance. Under flexible exchange rate system, official reserves change very little, so the current and capital balances offset each other -- when the US is running a current account deficit (e.g. M>X), it must have a capital account surplus (foreign capital comes in, net) to offset it. Note exports and imports are both of goods ("merchandise") and services (e.g. royalties on recordings and software, airline tickets, insurance, etc). There is no good way to tell which causes which [i.e., if there is a current account deficit, it could be offsetting the fact that foreigners want to invest more in the US than US residents do abroad, or it could be that US preferences for imports are sucking in foreign capital]

Macro policy in an open economy:

If Money Supply grows faster in the US than abroad, tendency will be for the exchange rate to depreciate (via effects on interest rates, prices, and imports); [more US money relative to foreign money implies each unit of US money, i.e. $, will be worth less in terms of foreign money]

Expansionary fiscal policy will tend to increase imports, which would suggest $ tend to depreciate; BUT expansionary fiscal policy also tends to push up interest rates, which implies capital flows in and $ tends to appreciate. Actual outcome depends on balance between the two effects -- in 80s and early 90s, the $ has moved both up and down.

Overall, national income accounting GDP = C + I + G + (X - M) = income, Y

uses of income Y = C + S + T;

therefore [ignoring marginal corrections] C + S + T = C + I + G + (X - M),

rearranging terms gives (G - T) = (S - I) + (M - X),

i.e. if the Saving/Investment balance domestically [S — I] does not change, a larger fiscal government budget deficit (G - T) must imply a larger balance of payments current account deficit (M - X). Or, put differently, the effect of a budget deficit on the balance of payments depends on the savings/investment balance in the country. This is both why foreigners say the way for the US to get rid of its trade deficit is to reduce its government budget deficit, and why some US politicians argue that the US savings rate needs to be increased to cure the trade deficit.