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Chapter 36

Chapter 36. Exchange Rates and the Macroeconomy. No man is an island, entire of itself. JOHN DONNE. Macroeconomy. Open economy Trades with other nations Goods and services Financial assets Model – large open economy Substantial capital flows Floating exchange rate.

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Chapter 36

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  1. Chapter 36 Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE

  2. Macroeconomy • Open economy • Trades with other nations • Goods and services • Financial assets • Model – large open economy • Substantial capital flows • Floating exchange rate

  3. International Trade, Exchange Rates, AD • Increase in net exports (X-IM) • Increase X; decrease IM • Multiplier effect on economy • Aggregate demand – shifts outward-right • Increase real GDP • Increase price level • Determinants of net exports • Foreign incomes • Relative prices of foreign & domestic goods

  4. Figure 1 The effects of higher net exports D0 D1 S B Price Level A D0 D1 S Real GDP

  5. International Trade, Exchange Rates, AD • Relative prices of a country’s exports • Fall • Net exports – increase • Real GDP – increase • Rise • Net exports – decrease • Real GDP – decrease

  6. International Trade, Exchange Rates, AD • Price of foreign products • Rise • Net exports – increase • Real GDP – increase • Fall • Net exports – decrease • Real GDP – decrease • Currency appreciations or depreciations • Change international relative prices

  7. International Trade, Exchange Rates, AD • Currency depreciation • Raise net exports • Increase aggregate demand • Currency appreciation • Reduce net exports • Decrease aggregate demand

  8. Table 1 Exchange rates and home currency prices

  9. Figure 2 D1 Effects of exchange rate changes on aggregate demand D0 D2 S (depreciation) (appreciation) E2 E1 Price Level E0 D1 D2 D0 S Real GDP

  10. International Trade, Exchange Rates, AD • Late 1990s & early 2000s • U.S. trade deficit – grew enormously • 1995 – dollar appreciation • Boost U.S. imports (40% growth) • Damage U.S. exports (7% growth) • 1997: $105 billion real net export deficit • 2002: $471 billion deficit

  11. Aggregate Supply in an Open Economy • Depreciation of U.S. dollar • Prices of imported inputs – rise • U.S. aggregate supply curve • Shifts inward • Prices of domestic goods & services • Increase • Additional inflationary effects • On consumer prices

  12. Aggregate Supply in an Open Economy • Appreciation of U.S. dollar • Imported inputs – cheaper • U.S. aggregate supply curve • Shifts outward • Prices of domestic goods • Decrease

  13. (depreciation) Figure 3 Effects of exchange rate changes on aggregate supply D S0 S2 S1 (appreciation) E1 Price Level E0 E2 D S0 S2 S1 Real GDP

  14. Macroeconomic Effects of Exchange Rates • Dollar depreciation • Aggregate demand – shift outward • Aggregate supply – shift inward • U.S. price level – increase • GDP – rise or fall • Shifts in demand – larger • GDP – rises • Currency depreciation • Inflationary • Probably expansionary

  15. Figure 4 D1 The effects of a currency depreciation D0 S0 S1 A Price Level E D1 D0 S0 S1 Real GDP

  16. Macroeconomic Effects of Exchange Rates • Dollar appreciation • Aggregate demand – shift inward • Aggregate supply – shift outward • U.S. price level – falls • GDP – rise or fall • Shifts in demand – larger • GDP – falls • Currency appreciation • Disinflationary • Probably contractionary

  17. Figure 5 D2 The effects of a currency appreciation D0 S0 S2 E Price Level B D2 D0 S0 S2 Real GDP

  18. Macroeconomic Effects of Exchange Rates • International capital flows • Purchases & sales of financial assets • Across national borders • Rise in interest rates • Contract the economy • International capital inflows • Currency – appreciates • Net exports – decrease

  19. Macroeconomic Effects of Exchange Rates • Drop in interest rates • Expand the economy • International capital outflows • Currency – depreciates • Net exports – increase

  20. Fiscal & Monetary Policies - Open Economy • Fiscal expansion - Closed economy • Aggregate demand – increase • Closed economy • Does not trade with other nations • Goods • Assets

  21. Fiscal & Monetary Policies - Open Economy • Fiscal expansion - Open economy • Interest rates – increase • Exchange rate – appreciate • Attract foreign capital • Capital account surplus – increase • Net exports – decrease • Current account deficit – increase Capital account surplus + Current account deficit = 0

  22. Fiscal & Monetary Policies - Open Economy • Fiscal expansion - Open economy • Aggregate demand – outward shift • Aggregate supply – outward shift • Aggregate demand – inward shift • Fiscal multiplier – reduced

  23. Figure 6 D1 D2 A fiscal expansion in an open economy D0 S0 S2 B A Price Level C D2 D1 D0 S0 S2 Real GDP

  24. Table 2 Percentage shares of real GDP in U.S.; 1981 & 1986

  25. Fiscal & Monetary Policies - Open Economy • Contractionary monetary policy • Decrease aggregate demand • Interest rates – increase • Exchange rates – appreciate • Capital inflow • Strengthen monetary policy • Aggregate supply – outward shift

  26. Figure 7 D1 D2 A monetary contraction in an open economy D0 S0 S2 B A Price Level C D2 D1 D0 S0 S2 Real GDP

  27. International Aspects: Deficit Reduction • Policy mix • Fiscal contraction & Monetary expansion • Reduce interest rates strongly • Push down the value of the dollar • Strongly stimulate our foreign trade • Net effects on output and inflation • Uncertain

  28. Table 3 Expected effects of policy

  29. International Aspects: Deficit Reduction • Trade deficit • Excess of imports over exports • Trade surplus • Excess of exports over imports • Accounting relationship • X – IM = (S – I) – (G – T) • Trade deficit – can arise • Government budget deficit G > T • Excess investment over saving I > S

  30. Should we Worry about the Trade Deficit? • U.S. trade deficits • The nation • Consumes more then it produces • Mirror image: required capital inflows • Economic weakness • Mortgage our futures • To finance higher consumer spending • Economic strength • Foreigners – eager to lend capital

  31. On Curing the Trade Deficit • X-IM = (S-I) – (G-T) • Reduce trade deficit • Decrease budget deficit G-T • Tightening fiscal policy • Loosening monetary policy • More rapid economic growth abroad • Raise domestic saving • Reduce domestic investment • Protectionism

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