Transcript IPE3 (vnd.ms-powerpoint, it, 1318 KB, 3/10/11)

International Political Economy
Lesson 3
Section 3.1
Open Economies and its
mechanisms
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• An Economy has two basic kinds of
economic interactions with the rest of the
world:
– Buying and/or Selling
• Goods (e.g. lumber, automobiles, etc.)
• Services (e.g. transportation, tourism, etc.)
• Assets, mainly financial assets (e.g. interest and
dividend payments)
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Export
(Goods, Services, Financial Activities)
Domestic Currency (α)
Rest of the World
A
Foreign Currency (β)
Import
(Goods, Services, Financial Activities)
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• Each international actvities gives rise to a
situation in which either foreigners wish
obtain our currency or we wish obtain
foreign currency
• The former is viewed as a demand for our
currency on the foreign exchange market,
and the latter is viewed as a supply of our
currency on this market
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Domestic Currency Supply
Domestic Currency Demand
Rest of the World
A
Foreign Currency Demand
Foreign Currency Supply
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Domestic
Currency
Supply
Foreign
Currency
Supply
Country
Rest of the World
Foreign
Currency
Demand
Domestic
Currency
Demand
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€
Supply
$
Supply
Italy
€
USA
$
$
Demand
€
Demand
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Exchange rate
(€)
$ Supply
$ Demand
E1 ► QD1>QS1
E2 ► QD2<QS2
E2
E1
QD2
QS1
QD1
QS2
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D and S
Foreign Currency
($)
Exchange rate
(€)
$ Supply
$ Demand
E1 ► QD1>QS1
E2 ► QD2<QS2
E2
E1
QD2
QS1
QD1
QS2
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D and S
Foreign Currency
($)
Exchange rate
(€)
$ Supply
$ Demand
E* ► QD = QS
E*
Q*
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D and S
Foreign Currency
($)
USA good more expensive
Price 1$ = 2€
Import
decrease
Italy good less expensive
Price 1€ = 0,5$
Export
increase
USA good less expansive
Price 1$ = 0,5€
Import
increase
Italy good more expensive
Price 1€ = 2$
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Export
decrease
Exchange Rate increase
(e.g. 1$ = 2€)
Equilibrium Exchange Rate
(e.g. 1$ = 1€)
Exchange Rate decrease
(e.g. 1$ = 0,5€)
Lesson 3
Section 3.2
WHAT IS THE BALANCE OF
PAYMENTS?
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• The balance of payments is the difference
between the sum of all demands for and
the supplies of domestic currency on the
foreign exchange market
• If the total number of domestic currency
supplied is equal to the total number of
domestic currency demanded, the result is
a zero balance of payments
• In this case the international sector of the
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economy is in equilibrium
• A balance of payments surplus
• A balance
occursofwhen the
demand of domestic currency
payments
on the deficit
foreignis
exchange market exceeds the
the situation
supply where
the supply of
domestic currency
exceeds its demand
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• Domestic Currency Supply = Domestic Currency Demand
▼
Balance
• Domestic Currency Supply > Domestic Currency Demand
▼
Imbalance (deficit)
Domestic Currency Supply < Domestic Currency Demand
▼
Imbalance (surplus)
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Lesson 3
Section 3.3
DETERMINANTS OF FOREIGN
EXCHANGE MARKET ACTIVITY
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• Several variables affect supply and
demand activity in this market:
– Exchange rate
– Income
– Interest rate
– Price level
– Expectations
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• Exchange rate
– The price of domestic currency in terms of foreign currency is
determined in the foreign exchange market
– The exchange rate is a very important determinant of
international trade; in fact:
• If exchange rate of domestic currency increase, imports is cheaper,
so imports increase;
– Thus, increasing the supply of domestic currency on the foreign
exchange market
• Similarly, exports are more expensive to foreigners, so exports fall;
– Thus, the decreasing the demand of domestic currency
• This way the rise in the exchange rate eliminates the balance of
payments surplus
• The opposite occurs in case of a balance of payments deficit:
– The exchange rate falls to eliminate the deficit
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Demand/ Supply
Foreign Currency
Foreign
Currency
Demand
Foreign
Currency
Supply
Transaction Type
Import
Export
Exchange rate Variation
Inverse
Exchange Rate ▲
Currency Demand ▼
Direct
Exchange Rate ▼
Currency Supply ▲
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Exchange Rate
Increase
(consequences)
Devaluation
Export ▲
Import ▼
Revaluation
Export ▼
Import ▲
• Income
– At a higher level of income, imports increase
• The supply of domestic currency on the foreign
market increases, creating a balance of payments
deficit and downward pressure on exchange rate
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• Interest rate
• Two caveats concerning
capital inflows are
important:
– 1. the resul depends on the
interest rate
increaseare
not
– When domestic interes rate is higher,
foreigners
beingassets
part of a worldwide
more interested in buying financial
pattern
• So, increase the demand of domestic
currency on the foreign
– 2. the relevant difference in
exchange market
interest rates is the
• This demand creates
difference in real interest
– capital inflows,
– a balance of payments surplus, rates, and not nominal
interest
rates, because
– And upward pressure on the exchange
rate
investors are concerned
with real returns
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• Price level
– A rise of domestic prices level increase the
price of exports and the price of importcompeting goods and services
• So, exports fall and imports rise
– As the result the demand for domestic
currency decreases, and the supply of
domestic currency increases creating
• a balance of payments deficit, and
• Downward pressure on the exchange rate
– Again in this case, the effect occur only if
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there is no equivalent
price increase in the
• Expectations
– If foreigners expets the value of domestic
currency to rise, they can reap a capital gain
by buying our bonds and the selling them
again after the exchange rate has risen
• This speculation creates
– An inflow of capital,
– A balance of payments surplus,
– and upward pressure on the exchange rate
– Speculative activity is indeed the primary
determinant of exchange
rates in the short run
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Lesson 3
Section 3.4
THE INTERNATIONAL
ECONOMIC ACCOUNTS
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• Knowledge of the balance of payments is all that is
needed for analysis of the economic forces that
automatically are set in motion whenever there is a
disequilibrium in the international sector of the economy
• Often, however, analysts are interested in the source of
any disequilibrium in the international sector, that is, the
relative contributions to an equilibrium position of the
various components of the demand for and supply of
domestic currency on the foreign exchange market
• Consequently, the balance of payments is broken down
into several subsidiary measures, which together are
referred to as the international accounts or the balance
of payments accounts.
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• At the most general level, the balance of
payments is broken into two accounts, the
current and capital accounts
– The current account measures the difference
between the demand for and the supply of domestic
currency arising from transactions that affect the
current level of income here and abroad
– The capital account measures the difference between
the demand for and the supply of domestic currency
arising from sales or purchases of assets to or from
foreigners.
• The capital account measures capital flows between a
country and the rest of the world. A capital account surplus
measures a net capital inflow, and a capital account deficit
measures a net capital outflow.
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• The trade balance is the sum of following:
– Merchandise trade balance
• Difference between exports and imports of goods
– Services trade balance
• Difference between exports and imports of
services
• Net investment income from abroad
– Interest and dividend interest
• Net transfer from abroad
– Pension payments, foreign aid, etc.
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Lesson 3
Section 3.5
THE TWIN DEFICITS
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• An interesting aspect of the balance of
payments accounts is that it is quite
possible to have an economy in
international equilibrium while
simultaneously its subsidiary accounts are
unbalanced, as long as they offset each
other
• The U.S. economy, for example, for
several years had a current account deficit
that was offset by a surplus in its capital
account.
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• How might this situation come about?
– A prominent explanation is that it is a side effect of
large government budget deficits—hence termed the
twin deficit problem.
– A large government deficit increases the interest rate
as the government sells bonds to finance its deficit.
– This rise in the interest rate makes domestic bonds
look very attractive to overseas investors, so capital
flows into the country, creating a balance of payments
surplus.
– This bids up the value of the dollar, which in turn
decreases exports and increases imports, creating a
balance of trade deficit.
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• How budget deficits cause trade
deficits
– G increase and/or T decrease
• This causes
– Budget deficit
– Government sells bonds
– Interest rate increase
– Capital inflows increase
– Exchange rate increase
– Exports decrease
and imports increase
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Twin deficit USA
84.000
74.000
64.000
percent of GDP
54.000
44.000
34.000
24.000
14.000
4.000
-6.0001980
1985
1990
General government gross debt
1995
2000
Current account balance
2005