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35 Exchange Rates and the Macroeconomy No man is an island, entire of itself. JOHN DONNE Contents ● International Trade, Exchange Rates, and Aggregate Demand ● Aggregate Supply in an Open Economy ● The Macroeconomic Effects of Exchange Rates ● Fiscal and Monetary Policies in an Open Economy Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Contents (continued) ● International Aspects of Deficit Reduction ● Is the Trade Deficit a Problem? ● On Curing the Trade Deficit ● Conclusion: No Nation is an Island Copyright © 2003 South-Western/Thomson Learning. All rights reserved. International Trade, Exchange Rates, and AD ● exports and imports multiplier effects on GDP. ● Booms or recessions in one country affect other countries through international trade. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ● Relative Prices, Exports, and Imports ♦ relative prices of a country’s exports ■ that country’s net exports ■ its real GDP Copyright© 2003 Southwestern/Thomson Learning All rights reserved. International Trade, Exchange Rates, and AD ● Relative Prices, Exports, and Imports ♦ relative prices of a country’s exports ■ that country’s net exports ■ its real GDP Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 35-1 The Effects of Higher Net Exports FIGURE S D1 D0 Price Level B D1 A D0 S Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. International Trade, Exchange Rates, and AD ● The Effects of Changes in Exchange Rates ♦ A currency depreciation ■ relative prices of the country’s goods in international trade ■ its net exports and AD ♦ A currency appreciation has the opposite effects. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 35-1 Exchange Rates and Home Currency Prices TABLE Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 35-2 The Effects of Exchange Rate Changes on AD FIGURE D1 S D0 E1 Price Level D2 E0 D1 (depreciation) E2 D0 D2 (appreciation) S Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Aggregate Supply in an Open Economy ● Open Economy: one that trades with other nations in goods and services, and perhaps also in financial assets ● Closed Economy: one that does not trade with other nations in either goods or assets Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Aggregate Supply in an Open Economy ● A currency depreciation ♦ price of foreign goods ♦ AS shifts inward ● A currency appreciation has the opposite effects. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 35-3 The Effects of Exchange Rate Changes on AS FIGURE S1 (depreciation) S0 D Price Level S2 (appreciation) E1 E0 E2 S1 S0 S2 D Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Macroeconomic Effects of Exchange Rates ● Currency depreciation ♦ AD and AS ♦ Net result is inflation ♦ Probably also expansionary ■Impact on AD dominates impact on AS ● A currency appreciation has the opposite effects. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 35-4 The Effects of a Currency Depreciation FIGURE S1 D1 S0 Price Level D0 A E D1 S1 S0 D0 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 35-5 The Effects of a Currency Depreciation FIGURE S0 D0 S2 Price Level D2 E B S0 D0 S2 D2 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. The Macroeconomic Effects of Exchange Rates ● Interest Rates and International Capital Flows ♦ interest rates ■Attracts foreign capital flows ■Appreciates the currency ■ net exports ■ GDP ♦ interest rates has the opposite effects Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ● Fiscal Policy Revisited ♦ Expansionary fiscal policy ■ interest rates ■Attracts foreign capital ■Appreciates the currency ■ net exports Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ● Fiscal Policy Revisited ♦ Part of the expansionary effect of fiscal policy is “crowded out.” ♦ Thus, international capital flows reduce the power of fiscal policy. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Fiscal and Monetary Policies in an Open Economy ● Fiscal Policy Revisited ♦ The evidence indicates that the crowding-out effect of fiscal policy is greater on net exports than on investment. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 35-6 A Fiscal Expansion in an Open Economy FIGURE D1 D2 D0 Price Level S0 S2 B A C D1 D2 S0 S2 D0 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. 35-2 Percentage Shares of Real GDP in the U.S TABLE Copyright © 2003 South-Western/Thomson Learning. All rights reserved. Fiscal and Monetary Policies in an Open Economy ● Monetary Policy Revisited ♦ Expansionary monetary policy ■ interest rates ■Outflow of capital ■Currency depreciation ■ net exports ♦ Thus, international capital flows power of monetary policy Copyright© 2003 Southwestern/Thomson Learning All rights reserved. 35-7 A Monetary Contraction in an Open Economy FIGURE S0 D0 D1 D2 Price Level S2 A B C D0 S0 D1 D2 S2 Real GDP Copyright © 2003 South-Western/Thomson Learning. All rights reserved. International Aspects of Deficit Reduction ● According to theory, success in reducing the federal deficit through a policy mix of fiscal contraction and monetary expansion should: ♦ real interest rates ♦ exchange rate of the dollar ♦ net exports ♦ Have an uncertain effect on real GDP and inflation Copyright© 2003 Southwestern/Thomson Learning All rights reserved. TABLE 35-3 Expected Effects of Policy Copyright © 2003 South-Western/Thomson Learning. All rights reserved. International Aspects of Deficit Reduction ● What actually happened? ♦ Interest rates did fall, just as predicted. ♦ The U.S. economy expanded rapidly between 1992 and 1998. ■The monetary stimulus overwhelmed the fiscal contraction. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ♦ Inflation fell despite such rapid growth. ♦ The dollar generally declined from 1993 to 1995, as the theory predicted. ♦ But then it turned around and rose sharply from 1995 to 1998, just when the budget deficit was turning into a surplus. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ♦ America’s real net exports sagged from -$30 billion in 1992 to -$238 billion in 1998. ♦ The effect on the value of the dollar and net exports did not match the theoretical predictions. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ● The Loose Link Between The Budget Deficit and the Trade Deficit ♦ (X - IM) = (S - I) - (G - T) ♦ Apply this accounting relationship to actual U.S. events in the 1990s: ■ (G - T) ■ S and I (S - I) Copyright© 2003 Southwestern/Thomson Learning All rights reserved. International Aspects of Deficit Reduction ● The Loose Link Between The Budget Deficit and the Trade Deficit ♦ Taken by itself: budget deficit trade deficit ■But effect offset by private economic behavior ● S ● I ♦ Trade deficit depends on private sector behavior as well as public sector behavior. Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ● Pessimists: trade deficit increases long-term indebtedness to foreigners ● Optimists: trade deficit indicates the attractiveness of the U.S. economy to foreign investors Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ● Each view holds elements of truth. ● But there is a critical question: How long can a trade deficit continue? Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Is the Trade Deficit a Problem? ● At some point, foreign investors may conclude that they have acquired about all the American assets they want. ● If and when that happens, the U.S. trade deficit must be eliminated. ● The only question is how? Copyright© 2003 Southwestern/Thomson Learning All rights reserved. On Curing the Trade Deficit ● Four basic ways to cure the trade deficit: ♦ Tighter fiscal and looser monetary policy ♦ economic growth abroad ♦ savings (good) and/or investment (bad) ♦ Protectionism ■Would be bad for the U.S. and world economies ■Might very well fail to cure the problem Copyright© 2003 Southwestern/Thomson Learning All rights reserved. Conclusion: No Nation is an Island ● The fates of nations are intertwined. ● The major trading countries are linked by exports and imports, capital flows, and exchange rates. ● Mutual success may well require mutual coordination. Copyright© 2003 Southwestern/Thomson Learning All rights reserved.