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CHAPTER 13 THE BALANCE OF PAYMENT, FOREIGN EXHANGE MARKETS, AND EXHANGE RATES Balance of payments A summary statement of all the international transactions of the residents of a nation with the rest of the world during a particular period of time, usually a year. BALANCE OF PAYMENT ACCOUNTING PRINCI...

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CHAPTER 13 THE BALANCE OF PAYMENT, FOREIGN EXHANGE MARKETS, AND E Balance of payments A summary statement of all the international tra the world during a particular period of time, usually a year. BALANCE OF PAYMENT ACCOUNTING PRINCIPLES Credit transactions: Transactions that involve the receipt of payment services, unilateral transfers from foreigners, and capital inflows. Debit transactions Transactions that involve payments to foreigners. unilateral transfers to foreigners, and capital outflows. • Capital inflows: an increase in foreign assets in the nation, or • Capital outflows: a reduction in foreign assets in the nation, o Double-entry bookkeeping The accounting procedure whereby each credit and once as a debit of an equal amount. .

Unilateral transfers Gifts or grants extended to or received from abro

THE INTERNATIONAL TRANSACTIONS OF THE UNITED STATES Statistical discrepancy The entry made in a nation’s balance of payme required by double-entry bookkeeping

ACCOUNTING BALANCES AND DISEQUILIBRIUM IN INTERNATIONAL T Current account The account that includes all sales and purchases of c foreign investments, and unilateral transfers. • Goods • Services • Income: wages and interests • Unilateral transfers Capital account It includes debt forgiveness and goods and financial a enter the country. • Official reserve assets • Statistical discrepancy • Autonomous transactions and accommodating transactions

CHAPTER14 Cross-exchange rate The exchange rate between currency A and curre currency B with respect to currency C. For example, if the exchange rate (R) were 2 between the U.S. dollar an euro, then the exchange rate between the pound and the euro would be

Forward discount (FD): The percentage per year by which the forwar Forward premium (FP): The percentage per year by which the forwa

Covered interest arbitrage parity (CIAP): The situation where the in center equals the forward discount on the foreign currency.

CHAPTER15 PURCHASING-POWER PARITY THEORY Purchasing-power parity (PPP) theory: The theory that postulates th currencies is proportional to the change in the ratio in the two countrie Absolute purchasing-power parity theory: Postulates that the equili levels in the two nations. This version of the PPP theory can be very mi

This version of the PPP theory can be very misleading. There are sever  Appears to give the exchange rate that equilibrates trade in go capital account. Thus, a nation experiencing capital outflows w nation receiving capital inflows would have a surplus if the exc trade in goods and services.  Second, this version of the PPP theory will not even give the ex services because of the existence of many nontraded goods an prices of traded goods and services among nations but not the general price level in each nation includes both traded and non equalized by international trade, the absolute PPP theory will  Furthermore, the absolute PPP theory fails to take into accoun flow of international trade. As a result, the absolute PPP theory and 15-2). Whenever the purchasing-power parity theory is us Relative purchasing-power parity theory Postulates that the change proportional to the relative change in the price levels in the two nation

Difficulties remain with the relative PPP  One of these results from the fact that the ratio of the price of n services is systematically higher in developed nations than in d

On the other hand, the nation’s supply of money is given by:

Where:    

Ms = the nation’s total money supply m = money multiplier D = domestic component of the nation’s monetary base F = international or foreign component of the nation’s mon

The domestic component of the nation’s monetary base (D) is the dom or the domestic assets backing the nation’s money supply. The internat supply (F) refers to the international reserves of the nation, which can payments surpluses or deficits, respectively. D + F is called the monetar Monetary base The domestic credit created by the nation’s monetary

Monetary Approach under Flexible Exchange Rates Under a flexible exchange rate system, balance-of-payments disequilib exchange rates without any international flow of money or reserves. Th retains dominant control over its money supply and monetary policy. A domestic prices that accompanies the change in the exchange rate The actual exchange value of a nation’s currency in terms of the curren growth of the money supply and real income in the nation relative to th other nations. Thus, according to the monetary approach, a currency depreciation res time, while a currency appreciation result s from inadequate money gr

Monetary Approach to Exchange Rate Determination

k∗ and Y∗ and k and are assumed to be constant, R is constant as long as Note: 

It depends on the purchasing-power parity (PPP) theory and th



Second, Equation (15-7) was derived from the demand for nom which does not include the interest rate.



Third, the exchange rate adjusts to clear money markets in eac

Thus, for a small country (one that does not affect world prices by its tr fixed exchange rates and the exchange rate under flexible rates.

Expectations, Interest Differentials, and Exchange Rates Since monetarists assume that domestic and foreign bonds are perfect holding the foreign bond with respect to holding the domestic bond), th always equal the expected change in the exchange rate between the tw (Uncovered interest parity condition) Where i is the interest rate in the home country (say, the United States European Monetary Union), and EA is the expected percentage appreci respect to the home country’s currency (the $). ASSET MARKET MODEL (PORTFOLIO BALANCE MODEL) AND EXCH

Exchange rate overshooting The tendency of exchange rates to imme for long-run equilibrium, and then partially reversing their movement • •

Adjustments of Financial Assets are much larger and quicker th Differences in the size and quickness of stock adjustments in fi have very important implications for the process by which exc time.

The time path to a new equilibrium exchange rate (Rudi Dornbusc How is related with Uncovered Interest Parity (UIP) and PPP theo

CHAPTER16

THE PRICE ADJUSTMENT MECHANISM WITH FLEXIBLE AND • Depreciation implies flexible regimes. • Devaluation implies fixed regimes. Depreciation An increase in the domestic currency price of the foreign Devaluation A deliberate (policy) increase in the exchange rate by a na level to another. Balance-of-Payments Adjustments with Exchange Rate Changes The process of correcting a deficit in a nation’s balance of payments by in this figure: (elasticity of demand and supply is the key)

EFFECT OF EXCHANGE RATE CHANGES ON INFLATION • • • •

Depreciation will decrease prices in foreign currency Depreciation will increase prices in domestic currency Adjustm Inflation will reduce the effect of depreciation (Table 16.1) Effect on terms of trade is unclear

Dutch disease The appreciation of a nation’s currency resulting from t previously imported, and the resulting loss of international competitiv

STABILITY OF FX MARKET Stable foreign exchange market The condition in a foreign exchange exchange rate gives rise to automatic forces that push the exchange rat rectify deficit. Unstable foreign exchange market The condition in a foreign exchan pushes the exchange rate farther away from equilibrium. appreciation m

J-curve effect The deterioration before a net improvement in a country devaluation.

Under the gold standard, each nation defines the gold content of its cur amount of gold at that price. Since the gold content in one unit of each Mint parity The fixed exchange rates resulting under the gold standard currency and passively standing ready to buy or sell any amount of gol Gold export point The mint parity plus the cost of shipping an amount between the two nations. Gold import point The mint parity minus the cost of shipping an amou between the two nations. The automatic adjustment mechanism under the gold standard is the P It is The automatic adjustment mechanism under the gold standard. It experiencing a reduction in its money supply. This in turn reduces dom discourages its imports until the deficit is eliminated. A surplus is corre

Quantity theory of money Postulates that the nation’s money supply nation’s general price index times physical output at full employment. W directly proportional to the change in M. The reduction of internal prices in the deficit nation as a result of the g the quantity theory of money. This can be explained by using Equation

Rules of the game of the gold standard The requirement under the g the deficit nation and expand credit in the surplus nation (thus reinforc the nation’s money supply).

CHAPTER 17 THE INCOME ADJUSTMENT MECHANISM AND SYNTHESIS OF 1. Income determination in a closed economy (No trade 2. Small open economy case (No repercussion) 3. Large open economy case (repercussion) 4. Price and income adjustments 5. Monetary and a synthesis INCOME DETERMINATION IN A CLOSED ECONOMY Closed economy An economy in autarky or not engaging in internatio Equilibrium level of national income (YE ) The level of income at wh output, and desired saving equals desired investment.

Desired or planned investment The level of investment expenditures Marginal propensity to consume (MPC) The ratio of the change in co _C/_Y . Consumption function C(Y) The relationship between consumption e positive when income is zero (i.e., the nation dissaves) and rises as inc

Saving function The relationship between saving and income. In general, saving is negative when income is zero and rises as income plus the increase in saving equals the increase in income.

Marginal propensity to save (MPS) The ratio of the change in saving

Investment function (exogenous, indipendant) The relationship bet investment exogenous, the investment function is horizontal when plo That is, investment expenditures are independent of (or do not change

Multiplier (k) The ratio of the change in income to the change in inves =1/MPS.

INCOME DETERMINATION IN A SMALL OPEN ECONOMY Import function M(Y) The positive relationship between the nation’s

Equilibrium condition: Y=C+I+X-M Y=C+S

INCOME DETERMINATION IN A LARGE OPEN ECONOMY

•

For two countries, increase in the exports in Nati in Nation 2, which will decrease the national inco

FOREIGN REPERCUSSIONS Foreign repercussions The effect that a change in a large nation’s inco the rest of the world in turn has on the nation under consideration. Thi

MONETARY ADJUSTMENTS AND SYNTHESIS OF THE AUTOM   

monetary adjustments to balance-of-payments disequilibria. synthesis of the automatic price, income, and monetary adjustm disadvantages of automatic adjustment mechanisms.

MONETARY ADJUSTMENTS When the Exchange Rate is Not Free Flexible • A region with deficit in BOP  Reducing the domestic money supply  Rising interest rate  Less investment, low income  Less import -reducing deficit Meanwhile,  High interest rate will draw more capital inflow  Finance the deficit--reducing deficit Moreover,  Less money supply tends to reduce price. The com competiveness •

This automatic monetary-price adjustment mechanism c unemployment, but only in the long run.

SYNTHESIS OF AUTOMATIC ADJUSTMENTS

CHAPTER 18 OPEN-ECONOMY MACROECONOMICS: ADJUSTMENT POLICIE The most important economic goals or objectives of nations are (1) int of growth, (4) an equitable distribution of income, and (5) adequate pro Internal balance The objective of full employment with price stability (rate of unemployment 4-5) External balance The objective of equilibrium in a nation’s balance of

Expenditure-changing policies Fiscal and monetary policies directed

which postulates that a government budget deficit (G > T) must be fina X (see Case Study 18-1). Expansionary fiscal policy refers to an increas increase in G, a reduction in T, or both. Contractionary fiscal policy refe

INTERNAL AND EXTERNAL BALANCE WITH EXPENDITURE-C POLICIES Assumptions:  zero international capital flow (so that the balance of payment  We also assume that prices remain constant until aggregate de output Prices unchanged when Y is lower than full employm Both expenditure-changing and expenditure-switching policies ne

EQUILIBRIUM IN THE GOODS MARKET, IN THE MONEY MAR How a nation can use fiscal policy and monetary policy to ac without any change in exchange rate Mundell–Fleming model The model that shows how a nation can use and external balance without any change in the exchange rate Transaction demand for money The demand for active money balanc with the level of national income and the volume of business transactio Speculative demand for money The demand for inactive money balan can fall in price) so that one may take advantage of future investment o money varies inversely with the rate of interest. IS curve The negatively inclined curve showing the various combinatio the goods market is in equilibrium. LM curve The usually positively inclined curve showing the various co at which the money market is in equilibrium. BP curve The usually positively inclined curve showing the various com at which the nation’s balance of payments is in equilibrium at a given

FISCAL AND MONETARY POLICIES FOR INTERNAL AND EXTE

THE IS–LM–BP MODEL WITH FLEXIBLE EXCHANGE RATES THE IS–LM–BP MODEL WITH FLEXIBLE EXCHANGE RATES AND IMPE

THE IS–LM–BP MODEL WITH FLEXIBLE EXCHANGE RATES AND

MUNDELL POLICY MIX AND PRICE CHANGES •

The case when Exchange rate cannot be adjusted.

•

Mundell policy mix graph: why IB and EB curves are p

Note that the EB line is flatter than the IB line. This is always the case w responsive to international interest differentials. This can be explained income and increases the transaction demand for money in the nation. sufficiently to satisfy this increased demand, the interest rate will rema affects the level of national income but not the nation’s interest rate. O the money supply and the nation’s interest rate. The change in the nati and national income (through the multiplier process) but also internat effective than fiscal policy in achieving external balance, and so the EB

•

Principle of effective classification: –

Monetary policy for external balance

–

Fiscal policy for internal balance

DIRECT CONTROLS Direct controls Tariffs, quotas, and other restrictions on the flow of in Trade controls Tariffs, quotas, advance deposits on imports, and othe Exchange controls Restrictions on international capital flows, official rates, and other financial and monetary restrictions imposed by a natio Multiple exchange rates The different exchange rates often enforced depending on the usefulness of the various imports as determined by t

CHAPTER 19 PRICES AND OUTPUT IN AN OPEN ECONOMY: AGGREGATE D AGGREGATE DEMAND, AGGREGATE SUPPLY, AND EQUILIBRIUM • • • •

The derivation of AD curve: increase in P reduces real m versa AS in the long run: classical case AS in the short run: Keynesian case. Determination of equilibrium.

Aggregate demand (AD) curve The graphical relationship between th various prices. Aggregate supply (AS) curve The graphical relationship between the period.

AGGREGATE SUPPLY IN THE LONG RUN AND IN THE SHORT RU Long-run aggregate supply (LRAS) curve The fixed relationship betw output, which depends on the availability of labor, capital, natural reso Natural level of output (YN ) The fixed level of output that a nation ca labor, capital, natural resources, and technology. Short-run aggregate supply (SRAS) curve The temporary positive re level resulting from imperfect information or market imperfections.

AGGREGATE DEMAND IN AN OPEN ECONOMY UNDER FIXED Open economy which means that when the price rising, it wi run equilibrium. The key is to understand the influence of P • Fixed rate case. • Flexible rate case. AGGREGATE DEMAND IN AN OPEN ECONOMY UNDER FIXED EX

AGGREGATE DEMAND IN AN OPEN ECONOMY UNDER FLEXIBLE

EFFECT OF ECONOMIC SHOCKS AND MACROECONOMIC POLI ECONOMIES WITH FLEXIBLE PRICES • • •

Real shocks: assuming an increase in export. Have ef flexible rate. Monetary shocks: assuming an inflow of money. Have rate. Demand policies: fiscal policy effective under fixed ra flexible rate. (assuming elastic capital flow)

REAL-SECTOR SHOCKS AND AGGREGATE DEMAND

FISCAL AND MONETARY POLICIES AND AD IN OPEN ECONOMY

Fixed E Any shock affect real sector

Effecti

Any monetary shock affects AD (e.g., Capital inflow)

Effecti (AD mo

Fiscal policy

Effectiv

Monetary policy

No

EFFECT OF FISCAL AND MONETARY POLICIES IN OPEN ECON • Expansionary policy when Y is at full employment lev • Expansionary policy when Y is under full employmen • Problem of letting the recession to clear the market. • Independence of central banks.

MACROECONOMIC POLICIES TO STIMULATE GROWTH AND A Fiscal and monetary policy could also be used to stimulate th expenditure on education, infrastructures, basic research an  If LR growth, P can be lower and Y will be high MACROECONOMIC POLICIES FOR GROWTH

MACROECONOMIC POLICIES TO ADJUST TO SUPPLY SHOCKS...