Macroeconomics Study Guide: International Linkages, Exchange Rates, and Policy in an Open Economy

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Covid-19 and Globalization

Covid-19 Disrupts the Global Economy

The Covid-19 pandemic highlighted the interconnectedness of the global economy and the challenges of forecasting in uncertain times.

Globalization means that economic shocks in one country can have significant effects worldwide.
Example: Vehicle computer chip manufacturers underestimated demand, leading to a global shortage and higher automobile prices in the United States in 2021.

International Linkages and the Balance of Payments

The Balance of Payments: Linking the United States to the International Economy

Countries are linked through trade in goods and services and flows of financial investment. The balance of payments (BoP) records these interactions.

Trade: Exchange of goods and services between countries.
Financial investment: Cross-border flows of capital, such as investments in stocks, bonds, or physical assets.

Open and Closed Economies

Economies differ in their degree of interaction with the rest of the world.

Open economy: Engages in trade or finance with other countries.
Closed economy: No interactions in trade or finance with other countries (rare in practice).
Most countries today are open to some extent; North Korea is an example of a nearly closed economy.

Balance of Payments Structure

The BoP is divided into three main accounts:

Current account: Records net exports, net income on investments, and net transfers.
Financial account: Records purchases of assets abroad and foreign purchases of domestic assets.
Capital account: Records minor transactions such as migrants’ transfers and sales/purchases of nonproduced, nonfinancial assets.

U.S. Balance of Payments, 2020 (Billions of Dollars)

Account	Main Components	2020 Value (USD billions)
Current Account	Exports of goods/services, imports, net income, net transfers	-971
Financial Account	Foreign holdings of U.S. assets, U.S. holdings abroad	741
Capital Account	Migrants’ transfers, nonproduced/nonfinancial assets	-55

Additional info: Values are illustrative and may vary by year.

Current Account Details

Trade balance: Difference between exports and imports of goods.
Balance of services: Difference between exports and imports of services.
Net income on investments: Earnings from foreign investments minus payments to foreign investors.
Net transfers: Transfers such as foreign aid, remittances.
For simplicity, net exports are often treated as equal to the current account balance.

Financial Account Details

Capital outflows: Purchases of assets overseas by Americans.
Capital inflows: Purchases of American assets by foreigners.
Assets include financial assets (stocks, bonds: foreign portfolio investment) and physical assets (factories: foreign direct investment).

Net Foreign Investment

Net foreign investment is the difference between capital outflows and capital inflows.

Also equal to net foreign direct investment plus net foreign portfolio investment.
It is the negative of the financial account balance.

The Capital Account

Since 1999, the capital account only includes minor transactions.
Its balance is relatively small and often ignored in macroeconomic analysis.

Why Is the Balance of Payments Always Zero?

The sum of the current account, financial account, and capital account balances must be zero:

If a country spends more on foreign goods/services than it receives (current account deficit), it must finance this by selling assets or borrowing (financial account surplus).

Foreign Exchange Market and Exchange Rates

Exchange Rates

Exchange rates determine the value of one currency in terms of another.

Nominal exchange rate: The rate at which one currency can be exchanged for another.
Real exchange rate: Adjusts the nominal rate for differences in price levels between countries.
Example: If $1 = ¥100, then $1 can buy 100 Japanese yen.

Equilibrium in the Foreign Exchange Market

Exchange rates are determined by supply and demand for currencies.

Demand for $US comes from:
- Foreign firms/households buying U.S. goods/services
- Foreign investment in U.S. assets
- Currency traders expecting appreciation
Supply of $US comes from U.S. firms/households buying foreign goods/services or investing abroad.
Equilibrium exchange rate: Where quantity supplied equals quantity demanded.

Exchange Rate Adjustments

If the exchange rate is too high: Surplus of dollars, rate will depreciate.
If the exchange rate is too low: Shortage of dollars, rate will appreciate.

Market vs. Fixed Exchange Rates

Most exchange rates are determined by the market.
Some countries fix their exchange rates (e.g., China fixed the yuan at 8.28 yuan = $1 for over a decade).

Shifts in Demand and Supply for Foreign Exchange

Factors other than the exchange rate can shift demand and supply curves:

Changes in demand for domestic vs. foreign goods/services
Changes in investment preferences
Expectations about future exchange rates

Exchange Rates, Imports, and Exports

Exchange rate movements affect the price of imports and exports.

If the $US appreciates, imports become cheaper for Americans, exports become more expensive for foreigners.
Example: An iPhone priced at $200 costs €200 at $1=€1, but €240 at $1=€1.20.

Case Study: Toyota and Exchange Rate Fluctuations

A stronger yen means the yen is worth more relative to the dollar; 1 USD exchanges for fewer yen.
Effects on Toyota:
- Cars produced in Japan become more expensive in foreign currencies, reducing sales.
- Profits from U.S. sales, when converted to yen, decrease.
- If all vehicles sold in the U.S. were produced in Japan, Toyota would be more exposed to exchange rate risk.
- Producing vehicles in the U.S. reduces exposure to exchange rate fluctuations.

Is a Strong Currency Good for a Country?

A strong currency makes exports more expensive and imports cheaper.
The impact depends on the structure of a country's firms and trade patterns.

National Saving, Investment, and the International Sector

National Saving and Investment

When a country's spending exceeds its income, it finances the difference by selling assets or borrowing.

Current Account Balance + Financial Account Balance = 0
Current Account Balance = – Financial Account Balance
Net Export = Net Foreign Investment

Domestic Saving/Investment and Net Foreign Investment

National Saving = Private Saving + Public Saving
So:

The Saving and Investment Equation

Since (net exports) equals (net foreign investment):
National Saving = Investment + Net Foreign Investment

Using the Saving and Investment Equation

If net foreign investment (net exports) is negative, national saving is less than domestic investment.
Example: Saving used to buy a bond may finance domestic investment or foreign investment.

Government Budget Deficits and Investment

When the government runs a budget deficit, public saving is negative and national saving declines.
Deficits are financed by selling bonds, often raising interest rates to attract buyers.
Higher interest rates discourage private investment and attract foreign capital, causing the currency to appreciate and net exports to fall.

The Twin Deficits

When budget deficits lead to declines in net exports, this is called twin deficits.
Historically, large U.S. budget deficits in the 1980s led to high interest rates, a strong dollar, and large current account deficits.
Since 1990, the relationship between budget and current account deficits has weakened.

Policy in an Open Economy

Monetary Policy and Fiscal Policy in an Open Economy

Open economies have more channels through which policy can affect aggregate demand.

Monetary policy is more effective in an open economy because changes in interest rates also affect exchange rates and net exports.
Fiscal policy is less effective in an open economy because increased government spending may raise interest rates, appreciate the currency, and reduce net exports.

Summary Table: Effects of Policy in Open vs. Closed Economies

Policy	Closed Economy	Open Economy
Monetary Policy	Influences investment/consumption	Also affects exchange rates and net exports
Fiscal Policy	Directly increases aggregate demand	May crowd out net exports via exchange rate appreciation

Key Equations

Current Account Balance + Financial Account Balance + Capital Account Balance = 0

Examples and Applications

Apple and iPhone Manufacturing: U.S. policies may encourage domestic production, but practical constraints (supply chains, skilled labor) limit feasibility.
Ben Bernanke's Analysis: International capital flows can benefit developed countries but may be more efficient if high-income countries lend to low-income countries.