Jim’s Notes

Open Economy Issues

Balance of Payments:

ROW In the Circular Flow

Goods and Services

= Current Account

Finance and Capital

Capital Inflow
Capital Outflow
= Capital Account (Surplus)
= X-M

Balance of Payments Concept

Balance of Payments – Dynamics
If one increases, the other will also, and vice-versa
Capital Account and Current Account linked
Causality not clear

Balance of Payments An Example

Three sections.
Current Account
Capital Account
summaries or ‘balances’ in memoranda.

U.S. Issues – High Current Account Deficit and Capital Account Surplus

Unusual for developed nation

Possible factors:

Low U.S. savings rate
High U.S. consumption and govt spending
Strong dollar
$ as reserve currency
Weak yen and yuan as foreign growth strategy

Chicken-and-egg problem: causality is unclear. Does trade deficit ’cause’ capital surplus, or vice versa?

Foreign Exchange Rates

Forex rates are ‘prices’

how many Y’s does 1 X buy

Expressed two ways: reciprocals of each other
Example: suppose $1.00 CAD = $1.05 USD
then $1.00 USD = $ 0.9524 CAD
LESSON: always pay close attention to which way the exchange rate is expressed ‘

Exchange Rates An Example

What ‘Should’ Rates Be?

Whatever creates equilibrium
Absolute rate is irrelevant
Purchasing Power Parity Theory
‘Big Mac’ Index and others

Changes in Rates Matter

Pricing of imports and exports
Differences in inflation, interest rates, exchange rates change capital flows
Currency Exchange Needs

Forex change winners and losers

Wants weaker $

buys $USD
US exporter
Foreign Importer
Foreign Tourist

Wants stronger $

sells $USD
Foreign Exporter
US importer

US Tourist

a tourist going overseas is the same as an ‘Importer’ – they ‘import’ the foreign experience
a tourist attraction (like Disney World) is an ‘exporter’ of the experience

Fed International Role

Provides ‘Reserve Currency’ for World

bank reserves and central bank reserves around the world are usually held in either US dollars or dollar-denominated assets such as US bonds

The Fed’s ‘vault cash’

US currency not in circulation
US bonds
Currency of other nations

Fed sales/purchases of other currencies affects exchange rates

Exchange Rates and Interest Rates drive foreign investment in US (finance trade deficit)