Unit 6: Open-Economy - International Trade and Finance

Balance of Payments accounts measure all international transactions in a year. This includes the sale and purchase of goods/services and assets. There are two accounts within the balance of payments: (1) the current account, and (2) the capital account.

The difference in the value of all exported goods and services sold and all imported goods and services purchased, including labor. Exports count as a positive asset and imports count as a negative asset. If a country has more exports than imports, it has a 

. If a country has more imports than exports, it has a 

Any interest or dividend paid to or from domestic investors.  

Any aid or grants paid to and from the domestic economy. This includes international aid or the transfer of income. Paid to the domestic economy is positive, from is negative.

The purchase of foreign and domestic financial assets. Foreign purchase of domestic assets is positive, and domestic purchase of foreign assets is negative.

The purchase of foreign and domestic land and businesses, including plant capacities and factories. Foreign purchase of domestic assets is positive, domestic purchase of foreign assets is negative.

Let's look at some different examples from the current and capital account:

💡 A quick way to determine if an asset is positive or negative is:

If the money for the transaction is flowing out of the country it is negative

If the money for the transaction is flowing into the country it is positive.

Sample Balance of Payments Between Two Countries

Looking at the example above, the United States has a trade deficit of $500 ($300 Exports - $800 Imports) and China has a trade surplus of $500 ($800 Exports - $300 Imports).

The value of the current account for the United States is a deficit of $600. This is calculated by adding the trade deficit of $500 to the $100 in humanitarian aid that is leaving the country, so it is negative. You would also include the purchases made by Chinese tourists and money spent by American tourists but since those amounts are both $1000 they cancel each other out.

The value of the current account for China is a surplus of $600. This is calculated by adding the trade surplus of $500 to the $100 in humanitarian aid that they are receiving from the United States which is positive. You would also include the purchases made by Chinese tourists and money spent by American tourists but since those amounts are both $1000 they cancel each other out.

The value of the financial account for the United States is a surplus of $600. This is calculated by adding the +$600 they receive for the purchase of a U.S. business by the Chinese, the +$200 they received from the Chinese government purchase of U.S. bonds, and the -$200 spent on the American investment in the Chinese stock market ($600+$200-$200). 

The value of the financial account for China is a deficit of $600. This is calculated by adding the -$600 spent on the U.S. business, -$200 spent on the purchase of U.S. bonds, and the $200 they received from the investment by the U.S. in the Chinese stock market. (-$600-$200+$200).

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Balance of Payments Accounts

 are the price at which one international currency can be exchanged for another. In other words, it's the price at which one currency can be bought with another.  

💡When the exchange rate increases, it is more expensive to purchase currency. This makes goods and services from this country more expensive.    

💡When the exchange rate decreases, it is less expensive to purchase currency. This makes goods and services from this country less expensive.

 occurs when the value of a country's currency increases relative to a foreign currency.  

 occurs when the value of a country's currency falls.

💡Exchange rates between countries are reciprocals of each other, meaning that when one currency appreciates, the other currency depreciates.

Let's look at various currencies and their exchange rates to the U.S. Dollar and whether they have appreciated or depreciated:

If we look at the British Pound, we see that the exchange rate increases from .75 to .80 from March to July. This means that the British Pound has become more expensive or has appreciated in value.

If we look at the European Euro, we see that the exchange rate decreases from 1.10 to 1.05 from March to July. This means that the European Euro has become less expensive, or has depreciated in value.

We can also use the information above to calculate the price of a U.S. good in the various currencies. We do this by simply multiplying the price of the U.S. good by the exchange rate for whichever country we are looking at. So for example, a $300 hotel room in the U.S. would cost 💷225 pounds in Britain. 

Exchange Rates

 is the quantity of an international currency that all domestic and foreign currencies are willing and able to purchase at various rates of exchange.

The relationship between exchange rates and the quantity of currency demanded is inverse:  

💡As the exchange rate rises, domestic and foreign consumers will purchase less quantity of the currency.

💡As the exchange rate falls, domestic and foreign consumers will purchase more quantity of the currency.

 is the quantity of an international currency that all domestic and foreign sellers are willing and able to sell at various rates of exchange.

The relationship between exchange rates and quantity of currency supplied is positive or direct:

💡As exchange rates rise, domestic and foreign consumers are willing to sell more.

💡As exchange rates fall, domestic and foreign consumers are willing to sell less.

Equilibrium is achieved in the FOREX Market (the market in which foreign currency is bought and sold) when the quantity supplied of the currency equals the quantity demanded of the currency at a specific exchange rate.

Let's draw the FOREX Market in Equilibrium for the EURO (💶) relative to the U.S. Dollar (💵):

Since in the FOREX market we are working with has flexible exchange rates, the exchange rates are constantly changing. When they rise above equilibrium or fall below equilibrium, the market will force them back up to equilibrium.

Foreign Exchange Market

6.4: Effect of Changes in Policies and Economic Conditions on the Foreign Exchange Market

There are four determinants that can change either the supply or demand in the FOREX Market.  These include:

Let's look at some scenarios that fall into these different determinants and see how they affect the various currencies.

When the government practices an expansionary fiscal policy (increase in spending or decrease in taxes), there is an effect on the exchange rate for that country's currency. The example below shows what would happen if this occurs in the United States.  

If the government increases spending or decreases taxes, aggregate demand (AD) will increase, which will increase real GDP output and increase the price level. This makes U.S. goods more expensive which means that other countries will not buy as much. So, there will be less of a demand for the U.S. dollar which will depreciate it.

When the government practices a contractionary fiscal policy (decreases spending or increases taxes), there is an effect on the exchange rate of that country's currency. The example below shows what would happen if this occurs in the United States. 

If the government either decreases spending or increases taxes, that will decrease aggregate demand which will decrease real GDP output and decrease price level. This will make U.S. goods less expensive which will make them more attractive to foreign consumers. Foreign consumers will increase their purchases of U.S. goods and will need to exchange their currency for the dollar which will increase the demand for the dollar. When the demand for the dollar increases, the value of the dollar will appreciate.

If the central bank of a country is practicing an expansionary monetary policy (decreasing the reserve ratio, decreasing the discount rate, or buy bonds) it will have an effect on the exchange rate as well. In the following example, we are looking at the actions of the Federal Reserve in the United States.  

When the FED increases the money supply, that lowers the interest rate which will increase investment spending. When investment spending increases, aggregate demand increases which raises the price level. This means that both the national income levels and export prices will increase. With the U.S. good at higher prices, foreign customers do not want to buy the goods which will decrease the demand for the U.S. dollar, causing a depreciation of the U.S. dollar.  

If the central bank of a country is practicing a contractionary monetary policy (increasing the reserve ratio, increasing the discount rate, or selling bonds), it will have an effect on the value of the exchange rate. In the following example, we are looking at the actions of the Federal Reserve in the United States.  

When the FED decreases the money supply, that raises the interest rate which will decrease investment spending. When investment spending decreases, aggregate demand decreases which lower the price level. This means that both the national income levels and export prices will decrease. With the U.S. goods at lower prices, foreign customers want to buy the goods which will increase the demand for the U.S. dollar, causing an appreciation of the U.S. dollar.   

Effect of Changes in Policies & Economic Conditions on the Foreign Exchange Market

6.5: Changes in the Foreign Exchange Market and Net Exports

When there are changes in the foreign exchange market causing the currency of the country to appreciate or depreciate, it will lead to a change in net exports.

Let's take the scenario that tourists from all over the world travel to Mexico for vacation. This will cause the demand for the peso (Mexican currency) to appreciate. When the currency appreciates, it causes Mexican goods to become more expensive, decreasing the number of exports to other countries. 

Mexican consumers will also go looking for cheaper goods outside of their country, which will increase imports. As exports decrease and imports increase, the value of net exports will decrease which will decrease aggregate demand. Let's look at this situation in a graphical description:

Let's take a scenario where there is a trade war with the U.S. and tariffs are placed on Canadian exported goods. This will cause Canadian goods to become more expensive, so foreign consumers will not want to purchase them.  As a result, they will be demanding less of the Canadian dollars. When the demand decreases for the Canadian dollar, it will depreciate, making those goods cheaper. As their goods become cheaper, exports will increase and imports will decrease. This will lead to an increase in aggregate demand because exports will then increase for Canadian goods and imports will decrease. Let's look at this example graphically:

Changes in the Foreign Exchange Market and Net Exports

6.6: Real Interest Rates and International Capital Flows

Capital flow is the movement of money for the purpose of investment, trade or business production.

There are two types of capital flow: (1) inbound capital flow and (2) outbound capital flow.  

 is the injection of funds into a domestic economy that occurs through the purchase of domestic assets by foreign investors. An example would be a Japanese investor purchasing assets in the United States because they have a higher interest rate compared to similar assets in Japan. These domestic assets include stocks, bonds, or any other interest-bearing accounts. When real interest rates are high, it generates inbound capital flow. This is due to the fact that foreign investors look to invest their money into assets that have high-interest rates because they can earn a higher profit.

 is the extraction of funds from a domestic economy that occurs through the purchase of foreign assets by domestic investors. An example of this is an American buying assets in Germany because they are yielding a higher interest rate, and they can earn more by doing this.  Just like with inbound capital flow, these assets can include stocks, bonds, or any other interest-bearing accounts. When real interest rates fall, it generates outbound capital flow. This is due to the fact that domestic investors look to invest in other countries because the interest rate is higher there than in their own country.

The inflow or outflow of capital affects foreign exchange markets as well as the loanable funds market.  Let's look at this effect in a graphical representation.

In this particular situation, since interest rates are higher in Japan than they are in the United States, there is an increase in the number of Americans that are looking to invest in Japanese interest-bearing assets. When they do this, they will increase the demand for the Yen because they will need to exchange their dollars for the Yen. As a result, this will increase the amount of money that is available in loanable funds in Japan. 

Unit 6: Open Economy-International Trade and Finance

AP Macroeconomics

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Unit 1: Basic Economic Concepts

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Unit 3: National Income and Price Determination

Unit 4: Financial Sector

Unit 5: Long-Run Consequences of Stabilization Policies

Unit 6: Open Economy-International Trade and Finance

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Exam Skills: MCQ/FRQ

Unit 6: Open Economy-International Trade and Finance

AP Macroeconomics

all

study guides

blogs

browse by units

Free Reviews﻿

Unit 1: Basic Economic Concepts﻿

Unit 2: Economic Indicators and the Business Cycle﻿

Unit 3: National Income and Price Determination﻿

Unit 4: Financial Sector﻿

Unit 5: Long-Run Consequences of Stabilization Policies﻿

Unit 6: Open Economy-International Trade and Finance﻿

Blogs﻿

Exam Skills: MCQ/FRQ﻿

Free Reviews

Unit 1: Basic Economic Concepts

Unit 2: Economic Indicators and the Business Cycle

Unit 3: National Income and Price Determination

Unit 4: Financial Sector

Unit 5: Long-Run Consequences of Stabilization Policies

Unit 6: Open Economy-International Trade and Finance

Blogs

Exam Skills: MCQ/FRQ