452 section 8 The Open Economy: International Trade and Finance
- Assume the United States is operating below potential output.
a. Draw a correctly labeled aggregate demand and supply
graph showing equilibrium in the economy.
b. Suppose the government decreases taxes. On your graph,
show how the decrease in taxes will affect AD, SRAS, LRAS,
equilibrium aggregate price level, and output.
c. Assume the decrease in taxes led to an increased budget
deficit and that the deficit spending was funded through
government borrowing from the public. Use a correctly
labeled graph of the market for loanable funds to show the
effect of increased borrowing on the interest rate.
d. Given the effect on the interest rate from part c, draw a
correctly labeled graph of the foreign exchange market
showing the effect of the change in the interest rate on the
supply of U.S. dollars. Explain how the interest rate affects
the supply of U.S. dollars.
e. According to your graph from part d, what has happened to
the value of the U.S. dollar? How will this affect U.S. exports
and aggregate demand?Summary
1.A country’s balance of payments accountssummarize
its transactions with the rest of the world. The balance
of payments on the current account,or the current
account,includes the balance of payments on goods
and servicestogether with balances on factor income
and transfers. The merchandise trade balance,ortrade
balance,is a frequently cited component of the balance
of payments on goods and services. The balance of pay-
ments on the financial account,orthe financial ac-
count,measures capital flows. By definition, the balance
of payments on the current account plus the balance of
payments on the financial account is zero.
2.Capital flows respond to international differences in in-
terest rates and other rates of return; they can be usefully
analyzed using an international version of the loanable
funds model, which shows how a country where the in-
terest rate would be low in the absence of capital flows
sends funds to a country where the interest rate would be
high in the absence of capital flows. The underlying de-
terminants of capital flows are international differences
in savings and opportunities for investment spending.
3.Currencies are traded in the foreign exchange market;
the prices at which they are traded are exchange rates.
When a currency rises against another currency, it ap-
preciates;when it falls, it depreciates.Theequilib-
rium exchange ratematches the quantity of that
currency supplied to the foreign exchange market to the
quantity demanded.
4.To correct for international differences in inflation
rates, economists calculate real exchange rates,which
multiply the exchange rate between two countries’ re-
spective currencies by the ratio of the countries’ price
levels. The current account responds only to changes in
the real exchange rate, not the nominal exchange rate.
Purchasing power parityis the exchange rate that
makes the cost of a basket of goods and services equal
in two countries. While purchasing power parity and
the nominal exchange rate almost always differ, pur-chasing power parity is a good predictor of actual
changes in the nominal exchange rate.
5.Countries adopt different exchange rate regimes,rules
governing exchange rate policy. The main types are fixed
exchange rates,where the government takes action to
keep the exchange rate at a target level, and floating ex-
change rates,where the exchange rate is free to fluctu-
ate. Countries can fix exchange rates using exchange
market intervention,which requires them to hold for-
eign exchange reservesthat they use to buy any surplus
of their currency. Alternatively, they can change domes-
tic policies, especially monetary policy, to shift the de-
mand and supply curves in the foreign exchange market.
Finally, they can use foreign exchange controls.
6.Exchange rate policy poses a dilemma: there are economic
payoffs to stable exchange rates, but the policies used to
fix the exchange rate have costs. Exchange market inter-
vention requires large reserves, and exchange controls dis-
tort incentives. If monetary policy is used to help fix the
exchange rate, it isn’t available to use for domestic policy.
7.Fixed exchange rates aren’t always permanent commit-
ments: countries with a fixed exchange rate sometimes
engage in devaluationsorrevaluations.In addition to
helping eliminate a surplus of domestic currency on the
foreign exchange market, a devaluation increases aggre-
gate demand. Similarly, a revaluation reduces shortages
of domestic currency and reduces aggregate demand.
8.Under floating exchange rates, expansionary monetary
policy works in part through the exchange rate: cutting
domestic interest rates leads to a depreciation, and
through that to higher exports and lower imports,
which increases aggregate demand. Contractionary
monetary policy has the reverse effect.
9.The fact that one country’s imports are another coun-
try’s exports creates a link between the business cycles
in different countries. Floating exchange rates, however,
may reduce the strength of that link.Section 8 Review