CHAPTER
21
Open-Economy
Macroeconomics: The
Balance of Payments and
Exchange Rates
Appendix: World Monetary Systems Since 1900
Prepared by: Fernando Quijano
and Yvonn Quijano
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates
• The main difference between an
international transaction and a
domestic transaction concerns
currency exchange.
• International exchange must be
managed in a way that allows each
partner in the transaction to wind up
with his or her own currency.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
2 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates
• The exchange rate is the price of
one country’s currency in terms of
another country’s currency; the ratio
at which two currencies are traded
for each other.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
3 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Balance of Payments
• Foreign exchange is simply all
currencies other than the domestic
currency of a given country.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
4 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Balance of Payments
• The balance of payments is the
record of a country’s transactions in
goods, services, and assets with the
rest of the world; also the record of a
country’s sources (supply) and uses
(demand) of foreign exchange.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
5 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
United States Balance of Payments, 2002
CURRENT ACCOUNT
Goods exports
Goods imports
(1) Net export of goods
682.6
– 1,166.9
– 484.3
Export of services
Import of services
(2) Net export of services
289.3
– 240.5
48.8
Income received on investments
Income payments on investments
244.6
– 256.5
(3) Net investment income
(4) Net transfer payments
(5) Balance on current account (1 + 2 + 3 + 4)
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –)
(7) Change in foreign private assets in the United States
(8) Change in U.S. government assets abroad (increase is –)
(9) Change in foreign government assets in the United States
(10) Balance on capital account (6 + 7 + 8 + 9)
(11) Statistical discrepancy
(12) Balance of payments (5 + 10 + 11)
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
– 11.9
– 56.0
– 503.4
– 152.9
533.7
– 3.3
46.6
474.1
29.3
0
Karl Case, Ray Fair
6 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• A country’s current account is the
sum of its:
• net exports (exports minus imports),
• net income received from investments
abroad, and
• net transfer payments from abroad.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
7 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• Exports earn foreign exchange and
are a credit (+) item on the current
account. Imports use up foreign
exchange and are a debit (–) item.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
8 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• The balance of trade is the
difference between a country’s
exports of goods and services and
its imports of goods and services.
• A trade deficit occurs when a
country’s exports are less than its
imports.
• Net exports of goods and services
(EX – IM), is the difference between
a country’s total exports and total
imports.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
9 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• Investment income consists of
holdings of foreign assets that yield
dividends, interest, rent, and profits
paid to U.S. asset holders (a source
of foreign exchange).
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
10 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• Net transfer payments are the
difference between payments from
the United States to foreigners and
payments from foreigners to the
United States.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
11 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Current Account
• The balance on current account
consists of net exports of goods, plus
net exports of services, plus net
investment income, plus net transfer
payments. It shows how much a
nation has spent relative to how
much it has earned.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
12 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Capital Account
• For each transaction recorded in the
current account, there is an offsetting
transaction recorded in the capital
account.
• The capital account records the
changes in assets and liabilities.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
13 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Capital Account
• The balance on capital account in the
United States is the sum of the following
(measured in a given period):
• the change in private U.S. assets abroad
• the change in foreign private assets in the
United States
• the change in U.S. government assets abroad,
and
• the change in foreign government assets in the
United States
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
14 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Capital Account
• In the absence of errors, the balance on
capital account would equal the negative
of the balance on current account.
• If the capital account is positive, the
change in foreign assets in the country is
greater than the change in the country’s
assets abroad, which is a decrease in the
net wealth of the country.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
15 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The United States as a Debtor Nation
• A country’s net wealth is the sum of
all its past current account balances.
• Prior to the mid-1970s, the United
States was a creditor nation. After
the mid-1970s, the United Sates
began to have a negative net wealth
position vis-à-vis the rest of the
world.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
16 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The United States as a Debtor Nation
• A negative net wealth position vis-àvis the rest of the world reflects the
fact that the United States spent
much more on foreign goods and
services than it earned through the
sales of its goods and services.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
17 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Equilibrium Output (Income)
in an Open Economy
Planned aggregate expenditure (AE) in an open economy:
AE  C  I  G  EX  IM
• In equilibrium:
C  a  bY
Y  C  I  G  EX  IM
I  I0
Y  a  bY  I  G  EX  mY
Y  bY  mY  a  I  G  EX
Y (1 b  m)  a  I  G  EX
G  G0
EX  EX 0
IM  mY
m = marginal propensity
to import (or MPM)
© 2004 Prentice Hall Business Publishing
1
Y* 
(a  I  G  EX )
1 b  m
multiplier autonomous expenditures
Principles of Economics, 7/e
Karl Case, Ray Fair
18 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Equilibrium Output (Income)
in an Open Economy
• Exports contribute to an
increase in autonomous
expenditures and cause the
planned aggregate expenditure
function to shift upward.
© 2004 Prentice Hall Business Publishing
• Imports affect the value of the
multiplier. After imports are
included, the aggregate
expenditure function rotates and
equilibrium income decreases.
Principles of Economics, 7/e
Karl Case, Ray Fair
19 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Imports and Exports and
the Trade Feedback Effect
• The determinants of imports are the
same as the factors that affect
consumption and investment
behavior.
• Spending on imports also depends
on the relative prices of domestically
produced and foreign-produced
goods.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
20 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Imports and Exports and
the Trade Feedback Effect
• The demand for U.S. exports
depends on economic activity in the
rest of the world. If foreign output
increases, U.S. exports tend to
increase.
• Because U.S. imports are somebody
else’s exports, the extra import
demand from the United States
raises the exports of the rest of the
world.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
21 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Imports and Exports and
the Trade Feedback Effect
• The trade feedback effect is the
tendency for an increase in the
economic activity of one country to
lead to a worldwide increase in
economic activity, which then feeds
back to that country.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
22 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Imports and Export Prices
and the Trade Feedback Effect
• When the export prices of one
country rise, with no change in the
exchange rate, the import prices of
another rise.
• If the inflation rate abroad is high,
U.S. import prices are likely to rise.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
23 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Imports and Export Prices
and the Trade Feedback Effect
• The price feedback effect is the
process by which a domestic price
increase in one country can “feed
back” on itself through export and
import prices.
• Inflation is “exportable.”
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
24 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Open Economy with
Flexible Exchange Rates
• Floating, or market-determined,
exchange rates are exchange rates
determined by the unregulated
forces of supply and demand.
• Exchange rate movements have
important impacts on imports,
exports, and movement of capital
between countries.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
25 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
• In a world where there are only two
countries, the United States and
Britain, the demand for pounds is
comprised of holders of dollars
wishing to acquire pounds. The
supply of pounds is comprised of
holders of pounds seeking to
exchange them for dollars.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
26 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
Some Private Buyers and Sellers in International
Exchange Markets: United States and Great Britain
THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS)
1.
Firms, households, or governments that import British goods into the United States
or wish to buy British-made goods and services
2.
U.S. citizens traveling in Great Britain
3.
Holders of dollars who want to buy British stocks, bonds, or other financial
instruments
4.
U.S. companies that want to invest in Great Britain
5.
Speculators who anticipate a decline in the value of the dollar relative to the pound
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
27 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
Some Private Buyers and Sellers in International
Exchange Markets: United States and Great Britain
THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS)
1.
Firms, households, or governments that import U.S. goods into Great Britain or wish
to buy U.S.-made goods and services
2.
British citizens traveling in the United States
3.
Holders of pounds who want to buy stocks, bonds, or other financial instruments in
the United States
4.
British companies that want to invest in the United States
5.
Speculators who anticipate a rise in the value of the dollar relative to the pound
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
28 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
• The demand for pounds in
the foreign exchange market
shows a negative relationship
between the price of pounds
(dollars per pound) ($/£) and
the quantity of pounds
demanded.
• When the price of pounds falls, British-made goods and services
appear less expensive to U.S. buyers. If British prices are
constant, U.S. buyers will buy more British goods and services,
and the quantity demanded of pounds will rise.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
29 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Market for Foreign Exchange
• The supply of pounds in
the foreign exchange
market shows a positive
relationship between the
price of pounds (dollars per
pound) ($/£) and the
quantity of pounds
supplied.
• When the price of pounds rises, the British can obtain more dollars
for each pound. This means that U.S.-made goods and services
appear less expensive to British buyers. Thus, the quantity of
pounds supplied is likely to rise with the exchange rate.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
30 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Equilibrium Exchange Rate
© 2004 Prentice Hall Business Publishing
• The equilibrium exchange
rate occurs at the point at
which the quantity
demanded of a foreign
currency equals the
quantity of that currency
supplied.
Principles of Economics, 7/e
Karl Case, Ray Fair
31 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Equilibrium Exchange Rate
• An excess supply of pounds will
cause the price of pounds to fall—
the pound will depreciate (fall in
value) with respect to the dollar.
• An excess demand for pounds will
cause the price of pounds to rise—
the pound will appreciate (rise in
value) with respect to the dollar.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
32 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• Purchasing Power Parity: The
Law of One Price If the costs of
transportation are small, the price of
the same good in different countries
should be roughly the same.
• If the law of one price held for all goods,
and if each country consumed the same
market basket of goods, the exchange
rate between the two currencies would
be determined simply by the relative
price levels in the two countries.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
33 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• The theory that exchange rates are
set so that the price of similar goods
in different countries is the same is
known as the purchasing-power
parity.
• If it takes ten times as many pesos to
buy a pound of salt in Mexico as it takes
U.S. dollars to buy a pound of salt in the
United States, then the equilibrium
exchange rate should be 10 pesos per
dollar.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
34 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• A high rate of inflation in one country
relative to another puts pressure on
the exchange rate between the two
countries, and there is a general
tendency for the currencies of
relative high-inflation countries to
depreciate.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
35 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
© 2004 Prentice Hall Business Publishing
• A higher price level in
the United States
increases the demand
for pounds and
decreases the supply
of pounds. The result
is appreciation of the
pound against the
dollar.
Principles of Economics, 7/e
Karl Case, Ray Fair
36 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
• The level of a country’s interest rate
relative to interest rates in other
countries is another determinant of
the exchange rate. If U.S. interest
rates rise relative to British interest
rates, British citizens may be
attracted to U.S. securities.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
37 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Factors that Affect Exchange Rates
© 2004 Prentice Hall Business Publishing
• A higher interest rate in
the United States
increases the supply
and decreases the
demand for pounds.
The result is
depreciation of the
pound against the
dollar.
Principles of Economics, 7/e
Karl Case, Ray Fair
38 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Effects of Exchange
Rates on the Economy
• When a country’s currency
depreciates (falls in value), its import
prices rise and its export prices (in
foreign currencies) fall.
• When the U.S. dollar is cheap, U.S.
products are more competitive in
world markets, and foreign-made
goods look expensive to U.S.
citizens.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
39 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
The Effects of Exchange
Rates on the Economy
• A depreciation of a country’s
currency can serve as a stimulus to
the economy:
• Foreign buyers are likely to increase
their spending on U.S. goods
• Buyers substitute U.S.-made goods for
imports
• Aggregate expenditure on domestic
output will rise
• Inventories will fall
• GDP (Y) will increase
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
40 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates and the
Balance of Trade: The J Curve
• The balance of trade is equal to
export revenue minus import costs:
balance of trade = dollar price of exports x
quantity of exports
 dollar price of imports x quantity of imports
• According to the J-curve effect, the
balance of trade gets worse before it
gets better following a currency
depreciation.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
41 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates and the
Balance of Trade: The J Curve
© 2004 Prentice Hall Business Publishing
• Initially, the negative effect
on the price of imports may
dominate the positive effects
of an increase in exports
and a decrease in imports.
• But when imports and
exports have had a time to
respond to price changes,
the balance of trade
improves.
Principles of Economics, 7/e
Karl Case, Ray Fair
42 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Exchange Rates and Prices
• Depreciation of a country’s currency tends
to increase the price level.
• Export demand rises.
• Domestic buyers substitute domestic products
for the now more expensive imports.
• If the economy is operating close to capacity, the
increase in aggregate demand is likely to result
in higher prices.
• If import prices rise, costs may rise for business
firms, shifting the AS curve to the left.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
43 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Monetary Policy with
Flexible Exchange Rates
• Fed actions to lower interest rates
result in a decrease in the demand
for dollars and an increase in the
supply of dollars, causing the dollar
to depreciate.
• If the purpose of the Fed is to
stimulate the economy, dollar
depreciation is a good thing. It
increases U.S. exports and
decreases imports.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
44 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Fiscal Policy with
Flexible Exchange Rates
• Flexible interest rates may not help
in the attempt by government to cut
taxes in order to stimulate the
economy.
• A tax cut results in increased
household spending, but some of
that spending leaks out as imports,
reducing the multiplier.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
45 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Fiscal Policy with
Flexible Exchange Rates
• As income increases, the demand
for money increases. The resulting
higher interest rates cause the dollar
to appreciate. Exports fall, imports
rise, again reducing the multiplier.
• If interest rates rise, private
investment may be crowed out, also
lowering the multiplier.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
46 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Monetary Policy with
Fixed Exchange Rates
• Monetary policy has no role in a
country that has a fixed exchange
rate.
• For example, an attempt to lower
interest rates results in currency
depreciation and a lower (not a fixed)
exchange rate.
• In the absence of capital controls,
the monetary authority loses its
independence.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
47 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
THE GOLD STANDARD
• Early in the century, during the gold
standard era, nearly all currencies were
backed by gold. Their values were
fixed in terms of a specific number of
ounces of gold, which determined their
values in international trading—
exchange rates.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
48 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
“PURE” FIXED EXCHANGE RATES
• Under this type of system,
governments set a particular fixed rate
at which their currencies will exchange
for each other.
• There is no automatic mechanism to
keep exchange rates aligned with each
other, as with the gold standard.
Therefore, governments must at times
intervene to keep currencies aligned at
their established values.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
49 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
© 2004 Prentice Hall Business Publishing
Government Intervention
in the Foreign Exchange
Market
• If the government has
committed itself to
keeping the value of
the lira at .020, it must
buy up the excess
supply of lira (Qs – Qd).
Principles of Economics, 7/e
Karl Case, Ray Fair
50 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
•
At the end of World War II, economists
from the United States and Europe met to
formulate a new set of rules for exchange
rate determination, known as the Bretton
Woods system:
1. Countries were to maintain fixed exchange
rates with each other. All currencies were
fixed in terms of the U.S. dollar.
2. Countries experiencing a persistent current
account deficit (or fundamental disequilibrium)
in their balance of payments were allowed to
change their exchange rates.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
51 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Appendix: World Monetary
Systems Since 1900
• The alternative to a fixed exchange
rate system is a flexible system:
• In a freely floating system,
governments do not intervene at
all in the foreign exchange
market.
• In a managed floating system,
governments intervene if markets
are becoming disorderly.
© 2004 Prentice Hall Business Publishing
Principles of Economics, 7/e
Karl Case, Ray Fair
52 of 53
C H A P T E R 21: Open-Economy Macroeconomics: The Balance of
Payments and Exchange Rates
Review Terms and Concepts
appreciation of a currency
foreign exchange
balance of payments
J-curve effect
balance of trade
law of one price
balance on capital account
marginal propensity to import
(MPM)
balance on current account
depreciation of a currency
net exports of goods and
services (EX – IM)
exchange rate
price feedback effect
floating, or market-determined,
exchange rates
purchasing-power-parity theory
© 2004 Prentice Hall Business Publishing
trade deficit
trade feedback effect
Principles of Economics, 7/e
Karl Case, Ray Fair
53 of 53