Robert J. Gordon,
Macroeconomics, 10th edition,
2006, Addison-Wesley
Chapter 6:
International Trade, Exchange Rates, and
Macroeconomic Policy
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
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An economy with positive NX must lend to foreigners (lending or foreign
investment) while an economy with negative NX must borrow from
foreigners.
We also learned that government budget deficit can be financed partially or
totally by foreign borrowing depending on the size of the economy.
A small open economy can borrow the entire deficit without crowding out,
while a large economy influences world interest rates and thus crowd out
private investment.
The trilemma
Is the impossibility to maintain simultaneously :
1.
Independent control of domestic monetary policy
2.
Fixed exchange rates
3.
Free flows of capital with other nations.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The current account and the balance of payments (BOP)
 Current account equals NX plus two additional components
(are not part of GDP);
 Net flow of international investment income, these do not
represent production in the domestic economy. They are added
to the Gross National product not GDP.
 Net international transfers, e.g., remittances, they are also
excluded from GDP.
 The current account and the capital account
 BOP is divided into two parts.
1.
The current account, which records all types of flows for current
income and output.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
2.
The capital account, records purchases and sales of foreign assets
by citizens and purchases and sales of foreign assets by foreigners.
 BOP outcome
 When total credits are greater than debits, the country is said to
run a BOP surplus, i.e., it will receive more foreign money for
credits than domestic money it pays for debits. The opposite is
called a BOP deficit.
 The overall BOP surplus or deficit is the sum of the current
account and capital account.
Current account balance + capital account balance
= BOP outcome.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Foreign borrowing and international indebtedness
 A current account deficit must be financed either by borrowing
from foreign firms, households and governments. IT must
increase its indebtedness.
 A current account surplus implies a reduction in indebtedness or
an increase in the countries net investment surplus.
Change in international investment position =
current account balance
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Exchange rates
 The price of one currency in terms of another is called the
foreign exchange rate. It can be shown in two ways,
1. The dollar per yen $ 0.009437 per yen.
2. The yen per dollar yen 106.00 per $.
 Note: the two rates are equivalent (1/106 = .009437)
 But it is conventional (in USA) to express the foreign exchange
rate as the foreign currency per dollar, i.e., Yen 106.00 per $.
Except for the British pound and the euro.
 Changes in exchange rates
 A higher number means that the dollar experiences an A lower
number indicates a depreciation. ¥/$ decreases from 106.25 to
1.06 and the €/$ rate declines from .7798 to .7769, indicating a
depreciation of the dollar against the euro.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Sometimes the depreciation is high over time, e.g., the €/$ rate.
 The market for foreign exchange
 Tourists when they travel to any country they need to exchange
their currency into that country’s currency
 Banks that have too much of too little of foreign money can trade
for what they need in the foreign exchange market.
 The results of trading in foreign exchange are illustrated for four
foreign nations.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-2 Foreign Exchange Rates of the Dollar Against Four Major Currencies,
Quarterly, 1970–2005 (1 of 2)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-2 Foreign Exchange Rates of the Dollar Against Four Major Currencies,
Quarterly, 1970–2005 (2 of 2)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The factors that determine the foreign exchange rate and
influences its fluctuations can be summarized on the a demand
supply diagram like those used in figure 6-3
 Why people hold dollars and Swiss Francs
 People in many countries may find dollars or Swiss Francs more
convenient or safer than their own currencies. Sellers in these
countries also accept dollars and Swiss Francs.
 A change in preferences of people will shift the demand curve for
dollars and thus exchange rates.
 Demand for currencies is driven from the demand for its imports
and capital outflows. It also has a supply driven from the
demand of its exports and capital inflows.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-3 Determination of the Price in Swiss Francs of the Dollar
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 What explains the slopes of the demand and supply curves for
dollars in figure 6-3. D0 will be vertical if the price elasticity for
Swiss demand for US imports is zero.
 If price elasticity is negative the demand curve will be negatively
slopped. Look at figure 6-3
 The analysis for S0 is different. S0 will be vertical if the price
elasticity of the US demand for Swiss imports is -1 (since
revenues in foreign exchange will be the same with changes in
exchange rate). only if the price elasticity is greater than unity
(in absolute terms) S0 will be positively slopped.
 How governments can influence foreign exchange rates.
 If exchange rate of the dollar is higher than market equilibrium,
people must accept a lower rate for it to induce foreigners to
accept it.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 But some countries may prevent the depreciation of the dollar,
because it will make their exports expensive to sell.
 How they do that? Look at figure 6-3, the Switzerland
government can purchase the distance AB to maintain the dollar
appreciated at a rate of CHF 2.00/$.
 Real exchange rates and purchasing power parity.
 The real exchange rate (e) is equal to the nominal rate (e’)
adjusted for differences in inflation rates between the two
countries.
e = e’ × p/pf
 Suppose that in 2005 e and e’ for the Mexican peso is 10/$, the
price level in the two countries is 100
10 pesos/$ = 10 pesos × 100/100
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Assume that in 2006 pf is 200 while the US price remains fixed at
100
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


5 pesos/$ = 10 pesos × 100/200
The dollar experienced a real depreciation against the peso. If
the opposite is true the dollar would experience a real
appreciation.
Countries experience high inflation, find their nominal exchange
rate depreciates, while their real exchange rate remains roughly
unchanged.
Suppose that e jumps from 10 to 20 pesos/$ (nominal
depreciation), hence;
10 = 20 × 100/200 no real depreciation
Countries with rapid inflation usually witness nominal
depreciation without any major change in real exchange rate.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 We care about e more than e’, because it is a major determinant
of NX. When e appreciates M become cheaper an X become
expensive, business profits go down and unemployment increases
and vice versa.
 The theory of purchasing power parity
 PPP states that in open economies prices of traded goods should
be the same everywhere, therefore e should be constant (1);
1 = e’ × p/pf
 Swapping the left hand side and solve for e’
e’ = pf/p
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 PPP and inflation differentials
∆e’/e’ = pf - p
 Growth rate of e’ = growth rate of pf – p. the term ∆e’/e’ is
positive when there is an appreciation of a currency. The term
pf – p is the inflation differential between foreign and domestic
inflation.
 Why PPP breaks down
1.
2.
3.
4.
5.
New inventions
Discovery of new deposits of raw materials
Higher demand for a currency e.g., to deposit in banks.
Non-traded goods
Government policy e.g., subsidization.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Exchange rate systems
 Flexible exchange rate system
 Exchange rate is free to change, a depreciation and appreciation
would correct for deficit or surplus of BOP.
 Fixed exchange rate system
 The central bank agreed to finance any surplus or deficit in BOP.
To do so CB maintains foreign exchange reserves and stands
ready to buy or sell dollars as needed to maintain the foreign
exchange rate of its currency.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Determinants of net exports
 Net exports and the foreign exchange rate
 Effect of real income.
NX = NXa – nxY
 NXa is the autonomous component of net exports (determined
mainly by foreign income).
 nx is the fraction of real income spent on imports. During
expansions imports would be high (NX will be low) while during
recessions imports will be low (NX will be high).
 Effect of the foreign exchange rate
 When exchange rate appreciates X tends to decline and M tend
to increase, NX go down. To reflect this negative relationship
NX = NXa – nxY – ue.
e.g., NX = 1000 - .1Y – 2e
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Suppose that Y = 8000, e=100 NX would be zero. An appreciation
in e to 150 would reduce NX to -100.
 The real exchange rate and interest rate
 The demand for dollars and the fundamentals
 The demand for dollars is to buy American products or assets.
Why the outside world hold dollars, The fundamentals include
changes in the world wide to buy American goods, e.g., an
invention of new products in USA (+ve), or outside USA (-ve),
 But fundamentals change slowly, therefore they are not
responsible for volatile changes in e. sharp ups and downs in e
are due to the desire of foreigners to buy American securities. If
American securities are attractive (+ve effect), or foreign
securities became more attractive (-ve effect). Relative
attractiveness depends on (average) interest rate differentials.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 (r-rf) if r > rf US securities would be more attractive, and vice
versa. a rise in US interest should thus cause an appreciation and
vice versa.
 Interest rates and capital mobility
 Interest rates affect e through capital mobility.
 Perfect capital mobility if residents of one country can buy any
desired assets with very low commissions and fees, interest rates
would be tightly linked. If rf increases, the demand for foreign
securities increases, which raises r relative to rf.
 Any event the a country tends to change r relative to rf will
generate a huge capital movement that will soon eliminate the (rrf), e.g., capital expansion lowers r and causes capital outflows
which bring r back to its original level.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The tow adjustment mechanisms: fixed and flexible rates
 Perfect capital mobility implies that fiscal and monetary policies do not affect
domestic interest rates r.
 With fixed e, a stimulative monetary policy will not reduce domestic r but
instead causes will lead the country to a loss of international reserves as the
capital account causes a BOP deficit.
 In a pure flexible e, monetary policy stimulus generates excess supply of
money and lowers e till supply and demand are in balance again.
 In short under perfect capital mobility both monetary and fiscal policy lose
control over r. under fixed e monetary stimulus causes a loss of reserves, and
fiscal stimulus causes reserves to increase.
 Under flexible e monetary stimulus causes depreciation and fiscal stimulus
causes an appreciation, and vice versa.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The IS-LM model in a small open economy
 The assumption of perfect capital mobility introduces a new
assumption in the IS-LM that (r-rf) is zero.
 Any small change in r caused by shifts in monetary and fiscal
policy will generate capital flows that will quickly bring the
domestic interest rate into line with the unchanged foreign
interest rate.
 The BP schedule
 Under perfect capital mobility BOP can be in equilibrium only at
a single r equal to rf. Any higher interest rate will lead to
unlimited capital inflows causing a huge BOP surplus. Any
lower r will lead to unlimited capital outflows causing a huge
BOP deficit. The BOP is in equilibrium only along the BP line,
capital and current accounts are in equilibrium. (figure 6-8)
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 The analysis of fixed exchange rates
 We will examine the effects of monetary and the fiscal expansion.
We will assume that price level is fixed.
 Monetary expansion
 Figure 6-8, if real money supply increases LM shifts to the RHS,
while IS is assumed to be unchanged, r will go down to r1. This
generates huge capital outflows and loss of international
reserves. To prevent such movements, the CB must boast interest
rate back to r by reversing the monetary stimulus. LM shifts
back to LM0 and the economy returns back to E0. Monetary
policy is impotent.
 Fiscal expansion
 With fixed exchange rates, the only way domestic policy makers
can alter the real income is to use fiscal policy
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-8 Effect of an Increase in the Money Supply with Fixed Exchange Rates
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Figure 6-9, a fiscal expansion shifts IS to the RHS which moves
the economy to E2, r increases to r2, leading to huge capital
inflows. International reserves increase and the since e is fixed,
CB must increase MS until r returns to its initial level.
 In a closed economy without capital inflows, the economy would
move to point E3.
 Perfect capital mobility with fixed r makes fiscal policy very
effective.
 Analysis with flexible exchange rates
 The CB does nothing to prevent an appreciation or depreciation.
Monetary policy becomes very effective while fiscal policy
becomes ineffective.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-9 Effect of a Fiscal Policy Stimulus with Fixed Exchange Rates
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Figure 6-10. Note that the currency depreciates whenever the
economy moves below the BP (increases NX and shifts IS to the
RHS) and appreciates whenever it moves above the BP line
(reduces NX and shifts IS to the LHS).
 Monetary expansion
 Shifts the LM to the RHS, capital outflows lead to a
depreciation and NX increase such that IS shifts to IS1, till the
economy arrives to E3, where the economy and BOP are in
equilibrium at higher Y.
 Fiscal expansion
 Shifts IS to the RHS, capital inflows lead to an appreciation and
NX decreases. IS falls back to its initial position E0.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-10 Effect of a Monetary and Fiscal Policy Stimulus with Flexible
Exchange Rates
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 LM does not shift and domestic crowding out is replaced by
international crowding out which is complete in this case. The
twin deficits are identical; trade deficit is the fiscal deficit.
 Notes:
 With fixed exchange rates, fiscal policy is highly effective and CB
is forced to accommodate fiscal policy actions. Monetary policy
is impotent.
 With flexible exchange rates, monetary policy is highly effective,
CB can stimulate the economy by causing the exchange rate to
depreciate. Fiscal policy is impotent and international crowding
out is complete.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Capital mobility and exchange rates in a large open economy
 How a large economy differs from a small open economy
 A large economy has a substantial control over its r, capital flows
are not substantial to change r to equate rf. Capital mobility is
imperfect to eliminate (r-rf).
 Figure 6-11, for a small open economy BP is horizontal. In a
large economy capital account surplus occurs with r is high, and
a deficit occurs when r is low.
 For a BOP balance any surplus in capital account must be offset
by a deficit in current account which requires a high level of
income, e.g., at point C.
 For a BOP balance any deficit in capital account must also be
offset by a surplus in current account caused by lower income
e.g., at point A. BP slopes up for a large economy because capital
mobility is positively related to r.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-11 The BP Line in a Small and Large Open Economy
Capital account surplus
Must be with a C. account
Deficit (needs large income
Capital account deficit
Must be with a C. account
surplus (needs small income
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
 Monetary and fiscal policy with fixed and flexible exchange rates
 With fixed e monetary policy is impotent in a large economy,
while fiscal policy is highly effective, but some what less than the
case of a small open economy, since its stimulus is divided
between an increase in real income and domestic r instead of
being entirely directed toward an increase in real income.
 With flexible e fiscal policy is impotent in a large economy, while
monetary policy is highly effective, but since higher income must
be accompanied by higher r (BP is upward slopping), there is
some crowding out of domestic expenditures, and this must be
offset by a larger stimulus to NX than in a small open economy
requiring an even larger depreciation. See the following
summary.
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Summary of Monetary and Fiscal Policy Effects in Open Economies
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Table 6-1 The U.S. Balance of Payments, Selected Years
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-1 The U.S. Current Account Balance and Its Net International
Investment Position, 1975–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Table 6-2 Daily Quotations of Foreign Exchange Rates
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-2 Foreign Exchange Rates of the Dollar Against
Four Major Currencies, Quarterly, 1970–2005
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
International Perspective Big Mac Meets PPP
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-4 Nominal and Real Effective Exchange Rates of the Dollar, 1970–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-5 Foreign Official Holdings of Dollar Reserves as a Percent of U.S. GDP
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-6 U.S. Real Net Exports and the Real Exchange Rate of the Dollar, 1970–
2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Figure 6-7 The U.S. Real Corporate Bond Rate and the Real Exchange Rate of
the Dollar, 1970–2004
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University
Macroeconomic Theory
Prof. M. El-Sakka
CBA. Kuwait University