AP Macro Modules 41-44
Terms in this set (61)
Balance of payments
A summary of the country's transactions with other countries
Explain why the net total of sources of cash and uses of cash must equal 0.
Because sources of cash and uses of cash are the same so the net total has to be zero in order to keep them equal.
What is factor income?
Payments for the use of factors of production owned by residents of other countries (investment income)
- Interest paid on loans from overseas
-Profits of foreign owned corporations
EXAMPLE: Profits owned by Disneyland in Paris
What are international transfers?
Funds sent by residents of one country to residents of another
-Remittances that immigrants send to their families in their country of origin
EXAMPLE: Mexican born workers employed in the US
What are private sales and purchases of assets?
EXAMPLE: The 2008 purchase of Budweiser, an American brewing company, by the Belgian corporation
What are official asset sales and purchases of assets?
EXAMPLE: In 2008, most of the US sales in this category involved the accumulation of foreign exchange reserves by the central banks of China and oil exporting countries.
Define balance of payments on the current account
Its balance of payments on goods and services plus net international transfer payments and factor income
Define balance of payments on goods and services
The difference between its exports and its imports during a given period
Define merchandise trade balance
The difference between a country's exports and imports of goods
Define balance of payments on the financial account
The difference between its sales of assets to foreigners and its purchases of assets from foreigners during a given period
What are the main differences between the financial and current accounts?
The current account includes transactions that don't create liabilities and the financial account includes transactions that involve the sale or purchase of assets and therefore do create future liabilities
What is financial capital?
Funds from savings that are available for investment spending
What are 2 major simplifications to the loanable funds model?
1) [we simplify the reality of international capital flows by assuming that all flows are in the form of loans] In reality, capital flows take many forms, including purchases of shares of stock in foreign companies and foreign real estate as well as foreign direct investment, in which companies build factories or acquire other productive assets abroad.
2) [we also ignore the effects of expected changes in exchange rates] the relative values of different national currencies. We'll analyze the determination of exchange rates later
The loanable funds model shows the relationship between what two things?
Interest rate and quantity of loanable funds
(Ceretis Paribus) What happens when the interest rate is higher in one country than another?
It creates an incentive for capital flow from one country to another
Why is there a different demand for loanable funds in different countries?
Because some interest rates are higher than others
What types of nations tend to have a higher demand for loanable funds?
Countries that are industrialized
How do savings rates affect loanable funds?
The higher the savings, the better the loan
What else affects capital flows?
List and describe the reasons there are usually two-way capital flows instead of only one-way.
To diversify the investments so that when one market is failing, another country's market could be flourishing.
Define exchange rate
The prices at which currencies trade
Define foreign exchange market
Where currencies are traded
Define currency appreciation
When a currency becomes more valuable in terms of other currencies
Define currency depreciation
When a currency becomes less valuable in terms of other currencies
Define equilibrium exchange rate
The exchange rate at which the quantity of a currency demanded in the foreign exchange market is equal to the quantity supplied
What type of currency is used to pay for goods and services from a given country?
What do movements in exchange rates affect?
They ensure that changes in the financial account off set each other
When foreigners want to purchase US goods and services, what happens in the foreign exchange market?
The demand for US dollars in the foreign exchange market increases.
What happens to exports and imports when a nation's currency rises versus when it falls?
Rises= decrease in U.S. exports
Falls=increase in U.S. exports
What happens when capital flown from a foreign nation to the US increase and why?
It leads to a weaker dollar and generates increase in US exports.
What are the consequences of this increased capital inflow for the balance of payments?
It leads to a decrease in US exports
What does any change in the US balance of payments in the financial account do?
It generates an equal and opposite reaction in the balance of payments on the current account.
Define real exchange rate
Exchange rates adjusted for international differences in aggregate price levels
[# of foreign currency per US dollar X P(Foreign country)/P(US)]
How does the exchange rate affect the current account?
The current account responds only to changes in the real exchange rate, not the nominal exchange rate
Define purchasing power parity
The nominal exchange rate at which a given basket of goods and services would cost the same amount in each country
Do governments have more power over exchange rates or prices?
Exchange rates because the government can change the exchange rate but they cant directly change price
Why is the nominal exchange rate so important to nations?
It determines the price of imports, exports, and they can have affects on aggregate exports and imports
Define exchange rate regime
A rule governing policy toward the exchange rate
Define fixed exchange rate
When the government tries to keep a certain currency exchange rate at a certain point
Define floating exchange rate
Where the government allows exchange rate to go wherever
Define market intervention
Government purchases and sales of currency in foreign exchange market constitute
Define foreign exchange reserves
Stocks of foreign currency that the government maintains to buy their own currency on the foreign exchange market
Define foreign exchange controls
Licensing systems that limit the right of individuals to buy foreign currency
What 3 things can a nation do to fix an exchange rate below its equilibrium?
1) intervene in the foreign market by selling money for other currency
2) reduce interest rates
3) put in policies to make it harder for foreigners to buy their currencies
Advantages fixed exchange rate
1) avoid currency fluctuations
2) stability encourages investment
3) keep inflation low
What 3 things can a nation do to fix an exchange rate above its equilibrium?
1) buy its own money in the exchange market
2) changing monetary policy to shift supply and demand curves
3) reducing the supply of its currency to the foreign exchange market monetary policy
Disadvantages fixed exchange rate
1) conflicts with other objectives
2) less flexibility
3) hard to know what the right rate to join is
4) current account imbalances
In order for a nation to have a fixed exchange rate, what must they have numbers of in reserve?
Large amounts of foreign currency on hold
A reduction in the value of a currency that is set under a fixed exchange rate regime
An increase in the value of a currency that is set under a fixed exchange rate regime
How does devaluation affect exports and imports?
It makes domestic goods cheaper in terms of foreign currency which leads to higher exports. It makes foreign goods more expensive in terms of domestic currency which reduces imports
What does this do to the current account?
It increases the balance of payments on the current account
How does revaluation affect exports and imports?
It makes domestic goods more expensive in terms of foreign currency which reduces exports. It makes foreign goods cheaper in domestic currency which increase imports.
What does this do to the current account?
It reduces the balance of payments on the current account.
What are the 2 major purposes of devaluations and revaluations in a fixed exchange regime?
-They can be used to eliminate shortages on surpluses in the foreign exchange markets
-They can be used as tools of macroeconomic policy: devaluation->reduce/eliminate recessionary gap...revaluation-> reduce/eliminate inflationary gap
How can a central bank affect monetary policy?
A country's central bank retains its ability to pursue independent monetary policy: it can increase aggregate demand by cutting the interest rate or decrease aggregate demand by raising the interest rate (closed economy). Interest rate reduction leads to increased investment and consumer spending, therefore increasing aggregate demand (open economy).
What does a lower interest rate do to C and I in a nation?
Why does a recession in one nation affect another nation?
A recession decreases the country's imports which will in turn reduce their demand for goods from foreign countries which will reduce their AD
How would a foreign recession affect a domestic currency (with floating exchange rates)?
The domestic currency would depreciate due to decreased demand for domestic goods and services, which would decrease price exporting and increase the price of importing
Why does the above happen?
A recession causes a decreased demand for domestic goods and services and an increased supply of domestic currency on the foreign exchange market which depreciates the value, causing exports to increase and imports to decrease.
What is a major advantage of floating exchange rates?
It allows for automatic stabilization of open economies to reduce affects of recession and inflation