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Macroeconomics Unit 6: Open economy: international trade and finance

Trade and capital flows link economies through the balance of payments and exchange rates, which respond to interest rates and policy.

Covers: Balance of payments, exchange rates, the foreign exchange market, effects of policy on exchange rates and net exports, real interest rates and international capital flows

Study guide

The balance of payments records a country's transactions with the rest of the world. The current account includes trade in goods and services (the balance of trade), investment income and transfers. The capital and financial account records purchases of assets, like foreign stocks, bonds, real estate and factories. Because every purchase must be paid for, the current account and financial account balance: a current account deficit is matched by a financial account surplus, meaning foreigners are buying the country's assets.

An exchange rate is the price of one currency in terms of another. In the foreign exchange market, demand for a currency comes from foreigners wanting to buy that country's goods, services and assets, and supply comes from residents wanting foreign goods and assets. A currency appreciates when it gains value and depreciates when it loses value. Appreciation makes a country's exports more expensive and imports cheaper, reducing net exports; depreciation does the opposite. Exchange rates change with tastes for foreign goods, relative incomes, relative price levels, and especially relative interest rates.

Policy affects exchange rates through interest rates. Higher real interest rates in the US, from contractionary monetary policy or government borrowing, attract foreign financial capital. Foreigners demand more dollars, the dollar appreciates, US exports fall and net exports decrease. Lower US interest rates cause capital outflows and depreciation, increasing net exports. In the loanable funds market, capital inflows increase the supply of loanable funds. Countries may let exchange rates float or try to fix them, and trade barriers such as tariffs and quotas affect trade flows and efficiency.

To weaken its own currency, a central bank sells its currency for foreign currency, which increases the currency's supply and depreciates it. To strengthen it, the bank uses foreign reserves to buy its own currency. This is how countries keep fixed or managed exchange rates. A tariff (a tax on imports) and an import quota both raise the domestic price and reduce imports. A tariff raises revenue for the government, while with a quota the extra money goes to whoever holds the import licenses.

If a country's inflation is higher than its trading partner's, its goods become relatively more expensive. Demand for its currency falls, and the currency depreciates. In the market for a currency, the horizontal axis is the quantity of that currency, and the vertical axis is its price in terms of the other currency (such as dollars per euro on the euro's graph). Demand comes from foreigners buying the country's goods and assets, and supply comes from residents buying foreign ones.

Key ideas

• The current account and financial account balance each other.
• Exchange rates come from supply and demand in the foreign exchange market.
• Appreciation reduces net exports; depreciation increases them.
• Higher real interest rates attract foreign capital and appreciate the currency.
• Monetary and fiscal policy affect trade through interest rates and exchange rates.

Formulas and rules

Common mistakes

• Thinking a stronger currency always helps a country's exporters; it hurts them.
• Mixing up the current account (goods, services, income) with the financial account (assets).

Words to know

Balance of payments

A record of all of a country's international transactions.

Current account

Trade in goods and services, investment income and transfers.

Balance of trade

Exports minus imports of goods and services.

Trade deficit

Imports exceed exports.

Capital and financial account

Records international purchases of assets.

Exchange rate

The price of one currency in terms of another.

Foreign exchange market

Where currencies are bought and sold.

Appreciation

A currency increasing in value.

Depreciation

A currency decreasing in value.

Floating exchange rate

Set by supply and demand.

Fixed exchange rate

Set by a government at a certain level.

Capital inflow

Foreigners buying a country's assets.

Capital outflow

Residents buying foreign assets.

Net exports

Exports minus imports; part of AD.

Sample practice questions

5 more questions like these, from level 1 to 5, are in the practice set.