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Foreign Trade and the Foreign Trade and the

Exchange RateExchange Rate

Chapter 12Chapter 12

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OutlineOutline��Foreign trade and aggregate demandForeign trade and aggregate demand

��The exchange rateThe exchange rate

��The determinants of net exportsThe determinants of net exports

��A model of the real exchange ratesA model of the real exchange rates

��The IS curve and economic policy in an The IS curve and economic policy in an open economyopen economy

��The exchange rate and the price levelThe exchange rate and the price level

��Fixed and floating exchange rates in the long Fixed and floating exchange rates in the long runrun

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12.1 FOREIGN TRADE12.1 FOREIGN TRADE

AND AGGREGATE DEMANDAND AGGREGATE DEMAND

��The quantity of goods and services flowing into The quantity of goods and services flowing into

and out of the United States is not the only and out of the United States is not the only

important dimension of trade.important dimension of trade.

��It matters how much we have to pay for imports and It matters how much we have to pay for imports and

how much we can get for our exports. how much we can get for our exports.

��Nominal or dollar flows are important in foreign Nominal or dollar flows are important in foreign

trade, whereas real flows concern us in trade, whereas real flows concern us in

considering domestic production.considering domestic production.

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12.1 FOREIGN TRADE12.1 FOREIGN TRADE

AND AGGREGATE DEMANDAND AGGREGATE DEMAND

��The The terms of trade terms of trade is the ratio of the price of is the ratio of the price of

exports to the price of imports. exports to the price of imports.

��When the prices of imports rise, we say there has When the prices of imports rise, we say there has

been an adverse shift in the terms of trade.been an adverse shift in the terms of trade.

��Foreign trade influences U.S. aggregate demand Foreign trade influences U.S. aggregate demand

in two ways.in two ways.

��Import and export of goods and servicesImport and export of goods and services

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12.2 THE EXCHANGE RATE12.2 THE EXCHANGE RATE��The The exchange rate exchange rate is the amount of foreign is the amount of foreign

currency that can be bought with 1 U.S. dollar.currency that can be bought with 1 U.S. dollar.

��The exchange rate is determined in the The exchange rate is determined in the foreign foreign exchange market, exchange market, where dollars and other where dollars and other currencies are traded freely.currencies are traded freely.

��In todayIn today’’s monetary system the dollar exchange s monetary system the dollar exchange rate is allowed to rate is allowed to float float against the currencies of against the currencies of other large countries.other large countries.

��The system is called a The system is called a floating floating or or flexible exchangeflexible exchange--rate system.rate system.

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12.2 THE EXCHANGE RATE12.2 THE EXCHANGE RATE

��A convenient single measure of the dollar A convenient single measure of the dollar

exchange rate is the exchange rate is the tradetrade--weighted exchange weighted exchange

rate, rate, which we denote by the symbol which we denote by the symbol EE..

��This is an average of several different exchange This is an average of several different exchange

rates, each one weighted according to the amount of rates, each one weighted according to the amount of

trade with the United States.trade with the United States.

��Depreciation of the dollar Depreciation of the dollar occurs when the occurs when the

exchange rate exchange rate E E falls. falls. Appreciation of the dollar Appreciation of the dollar

occurs when the exchange rate occurs when the exchange rate E E rises.rises.

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The Exchange Rate and Relative PricesThe Exchange Rate and Relative Prices

��The The real exchange rate real exchange rate is a measure of the is a measure of the

exchange rate adjusted for differences in price exchange rate adjusted for differences in price

levels between the United States and the Rest of levels between the United States and the Rest of

the World (ROW).the World (ROW).

��It is a measure of the relative price of goods It is a measure of the relative price of goods

produced in the United States compared with produced in the United States compared with

goods produced in the ROW.goods produced in the ROW.

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The Exchange Rate and Relative PricesThe Exchange Rate and Relative Prices

Real exchange rate

=

WP

ExP=

goodsROW of priceForeign

goods USof priceForeign

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Purchasing Power ParityPurchasing Power Parity

��If the United States and the ROW produced all If the United States and the ROW produced all

the same products, the exchange rate could not the same products, the exchange rate could not

fluctuate in the short run and would change in fluctuate in the short run and would change in

the longer run only by as much as prices in the the longer run only by as much as prices in the

ROW rose by more than prices in the United ROW rose by more than prices in the United

States. States.

��This theory of exchangeThis theory of exchange--rate fluctuations is rate fluctuations is

called called purchasing power parity.purchasing power parity.

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12.3 THE DETERMINANTS OF 12.3 THE DETERMINANTS OF

NET EXPORTSNET EXPORTS

��Fluctuations in the exchange rate change the Fluctuations in the exchange rate change the

relative price of U.S. and ROW goods and relative price of U.S. and ROW goods and

thereby affect the demand for imports and thereby affect the demand for imports and

exports.exports.

��Imports depend positively on the exchange rate.Imports depend positively on the exchange rate.

��Exports depend negatively on the exchange rate.Exports depend negatively on the exchange rate.

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The Effect of IncomeThe Effect of Income

��Generally, imports respond positively to GDP. Generally, imports respond positively to GDP.

On the other hand, there is little connection On the other hand, there is little connection

between U.S. exports and U.S. GDP. between U.S. exports and U.S. GDP.

��Hence, net exports depend negatively on GDP. Hence, net exports depend negatively on GDP.

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The Net Export FunctionThe Net Export Function

��We can combine imports and exports into a We can combine imports and exports into a

single measure, net exports single measure, net exports XX, defined as , defined as

exports less imports.exports less imports.

��Net exports depend negatively on the real exchange Net exports depend negatively on the real exchange

rate.rate.

��Net exports depend negatively on real income in the Net exports depend negatively on real income in the

United States.United States.

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The Net Export FunctionThe Net Export Function

��We can summarize these ideas in a simple algebraic We can summarize these ideas in a simple algebraic

formula:formula:

��Equation 12.1 is the net export function.Equation 12.1 is the net export function.

�� It says that net exports equal a constant It says that net exports equal a constant g g minus a coefficient minus a coefficient

m m times income times income YY, minus a coefficient , minus a coefficient n n times the real times the real

exchange rate. exchange rate.

(12.1)EP

X g mY nPw

= − −

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Numerical ExampleNumerical Example

��A numerical example of the net export function A numerical example of the net export function can be written:can be written:

��Suppose that the price level in both the United Suppose that the price level in both the United States and the ROW are predetermined at the value States and the ROW are predetermined at the value of 1.0 of 1.0

��If output If output Y Y is $5,000 billion and the exchange rate is $5,000 billion and the exchange rate E E is 1.0, then net exports is 1.0, then net exports X X equal zero.equal zero.

600 0.1 100 (12.2)EP

X YPw

= − −

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Numerical ExampleNumerical Example

��If output If output Y Y rises by $100 billion, then net rises by $100 billion, then net

exports fall by $10 billion, because imports rise exports fall by $10 billion, because imports rise

by this amount. by this amount.

��If the exchange rate falls from 1.0 to 0.6, about If the exchange rate falls from 1.0 to 0.6, about

as much as it did from 1985 to 1992, then net as much as it did from 1985 to 1992, then net

exports would rise by $40 billion.exports would rise by $40 billion.

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12.4 A MODEL OF THE REAL12.4 A MODEL OF THE REAL

EXCHANGE RATEEXCHANGE RATE

��Fluctuations in the exchange rate are closely Fluctuations in the exchange rate are closely

related to interest rates in the United States and related to interest rates in the United States and

the ROW. the ROW.

��In particular, policies in the United States that raise In particular, policies in the United States that raise

interest rates tend to cause the dollar to appreciate.interest rates tend to cause the dollar to appreciate.

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12.4 A MODEL OF THE REAL12.4 A MODEL OF THE REAL

EXCHANGE RATEEXCHANGE RATE

��In algebra, we can express the positive relation In algebra, we can express the positive relation

between the real exchange rate and the U.S. between the real exchange rate and the U.S.

interest rate asinterest rate as

(EP/(EP/PwPw) = q + ) = q + vRvR (12.3)(12.3)

where where R R is the U.S. interest rate and is the U.S. interest rate and q q and and v v are are

constants.constants.

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12.5 THE IS CURVE AND ECONOMIC12.5 THE IS CURVE AND ECONOMIC

POLICY IN AN OPEN ECONOMYPOLICY IN AN OPEN ECONOMY

��Without Without net exports in the income identity, the IS net exports in the income identity, the IS curve slopes downward, because higher interest curve slopes downward, because higher interest rates reduce investment and, through the rates reduce investment and, through the multiplier, reduce GDP.multiplier, reduce GDP.

��With With net exports, an increase in the interest rate net exports, an increase in the interest rate also raises the exchange rate and thereby reduces also raises the exchange rate and thereby reduces net exports.net exports.

�� This makes the IS curve flatter than it would be in a This makes the IS curve flatter than it would be in a closed economy.closed economy.

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12.5 THE IS CURVE AND ECONOMIC12.5 THE IS CURVE AND ECONOMIC

POLICY IN AN OPEN ECONOMYPOLICY IN AN OPEN ECONOMY

��The presence of net exports also reduces the The presence of net exports also reduces the

size of the multiplier, making the IS curve size of the multiplier, making the IS curve

steeper.steeper.

��Net exports depend negatively on GDP. As Net exports depend negatively on GDP. As

GDP rises, part of the increase in spending goes GDP rises, part of the increase in spending goes

overseas and does not enter domestic aggregate overseas and does not enter domestic aggregate

demand. demand.

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Algebraic Derivation of the OpenAlgebraic Derivation of the Open--

Economy IS CurveEconomy IS Curve

��Y = C + I + G + XY = C + I + G + X

��Y = aY = a––b(1b(1--t)Y + et)Y + e––dRdR + G + g+ G + g––mYmY––n(EP/Pwn(EP/Pw))

��Substitute the real interest rate from Equation Substitute the real interest rate from Equation

12.3 and solve as in Chapter 812.3 and solve as in Chapter 8

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Effects of Monetary and Fiscal Policy on Effects of Monetary and Fiscal Policy on

Trade in the Short RunTrade in the Short Run

��Suppose the Fed increases the money supply. Suppose the Fed increases the money supply.

��The decline in interest rates depreciates the exchange The decline in interest rates depreciates the exchange

rate, net exports rise, and GDP rises.rate, net exports rise, and GDP rises.

��However, the increase in GDP tends to decrease net However, the increase in GDP tends to decrease net

exports because imports rise.exports because imports rise.

��There are thus two offsetting effects of an increase in the There are thus two offsetting effects of an increase in the

money supply on net exports: exports rise, but imports money supply on net exports: exports rise, but imports

may rise even more.may rise even more.

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Effects of Monetary and Fiscal Policy on Effects of Monetary and Fiscal Policy on

Trade in the Short RunTrade in the Short Run

��Suppose that government spending is increased. Suppose that government spending is increased.

��The rise in interest rates causes the exchange rate to The rise in interest rates causes the exchange rate to appreciate. appreciate.

��The higher exchange rate reduces exports The higher exchange rate reduces exports

��The increase in government spending crowds out The increase in government spending crowds out exports as well as investment. exports as well as investment.

��Imports also rise because of the increase in the Imports also rise because of the increase in the dollar and GDP. dollar and GDP.

��Thus, an increase in government spending increases Thus, an increase in government spending increases the trade deficit or reduces the trade surplus. the trade deficit or reduces the trade surplus.

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Price AdjustmentPrice Adjustment

��An increase in the money supply eventually causes An increase in the money supply eventually causes

prices to rise.prices to rise.

��The price level will increase by the amount of the The price level will increase by the amount of the

original increase in the money supply. original increase in the money supply.

��The real exchange rate will return to normal so that The real exchange rate will return to normal so that

the nominal exchange rate the nominal exchange rate E E will depreciate by the will depreciate by the

amount of the increase in the price level. amount of the increase in the price level.

��In the long run, money is neutral. In the long run, money is neutral.

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Price AdjustmentPrice Adjustment

��An increase in government spending eventually An increase in government spending eventually

causes an upward adjustment in pricescauses an upward adjustment in prices

��The reduction in real balances raises interest rates The reduction in real balances raises interest rates

and further reduces investment and net exports. and further reduces investment and net exports.

��Output returns to potential output, and the sum of Output returns to potential output, and the sum of

investment and net exports declines by exactly the investment and net exports declines by exactly the

amount of the increase in government spending. amount of the increase in government spending.

��The real exchange rate and the real interest rate are The real exchange rate and the real interest rate are

permanently higher after the process is complete.permanently higher after the process is complete.

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12.6 THE EXCHANGE RATE12.6 THE EXCHANGE RATE

AND THE PRICE LEVELAND THE PRICE LEVEL

��Changes in a small countryChanges in a small country’’s exchange rate bring s exchange rate bring

immediate and important changes in that immediate and important changes in that

countrycountry’’s price level.s price level.

��This is not true for the large U.S. economy.This is not true for the large U.S. economy.

��Movements in the exchange rate do not create Movements in the exchange rate do not create

price shocks for the U.S.price shocks for the U.S.

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12.8 STABILIZING THE 12.8 STABILIZING THE

EXCHANGE RATEEXCHANGE RATE

��The exchange rate strengthens (appreciates) if The exchange rate strengthens (appreciates) if

the domestic interest rate rises relative to the the domestic interest rate rises relative to the

foreign interest rateforeign interest rate

��The exchange rate weakens (depreciates) if the The exchange rate weakens (depreciates) if the

domestic interest rate falls relative to the foreign domestic interest rate falls relative to the foreign

interest rateinterest rate

��The Fed does not attempt to set the exchange The Fed does not attempt to set the exchange

raterate

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12.8 STABILIZING THE 12.8 STABILIZING THE

EXCHANGE RATEEXCHANGE RATE

��How might U.S. policy be changed to stabilize How might U.S. policy be changed to stabilize

the exchange rate?the exchange rate?

��The Fed would have to keep the interest rate The Fed would have to keep the interest rate

constant by setting a horizontal LM curve.constant by setting a horizontal LM curve.

��It would not be able to use monetary policy to It would not be able to use monetary policy to

achieve other goals such as stability of GDP and achieve other goals such as stability of GDP and

prices.prices.

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12.8 STABILIZING THE 12.8 STABILIZING THE

EXCHANGE RATEEXCHANGE RATE

��Positive shock to investment raises GDP more Positive shock to investment raises GDP more

with a fixed exchange rate?with a fixed exchange rate?

��But what about a negative shock?But what about a negative shock?

��Decrease in residential investment due to the Decrease in residential investment due to the

collapse of the subcollapse of the sub--prime loan market.prime loan market.

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12.8 STABILIZING THE 12.8 STABILIZING THE

EXCHANGE RATEEXCHANGE RATE

��Increase in the foreign interest rateIncrease in the foreign interest rate

��UK, France, and Italy in 1992 and 1993UK, France, and Italy in 1992 and 1993

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12.9 FIXED AND FLOATING 12.9 FIXED AND FLOATING

EXCHANGE RATES IN THE LONG RUNEXCHANGE RATES IN THE LONG RUN

��The exchange rate, price level, and monetary The exchange rate, price level, and monetary

policy for an economy in the long run are policy for an economy in the long run are

related byrelated by

��PE = PE = PwPw

��Purchasing power parity Purchasing power parity holds in the long run.holds in the long run.

��With a floating exchange rate, the equation has With a floating exchange rate, the equation has

the following interpretation.the following interpretation.

��E = E = PwPw/P/P

��Rate of appreciation = foreign inflation Rate of appreciation = foreign inflation –– domestic domestic

inflationinflation