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To distinguish among the different types of expenditure that make up a country's GNP,government economists and statisticians who compile national income accounts divide GNP among the fou

PART 3 Exchange Rates

and Open-Economy Macroeconomics

292

C H A P T E R 1 2

National Income Accounting and the Balance of Payments

Over the decade from 1991 to 2000,Japan's national product grew at an annual

aver-age rate of only 1.5 percent, while that of the United States grew by nearly 3.5 cent per year A t the same time,Japan's unemployment rate rose, reaching nearly 5 percent and overtaking that of the United States for the first time in fifty years In 2001, however, the U.S economy entered a recession and the entire world economy slowed Can eco- nomic analysis help us t o understand both the interdependencies among national economies as well as the reasons why their fortunes often differ?

per-Previous chapters have been concerned primarily with the problem of making the best use of the world's scarce productive resources at a single point in time The branch of eco-

nomics called microeconomics studies this problem from the perspective of individual

firms and consumers Microeconomics works "from the bottom up" t o show how ual economic actors, by pursuing their own interests, collectively determine how resources are used In our study of international microeconomics we have learned how individual production and consumption decisions produce patterns of international trade and spe- cialization We have seen that while free trade usually encourages efficient resource use, government intervention or market failures can cause waste even when all factors of pro- duction are fully employed.

individ-W i t h this chapter we shift our focus and ask: How can economic policy ensure that

fac-tors of production are fully employed? And what determines how an economy's capacity t o

produce goods and services changes over time? To answer these questions we must

understand macroeconomics, the branch of economics that studies how economies'

overall levels of employment, production, and growth are determined Like ics, macroeconomics is concerned with the effective use of scarce resources But while microeconomics focuses on the economic decisions of individuals, macroeconomics ana- lyzes the behavior of the economy as a whole In our study of international macroeco- nomics, we will learn how the interactions of national economies influence the worldwide pattern of macroeconomic activity.

microeconom-Macroeconomic analysis emphasizes four aspects of economic life that we have usually kept in the background until now to simplify our discussion of international economics:

I Unemployment We know that in the real world workers may be unemployed

294 and factories may be idle Macroeconomics studies the factors that cause

unemploy-ment and the steps governunemploy-ments can take to prevent it A main concern of international

macroeconomics is the problem of ensuring full employment in economies open to

international trade.

2 Saving In earlier chapters we usually assumed that every country consumes an

amount exactly equal to its income—no more and no less In reality, though, households

can put aside part of their income to provide for the future, or they can borrow

tem-porarily to spend more than they earn A country's saving or borrowing behavior

affects domestic employment and future levels of national wealth From the standpoint

of the international economy as a whole, the world saving rate determines how

quick-ly the world stock of productive capital can grow.

3 Trade imbalances As we saw in earlier chapters, the value of a country's imports

equals the value of its exports when spending equals income This state of balanced

trade is seldom attained by actual economies, however Trade imbalances play a large

role in the following chapters because they redistribute wealth among countries and are

a main channel through which one country's macroeconomic policies affect its trading

partners It should be no surprise, therefore, that trade imbalances, particularly when

they are large and persistent, quickly can become a source of international discord.

4 Money and the price level The trade theory you have studied so far is a barter

theory, one in which goods are exchanged directly for other goods on the basis of their

relative prices In practice it is more convenient to use money, a widely acceptable

medium of exchange, in transactions, and to quote prices in terms of money Because

money changes hands in virtually every transaction that takes place in a modern

econ-omy, fluctuations in the supply of money or the demand for it can affect both output and

employment International macroeconomics takes into account that every country uses

a currency and that a monetary change in one country (for example, a change in money

supply) can have effects that spill across its borders to other countries Stability in

money price levels is an important goal of international macroeconomic policy.

This chapter takes the first step in our study of international macroeconomics by

explaining the accounting concepts economists use to describe a country's level of

pro-duction and its international transactions.To get a complete picture of the macroeconomic

linkages among economies that engage in international trade, we have to master two

related and essential tools The first of these tools, national income accounting,

records all the expenditures that contribute to a country's income and output The second

tool, balance of payments accounting, helps us keep track of both changes in a

coun-try's indebtedness to foreigners and the fortunes of its export- and import-competing

industries The balance of payments accounts also show the connection between foreign

transactions and national money supplies «

National Income Accounts

Of central concern to macroeconomic analysis is a country's gross national product

(GNP), the value of all final goods and services produced by its factors of production and

sold on the market in a given time period GNP, which is the basic measure of a country's

output studied by macroeconomists, is calculated by adding up the market value of all

expenditures on final output GNP therefore includes the value of goods like bread sold in

296 PART 3 Exchange Rates and Open-Economy Macroeconomics

a supermarket and textbooks sold in a bookstore, as well as the value of services provided

by supermarket checkers and baggers and by university professors Because output cannot

be produced without the aid of factor inputs, the expenditures that make up GNP are closelylinked to the employment of labor, capital, and other factors of production

To distinguish among the different types of expenditure that make up a country's GNP,government economists and statisticians who compile national income accounts divide

GNP among the four possible uses for which a country's output is purchased: consumption (the amount consumed by private domestic residents), investment (the amount put aside by private firms to build new plant and equipment for future production), government pur- chases (the amount used by the government), and the current account balance (the amount

of net exports of goods and services to foreigners) The term national income accounts, rather than national output accounts, is used to describe this fourfold classification because

a country's income in fact equals its output Thus, the national income accounts can bethought of as classifying each transaction that contributes to national income according tothe type of expenditure that gives rise to it Figure 12-1 shows how U.S GNP was dividedamong its four components in 2000.'

Why is it useful to divide GNP into consumption, investment, government purchases,and the current account? One major reason is that we cannot hope to understand the cause

of a particular recession or boom without knowing how the main categories of spendinghave changed And without such an understanding, we cannot recommend a sound policyresponse In addition, the national income accounts provide information essential for studyingwhy some countries are rich—that is, have a high level of GNP relative to population s i z e -while some are poor

National Product and National Income

Our first task in understanding how economists analyze GNP is to explain in greater detail

why the GNP a country generates over some time period must equal its national income,

the income earned in that period by its factors of production

The reason for this equality is that every dollar used to purchase goods or services matically ends up in somebody's pocket A visit to the doctor provides a simple example ofhow an increase in national output raises national income by the same amount The $75 youpay the doctor represents the market value of the services he or she provides for you, soyour visit raises GNP by $75 But the $75 you pay the doctor also raises his or her income

auto-So national income rises by $75

The principle that output and income are the same also applies to goods, even goods thatare produced with the help of many factors of production Consider the example of an eco-nomics textbook When you purchase a new book from the publisher, the value of your pur-chase enters GNP But your payment enters the income of the productive factors that havecooperated in producing the book, because the publisher must pay for their services with theproceeds of sales First, there are the authors, editors, artists, and typesetters who provide

'Our definition of the current account is not strictly accurate when a country is a net donor or recipient of foreign gifts This possibility, along with some others, also complicates our identification of GNP with national income.

We describe later in this chapter how the definitions of national income and the current account must be changed

in such cases.

Figure 12-1 U.S GNP and Its Components

America's $9.9 trillion

2000 gross national

product can be broken

down into the four

components shown.

Source: Economic

Indi-cators, U.S Government

Printing Office, April

1 i

Current account

the labor inputs necessary for the book's production Second, there are the publishing

com-pany's shareholders, who receive dividends for having financed acquisition of the capital

used in production Finally, there are the suppliers of paper and ink, who provide the

inter-mediate materials used in producing the book

The paper and ink purchased by the publishing house to produce the book are not counted

separately in GNP because their contribution to the value of national output is already

included in the book's price It is to avoid such double counting that we allow only the sale

of final goods and services to enter into the definition of GNP Sales of intermediate goods,

such as paper and ink purchased by a publisher, are not counted Notice also that the sale of

a used textbook does not enter GNP Our definition counts only final goods and services that

are produced and a used textbook does not qualify: It was counted in GNP at the time it was

first sold Equivalently, the sale of a used textbook does not generate income for any factor

of production

Capital Depreciation, International

Transfers, and Indirect Business Taxes

Because we have defined GNP and national income so that they are necessarily equal,

their equality is really an identity Some adjustments to the definition of GNP must be

made, however, before the identification of GNP and national income is entirely correct in

practice

298 PART 3 Exchange Rates and Open-Economy Macroeconomics

1 GNP does not take into account the economic loss due to the tendency of machinery

and structures to wear out as they are used This loss, called depreciation, reduces the

income of capital owners To calculate national income over a given period, we musttherefore subtract from GNP the depreciation of capital over the period GNP less

depreciation is called net national product (NNP).

2 A country's income may include gifts from residents of foreign countries, called

unilateral transfers Examples of unilateral transfers of income are pension payments to

retired citizens living abroad, reparation payments, and foreign aid such as relief fundsdonated to drought-stricken nations For the United States in 2000, the balance of suchpayments amounted to around $53.2 billion, representing a 0.53 percent of GNP nettransfer to foreigners Net unilateral transfers are part of a country's income but are notpart of its product, and they must be added to NNP in calculations of national income

3 National income depends on the prices producers receive for their goods, GNP on the prices purchasers pay These two sets of prices need not, however, be identical For

example, sales taxes make buyers pay more than sellers receive, leading GNP to

over-estimate national income The amount of this tax wedge, called indirect business taxes,

must therefore be subtracted from GNP in calculating true national income

National income equals GNP less depreciation, plus net unilateral transfers, less indirect

business taxes The difference between GNP and national income is by no means aninsignificant amount, but macroeconomics has little to say about it, and it is of little impor-tance for macroeconomic analysis Therefore, for the purposes of this text we usually use

the terms GNP and national income interchangeably, emphasizing the distinction between

the two only when it is essential

Gross Domestic Product

Most countries other than the United States have long reported gross domestic product (GDP) rather than GNP as their primary measure of national economic activity In 1991 the

United States began to follow this practice as well GDP is supposed to measure the volume

of production within a country's borders GNP equals GDP plus net receipts of factor

income from the rest of the world These net receipts are primarily the income domestic idents earn on wealth they hold in other countries less the payments domestic residentsmake to foreign owners of wealth located at home

res-GDP does not correct, as GNP does, for the portion of countries' production carried outusing services provided by foreign-owned capital Consider an example The earnings of aSpanish factory with British owners are counted in Spain's GDP but are part of Britain'sGNP The services British capital provides in Spain are a service export from Britain,therefore they are added to British GDP in calculating British GNP At the same time, tofigure Spain's GNP we must subtract from its GDP the corresponding service importfrom Britain

As a practical matter, movements in GDP and GNP usually do not differ greatly Wewill focus on GNP in this book, however, because GNP tracks national income moreclosely than GDP, and national welfare depends more directly on national income than ondomestic product

•National Income Accounting for an Open Economy

In this section we extend to the case of an open economy the closed-economy national

income accounting framework you may have seen in earlier economics courses We begin

with a discussion of the national income accounts because they highlight the key role of

international trade in open-economy macroeconomic theory Since a closed economy's

resi-dents cannot purchase foreign output or sell their own to foreigners, all of national income

must be generated by domestic consumption, investment, or government purchases In an

economy open to international trade, however, the closed-economy version of national income

accounting must be modified because some domestic output is exported to foreigners while

some domestic income is spent on imported foreign products

The main lesson of this section concerns the relation among national saving, investment,

and trade imbalances We will see that in open economies, saving and investment are not

necessarily equal as they are in a closed economy This is because countries can save by

exporting more than they import, and they can dissave—that is, reduce their wealth—by

exporting less than they import

Consumption

The portion of GNP purchased by the private sector to fulfill current wants is called

consumption Purchases of movie tickets, food, dental work, and washing machines all

fall into this category Consumption expenditure is the largest component of GNP in most

economies In the United States, for example, the fraction of GNP devoted to consumption

has fluctuated in a range of about 62 to 69 percent since the Korean War

Investment

The part of output used by private firms to produce future output is called investment.

Investment spending may be viewed as the portion of GNP used to increase the nation's

stock of capital Steel and bricks used to build a factory are part of investment spending, as

are services provided by a technician who helps build business computers Firms'

pur-chases of inventories are also counted in investment spending because carrying inventories

is just another way for firms to transfer output from current use to future use Investment is

usually more variable than consumption In the United States, (gross) investment has

fluc-tuated between 12 and 19 percent of GNP in recent years While we often use the word

investment to describe individual households' purchases of stocks, bonds, or real estate, you

should be careful not to confuse this everyday meaning of the word with the economic

defin-ition of investment as a component of GNP When you buy a share of Microsoft stock, you are

buying neither a good nor a service, so your purchase does not show up in GNP

Government Purchases

Any goods and services purchased by federal, state, or local governments are classified as

government purchases in the national income accounts Included in government purchases

are federal military spending, government support of cancer research, and government funds

spent on highway repair and education Government transfer payments like social security

300 PART 3 Exchange Rates and Open-Economy Macroeconomics

and unemployment benefits do not require the recipient to give the government any goods

or services in return Thus, transfer payments are not included in government purchases.Government purchases currently take up about 18 percent of U.S GNP, and this sharehas not changed much since the late 1950s (The corresponding figure for 1959, forexample, was around 20 percent.) In 1929, however, government purchases accounted foronly 8.5 percent of U.S GNP

The National Income Identity for an Open Economy

In a closed economy any final good or service that is not purchased by households or thegovernment must be used by firms to produce new plant, equipment, and inventories Ifconsumption goods are not sold immediately to consumers or the government, firms (per-haps reluctantly) add them to existing inventories, thus increasing investment

This information leads to a fundamental identity for closed economies Let Y stand for GNP, C for consumption, / for investment, and G for government purchases Since all of

a closed economy's output must be consumed, invested, or bought by the government, wecan write

Y = C + I + G.

We derived the national income identity for a closed economy by assuming that all outputwas consumed or invested by the country's citizens or purchased by its government Whenforeign trade is possible, however, some output is purchased by foreigners while somedomestic spending goes to purchase goods and services produced abroad The GNP identityfor open economies shows how the national income a country earns by selling its goods andservices is divided between sales to domestic residents and sales to foreign residents.Since residents of an open economy may spend some of their income on imports, that is,goods and services purchased from abroad, only the portion of their spending that is not

devoted to imports is part of domestic GNP The value of imports, denoted by IM, must be subtracted from total domestic spending, C + I + G, to find the portion of domestic spending

that generates domestic national income Imports from abroad add to foreign countries' GNPsbut do not add directly to domestic GNP

Similarly, the goods and services sold to foreigners make up a country's exports

Exports, denoted by EX, are the amount foreign residents' purchases add to the national

income of the domestic economy

The national income of an open economy is therefore the sum of domestic and foreignexpenditure on the goods and services produced by domestic factors of production Thus,the national income identity for an open economy is

Y= C + 1 + G + EX - IM (12-1)

Art Imaginary Open Economy

To make identity (12-1) concrete, let's consider an imaginary closed economy, Agraria,whose only output is wheat Each citizen of Agraria is a consumer of wheat, but each is also

a farmer and therefore can be viewed as a firm Farmers invest by putting aside a portion of

T a b l e 1 2 - 1 National Income Accounts for Agraria,

an Open Economy (bushels of wheat)

GNP * • _ » * * • Government

= Consumption + Investment + + Exports — Imports (total output) purchases

"55 bushels of wheat + (0.5 bushel per gallon) X (40 gallons of milk).

b 0.5 bushel per gallon X 40 gallons of milk.

each year's crop as seed for the following year's planting There is also a government that

appropriates part of the crop to feed the Agrarian army Agraria's total annual crop is

100 bushels of wheat Agraria can import milk from the rest of the world in exchange for

exports of wheat We cannot draw up the Agrarian national income accounts without knowing

the price of milk in terms of wheat because all the components in the GNP identity (12-1)

must be measured in the same units If we assume the price of milk is 0.5 bushel of wheat per

gallon, and that at this price Agrarians want to consume 40 gallons of milk, then Agraria's

imports are equal in value to 20 bushels of wheat

In Table 12-1 we see that Agraria's total output is 100 bushels of wheat Consumption is

divided between wheat and milk, with 55 bushels of wheat and 40 gallons of milk (equal in

value to 20 bushels of wheat) consumed over the year The value of consumption in terms of

wheat is 55 + (0.5 X 40) - 55 + 20 = 75

The 100 bushels of wheat produced by Agraria are used as follows: 55 are consumed by

domestic residents, 25 are invested, 10 are purchased by the government, and 10 are

exported abroad National income (Y = 100) equals domestic spending (C + I + G = 110)

plus exports (EX = 10) less imports (IM = 20).

The Current Account and Foreign Indebtedness

In reality a country's foreign trade is exactly balanced only rarely The difference between

exports of goods and services and imports of goods and services is known as the current

account balance (or current account) If we denote the current account by CA, we can

express this definition in symbols as

CA = EX IM.

When a country's imports exceed its exports, we say the country has a current account

deficit A country has a current account surplus when its exports exceed its imports.2

2 In addition to net exports of goods and services, the current account balance includes net unilateral transfers of

income, which we discussed briefly above Following our earlier assumption, we continue to ignore such

trans-fers for now to simplify the discussion We will see how transtrans-fers of current income enter the current account later

in this chapter when we analyze the U.S balance of payments in detail.

302 P A R T 3 Exchange Rates and Open-Economy Macroeconomics

The GNP identity, equation (12-1), shows one reason why the current account is important

in international macroeconomics Since the right-hand side of (12-1) is total expenditure ondomestic output, changes in the current account can be associated with changes in output and,thus, employment

The current account is also important because it measures the size and direction ofinternational borrowing When a country imports more than it exports, it is buying morefrom foreigners than it sells to them and must somehow finance this current account deficit.How does it pay for additional imports once it has spent its export earnings? Since thecountry as a whole can import more than it exports only if it can borrow the difference fromforeigners, a country with a current account deficit must be increasing its net foreign debts

by the amount of the deficit.3

Similarly, a country with a current account surplus is earning more from its exports than

it spends on imports This country finances the current account deficit of its trading partners

by lending to them The foreign wealth of a surplus country rises because foreigners pay forany imports not covered by their exports by issuing IOUs that they will eventually have to

redeem The preceding reasoning shows that a country's current account balance equals the change in its net foreign wealth.

We have defined the current account as the difference between exports and imports.Equation (12-1) says that the current account is also equal to the difference between national

income and domestic residents' spending C + I + G:

Y - (C + / + G) = CA.

It is only by borrowing abroad that a country can have a current account deficit and usemore output than it is currently producing If it uses less than its output, it has a currentaccount surplus and is lending the surplus to foreigners.4 International borrowing and lending

were identified with intertemporal trade in Chapter 7 A country with a current account

deficit is importing present consumption and exporting future consumption A countrywith a current account surplus is exporting present consumption and importing futureconsumption

As an example, consider again the imaginary economy of Agraria described in Table 12-1.The total value of its consumption, investment, and government purchases, at 110 bushels

of wheat, is greater than its output of 100 bushels This inequality would be impossible in aclosed economy; it is possible in this open economy because Agraria now imports 40 gallons

of milk, worth 20 bushels of wheat, but exports only 10 bushels of wheat The currentaccount deficit of 10 bushels is the value of Agraria's borrowing from foreigners, which thecountry will have to repay in the future

'Alternatively, a country could finance a current account deficit by using previously accumulated foreign wealth to pay for imports This country would be running down its net foreign wealth, which is the same as running up its net foreign debts.

Our discussion here is ignoring the possibility that a country receives gifts of foreign assets (or gives such gifts),

as when one country agrees to forgive another's debts As we will discuss below, such asset transfers (unlike fers of current income) are not part of the current account, but they nonetheless do affect net foreign wealth They

trans-are recorded in the capital account of the balance of payments.

4The sum C + / + G is often called domestic absorption in the literature on international macroeconomics Using

this terminology, we can describe the current account surplus as the difference between income and absorption.

Figure 12-2 The U.S Current Account and Net Foreign Wealth Position, 1977-2000

Current account,

net foreign wealth (billions of dollars)

Net foreign wealth

1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

A string of current account deficits in the 1980s reduced America's net foreign wealth until, by the

decade's end, the country had accumulated a substantial net foreign debt.

Source: U.S, Government Printing Office, Economic Indicators, March 1998, April 2001.

Figure 12-2 gives a vivid illustration of how a string of current account deficits can

add up to a large foreign debt The figure plots the U.S current account balance since the

late 1970s along with a measure of the nation's stock of net foreign wealth As you can see,

the United States had accumulated substantial foreign wealth by the early 1980s, when a

sustained current account deficit of proportions unprecedented in the twentieth century

opened up In 1987 the country became a net debtor to foreigners for the first time since

World War I

As the Case Study on p 316 shows, it is surprisingly hard to measure accurately a

country's net foreign wealth Some economic analysts therefore question the data in

Figure 12-2 and disagree over when the United States became a debtor country and how

large its foreign debt really is But there is no question that a large decrease in U.S foreign

assets did occur over the 1980s

Saving and the Current Account

Simple as it is, the GNP identity has many illuminating implications To explain the most

important of these implications, we define the concept of national saving, that is, the portion

of output, Y, that is not devoted to household consumption, C, or government purchases,

304 PART 3 Exchange Rates and Open-Economy Macroeconomics

G 5 In a closed economy, national saving always equals investment This tells us that the

economy as a whole can increase its wealth only by accumulating new capital

Let S stand for national saving Our definition of S tells us that

Unlike a closed economy, an open economy with profitable investment opportunitiesdoes not have to increase its saving in order to exploit them The preceding expressionshows that it is possible simultaneously to raise investment and foreign borrowing withoutchanging saving For example, if New Zealand decides to build a new hydroelectric plant,

it can import the materials it needs from the United States and borrow American funds to payfor them This transaction raises New Zealand's domestic investment because the importedmaterials contribute to expanding the country's capital stock The transaction also raises NewZealand's current account deficit by an amount equal to the increase in investment NewZealand's saving does not have to change, even though investment rises For this to be pos-sible, however, U.S residents must be willing to save more so that the resources needed tobuild the plant are freed for New Zealand's use The result is another example of intertem-poral trade, in which New Zealand imports present consumption (when it borrows from theUnited States) and exports future consumption (when it pays off the loan)

Because one country's savings can be borrowed by a second country to increase thesecond country's stock of capital, a country's current account surplus is often referred to as

its net foreign investment Of course, when one country lends to another to finance

invest-ment, part of the income generated by the investment in future years must be used to payback the lender Domestic investment and foreign investment are two different ways inwhich a country can use current savings to increase its future income

5 The U.S national income accounts assume that government purchases are not used to enlarge the nation's

capi-tal stock We follow this convention here by subtracting all government purchases from output to calculate

national saving Most other countries' national accounts distinguish between government consumption and ernment investment (for example, investment by publicly owned enterprises) and include the latter as part of national saving Often, however, government investment figures include purchases of military equipment.

gov-Private and Government Saving

So far our discussion of saving has not stressed the distinction between saving decisions

made by the private sector and saving decisions made by the government Unlike private

saving decisions, however, government saving decisions are often made with an eye toward

their effect on output and employment The national income identity can help us to analyze

the channels through which government saving decisions influence macroeconomic

condi-tions To use the national income identity in this way, we first have to divide national

saving into its private and government components

Private saving is defined as the part of disposable income that is saved rather than

con-sumed Disposable income is national income, Y, less the net taxes collected from

house-holds and firms by the government, T b Private saving, denoted S p , can therefore be

expressed as

S p =Y-T-C.

Government saving is defined similarly to private saving The government's "income" is

its net tax revenue, T, while its "consumption" is government purchases, G If we let S s

stand for government saving, then

The two types of saving we have defined, private and government, add up to national

saving To see why, recall the definition of national saving, S, as Y — C — G Then

5 = Y - C - G = (Y - T - C) + (T - G) = S" + S*.

We can use the definitions of private and government saving to rewrite the national

income identity in a form that is useful for analyzing the effects of government saving

deci-sions on open economies Because S = S p + 5s = / + CA,

S p = I + CA - S g = I + CA ~ (T - G) = I + CA + (G - T) (12-2)

Equation (12-2) relates private saving to domestic investment, the current account

sur-plus, and government saving To interpret equation (12-2), we define the government

budget deficit as G — T, that is, as government saving preceded by a minus sign The

government budget deficit measures the extent to which the government is borrowing to

finance its expenditures Equation (12-2) then states that a country's private saving can take

three forms: investment in domestic capital (/), purchases of wealth from foreigners (CA),

and purchases of the domestic government's newly issued debt (G — T)J The usefulness of

equation (12-2) is illustrated by the following Case Study

'Net taxes are taxes less government transfer payments The term government refers to the federal, state, and local

governments considered as a single unit.

7In a closed economy the current account is always zero, so equation (12-2) is simply S' 1 = / + (G - T).

306 PART 3 Exchange Rates and Open-Economy Macroeconomics

CASE STUDY

Government Deficit Reduction May Not Increase

the Current Account Surplus

The linkage among the current account balance, investment, and private and government savinggiven by equation (12-2) is very useful for thinking about the results of economic policies andevents Our predictions about such outcomes cannot possibly be correct unless the currentaccount, investment, and saving rates adjust in a way that is consistent with (12-2) Because that

equation is an identity, however, and is not based on any theory of economic behavior, we

cannot forecast the results of policies without some model of the economy Equation (12-2) is anidentity because it must be included in any valid economic mode]; but there are any number ofmodels consistent with (12-2)

A good example of how hard it can be to forecast policies' effects comes from thinking aboutthe effects of government deficits on the current account During the administration of PresidentRonald Reagan in the early 1980s, the United States slashed taxes and raised some governmentexpenditures, generating both a big government deficit and a sharply increased current accountdeficit Those events gave rise to the argument that the government and current account deficitswere "twin deficits," both generated primarily by the Reagan policies If you rewrite identity(12-2) in the form

CA = S p -I-(G- T),

you can see how that outcome could have occurred If the government deficit rises (G - T goes

up) and private saving and investment don't change much, the current account surplus must fall

by roughly the same amount as the increase in the fiscal deficit In the United States between

1981 and 1985, the government deficit increased by a bit over 2 percent of GNP, while S p - I

fell by about a half a percent of GNP, so the current account fell from approximate balance toabout —3 percent of GNP (The variables in (12-2) are expressed as percentages of GNP for easycomparison.) Thus, the twin deficits prediction is not too far off the mark

The twin deficits theory story can lead us seriously astray, however, when changes in ernment deficits lead to bigger changes in private saving and investment behavior A goodexample of these effects comes from European countries' efforts to cut their government budgetdeficits prior to the launch of their new common currency, the euro, in January 1999 As we willdiscuss in Chapter 20, the European Union (EU) had agreed that no member country with alarge government deficit would be allowed to adopt the new currency along with the initial wave

gov-of euro zone members As 1999 approached, therefore, EU governments made frantic efforts tocut government spending and raise taxes

Under the "twin deficits" theory, we would have expected the EU's current account surplus toincrease sharply as a result of the fiscal change As the table below shows, however, nothing ofthe sort actually happened For the EU as a whole, government deficits fell by about 4.5 percent

of output, yet the current account surplus remained about the same

The table reveals the main reason the current account didn't change much: a sharp fall in theprivate saving rate, which declined by about 4 percent of output, almost as much as the increase

European Union (percentage of GNP)

25.924.623.422.621.8

19.919.319.420.020.8

-5.4-4.3-2.5-1.6-0.8

Source: Organization for Economic Cooperation and Development, OECD Economic Outlook 68 (December

2000), Annex Tables 27, 30, and 52 (with investment calculated as the residual).

in government saving (Investment rose slightly at the same time.) In this case, the behavior ofprivate savers just about neutralized governments' efforts to raise national saving!

It is difficult to know why this offset occurred, but there are a number of possible tions One is based on an economic theory known as the "Ricardian equivalence" of taxes andgovernment deficits (The theory is named after the same David Ricardo who discovered thetheory of comparative advantage—recall Chapter 2—although he himself did not believe inRicardian equivalence.) Ricardian equivalence argues that when the government cuts taxes andraises its deficit, consumers anticipate that they will face higher taxes later to pay off the result-ing government debt In anticipation, they raise their own (private) saving to offset the fall in

explana-government saving Conversely, explana-governments that lower their deficits (thereby increasing ernment saving) will induce the private sector to lower its own saving Qualitatively, this is the

gov-kind of behavior we see in Europe in the late 1990s

Economists' statistical studies suggest, however, that Ricardian equivaler ; doesn't holdexactly in practice Most economists would attribute no more than half the decline in Europeanprivate saving to Ricardian effects What explains the rest of the decline? The values of Euro-pean financial assets were generally rising in the late 1990s, a development fueled in part byoptimism over the beneficial economic effects of the planned common currency It is likely thatincreased household wealth was a second factor lowering the private saving rate in Europe

Because private saving, investment, the current account, and the government deficit arejointly determined variables, we can never fully determine the cause of a current account changeusing identity (12-2) alone Nonetheless, the identity provides an essential framework for think-ing about the current account and can furnish useful clues

•The Balance of Payments Accounts

In the previous section, we examined the components of the national income accounts:

con-sumption, investment, government purchases, and the current account (the measure of a

country's net foreign investment or, equivalently, of the difference between its exports and

imports) In addition to national income accounts, government economists and statisticians

also keep balance of payments accounts, a detailed record of the composition of the current

account balance and of the many transactions that finance it Balance of payments figures

308 PART 3 Exchange Rates and Open-Economy Macroeconomics

are of great interest to the general public, as indicated by the attention that various newsmedia pay to them But press reports sometimes confuse different measures of international

payments flows Should we be alarmed or cheered by a Wall Street Journal headline

pro-claiming "U.S Chalks Up Record Balance of Payments Deficit"? A thorough understanding

of balance of payments accounting will help us evaluate the implications of a country's national transactions

inter-A country's balance of payments accounts keep track of both its payments to and itsreceipts from foreigners Any transaction resulting in a payment to foreigners is entered in

the balance of payments accounts as a debit and is given a negative (—) sign Any transaction resulting in a receipt from foreigners is entered as a credit and is given a positive (+) sign.

Three types of international transaction are recorded in the balance of payments:

1 Transactions that involve the export or import of goods or services and thereforeenter directly into the current account When a French consumer imports American bluejeans, for example, the transaction enters the U.S balance of payments accounts as acredit on current account

2 Transactions that involve the purchase or sale of financial assets An asset is any

one of the forms in which wealth can be held, such as money, stocks, factories, or

gov-ernment debt The financial account of the balance of payments records all international

purchases or sales of financial assets When an American company buys a French tory, the transaction enters the U.S balance of payments as a debit in the financialaccount It may seem strange to give a negative sign to a purchase of assets and a posi-tive sign to a sale of assets It will seem less so if you think in terms of the U.S "import-ing" (purchasing) assets and the U.S "exporting" (selling) assets and give the transactionthe same sign you would give to an import ( —) or export ( + ) transaction recorded in thecurrent account The difference between a country's exports and imports of assets iscalled its financial account balance, or financial account for short

fac-3 Certain other activities resulting in transfers of wealth between countries are

record-ed in the capital account These international asset movements—which are generally

very small for the United States—differ from those recorded in the financial account Forthe most part they result from nonmarket activities, or represent the acquisition or disposal

of nonproduced, nonfinancial, and possibly intangible assets (such as copyrights andtrademarks) For example, if the United States government forgives $1 billion in debtowed to it by the government of Pakistan, U.S wealth declines by $1 billion and a $ 1 bil-lion debit is recorded in the U.S capital account As another example, if a Swede immi-grates to the United States and brings with him title to $100,000 in Swedish assets, theresult would be a $100,000 credit in the U.S capital account.8

8 Until July 1999 the United States classified all transactions either as current account or capital account tions, including in the (old) capital account the items that are now reported in the financial account and including,

transac-in the current account, items that are now placed transac-in the capital account Thus, the hypothetical example of debt forgiveness to Pakistan would have been considered a current transfer payment to Pakistan under the old account- ing rules, and recorded as a $ 1 billion debit in the current account The motivation for the changed accounting format was to separate such nonmarket international asset transfers, which "mainly represent changes in owner- ship of existing assets, which affect nations' balance sheets, from current transfers, which affect nations' income and product in the current period." See Christopher L Bach, "U.S International Transactions, Revised Estimates

for 1982-98," Survey of Current Business (July 1999), p 61.

You will find the complexities of the balance of payments accounts less confusing if you

keep in mind the following simple rule of double-entry bookkeeping: Every international

transaction automatically enters the balance of payments twice, once as a credit and once

as a debit This principle of balance of payments accounting holds true because every

transaction has two sides: If you buy something from a foreigner you must pay him in some

way, and the foreigner must then somehow spend or store your payment

Examples of Paired Transactions

Some examples will show how the principle of double-entry bookkeeping operates in

practice

Imagine you buy a typewriter from the Italian company Olivetti and pay for your purchase

with a $ 1000 check Your payment to buy a good (the typewriter) from a foreign resident

enters the U.S current account with a negative sign But where is the offsetting balance of

payments credit? Olivetti's U.S salesperson must do something with your check—let's say

he deposits it in Olivetti's account at Citibank in New York In this case, Olivetti has

pur-chased, and Citibank has sold, a U.S asset—a bank deposit worth $1000—and the

trans-action shows up as a $ 1000 credit in the U.S financial account The transtrans-action creates the

following two offsetting bookkeeping entries in the U.S balance of payments:

Credit Debit

Typewriter purchase (Current account, U.S good import) —$1000

Sale of bank deposit by Citibank

(Financial account, U.S asset export) +$1000

As another example, suppose that during your travels in France you pay $200 for a fine

dinner at the Restaurant de l'Escargot d'Or Lacking cash, you place the charge on your Visa

credit card Your payment, which is a tourist expenditure, would be counted as a service

import for the United States, and therefore as a current account debit Where is the offsetting

credit? Your signature on the Visa slip entitles the restaurant to receive $200 (actually, its

local currency equivalent) from First Card, the company that issued your Visa card It is

therefore an asset, a claim on a future payment from First Card So when you pay for your

meal abroad with your credit card, you are selling an asset to France and generating a $200

credit in the U.S financial account The pattern of offsetting debits and credits in this case is

Credit Debit

Meal purchase (Current account, U.S service import) —$200

Sale of claim on First Card

(Financial account, U.S asset export) +$200

Imagine next that your Uncle Sid from Los Angeles buys a newly issued share of stock

in the United Kingdom oil giant British Petroleum (BP) He places his order with his

stockbroker, Go-for-Broke, Inc., paying $95 with a check drawn on his Go-for-Broke

money market account BP, in turn, deposits the $95 dollars Sid has paid in its own U.S

bank account at Second Bank of Chicago Uncle Sid's acquisition of the stock creates a $95

debit in the U.S financial account (he has purchased an asset from a foreign resident, BP),

while BP's $95 deposit at its Chicago bank is the offsetting financial-account credit (BP has

310 PART 3 Exchange Rates and Open-Economy Macroeconomics

expanded its U.S asset holdings) The mirror-image effects on the U.S balance of ments therefore both appear in the financial account:

pay-Credit Debit

Uncle Sid's purchase of a share of BP(Financial account, U.S asset import) —$95BP's deposit of Uncle Sid's payment at Second Bank

of Chicago (Financial account, U.S asset export) +$95Finally, let's consider how the United States balance of payments accounts are affectedwhen U.S banks forgive (that is, announce that they will simply forget about) $5000 in debtowed to them by the government of the imaginary country of Bygonia In this case, theUnited States makes a $5000 capital transfer to Bygonia, which appears as a —$5000 entry

in the capital account The associated credit is in the financial account, in the form of a

$5000 reduction in U.S assets held abroad (a net asset "export," and therefore a positivebalance of payments entry):

Credit Debit

U.S banks' debt forgiveness(Capital account, U.S transfer payment) —$5000Reduction in banks' claims on Bygonia

(Financial account, U.S asset export) +$5000These examples show that many different circumstances can affect the way a transactiongenerates its offsetting balance of payments entry We can never be sure where the flip side

of a particular transaction will show up, but we can be sure it will show up somewhere.The Fundamental Balance of Payments Identity

Because any international transaction automatically gives rise to two offsetting entries in thebalance of payments, the current account balance, the financial account balance, and the cap-ital account balance automatically add up to zero:

Current account + financial account + capital account = 0 (12-3)This identity can also be understood by recalling the relation linking the current account

to international lending and borrowing Because the sum of the current and capital accounts

is the total change in a country's net foreign assets, that sum necessarily equals the ence between a country's imports of assets from foreigners and its exports of assets to them,that is, the capital account balance preceded by a minus sign

differ-We now turn to a more detailed description of the balance of payments accounts, using

as an example the U.S accounts for 2000 Table 12-2 reproduces the record of America'sinternational transactions in that year

The Current Account, Once Again

As you have learned, the current account balance measures a country's net exports of goods

and services Table 12-2 shows that U.S exports were $1,414.9 billion in 2000 while U.S.

imports were $1,797.1 billion Because imports give rise to payments to foreigners, theyenter the accounts with a negative sign, as shown

T a b l e 12-2 U.S Balance of Payments Accounts for 2000

(billions of dollars)

Credits DebitsCurrent Account

(3) Net unilateral current transfers

Balance on current account

+ 0.7

+952.4

+ 35.9+916.5+399.1+ 35.6

-1,797.1

-1,222.8-215.2-359.1-53.2-435.4

-553.3

-0.3 -553.0

Source: U.S Department of Commerce, Survey of Current Business, April 2001 Totals may differ from sums

because of rounding.

The balance of payments accounts divide exports and imports into three finer categories

The first is merchandise trade, that is, exports or imports of goods The second category,

ser-vices, includes items such as payments for legal assistance, tourists' expenditures, and

ship-ping fees The final category, income, is made up mostly of international interest and

divi-dend payments and the earnings of domestically owned firms operating abroad If you own

312 PART 3 Exchange Rates and Open-Economy Macroeconomics

a share of a German firm's stock and receive a dividend payment of $5, that payment shows

up in the accounts as a U.S investment income receipt of $5 Wages that workers earnabroad can also enter the income account

We include income on foreign investments in the current account because that income

really is compensation for the services provided by foreign investments This idea, as we

saw earlier, is behind the distinction between GNP and GDP When a U.S corporationbuilds a plant in Canada, for instance, the productive services the plant generates are viewed

as a service export from the United States to Canada equal in value to the profits the plantyields for its American owner To be consistent, we must be sure to include these profits inAmerican GNP and not in Canadian GNP Remember, the definition of GNP refers to

goods and services generated by a country's factors of production, but it does not specify

that those factors must work within the borders of the country that owns them

Before calculating the current account, we must include one additional type of tional transaction that we have largely ignored until now In discussing the relation betweenGNP and national income, we defined unilateral transfers between countries as interna-tional gifts, that is, payments that do not correspond to the purchase of any good, service,

interna-or asset Net unilateral transfers are considered part of the current account as well as a part of

national income, and the identity Y — C + 1 + G + CA holds exactly if Y is interpreted as GNP plus net transfers In 2000, the U.S balance of unilateral transfers was —$53.2 billion.

The table shows a 2000 current account balance of $1,414.9 billion $1,797.1 billion

-$53.2 billion = —$435.4 billion, a deficit The negative sign means that current paymentsexceeded current receipts and that U.S residents used more output than they produced.Since these current account transactions were paid for in some way, we know that this neg-ative $435.4 billion entry must be offset by positive $435.4 billion entries in the other twoaccounts of the balance of payments

The Capital Account

The capital account entry in Table 12-2 shows that in 2000, the United States received ital asset transfers of roughly $700 million, or only $0.7 billion These receipts by theUnited States are a balance of payments credit that enter with a positive sign After we addthem to the payments deficit implied by the current account, we find that the United States'need to cover its excess payments to foreigners is reduced very slightly, from $435.4 billion

cap-to $435.4 billion - $0.7 billion = $434.7 billion Because overall U.S foreign receipts

must equal foreign payments every year, that —$434.7 billion entry in the U.S balance of

payments must be matched by a +$434.7 billion entry in the remaining balance of ments account, the financial account

pay-The Financial Account

Just as the current account is the difference between sales of goods and services to eigners and purchases of goods and services from them, the financial account measures thedifference between sales of assets to foreigners and purchases of assets located abroad.When the United States borrows $1 from foreigners, it is selling them an asset—a promisethat they will be repaid $1, with interest, in the future Such a transaction enters the finan-cial account with a positive sign because the loan is itself a payment to the United States, or

for-a finfor-ancifor-al inflow (for-also sometimes cfor-alled for-a cfor-apitfor-al inflow) When the United Stfor-ates lends

abroad, however, a payment is made to foreigners and the capital account is debited This

transaction involves the purchase of an asset from foreigners and is called a financial

out-flow (or, alternatively, a capital outout-flow).

To cover its 2000 current plus capital account deficit of $434.7 billion, the United States

required a net financial inflow of $434.7 billion In other words, its net borrowing or sales

of assets to foreigners should have amounted to $434.7 billion We can look again at

Table 12-2 to see exactly how this net financial inflow came about

The table records separately increases in U.S holdings of assets located abroad (which are

financial outflows and enter with a negative sign) and increases in foreign holdings of assets

located in the United States (which are financial inflows and enter with a positive sign)

According to Table 12-2, U.S owned assets held abroad increased by $553.3 billion in

2000, contributing a —$553.3 billion entry to the U.S balance of payments Foreign owned

assets held in the United States rose by $952.4 billion in the year, and these purchases are

shown with a positive sign We calculate the balance on financial account as $553.3 billion

- $952.4 billion = $399.1 billion, a surplus

The Statistical Discrepancy

We come out with a financial account surplus of $399.1 billion rather than the larger $434.7

billion financial account surplus we expected If every balance of payments credit

auto-matically generates an equal counterpart debit, and vice versa, how is this difference

pos-sible? The reason is that information about the offsetting debit and credit items associated

with a given transaction may be collected from different sources For example, the import

debit that a shipment of VCRs from Japan generates may come from a U.S customs

inspec-tor's report and the corresponding financial account credit from a report by the U.S bank in

which the check paying for the VCRs is deposited Because data from different sources may

differ in coverage, accuracy, and timing, the balance of payments accounts seldom balance

in practice as they must in theory Account keepers force the two sides to balance by adding

to the accounts a statistical discrepancy For 2000 unrecorded (or misrecorded) international

transactions generated a balancing credit of +$35.6 billion

We have no way of knowing exactly how to allocate this discrepancy among the current,

capital, and financial accounts (If we did, it wouldn't be a discrepancy!) The financial

account is the most likely culprit, since it is notoriously difficult to keep track of the

com-plicated financial trades between residents of different countries But we cannot conclude

that net financial inflows were $35.6 billion higher than recorded, because the current

account is also highly suspect Balance of payments accountants consider merchandise

trade data relatively reliable, but data on services are not Service transactions such as

sales of financial advice and computer programming assistance may escape detection

Accurate measurement of international interest and dividend receipts is particularly

diffi-cult (See the box on page 314.)

Official Reserve Transactions

Although there are many types of capital account transaction, one type is important enough

to merit separate discussion This type of transaction involves the purchase or sale of official

reserve assets by central banks

An economy's central bank is the institution responsible for managing the supply of

money In the United States, the central bank is the Federal Reserve System Official

international reserves are foreign assets held by central banks as a cushion against

314 PART 3 Exchange Rates and Open-Economy Macroeconomics

Because the world as a whole is aclosed economy, world saving must equal world

investment and world spending must equal world

output Individual countries can run current account

surpluses or deficits to invest or borrow abroad

Because one country's lending is another country's

borrowing, however, the sum of all these individual

current account imbalances necessarily equals zero

Or does it? National current account data show

that the world as a whole is running a substantial

current account deficit that increased sharply in

the early 1980s and has remained high Below are

figures for the sum total of all countries' current

account balances between 1980 and 1994

The global discrepancies in the table are far

greater in magnitude than most reported national

current accounts Since positive and negative

errors cancel out in the summation leading to the

global figures, discrepancies of this size raise the

worrisome possibility that the national current

account statistics on which policymakers base

decisions are seriously inaccurate

What explains the theoretically impossible

deficit shown by total world current account

num-bers? Your first reaction may be to blame the

prob-lem on the statistical discrepancies that bedevil the

national income and balance of payment accounts

of individual countries An additional tion is introduced by timing factors Goods thatleave one country's ports near the end of anaccounting year, for example, may not reach theirdestination in time to be recorded in the recipi-ent's import statistics for the same year

complica-A general appeal to accounting anomalies such

as these does not explain, however, why the world

as a whole should appear to be persistently indeficit (rather than in surplus) or why that deficitshould have tripled in the early 1980s A moreplausible hypothesis links the missing surplus toone specific cause of accounting discrepancies atthe national level, the systematic misreporting ofinternational interest income flows Interest pay-ments earned abroad are often not reported to gov-ernment authorities in the recipient's home country

In many cases such interest payments are crediteddirectly to a foreign bank account and do not evencross national borders There is thus a consistenttendency to observe a negative global balance ofinternational interest flows

World interest rates rose sharply after 1980,and the size of the world interest payment discrep-ancy increased with them The interest payment

national economic misfortune At one time official reserves consisted largely of gold, buttoday central banks' reserves include substantial foreign financial assets, particularly U.S.dollar assets such as Treasury bills The Federal Reserve itself holds only a small level ofofficial reserve assets other than gold; its own holdings of dollar assets are not consideredinternational reserves

Central banks often buy or sell international reserves in private asset markets to affectmacroeconomic conditions in their economies Official transactions of this type are called

official foreign exchange intervention One reason why foreign exchange intervention can

alter macroeconomic conditions is that it is a way for the central bank to inject money intothe economy or withdraw it from circulation We will have much more to say later about thecauses and consequences of foreign exchange intervention

Government agencies other than central banks may hold foreign reserves and interveneofficially in exchange markets The U.S Treasury, for example, operates an Exchange Stabi-lization Fund that sometimes plays an active role in market trading Because the operations ofsuch agencies usually have no noticeable impact on the money supply, however, we willsimplify our discussion by speaking (when this is not too misleading) as if the central bankalone holds foreign reserves and intervenes

hypothesis therefore offers a potential explanation

for the increase in the global deficit The downturn

in world interest rates after the mid-1980s

pro-vides partial confirmation of the hypothesis, since

the world current account deficit did drop as

inter-est rates fell Subsequent data are no less

consis-tent with a key role for interest payments Interest

rates in most of the main industrial countries rose

after 1987, and this helped to more than double the

world payments gap The dramatic size of this

effect, involving discrepancies even larger than the

previous 1982 peak, is explained by the much

greater volume of gross international assets and

liabilities that existed by the late 1980s The

gen-eralized easing of world interest rates after 1990, a

process that accelerated in 1993 as Europe joined

in (see Chapter 20), is clearly associated with yetanother fall in the world current account deficit.Other measurement problems are probably also

at work, as an International Monetary Fund (IMF)study of the current account discrepancy concluded(see Further Reading) The IMF found that whileinterest payments explain a good part of the dis-crepancy, several additional factors are involved.For example, much of the world's merchant ship-ping fleet is registered in countries that do notreport maritime freight earnings to the IMF Theseunrecorded earnings make up a significant portion

of the missing world surplus

Measured World Current Account Balance, 1980-1994 (Bifiions of U.S dollars)

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 -38.5 -68.3 -100.2 -61.2 -73.4 -80.8 -76.7 -62.3 -78.9 -96.2 -126.0 -118.2 -99.0 -59.7 -50.3

Source: International Monetary Fund, World Economic Outlook, 1989-1994, Table A26, October 1997, October 2000,

Table A27.

When a central bank purchases or sells a foreign asset, the transaction appears in its

country's financial account just as if the same transaction had been carried out by a private

citizen A transaction in which the central bank of Germany (called the Bundesbank)

acquires dollar assets might occur as follows A U.S auto dealer imports a Volkswagen

from Germany and pays the auto company with a check for $15,000 Volkswagen does not

want to invest the money in dollar assets, but it so happens that the Bundesbank is willing

to give Volkswagen German money in exchange for the $15,000 check The Bundesbank's

international reserves rise by $15,000 as a.result of the deal Because the Bundesbank's

dollar reserves are part of total German assets held in the United States, the latter rise by

$15,000 This transaction therefore results in a positive $15,000 entry in the U.S financial

account, the other side of the —$15,000 entry in the U.S current account due to the

pur-chase of the car.9

Table 12-2 shows the size and direction of official reserve transactions involving the

United States in 2000 United States official reserve assets—that is, international reserves

held by the Federal Reserve—rose by $0.3 billion (recall that a negative sign here means an

increase in U.S owned assets held abroad, that is, an "import" of assets from foreigners)

9 To test your understanding, see if you can explain why the same sequence of actions causes a $15,000

improve-ment in Germany's current account but a $15,000 worsening of its financial account.

316 PART 3 Exchange Rates and Open-Economy Macroeconomics

Foreign central banks purchased $35.9 billion to add to their reserves The net increase in

foreign official reserve claims on the United States less the net increase in U.S official reserves is the balance of official reserve transactions, which stood at $35.9 billion — $0.3

billion = $35.6 billion in 2000

You can think of this $35.6 billion balance as measuring the degree to which monetaryauthorities in the United States and abroad joined with other lenders to cover the U.S cur-rent account deficit In the example above, the Bundesbank, by acquiring a $15,000 U.S.bank deposit, indirectly finances an American import of a $15,000 German car The book-

keeping offset to the balance of official reserve transactions is called the official ments balance or (in less formal usage) the balance of payments This balance is the sum

settle-of the current account balance, the capital account balance, the nonreserve portion settle-of thefinancial account balance, and the statistical discrepancy, and it indicates the payments gapthat official reserve transactions need to cover Thus the U.S balance of payments in 2000was —$35.6 billion, that is, the balance of official reserve transactions with its sign reversed.Table 12-3 reorganizes the major categories in Table 12-2 to emphasize the role of offi-cial reserve transactions in bridging the gap between the current (plus capital) account

deficit and the nonreserve portion of the financial account surplus The balance of payments

played an important historical role as a measure of disequilibrium in international ments, and for many countries it still plays this role A negative balance of payments (adeficit) may signal a crisis, for it means that a country is running down its internationalreserve assets or incurring debts to foreign monetary authorities If a country faces the risk

pay-of being suddenly cut pay-off from foreign loans, it will want to maintain a "war chest" pay-of national reserves as a precaution

inter-Like any summary measure, however, the balance of payments must be interpreted withcaution To return to our running example, the German Bundesbank's decision to expand itsU.S bank deposit holdings by $15,000 swells the measured U.S balance of paymentsdeficit by the same amount Suppose the Bundesbank instead places its $15,000 with Bar-clays Bank in London, which in turn deposits the money with Bankers Trust in New York.Nonreserve U.S financial inflows rise by $15,000 in this case, and the U.S balance of pay-ments deficit does not rise But this "improvement" in the balance of payments is of littleeconomic importance: It makes no difference to the United States whether it borrows theBundesbank's money directly or through a London bank

CASE STUDY

Is the United States the World's Biggest Debtor?

The Bureau of Economic Analysis (BEA) of the U.S Department of Commerce oversees thevast data collection operation behind the U.S national income and product accounts and balance

of payments statistics In addition, the BEA reports annual estimates of the "international ment position of the United States"—the country's net foreign wealth These estimates showed

invest-that at the end of 1999 the United States had a negative net foreign wealth position far greater

than that of any other single country

T a b l e 1 2 - 3 Calculating the U.S Official Settlements Balance for 2000

(billions of dollars)

Credits Debits Current Account

(1) Exports +1,414.9

(2) Imports -1,797.1

(3) Net unilateral transfers —53.2

(4) Balance on current account -435.4

Capital Account

(5) +0.7

Nonreserve financial account

(6) U.S assets held abroad - 5 5 3 0

(excluding U.S official reserves)

(increase —)

(7) Foreign assets held in U.S +916.5

(excluding foreign official reserves)

Official reserve transactions

(11) U.S official reserve assets held abroad —0.3

(increase —)

Of which:

Gold 0.0

Special Drawing Rights —0.7

Reserve position in the International Monetary Fund +2.3

Foreign currencies — 1.9

(12) Foreign official reserve assets held in U.S +35.9

(increase + )

Of which:

U.S government securities +29.5

Other U.S government liabilities —2.5

Liabilities reported by U.S banks +5.8

not included elsewhere

3 I 8 PART 3 Exchange Rates and Open-Economy Macroeconomics

We saw earlier that the current account balance measures the flow of new net claims on eign wealth that a country acquires by exporting more goods and services than it imports Thisflow is not, however, the only factor that causes a country's net foreign wealth to change Inaddition, changes in the market price of wealth previously acquired can alter a country's net for-eign wealth When Japan's stock market lost three quarters of its value over the 1990s, forexample, American and European owners of Japanese shares saw the value of their claims on

for-Japan plummet, and for-Japan's net foreign wealth increased as a result The BEA must adjust the

value of existing claims for such capital gains and losses before arriving at its estimate of U.S.net foreign wealth

The BEA now reports two estimates of U.S net foreign wealth that differ in their treatment

of foreign direct investments (see Chapter 7) Until 1991 foreign direct investments were valued

at their historical, that is, original, purchase prices Now the BEA uses two different methods to

place current values on foreign direct investments: the current cost method, which values direct investments at the cost of buying them today, and the market value method, which is

meant to measure the price at which the investments could be sold These methods can lead todifferent valuations, because the cost of replacing a particular direct investment and the price itwould command if sold on the market may be hard to measure (The net foreign wealth datagraphed in Figure 12-2 are current cost estimates.)

Table 12-4 reproduces the BEA's account of how it made its valuation adjustments to find theU.S net foreign position at the end of 1999 Starting with its estimate of 1998 net foreignwealth ( — $1,111.8 billion at current cost or —$1,407.7 billion at market value), the BEA(column a) subtracted the amount of the 1999 U.S net financial inflow of $323.4 billion—thesum of lines 5 and 6 in the 1999 version of Table 12-2 (Do you remember why a financial

inflow to the United States results in a reduction in U.S net foreign assets?) Then the BEA

adjusted the values of previously held assets for various changes in their dollar prices (columns

b, c, and d) As a result of these valuation changes, U.S net foreign wealth fell by an amount

dif-ferent from the $323.4 billion in new net financial inflows from abroad Based on the currentcost method for valuing direct investments, the BEA's 1999 estimate of U.S net foreign wealthwas -$1,082.5 billion On a market value basis, the BEA places 1999 net foreign wealth lower,

a t - $ 1 , 4 7 3 7 billion

This debt is larger than the total foreign debt owed by all the Western Hemisphere's oping countries, which was $764.5 billion in 1999 To put these figures in perspective, howev-

devel-er, it is important to realize that the U.S net foreign debt (at current cost) amounted to less than

12 percent of its GDP, while that of Argentina, Brazil, Mexico, Venezuela, and the other ern Hemisphere debtors was 43 percent of their collective GDP! Thus, the U.S external debtrepresents a much lower income drain than that of its southern neighbors

West-The United States certainly is the world's biggest debtor West-There is no reason to be alarmed,however, because the U.S GNP is also the world's largest and the United States is not in danger

of being unable to repay its foreign debts Remember also that foreign borrowing may notalways be a bad idea: A country that borrows abroad to undertake profitable domestic invest-ments can pay back its creditors and still have money left over (Chapter 7) Unfortunately for theUnited States, most of its foreign borrowing over the 1980s financed government budget deficitsrather than investment, as we saw in the last Case Study Future generations of U.S citizenstherefore will face a real burden in repaying the resulting foreign debt

T a b l e 12-4 International Investment Position of the United States at Year End,

1998 and 1999 (millions of dollars)

t998

Changes in position in 1999 (decrease (-)) Attributable to:

Financial flows

(a)

Valuation adjustments Price

changes

(b)

Exchange rate changes'

Other changes :

Total

(a+b+c+d)

Position,

1999^

Net international investment position of th« United States:

With direct investment positions at current cost (line 3 less line 24)

With direct investment positions at market value (line 4 less line 25)

U.S.-owned assets abroad:

With direct investment positions at current cost (lines 5+10+15)

With direct investment positions at market value (lines 5+10+16)

U.S official reserve assets

Gold

Special drawing rights

Reserve position in the International Monetary Fund

Foreign currencies

U.S Government assets, other than official reserve assets

U.S credits and other long-term assets 3

Repayable in dollars

Other"

U.S loreign currency holdings and U.S short-term assets

U.S private assets:

With direct investment at current cost (lines 17+19+22+23)

With direct investment at market value (lines 18+19+22+23)

Direct investment abroad:

U.S claims reported by U.S banks, not included elsewhere

Foreign-owned assets in the United States:

With direct investment at current cost (lines 26+33)

With direct investment at market value (lines 26+34)

Foreign official assets in the United Slates

U.S Government securities

U.S Treasury securities

Other

Other U.S Government liabilities 7

U.S liabilities reported by U.S banks, not included elsewhere

Other foreign official assets

Other loreign assets:

With direct investment at current cost (lines 36+37+38+41+42+43)

With direct investment at market value (lines 36+37+38+41+42+43)

Direct investment in the United States:

At current cost

At market value

U.S Treasury securities .

U.S securities other than U.S Treasury securities

Corporate and other bonds

5,079,056 6,045,544

146,006 75,291 10,603 24,111 36,001 66,768 B4.850 84,528 322 1,918

4.846,262 5,812,770

1,207,059 2,173,547 2,052,929 576,745 1,476,184 565,466 1,020,828

6,190,869 7,453,214

837,701 620,285 589,023 31,262 125,883 73,533

5,353,168

928,645 2,190,990 729,738 2,012,431 902,155 1,110,276 228,250 437,973 1,016,131

-323,377 -323,377

430,187 430,187

-8,747

-5,484 -3,253 -2,751 -3.384 -3,363 -21

441,685 441,685 150,901 150,901 128,594 14,193 114.401 92,328 69,862

753,564 753,564

42,864 12,177 20,360 -3,265 12,692 900

710,700 710,700

275,533 275,533 -20,464 331,523 98,709 22,407 34,298 67,403

344,215

455,115 755,413

642 '642

454,473 754,771 5,475 305,773 448,998 -31,341 480,339

110,900 453,516

-11,231 -23,905 -22,975 -930 12,674 122,131 464,747

1,766 344,382 SE2 168,917 -67,690 236,607

-60,235 -57,364

-71,115 -63,035

-1,500 -257 -677 -566

7 -11 -11

18

-69,622

-61,542

-17,646 -9,566 -47.135 -2,649 -44,286 -8,037 3,196

-10,680 -5,671

-10,880 -5,671

-5,209

-3,549 -3,549

-1,050 -1,072

68,702 12,629

-4,215 5,264

17

"17

202 202 202

-4,434 5,045

-14,602 -5,123

-6,010 16,178

-72,917 -7,565

-72,917 -7,565

-75,521

2,604

29,305 -66,015

909,972 1,127,829

-9.588 659 -267 -6,161 -3.819 -2,542 -3,193 -3,161 -32 651

822,102 1,139,959

124,128 441,985 530,457 -19,997 550,454 78,281 89,236

780,667 1,193,644

31.633 8,622 -10,796 19,420 -3,255 12,692 13,574

749,034 1,162,211

196,569 -69,016 496,891 161,575 335,316 22,407 35,852 66,331

-1,082,508 -1,473,665 5,849,028 7,173,373

136,418 75,950 10.336 17,950 32.182 84,226 81,657 81,367 290 2,569

5.668.3B4 6,952,729

1,331,187 2,615,532 2,583,386 556,748 2,026,638 643,747 1.110,064

6,971,536 8,647,058

869,334 628,907 678,225 50,682 14,745 138,575 87,107

6,102,202 7,777,724

1,125,214 2,800,736 660,722 2,509,322 1,445,592 250,657 473,825 1,082,462

f Preliminary,

' Revised.

1 Represents gains or losses on loreign-currency-denomhalerj assets due to their revaluation

at current exchange rates.

2 Includes changes in coverage, statistical discrepancies, and other adjustments to the value

c-l assets.

3 Reflects changes in itie value el the official gold stock due to fluctuations in the market

price ol gold.

4 Refects changes in goW stock from US Treasury sales of gold medallions and

commemo-rative and bullion coins, also reflects replenishment through open mantel purchases These

de-monetizations/monetirations are noi included in international transactions financial flows.

5 Also includes paid-in capital subscriptions to international financial institutions and outstanding amounts of miscellaneous claims that have oeen settled through intemattonaf agreements to be payable to the U.S Government over periods in excess of 1 year Excludes Wortd War I debts that are not being serviced.

6 Includes indebtedness ina! the borrower may contractually Of at its option, repay with its currency, wrth a third country's currency, or by delivery ot matenals or transfer of services

7 Primarily U.S Government liabilities associated with military sales contracts and other actions arranged with or through loreign official agencies,

trans-NOTE—The data in this table are from table 1 in International Investment Position of the United Stales at Yearend 1999' m the July 2000 Issue of the SURVEY OF CURRENT BUSINESS

Source: U.S Department of Commerce, Bureau of Economic Analysis, Survey of Current Business, April 2001,

p D-57.

320 PART 3 Exchange Rates and Open-Economy Macroeconomics

Summary

1 International macroeconomics is concerned with the full employment of scarce

eco-nomic resources and price level stability throughout the world economy Becausethey reflect national expenditure patterns and their international repercussions, the

national income accounts and the balance of payments accounts are essential tools

for studying the macroeconomics of open, interdependent economies

2 A country's gross national product (GNP) is equal to the income received by its

fac-tors of production The national income accounts divide national income according to

the types of spending that generate it: consumption, investment, government chases, and the current account balance Gross domestic product (GDP), equal to

pur-GNP less net receipts of factor income from abroad, measures the output producedwithin a country's territorial borders

3 In an economy closed to international trade, GNP must be consumed, invested, orpurchased by the government By using current output to build plant, equipment, andinventories, investment transforms present output into future output For a closedeconomy, investment is the only way to save in the aggregate, so the sum of the

saving carried out by the private and public sectors, national saving, must equal

5 The current account also equals the country's net lending to foreigners Unlike a

closed economy, an open economy can save by domestic and foreign investment.

National saving therefore equals domestic investment plus the current account balance

6 Balance of payments accounts provide a detailed picture of the composition andfinancing of the current account All transactions between a country and the rest ofthe world are recorded in its balance of payments accounts The accounts are based

on the convention that any transaction resulting in a payment to foreigners is enteredwith a minus sign while any transaction resulting in a receipt from foreigners isentered with a plus sign

7 Transactions involving goods and services appear in the current account of the balance

of payments, while international sales or purchases of assets appear in the, financial account The capital account records asset transfers and tends to be small for the

United States Any current account deficit must be matched by an equal surplus in theother two accounts of the balance of payments, and any current account surplus by adeficit somewhere else This feature of the accounts reflects the fact that discrepanciesbetween export earnings and import expenditures must be matched by a promise torepay the difference, usually with interest, in the future

8 International asset transactions carried out by central banks are included in the

finan-cial account Any central bank transaction in private markets for foreign currency

assets is called official foreign exchange intervention One reason intervention is

important is that central banks use it as a way of altering the amount of money in

cir-culation A country has a deficit in its balance of payments when it is running down its

official international reserves or borrowing from foreign central banks; it has a

sur-plus in the opposite case

macroeconomics; p 294 microeconomics, p 294 national income, p 296 national income accounting, p 295 national saving, p 303

official foreign exchange intervention, p 314 official international reserves, p 313

official settlements balance (or balance

of payments), p 316 private saving, p 305

Problems

1 We stated in this chapter that GNP accounts avoid double counting by including

only the value of final goods and services sold on the market Should the measure of

imports used in the GNP accounts therefore be defined to include only imports of

final goods and services from abroad? What about exports?

2 Equation (12-2) tells us that to reduce a current account deficit, a country must

increase its private saving, reduce domestic investment, or cut its government budget

deficit In the 1980s, many people recommended restrictions on imports from Japan

(and other countries) to reduce the American current account deficit How would

higher U.S barriers to imports affect its private saving, domestic investment, and

government deficit? Do you agree that import restrictions would necessarily reduce a

U.S current account deficit?

3 Explain how each of the following transactions generates two entries—a credit and a

debit—in the American balance of payments accounts, and describe how each entry

would be classified:

a An American buys a share of German stock, paying by writing a check on an

account with a Swiss bank

b An American buys a share of German stock, paying the seller with a check on an

American bank

c The French government carries out an official foreign exchange intervention in

which it uses dollars held in an American bank to buy French currency from its

citizens

d A tourist from Detroit buys a meal at an expensive restaurant in Lyons, France,

paying with a traveler's check

322 PART 3 Exchange Rates and Open-Economy Macroeconomics

e A California winegrower contributes a case of cabernet sauvignon for a Londonwine tasting

f A U.S.-owned factory in Britain uses local earnings to buy additional machinery

4 A New Yorker travels to New Jersey to buy a $ 100 telephone answering machine TheNew Jersey company that sells the machine then deposits the $100 check in itsaccount at a New York bank How would these transactions show up in the balance ofpayments accounts of New York and New Jersey? What if the New Yorker pays cashfor the machine?

5 The nation of Pecunia had a current account deficit of $1 billion and a nonreservefinancial account surplus of $500 million in 2002

a What was the balance of payments of Pecunia in that year? What happened to thecountry's net foreign assets?

b Assume that foreign central banks neither buy nor sell Pecunian assets How didthe Pecunian central bank's foreign reserves change in 2002? How would thisofficial intervention show up in the balance of payments accounts of Pecunia?

c How would your answer to (b) change if you learned that foreign central bankshad purchased $600 million of Pecunian assets in 2002? How would these officialpurchases enter foreign balance of payments accounts?

d Draw up the Pecunian balance of payments accounts for 2002 under the assumptionthat the event described in (c) occurred in that year

6 Can you think of reasons why a government might be concerned about a large currentaccount deficit or surplus? Why might a government be concerned about its officialsettlements balance (that is, its balance of payments)?

7 Do data on the U.S official settlements balance give an accurate picture of the extent

to which foreign central banks buy and sell dollars in currency markets?

8 Is it possible for a country to have a current account deficit at the same time it has asurplus in its balance of payments? Explain your answer, using hypothetical figures forthe current and nonreserve financial accounts Be sure to discuss the possible impli-cations for official international reserve flows

Further Reading

Peter Hooper and J David Richardson, eds International Economic Transactions Chicago:

Uni-versity of Chicago Press, 1991 Useful papers on international economic measurement.

David H Howard "Implications of the U.S Current Account Deficit." Journal of Economic

Per-spectives 3 (Fall 1989), pp 153-165 Examines how U.S current account deficits may affect

American welfare and net foreign wealth.

International Monetary Fund Final Report of the Working Party on the Statistical Discrepancy in

World Current Account Balances Washington, D.C.: International Monetary Fund, September

1987 Discusses the statistical discrepancy in the world current account balance, its tions for policy analysis, and recommendations for more accurate measurement.

implica-International Monetary Fund Balance of Payments Manual, 5th edition Washington, D.C.:

Inter-national Monetary Fund, 1993 Authoritative treatment of balance of payments accounting Robert E Lipsey "Changing Patterns of International Investment in and by the United States," in

Martin S Feldstein, ed The United States in the World Economy Chicago: University of

Chicago Press, 1988, pp 475-545 Historical perspective on capital flows to and from the United States.

Rita M Maldonado "Recording and Classifying Transactions in the Balance of Payments."

Inter-national Journal of Accounting 15 (Fall 1979), pp 105-133 Provides detailed examples of

how various international transactions enter the balance of payments accounts.

James E Meade The Balance of Payments, Chapters 1-3 London: Oxford University Press,

1952 A classic analytical discussion of balance of payments concepts.

Lois Stekler "Adequacy of International Transactions and Position Data for Policy Coordination,"

in William H Branson, Jacob A Frenkel, and Morris Goldstein, eds International Policy

Coordination and Exchange Rate Fluctuations Chicago: University of Chicago Press, 1990,

pp 347-371 A critical look at the interpretation of official data on current accounts and external

indebtedness.

Robert M Stern, Charles F Schwartz, Robert Triffin, Edward M Bernstein, and Walther Lederer.

The Presentation of the Balance of Payments: A Symposium, Princeton Essays in International

Finance 123 International Finance Section, Department of Economics, Princeton University,

August 1977 A discussion of changes in the presentation of the U.S balance of payments

accounts.

U.S Bureau of the Budget, Review Committee for Balance of Payments Statistics The Balance of

Payments Statistics of the United States: A Review and Appraisal Washington, D.C.:

Govern-ment Printing Office, 1965 A major official reappraisal of U.S balance of payGovern-ments accounting

procedures Chapter 9 focuses on conceptual difficulties in defining surpluses and deficits in the

balance of payments.

C H A P T E R 1 3

Exchange Rates and the Foreign Exchange Market: An Asset

Approach

In the year 2000 Americans flocked to Paris to enjoy French cuisine while shopping for designer clothing and other specialties When measured in terms of dollars, prices in France had actually fallen enough that an American shopper's savings could offset the cost of the airplane ride from home What economic forces made French goods appear so cheap to residents of the United States? One major factor was a sharp fall in the dollar price of France's currency, a development that made French lodging, dining, and merchan- dise cheaper for Americans.

The price of one currency in terms of another is called an exchange rate A t 4 P.M.

New York time on October 24, 2001,you would have needed 0.8935 dollars to buy one unit of the European currency, the euro, so the dollar's exchange rate against the euro was

$0.8935 per euro Because of their strong influence on the current account and other macroeconomic variables, exchange rates are among the most important prices in an open economy.

Because an exchange rate, as the price of one country's money in terms of another's, is also an asset price, the principles governing the behavior of other asset prices also govern the behavior of exchange rates As you will recall from Chapter 12, the defining charac- teristic of an asset is that it is a form of wealth, a way of transferring purchasing power from the present into the future The price that an asset commands today is therefore directly related to the purchasing power over goods and services that buyers expect it t o

yield in the future Similarly, today's dollar/euro exchange rate is closely tied t o people's expectations about the future level of that rate Just as the price of Microsoft stock rises

immediately upon favorable news about Microsoft's future prospects, so do exchange rates respond immediately to any news concerning future currency values.

Our general goals in this chapter are to understand the role of exchange rates in national trade and how exchange rates are determined To begin, we first learn how exchange rates allow us to compare the prices of different countries' goods and services Next we describe the international asset market in which currencies are traded and show how equilibrium exchange rates are determined in that market A final section underlines our asset market approach by showing how today's exchange rate responds t o changes in the expected future values of exchange rates, s

inter-324

Jjtxchange Rates and International Transactions

Each country has a currency in which the prices of goods and services are quoted—the

dollar in the United States, the euro in Germany, the pound sterling in Britain, the yen in

Japan, and the peso in Mexico, to name just a few Exchange rates play a central role in

international trade because they allow us to compare the prices of goods and services

pro-duced in different countries A consumer deciding which of two American cars to buy

must compare their dollar prices, for example, $39,000 (for a Lincoln Continental) or

$19,000 (for a Ford Taurus) But how is the same consumer to compare either of these

prices with the 3,000,000 yen (¥3,000,000) it costs to import a Subaru from Japan? To make

this comparison, he or she must know the relative price of dollars and yen

The relative prices of currencies are reported daily in newspapers' financial sections

Table 13-1 shows the dollar exchange rates for currencies traded in New York at 4 P.M on

October 24, 2001, as reported in the Wall Street Journal Notice that an exchange rate can

be quoted in two ways: as the price of the foreign currency in terms of dollars (for example,

$0.008139 per yen) or as the price of dollars in terms of the foreign currency (for example,

¥ 122.87 per dollar) The first of these exchange rate quotations (dollars per foreign currency

unit) is said to be in direct (or "American") terms, the second (foreign currency units per

dollar) in indirect (or "European") terms.

Households and firms use exchange rates to translate foreign prices into domestic

currency terms Once the money prices of domestic goods and imports have been

expressed in terms of the same currency, households and firms can compute the relative

prices that affect intentional trade flows

Domestic and Foreign Prices

If we know the exchange rate between two countries' currencies, we can compute the price

of one country's exports in terms of the other country's money For example, how many

dol-lars would it cost to buy an Edinburgh Woolen Mill sweater costing 50 British pounds

(£50)? The answer is found by multiplying the price of the sweater in pounds, 50, by the

price of a pound in terms of dollars—the dollar's exchange rate against the pound At an

exchange rate of $1.50 per pound (expressed in American terms), the dollar price of the

sweater is

(1.50$/£)X (£50) = $75

A change in the dollar/pound exchange rate would alter the sweater's dollar price At an

exchange rate of $ 1.25 per pound, the sweater would cost only

(1.25$/£)X (£50) = $62.50,

assuming its price in terms of pounds remained the same At an exchange rate of $1.75 per

pound, the sweater's dollar price would be higher, equal to

(1.75 $/£) X (£50) = $87.50

326 PART 3 Exchange Rates and Open-Economy Macroeconomics

T a b l e 13-1 I Exchange Rate Quotations

CURRENCY TRADING

Wednesday, October 24, 2 0 0 1

EXCHANGE RATES

The New York foreign exchangei mid-ramge rates below apply

as Quoted at 4 p.m Eastern time I

sources Retail transactions provide

:y Reuters and other cunency per dollar Rates for trie 12 Euro currency countries are derived from the

change ratios set 1 / Cuintty

Arpttlna (Fwi) Austria ISchWng) Bahrain ( W a r ) Salsium ( F u e l Braa (Real) Britain (Pound) 1-monln forward 3-montte forward 6-morrths toward Canada ( D u b )

1 month lorward ,

3 montlis forward Chts (Piso) China ( M n n M O Crtjma/a (PBSO)

Cnch tan, (Koruna)

Commercial rate Dtwrark (Krone) Ecuador (US DoUr)-!

Finland (Markka) France (Fran.)

1 month forward 3-months forward Gummy (Matt) 1-month forward 3-monms lorward Qnaca (Dratrma) Hom Kuril ( O c t a l Hungary (Forinl) India (Rupae) Indonesia (Rupiah) Inland (Punl) Israel (Statol)

C W 3 0 3 02682 ,1202 1,0000 1503 1352 1361 ,1354 4563 4554

4M2

002622 128?

.003538 02082 0COOW8 1.1346 ,2319 0004615

Tut 1.0001 ,5075 06473 2,6525 0221 3663 1.4259 1.4233 1.4187 6363 6357 6353 OOU08 ,1208 ,0004312 02679 1196 1.0000 1496 1366 1353 1350 4554 ,4549 4539 002614 ,1282 003550 02O84 0000983 11308 2327 ,0004600

XLIffllFJJCy

"Wid 9999 1-967S 3770 45.1482 2.7580 6998 7010 7065 1.5739 1.5745 1.5754 71015

?3?ff ,50 37,291 1.0000 7.3414 7.3554 2.1890 2.1961 381,37 282-69 10230 8814 4.3130 2167,06

I the

ex-P€R U.S i

Tin 9999 1.9704 3770 45.2927 2.7300 7013 7049 1.5717 1,5731

710 35 2315.03 37.326 1.0OO0 73649 7,3886 2,1960 2»3O 2,2086 7.79»

47.980 10170 8843 42980 2174.00

G M M try Japw 1 * ) 1-month forward 3-months forward , 6-montris lorward Jordan (Brar) Kimil ( D M Lebanon (Pound)

»*m mm*

M*a (lira) Mules (Peso)

F t a f a g rate.

NorMands (GuUdtt)

N M ZaaM ( M M Nonwy (Knn) PalosUn (««««) Pttu ( a t * Soil PN*pk»s (Peu)

Mam am-'

-Pgrlugal (Eieudo) flunk (RuiW-a Said Ante (Hyai]

smgapon (Dour) Skmk Rev (Koninl)

Soutti Alric3 (RVKI) Spaii (Pseb) _ Saadeti (Krtna) Swtarfeml (Franc) 1-nonth forward 3-months toward Tahrai | M « ) rhJand !B#!) Tuitq (Ura)-f

UofM M i (DMam)

Uruguay Ota Pan) Financial Venezuela (Bolter)

U.S S EQUV.

Wed 008139 006186 ,008229 14104 32658 0006634 ,2632 22212 1083

«54 ,4184 1123 01623 ,2897 01927 24 29 004457 03381 2666 5472 02TO ,1067 0007731 005370 0943 6034 6035 02*96 1)2233 00000062 2723 07177 001346

Tue

,008151 008198 ,008242 14104 32658 0006614 2632 2.2163 1064 4191 1120 01626 ,2897 01925 2432 004443 03382 21566 5477 02O46 '059 0007683 005353 0940 6024 6025 6030 02896 02233 00000062 2723 07194 ,001346

CUBMNCY PER U.S I Wed 122.87 12216 7090 ,3062 1507,50 3.8000 4502 9.2306 2,4664 2,3901 61,600 51.900

224 38 29.576 1.B275 9.3716 1293.50 186.22 10.6060 1,6575 1.6571 34.630 44.790 1616000 3.6730 13.933

TK 122.68 12198 7090 3062 151200 3.8000 4612 92250 2.4743 2.391 B 8.9311 3.4520 51950 4,1125 22510 37510 48.869 9.4400 1301,50 186.81 106382 1,6600 1,6596 34.530 44775 1610000 3,6730 13.900 74275 S0d 1.2687 1.2663 ,7882 7897 Euio 8935 8907 11192 1,1227 Special Drawing Rights (SDR) are based on exchange rates cies Source: International Monetary Fund.

a-Russian Central Bank rate b-Government rate d-Floating Hollar as of 9 / 1 l/OO (Floating rate, eff, Feb 2 2

Source: The Wall Street Journal, October 25, 2001 Republished by permission of

Dow Jones, Inc., via Copyright Clearance Center, Inc ©2001 Dow Jones and

Com-pany, Inc All rights reserved worldwide.

Changes in exchange rates are described as depreciations or appreciations A tion of the pound against the dollar is a fall in the dollar price of pounds, for example, a

deprecia-change in the exdeprecia-change rate from $1.50 per pound to $1.25 per pound The preceding

example shows that all else equal, a depreciation of a country's currency makes its goods cheaper for foreigners A rise in the pound's price in terms of dollars—for example, from

$ J 50 per pound to $ 1.75 per pound—is an appreciation of the pound against the dollar AH

else equal, an appreciation of a country's currency makes its goods more expensive for foreigners.

The exchange rate changes discussed in the example simultaneously alter the pricesBritons pay for American goods At an exchange rate of $1.50 per pound, the pound price of

a pair of American designer jeans costing $45 is ($45)/(1.50 $/£) = £30 A change in theexchange rate from $ 1.50 per pound to $ 1.25 per pound, while a depreciation of the pound

against the dollar, is also a rise in the pound price of dollars, an appreciation of the dollar

against the pound This appreciation of the dollar makes the American jeans more expensivefor Britons by raising their pound price to

($45)7(1.25 $/£) = £36

The change in the exchange rate from $ 1.50 per pound to $ 1.75 per pound—an appreciation

of the pound against the dollar but a depreciation of the dollar against the pound—lowers

the pound price of the jeans to

($45)/(1.75$/£) = £25.71

As you can see, descriptions of exchange rate changes as depreciations or appreciations

can be bewildering, because when one currency depreciates against another, the second

cur-rency must simultaneously appreciate against the first To avoid confusion in discussing

exchange rates, we must always keep track of which of the two currencies we are

examin-ing has depreciated or appreciated against the other

If we remember that a depreciation of the dollar against the pound is at the same time an

appreciation of the pound against the dollar, we reach the following conclusion: When a

country's currency depreciates, foreigners find that its exports are cheaper and domestic

residents find that imports from abroad are more expensive An appreciation has opposite

effects: Foreigners pay more for the country's products and domestic consumers pay less for

foreign products.

Exchange Rates and Relative Prices

Import and export demands, like the demands for all goods and services, are influenced by

relative prices, such as the price of sweaters in terms of designer jeans We have just seen

how exchange rates allow individuals to compare domestic and foreign money prices by

expressing them in a common currency unit Carrying this analysis one step further, we can

see that exchange rates also allow individuals to compute the relative prices of goods and

services whose money prices are quoted in different currencies

An American trying to decide how much to spend on American jeans and how much to

spend on British sweaters must translate their prices into a common currency to compute

the price of sweaters in terms of jeans As we have seen, an exchange rate of $1.50 per

pound means that an American pays $75 for a sweater priced at £50 in Britain Because

the price of a pair of American jeans is $45, the price of sweaters in terms of jeans is ($75

per sweater)/($45 per pair of jeans) = 1.67 pairs of jeans per sweater Naturally, a Briton

faces the same relative price of (£50 per sweater)/(£30 per pair of jeans) = 1.67 pairs of

jeans per sweater

Table 13-2 shows the relative prices implied by exchange rates of $1.25 per pound,

$ 1.50 per pound, and $1.75 per pound, on the assumption that the dollar price of jeans and

the pound price of sweaters are unaffected by the exchange rate changes To test your

understanding, try to calculate these relative prices for yourself and confirm that the

out-come of the calculation is the same for a Briton and for an American

The table shows that if the goods' money prices do not change, an appreciation of the

dollar against the pound makes sweaters cheaper in terms of jeans (each pair of jeans buys

more sweaters) while a depreciation of the dollar against the pound makes sweaters more

expensive in terms of jeans (each pair of jeans buys fewer sweaters) The computations

illustrate a general principle: All else equal, an appreciation of a country's currency raises

the relative price of its exports and lowers the relative price of its imports Conversely, a

depreciation lowers the relative price of a country's exports and raises the relative price of

its imports.

328 PART 3 Exchange Rates and Open-Economy Macroeconomics

T a b l e 1 3 - 2 $/£ Exchange Rates and the Relative Price

of American Designer Jeans and British Sweaters

Exchange rate ($/£) 1.25 1.50 1.75Relative price (pairs of jeans/sweater) 1.39 1.67 1.94

Note: The above calculations assume unchanged money prices of $45 per pair of jeans and £50 per sweater.

H f h e Foreign Exchange Market

Just as other prices in the economy are determined by the interaction of buyers and sellers,exchange rates are determined by the interaction of the households, firms, and financialinstitutions that buy and sell foreign currencies to make international payments The market

in which international currency trades take place is called the foreign exchange market.

The Actors

The major participants in the foreign exchange market are commercial banks, tions that engage in international trade, nonbank financial institutions such as asset-man-agement firms and insurance companies, and central banks Individuals may also participate

corpora-in the foreign exchange market—for example, the tourist who buys foreign currency at ahotel's front desk—but such cash transactions are an insignificant fraction of total foreignexchange trading

We now describe the major actors in the market and their roles

1 Commercial banks Commercial banks are at the center of the foreign exchange

market because almost every sizable international transaction involves the debiting andcrediting of accounts at commercial banks in various financial centers Thus, the vast

majority of foreign exchange transactions involve the exchange of bank deposits

denom-inated in different currencies

Let's look at an example Suppose Exxon Corporation wishes to pay €160,000 to aGerman supplier First, Exxon gets an exchange rate quotation from its own commercialbank, the Third National Bank Then it instructs Third National to debit Exxon's dollaraccount and pay €160,000 into the supplier's account at a German bank If the exchangerate quoted to Exxon by Third National is $1.2 per euro, $192,000 ( = $1.2 per euro X

€160,000) is debited from Exxon's account The final result of the transaction is theexchange of a $192,000 deposit at Third National Bank (now owned by the Germanbank that supplied the euros) for the €160,000 deposit used by Third National to payExxon's German supplier

As the example shows, banks routinely enter the foreign exchange market to meetthe needs of their customers—primarily corporations In addition, a bank will alsoquote to other banks exchange rates at which it is willing to buy currencies from them

and sell currencies to them Foreign currency trading among banks—called interbank trading—accounts for most of the activity in the foreign exchange market In fact, the

exchange rates listed in Table 13-1 are interbank rates, the rates banks charge to eachother No amount less than $1 million is traded at those rates The rates available to cor-

A TALE OF T W O DOLLARS

Back in 1976, the United States dollar

and the Canadian dollar traded roughly at par, that

is, at a one-to-one exchange rate In the following

decades, however, Canada's dollar has steadily

depreciated against its American cousin By early

2002, a Canadian dollar was worth only about 65

United States cents.*

The tendency of the Canadian currency to

depre-ciate accelerated in the late 1990s as the world

prices of many of Canada's natural resource exports

slumped Canadian manufacturing exporters were

cheered by their ability to sell goods more easily

abroad, while importers grimaced at the higher

prices they had to pay Nowhere were the effects

more striking than at Niagara Falls, where

thou-sands cross the U.S.-Canada border, going in both

directions, every day Canadians accustomed to

going to the U.S side for a weekend dinner found

it harder to afford the meal At the same time,

Americans could suddenly find bargains on the

Canadian side

Canadian one-dollar coins carry on their backs

the picture of a loon, the web-footed, fish-eating

bird often seen and heard on Canada's lakes.Canada's dollar therefore is widely known as the

"loonie." One group of Canadian birds avoidingthe loonie in the late 1990s was the Toronto BlueJays Because the American League baseball teamplays most of its games south of the Canadianborder and participates in a United States-basedmarket for players, 80 percent of its expenses(including players' salaries) are set in U.S dol-lars On the other hand, 80 percent of its revenues(including ballpark receipts) are paid in Canadiandollars A sudden and sharp depreciation of theloonie thus would cause big losses for the team

by raising its expenses relative to its receipts Toprotect itself from the vagaries of the exchangerate, the team tries to predict its need for U.S dol-lars ahead of time so that it can sell loonies andpurchase the American currency in advance tolock in the exchange rate Errors in the currencymarket can be more costly to the Blue Jays thanerrors on the field.t

*See "Showing in Canada: The Mystery of the Falling Dollar." New York Times, Wednesday, January 9,

2002, p Wl

f See "Don't Cry Over Diving Loonies: Canadian Dollar Plummets to a Collective Ho-Hum." New York Times, Tuesday, June 23, 1998, p Cl.

porate customers, called "retail" rates, are usually less favorable than the "wholesale"

interbank rates The difference between the retail and wholesale rates is the bank's

com-pensation for doing the business

Because their international operations are so extensive, large commercial banks are

well-suited to bring buyers and sellers of currencies together A multinational

corpora-tion wishing to convert $100,000 into Swedish kronor might find it difficult and costly to

locate other corporations wishing to sell the right amount of kronor By serving many

customers simultaneously through a single large purchase of kronor, a bank can

econo-mize on these search costs

2 Corporations Corporations with operations in several countries frequently make

or receive payments in currencies other than that of the country in which they are

head-quartered To pay workers at a plant in Mexico, for example, IBM may need Mexican

pesos If IBM has only dollars earned by selling computers in the United States, it can

acquire the pesos it needs by buying them with its dollars in the foreign exchange market

330 PART 3 Exchange Rates and Open-Economy Macroeconomics

3 Nonbank financial institutions Over the years, deregulation of financial markets in

the United States, Japan, and other countries has encouraged nonbank financial tions to offer their customers a broader range of services, many of them indistinguishablefrom those offered by banks Among these have been services involving foreignexchange transactions Institutional investors, such as pension funds, often trade foreigncurrencies

institu-4 Central banks In the previous chapter we learned that central banks sometimes

intervene in foreign exchange markets While the volume of central bank transactions istypically not large, the impact of these transactions may be great The reason for thisimpact is that participants in the foreign exchange market watch central bank actionsclosely for clues about future macroeconomic policies that may affect exchange rates.Government agencies other than central banks may also trade in the foreign exchangemarket, but central banks are the most regular official participants

Characteristics of the Market

Foreign exchange trading takes place in many financial centers, with the largest volume oftrade occurring in such major cities as London (the largest market), New York, Tokyo,Frankfurt, and Singapore The worldwide volume of foreign exchange trading is enor-mous, and it has ballooned in recent years In April 1989 the average total value of global

foreign exchange trading was close to $600 billion per day, of which $184 billion were

traded daily in London, $115 billion in the United States, and $111 billion in Tokyo Onlytwelve years later, in April 2001, the daily global value of foreign exchange trading hadjumped to around $1.2 trillion, of which $504 billion were traded daily in London, $254 bil-lion in New York, and $147 billion in Tokyo.1

Direct telephone, fax, and Internet links among the major foreign exchange trading ters make each a part of a single world market on which the sun never sets Economicnews released at any time of the day is immediately transmitted around the world and mayset off a flurry of activity by market participants Even after trading in New York has fin-ished, New York-based banks and corporations with affiliates in other time zones canremain active in the market Foreign exchange traders may deal from their homes when alate-night communication alerts them to important developments in a financial center onanother continent

cen-The integration of financial centers implies that there can be no significant differencebetween the dollar/euro exchange rate quoted in New York at 9 A.M and the dollar/euroexchange rate quoted in London at the same time (which corresponds to 2 P.M Londontime) If the euro were selling for $1.1 in New York and $1.2 in London, profits could be

made through arbitrage, the process of buying a currency cheap and selling it dear At the

prices listed above, a trader could, for instance, purchase €1 million in New York for $1.1million and immediately sell the euros in London for $1.2 million, making a pure profit of

'April 1989 figures come from surveys carried out simultaneously by the Federal Reserve Bank of New York, the Bank of England, the Bank of Japan, the Bank of Canada, and monetary authorities from France, Italy, the Netherlands, Singapore, Hong Kong, and Australia The April 2001 survey was carried out by 48 central banks Revised figures for 1989-2001 are reported in "Central Bank Survey of Foreign Exchange and Derivatives Market Activity in April 2001: Preliminary Global Data," Press Release, Bank for International Settlements, Basle, Switzerland, October 9, 2001 Daily U.S foreign currency trading in 1980 averaged only around $18 billion.

$100,000 If all traders tried to cash in on the opportunity, however, their demand for euros

in New York would drive up the dollar price of euros there, and their supply of euros in

London would drive down the dollar price of euros there Very quickly, the difference

between the New York and London exchange rates would disappear Since foreign exchange

traders carefully watch their computer screens for arbitrage opportunities, the few that

arise are small and very short-lived

While a foreign exchange transaction can involve any two currencies, most transactions

between banks (around 90 percent in 2001) involve exchanges of foreign currencies for U.S

dollars This is true even when a bank's goal is to sell one nondollar currency and buy

another! A bank wishing to sell Swiss francs and buy Israeli shekels, for example, will

usu-ally sell its francs for dollars and then use the dollars to buy shekels While this procedure

may appear roundabout, it is actually cheaper for the bank than the alternative of trying to

find a holder of shekels who wishes to buy Swiss francs The advantage of trading through

the dollar is a result of the United States' importance in the world economy Because the

volume of international transactions involving dollars is so great, it is not hard to find

par-ties willing to trade dollars against Swiss francs or shekels In contrast, relatively few

transactions require direct exchanges of Swiss francs for shekels.2

Because of its pivotal role in so many foreign exchange deals, the dollar is sometimes

called a vehicle currency A vehicle currency is one that is widely used to denominate

international contracts made by parties who do not reside in the country that issues the

vehicle currency It has been suggested that the euro, which was introduced at the start of

1999, will evolve into a vehicle currency on a par with the dollar By April 2001,

howev-er, only about 38 percent of foreign exchange trades involved euros The pound sterling,

once second only to the dollar as a key international currency, has declined in importance.3

Spot Rates and Forward Rates

The foreign exchange transactions we have been discussing take place on the spot: two

par-ties agree to an exchange of bank deposits and execute the deal immediately Exchange

rates governing such "on-the-spot" trading are called spot exchange rates, and the deal is

called a spot transaction

The term spot is a bit misleading because even spot exchanges usually become effective

only two days after a deal is struck The delay occurs because in most cases it takes two

days for payment instructions (such as checks) to be cleared through the banking system.4

Suppose Apple Computer has pounds in an account at the National Westminster Bank in

2 The Swiss franc/shekel exchange rate can be calculated from the dollar/franc and dollar/shekel exchange rates as

the dollar/shekel rate divided by the dollar/franc rate If the dollar/franc rate is $0.80 per franc and the

dollar/shekel rate is $0.20 per shekel, then the Swiss franc/shekel rate is (0.20 $/shekel)/(0.80 $/franc) = 0.25

Swiss francs/shekel Exchange rates between nondollar currencies are called "cross rates" by foreign exchange

traders.

3 For more detailed discussion of vehicle currencies, see Richard Portes and Helene Rey, "The Emergence of the

Euro as an International Currency," Economic Policy 26 (April 1998), pp 307-343 Data on currency shares come

from Bank for International Settlements, op cit., footnote 1.

4 A major exception involves trades of U.S dollars for Canadian dollars in New York These are executed with a

one-day lag Currently international banks are working on ways to reduce these settlement lags through a system

called Continuous Linked Settlement that is due to be introduced soon.

332 PART 3 Exchange Rates and Open-Economy Macroeconomics

London but sells them to the Bank of America in San Francisco, which has offered Apple amore favorable spot exchange rate for pounds than the bank where it has its dollar account,Wells Fargo On Monday, June 20, Apple pays the pounds to Bank of America with apound check drawn on National Westminster, while Bank of America, to pay Apple, wiresdollars into Apple's account at Wells Fargo Normally, Apple cannot use the dollars it hasbought, nor can Bank of America use its pounds, until Wednesday, June 22, two business

days later In the jargon of the foreign exchange market, the value date for a spot

transac-t i o n ^ transac-t h e datransac-te on which transac-the partransac-ties actransac-tually receive transac-the funds transac-they have purchased—occurstwo business days after the deal is made

Foreign exchange deals sometimes specify a value date farther away than two days—

30 days, 90 days, 180 days, or even several years The exchange rates quoted in such

trans-actions are called forward exchange rates In a 30-day forward transaction, for example,

two parties may agree on April 1 to a spot exchange of £100,000 for $155,000 on May 1.The 30-day forward exchange rate is therefore $1.55 per pound, and it is generally differentfrom the spot rate and from the forward rates applied to different value dates When youagree to sell pounds for dollars on a future date at a forward rate agreed on today, you have

"sold pounds forward" and "bought dollars forward."

Table 13-1 reports forward exchange rates for the most heavily traded foreign currencies.(The forward quotations, when available, are listed below the corresponding spot quota-tions.) Forward and spot exchange rates, while not necessarily equal, do move closelytogether, as illustrated for dollar/pound rates in Figure 13-1 The appendix to this chapter,which discusses how forward exchange rates are determined, explains this close relationshipbetween movements in spot and forward rates

An example shows why parties may wish to engage in forward exchange transactions.Suppose an American who imports radios from Japan knows that in 30 days he must payyen to a Japanese supplier for a shipment arriving then The importer can sell each radio for

$100 and must pay his supplier ¥9,000 per radio; so his profit depends on the dollar/yenexchange rate At the current spot exchange rate of $0.0105 per yen, the importer would pay($0.0105 per yen) X (¥9,000 per radio) = $94.50 per radio and would therefore make

$5.50 on each radio imported But the importer will not have the funds to pay the supplieruntil the radios arrive and are sold If over the next 30 days the dollar unexpectedly depre-ciates to $0.0115 per yen, the importer will have to pay ($0.0115 per yen) X (¥9,000 per

radio) = $103.50 per radio and so will take a $3.50 loss on each.

To avoid this risk, the importer can make a 30-day forward exchange deal with hisbank If the bank agrees to sell yen to the importer in 30 days at a rate of $0.0107, theimporter is assured of paying exactly ($0.0107 per yen) X (¥9,000 per radio) = $96.30 perradio to the supplier By buying yen and selling dollars forward, the importer is guaranteed

a profit of $3.70 per radio and is insured against the possibility that a sudden exchange ratechange will turn a profitable importing deal into a loss

From now on, when we mention an exchange rate without specifying whether it is a spotrate or a forward rate, we will always be referring to the spot rate

Foreign Exchange Swaps

A foreign exchange swap is a spot sale of a currency combined with a forward repurchase

of the currency For example, a multinational company has just received $1 million fromsales and knows it will have to pay those dollars to a California supplier in three months