Exchange Rates and Net Exports in International Trade, Lecture notes of Foreign Trade

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Foreign Trade and the

Foreign Trade and the

Exchange Rate

Exchange Rate

Chapter 12 Chapter 12

Outline

Outline

Foreign trade and aggregate demand

Foreign trade and aggregate demand

The exchange rate

The exchange rate

The determinants of net exports

The determinants of net exports

A model of the real exchange rates

A model of the real exchange rates

The IS curve and economic policy in an

The IS curve and economic policy in an

open economy

open economy

The exchange rate and the price level

The exchange rate and the price level

Fixed and floating exchange rates in the long

Fixed and floating exchange rates in the long

run

run

12.1 FOREIGN TRADE 12.1 FOREIGN TRADE

AND AGGREGATE DEMAND AND AGGREGATE DEMAND

The The

terms of trade terms of trade

is the ratio of the price of is the ratio of the price of

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

When the prices of imports rise, we say there has When the prices of imports rise, we say there has been an adverse shift in the terms of trade. been an adverse shift in the terms of trade.

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

in two ways. in two ways.

Import and export of goods and services Import and export of goods and services

12.2 THE EXCHANGE RATE 12.2 THE EXCHANGE RATE

The The

exchange rate exchange rate

is the amount of foreign is the amount of foreign

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

The exchange rate is determined in the The exchange rate is determined in the

foreign foreign

exchange market, exchange market,

where dollars and other where dollars and other

currencies are traded freely. currencies are traded freely.

In today In today

s monetary system the dollar exchange s monetary system the dollar exchange

rate is allowed to rate is allowed to

float float

against the currencies of against the currencies of

other large countries. other large countries.

The system is called a The system is called a

floating floating

or or

flexible exchange flexible exchange

rate system. rate system.

The Exchange Rate and Relative Prices The Exchange Rate and Relative Prices

The The

real exchange rate real exchange rate

is a measure of the is a measure of the

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

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

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

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

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

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

The Exchange Rate and Relative Prices The Exchange Rate and Relative Prices

Real exchange rate =

W

P

ExP

goods

ROW

of

price

Foreign

goods

US

of

price

Foreign

12.3 THE DETERMINANTS OF 12.3 THE DETERMINANTS OF

NET EXPORTS NET EXPORTS

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

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

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

exports. exports.

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

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

The Effect of Income The Effect of Income

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

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

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

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

The Net Export Function The Net Export Function

We can summarize these ideas in a simple algebraic We can summarize these ideas in a simple algebraic formula: formula:

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

It says that net exports equal a constant It says that net exports equal a constant

g g

minus a coefficient minus a coefficient

m m

times income times income

Y Y

, minus a coefficient, minus a coefficient

n n

times the realtimes the real

exchange rate. exchange rate.

EP

X

g

mY

n

Pw

slide 13

Numerical Example Numerical Example

A numerical example of the net export function A numerical example of the net export function

can be written: can be written:

Suppose that the price level in both the United Suppose that the price level in both the United States and the ROW are predetermined at the value States and the ROW are predetermined at the value of 1. of 1.

If output If output

Y Y

is $5,000 billion and the exchange rate is $5,000 billion and the exchange rate

E E

is 1.0, then net exports is 1.0, then net exports

X X

equal zero. equal zero.

600

100

(12.2)

EP

X

Y

Pw

=

−

−

12.4 A MODEL OF THE REAL 12.4 A MODEL OF THE REAL

EXCHANGE RATE EXCHANGE RATE

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

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

the ROW. the ROW.

In particular, policies in the United States that raise In particular, policies in the United States that raise interest rates tend to cause the dollar to appreciate. interest rates tend to cause the dollar to appreciate.

12.4 A MODEL OF THE REAL 12.4 A MODEL OF THE REAL

EXCHANGE RATE EXCHANGE RATE

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

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

interest rate as interest rate as

(EP/ (EP/

Pw Pw

) = q + ) = q +

vR vR

(12.3) (12.3)

where where

R R

is the U.S. interest rate and is the U.S. interest rate and

q q

and and

v v

are are

constants. constants.

12.5 THE IS CURVE AND ECONOMIC

12.5 THE IS CURVE AND ECONOMIC

POLICY IN AN OPEN ECONOMY

POLICY IN AN OPEN ECONOMY

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

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

steeper. steeper.

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

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

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

demand. demand.

slide 19

Algebraic Derivation of the Open Algebraic Derivation of the Open

Economy IS Curve Economy IS Curve

Y = C + I + G + X

Y = C + I + G + X

Y = a Y = a

b( b(

t)Y + e t)Y + e

dR dR

• G + g
• G + g

mY mY

n(EP/Pw n(EP/Pw

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

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