an economic barometer what exactly is gdp? how do we use gdp to tell us whether our economy is in a...

An Economic Barometer• What exactly is GDP?

• How do we use GDP to tell us whether our economy is in a recession or how rapidly our economy is expanding?

• How do we take the effects of inflation out of GDP to reveal the rate of growth of our economic well-being?

• And how to we compare economic well-being across countries?

Gross Domestic Product

• GDP Defined– GDP or gross domestic product is the market

value of all final goods and services produced in a country in a given time period.

– This definition has four parts: Market value Final goods and services Produced within a country In a given time period


– Market Value– GDP is a market value—goods and services are

valued at their market prices. – To add apples and oranges, computers and

popcorn, we add the market values so we have a total value of output in dollars.

Gross Domestic Product – Final Goods and Services– GDP is the value of the final goods and services

produced. – A final good (or service) is an item bought by its final

user during a specified time period. – A final good contrasts with an intermediate good,

which is an item that is produced by one firm, bought by another firm, and used as a component of a final good or service.

– Excluding intermediate goods and services avoids double counting.


– Produced Within a Country– GDP measures production within a country—

domestic production.– In a Given Time Period– GDP measures production during a specific time

period, normally a year or a quarter of a year.


• GDP and the Circular Flow of Expenditure and Income– GDP measures the value of production, which also

equals total expenditure on final goods and total income.

– The equality of income and output shows the link between productivity and living standards.

– The circular flow diagram illustrates the equality of income, expenditure, and the value of production.

Gross Domestic Product – The circular flow diagram shows the transactions among

households, firms, governments, and the rest of the world.

Gross Domestic Product – These transactions take place in factor markets, goods

markets, and financial markets.

Gross Domestic Product – Firms hire factors of production from households. The blue

flow, Y, shows total income paid by firms to households.

Gross Domestic Product – Households buy consumer goods and services. The

red flow, C, shows consumption expenditure.

Gross Domestic Product – Households save, S, and pay net taxes, T. Firms borrow

some of what households save to finance their investment.

Gross Domestic Product – Firms buy capital goods from other firms. The red

flow I represents this investment by firms.

Gross Domestic Product – Governments buy goods and services, G, and borrow or

repay debt if spending exceeds or is less than net taxes.

Gross Domestic Product – The rest of the world buys goods and services from us, X,

and sells us goods and services, M. Net exports are X – M.

Gross Domestic Product – And the rest of the world borrows from us or lends to us

depending on whether net exports are positive or negative.

Gross Domestic Product – The blue and red flows are the circular flow of expenditure

and income. The green flows are financial flows.

Gross Domestic Product – The sum of the red flows equals the blue flow.

Gross Domestic Product – That is: Y = C + I + G + X – M


– The circular flow demonstrates how GDP can be measured in two ways.

– Aggregate expenditure– Total expenditure on final goods and services,

equals the value of output of final goods and services, which is GDP.

– Total expenditure = C + I + G + (X – M).


– Aggregate income– Aggregate income equals the total amount paid

for the use of factors of production: wages, interest, rent, and profit.

– Firms pay out all their receipts from the sale of final goods, so income equals expenditure,

– Y = C + I + G + (X – M).

Gross Domestic Product – If G exceeds T, the government has a budget deficit

(G –T) and the government borrows from the financial markets.

– If T exceeds G, the government has a budget surplus (T – G) and this surplus flows to the financial markets.

– If U.S. imports exceed U.S. exports, the United States borrows an amount equal to (M – X) from the rest of the world. Rest of world saving finances some investment in the United States.

– If U.S. exports exceed U.S. imports, the United States lends an amount equal to (X – M) to the rest of the world. U.S. saving finances some investment in other countries.


• How Investment Is Financed– Investment is financed from three sources:– 1. Private saving, S– 2. Government budget surplus, (T – G)– 3. Borrowing from the rest of the world (M – X).


• Gross and Net Domestic Product– “Gross” means before deducting the depreciation

of capital. The opposite of gross is net. – To understand this distinction, we need to

distinguish between flows and stocks. – Flows and Stocks in Macroeconomics– A flow is a quantity per unit of time.– A stock is the quantity that exists at a point in

time.


– Wealth and Saving– Wealth, the value of all the things that people

own, is a stock. – Saving is the flow that changes the stock of

wealth.– Wealth at the start of this year equals wealth at

the start of last year plus saving during last year.


– Capital and Investment– Capital is the plant, equipment, and inventories of

raw and semi-finished materials that are used to produce other goods.

– Capital is a stock.– Investment is the flow that changes the stock of

capital.


– Depreciation is the decrease in the capital stock that results from wear and tear and obsolescence.

– Gross investment is the total amount spent on purchases of new capital and on replacing depreciated capital.

– Net investment is the change in the capital stock.– Net investment = Gross investment

Depreciation.


– Figure illustrates the relationships among the capital stock, gross investment, depreciation, and net investment.


– The Short Run Meets the Long Run– Capital and investment play a central role in the

understanding the growth and fluctuations in real GDP.

– Investment adds to the capital stock, so investment is one source of real GDP growth.

– Investment fluctuates, so investment is one source of fluctuations in real GDP.

Measuring U.S. GDP

– The Bureau of Economic Analysis uses two approaches to measure GDP:

The expenditure approach The income approach

Measuring U.S. GDP

• The Expenditure Approach– The expenditure approach measures GDP as the sum

of consumption expenditure, investment, government expenditure on goods and services, and net exports.

– GDP = C + I + G + (X M)– Table in the textbook shows the expenditure

approach with data for 2006.– GDP = $9,079 + $2,215 + $2,479 $765– = $13,008

Measuring U.S. GDP

• The Income Approach– The income approach measures GDP by summing

the incomes that firms pay households for the factors of production they hire.

Measuring U.S. GDP

– The National Income and Expenditure Accounts divide incomes into five categories:

1. Compensation of employees2. Net interest3. Rental income4. Corporate profits5. Proprietors’ income

– These five income components sum to net domestic income at factor cost.

Real GDP and the Price Level

– Real GDP is the value of final goods and services produced in a given year when valued at constant prices.

• Calculating Real GDP– The first step in calculating real GDP is to calculate

nominal GDP.– Nominal GDP is the value of goods and services

produced during a given year valued at the prices that prevailed in that same year.


– Nominal GDP Calculations

– The table provides data for 2005 and 2006.

– In 2005, – Expenditure on balls =

$100– Expenditure on bats =

$100– Nominal GDP = $200

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50


– In 2006, – Expenditure on balls

= $80– Expenditure on bats

= $495– Nominal GDP = $575

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50

Real GDP and the Price Level– Base-Year Prices Value

of Real GDP– This method of

calculating real GDP is to value each year’s output at the prices of a base year.

– In the base year, real GDP equals nominal GDP.

– Suppose 2005 is the base year, then real GDP in 2005 is $200.

– This method is the traditional method.

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50

Real GDP and the Price Level– Using the traditional

base-year prices method to calculate real GDP in 2006:

– Expenditure on balls in 2006 valued at 2005 prices is $160.

– Expenditure on bats in 2006 valued at 2005 prices is $110.

– So real GDP in 2006 would be recorded as $270.

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50


– The new method of calculating real GDP, which is called the chain-weighted output index.

– The chain-weighted output index method, uses the prices of two adjacent years to calculate the real GDP growth rate.

– This calculation has four steps described on the next slide.


– Step 1: Value last year’s production and this year’s production at last year’s prices and then calculate the growth rate of this number from last year to this year.

– Step 2: Value last year’s production and this year’s production at this year’s prices and then calculate the growth rate of this number from last year to this year.

– Step 3: Calculate the average of the two growth rates. This average growth rate is the growth rate of real GDP from last year to this year.

– Step 4: Apply the growth rate this year to last year’s real GDP to calculate this year’s real GDP.


– We’ve done step 1. – Value of 2005

quantities at 2005 prices (GDP in 2005) is $200.

– Value of 2006 quantities at 2005 prices is $270.

– At 2005 prices, the value of production increased from $200 to $270—an increase of 35 percent.

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50


– Step 2. – Value of 2005

quantities at 2006 prices is $500.

– Value of 2006 quantities at 2006 prices (GDP in 2006) is $575.

– At 2006 prices, the value of production increased from $500 to $575—an increase of 15 percent.

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50


– Step 3. – At 2005 prices, the

2006 growth rate is 35 percent.

– At 2006 prices, the 2006 growth rate is 15 percent.

– The average of these two growth rates is 25 percent.

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50


– Step 4. – So with 2005 as the

base year, real GDP in 2006 is $250—25 percent more that $200 in 2005.

– Real GDP in 2005 is $200

– Real GDP in 2006 is $250

Item Quantity Price

2005

Balls 100 $1.00

Bats 20 $5.00

2006

Balls 160 $0.50

Bats 22 $22.50


• Calculating the Price Level– The average level of prices is called the price level. – One measure of the price level is the GDP

deflator, which is an average of the prices of the goods and services in GDP in the current year expressed as a percentage of the base-year prices.

– The GDP deflator is calculated in the table on the next slide.


– Nominal GDP and real GDP are calculated in the way that you’ve just seen.

– GDP Deflator = (Nominal GDP ÷ Real GDP) 100.– In 2005, the GDP deflator is ($200 ÷ $200) 100 = 100.– In 2006, the GDP deflator is ($575 ÷ $250) 100 = 230.

Year Nominal GDP

Real GDP

GDP deflator

2005 $200 $200 100

2006 $575 $250 230

Real GDP and the Price Level• Deflating the GDP Balloon

– Nominal GDP increases because production—real GDP– increases.


– Nominal GDP also increases because prices rise.


– We use the GDP deflator to let the inflation air out of the nominal GDP balloon and reveal real GDP.

The Uses and Limitations of Real GDP

– We use real GDP to calculate the economic growth rate.

– The economic growth rate is the percentage change in the quantity of goods and services produced from one year to the next.

– We measure economic growth so we can make Economic welfare comparisons across time International comparisons across countries Business cycle forecasts


• Economic Welfare Comparisons Over Time– Economic welfare measures the nation’s overall

state of economic well-being. – Real GDP is not a perfect measure of economic

welfare for seven reasons:– 1. Inflation rate tends to be overestimated

because quality improvements are neglected, so real GDP is underestimated.

– 2. Real GDP does not include household production— productive activities done in and around the house by members of the household.


– 3. Real GDP, as measured, omits the underground economy, which is illegal economic activity or legal economic activity that goes unreported for tax avoidance reasons.

– 4. Health and life expectancy are not directly included in real GDP.

– 5. Leisure time, a valuable component of an individual’s welfare, is not included in real GDP.

– 6. Environmental damage is not deducted from real GDP.

– 7. Political freedom and social justice are not included in real GDP.


• Economic Welfare Comparisons Across Countries– Real GDP is used to compare economic welfare in one

country with that in another. – Two special problems arise in making these

comparisons.– Real GDP of one country must be converted into the

same currency units as the real GDP of the other country, so an exchange rate must be used.

– The same prices should be used to value the goods and services in the countries being compared, but often are not.


– Using the exchange rate to compare GDP in one country with GDP in another country is problematic because prices of particular products in one country may be much less or much more than in the other country.

– For example, using the market exchange rate to value Chinese GDP in dollars leads to an estimate that in 2006, U.S. real GDP per person was 28 times Chinese real GDP per person.


– Figure illustrates the problem.

– Using the market exchange rate and domestic prices leads to an estimate that China is very poor.

– U.S. GDP per person is 28 times that in China.


– Using purchasing power parity prices leads to an estimate that U.S. GDP per person is (only) 12 times that in China.


• Business Cycle Forecasts– Real GDP is used to measure business cycle

fluctuations. – These fluctuations are probably accurately timed,

but the changes in real GDP probably overstate the changes in total production and people’s welfare caused by business cycles.

Unemployment and Full Employment

• Full Employment– Full employment occurs when there is no cyclical

unemployment or, equivalently, when all unemployment is frictional and structural.

– The unemployment rate at full employment is called the natural unemployment rate.

– The natural unemployment rate was high during the early 1980s but has gradually decreased.

Unemployment and Full Employment

• Real GDP and Unemployment Over the Cycle– Potential GDP is the quantity of real GDP produced at

full employment. – Potential GDP corresponds to the capacity of the

economy to produce output on a sustained basis.– Over the business cycle, actual real GDP fluctuates

around potential GDP and the unemployment rate fluctuates around the natural rate of unemployment.

Unemployment andFull Employment

• Real GDP and Unemployment Over the Cycle

– Figure 6.10 shows real GDP, and the unemployment rate...

…and estimates of potential GDP and the natural unemployment rate.

The Consumer Price Index

– The BLS calculates the Consumer Price Index every month.

– The Consumer Price Index, or CPI, measures the average of the prices paid by urban consumers for a “fixed” basket of consumer goods and services.


• Reading the CPI Numbers– The CPI is defined to equal 100 for the reference base

period. – Currently, the reference base period is 19821984.– That is, for the average of the 36 months from January

1982 through December 1984, the CPI equals 100.– In June 2006, the CPI was 202.9.– This number tells us that the average of the prices

paid by urban consumers for a fixed basket of goods was 102.9 percent higher in 2006 than it was during 19821984.


• Constructing the CPI– Constructing the CPI involves three stages: Selecting the CPI basket Conducting a monthly price survey Calculating the CPI


– The CPI Basket– The CPI basket is based on a Consumer

Expenditure Survey, which is undertaken infrequently.

– The CPI basket today is based on data collected in the Consumer Expenditure Survey of 20012002.

– The CPI basket contains 80,000 goods.


– Figure 6.11 illustrates the CPI basket.– Housing is the largest component.– Transportation and food and beverages are the

next largest components.– The remaining components account for 25

percent of the basket.


– The Monthly Price Survey– Every month, BLS employees check the prices of

80,000 goods on 30 metropolitan areas. – Calculating the CPI– 1. Find the cost of the CPI basket at base-period

prices.– 2. Find the cost of the CPI basket at current-period

prices.– 3. Calculate the CPI for the current period.

The Consumer Price Index– Let’s work an example of the CPI calculation. – In a simple economy, people consume only oranges

and haircuts. The CPI basket is 10 oranges and 5 haircuts.

– The table also shows the prices in the base period.

Item Quantity Price

Oranges 10 $1.00

Haircuts 5 $8.00


– The cost of the CPI basket in the base period was $50.

Item Quantity Price

Cost of CPI basket

Oranges 10 $1.00 $10

Haircuts 5 $8.00 $40

Cost of CPI basket at base period prices $50


Item Quantity Price

Cost of CPI basket

Oranges 10 $2.00 $20

Haircuts 5 $10.00 $50

Cost of CPI basket at current-period prices

$70

– This table shows the prices in the current period.– The cost of the CPI basket at current-period prices is

$70.


– The CPI is calculated using the formula:– CPI = (Cost of basket at current-period prices ÷

Cost of basket at base-period prices) 100.– Using the numbers for the simple example,

– CPI = ($70 ÷ $50) 100 = 140.– The CPI is 40 percent higher in the current period

than it was in the base period.


• Measuring Inflation– The major purpose of the CPI is to measure inflation.– The inflation rate is the percentage change in the

price level from one year to the next.– The inflation formula is:– Inflation rate = [(CPI this year – CPI last year) ÷ CPI last

year] 100.

The Consumer Price Index– Figure shows the relationship between the price

level and inflation.– Figure (a) shows the CPI from1971 to 2006.

The Consumer Price Index– Figure (b) shows that the inflation rate is High when the price level is rising rapidly and Low when the price level is rising slowly.


• The Biased CPI– The CPI might overstate the true inflation for four

reasons: New goods bias Quality change bias Commodity substitution bias Outlet substitution bias


– New Goods Bias – New goods that were not available in the base

year appear and, if they are more expensive than the goods they replace, they put an upward bias into the CPI.

– Quality Change Bias – Quality improvements occur every year. Part of

the rise in the price is payment for improved quality and is not inflation.

– The CPI counts all the price rise as inflation.


– Commodity Substitution Bias – The market basket of goods used in calculating

the CPI is fixed and does not take into account consumers’ substitutions away from goods whose relative prices increase.

– Outlet Substitution Bias – As the structure of retailing changes, people

switch to buying from cheaper sources, but the CPI, as measured, does not take account of this outlet substitution.

The Consumer Price Index• Some Consequences of the Bias– The bias in the CPI Distorts private contracts. Increases government outlays (close to a third of

federal government outlays are linked to the CPI). Biases estimates of real earnings.– Reducing the Bias – The BLS now undertakes consumer spending

surveys at more frequent intervals and is experimenting with a chained CPI.

What is Money?

• Official Measures of Money– The two main official measures of money in the

United States are M1 and M2.– M1 consists of currency and traveler’s checks and

checking deposits owned by individuals and businesses.

– M2 consists of M1 plus time, saving deposits, money market mutual funds, and other deposits.

What is Money?

– Figure 9.1 illustrates the composition of M1 and M2 in June 2005 and shows the relative magnitudes of their components.

What is Money?– Are M1 and M2 Really Money?– All the items in M1 are means of payment. – Some saving deposits in M2 are not means of

payments—they are called liquid assets.– Liquidity is the property of being instantly

convertible into a means of payment with little loss of value.

– Deposits are money, but checks are not–a check is an instruction to a bank to transfer money.

– Credit cards are not money. A credit card enables the holder to obtain a loan quickly, but the loan must be repaid with money.

Depository Institutions

– A depository institution is a firm that takes deposits from households and firms and makes loans to other households and firms.

– The institutions in the banking system divide into Commercial banks Thrift institutions Money market mutual funds

Many Monies!• The dollar, the yen, and the euro are three of the

world’s monies. But they are among more than 100 different monies that circulate in the global economy.

• The dollar and the yen have been around for a long time. The euro was created in the 1990s.

• In August 2002, 1 dollar bought 1.02 euros. In August 2006, 1 dollar bought 0.78 euros. Why do currency exchange rates fluctuate?

• The U.S. economy has become attractive to foreign investors.

• What determines the amount of international borrowing and lending?

Currencies and Exchange Rates

– To buy goods and services produced in another country we need money of that country.

– Foreign bank notes, coins, and bank deposits are called foreign currency.

– We get foreign currency in the foreign exchange market.


– The Foreign Exchange Market– We get foreign currency and foreigners get U.S

dollars in the foreign exchange market.– The foreign exchange market is the market in

which the currency of one country is exchanged for the currency of another.


– Foreign Exchange Rates– The price at which one currency exchanges for

another is called a foreign exchange rate.– A fall in the value of one currency in terms of

another currency is called currency depreciation.– A rise in value of one currency in terms of another

currency is called currency appreciation.


– Figure 10.1 shows how the U.S. dollar has moved against other currencies from 1995 to 2005.


– Nominal and Real Exchange Rates– The nominal exchange rate is the value of the U.S.

dollar expressed in units of foreign currency per U.S. dollar.

– It is a measure of how much of one money exchanges for a unit of another currency.

– The real exchange rate is the relative price of foreign-produced goods and services.

– It is a measure of the quantity of real GDP of other countries that we get for a unit of U.S. real GDP.


– Trade-Weighted Index– The trade-weighted index is the average

exchange rate of the U.S. dollar against other currencies, with individual currencies weighted by their importance in U.S. international trade.

The Foreign Exchange Market

• The Demand for One Money Is the Supply of Another Money– When people who are holding one money want to

exchange it for U.S. dollars, they demand U.S. dollars and they supply that other country’s money.

– So the factors that influence the demand for U.S. dollars also influence the supply of Canadian dollars, E.U. euros, U.K. pounds, and Japanese yen.

– And the factors that influence the demand for another country’s money also influence the supply of U.S. dollars.


• Demand in the Foreign Exchange Market– The quantity of U.S. dollars that traders plan to

buy in the foreign exchange market during a given period depends on

– 1. The exchange rate– 2. World demand for U.S. exports– 3. Interest rates in the United States and other

countries– 4. The expected future exchange rate


• The Law of Demand for Foreign Exchange– The demand for dollars is a derived demand.– People buy U.S. dollars so that they can buy U.S.-

produced goods and services or U.S. assets.– Other things remaining the same, the higher the

exchange rate, the smaller is the quantity of U.S. dollars demanded in the foreign exchange market.

The Foreign Exchange Market– The exchange rate influences the quantity of U.S.

dollars demanded for two reasons: Exports effect Expected profit effect– Exports Effect– The larger the value of U.S. exports, the greater is

the quantity of U.S. dollars demanded on the foreign exchange market.

– And the lower the exchange rate, the greater is the value of U.S. exports, so the greater is the quantity of U.S. dollars demanded.


– Expected Profit Effect– The larger the expected profit from holding U.S.

dollars, the greater is the quantity of U.S. dollars demanded today.

– But expected profit depends on the exchange rate.– The lower today’s exchange rate, other things

remaining the same, the larger is the expected profit from buying U.S. dollars and the greater is the quantity of U.S. dollars demanded today.

The Foreign Exchange Market• Supply in the Foreign Exchange Market

– The quantity of U.S. dollars supplied in the foreign exchange market is the amount that traders plan to sell during a given time period at a given exchange rate.

– This quantity depends on many factors but the main ones are

– 1. The exchange rate– 2. U.S. demand for imports– 3. Interest rates in the United States and other

countries– 4. The expected future exchange rate


• The Law of Supply of Foreign Exchange– Other things remaining the same, the higher the

exchange rate, the greater is the quantity of U.S. dollars supplied in the foreign exchange market.

– The exchange rate influences the quantity of U.S.dollars supplied for two reasons:

Imports effect Expected profit effect

The Foreign Exchange Market– Imports Effect– The larger the value of U.S. imports, the larger is

the quantity of U.S. dollars supplied on the foreign exchange market.

– And the higher the exchange rate, the greater is the value of U.S. imports, so the greater is the quantity of U.S. dollars supplied.

The Foreign Exchange Market– Expected Profit Effect– For a given expected future U.S. dollar exchange

rate, the lower the exchange rate, the greater is the expected profit from holding U.S. dollars, and the smaller is the quantity of U.S. dollars supplied on the foreign exchange market.

Exchange Rate Fluctuations

• Changes in the Demand for U.S. Dollars– A change in any influence on the quantity of

U.S.dollars that people plan to buy, other than the exchange rate, brings a change in the demand for U.S. dollars and a shift in the demand curve for U.S. dollars.

– These other influences are World demand for U.S. exports U.S. interest rate relative to the foreign interest rate The expected future interest rate


– World Demand for U.S. Exports Increases– At a given exchange rate, if world demand for U.S.

exports increases, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward.

– U.S. Interest Rate Relative to the Foreign Interest Rate

– The U.S. interest rate minus the foreign interest rate is called the U.S. interest rate differential.

– If the U.S. interest differential rises, the demand for U.S. dollars increases and the demand curve for U.S. dollars shifts rightward.


– The Expected Future Exchange Rate– At a given exchange rate, if the expected future

exchange rate for U.S. dollars rises, the demand for U.S. dollars increases and the demand curve for dollars shifts rightward.


• Changes in the Supply of Dollars– A change in any influence on the quantity of U.S.

dollars that people plan to sell, other than the exchange rate, brings a change in the supply of dollars and a shift in the supply curve of dollars.

– These other influences are U.S. demand for imports U.S. interest rates relative to the foreign interest rate The expected future exchange rate


– U.S. Demand for Imports– At a given exchange rate, if the U.S. demand for

imports increases, the supply of U.S. dollars on the foreign exchange market increases and the supply curve of U.S. dollars shifts rightward.

– U.S. Interest Rates Relative to the Foreign Interest Rate

– If the U.S. interest differential rises, the supply for U.S. dollars decreases and the supply curve of U.S. dollars shifts leftward.


– The Expected Future Exchange Rate– At a given exchange rate, if the expected future

exchange rate for U.S. dollars rises, the supply of U.S. dollars decreases and the demand curve for dollars shifts leftward.

Exchange Rate Fluctuations• Changes in the Exchange Rate

– Changes in demand and supply in the foreign exchange market change the exchange rate (just like they change the price in any market).

If demand for U.S. dollars increases and supply does not change, the exchange rate rises.

If demand for U.S. dollars decreases and supply does not change, the exchange rate falls.

If supply of U.S. dollars increases and demand does not change, the exchange rate falls.

If supply of U.S. dollars decreases and demand does not change, the exchange rate rises.

Exchange Rate Fluctuations• An Appreciating U.S. Dollar: 20002002

– Between 2000 and 2002, the U.S. dollar appreciated against the yen.

– Investors expected higher profits in the United States than in Japan and the demand for U.S. dollars increased.

– Currency traders expected the U.S. dollar to appreciate and the supply of U.S. dollars decreased.

– The exchange rate rose from 108 yen per U.S. dollar to 127 yen per U.S. dollar.


• A Depreciating Dollar: 20022004– Between 2000 and 2002, the U.S. dollar

depreciated against the yen. – Investors began to expect higher profits in Japan

and the demand for U.S. dollars increased.– Currency traders expected the U.S. dollar to

depreciate and the supply of U.S. dollars increased.

– The exchange rate fell from 127 yen per U.S. dollar to 109 yen per U.S. dollar.


• Exchange Rate Expectations– The exchange rate changes when it is expected to

change.– But expectations about the exchange rate are

driven by deeper forces. Two such forces are Interest rate parity Purchasing power parity


– Interest Rate Parity– A currency is worth what it can earn.– The return on a currency is the interest rate on that

currency plus the expected rate of appreciation over a given period.

– When the rates of returns on two currencies are equal, interest rate parity prevails.

– Interest rate parity means equal interest rates when exchange rate changes are taken into account.

– Market forces achieve interest rate parity very quickly.


– Purchasing Power Parity– A currency is worth the value of goods and

services that it will buy.– The quantity of goods and services that one unit

of a particular currency will buy differs from the quantity of goods and services that one unit of another currency will buy.

– When two quantities of money can buy the same quantity of goods and services, the situation is called purchasing power parity, which means equal value of money.


– Instant Exchange Rate Response– The exchange rate responds instantly to news

about changes in the variables that influence demand and supply in the foreign exchange market.

– Suppose that the Bank of Japan is considering raising the interest rate next week.

– With this news, currency traders expect the demand for yen to increase and the demand for dollars to decrease—they expect the U.S. dollar to depreciate.

Exchange Rate Fluctuations– But to benefit from a yen appreciation, yen must be

bought and dollars must be sold before the exchange rate changes.

– Each trader knows that all the other traders share the same information and have similar expectations.

– Each trader knows that when people begin to sell dollars and buy yen, the exchange rate will change.

– To transact before the exchange rate changes means transacting right away, as soon as the news is received.


– Nominal and Real Exchange Rates in Short Run and the Long Run

– The equation that links the nominal exchange rate (E) and real exchange rate (RER) is

– RER = E x (P/P*)– where P is the U.S. price level and P* is the

Japanese price level. – In the short run, this equation determines RER.– In the short run, (P/P*) doesn’t change and a

change in E brings an equivalent change in RER.


– In the long run, RER is determined by the real forces of demand and supply in markets for goods and services.

– So in the long run E determined by RER and the price levels. That is

– E = RER x (P*/P)– A rise in the Japanese price level P* brings an

appreciation of the U.S. dollar in the long run.– A rise in the U.S. price level P brings a depreciation

of the U.S. dollar in the long run.

Financing International Trade– We’ve seen how the exchange rate is determined,

but what is the effect of the exchange rate?– How does currency appreciation or appreciation

influence U.S. international trade?– We record international transactions in the

balance of payments accounts.

• Balance of Payments Accounts– A country’s balance of payments accounts

records its international trading, borrowing, and lending.

Financing International Trade– There are three balance of payments accounts:– 1. Current account– 2. Capital account– 3. Official settlements account– The current account records receipts from exports of

goods and services sold abroad, payments for imports of goods and services from abroad, net interest paid abroad, and net transfers (such as foreign aid payments).

– The current accounts balance equals the sum of: exports minus imports, net interest income, and net transfers.

Financing International Trade– The capital account records foreign investment in

the United States minus U.S. investment abroad. – The official settlements account records the

change in U.S. official reserves.– U.S. official reserves are the government’s

holdings of foreign currency.– If U.S. official reserves increase, the official

settlements account is negative. – The sum of the balances of the three accounts

always equals zero.

Financing International Trade– Figure 10.9 shows the balance of payments (as a

percentage of GDP) over the period 1980 to 2005.

Financing International Trade

• Borrowers and Lenders– A country that is borrowing more from the rest of

the world than it is lending to it is called a net borrower.

– A country that is lending more to the rest of the world than it is borrowing from it is called a net lender.

– The United States is currently a net borrower but during the 1960s and 1970s, the United States was a net lender.

Financing International Trade– Debtors and Creditors– A debtor nation is a country that during its entire

history has borrowed more from the rest of the world than it has lent to it.

– Since 1986, the United States has been a debtor nation.

– A creditor nation is a country that has invested more in the rest of the world than other countries have invested in it.

– The difference between being a borrower/lender nation and being a creditor/debtor nation is the difference between stocks and flows of financial capital.


– Being a net borrower is not a problem provided the borrowed funds are used to finance capital accumulation that increases income.

– Being a net borrower is a problem if the borrowed funds are used to finance consumption.


• Current Account Balance– The current account balance (CAB) is– CAB = NX + Net interest income + Net transfers– The main item in the current account balance is net

exports (NX).– The other two items are much smaller and don’t

fluctuate much.


– The government sector surplus or deficit is equal to net taxes, T, minus government expenditures on goods and services G.

– The private sector surplus or deficit is saving, S, minus investment, I.

– Net exports is equal to the sum of government sector balance and private sector balance:

– NX = (T – G) + (S – I)


– For the United States in 2006, – Net exports is a deficit of $784 billion, which equals

the sum of the government sector deficit of $313 billion and the private sector deficit of $471 billion.

Financing International Trade• The Three Sector Balances

– Figure 10.10 shows these three balances from 1980 through 2005.

– The private sector balance and the government sector balance tend to move in opposite directions.

– Net exports is the sum of the private sector and government sector balances.

Financing International Trade– Where is the Exchange Rate? – In the short run, a fall in the nominal exchange rate

lowers the real exchange rate, which makes our imports more costly and our exports more competitive.

– So in the short run, fall in the nominal exchange rate decreases the current account deficit.

– But in the long run, a change in the nominal exchange rate leaves the real exchange rate unchanged.

– So in the long run, the nominal exchange rate plays no role in influencing the current account balance.

Exchange Rate Policy

• Three possible exchange rate policies are Flexible exchange rate Fixed exchange rate Crawling peg

• Flexible Exchange Rate• A flexible exchange rate policy is one that permits

the exchange rate to be determined by demand and supply with no direct intervention in the foreign exchange market by the central bank.


• Fixed Exchange Rate• A fixed exchange rate policy is one that pegs the

exchange rate at a value decided by the government or central bank and that blocks the unregulated forces of demand and supply by direct intervention in the foreign exchange market.

• A fixed exchange rate requires active intervention in the foreign exchange market.

Exchange Rate Policy– Figure shows how the

central bank can intervene in the foreign exchange market to keep the exchange rate close to a target rate.

– Suppose that the target is 100 yen per U.S. dollar.

– If demand increases, the central bank sells U.S. dollars to increase supply.


– If demand decreases, the central bank buys U.S. dollars to decrease supply.

– Persistent intervention on one side of the foreign exchange market cannot be sustained.


• Crawling Peg• A crawling peg exchange rate policy is one that selects

a target path for the exchange rate with intervention in the foreign exchange market to achieve that path.

• China is a country that operates a crawling peg.• A crawling peg works like a fixed exchange rate except

that the target value changes. • The idea behind a crawling peg is to avoid wild swings

in the exchange rate that might happen if expectations became volatile and to avoid the problem of running out of reserves, which can happen with a fixed exchange rate.

Exchange Rate Policy• People’s Bank of

China in the Foreign exchange Market

• Figure 10.12(a) shows the immediate effect of the fixed yuan exchange rate.

• China’s official foreign currency reserves are piling up.

Exchange Rate Policy• Figure (b) illustrates

what is happening in the market for U.S. dollars priced in terms of the yuan.

• The People’s bank buy U.S. dollars to maintain the target exchange rate.

• China’s official foreign reserves increase.

an economic barometer what exactly is gdp? how do we use gdp to tell us whether our economy is in a...

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gross domestic product

gross domestic product

services gdp

country domestic production

market value final goods

income gdp

goods markets

given time period slide