Lecture: Open-Economy Macro: Exchange Rates & the Balance of Payments
Lecture script · about 15–20 minutes spoken · Week 14
Opening
Here's a question you've probably heard on the news without anyone answering it. What does a "strong dollar" actually do?
Think about who cares about the answer. A student is changing dollars at an airport counter before a trip abroad. A small furniture maker is quoting a price for dining chairs to a buyer overseas. A repair shop owner is pricing a machine built in Japan. A hotel worker is hoping visitors from abroad fill the rooms. Not one of them sets the price of the dollar. All of them live with it.
Here's where we are. In Week 2, Measuring Output, you met net exports, exports minus imports, as one piece of GDP. In Week 5, Aggregate Demand & Aggregate Supply, you learned to tell a shift of a curve from a movement along it. In Weeks 10 and 11 you watched the central bank move interest rates. And in Week 13, International Trade & Comparative Advantage, you saw why countries trade at all. In this lecture we put a price tag on that trade.
Here's the plan. I'll show you how to read an exchange rate, then walk one car and one machine across the border. Then we'll meet the market where currencies trade, read a country's books with the world, and weigh whether a strong dollar is a problem. Every number in this lecture is illustrative, built for this course, not real data.
1. Reading an exchange rate
Start at that airport counter. The student hands over dollars and gets euros back. The counter is selling euros and buying dollars, and the posted rate is the price of that deal.
Here's the term. An exchange rate is the price of one currency expressed in another; this course writes it as the amount of foreign currency one dollar buys, so 1 dollar = 120 yen means a dollar buys 120 yen.
In this course we always quote the rate from the dollar's side. So if the counter posts 0.90 euros per dollar, every dollar buys 0.90 euros. The student's 300 dollars become 270 euros. Going the other way, a museum pass priced at 45 euros costs her 45 divided by 0.90, which is 50 dollars.
Here's the habit that keeps you out of trouble. To turn dollars into foreign money, multiply by the rate. To turn foreign money into dollars, divide by it. If you're unsure, say the units out loud.
Pause and try this. The rate is 0.90 euros per dollar. To find the dollar price of a 45-euro pass, do you multiply or divide?
Say the units before you decide.
Here's the answer. You divide: 45 divided by 0.90 is 50 dollars. Multiplying would leave you with a unit that makes no sense.
2. Appreciation and depreciation
When the rate moves, you need a word for which way it went. The words come from the dollar's point of view.
Here's the course's illustrative chain. The dollar starts at 100 yen and moves to 120 yen. Each dollar now buys 20 more yen. As a percentage, that's 20 divided by 100, times 100, so the rate rose 20 percent.
Here's the term. An appreciation is a rise in a currency's value against another currency: after an appreciation of the dollar, one dollar buys more foreign currency than before, which makes the country's exports pricier abroad and its imports cheaper at home.
And its opposite. A depreciation is a fall in a currency's value against another currency: after a depreciation of the dollar, one dollar buys less foreign currency than before, which makes the country's exports cheaper abroad and its imports pricier at home.
There's a mirror here. When a dollar buys more yen, each yen buys fewer dollars, so the yen depreciated.
Pause and try this. A friend says, "The dollar went from 100 to 120 yen, so it got weaker." Is your friend right?
Ask what the number measures.
Here's the answer. No. The number is how much a dollar buys, and a dollar that buys 120 yen instead of 100 is worth more, so the dollar appreciated.
3. The export link
Now let's walk one product across the border. A U.S. factory sells a car for 25,000 dollars, and it keeps that price the whole time. A buyer in Japan pays in yen, so the buyer multiplies by the rate.
At 100 yen per dollar, the car costs 2,500,000 yen. At 120 yen per dollar, it costs 3,000,000 yen. That's 500,000 yen more for the very same car. Nothing about the car changed, and the factory didn't raise its price. Only the exchange rate moved.
Think about the furniture maker, too. Her chairs carry a dollar price she hasn't touched, but her overseas buyer now sees a higher price in his own money. Across the economy, U.S. goods look pricier abroad, so exports tend to fall.
Here's the trap. "Strong" sounds like good news for everyone, but a stronger dollar makes every U.S. export cost more in foreign money.
Pause and try this. After the dollar appreciates, does the yen price of the 25,000-dollar car rise or fall, and what tends to happen to exports?
Picture the buyer in Japan paying in yen.
Here's the answer. The yen price rises, from 2,500,000 to 3,000,000 yen, so the car is pricier abroad and exports tend to fall.
4. The import link, and net exports
Now cross the other way. A factory in Japan sells a machine for 1,200,000 yen. The repair shop here pays in dollars, so the shop divides by the rate.
At 100 yen per dollar, the machine costs 12,000 dollars. At 120 yen per dollar, it costs 10,000 dollars. The same machine is 2,000 dollars cheaper. The shop owner buys it, and so do other buyers, so imports tend to rise.
Now put the two links together. Exports tend to fall. Imports tend to rise. Net exports are exports minus imports, so a smaller first number and a larger second number both pull net exports down. After an appreciation, net exports fall.
One honest caveat. This chain holds other things equal. If incomes abroad are booming, foreign buyers might buy more U.S. cars anyway. That's why we say exports "tend" to fall.
Pause and try this. After an appreciation, exports tend to fall and imports tend to rise. What happens to net exports?
Remember which number gets subtracted.
Here's the answer. Net exports fall. Exports minus imports gets smaller from both sides, because the first number shrinks and the second one grows.
5. Running the chain backwards
Now let the dollar slide back, from 120 yen to 100 yen. Each dollar buys fewer yen, so the dollar has depreciated. And every arrow in the chain flips.
The car goes from 3,000,000 yen back to 2,500,000 yen abroad. It's cheaper for the buyer in Japan, so exports tend to rise. The machine goes from 10,000 dollars back to 12,000 dollars here. It's pricier for the repair shop, so imports tend to fall. Exports up, imports down, and net exports rise. The furniture maker smiles, and the repair shop owner frowns.
The classic slip here is flipping the rate and the last step but leaving a middle link alone. Someone writes, "The dollar depreciated, so imports got cheaper." That middle link didn't flip. After a depreciation, a dollar buys fewer yen, so a yen price costs more dollars.
Pause and try this. The dollar depreciates from 120 to 100 yen. Does the 1,200,000-yen machine get cheaper or pricier here?
Divide by the new rate in your head.
Here's the answer. Pricier. It goes from 10,000 dollars to 12,000 dollars, because each dollar now buys fewer yen, so imports tend to fall.
6. The chain on the AD–AS diagram
Now bring back the diagram from Week 5. Real output runs along the bottom. The price level runs up the side. Aggregate demand slopes down, and short-run aggregate supply slopes up.
Net exports are one of the four parts of aggregate demand, alongside consumption, investment, and government purchases. So when the exchange rate moves net exports, spending on U.S. output changes at every price level. That shifts the whole aggregate demand curve.
Follow an appreciation. Net exports fall, so aggregate demand shifts left. The economy walks down the short-run aggregate supply curve. The price level falls, and real output falls, together. A depreciation does the reverse: aggregate demand shifts right, and both rise.
Here's a distinction worth guarding. In Week 5 you met the exchange-rate effect, one reason aggregate demand slopes down. That effect starts with a change in the price level itself, so it's a movement along the curve. Here, the currency market started the story, not the price level. A change in anything other than the price level shifts the whole curve.
Pause and try this. The dollar appreciates, all else equal. Which curve shifts, which way, and what happens to the price level and real output?
Name the curve before you name the direction.
Here's the answer. Aggregate demand shifts left, so the price level and real output both fall, because net exports, a part of aggregate demand, fell.
7. The foreign-exchange market
So who decides that a dollar buys 120 yen and not 100? Nobody alone. The rate comes out of a market.
Here's the term. The foreign-exchange market is the market where currencies are traded for one another; buyers of a country's exports and assets demand its currency, and the country's buyers of imports and foreign assets supply it.
Picture two crowds. The first crowd wants dollars: a buyer in Japan paying for a U.S. car, a family from abroad paying for a hotel here, a saver abroad buying a U.S. bond or a share in a U.S. company. The second crowd has dollars and wants foreign money: the repair shop paying for its machine, the student at the airport counter, a U.S. saver buying shares abroad.
A floating exchange rate is an exchange rate that is set in the foreign-exchange market by the demand for and supply of a currency, with no government holding it at a chosen level. This course models the dollar that way. A fixed exchange rate is the other arrangement: an exchange rate that a government or central bank commits to hold at a chosen level by buying or selling currency whenever market pressure pushes the rate away from it.
Pause and try this. A tour group from abroad pays for a trip here. Is that group demanding dollars or supplying them?
Ask which currency the group needs.
Here's the answer. Demanding dollars. The trip is priced in dollars, so the group has to buy dollars to pay for it.
8. What drives the dollar
If the rate comes from two crowds, anything that changes either crowd moves the rate. Economists name three drivers, and each one compares countries.
First, relative interest rates. Savers go where their money earns more. Picture a saver in Japan who can earn 2 percent on a bond at home or 5 percent on a U.S. bond of the same risk. She buys the U.S. bond, and to buy it she needs dollars. Higher U.S. interest rates attract foreign savers, who demand more dollars, so the dollar tends to appreciate. That ties back to Week 11: a move that raises U.S. interest rates can also lift the dollar.
Second, relative inflation. If prices here climb faster than prices abroad, U.S. goods get dearer next to foreign goods. Foreign buyers want fewer dollars, and buyers here turn toward imports. Faster U.S. inflation makes the dollar tend to depreciate.
Third, relative growth pulls two ways. Faster growth here raises spending on imports, which supplies dollars, but it can also draw foreign investment, which demands dollars. Which pull wins is a question for evidence.
Pause and try this. U.S. interest rates rise relative to rates abroad. Which way does the dollar tend to move?
Think about the saver choosing a bond.
Here's the answer. It tends to appreciate. A higher return here pulls in foreign savers, and to bring their money in they have to buy dollars.
9. The balance of payments
Here's a puzzle. Every dollar a repair shop spends on an imported machine ends up in someone's hands abroad. Where does it go next?
Start with a household. Picture a family that earns 50,000 dollars in a year and spends 53,000 dollars. It covers the 3,000-dollar gap by selling shares. Spending beyond its income on one side, selling assets on the other, and the two sides net to 0. The money didn't vanish; it was paid for.
A country keeps the same kind of books. The balance of payments is the record of all of a country's transactions with the rest of the world over a period, organized into the current account and the financial account. The current account is the part of the balance of payments that records trade in goods and services together with international income and transfer flows; at the principles level it is mostly net exports. The financial account is the part of the balance of payments that records purchases and sales of assets such as bonds, shares, and buildings across borders; a positive balance means a net inflow of foreign investment.
Use the course's illustrative account from Week 2, in billions of dollars. Exports are 100 and imports are 150, so the current account is 100 minus 150, which is negative 50. That's a current-account deficit. Foreign savers use those 50 to buy U.S. assets, so the financial account is positive 50. Add them, and you get 0. This is an accounting identity: an equation that holds by the way the books are kept, whatever the economy does; it records what happened and passes no judgment on it.
Pause and try this. The current account is negative 50. What must the financial account be, and did that money disappear?
Picture where the dollars go after they leave.
Here's the answer. Positive 50, and no. The dollars spent on imports came back as foreign purchases of U.S. bonds, shares, and buildings.
10. Is a strong dollar a problem?
Now we stop computing and start weighing. Both sides of this debate accept the price chain and the identity you've learned. They disagree about how big the effects are and whose interests count most.
The first view says a strong dollar and a lasting deficit are a problem. Exporters like the furniture maker lose sales abroad. Workers in industries that compete with cheaper imports lose ground. And a deficit year after year means foreign savers own a growing share of U.S. assets, so more future income, interest and profits, is paid abroad.
The second view says they can be a sign of strength. A strong dollar raises what households' dollars buy, so the student and the repair shop owner gain. It cheapens imported parts that producers here use. And the financial-account inflows pay for investment here: foreign savers buy U.S. bonds and shares because they want to invest here, and that money can fund new factories, offices, and homes.
Notice which claims are positive and which are normative. That an appreciation makes exports pricier is positive and agreed. How large the effects are is positive but disputed, a question for evidence. Whether export jobs or cheaper goods for households should come first is normative, a question of values. This course gives you both views and leaves the verdict to the evidence and your own values.
Pause and try this. "Cheaper goods for households should matter more than export jobs." Is that statement positive or normative?
Notice the word "should."
Here's the answer. Normative. It says what ought to matter, which rests on values, so no data set can prove it right or wrong.
Closing
Let's pull it together. An exchange rate is the price of one currency in another. More foreign money per dollar is an appreciation; less is a depreciation. An appreciation makes U.S. exports pricier abroad and imports cheaper at home, so net exports fall, and a depreciation flips every arrow. Because net exports are part of aggregate demand, an appreciation shifts aggregate demand left, and the price level and real output fall together.
The rate itself comes out of the foreign-exchange market, where buyers of U.S. goods and assets demand dollars and U.S. buyers of foreign goods and assets supply them. Relative interest rates, relative inflation, and relative growth move those crowds. The balance of payments keeps the books: the current account and the financial account sum to zero, so a current-account deficit is matched by inflows. Whether a strong dollar is a problem is partly evidence and partly values.
Next in this module come the slide deck, the Readings & Resources page, the lecture tutorial, the practice set, and the quiz. And in Week 15, Macroeconomic Schools & Policy Debates, the course closes by setting the Keynesian and classical / monetarist views side by side on the policy questions you've met in every unit.
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