Open Economy—International Trade and Finance

The balance of payments (BOP) records all of a country's transactions with the rest of the world in two parts. The current account (CA) tracks net exports of goods and services, net income from abroad and net transfers, and the capital and financial account (CFA) tracks purchases and sales of assets like stocks, bonds, land and factories. Money flowing in is a credit and money flowing out is a debit, and the two accounts balance (CA + CFA = 0), so a current account deficit comes with a financial account surplus.

An exchange rate is the price of one currency in terms of another, such as $1.10 per euro. If it takes more dollars to buy a euro, the euro has appreciated (gained value) and the dollar has depreciated (lost value). You can flip any rate to get the other currency's price, so $1.25 per euro is the same as 0.80 euros per dollar.

A foreign exchange graph for euros puts the price of a euro (dollars per euro) on the vertical axis and the quantity of euros on the horizontal axis. Demand for euros (D) slopes downward and comes from people who want European goods, services and assets; supply of euros (S) slopes upward and comes from Europeans paying for things in other currencies. They cross at the equilibrium exchange rate (e1). A rate above e1 creates a surplus of euros and a rate below it a shortage, which pushes the rate back to e1.

Anything that changes how much foreigners want a country's goods, services or assets shifts the demand for its currency: tastes, relative incomes, relative price levels and relative interest rates. Anything that changes how much its own people want foreign things shifts the supply of its currency; for example, a tariff or quota on imports means people buy fewer foreign goods, so they supply less of their own currency and it appreciates. If expansionary monetary policy lowers U.S. interest rates, U.S. assets pay less, so foreigners demand fewer dollars and Americans supply more dollars to buy foreign assets. Both push the dollar to depreciate.

When a country's currency appreciates, its exports become more expensive for foreign buyers and imports become cheaper at home, so net exports fall and AD shifts left. When its currency depreciates, exports rise and imports fall, so net exports increase and AD shifts right, raising real GDP and the price level in the short run.

Money for investment (financial capital) tends to flow to whichever country offers the higher real interest rate, since its bonds and other assets pay a better return. If U.S. real interest rates rise compared with other countries, foreigners want more U.S. assets, so the demand for dollars rises and the dollar appreciates. That capital inflow also adds to the supply of loanable funds in the U.S.