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Part 4
380 The United States in the World Economy

For years before it actually started happening, economists predicted that
America™s huge trade deficits would eventually drive the international value
of the U.S. dollar down. In early 2002, this prophecy finally started to come
true. However, the dollar declined only for about two years, before stabiliz-
ing at the end of 2004. Then, after a two-year hiatus, dollar depreciation re-
sumed in 2007 and into 2008, when the greenback tumbled sharply. This time
the dollar™s weakness even grabbed the headlines”a rare event in our country. People
looked on in amazement as the British pound topped $2, the euro soared above $1.50,
and the Canadian dollar became worth more than the U.S. dollar for the first time since
the 1970s.
Some observers were alarmed by the falling dollar. They urged the United States
government to fight the dollar™s decline. Both European and Japanese businesspeople
complained that they were losing export markets to the Americans, which was damag-
ing European and Japanese growth. But there was also a bright side: The massive U.S.
trade deficit at last started to shrink. Weighing the pros and cons, the U.S. government
decided that currency values should remain “flexible,” that is, determined in world
markets by the forces of supply and demand that we studied in the previous chapter. It
refused to intervene to try to stop the dollar from falling.
Who was right? We will examine this question as the chapter progresses.

We know from earlier chapters that a country™s net exports, (X 2 IM), are one component
of its aggregate demand, C 1 I 1 G 1 (X 2 IM). It follows that an autonomous increase in
exports or decrease in imports has a multiplier effect on the economy, just like an increase
in consumption, investment, or government purchases.1 Figure 1 depicts this conclusion
on an aggregate demand-and-supply diagram. A rise in net exports shifts the aggregate
demand curve outward to the right, pushing equilibrium from point A to point B. Both
F I GU R E 1
GDP and the price level therefore rise.
The Effects of Higher
But what forces might make net exports increase? One
Net Exports
factor mentioned in Chapter 8 was a rise in foreign incomes.
If foreign economies boom, their citizens are likely to
spend more on a wide variety of products, some of which
will be American exports. Thus, Figure 1 illustrates the
effect on the U.S. economy of more rapid growth in for-
eign countries. By like reasoning, a recession abroad
B would reduce U.S. exports and shift the U.S. aggregate
Price Level

demand curve inward. Thus, as we learned in Chapter 9:
Booms or recessions in one country tend to be trans-
mitted to other countries through international trade
in goods and services.

A second important determinant of net exports was
mentioned in Chapter 8, but not discussed in depth
there: the relative prices of foreign and domestic goods.
The idea is a simple application of the law of demand.
Namely, if the prices of the goods of Country X rise, peo-
Real GDP
ple everywhere will tend to buy fewer of them”and

An appendix to Chapter 9 showed that international trade lowers the numerical value of the multiplier.

Autonomous changes in C, I, G, and (X 2 IM) all have the same multiplier.

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Chapter 19 381
Exchange Rates and the Macroeconomy

more of the goods of Country Y. As we will see next, this simple idea holds the key to
understanding how exchange rates affect international trade.

Relative Prices, Exports, and Imports
First assume”just for this short section”that exchange rates are fixed. Think about what
happens if the prices of American goods fall while, say, Japanese prices are constant. With
U.S. products now less expensive relative to Japanese products, both Japanese and American
consumers will buy more American goods and fewer Japanese goods. That means
America™s exports will rise and its imports will fall, thus adding to aggregate demand in
the United States. Conversely, a rise in American prices (relative to Japanese prices) will
decrease U.S. net exports and aggregate demand. Thus:
A fall in the relative prices of a country™s exports tends to increase that country™s net ex-
ports and, thereby, to raise its real GDP. Analogously, a rise in the relative prices of a
country™s exports will decrease that country™s net exports and GDP.
Precisely the same logic applies to changes in Japanese prices. If Japanese prices
rise, Americans will export more to and import less from Japan. So X 2 IM in the U.S.
will rise, boosting GDP here. Figure 1 applies to this case without change. By similar rea-
soning, falling Japanese prices decrease U.S. net exports and depress our economy. Thus:
Price increases for foreign products raise a country™s net exports and hence its GDP.
Price decreases for foreign products have the opposite effects.

The Effects of Changes in Exchange Rates
From here, it is a simple matter to figure out how changes in exchange rates affect a coun-
try™s net exports, because currency appreciations or depreciations change international relative
Recall that the basic role of an exchange rate is to
convert one country™s prices into another country™s cur- TA BL E 1
rency. Table 1 uses two examples of U.S.“Japanese trade Exchange Rates and Home Currency Prices
to remind us of this role. Suppose the dollar depreciates
¥30,000 Japanese $1,000 U.S.
from 120 yen to 100 yen. Then, from the American con-
TV Set Home Computer
sumer™s viewpoint, a television set that costs ¥30,000
Exchange Price in Price in Price in Price in
in Japan goes up in price from $250 (that is, 30,000/120)
Rate Japan the U.S. the U.S. Japan
to $300 (that is, 30,000/100). To Americans, it is just as
$1 5 120 yen ¥30,000 $250 $1,000 ¥120,000
if Japanese manufacturers had raised TV prices by
$1 5 100 yen ¥30,000 $300 $1,000 ¥100,000
20 percent. Naturally, Americans will react by purchas-
ing fewer Japanese products, so American imports
will decline.
Now consider the implications for Japanese consumers interested in buying American
personal computers that cost $1,000. When the dollar falls from 120 yen to 100 yen, they
see the price of these computers falling from ¥120,000 to ¥100,000. To them, it is just as if
American producers had offered a 16.7 percent markdown. Under such circumstances, we
expect U.S. sales to the Japanese to rise, so U.S. exports should increase. Putting these two
findings together, we conclude that
A currency depreciation should raise net exports and therefore increase aggregate
demand. Conversely, a currency appreciation should reduce net exports and therefore
decrease aggregate demand.
The aggregate supply-and-demand diagram in Figure 2 on the next page illustrates
this conclusion. If the currency depreciates, net exports rise and the aggregate demand
curve shifts outward from D0D0 to D1D1. Both prices and output rise as the economy™s
equilibrium moves from E0 to E1. If the currency appreciates instead, everything operates
in reverse: Net exports fall, the aggregate demand curve shifts inward to D2D2, and both
prices and output decline.

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Licensed to:
Part 4
382 The United States in the World Economy

This simple analysis helps us understand why the
F I GU R E 2
U.S. trade deficit grew so enormously in the late 1990s
The Effects of Exchange Rate Changes on Aggregate Demand
and early 2000s and has fallen a bit recently. We learned
in the previous chapter that the international value of
the dollar began to climb in 1995. According to the rea-
soning we have just completed, within a few years such
an appreciation of the dollar should have boosted U.S.
E1 imports and damaged U.S. exports. That is precisely
D2 (depreciation)
what happened. In constant dollars, American imports
Price Level

soared by over 40 percent between 1997 and 2002, while
American exports rose by only 7 percent. The result was
(appreciation) D1
that a $105 billion real net export deficit in 1997 turned
E2 into a monumental $471 billion deficit by 2002. More re-
D0 cently, the dollar™s decline has helped push the trade
deficit down from a record $625 billion in 2006 to “only”
$556 billion in 2007.

Real GDP

So far we have concluded that a currency depreciation increases aggregate demand and
that a currency appreciation decreases it. To complete our model of macroeconomics in an
open economy, we must turn to the implications of international trade for aggregate supply.
Part of the story is already familiar. We know from previous chapters that the United
States, like all economies, purchases some of its productive inputs from abroad. Oil is by
far the most prominent example. But we also rely on foreign suppliers for metals such as
titanium, raw agricultural products such as coffee beans, and thousands of other items
used by American industry. When the dollar depreciates, all of these imported inputs cost
more in U.S. dollars”just as if foreign prices had risen.
The consequence is clear: With imported inputs more expensive, American firms will
be forced to charge higher prices at any given level of output. Graphically, this means that
the aggregate supply curve will shift upward (or inward to the left).
F I GU R E 3
When the dollar depreciates, the prices of imported inputs rise. The U.S. aggregate sup-
The Effects of
ply curve therefore shifts inward, pushing up the prices of American-made goods and
Exchange Rate Changes
on Aggregate Supply services. By exactly analogous reasoning, an appre-
ciation of the dollar makes imported inputs
cheaper and shifts the U.S. aggregate supply curve
outward, thus pushing American prices down. (See
S1 (depreciation)
D S0 Figure 3.)
Beyond this, a depreciating dollar has addi-
tional inflationary effects that do not even show
Price Level

up on an aggregate demand-and-supply diagram,
because the price level depicted on the vertical
axis is the price of gross domestic product. Most obvi-
E2 ously, prices of imported goods are included in
U.S. price indexes like the Consumer Price Index
(CPI). So when the dollar prices of Japanese cars,
French wine, and Swiss watches increase, the CPI
goes up even if no American prices rise. For this and
other reasons, the inflationary impact of a dollar
depreciation on consumer prices is greater than
Real GDP
that indicated by Figure 3.

Copyright 2009 Cengage Learning, Inc. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part.
Licensed to:

Chapter 19 383
Exchange Rates and the Macroeconomy

Let us now put aggregate demand and aggregate supply F I GU R E 4
together and think through the macroeconomic effects of The Effects of a
changes in exchange rates. Currency Depreciation
First, suppose the international value of the dollar falls. Re-
ferring back to the blue lines in Figures 2 and 3, we see that this
depreciation will shift the aggregate demand curve outward S1
and the aggregate supply curve inward. The result, as Figure 4 D1 S0
shows, is that the U.S. price level certainly rises. But whether
real GDP rises or falls depends on whether the supply or de-


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