• Trade balance: Exports of goods and services minus imports
• Net income: Investment income (dividends, interest) earned minus paid abroad
• Net transfers: Unilateral transfers (remittances, foreign aid) received minus paid
• Current account surplus -> nation is net lender to world
• Current account deficit -> nation is net borrower from world
• US has run current account deficits since 1970s

• Financial account: Net flows of financial assets
• Foreign Direct Investment (FDI): long-term investment in businesses
• Portfolio investment: stocks, bonds, other securities
• Other investment: loans, bank deposits, currency
• Capital account: small (debt forgiveness, migrants' transfers)
• Surplus -> net capital inflow (foreigners buying domestic assets)
• Deficit -> net capital outflow (domestic residents buying foreign assets)

• Current Account + Capital/Financial Account = 0 (ignoring errors and omissions)
• Must balance in accounting sense
• Current account deficit financed by capital/financial account surplus (foreign borrowing)
• Current account surplus corresponds to capital/financial account deficit (lending to world)
• Exchange rates adjust to ensure balance

Appreciation: An increase in the value of a currency relative to another currency.

• Imports become cheaper for domestic consumers
• Exports become more expensive for foreigners
• Net exports tend to fall, shifting AD left

Depreciation: A decrease in the value of a currency relative to another currency.

• Imports become more expensive
• Exports become cheaper for foreigners
• Net exports tend to rise, shifting AD right

Nominal exchange rate: The market price of one currency in terms of another.

• Example: yen per dollar or dollars per euro

Real exchange rate: The nominal exchange rate adjusted for price levels in the two countries.

• Measures the relative price of domestic goods compared with foreign goods
• Real appreciation makes domestic goods less competitive internationally
• Real depreciation makes domestic goods more competitive
• Purchasing power parity is the idea that exchange rates tend to reflect relative price levels over time

The foreign exchange market is the market where currencies are bought and sold.

• Exchange rates are determined by supply and demand for a currency
• Demand for a currency comes from foreigners buying domestic goods, services, and assets
• Supply of a currency comes from domestic residents buying foreign goods, services, and assets
• Equilibrium exchange rate occurs where quantity demanded equals quantity supplied
• Appreciation occurs when demand rises or supply falls; depreciation occurs when demand falls or supply rises

• Derived from foreign demand for domestic goods, services, assets
• Factors increasing demand (appreciation pressure):
• Exports increase (foreigners need domestic currency)
• Domestic interest rates rise (attracts foreign capital)
• Investment opportunities improve
• Speculation on future appreciation
• Downward sloping: higher exchange rate -> lower quantity demanded

• Derived from domestic demand for foreign goods, services, assets
• Factors increasing supply (depreciation pressure):
• Imports increase (need foreign currency)
• Foreign interest rates rise (capital outflows)
• Desire for foreign investment
• Speculation on future depreciation
• Upward sloping: higher exchange rate -> higher quantity supplied

• Where demand for currency equals supply
• No tendency to change unless underlying factors shift
• Overvalued currency: quantity supplied > quantity demanded -> downward pressure
• Undervalued currency: quantity demanded > quantity supplied -> upward pressure
• Central banks may intervene to maintain fixed or managed rates

• Interest rate differentials: Higher domestic rates -> capital inflows -> appreciation
• Inflation differentials: Higher domestic inflation -> depreciation (real)
• Income growth: Faster domestic growth -> more imports -> depreciation
• Government policies: Tariffs, quotas affect trade flows
• Productivity: Higher productivity -> appreciation (competitiveness)
• Political stability: Instability causes capital outflows -> depreciation
• Speculation: Expectations become self-fulfilling

• Higher interest rates attract foreign capital (seeking higher returns)
• Capital inflows increase demand for domestic currency -> appreciation
• Capital mobility: Higher when capital flows freely across borders
• Expansionary monetary policy -> lower interest rates -> capital outflows -> depreciation
• Contractionary monetary policy -> higher interest rates -> capital inflows -> appreciation
• Important for small open economies with high capital mobility

• Higher domestic inflation -> exports more expensive, imports cheaper -> trade deficit -> depreciation pressure
• Purchasing Power Parity (PPP): Exchange rates adjust to equalize purchasing power
• Absolute PPP: Exchange rate = ratio of price levels
• Relative PPP: Countries with higher inflation see currency depreciation
• In real world, deviations from PPP persist due to:
• Non-tradable goods (services)
• Transportation costs
• Trade barriers
• Financial flows

• Depreciation: Makes exports cheaper, imports more expensive
• Exports increase, imports decrease (Marshall-Lerner condition)
• Net exports increase -> AD shifts right
• Current account improves
• May cause inflation (imported goods more expensive)
• Appreciation: Opposite effects
• Exports decrease, imports increase
• Net exports decrease -> AD shifts left
• Current account worsens

• Short-run vs long-run effect of depreciation on trade balance
• Short run: Trade balance may worsen after depreciation
• Quantities adjust slowly (contracts, habits)
• Prices adjust immediately
• Import spending increases (same quantity × higher price)
• Long run: Trade balance improves
• Quantities adjust to price changes
• Export volumes increase, import volumes decrease
• Creates J-shaped pattern: initial worsening, then improvement

Tariff: A tax on imports.

• Raises import prices and reduces import quantity
• Benefits domestic producers but harms domestic consumers
• Generates government revenue
• Creates deadweight loss and reduces total surplus

Quota: A direct limit on the quantity of imports.

• Also reduces imports and raises domestic price
• Benefits domestic producers and harms consumers
• Unlike a tariff, the gains often go to quota holders rather than the government
• Both policies reduce efficiency and the gains from trade

Net exports rise when exports increase relative to imports.

• Higher foreign income increases demand for domestic exports
• Depreciation of the domestic currency makes exports cheaper and imports more expensive, raising net exports
• Higher domestic income usually increases imports, lowering net exports
• Appreciation of the domestic currency makes exports less competitive and imports cheaper, lowering net exports
• Changes in tastes, trade policy, and foreign growth all shift net exports

Net exports are a component of aggregate demand.

• Currency depreciation tends to increase exports and reduce imports, so AD shifts right
• Currency appreciation tends to reduce exports and increase imports, so AD shifts left
• Tariffs and quotas may raise net exports in the short run, but they can also trigger retaliation and reduce trade
• Trade restrictions can raise firms' input costs, which may shift SRAS left and create cost-push inflation
• In the long run, freer trade generally improves efficiency and productive capacity

• Integration of national capital markets
• Capital flows to highest real returns
• Arbitrage equalizes real interest rates across countries (adjusted for risk)
• Capital mobility: Degree to which capital flows freely
• High mobility: interest rates closely linked
• Low mobility: domestic policies more effective
• Small open economy: interest rate determined by world market
• Large open economy: influences world interest rate

Capital flows and exchange rates:

• Capital inflows (buying domestic assets) -> demand for currency -> appreciation
• Capital outflows (buying foreign assets) -> supply of currency -> depreciation
• Linked to interest rate differentials and expected returns
• Explains rapid exchange rate movements (financial flows larger than trade flows)