Link between exchange rates, imports, exports, and aggregate demand
Effect on Net Exports and Aggregate Demand
● How is AD affected when the dollar appreciates? There are two related paths that will lead
to a decrease in AD when the dollar appreciates:
o Foreign goods are cheaper in the U.S., which causes U.S. imports to rise.
o U.S. goods become more expensive abroad, which causes U.S. exports to fall.
o Both of these channels reduce U.S. aggregate demand. That is, "net exports"
(Exports – Imports) decline.
● In general, a strong currency can be bad for an economy because it lowers AD, which can
weaken the economy through the demand side, as we have discussed extensively.
a) Channel for Monetary Policy
● The Fed can affect foreign trade by changing interest rates. Suppose the Fed wants to slow
down AD growth because of fears of inflation. The Fed would then raise interest rates. In
addition to decreasing consumption and investment (as we discussed previously), raising
interest rates can also affect exports and imports.
● Higher interest rates cause the dollar to appreciate (see discussion from an earlier lecture).
The stronger dollar reduces net exports and AD.
● Short review: We now have three ways that the interest rate can affect aggregate demand.
(Learn all of these; they are important.) A lower interest rate will:
o Increase consumption because it lowers the reward for saving
o Increase investment because it decreases the cost of capital.
o Increases exports and decreases imports because of depreciating currency.
o Symmetrically, higher interest rates reduce AD through all three channels above.
9. Trade Deficits
a) Trade deficits and international debt
● TRADE DEFICIT = IMPORTS - EXPORTS
o A positive trade deficit implies that Imports > Exports
● A trade deficit creates a possible problem because the country will accumulate foreign debt.
The idea of a country accumulating debt is like a household accumulating debt. If a
household spends more than it earns, it accumulates debt. Similarly, if a country spends (buy
imports) more than it earns (sell exports), it will accumulate foreign debt. The need to