# Exchange Rates and International Capital Flows

## How the Foreign Exchange Market Works

Most countries have different currencies, but not all. Sometimes small economies use an economically larger neighbor's currency. For example, Ecuador, El Salvador, and Panama have decided to dollarize—that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. A large-scale example of a common currency is the decision by 17 European nations—including some very large economies such as France, Germany, and Italy—to replace their former currencies with the euro at the start of 1999. With these exceptions, most of the international economy takes place in a situation of multiple national currencies in which both people and firms need to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. We call the market in which people or firms use one currency to purchase another currency the foreign exchange market.
You have encountered the basic concept of exchange rates in earlier chapters. In The International Trade and Capital Flows, for example, we discussed how economists use exchange rates to compare GDP statistics from countries where they measure GDP in different currencies. These earlier examples, however, took the actual exchange rate as given, as if it were a fact of nature. In reality, the exchange rate is a price—the price of one currency expressed in terms of units of another currency. The key framework for analyzing prices, whether in this course, any other economics course, in public policy, or business examples, is the operation of supply and demand in markets.

### The Extraordinary Size of the Foreign Exchange Markets

If you travel to a foreign country that uses a different currency, you will undoubtedly need to make a trip to a bank or foreign currency office to exchange whatever currency you’re holding for that country’s currency. Even though this is a simple transaction, it is part of a very large market. The quantities traded in foreign exchange markets are breathtaking. A 2019 Bank of International Settlements survey found that $5.3 trillion per day was traded on foreign exchange markets, which makes the foreign exchange market the largest market in the world economy. In contrast, 2019 U.S. real GDP was $21.4 trillion per year.
Your transaction is simple enough. Suppose you carry a $100 bill. You bring it into the foreign currency office and look up, and you see a bunch of different numbers on a digital board. For example, if you are traveling to Turkey, whose national currency is the Turkish Lira, one line of the board might read: “U.S. DOLLARS: BUY 5.50; SELL 5.80.” This means that the office will give you 5.50 Turkish Lira in exchange for 1 U.S. dollar. If you have $100, the office will give you 550 Turkish Lira. If you want to sell Turkish Lira for U.S. dollars, the office will surely buy them from you, but not at the same exchange rate, since the office will make some money on the exchange. So if you bring 550 Turkish Lira and ask for U.S. dollars, it will not give you 100 dollars, but instead about $95. The important point is that this one transaction, when repeated all over the world for all sorts of different transactions, ends up totaling $6.6 trillion worth of exchanges per day.
 shows the currencies most commonly traded on foreign exchange markets. The U.S. dollar dominates the foreign exchange market, being on one side of 88.3% of all foreign exchange transactions. The U.S. dollar is followed by the euro, the British pound, the Australian dollar, and the Japanese yen.

### Demanders and Suppliers of Currency in Foreign Exchange Markets

In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency—and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market: (1) firms that are involved in international trade of goods and services; (2) tourists visiting other countries; (3) international investors buying ownership (or part-ownership) of a foreign firm; (4) international investors making financial investments that do not involve ownership. Let’s consider these categories in turn.
Firms that buy and sell on international markets find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. Thus, a Chinese firm exporting abroad will earn some other currency—say, U.S. dollars—but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.
International tourists will supply their home currency to receive the currency of the country they are visiting. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan.
We often divide financial investments that cross international boundaries, and require exchanging currency into two categories. Foreign direct investment (FDI) refers to purchasing a firm (at least ten percent) in another country or starting up a new enterprise in a foreign country For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this purchase, InBev would have to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars.
The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased U.K. government bonds, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.
Business people often link portfolio investment to expectations about how exchange rates will shift. Look at a U.S. financial investor who is considering purchasing U.K. issued bonds. For simplicity, ignore any bond interest payment (which will be small in the short run anyway) and focus on exchange rates. Say that a British pound is currently worth $1.50 in U.S. currency. However, the investor believes that in a month, the British pound will be worth $1.60 in U.S. currency. Thus, as  (a) shows, this investor would change $24,000 for 16,000 British pounds. In a month, if the pound is worth $1.60, then the portfolio investor can trade back to U.S. dollars at the new exchange rate, and have $25,600—a nice profit. A portfolio investor who believes that the foreign exchange rate for the pound will work in the opposite direction can also invest accordingly. Say that an investor expects that the pound, now worth $1.50 in U.S. currency, will decline to $1.40. Then, as  (b) shows, that investor could start off with £20,000 in British currency (borrowing the money if necessary), convert it to $30,000 in U.S. currency, wait a month, and then convert back to approximately £21,429 in British currency—again making a nice profit. Of course, this kind of investing comes without guarantees, and an investor will suffer losses if the exchange rates do not move as predicted.
Many portfolio investment decisions are not as simple as betting that the currency's value will change in one direction or the other. Instead, they involve firms trying to protect themselves from movements in exchange rates. Imagine you are running a U.S. firm that is exporting to France. You have signed a contract to deliver certain products and will receive 1 million euros a year from now. However, you do not know how much this contract will be worth in U.S. dollars, because the dollar/euro exchange rate can fluctuate in the next year. Let’s say you want to know for sure what the contract will be worth, and not take a risk that the euro will be worth less in U.S. dollars than it currently is. You can hedge, which means using a financial transaction to protect yourself against a risk from one of your investments (in this case, currency risk from the contract). Specifically, you can sign a financial contract and pay a fee that guarantees you a certain exchange rate one year from now—regardless of what the market exchange rate is at that time. Now, it is possible that the euro will be worth more in dollars a year from now, so your hedging contract will be unnecessary, and you will have paid a fee for nothing. However, if the value of the euro in dollars declines, then you are protected by the hedge. When parties wish to enter financial contracts like hedging, they normally rely on a financial institution or brokerage company to handle the hedging. These companies either take a fee or create a spread in the exchange rate in order to earn money through the service they provide.
Both foreign direct investment and portfolio investment involve an investor who supplies domestic currency and demands a foreign currency. With portfolio investment, the client purchases less than ten percent of a company. As such, business players often get involved with portfolio investment with a short term focus. With foreign direct investment the investor purchases more than ten percent of a company and the investor typically assumes some managerial responsibility. Thus, foreign direct investment tends to have a more long-run focus. As a practical matter, an investor can withdraw portfolio investments from a country much more quickly than foreign direct investments. A U.S. portfolio investor who wants to buy or sell U.K. government bonds can do so with a phone call or a few computer keyboard clicks. However, a U.S. firm that wants to buy or sell a company, such as one that manufactures automobile parts in the United Kingdom, will find that planning and carrying out the transaction takes a few weeks, even months.  summarizes the main categories of currency demanders and suppliers.

### Participants in the Exchange Rate Market

The foreign exchange market does not involve the ultimate suppliers and demanders of foreign exchange literally seeking each other. If Martina decides to leave her home in Venezuela and take a trip in the United States, she does not need to find a U.S. citizen who is planning to take a vacation in Venezuela and arrange a person-to-person currency trade. Instead, the foreign exchange market works through financial institutions, and it operates on several levels.
Most people and firms who are exchanging a substantial quantity of currency go to a bank, and most banks provide foreign exchange as a service to customers. These banks (and a few other firms), known as dealers, then trade the foreign exchange. This is called the interbank market.
In the world economy, roughly 2,000 firms are foreign exchange dealers. The U.S. economy has less than 100 foreign exchange dealers, but the largest 12 or so dealers carry out more than half the total transactions. The foreign exchange market has no central location, but the major dealers keep a close watch on each other at all times.
The foreign exchange market is huge not because of the demands of tourists, firms, or even foreign direct investment, but instead because of portfolio investment and the actions of interlocking foreign exchange dealers. International tourism is a very large industry, involving about $1 trillion per year. Global exports are about 23.5% of global GDP or about $19 trillion per year. Foreign direct investment totaled about $870 billion in the end of 2021. These quantities are dwarfed, however, by the $6.6 trillion per day traded in foreign exchange markets. Most transactions in the foreign exchange market are for portfolio investment—relatively short-term movements of financial capital between currencies—and because of the large foreign exchange dealers' actions as they constantly buy and sell with each other.

### Strengthening and Weakening Currency

When the prices of most goods and services change, the price "rises or "falls". For exchange rates, the terminology is different. When the exchange rate for a currency rises, so that the currency exchanges for more of other currencies, we refer to it as appreciating or “strengthening.” When the exchange rate for a currency falls, so that a currency trades for less of other currencies, we refer to it as depreciating or “weakening.”
To illustrate the use of these terms, consider the exchange rate between the U.S. dollar and the Canadian dollar since 1980, in  (a). The vertical axis in  (a) shows the price of $1 in U.S. currency, measured in terms of Canadian currency. Clearly, exchange rates can move up and down substantially. A U.S. dollar traded for $1.17 Canadian in 1980. The U.S. dollar appreciated or strengthened to $1.39 Canadian in 1986, depreciated or weakened to $1.15 Canadian in 1991, and then appreciated or strengthened to $1.60 Canadian by early in 2002, fell to roughly $1.20 Canadian in 2009, and then had a sharp spike up and decline in 2009 and 2010. In August 2022, the U.S. dollar stood at $1.28 Canadian. The units in which we measure exchange rates can be confusing, because we measure the exchange rate of the U.S. dollar exchange using a different currency—the Canadian dollar. However, exchange rates always measure the price of one unit of currency by using a different currency.
In looking at the exchange rate between two currencies, the appreciation or strengthening of one currency must mean the depreciation or weakening of the other.  (b) shows the exchange rate for the Canadian dollar, measured in terms of U.S. dollars. The exchange rate of the U.S. dollar measured in Canadian dollars, in  (a), is a perfect mirror image with the Canadian dollar exchange rate measured in U.S. dollars, in  (b). A fall in the Canada $/U.S. $ ratio means a rise in the U.S. $/Canada $ ratio, and vice versa.
Canadian Dollars per 1 U.S. Dollar.
With the price of a typical good or service, it is clear that higher prices benefit sellers and hurt buyers, while lower prices benefit buyers and hurt sellers. In the case of exchange rates, where the buyers and sellers are not always intuitively obvious, it is useful to trace how a stronger or weaker currency will affect different market participants. Consider, for example, the impact of a stronger U.S. dollar on six different groups of economic actors, as  shows: (1) U.S. exporters selling abroad; (2) foreign exporters (that is, firms selling imports in the U.S. economy); (3) U.S. tourists abroad; (4) foreign tourists visiting the United States; (5) U.S. investors (either foreign direct investment or portfolio investment) considering opportunities in other countries; (6) and foreign investors considering opportunities in the U.S. economy.
For a U.S. firm selling abroad, a stronger U.S. dollar is a curse. A strong U.S. dollar means that foreign currencies are correspondingly weak. When this exporting firm earns foreign currencies through its export sales, and then converts them back to U.S. dollars to pay workers, suppliers, and investors, the stronger dollar means that the foreign currency buys fewer U.S. dollars than if the currency had not strengthened, and that the firm’s profits (as measured in dollars) fall. As a result, the firm may choose to reduce its exports, or it may raise its selling price, which will also tend to reduce its exports. In this way, a stronger currency reduces a country’s exports.
Conversely, for a foreign firm selling in the U.S. economy, a stronger dollar is a blessing. Each dollar earned through export sales, when traded back into the exporting firm's home currency, will now buy more home currency than expected before the dollar had strengthened. As a result, the stronger dollar means that the importing firm will earn higher profits than expected. The firm will seek to expand its sales in the U.S. economy, or it may reduce prices, which will also lead to expanded sales. In this way, a stronger U.S. dollar means that consumers will purchase more from foreign producers, expanding the country’s level of imports.
For a U.S. tourist abroad, who is exchanging U.S. dollars for foreign currency as necessary, a stronger U.S. dollar is a benefit. The tourist receives more foreign currency for each U.S. dollar, and consequently the cost of the trip in U.S. dollars is lower. When a country’s currency is strong, it is a good time for citizens of that country to tour abroad. Imagine a U.S. tourist who has saved up $5,000 for a trip to South Africa. In February 2018, $1 bought 11.9 South African rand, so the tourist had 59,500 rand to spend. By 2018, $1 bought 14.5 rand, which for the tourist translates to 72,500 rand. For foreign visitors to the United States, the opposite pattern holds true. A relatively stronger U.S. dollar means that their own currencies are relatively weaker, so that as they shift from their own currency to U.S. dollars, they have fewer U.S. dollars than previously. When a country’s currency is strong, it is not an especially good time for foreign tourists to visit.
A stronger dollar injures the prospects of a U.S. financial investor who has already invested money in another country. A U.S. financial investor abroad must first convert U.S. dollars to a foreign currency, invest in a foreign country, and then later convert that foreign currency back to U.S. dollars. If in the meantime the U.S. dollar becomes stronger and the foreign currency becomes weaker, then when the investor converts back to U.S. dollars, the rate of return on that investment will be less than originally expected at the time it was made.
However, a stronger U.S. dollar boosts the returns of a foreign investor putting money into a U.S. investment. That foreign investor converts from the home currency to U.S. dollars and seeks a U.S. investment, while later planning to switch back to the home currency. If, in the meantime, the dollar grows stronger, then when the time comes to convert from U.S. dollars back to the foreign currency, the investor will receive more foreign currency than expected at the time the original investment was made.
The preceding paragraphs all focus on the case where the U.S. dollar becomes stronger. The first column in  illustrates the corresponding happy or unhappy economic reactions. The following Work It Out feature centers the analysis on the opposite: a weaker dollar.
At this point, you should have a good sense of the major players in the foreign exchange market: firms involved in international trade, tourists, international financial investors, banks, and foreign exchange dealers. The next module shows how players can use the tools of demand and supply in foreign exchange markets to explain the underlying causes of stronger and weaker currencies (we address “stronger” and “weaker” more in the following Clear It Up feature).

### Key Concepts and Summary

In the foreign exchange market, people and firms exchange one currency to purchase another currency. The demand for dollars comes from those U.S. export firms seeking to convert their earnings in foreign currency back into U.S. dollars; foreign tourists converting their earnings in a foreign currency back into U.S. dollars; and foreign investors seeking to make financial investments in the U.S. economy. On the supply side of the foreign exchange market for the trading of U.S. dollars are foreign firms that have sold imports in the U.S. economy and are seeking to convert their earnings back to their home currency; U.S. tourists abroad; and U.S. investors seeking to make financial investments in foreign economies. When currency A can buy more of currency B, then currency A has strengthened or appreciated relative to B. When currency A can buy less of currency B, then currency A has weakened or depreciated relative to B. If currency A strengthens or appreciates relative to currency B, then currency B must necessarily weaken or depreciate with regard to currency A. A stronger currency benefits those who are buying with that currency and injures those who are selling. A weaker currency injures those, like importers, who are buying with that currency and benefits those who are selling with it, like exporters.

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### Critical Thinking Question

### Problems


# Exchange Rates and International Capital Flows

## Demand and Supply Shifts in Foreign Exchange Markets

The foreign exchange market involves firms, households, and investors who demand and supply currencies coming together through their banks and the key foreign exchange dealers.  (a) offers an example for the exchange rate between the U.S. dollar and the Mexican peso. The vertical axis shows the exchange rate for U.S. dollars, which in this case is measured in pesos. The horizontal axis shows the quantity of U.S. dollars traded in the foreign exchange market each day. The demand curve (D) for U.S. dollars intersects with the supply curve (S) of U.S. dollars at the equilibrium point (E), which is an exchange rate of 10 pesos per dollar and a total volume of $8.5 billion.
 (b) presents the same demand and supply information from the perspective of the Mexican peso. The vertical axis shows the exchange rate for Mexican pesos, which is measured in U.S. dollars. The horizontal axis shows the quantity of Mexican pesos traded in the foreign exchange market. The demand curve (D) for Mexican pesos intersects with the supply curve (S) of Mexican pesos at the equilibrium point (E), which is an exchange rate of 10 cents in U.S. currency for each Mexican peso and a total volume of 85 billion pesos. Note that the two exchange rates are inverses: 10 pesos per dollar is the same as 10 cents per peso (or $0.10 per peso). In the actual foreign exchange market, almost all of the trading for Mexican pesos is for U.S. dollars. What factors would cause the demand or supply to shift, thus leading to a change in the equilibrium exchange rate? We discuss the answer to this question in the following section.

### Expectations about Future Exchange Rates

One reason to demand a currency on the foreign exchange market is the belief that the currency's value is about to increase. One reason to supply a currency—that is, sell it on the foreign exchange market—is the expectation that the currency's value is about to decline. For example, imagine that a leading business newspaper, like the Wall Street Journal or the Financial Times, runs an article predicting that the Mexican peso will appreciate in value.  illustrates the likely effects of such an article. Demand for the Mexican peso shifts to the right, from D0 to D1, as investors become eager to purchase pesos. Conversely, the supply of pesos shifts to the left, from S0 to S1, because investors will be less willing to give them up. The result is that the equilibrium exchange rate rises from 10 cents/peso to 12 cents/peso and the equilibrium exchange rate rises from 85 billion to 90 billion pesos as the equilibrium moves from E0 to E1.
 also illustrates some peculiar traits of supply and demand diagrams in the foreign exchange market. In contrast to all the other cases of supply and demand you have considered, in the foreign exchange market, supply and demand typically both move at the same time. Groups of participants in the foreign exchange market like firms and investors include some who are buyers and some who are sellers. An expectation of a future shift in the exchange rate affects both buyers and sellers—that is, it affects both demand and supply for a currency.
The shifts in demand and supply curves both cause the exchange rate to shift in the same direction. In this example, they both make the peso exchange rate stronger. However, the shifts in demand and supply work in opposing directions on the quantity traded. In this example, the rising demand for pesos is causing the quantity to rise while the falling supply of pesos is causing quantity to fall. In this specific example, the result is a higher quantity. However, in other cases, the result could be that quantity remains unchanged or declines.
This example also helps to explain why exchange rates often move quite substantially in a short period of a few weeks or months. When investors expect a country’s currency to strengthen in the future, they buy the currency and cause it to appreciate immediately. The currency's appreciation can lead other investors to believe that future appreciation is likely—and thus lead to even further appreciation. Similarly, a fear that a currency might weaken quickly leads to an actual weakening of the currency, which often reinforces the belief that the currency will weaken further. Thus, beliefs about the future path of exchange rates can be self-reinforcing, at least for a time, and a large share of the trading in foreign exchange markets involves dealers trying to outguess each other on what direction exchange rates will move next.

### Differences across Countries in Rates of Return

The motivation for investment, whether domestic or foreign, is to earn a return. If rates of return in a country look relatively high, then that country will tend to attract funds from abroad. Conversely, if rates of return in a country look relatively low, then funds will tend to flee to other economies. Changes in the expected rate of return will shift demand and supply for a currency. For example, imagine that interest rates rise in the United States as compared with Mexico. Thus, financial investments in the United States promise a higher return than previously. As a result, more investors will demand U.S. dollars so that they can buy interest-bearing assets and fewer investors will be willing to supply U.S. dollars to foreign exchange markets. Demand for the U.S. dollar will shift to the right, from D0 to D1, and supply will shift to the left, from S0 to S1, as  shows. The new equilibrium (E1), will occur at an exchange rate of nine pesos/dollar and the same quantity of $8.5 billion. Thus, a higher interest rate or rate of return relative to other countries leads a nation’s currency to appreciate or strengthen, and a lower interest rate relative to other countries leads a nation’s currency to depreciate or weaken. Since a nation’s central bank can use monetary policy to affect its interest rates, a central bank can also cause changes in exchange rates—a connection that we will discuss in more detail later in this chapter.

### Relative Inflation

If a country experiences a relatively high inflation rate compared with other economies, then the buying power of its currency is eroding, which will tend to discourage anyone from wanting to acquire or to hold the currency.  shows an example based on an actual episode concerning the Mexican peso. In 1986–87, Mexico experienced an inflation rate of over 200%. Not surprisingly, as inflation dramatically decreased the peso's purchasing power in Mexico. The peso's exchange rate value declined as well.  shows that the demand for the peso on foreign exchange markets decreased from D0 to D1, while the peso's supply increased from S0 to S1. The equilibrium exchange rate fell from $2.50 per peso at the original equilibrium (E0) to $0.50 per peso at the new equilibrium (E1). In this example, the quantity of pesos traded on foreign exchange markets remained the same, even as the exchange rate shifted.

### Purchasing Power Parity

Over the long term, exchange rates must bear some relationship to the currency's buying power in terms of internationally traded goods. If at a certain exchange rate it was much cheaper to buy internationally traded goods—such as oil, steel, computers, and cars—in one country than in another country, businesses would start buying in the cheap country, selling in other countries, and pocketing the profits.
For example, if a U.S. dollar is worth $1.30 in Canadian currency, then a car that sells for $20,000 in the United States should sell for $26,000 in Canada. If the price of cars in Canada were much lower than $26,000, then at least some U.S. car-buyers would convert their U.S. dollars to Canadian dollars and buy their cars in Canada. If the price of cars were much higher than $26,000 in this example, then at least some Canadian buyers would convert their Canadian dollars to U.S. dollars and go to the United States to purchase their cars. This is known as arbitrage, the process of buying and selling goods or currencies across international borders at a profit. It may occur slowly, but over time, it will force prices and exchange rates to align so that the price of internationally traded goods is similar in all countries.
We call the exchange rate that equalizes the prices of internationally traded goods across countries the purchasing power parity (PPP) exchange rate. A group of economists at the International Comparison Program, run by the World Bank, have calculated the PPP exchange rate for all countries, based on detailed studies of the prices and quantities of internationally tradable goods.
The purchasing power parity exchange rate has two functions. First, economists often use PPP exchange rates for international comparison of GDP and other economic statistics. Imagine that you are preparing a table showing the size of GDP in many countries in several recent years, and for ease of comparison, you are converting all the values into U.S. dollars. When you insert the value for Japan, you need to use a yen/dollar exchange rate. However, should you use the market exchange rate or the PPP exchange rate? Market exchange rates bounce around. In 2014, the exchange rate was 105 yen/dollar, but in late 2015 the U.S. dollar exchange rate versus the yen was 121 yen/dollar. For simplicity, say that Japan’s GDP was ¥500 trillion in both 2014 and 2015. If you use the market exchange rates, then Japan’s GDP will be $4.8 trillion in 2014 (that is, ¥500 trillion /(¥105/dollar)) and $4.1 trillion in 2015 (that is, ¥500 trillion /(¥121/dollar)).
The misleading appearance of a changing Japanese economy occurs only because we used the market exchange rate, which often has short-run rises and falls. However, PPP exchange rates stay fairly constant and change only modestly, if at all, from year to year.
The second function of PPP is that exchanges rates will often get closer to it as time passes. It is true that in the short and medium run, as exchange rates adjust to relative inflation rates, rates of return, and to expectations about how interest rates and inflation will shift, the exchange rates will often move away from the PPP exchange rate for a time. However, knowing the PPP will allow you to track and predict exchange rate relationships.

### Key Concepts and Summary

In the extreme short run, ranging from a few minutes to a few weeks, speculators who are trying to invest in currencies that will grow stronger, and to sell currencies that will grow weaker influence exchange rates. Such speculation can create a self-fulfilling prophecy, at least for a time, where an expected appreciation leads to a stronger currency and vice versa. In the relatively short run, differences in rates of return influence exchange rate markets. Countries with relatively high real rates of return (for example, high interest rates) will tend to experience stronger currencies as they attract money from abroad, while countries with relatively low rates of return will tend to experience weaker exchange rates as investors convert to other currencies.
In the medium run of a few months or a few years, inflation rates influence exchange rate markets. Countries with relatively high inflation will tend to experience less demand for their currency than countries with lower inflation, and thus currency depreciation. Over long periods of many years, exchange rates tend to adjust toward the purchasing power parity (PPP) rate, which is the exchange rate such that the prices of internationally tradable goods in different countries, when converted at the PPP exchange rate to a common currency, are similar in all economies.

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# Exchange Rates and International Capital Flows

## Macroeconomic Effects of Exchange Rates

A central bank will be concerned about the exchange rate for multiple reasons: (1) Movements in the exchange rate will affect the quantity of aggregate demand in an economy; (2) frequent substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nation’s banking system–this may contribute to an unsustainable balance of trade and large inflows of international financial capital, which can set up the economy for a deep recession if international investors decide to move their money to another country. Let’s discuss these scenarios in turn.

### Exchange Rates, Aggregate Demand, and Aggregate Supply

Foreign trade in goods and services typically involves incurring the costs of production in one currency while receiving revenues from sales in another currency. As a result, movements in exchange rates can have a powerful effect on incentives to export and import, and thus on aggregate demand in the economy as a whole.
For example, in 1999, when the euro first became a currency, its value measured in U.S. currency was $1.16/euro, which dropped to a low of about $0.83/euro in 2000. By the end of 2013, the euro had risen (and the U.S. dollar had correspondingly weakened) to $1.37/euro. However, by the beginning of 2021, the exchange rate was down to $1.12/euro. Consider the situation of a French firm that each year incurs €10 million in costs, and sells its products in the United States for $10 million. At a time in 1999, when this firm converted $10 million back to euros at the exchange rate of $1.06/euro (that is, $10 million × [€1/$1.06]), it received €9.4 million, and suffered a loss. In 2013, when this same firm converted $10 million back to euros at the exchange rate of $1.37/euro (that is, $10 million × [€1 euro/$1.37]), it received approximately €7.3 million and an even larger loss. In the beginning of 2021, with the exchange rate back at $1.12/euro the firm would suffer a loss once again. This example shows how a stronger euro discourages exports by the French firm, because it makes the costs of production in the domestic currency higher relative to the sales revenues earned in another country. From the point of view of the U.S. economy, the example also shows how a weaker U.S. dollar encourages exports.
Since an increase in exports results in more dollars flowing into the economy, and an increase in imports means more dollars are flowing out, it is easy to conclude that exports are “good” for the economy and imports are “bad,” but this overlooks the role of exchange rates. If an American consumer buys a Japanese car for $20,000 instead of an American car for $30,000, it may be tempting to argue that the American economy has lost out. However, the Japanese company will have to convert those dollars to yen to pay its workers and operate its factories. Whoever buys those dollars will have to use them to purchase American goods and services, so the money comes right back into the American economy. At the same time, the consumer saves money by buying a less expensive import, and can use the extra money for other purposes.

### Fluctuations in Exchange Rates

Exchange rates can fluctuate a great deal in the short run. As yet one more example, the Indian rupee moved from 39 rupees/dollar in February 2008 to 51 rupees/dollar in March 2009, a decline of more than one-fourth in the value of the rupee on foreign exchange markets.  earlier showed that even two economically developed neighboring economies like the United States and Canada can see significant movements in exchange rates over a few years. For firms that depend on export sales, or firms that rely on imported inputs to production, or even purely domestic firms that compete with firms tied into international trade—which in many countries adds up to half or more of a nation’s GDP—sharp movements in exchange rates can lead to dramatic changes in profits and losses. A central bank may desire to keep exchange rates from moving too much as part of providing a stable business climate, where firms can focus on productivity and innovation, not on reacting to exchange rate fluctuations.
One of the most economically destructive effects of exchange rate fluctuations can happen through the banking system. Financial institutions measure most international loans are measured in a few large currencies, like U.S. dollars, European euros, and Japanese yen. In countries that do not use these currencies, banks often borrow funds in the currencies of other countries, like U.S. dollars, but then lend in their own domestic currency. The left-hand chain of events in  shows how this pattern of international borrowing can work. A bank in Thailand borrows one million in U.S. dollars. Then the bank converts the dollars to its domestic currency—in the case of Thailand, the currency is the baht—at a rate of 40 baht/dollar. The bank then lends the baht to a firm in Thailand. The business repays the loan in baht, and the bank converts it back to U.S. dollars to pay off its original U.S. dollar loan.
This process of borrowing in a foreign currency and lending in a domestic currency can work just fine, as long as the exchange rate does not shift. In the scenario outlined, if the dollar strengthens and the baht weakens, a problem arises. The right-hand chain of events in  illustrates what happens when the baht unexpectedly weakens from 40 baht/dollar to 50 baht/dollar. The Thai firm still repays the loan in full to the bank. However, because of the shift in the exchange rate, the bank cannot repay its loan in U.S. dollars. (Of course, if the exchange rate had changed in the other direction, making the Thai currency stronger, the bank could have realized an unexpectedly large profit.)
In 1997–1998, countries across eastern Asia, like Thailand, Korea, Malaysia, and Indonesia, experienced a sharp depreciation of their currencies, in some cases 50% or more. These countries had been experiencing substantial inflows of foreign investment capital, with bank lending increasing by 20% to 30% per year through the mid-1990s. When their exchange rates depreciated, the banking systems in these countries were bankrupt. Argentina experienced a similar chain of events in 2002. When the Argentine peso depreciated, Argentina’s banks found themselves unable to pay back what they had borrowed in U.S. dollars.
Banks play a vital role in any economy in facilitating transactions and in making loans to firms and consumers. When most of a country’s largest banks become bankrupt simultaneously, a sharp decline in aggregate demand and a deep recession results. Since the main responsibilities of a central bank are to control the money supply and to ensure that the banking system is stable, a central bank must be concerned about whether large and unexpected exchange rate depreciation will drive most of the country’s existing banks into bankruptcy. For more on this concern, return to the chapter on The International Trade and Capital Flows.

### Summing Up Public Policy and Exchange Rates

Every nation would prefer a stable exchange rate to facilitate international trade and reduce the degree of risk and uncertainty in the economy. However, a nation may sometimes want a weaker exchange rate to stimulate aggregate demand and reduce a recession, or a stronger exchange rate to fight inflation. The country must also be concerned that rapid movements from a weak to a strong exchange rate may hurt its export industries, while rapid movements from a strong to a weak exchange rate can hurt its banking sector. In short, every choice of an exchange rate—whether it should be stronger or weaker, or fixed or changing—represents potential tradeoffs.

### Key Concepts and Summary

A central bank will be concerned about the exchange rate for several reasons. Exchange rates will affect imports and exports, and thus affect aggregate demand in the economy. Fluctuations in exchange rates may cause difficulties for many firms, but especially banks. The exchange rate may accompany unsustainable flows of international financial capital.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions


# Exchange Rates and International Capital Flows

## Exchange Rate Policies

Exchange rate policies come in a range of different forms listed in : let the foreign exchange market determine the exchange rate; let the market set the value of the exchange rate most of the time, but have the central bank sometimes intervene to prevent fluctuations that seem too large; have the central bank guarantee a specific exchange rate; or share a currency with other countries. Let’s discuss each type of exchange rate policy and its tradeoffs.

### Floating Exchange Rates

We refer to a policy which allows the foreign exchange market to set exchange rates as a floating exchange rate. The U.S. dollar is a floating exchange rate, as are the currencies of about 40% of the countries in the world economy. The major concern with this policy is that exchange rates can move a great deal in a short time.
Consider the U.S. exchange rate expressed in terms of another fairly stable currency, the Japanese yen, as  shows. On January 1, 2002, the exchange rate was 133 yen/dollar. On January 1, 2005, it was 103 yen/dollar. On June 1, 2007, it was 122 yen/dollar, on January 1, 2012, it was 77 yen per dollar, and on March 1, 2015, it was 120 yen per dollar. Since 2015, it has dropped again; by the end of December 2020, the exchange rate stood at 103 yen per dollar. As investor sentiment swings back and forth, driving exchange rates up and down, exporters, importers, and banks involved in international lending are all affected. At worst, large movements in exchange rates can drive companies into bankruptcy or trigger a nationwide banking collapse. However, even in the moderate case of the yen/dollar exchange rate, these movements of roughly 30 percent back and forth impose stress on both economies as firms must alter their export and import plans to take the new exchange rates into account. Especially in smaller countries where international trade is a relatively large share of GDP, exchange rate movements can rattle their economies.
However, movements of floating exchange rates have advantages, too. After all, prices of goods and services rise and fall throughout a market economy, as demand and supply shift. If an economy experiences strong inflows or outflows of international financial capital, or has relatively high inflation, or if it experiences strong productivity growth so that purchasing power changes relative to other economies, then it makes economic sense for the exchange rate to shift as well.
Floating exchange rate advocates often argue that if government policies were more predictable and stable, then inflation rates and interest rates would be more predictable and stable. Exchange rates would bounce around less, too. The economist Milton Friedman (1912–2006), for example, wrote a defense of floating exchange rates in 1962 in his book Capitalism and Freedom:
Advocates of floating exchange rates admit that, yes, exchange rates may sometimes fluctuate. They point out, however, that if a central bank focuses on preventing either high inflation or deep recession, with low and reasonably steady interest rates, then exchange rates will have less reason to vary.

### Using Soft Pegs and Hard Pegs

When a government intervenes in the foreign exchange market so that the currency's exchange rate is different from what the market would have produced, it establishes a “peg” for its currency. A soft peg is the name for an exchange rate policy where the government usually allows the market to set exchange rate, but in some cases, especially if the exchange rate seems to be moving rapidly in one direction, the central bank will intervene in the market. With a hard peg exchange rate policy, the central bank sets a fixed and unchanging value for the exchange rate. A central bank can implement soft peg and hard peg policies.
Suppose the market exchange rate for the Brazilian currency, the real, would be 35 cents/real with a daily quantity of 15 billion real traded in the market, as the equilibrium E0 in  (a) and  (b) show. However, Brazil's government decides that the exchange rate should be 30 cents/real, as  (a) shows. Perhaps Brazil sets this lower exchange rate to benefit its export industries. Perhaps it is an attempt to stimulate aggregate demand by stimulating exports. Perhaps Brazil believes that the current market exchange rate is higher than the long-term purchasing power parity value of the real, so it is minimizing fluctuations in the real by keeping it at this lower rate. Perhaps the government set the target exchange rate sometime in the past, and it is now maintaining it for the sake of stability. Whatever the reason, if Brazil’s central bank wishes to keep the exchange rate below the market level, it must face the reality that at this weaker exchange rate of 30 cents/real, the quantity demanded of its currency at 17 billion reals is greater than the quantity supplied of 13 billion reals in the foreign exchange market.
The Brazilian central bank could weaken its exchange rate in two ways. One approach is to use an expansionary monetary policy that leads to lower interest rates. In foreign exchange markets, the lower interest rates will reduce demand and increase supply of the real and lead to depreciation. Central banks do not use this technique often because lowering interest rates to weaken the currency may be in conflict with the country’s monetary policy goals. Alternatively, Brazil’s central bank could trade directly in the foreign exchange market. The central bank can expand the money supply by creating reals, use the reals to purchase foreign currencies, and avoid selling any of its own currency. In this way, it can fill the gap between quantity demanded and quantity supplied of its currency.
 (b) shows the opposite situation. Here, the Brazilian government desires a stronger exchange rate of 40 cents/real than the market rate of 35 cents/real. Perhaps Brazil desires the stronger currency to reduce aggregate demand and to fight inflation, or perhaps Brazil believes that that current market exchange rate is temporarily lower than the long-term rate. Whatever the reason, at the higher desired exchange rate, the quantity supplied of 16 billion reals exceeds the quantity demanded of 14 billion reals.
Brazil’s central bank can use a contractionary monetary policy to raise interest rates, which will increase demand and reduce currency supply on foreign exchange markets, and lead to an appreciation. Alternatively, Brazil’s central bank can trade directly in the foreign exchange market. In this case, with an excess supply of its own currency in foreign exchange markets, the central bank must use reserves of foreign currency, like U.S. dollars, to demand its own currency and thus cause an appreciation of its exchange rate.
Both a soft peg and a hard peg policy require that the central bank intervene in the foreign exchange market. However, a hard peg policy attempts to preserve a fixed exchange rate at all times. A soft peg policy typically allows the exchange rate to move up and down by relatively small amounts in the short run of several months or a year, and to move by larger amounts over time, but seeks to avoid extreme short-term fluctuations.

### Tradeoffs of Soft Pegs and Hard Pegs

When a country decides to alter the market exchange rate, it faces a number of tradeoffs. If it uses monetary policy to alter the exchange rate, it then cannot at the same time use monetary policy to address issues of inflation or recession. If it uses direct purchases and sales of foreign currencies in exchange rates, then it must face the issue of how it will handle its reserves of foreign currency. Finally, a pegged exchange rate can even create additional movements of the exchange rate. For example, even the possibility of government intervention in exchange rate markets will lead to rumors about whether and when the government will intervene, and dealers in the foreign exchange market will react to those rumors. Let’s consider these issues in turn.
One concern with pegged exchange rate policies is that they imply a country’s monetary policy is no longer focused on controlling inflation or shortening recessions, but now must also take the exchange rate into account. For example, when a country pegs its exchange rate, it will sometimes face economic situations where it would like to have an expansionary monetary policy to fight recession—but it cannot do so because that policy would depreciate its exchange rate and break its hard peg. With a soft peg exchange rate policy, the central bank can sometimes ignore the exchange rate and focus on domestic inflation or recession—but in other cases the central bank may ignore inflation or recession and instead focus on its soft peg exchange rate. With a hard peg policy, domestic monetary policy is effectively no longer determined by domestic inflation or unemployment, but only by what monetary policy is needed to keep the exchange rate at the hard peg.
Another issue arises when a central bank intervenes directly in the exchange rate market. If a central bank ends up in a situation where it is perpetually creating and selling its own currency on foreign exchange markets, it will be buying the currency of other countries, like U.S. dollars or euros, to hold as reserves. Holding large reserves of other currencies has an opportunity cost, and central banks will not wish to boost such reserves without limit.
In addition, a central bank that causes a large increase in the supply of money is also risking an inflationary surge in aggregate demand. Conversely, when a central bank wishes to buy its own currency, it can do so by using its reserves of international currency like the U.S. dollar or the euro. However, if the central bank runs out of such reserves, it can no longer use this method to strengthen its currency. Thus, buying foreign currencies in exchange rate markets can be expensive and inflationary, while selling foreign currencies can work only until a central bank runs out of reserves.
Yet another issue is that when a government pegs its exchange rate, it may unintentionally create another reason for additional fluctuation. With a soft peg policy, foreign exchange dealers and international investors react to every rumor about how or when the central bank is likely to intervene to influence the exchange rate, and as they react to rumors the exchange rate will shift up and down. Thus, even though the goal of a soft peg policy is to reduce short-term fluctuations of the exchange rate, the existence of the policy—when anticipated in the foreign exchange market—may sometimes increase short-term fluctuations as international investors try to anticipate how and when the central bank will act. The following Clear It Up feature discusses the effects of international capital flows—capital that flows across national boundaries as either portfolio investment or direct investment.
A hard peg exchange rate policy will not allow short-term fluctuations in the exchange rate. If the government first announces a hard peg and then later changes its mind—perhaps the government becomes unwilling to keep interest rates high or to hold high levels of foreign exchange reserves—then the result of abandoning a hard peg could be a dramatic shift in the exchange rate.
In the mid-2000s, about one-third of the countries in the world used a soft peg approach and about one-quarter used a hard peg approach. The general trend in the 1990s was to shift away from a soft peg approach in favor of either floating rates or a hard peg. The concern is that a successful soft peg policy may, for a time, lead to very little variation in exchange rates, so that firms and banks in the economy begin to act as if a hard peg exists. When the exchange rate does move, the effects are especially painful because firms and banks have not planned and hedged against a possible change. Thus, the argument went, it is better either to be clear that the exchange rate is always flexible, or that it is fixed, but choosing an in-between soft peg option may end up being worst of all.

### A Merged Currency

A final approach to exchange rate policy is for a nation to choose a common currency shared with one or more nations is also called a merged currency. A merged currency approach eliminates foreign exchange risk altogether. Just as no one worries about exchange rate movements when buying and selling between New York and California, Europeans know that the value of the euro will be the same in Germany and France and other European nations that have adopted the euro.
However, a merged currency also poses problems. Like a hard peg, a merged currency means that a nation has given up altogether on domestic monetary policy, and instead has put its interest rate policies in other hands. When Ecuador uses the U.S. dollar as its currency, it has no voice in whether the Federal Reserve raises or lowers interest rates. The European Central Bank that determines monetary policy for the euro has representatives from all the euro nations. However, from the standpoint of, say, Portugal, there will be times when the decisions of the European Central Bank about monetary policy do not match the decisions that a Portuguese central bank would have made.
The lines between these four different exchange rate policies can blend into each other. For example, a soft peg exchange rate policy in which the government almost never acts to intervene in the exchange rate market will look a great deal like a floating exchange rate. Conversely, a soft peg policy in which the government intervenes often to keep the exchange rate near a specific level will look a lot like a hard peg. A decision to merge currencies with another country is, in effect, a decision to have a permanently fixed exchange rate with those countries, which is like a very hard exchange rate peg.  summarizes the range of exchange rates policy choices, with their advantages and disadvantages.
Global macroeconomics would be easier if the whole world had one currency and one central bank. The exchange rates between different currencies complicate the picture. If financial markets solely set exchange rates, they fluctuate substantially as short-term portfolio investors try to anticipate tomorrow’s news. If the government attempts to intervene in exchange rate markets through soft pegs or hard pegs, it gives up at least some of the power to use monetary policy to focus on domestic inflations and recessions, and it risks causing even greater fluctuations in foreign exchange markets.
There is no consensus among economists about which exchange rate policies are best: floating, soft peg, hard peg, or merged currencies. The choice depends both on how well a nation’s central bank can implement a specific exchange rate policy and on how well a nation’s firms and banks can adapt to different exchange rate policies. A national economy that does a fairly good job at achieving the four main economic goals of growth, low inflation, low unemployment, and a sustainable balance of trade will probably do just fine most of the time with any exchange rate policy. Conversely, no exchange rate policy is likely to save an economy that consistently fails at achieving these goals. Alternatively, a merged currency applied across wide geographic and cultural areas carries with it its own set of problems, such as the ability for countries to conduct their own independent monetary policies.

### Key Concepts and Summary

In a floating exchange rate policy, a government determines its country’s exchange rate in the foreign exchange market. In a soft peg exchange rate policy, the foreign exchange market usually determines a country's exchange rate, but the government sometimes intervenes to strengthen or weaken it. In a hard peg exchange rate policy, the government chooses an exchange rate. A central bank can intervene in exchange markets in two ways. It can raise or lower interest rates to make the currency stronger or weaker. It also can directly purchase or sell its currency in foreign exchange markets. All exchange rates policies face tradeoffs. A hard peg exchange rate policy will reduce exchange rate fluctuations, but means that a country must focus its monetary policy on the exchange rate, not on fighting recession or controlling inflation. When a nation merges its currency with another nation, it gives up on nationally oriented monetary policy altogether.
A soft peg exchange rate may create additional volatility as exchange rate markets try to anticipate when and how the government will intervene. A flexible exchange rate policy allows monetary policy to focus on inflation and unemployment, and allows the exchange rate to change with inflation and rates of return, but also raises a risk that exchange rates may sometimes make large and abrupt movements. The spectrum of exchange rate policies includes: (a) a floating exchange rate, (b) a pegged exchange rate, soft or hard, and (c) a merged currency. Monetary policy can focus on a variety of goals: (a) inflation; (b) inflation or unemployment, depending on which is the most dangerous obstacle; and (c) a long-term rule based policy designed to keep the money supply stable and predictable.

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### References

Friedman, Milton. Capitalism and Freedom. Chicago: University of Chicago Press, 1962.


# Government Budgets and Fiscal Policy

## Introduction to Government Budgets and Fiscal Policy

All levels of government—federal, state, and local—have budgets that show how much revenue the government expects to receive in taxes and other income and how the government plans to spend it. Budgets, however, can shift dramatically within a few years, as policy decisions and unexpected events disrupt earlier tax and spending plans.
In this chapter, we revisit fiscal policy, which we first covered in Welcome to Economics! Fiscal policy is one of two policy tools for fine tuning the economy (the other is monetary policy). While policymakers at the Federal Reserve make monetary policy, Congress and the President make fiscal policy.
The discussion of fiscal policy focuses on how federal government taxing and spending affects aggregate demand. All government spending and taxes affect the economy, but fiscal policy focuses strictly on federal government policies. We begin with an overview of U.S. government spending and taxes. We then discuss fiscal policy from a short-run perspective; that is, how government uses tax and spending policies to address recession, unemployment, and inflation; how periods of recession and growth affect government budgets; and the merits of balanced budget proposals.


# Government Budgets and Fiscal Policy

## Government Spending

Government spending covers a range of services that the federal, state, and local governments provide. When the federal government spends more money than it receives in taxes in a given year, it runs a budget deficit. Conversely, when the government receives more money in taxes than it spends in a year, it runs a budget surplus. If government spending and taxes are equal, it has a balanced budget. For example, in 2020, the U.S. government experienced its largest budget deficit ever, as the federal government spent $3.1 trillion more than it collected in taxes. This deficit was about 15% of the size of the U.S. GDP in 2020, making it by far the largest budget deficit relative to GDP since the mammoth borrowing the government used to finance World War II. To put it into perspective, the previous record deficits were experienced during the Great Recession of 2007–2009, when the deficit reached 9.6% of GDP.
This section presents an overview of government spending in the United States.

### Total U.S. Government Spending

Federal spending in nominal dollars (that is, dollars not adjusted for inflation) has grown by a multiple of more than 38 over the last four decades, from $93.4 billion in 1960 to $6.8 trillion in 2020. Comparing spending over time in nominal dollars is misleading because it does not take into account inflation or growth in population and the real economy. A more useful method of comparison is to examine government spending as a percent of GDP over time.
The top line in  shows the federal spending level since 1960, expressed as a share of GDP. Despite a widespread sense among many Americans that the federal government has been growing steadily larger, the graph shows that federal spending has hovered in a range from 18% to 22% of GDP most of the time since 1960. For example, throughout the latter part of the 2010s, government expenditures were around 20% of GDP. The other lines in  show the major federal spending categories: national defense, Social Security, health programs, and interest payments. From the graph, we see that national defense spending as a share of GDP has generally declined since the 1960s, although there were some upward bumps in the 1980s buildup under President Ronald Reagan and in the aftermath of the terrorist attacks on September 11, 2001. In contrast, Social Security and healthcare have grown steadily as a percent of GDP. Healthcare expenditures include both payments for senior citizens (Medicare), and payments for low-income Americans (Medicaid). State governments also partially fund Medicaid. Interest payments are the final main category of government spending in Figure 30.2.
Each year, the government borrows funds from U.S. citizens and foreigners to cover its budget deficits. It does this by selling securities (Treasury bonds, notes, and bills)—in essence borrowing from the public and promising to repay with interest in the future. From 1961 to 1997, the U.S. government has run budget deficits, and thus borrowed funds, in almost every year. It had budget surpluses from 1998 to 2001, and then returned to deficits.
The interest payments on past federal government borrowing were typically 1–2% of GDP in the 1960s and 1970s but then climbed above 3% of GDP in the 1980s and stayed there until the late 1990s. The government was able to repay some of its past borrowing by running surpluses from 1998 to 2001 and, with help from low interest rates, the interest payments on past federal government borrowing had fallen back to 1.6% of GDP by 2020.
We investigate the government borrowing and debt patterns in more detail later in this chapter, but first we need to clarify the difference between the deficit and the debt. The deficit is not the debt. The difference between the deficit and the debt lies in the time frame. The government deficit (or surplus) refers to what happens with the federal government budget each year. The government debt is accumulated over time. It is the sum of all past deficits and surpluses. If you borrow $10,000 per year for each of the four years of college, you might say that your annual deficit was $10,000, but your accumulated debt over the four years is $40,000.
These four categories—national defense, Social Security, healthcare, and interest payments—generally account for roughly 60% of all federal spending, as  shows. (Due to the large amount of one-time expenditures by the federal government in 2020 due to the pandemic, the 2019 statistics are presented here.) The remaining 40% wedge of the pie chart covers all other categories of federal government spending: international affairs; science and technology; natural resources and the environment; transportation; housing; education; income support for people in poverty; community and regional development; law enforcement and the judicial system; and the administrative costs of running the government.

### State and Local Government Spending

Although federal government spending often gets most of the media attention, state and local government spending is also substantial—at about $3.3 trillion in 2021.  shows that state and local government spending has increased during the last four decades from around 8% to around 14% today. The single biggest item is education, which accounts for about one-third of the total. The rest covers programs like highways, libraries, hospitals and healthcare, parks, and police and fire protection. Unlike the federal government, all states (except Vermont) have balanced budget laws, which means any gaps between revenues and spending must be closed by higher taxes, lower spending, drawing down their previous savings, or some combination of all of these.
U.S. presidential candidates often run for office pledging to improve the public schools or to get tough on crime. However, in the U.S. government system, these tasks are primarily state and local government responsibilities. In fiscal year 2020 state and local governments spent about $970 billion per year on education (including K–12 and college and university education), compared to only $100 billion by the federal government. In other words, about 90 cents of every dollar spent on education happens at the state and local level. A politician who really wants hands-on responsibility for reforming education or reducing crime might do better to run for mayor of a large city or for state governor rather than for president of the United States.
Taxes are paid by most, but not all, people who work. Even if you are part of the so-called “1099” or “gig” economy, you are considered an independent contractor and must pay taxes on the income you earn in those occupations. Taxes are also paid by consumers whenever they purchase goods and services. Taxes are used for all sorts of spending—from roads, to bridges, to schools (K–12 and public higher education), to police and other public safety functions. Taxes fund vital public services that support our communities.

### Key Concepts and Summary

Fiscal policy is the set of policies that relate to federal government spending, taxation, and borrowing. In recent decades, the level of federal government spending and taxes, expressed as a share of GDP, has not changed much, typically fluctuating between about 18% to 22% of GDP. However, the level of state spending and taxes, as a share of GDP, has risen from about 12–13% to about 20% of GDP over the last four decades. The four main areas of federal spending are national defense, Social Security, healthcare, and interest payments, which together account for about 70% of all federal spending. When a government spends more than it collects in taxes, it is said to have a budget deficit. When a government collects more in taxes than it spends, it is said to have a budget surplus. If government spending and taxes are equal, it is said to have a balanced budget. The sum of all past deficits and surpluses make up the government debt.

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### References

Kramer, Mattea, et. al. A People's Guide to the Federal Budget.  National Priorities Project. Northampton: Interlink Books, 2012.
Kurtzleben, Danielle. “10 States With The Largest Budget Shortfalls.” U.S. News & World Report. January 14, 2011. http://www.usnews.com/news/articles/2011/01/14/10-states-with-the-largest-budget-shortfalls.
Miller, Rich, and William Selway. “U.S. Cities and States Start Spending Again.” BloombergBusinessweek, January 10, 2013. http://www.businessweek.com/articles/2013-01-10/u-dot-s-dot-cities-and-states-start-spending-again.
Weisman, Jonathan. “After Year of Working Around Federal Cuts, Agencies Face Fewer Options.” The New York Times, October 26, 2013. http://www.nytimes.com/2013/10/27/us/politics/after-year-of-working-around-federal-cuts-agencies-face-fewer-options.html?_r=0.
Chantrill, Christopher. USGovernmentSpending.com. “Government Spending Details: United States Federal State and Local Government Spending, Fiscal Year 2013.” http://www.usgovernmentspending.com/year_spending_2013USbn_15bs2n_20.


# Government Budgets and Fiscal Policy

## Taxation

There are two main categories of taxes: those that the federal government collects and those that the state and local governments collect. What percentage the government collects and for what it uses that revenue varies greatly. The following sections will briefly explain the taxation system in the United States.
Taxes are paid by most, but not all, people who work. Even if you are part of the so-called “1099” or “gig” economy, you are considered an independent contractor and must pay taxes on the income you earn in those occupations. Taxes are also paid by consumers whenever they purchase goods and services. Taxes are used for all sorts of spending—from roads, to bridges, to schools (K–12 and public higher education), to police and other public safety functions. Taxes fund vital public services that support our communities.

### Federal Taxes

Just as many Americans erroneously think that federal spending has grown considerably, many also believe that taxes have increased substantially. The top line of  shows total federal taxes as a share of GDP since 1960. Although the line rises and falls, it typically remains within the range of 17% to 20% of GDP, except for 2009–2011, when taxes fell substantially below this level, due to the Great Recession.
 also shows the taxation patterns for the main categories that the federal government taxes: individual income taxes, corporate income taxes, and social insurance and retirement receipts. When most people think of federal government taxes, the first tax that comes to mind is the individual income tax that is due every year on April 15 (or the first business day after). The personal income tax is the largest single source of federal government revenue, but it still represents less than half of federal tax revenue.
The second largest source of federal revenue is the payroll tax (captured in social insurance and retirement receipts), which provides funds for Social Security and Medicare. Payroll taxes have increased steadily over time. Together, the personal income tax and the payroll tax accounted for over 85% of federal tax revenues in 2020. Although personal income tax revenues account for more total revenue than the payroll tax, nearly three-quarters of households pay more in payroll taxes than in income taxes.
The income tax is a progressive tax, which means that the tax rates increase as a household’s income increases. Taxes also vary with marital status, family size, and other factors. The marginal tax rates (the tax due on all yearly income) for a single taxpayer range from 10% to 35%, depending on income, as the following Clear It Up feature explains.
The key fact here is that the federal income tax is designed so that tax rates increase as income increases, up to a certain level. The payroll taxes that support Social Security and Medicare are designed in a different way. First, the payroll taxes for Social Security are imposed at a rate of 12.4% up to a certain wage limit, set at $137,700 in 2020. Medicare, on the other hand, pays for elderly healthcare, and is fixed at 2.9%, with no upper ceiling.
In both cases, the employer and the employee split the payroll taxes. An employee only sees 6.2% deducted from their paycheck for Social Security, and 1.45% from Medicare.  However, as economists are quick to point out, the employer’s half of the taxes are probably passed along to the employees in the form of lower wages, so in reality, the worker pays all of the payroll taxes. If you are a member of the “gig economy” and receive a 1099 tax statement, then you are considered an independent contractor and so you must pay the employee and employer side of the payroll tax.
We also call the Medicare payroll tax a proportional tax; that is, a flat percentage of all wages earned. The Social Security payroll tax is proportional up to the wage limit, but above that level it becomes a regressive tax, meaning that people with higher incomes pay a smaller share of their income in tax.
The third-largest source of federal tax revenue, as  shows is the corporate income tax. The common name for corporate income is “profits.” Over time, corporate income tax receipts have declined as a share of GDP, from about 4% in the 1960s to an average of 1% to 2% of GDP in the past 40 years.
The federal government has a few other, smaller sources of revenue. It imposes an excise tax—that is, a tax on a particular good—on gasoline, tobacco, and alcohol. As a share of GDP, the amount the government collects from these taxes has stayed nearly constant over time, from about 2% of GDP in the 1960s to roughly 3% by 2020, according to the nonpartisan Congressional Budget Office. The government also imposes an estate and gift tax on people who pass large amounts of assets to the next generation—either after death or during life in the form of gifts. These estate and gift taxes collected about 0.2% of GDP in 2020. By a quirk of legislation, the government repealed the estate and gift tax in 2010, but reinstated it in 2011. Other federal taxes, which are also relatively small in magnitude, include tariffs the government collects on imported goods and charges for inspections of goods entering the country.

### State and Local Taxes

At the state and local level, taxes have been rising as a share of GDP over the last few decades to match the gradual rise in spending, as  illustrates. The main revenue sources for state and local governments are sales taxes, property taxes, and revenue passed along from the federal government, but many state and local governments also levy personal and corporate income taxes, as well as impose a wide variety of fees and charges. The specific sources of tax revenue vary widely across state and local governments. Some states rely more on property taxes, some on sales taxes, some on income taxes, and some more on revenues from the federal government.

### Key Concepts and Summary

The two main federal taxes are individual income taxes and payroll taxes that provide funds for Social Security and Medicare; these taxes together account for more than 80% of federal revenues. Other federal taxes include the corporate income tax, excise taxes on alcohol, gasoline and tobacco, and the estate and gift tax. A progressive tax is one, like the federal income tax, where those with higher incomes pay a higher share of taxes out of their income than those with lower incomes. A proportional tax is one, like the payroll tax for Medicare, where everyone pays the same share of taxes regardless of income level. A regressive tax is one, like the payroll tax (above a certain threshold) that supports Social Security, where those with high income pay a lower share of income in taxes than those with lower incomes.

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### Critical Thinking Questions

### References

Burman, Leonard E., and Joel Selmrod. Taxes in America: What Everyone Needs to Know. New York: Oxford University Press, 2012.
Hall, Robert E., and Alvin Rabushka. The Flat Tax (Hoover Classics). Stanford: Hoover Institution Press, 2007.
Kliff, Sarah. “How Congress Paid for Obamacare (in Two Charts).” The Washington Post: WonkBlog  (blog), August 30, 2012. http://www.washingtonpost.com/blogs/wonkblog/wp/2012/08/30/how-congress-paid-for-obamacare-in-two-charts/.
Matthews, Dylan. “America’s Taxes are the Most Progressive in the World. Its Government is Among the Least.” The Washington Post: WonkBlog (blog). April 5, 2013. http://www.washingtonpost.com/blogs/wonkblog/wp/2013/04/05/americas-taxes-are-the-most-progressive-in-the-world-its-government-is-among-the-least/.


# Government Budgets and Fiscal Policy

## Federal Deficits and the National Debt

Having discussed the revenue (taxes) and expense (spending) side of the budget, we now turn to the annual budget deficit or surplus, which is the difference between the tax revenue collected and spending over a fiscal year, which starts October 1 and ends September 30 of the next year.
 shows the pattern of annual federal budget deficits and surpluses, back to 1930, as a share of GDP. When the line is above the horizontal axis, the budget is in surplus. When the line is below the horizontal axis, a budget deficit occurred. Clearly, the biggest deficits as a share of GDP during this time were incurred to finance World War II. Deficits were also large during the 1930s, the 1980s, the early 1990s, 2007–2009 (the Great Recession), and 2020 (the pandemic-induced recession).
Federal Surplus or Deficit as a Percentage of Gross Domestic Product

### Debt/GDP Ratio

Another useful way to view the budget deficit is through the prism of accumulated debt rather than annual deficits. The national debt refers to the total amount that the government has borrowed over time. In contrast, the budget deficit refers to how much the government has borrowed in one particular year.  shows the ratio of debt/GDP since 1966. Until the 1970s, the debt/GDP ratio revealed a fairly clear pattern of federal borrowing. The government ran up large deficits and raised the debt/GDP ratio in World War II, but from the 1950s to the 1970s the government ran either surpluses or relatively small deficits, and so the debt/GDP ratio drifted down. Large deficits in the 1980s and early 1990s caused the ratio to rise sharply. When budget surpluses arrived from 1998 to 2001, the debt/GDP ratio declined substantially. The budget deficits starting in 2002 then tugged the debt/GDP ratio higher—with a big jump when the recession took hold in 2008–2009. There was another leap in the ratio in 2020.
The next Clear it Up feature discusses how the government handles the national debt.
Gross Federal Debt as a Percentage of Gross Domestic Product

### The Path from Deficits to Surpluses to Deficits

Why did the budget deficits suddenly turn to surpluses from 1998 to 2001 and why did the surpluses return to deficits in 2002? Why did the deficit become so large in 2020?  suggests some answers. The graph combines the earlier information on total federal spending and taxes in a single graph, but focuses on the federal budget since 1990.
Government spending as a share of GDP declined steadily through the 1990s. The biggest single reason was that defense spending declined from 5.2% of GDP in 1990 to 3.0% in 2000, but interest payments by the federal government also fell by about 1.0% of GDP. However, federal tax collections increased substantially in the later 1990s, jumping from 18.1% of GDP in 1994 to 20.8% in 2000. Powerful economic growth in the late 1990s fueled the boom in taxes. Personal income taxes rise as income goes up; payroll taxes rise as jobs and payrolls go up; corporate income taxes rise as profits go up. At the same time, government spending on transfer payments such as unemployment benefits, foods stamps, and welfare declined with more people working.
This sharp increase in tax revenues and decrease in expenditures on transfer payments was largely unexpected even by experienced budget analysts, and so budget surpluses came as a surprise. However, in the early 2000s, many of these factors started running in reverse. Tax revenues sagged, due largely to the recession that started in March 2001, which reduced revenues. Congress enacted a series of tax cuts and President George W. Bush signed them into law, starting in 2001. In addition, government spending swelled due to increases in defense, healthcare, education, Social Security, and support programs for those who were hurt by the recession and the slow growth that followed. Deficits returned. When the severe recession hit in late 2007, spending climbed and tax collections fell to historically unusual levels, resulting in enormous deficits.
Longer-term U.S. budget forecasts, a decade or more into the future, predict enormous deficits. The higher deficits during the 2007–2009 Great Recession and the 2020 pandemic-induced recession have repercussions, and the demographics will be challenging. The primary reason is the “baby boom”—the exceptionally high birthrates that began in 1946, right after World War II, and lasted for about two decades. Starting in 2010, the front edge of the baby boom generation reached age 65, and in the next two decades, the proportion of Americans over the age of 65 will increase substantially. During the 2020 recession, we saw another wave of early retirements, and we are now in the middle of this major demographic shift. The current level of the payroll taxes that support Social Security and Medicare will fall well short of the projected expenses of these programs, as the following Clear It Up feature shows; thus, the forecast is for increasingly large budget deficits. A decision to collect more revenue to support these programs or to decrease benefit levels would alter this long-term forecast.
In the next module we shift to the use of fiscal policy to counteract business cycle fluctuations. In addition, we will explore proposals requiring a balanced budget—that is, for government spending and taxes to be equal each year. The Impacts of Government Borrowing will also cover how fiscal policy and government borrowing will affect national saving—and thus affect economic growth and trade imbalances.

### Key Concepts and Summary

For most of the twentieth century, the U.S. government took on debt during wartime and then paid down that debt slowly in peacetime. However, it took on quite substantial debts in peacetime in the 1980s and early 1990s, before a brief period of budget surpluses from 1998 to 2001, followed by a return to annual budget deficits since 2002, with very large deficits in the recession of 2008 and 2009. A budget deficit or budget surplus is measured annually. Total government debt or national debt is the sum of budget deficits and budget surpluses over time.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Eisner, Robert. The Great Deficit Scares: The Federal Budget, Trade, and Social Security. New York: Priority Press Publications, 1997.
Weisman, Jonathan, and Ashley Parker. “Republicans Back Down, Ending Crisis Over Shutdown and Debt Limit.” The New York Times, October 16, 2013. http://www.nytimes.com/2013/10/17/us/congress-budget-debate.html.
Wessel, David. Red Ink: Inside the High-Stakes Politics of Federal Budget. New York: Crown Publishing Group, 2013.


# Government Budgets and Fiscal Policy

## Using Fiscal Policy to Fight Recession, Unemployment, and Inflation

Fiscal policy is the use of government spending and tax policy to influence the path of the economy over time. Graphically, we see that fiscal policy, whether through changes in spending or taxes, shifts the aggregate demand outward in the case of expansionary fiscal policy and inward in the case of contractionary fiscal policy. We know from the chapter on economic growth that over time the quantity and quality of our resources grow as the population and thus the labor force get larger, as businesses invest in new capital, and as technology improves. The result of this is regular shifts to the right of the aggregate supply curves, as  illustrates.
The original equilibrium occurs at E0, the intersection of aggregate demand curve AD0 and aggregate supply curve SRAS0, at an output level of 200 and a price level of 90. One year later, aggregate supply has shifted to the right to SRAS1 in the process of long-term economic growth, and aggregate demand has also shifted to the right to AD1, keeping the economy operating at the new level of potential GDP. The new equilibrium (E1) is an output level of 206 and a price level of 92. One more year later, aggregate supply has again shifted to the right, now to SRAS2, and aggregate demand shifts right as well to AD2. Now the equilibrium is E2, with an output level of 212 and a price level of 94. In short, the figure shows an economy that is growing steadily year to year, producing at its potential GDP each year, with only small inflationary increases in the price level.
Aggregate demand and aggregate supply do not always move neatly together. Think about what causes shifts in aggregate demand over time. As aggregate supply increases, incomes tend to go up. This tends to increase consumer and investment spending, shifting the aggregate demand curve to the right, but in any given period it may not shift the same amount as aggregate supply. What happens to government spending and taxes? Government spends to pay for the ordinary business of government- items such as national defense, social security, and healthcare, as  shows. Tax revenues, in part, pay for these expenditures. The result may be an increase in aggregate demand more than or less than the increase in aggregate supply.

  Aggregate demand may fail to increase along with aggregate supply, or aggregate demand may even shift left, for a number of possible reasons: households become hesitant about consuming; firms decide against investing as much; or perhaps the demand from other countries for exports diminishes.
For example, investment by private firms in physical capital in the U.S. economy boomed during the late 1990s, rising from 14.1% of GDP in 1993 to 17.2% in 2000, before falling back to 15.2% by 2002. Conversely, if shifts in aggregate demand run ahead of increases in aggregate supply, inflationary increases in the price level will result. Business cycles of recession and recovery are the consequence of shifts in aggregate supply and aggregate demand. As these occur, the government may choose to use fiscal policy to address the difference.
Monetary Policy and Bank Regulation shows us that a central bank can use its powers over the banking system to engage in countercyclical—or “against the business cycle”—actions. If recession threatens, the central bank uses an expansionary monetary policy to increase the money supply, increase the quantity of loans, reduce interest rates, and shift aggregate demand to the right. If inflation threatens, the central bank uses contractionary monetary policy to reduce the money supply, reduce the quantity of loans, raise interest rates, and shift aggregate demand to the left. Fiscal policy is another macroeconomic policy tool for adjusting aggregate demand by using either government spending or taxation policy.

### Expansionary Fiscal Policy

Expansionary fiscal policy increases the level of aggregate demand, through either increases in government spending or reductions in tax rates. Expansionary policy can do this by (1) increasing consumption by raising disposable income through cuts in personal income taxes or payroll taxes; (2) increasing investment spending by raising after-tax profits through cuts in business taxes; and (3) increasing government purchases through increased federal government spending on final goods and services and raising federal grants to state and local governments to increase their expenditures on final goods and services. Contractionary fiscal policy does the reverse: it decreases the level of aggregate demand by decreasing consumption, decreasing investment, and decreasing government spending, either through cuts in government spending or increases in taxes. The aggregate demand/aggregate supply model is useful in judging whether expansionary or contractionary fiscal policy is appropriate.
Consider first the situation in , which is similar to the U.S. economy during the 2007-2009 recession. The intersection of aggregate demand (AD0) and aggregate supply (SRAS0) is occurring below the level of potential GDP as the LRAS curve indicates. At the equilibrium (E0), a recession occurs and unemployment rises. In this case, expansionary fiscal policy using tax cuts or increases in government spending can shift aggregate demand to AD1, closer to the full-employment level of output. In addition, the price level would rise back to the level P1 associated with potential GDP.
Should the government use tax cuts or spending increases, or a mix of the two, to carry out expansionary fiscal policy? During the 2007-2009 Great Recession, the U.S. economy suffered a 3.1% cumulative loss of GDP.  That may not sound like much, but it’s more than one year’s average growth rate of GDP.  Over that time frame, the unemployment rate doubled from 5% to 10%. The choice between whether to use tax or spending tools often has a political tinge. As a general statement, conservatives and Republicans prefer to see expansionary fiscal policy carried out by tax cuts, while liberals and Democrats prefer that the government implement expansionary fiscal policy through spending increases. In a bipartisan effort to address the extreme situation, the Obama administration and Congress passed an $830 billion expansionary policy in early 2009 involving both tax cuts and increases in government spending. At the same time, however, the federal stimulus was partially offset when state and local governments, whose budgets were hard hit by the recession, began cutting their spending.
Events were even more severe during the more recent pandemic-induced recession. In a single quarter (Quarter 2 of 2020), GDP fell by over 9%, or at an annualized rate of about 34%. Policymakers were quick to respond with expanded unemployment insurance, aid to state and local governments (so that they didn’t have to cut their spending like they did during the Great Recession), grants and tax breaks for small businesses, and perhaps most significantly, stimulus checks sent to over 100 million households, totaling thousands of dollars each. Since these were mostly spending measures, they were supported more by Democrats than by Republicans, although both groups recognized the severity of the problem and were largely in agreement early on. Especially during the debates over later rounds of the stimulus checks, many discussions were had over the appropriate size and target of the checks. Ultimately, compromises were made and no side got exactly what it wanted.
The conflict over which policy tool to use can be frustrating to those who want to categorize economics as “liberal” or “conservative,” or who want to use economic models to argue against their political opponents. However, advocates of smaller government, who seek to reduce taxes and government spending can use the AD AS model, as well as advocates of bigger government, who seek to raise taxes and government spending. Economic studies of specific taxing and spending programs can help inform decisions about whether the government should change taxes or spending, and in what ways. Ultimately, decisions about whether to use tax or spending mechanisms to implement macroeconomic policy is a political decision rather than a purely economic one.

### Contractionary Fiscal Policy

Fiscal policy can also contribute to pushing aggregate demand beyond potential GDP in a way that leads to inflation. As  shows, a very large budget deficit pushes up aggregate demand, so that the intersection of aggregate demand (AD0) and aggregate supply (SRAS0) occurs at equilibrium E0, which is an output level above potential GDP. Economists sometimes call this an “overheating economy” where demand is so high that there is upward pressure on wages and prices, causing inflation. In this situation, contractionary fiscal policy involving federal spending cuts or tax increases can help to reduce the upward pressure on the price level by shifting aggregate demand to the left, to AD1, and causing the new equilibrium E1 to be at potential GDP, where aggregate demand intersects the LRAS curve.
Again, the AD–AS model does not dictate how the government should carry out this contractionary fiscal policy. Some may prefer spending cuts; others may prefer tax increases; still others may say that it depends on the specific situation. The model only argues that, in this situation, the government needs to reduce aggregate demand.

### Key Concepts and Summary

Expansionary fiscal policy increases the level of aggregate demand, either through increases in government spending or through reductions in taxes. Expansionary fiscal policy is most appropriate when an economy is in recession and producing below its potential GDP. Contractionary fiscal policy decreases the level of aggregate demand, either through cuts in government spending or increases in taxes. Contractionary fiscal policy is most appropriate when an economy is producing above its potential GDP.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Alesina, Alberto, and Francesco Giavazzi. Fiscal Policy after the Financial Crisis (National Bureau of Economic Research Conference Report). Chicago: University Of Chicago Press, 2013.
Martin, Fernando M. “Fiscal Policy in the Great Recession and Lessons from the Past.” Federal Reserve Bank of St. Louis: Economic Synopses. no. 1 (2012). http://research.stlouisfed.org/publications/es/12/ES_2012-01-06.pdf.
Bivens, Josh, Andrew Fieldhouse, and Heidi Shierholz. “From Free-fall to Stagnation: Five Years After the Start of the Great Recession, Extraordinary Policy Measures Are Still Needed, But Are Not Forthcoming.” Economic Policy Institute. Last modified February 14, 2013. http://www.epi.org/publication/bp355-five-years-after-start-of-great-recession/.
Lucking, Brian, and Dan Wilson. Federal Reserve Bank of San Francisco, “FRBSF Economic Letter—U.S. Fiscal Policy: Headwind or Tailwind?” Last modified July 2, 2012. http://www.frbsf.org/economic-research/publications/economic-letter/2012/july/us-fiscal-policy/.
Greenstone, Michael, and Adam Looney. Brookings. “The Role of Fiscal Stimulus in the Ongoing Recovery.” Last modified July 6, 2012. http://www.brookings.edu/blogs/jobs/posts/2012/07/06-jobs-greenstone-looney.