Eco 200 – Principles of Macroeconomics

Chapter 7: Foreign Exchange Markets and the Balance of

Payments

Foreign exchange market Foreign exchange = money

denominated in foreign currency

Foreign exchange market Foreign exchange = money

denominated in foreign currency Foreign exchange market = global

market in which currencies are exchanged for each other

Foreign exchange market Foreign exchange = money

denominated in foreign currency Foreign exchange market = global

market in which currencies are exchanged for each other

Most foreign exchange transactions involve the purchase and sale of bank deposits

Exchange rate Exchange rate = price of one

currency in terms of another

Exchange rate Exchange rate = price of one

currency in terms of another Reciprocal exchange rates – If $1 is

worth ½ of a British pound, each British pound is worth 2 dollars.

Exchange rate Exchange rate = price of one

currency in terms of another Reciprocal exchange rates – If $1 is

worth ½ of a British pound, each British pound is worth 2 dollars.

Domestic currency price = foreign currency price x exchange

rate

Appreciation and depreciation If the domestic currency appreciates,

Imports become less expensive Imports rise

Exports become more expensive in the rest of the world.

Exports decline

Appreciation and depreciation If the domestic currency appreciates,

Imports become less expensive Imports rise

Exports become more expensive in the rest of the world.

Exports decline If the domestic currency depreciates,

Imports become more expensive Imports decline

Exports become less expensive in the rest of the world.

Exports rise

Balance of payments Double-entry bookkeeping

Two sides to each transaction Dollar value of money flowing into the country

must equal the dollar value of the money flowing out (two sides of the same transaction)

Balance of payments Double-entry bookkeeping

Two sides to each transaction Dollar value of money flowing into the country

must equal the dollar value of the money flowing out (two sides of the same transaction)

Credits activities that brings payments into the country

Balance of payments Double-entry bookkeeping

Two sides to each transaction Dollar value of money flowing into the country

must equal the dollar value of the money flowing out (two sides of the same transaction)

Credits activities that brings payments into the country

Debits activities that involve payments to the rest of

the world

Current and financial accounts Current account = trade in goods

and services

Current and financial accounts Current account = trade in goods

and services Financial account = trade in

financial assets

Current and financial accounts Current account = trade in goods

and services Financial account = trade in

financial assets Net balance on current account

+ net balance on financial account + statistical discrepancy = 0 (overall balance of payments = 0)

Current account Merchandise – trade in goods

Current account Merchandise – trade in goods Services – trade in services

Current account Merchandise – trade in goods Services – trade in services Income = payment for labor and

capital services (interest and dividend payments)

Current account Merchandise – trade in goods Services – trade in services Income = payment for labor and

capital services (interest and dividend payments)

Unilateral transfers – payments for which no goods or services are provided in return

Current account

Balance of payment accounts – 2000 (in millions)Account Credit Debit Net

balance

Merchandise $183,728

$289,566

-$105,838

Services $71,309 $51,647 $19,662

Income $79,749 $83,949 -$4,200

Unilateral transfers -$11,925

Current Account -$102,301

Financial Account $215,008

$143,283

$71,725

Statistical discrepancy

-$30,410

Overall BOP $0