CH 36 & 37: International Trade and the...

CH 36 & 37:

International Trade

and the FOREX

LECTURE

Balance of Trade (BOT)

Balance of trade: the difference between exports and imports (Xn)

Includes goods and services

Balance of Trade (BOT) The U.S. has a trade deficit—importing more than it is exporting

In 2018, the U.S. trade deficit (goods only) was $810 billion

It imported $2.3 trillion of goods and services while exporting $1.5 trillion

65% of our trade deficit is due to trade with China (second largest is Japan, third largest is Germany)

The U.S. is financing its trade deficit by selling off assets

Balance of Payments (BOP)

Balance of payments: is a country’s record of all transactions between its residents and the residents of all foreign nations

A credit is a foreign payment to the U.S.

The U.S. earns a supply of foreign currency

A debit is a U.S. payment to another country

The U.S. uses its reserves of foreign currency to purchase goods; the country the U.S. is purchasing goods from earns reserves of U.S. dollars


A deficit in the balance of payments occurs when the U.S. is paying out more for foreign goods, services, and investments than it is receiving

The U.S. is not earning enough foreign reserves to cover its purchases from foreign nations


A surplus in the balance of payments occurs when payments to the U.S. are greater than U.S. payments to foreign nations

The U.S. is earning more in foreign currencies than it is using to purchase foreign goods, services, investments


Goods exported by the U.S. must be paid for in U.S. dollars

Exports cause a flow of payments into the U.S.

Goods imported by the U.S. must be paid for in foreign currency

Imports cause a flow of dollars outside the U.S.


Includes two accounts:

The current account and the financial (capital) account

The Current Account

The current account is made up of three parts:

1. Net Exports: Difference between a nation’s exports of goods and services and its imports of goods and services

Examples: Toys imported from China; U.S. cars exported to Mexico

(We will use this one the most, especially in FRQs)

The Current Account

2. Investment Income: Income from the factors of production, including payments made to foreign investors

Example: Money earned by Japanese car producers in the U.S.

3. Net Transfers: Money flows from the private or public sectors

Examples: Donations’ aids and grants

The Financial Account

The financial (capital) account measures the purchase and sale of financial assets abroad

Includes purchases of things that stay in the foreign country such as financial assets (stocks and bonds) and real estate

Examples: A U.S. citizen buys German stock; a U.S. company buys a hotel in Russia

The Current Account and the Financial Account

The current account balance and the financial account balance must equal zero

When they do not, the central bank must buy or sell currency (known as official reserves—government holdings of foreign currencies) to resolve this imbalance


When the current account is in a deficit it is due to importing more goods and services than it is exporting

Current account deficits must be offset by financial account surpluses

Increasing current account deficits means that capital inflows increase (this increases the supply of loanable funds)


When the current account is in a surplus it is due to exporting more goods and services than it is importing

Current account surpluses will be offset by financial account deficits

Current account surpluses means that capital outflows increase (this decreases the supply of loanable funds)

(Watch Mr. Clifford Video #1)

Sample Question Balance of payments accounts record all of a country’s

international transactions during a year.

a.) Two major subaccounts in the balance of payments accounts are the current account and the financial (capital) account. In which of these subaccounts will each of the following transactions be recorded?

(i) A U.S. resident buys chocolate from Belgium.

(ii) A U.S. manufacturer buys computer equipment from Japan.

b.) How would an increase in the real income in the U.S. affect the U.S. current account balance? Explain.

Answer:

(a). (i) Current account

(a) (ii) Current account

(b) The current account balance will decrease (move toward a deficit) because the increase in income causes imports to increase

Exchange Rates

Exchange rate: the rate at which one country’s currency can be traded for another country’s currency

It is determined by supply and demand in the FOREX market (foreign exchange market) where currency is bought and sold

Exchange Rates

In the FOREX market we only look at two countries/currencies at a time

Example: U.S. dollars and British pounds

We examine the price of one currency in terms of the other currency. Example:$2 = £1

The exchange rate depends on which currency you are converting

The price of one U.S. dollar in terms of pounds is

1 Dollar = £1/$2 = £.5

The price of one pound in terms of U.S. dollars is

1 Pound = $2/£1 = $2

Exchange Rates

What happens if you need more dollars to buy one pound (the price for a pound increases)?

Example: From $2=£1 to $5=£1

The U.S. dollar depreciates relative to the pound

Depreciation: the loss of value of a country's currency with respect to a foreign currency

More units of dollars are needed to buy a single unit of the other currency

The dollar is said to be “weaker”

Exchange Rates What happens if you need less dollars to buy one pound (the price

for a pound decreases)?

Example: From $2=£1 to $1=£4

The U.S. dollar appreciates relative to the pound

Appreciation: the increase of value of a country's currency with respect to a foreign currency

Less units of dollars are needed to buy a single unit of the other currency

The dollar is said to be “stronger”

FOREX Market Shifters

A country’s incomeChanges in a country’s prices (price level)The interest rate in a countryTastes and preferences


Changes in relative incomes (resulting in more imports)

Example: U.S. growth increases U.S. income

The U.S. buys more imports

U.S. demand for pounds increases

Supply of U.S. dollars increases

Pound: appreciates

Dollar: depreciates


Changes in relative price level (resulting in more imports)

Example: U.S. prices increase relative to Britain

U.S. demand for cheaper imports increases

U.S. demand for pounds increases

Supply of U.S. dollars increases

Pound: appreciates

Dollar: depreciates


Changes in relative interest rates

Example: U.S. has a higher interest rate than Britain

British people want to put money in U.S. banks

Capital flow increases towards the U.S.

British demand for U.S. dollars increases

British supply more pounds

Pound: depreciates

Dollar: appreciates


• Tariffs increase the price of imports and reduce the quantity of imports demanded

• The supply of a country’s currency decreases since the demand to buy foreign currency to purchase the imports decreases

Sample Questions

1. U.S. income increases relative to other countries. Does the balance of payments move toward a deficit or a surplus?

U.S. citizens have more disposable income

Americans import more

Net exports (Xn) decrease

The current account balance decreases and moves toward a deficit

Sample Questions

2. If the U.S. dollar depreciates relative to other countries does the balance of payments move toward a deficit or a surplus?

U.S. exports are desirable

U.S. exports more

Net exports (Xn) increase

The current account balance decreases and moves toward a surplus

Drawing the Graph: The FOREX Market

What will this graph look like?

Supply and demand

What goes on each axis?

Price of currency (e) and quantity (in terms of the currency we are looking at)

On the graph, we will look at the supply of, and the demand for, euros in terms of U.S. dollars

The Graph: The Supply and Demand for U.S. Dollars and Euros

Euros/U.S. Dollars

Quantity of U.S. dollars

e1

Q1

S

D

This graph shows how many euros you get for each U.S. dollar

The Graph: The Supply and Demand for U.S. Dollars and Euros

U.S. Dollars/Euro

Quantity of Euros

S

D

e1

Q1

This graph shows how many U.S. dollars you get for each euro

Drawing the Graph: The FOREX Market

To demand one currency, you must supply your currency(Remember this!)

If Europeans want to buy U.S. goods they have to exchange euros for U.S. dollars

This means supplying euros in order to demand U.S. dollars

Drawing the Graph: The Supply and Demand for U.S. Dollars and Euros

U.S. Dollars/Euro

Quantity of Euros

S1

D

e1

Q1

S2

Q2

e2

If a European country wants to buy U.S. goods, what happens?

They will supply euros in order to demand U.S. dollars

Drawing the Graph: The Supply and Demand for U.S. Dollars and Euros

This results in an increase in the demand for U.S. dollars.

They will supply euros in order to demand U.S. dollars

Euros/U.S. Dollars

Quantity of U.S. Dollars

S1

D1

e1

Q1 Q2

e2

D2

Explaining the Graphs: The FOREX Market

As Europeans supply more euros to purchase U.S. dollars, the euro depreciates

As the demand for the U.S. dollar increases, the dollar appreciates

Explaining the Graphs: The FOREX Market

Which graph is correct?

Depends on what the FRQ asks you to graph.

In summary, if it helps you to graph both, do it (see next slide).

Also note, that both supply and demand moved in the same direction—this is a sign you did it correctly.

Explaining the Graph: The FOREX Market

U.S. Dollars/Euro

Quantity of Euros

S1

e1

Q1

S2

Q2

e2

Euros/U.S. Dollars

Quantity of U.S. Dollars

S1

e1

Q1 Q2

e2

D2D1 D1

(Analyze both graphs together; graph whatever the FRQ asks)

Example

If Canada wants to purchase goods from Russia, what happens?

Canada supplies Canadian Dollars in order to exchange them for Russian Rubles

What happens in the FOREX?

The supply of Canadian Dollars will increase

The demand for Russian Rubles will increase

(Note: If we draw two graphs, supply and demand will move in the same direction)

FOREX Market and Supply and Demand

Rubles/Canadian Dollars

Quantity of Canadian Dollars

S1

D

e1

Q1

S2

Q2

e2

Canadian Dollars/Rubles

Quantity of Rubles

S1

D1

e1

Q1 Q2

e2

D2

Sample FRQ

Assume that the real interest rate in both the U.S. and the European Union equals 4.5 percent.

a.) Assume that the real interest rate in the U.S. falls to 3.75 percent.

(i). How will the flow of financial capital between the U.S. and the European Union be affected? Explain.

(ii). Using a correctly labeled graph of the foreign exchange market for the euro, show how the value of the euro would change relative to the U.S. dollar in a flexible exchange rate system.

b.) Explain how the change in the value of the euro in part a.)(i) would affect the European Union's net exports.

a.) (i) Capital will flow out from the U.S. to the European Union countries. The higher interest rate in the EU attracts investment funds from the U.S.

(ii). See graph below

Dollar/euro

S

D1

D2

Quantity of euros

e2

e1

Q1 Q2

b.) The EU’s net exports would fall because the price of the euro is appreciating and EU goods would become more expensive to consumers in the U.S. Exports to the U.S. would decrease but the EU’s imports from the U.S. would increase.

How Monetary Policy Affects Exchange Rates

Monetary policy affects exchange rates in three ways:

1. Its effect on the interest rate

2. Its effect on income

3. Its effect on price levels and inflation

Changes in Interest Rates

Interest rates in the U.S. increase

Demand for U.S. interest-bearing assets increases

Demand for dollars to buy U.S. assets increases

The increase in the demand for dollars causes the price of dollars to increase

Changes in a Country’s Income or Prices

Income or prices increase in the U.S.

Imports increase

Demand for foreign currency to buy imports increaseswhich means the supply of the dollar increases

The increase in supply of the dollar causes the price of the dollar to decrease

How Monetary Policy Impacts Exchange Rates

All the effects of monetary policy on exchange rates move in the same direction

Expansionary monetary policy pushes a country’s exchange rates down

Contractionary monetary policy pushes a country’s exchange rates up


M

i

Y

Exchange Rate

P Competitiveness

ImportsExchange rate

Exchange rate

Exchange rate (LR)

• Expansionary monetary policy lowers exchange rates

• It decreases the relative value of a country’s currency


• Contractionary monetary policy increases exchange rates

• It increases the relative value of a country’s currency

M Y

i

Exchange Rate

Exchange rate

Exchange rate

Exchange rate (LR)P

Imports

Competitiveness

Direct Methods of Influencing Exchange Rates

Expectations, rumors, etc. cause fluctuations in exchange rates

To avoid the problems caused by fluctuating exchange rates, governments sometimes intervene to fix exchange rates by buying and selling its currency

If government buys its currency, it can increase its exchange rate

If government sells its currency, its value decreases

Alternative Exchange Rate Systems

Three exchange rate regimes are:

1. Fixed exchange rate where the government chooses an exchange rate and offers to buy and sell currencies at that rate

2. Flexible exchange rate where the determination of exchange rates is left totally up to the market

3. Partially flexible exchange rate where the government sometimes buys or sells currencies to influence the exchange rate, while at other times letting private market forces operate

Advantages and Disadvantages ofFlexible Exchange Rate Systems

Advantages

They provide for orderly incremental adjustment of exchange rates

They allow government to be flexible in conducting monetary and fiscal policy

DisadvantagesThey allow

speculation to cause large jumps in exchange rates

They allow government to be flexible in conducting monetary and fiscal policy

Advantages and Disadvantages ofFixed Exchange Rate Systems

Advantages

They provide international monetary stability

They force governments to make adjustments to meet international problems

Disadvantages

If they become unfixed, they create monetary instability

They force governments to make adjustments to meet international problems

Exchange Rates and Domestic Goals

In principle, the government can control the exchange rate with monetary policy

The problem with doing so is that monetary policy also affects the domestic economy

Expansionary monetary policy will push the exchange rate down

Contractionary monetary policy will push the exchange rate up and may decrease domestic income and jobs

Exchange Rates and Domestic Goals

If other countries stop buying U.S. assets that are financing the large trade deficit, the dollar exchange rate will fall

In the short run, the fall in the dollar will increase the prices of imports, creating inflation in the U.S

In the long run, the fall in the exchange rate will improve the competitiveness of the U.S. and increase exports (prices of goods produced domestically would have to decrease to remain competitive with foreign goods)

Monetary Policy’s Effect on the Balance of Trade

Expansionary monetary policy makes the trade deficit larger

M ImportsTrade deficitY

YM Imports

Trade deficit

Contractionary monetary policy makes the trade deficit smaller

Fiscal Policy’s Effect on the Balance of Trade

Expansionary fiscal policy makes the trade deficit larger

Fiscal Y

YFiscal Imports

Trade deficit

Contractionary fiscal policy makes the trade deficit smaller

ImportsTrade deficitFiscal Y

Chapter Summary

• The balance of payments is made up of the current account and the financial (capital) account

• Exchange rates in perfectly flexible systems are determined by the supply of and demand for a currency

• The following increase demand for foreign currencies and depreciate domestic currencies:

• An increase in domestic income• An increase in domestic prices• A decrease in domestic interest rates• A reduction in trade restrictions on imports

Chapter Summary

• To raise the value of its domestic currency a country can either increase private demand or decrease private supply through contractionary monetary policy

• Expansionary monetary policy, through its effect on interest rates, income, and price level, tends to lower a country’s exchange rate

• Fiscal policy has an ambiguous effect on a country’s exchange rate

Chapter Summary

• A country can stabilize or fix its exchange rate directly by buying and selling its own currency or indirectly by adjusting its monetary and fiscal policy to achieve its exchange rate goal

• It is easier technically for a country to bring the value of its currency down than it is to support its currency

• The purchasing power parity approach can be used to estimate the long-run equilibrium exchange rate

Chapter Summary

• Fixed exchange rates provide international monetary stability but can create enormous monetary instability if they become unfixed

• Fixed exchange rates force governments to make adjustments to meet their international problems

• Flexible exchange rates allow exchange rates to make incremental changes, but are also subject to large jumps in value as a result of speculation

• Flexible exchange rates give governments flexibility in conducting domestic monetary and fiscal policy

Chapter Summary

• A real exchange rate is an exchange rate adjusted for differences in inflation

• A common currency creates strong political ties, reduces the cost of trade, facilitates price comparisons, and creates a larger single market

• A common currency also makes it impossible to have an independent monetary policy

CH 36 & 37: International Trade and the...

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