Chapter 34

Chapter 34

Exchange Rates and the Balance of Payments

2

Introduction

The price of one currency in terms of another is set by the interaction of supply and demand in

international financial markets.

Among the participants in these markets are governments seeking to change or maintain

exchange rates.

3

Learning Objectives

Distinguish between the balance of trade and the balance of payments

Identify the key accounts within the balance of payments

Outline how exchange rates are determined in the markets for foreign exchange

4

Learning Objectives

Discuss factors that can induce changes in equilibrium exchange rates

Understand how policymakers can go about attempting to fix exchange rates

Explain alternative approaches to limiting exchange rate variability

5

The Balance of Payments and International Capital Movements

Determining Foreign Exchange Rates

The Gold Standard and the International Monetary Fund

Fixed Exchange Rates

Chapter Outline

6

Did You Know That...

Exchange rates between currencies are a factor in determining the location of vehicle production?

The recent decline in the value of the dollar against the yen and the euro led foreign automakers to locate more vehicle assembly in the U.S.?

7

Balance of Trade– The value of goods and services bought and sold

in the world market

– The difference between exports and imports of goods

Balance of Payments– A summary record of a country’s economic

transactions with foreign residents and governments over a year


8

Surplus (+) and Deficit (-) Items on the International Accounts

Surplus Items (+) Deficit Items (-)

Exports of merchandise Imports of merchandise

Private and government gifts from Private and governmental gifts to foreigners foreigners

Foreign use of domestically owned Use of foreign-owned transportation transportation

Foreign tourists’ expenditures in this country Tourism expenditures abroad

Foreign military spending in this country Military spending abroad

Interest and dividend receipts from foreigners Interest and dividends paid to foreigners

Sales of domestic assets to foreigners Purchases of foreign assets

Funds deposited in this country by foreigners Funds placed in foreign depository institutions

Sales of gold to foreigners Purchases of gold from foreigners

Sales of domestic currency to foreigners Purchases of foreign currency

Table 34-1

9

Accounting Identities

– Statements that certain numerical measurements are equivalent by accepted definition


10


When family expenditures exceed income, the family must do one of the following:

– Reduce its money holdings, or sell stocks, bonds, or other assets

– Borrow

– Receive gifts from friends or relatives

– Receive a public transfer from a government

Cannot continue indefinitely

11

Accounting identities

– Net lending by households must equal net borrowing by businesses and governments

Disequilibrium

– When a situation cannot continue indefinitely


12

Households, businesses, and governments must reach equilibrium.

When nations trade or interact, certain identities or constraints must hold.


13

Three categories of balance of payments transactions

– Current account transactions

– Capital account transactions

– Official reserve account transactions


14

Current account transactions

– Merchandise trade transactions• Importing and exporting of merchandise• Balance = merchandise exports - merchandise

imports


15


– Service exports and imports• Invisible or intangible items

– Shipping– Insurance– Tourism– Banking– Income from investments


16


– Unilateral transfers• Gifts by citizens • Gifts by governments


17

Example: Multinational Firms in Trade Statistics

When economic activities are conducted by multinational firms, there are different trade statistics that will be calculated depending on whether the activities are measured according to the ownership of resources or according to the location of productive activities.

18

Example: Multinational Firms in Trade Statistics

When the U.S. Commerce Department reports trade statistics on an ownership basis, exports and imports are adjusted to reflect purchases and sales involving foreign affiliates of U.S. firms.

19

Balancing the current account

– Net exports plus unilateral transfers plus net investment income exceeds zero• Current account surplus

– Net exports plus unilateral transfers plus net investment income is negative• Current account deficit


20


A current account surplus means the import of money or money equivalent which means a capital account deficit

A current account deficit must be paid by the export of money or money equivalent which means a capital account surplus

21

Capital account transactions

– Deals with the buying and selling of real and financial assets


22

The current account and capital account must sum to zero, in the absence of interventions by finance ministries or central banks.


Capital Account Current Account 0

23

Official reserve account transactions

– Foreign currencies

– Gold

– Special Drawing Rights (SDRs)• Reserve assets created by the International

Monetary Fund that countries can use to settle international payments


24

Official reserve account transactions

– The reserve position in the International Monetary Fund

– Financial assets held by an official agency such as the U.S. Treasury Department


25


What affects the balance of payments?

– Relative rate of inflation

– Political stability

26


What affects the balance of payments?

– Inflation among trading partners

– Political stability

27

Determining ForeignExchange Rates

Foreign Exchange Market

– The market for buying and selling foreign currencies

Exchange Rates

– The price of one currency in terms of another

28


Demand for and supply of foreign currency

– U.S. transactions involving imports constitute a supply of dollars and demand for some foreign currency

– The opposite is true for export transactions

29


The equilibrium foreign exchange rate

– Appreciation• An increase in the value of a currency in terms

of other currencies

– Depreciation• A decrease in the value of a currency in terms

of other currencies

30

Deriving the Demandfor Japanese Yen

Figure 34-2, Panels (a) and (b)

0

D

Quantity of Japanese Laptopsper Week

Panel (b)U.S. Demand Curve for Japanese Laptop Computers

100

1,500

300

1,250

500

1,000

700

750

Pric

e p

er

Un

it ($

)

31


Figure 34-2, Panels (c) and (b)

0

D

Quantity of Japanese Laptopsper Week

Panel (b)U.S. Demand Curve for Japanese Laptop Computers

100

1,500

300

1,250

500

1,000

700

750

Pric

e p

er

Un

it ($

)

32


Figure 34-2, Panels (d) and (e)

0

D1

Quantity of YenDemanded per Week (millions)

Panel (e)U.S. Derived Demand for Yen

10

.0150

30

.0125

50

.0100

70

.0075

Pric

e p

er

Fra

nc

($)

33


Supply of Japanese Yen– Price of U.S. microprocessor = $200

– Exchange rate = $0.01 for 1 yen

– 200,000 yen ($200@$0.01/yen) = 1 microprocessor

– Exchange rate = $0.0125

– 16,000 Yen ($200@ $0.0125/Yen) = 1 microprocessor

34

Determining Foreign Exchange Rates

Figure 34-3

0

S

Quantity of Yen Supplied per Week (millions)

Pric

e pe

r Y

en (

$)

40

0.0075

50

0.0100

60

0.0125

35

Total Demand for and Supply of Japanese Yen

Figure 34-4

0

Trillions of Yen per Year

S

2

0.0125

D

3

0.0100E

Pric

e pe

r Y

en($

)

36Figure 34-5

A Shift in the Demand Schedule

0

S

D1

D2


4

0.0120E 2

3

0.0100E 1

Pri

ce p

er

Ye

n (

$)

37Figure 34-6

A Shift in the Supply of Japanese Yen

0


S 1

S

D

3

0.0100E

E 1

5

0.0050Pric

e pe

r Y

en (

$)

38

International Example: South Africa’s Currency Appreciation

Gold and platinum are key South African exports.

The increased demand for these commodities has also increased the demand for South African rand.

As interest rates in South Africa became relatively higher, the demand for South African financial assets also increased.

39

International Example: South Africa’s Currency Appreciation

The result of these changes has been an appreciation of the rand.

The dollar price of the rand has doubled since the end of 2001.

40


Market determinants of exchange rates

– Changes in real interest rates

– Changes in productivity

– Changes in product preferences

– Perceptions of economic stability

41


Gold Standard

– An international monetary system in which nations fix their exchange rates in terms of gold

– All currencies are fixed in terms of all others, and any balance of payments deficits or surpluses can be made up by shipments of gold

42


Gold standard

– A balance of payments deficit• More gold flowed out than flowed in• Equivalent to an restrictive monetary policy

– A balance of payments surplus• More gold flowed in than out• Equivalent to an expansionary monetary policy

43


Problems with the gold standard

– A nation gives up control of its monetary policy

– New gold discoveries often caused inflation

44


Bretton Woods and the International Monetary Fund

– 1944—representatives of capitalist countries met in Bretton Woods, New Hampshire• Created a new international payment system to replace

the gold standard

– Members could change the par value once by 10 percent and after that par value changes needed IMF approval

45


End of the old IMF

– On August 15, 1971, President Richard Nixon suspended the convertibility of the dollar into gold.

– On December 18, 1971, the United States devalued the dollar relative to the currencies of 14 major industrial nations.

46

Current Foreign Exchange Rate Arrangements

Figure 34-7

47

Fixed versus Floating Exchange Rates

To maintain a fixed exchange rate, the central bank of a country can buy and sell currencies.

It must use its own foreign exchange reserves to engage in these financial market transactions.

48

A Fixed Exchange Rate

Figure 34-8

The Bank of Malaysia buysringgit with dollars shifting the demand for ringgit to the right

• The supply of ringgit shifts to the right as Thai residents demand more U.S. goods

• The value of the ringgit will fall

49

International Example:Central Banks’ Currencies of Choice

A central bank allocates foreign exchange reserves based on its perception of which currencies will be needed most frequently to alter the demand for its own currency.

The U.S. dollar is the currency most commonly held in foreign exchange reserves; but the euro, the Japanese yen, and the British pound also comprise a measurable portion of these accounts.

50


Pros and cons of fixed exchange rates

– Pros• Limiting foreign exchange risk

– The possibility that changes in the value of a nation’s currency will result in variations in market value of assets

51


Pros and cons of fixed exchange rates– Cons

• A country’s residents can avoid foreign exchange risk by hedging– A financial strategy that reduces the chance

of suffering losses arising from foreign exchange risk

• A nation’s output and employment can fall in the short run if demand for its products decreases and its labor is relatively immobile

52

The Dirty Float and Managed Exchange Rates

Dirty Float

– A system between flexible and fixed exchange rates in which central banks occasionally enter foreign exchange markets to influence rates

53

Managed Exchange Rates

What do you think?

– Is it possible to “manage” foreign exchange rates?

One study concludes that neither the Fed nor the central banks of the other G7 can successfully influence exchange rates in the long run.

54


Crawling Pegs

– An automatically adjusting target for the value of a nation’s currency

– The exchange rate gradually adjusts the upward or downward by a country’s central bank buying or selling its currency as needed to keep it consistent with long-run forces.

55


Target Zones

– Upper and lower limits or bands for values of an exchange rate are established and maintained by central banks

56

Issues and Applications: Japan’s Finance Ministry Learns a New Currency Trick

As the value of the dollar has declined against the Japanese yen in recent years, American consumers must pay more for Japanese-made goods.

In response, the Japanese government began buying dollars on the foreign exchange market.

Of late, the government has been using private banks to implement the foreign exchange transactions needed to arrest the yen appreciation.

57

Summary Discussion of Learning Objectives

The balance of trade versus the balance of payments

– Balance of trade • Exports of goods-imports

– Balance of payments• A system of account for all transactions

between a nation’s residents and the rest of the world

58


The key accounts within the balance of payments

– Current account

– Capital account

– Official reserve transactions account

59


Exchange rate determination in the market for foreign exchange

– The equilibrium exchange rate is the exchange rate at which the quantity of a country’s currency is equal to the quantity supplied

60


Factors that can induce changes in equilibrium exchange rates

– Changes in desired imports or exports

– Changes in real interest rates

– Changes in relative productivity

– Tastes and preferences of consumers

– Perceptions of stability

61


How policymakers can attempt to keep exchange rates fixed– A country’s central bank increases the demand for its

country’s currency if the exchange rate begins to fall

Alternative approaches to limiting exchange rate variability– Dirty floats

– Crawling pegs

– Target zones

End of Chapter 34Exchange Rates and the Balance of Payments

Chapter 34

Documents

Transcript of Chapter 34