Exchange Rates, the Balance of Payments, and Trade Deficits

Copyright 2008 The McGraw-Hill Companies36-1

Financing International Trade

Capital and Financial Account

Flexible Exchange Rates

Fixed Exchange Rates

International Exchange-Rates System

Recent U.S. Trade Deficits

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36Exchange Rates, the Balance of Payments, and Trade Deficits








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Chapter Objectives• How Currencies of Different Nations

are Exchanged When International Transactions Take Place

• About the Balance Sheet the United States Uses to Account for the International Payments it Makes and Receives

• How Exchange Rates are Determined in Currency Markets

• The Difference Between Flexible Exchange Rates and Fixed Exchange Rates

• The Causes and Consequences of Recent Record-High U.S. Trade Deficits








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Financing International Trade• U.S. Export Transactions• U.S. Import Transactions• Balance of Payments• The Current Account

–Balance on Goods–Balance on Services–Trade Deficit–Trade Surplus–Balance on Current Account

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• Involves different national currencies

• When U.S. firm exports to Mexico, they want to be paid in USDs

• Problem resolved in foreign exchange (currency) markets

• Foreign exchange markets facilitate exports and imports








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U.S. Export Transaction

• Assume U.S. is selling to GB• GB buyer draws a check on its

checking account at British bank and sends it to U.S. exporter

• U.S. bank sells its check in pounds to its bank, which is a dealer in foreign exchange

• Bank deposits the pounds into a correspondent London bank for future sale to a U.S. buyer who needs pounds








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U.S. Export Transaction

• U.S. exports create a foreign demand for dollars, and the fulfillment of that demand increases the supply of foreign currencies owned by U.S. banks and available to U.S. buyers








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U.S. Import Transaction

See p.697

U.S. imports create domestic demand for foreign currencies, and the fulfillment of that demand reduces the supply of foreign currencies








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The Balance of Payments

• The sum of all the transactions that take place b/w its residents and the residents of all foreign nations

• Include exports and imports, tourist expenditures, interest and dividends, purchases and sales of financial assets

• Compiled annually• Shows “flows” of in-payments

and out-payments for the U.S.








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Current Account

• Summarizes U.S. trade in currently produced g/s

• Balance on goods – the difference between its exports and its imports on goods (typically a deficit)

• Balance on services – difference b/w its exports and imports on goods

• Balance on goods and services – will show an overall trade deficit or surplus








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Balance on Current Account

• Net investment income – difference b/w interest and dividend payments foreigners paid to U.S. for use of exported U.S. capital and the interest and dividends the U.S. paid for the use of foreign capital invested in the United States

• Balance on current account – add all transactions in the current account








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• Capital account – a “net” account that mainly measures debt forgiveness

• Financial account – summarizes the purchase or sale of real or financial assets and the flows of monetary payments that accompany them

• Balance on the capital and financial account – sums the capital and financial accounts








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Payments, Deficits and Surpluses

• Balance of payments must always sum zero, but economists will discuss balance-of-payments deficits and surpluses

• Balance of payments deficit – in some years a nation must make an inpayment of official reserves to its capital and financial account to balance it w/ current account

• Balance of payments surplus – in some years an outpayment of official reserves from the capital and financial account must be needed to balance








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U.S. Trade Balances in Goods and ServicesSelect Nations, 2004

Goods and Services SurplusGood and Services Deficit

Australia

Belgium

Canada

China

Germany

Mexico

Netherlands

+6.8

-66.5

-45.8

+4.4

-162

-45.1

+11.8

Source: BEA

GLOBAL PERSPECTIVE

-10-20-30-40-50-60-70-160 10 20

Japan -75.6








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• Capital Account• Financial Account• Balance on the Capital and

Financial Account–Payments, Deficits, and

Surpluses–Balance-of-Payments

Deficits and Surpluses–Official Reserves








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Flexible Exchange Rates• Flexible or Floating Exchange

Rates• Fixed Exchange Rate system• Depreciation and Appreciation• Determinants of Exchange

Rates–Changes in Tastes–Relative Income Changes–Relative Price-Level Changes

• Purchasing-Power-Parity Theory–Relative Interest Rates–Speculation

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• 2 Types:• 1. flexible- or floating- exchange-

rate system – demand and supply determine exchange rates w/o gov. involvement

• 2. fixed-exchange-rate system – governments determine exchange rates and make necessary adjustments to those rates








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Depreciation and Appreciation

• If the dollar price of a foreign currency rises, the dollar depreciates in value relative to the foreign currency

• If the dollar price of a foreign currency falls, the dollar appreciates in value relative to the foreign currency








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Determinants of Exchange Rates

• 3 generalizations:• 1. if demand for a nation’s

currency increases, that currency will appreciate, and vice versa

• 2. if the supply of a nation’s currency increases, the currency will depreciate and vice versa

• 3. if a nation’s currency appreciates, some foreign currency depreciates relative to it








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Factors that Shift S/D Curves

• Changes in tastes • Relative income changes –

nation’s currency likely to depreciate if its growth of national income is more rapid than that of other nations b/c imports vary directly w/ income level








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Factors that Shift S/D Curves

• Relative Price-Level Changes – if domestic price levels rise, nation will import more and currency will depreciate

• Relative interest rates – higher interest rates will cause currency to appreciate in nation w/higher rates

• Speculation – self-fulfilling prophecies may result








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Q0

Do

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Pri

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f 1

Po

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d

Quantity of Pounds

P

Flexible Exchange RatesThe Market for Foreign Currency (Pounds)

Dl

Sl

DollarDepreciates(PoundAppreciates)

DollarAppreciates(PoundDepreciates)

ExchangeRate: $2 = £1

$2

$3

$1

Ql








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Quantity of Pounds

P

Flexible Exchange RatesThe Market for Foreign Currency (Pounds)

Dl

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$2

$3

$1

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D2


BalanceOf Payments

Deficit

Q2

x a

b

c








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• Flexible Rates and the Balance of Payments

• Disadvantages of Flexible Exchange Rates

• Uncertainty and Diminished Trade

• Terms-of-Trade Changes• Instability








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Flexible Rates and the Balance of Payments

• Flexible exchange rates automatically adjust and eventually eliminate balance-of-payment deficits or surpluses

• Will affect import/export levels








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Disadvantages of Flexible Exchange Rates

• Uncertainty and diminished trade

• Terms of trade changes – decline in international value of a nation’s currency will worsen its terms of trade

• Instability – may destabilize domestic economy (export industries)








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• At times nations have fixed their exchange rates to avoid disadvantages of flexible rates

• Nation will have to alter market demand and supply to avoid rate changes

• How??








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Fixed Exchange Rates• Use of Reserves

–Currency Interventions• Trade Policies• Exchange Controls and

Rationing–Distorted Trade–Favoritism–Restricted Choice–Black Markets

• Domestic Macroeconomic Adjustments








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Use of Reserves

• Currency interventions – selling reserves to maintain exchange rates

• Trade policies – control flow trade directly (barriers)

• Exchange Controls and Rationing – U.S. could demand all foreign currencies be sold to the U.S. gov and then rationed

• Major Objections: distorted trade, favoritism, restricted choice, black markets








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Domestic Macroeconomic Adjustments

• Use fiscal and monetary policy to eliminate shortage of foreign currency

• Contractionary policies would be used, but there is great opportunity cost








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International Exchange-Rate Systems

• The Gold Standard: Fixed Exchange Rates–Devaluation–Gold Flows–Domestic Macroeconomic

Adjustments–Collapse of the Gold

Standard








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• The Bretton Woods System– International Monetary Fund

(IMF)– IMF and Pegged Exchange

Rates• Official Reserves• Gold Sales• IMF Borrowing

–Fundamental Imbalances: Adjusting the Peg

–Demise of the Bretton Woods System








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• The Current System: The Managed Float–Managed Floating

Exchange Rates• In Support of the Managed Float

•Concerns With the Managed Float








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International Exchange Rate Systems

• Gold Standard• 1879-1974 – major nations of

world were on fixed-rate system of the gold standard

• Each nation had to define its currency in terms of gold, maintain a fixed relationship b/w stock of gold and $ supply, allow gold to be exported and imported








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Collapse of Gold Standard

• During Great Depression of 1930s• Devaluation of currency

occurred, exchange rates no longer fixed, system broke down








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The Bretton Woods System

• Modified fixed-exchange –rate system (adjustable peg system)

• Created the International Monetary Fund (IMF) – now plays a role in loaning to developing nations, nations experiencing crises, and nations transitioning to capitalism

• Bretton Woods system ended in 1971 – US abandons gold standard








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The Current System: The Managed Float

• Managed floating exchange rates – rates are free to float to equilibrium market levels but nations occasionally use currency interventions to stabilize or alter market exchange rates

• G8 nations meet regularly to discuss economic issues and coordinate policies (US, CAN, FR, GER, IT, JAP, RUS, UK)








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Support of Managed Float

• Has functioned well thus far• Has weathered severe economic

turbulence

Can adjust to world events








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Concerns w/ Managed Float

• Has not eliminated trade imbalances

• Can be volatile








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Recent U.S. Trade Deficits• Causes of Trade

Deficits• Implications of U.S.

Trade Deficits–Increased Current Consumption

–Increased U.S. Indebtedness








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Causes of Recent U.S. Trade Deficits

• U.S. growth/growth of imports

• Large trade deficits with China

• Decline in U.S. savings rate








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Implications of U.S. Trade Deficits

• Increased Current Consumption – benefits U.S. consumer

• Increased U.S. Indebtedness – trade deficit must be financed by borrowing from the rest of world, selling off assets, or dipping into official reserves








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Speculation in Currency Markets

• Currency Purchases to Purchase Goods and Services

• Contributing to Currency Market Fluctuations

• Speculator’s Role and Activities

• Smoothing Short-Term Fluctuations

• Absorbing Risk• Futures Market at Work• Positive Role Played Overall

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Negative or Positive Influence on Currency Markets and Trade








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Key Terms• balance of payments• current account• balance on goods an

d services• trade deficit• trade surplus• balance on current ac

count• capital and financial a

ccount• balance on capital an

d financial• balance-of-payments

deficits and surpluses

• official reserves

• flexible- or floating- exchange-rate system

• fixed-exchange-rate system

• purchasing-power-parity theory

• currency interventions

• exchange controls• gold standard• devaluation• Bretton Woods syste

m• International Monetar

y Fund (IMF)• managed floating exc

hange rates








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Course Review…

FinalDiscussions…








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The End

I am going to miss taking notes in Econ omics class!!!!!

Exchange Rates, the Balance of Payments, and Trade Deficits

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