Exchange Rates, The Balance of Payments,
and Trade Deficits
Chapter 38
Monetary Exchange Video
• http://www.youtube.com/watch?v=xwtgByffo
Uw&feature=colike
Financing International Trade
• Best Buy wants to buy 1 million Samsung TVs
– Japan, who produces the TVs, wants to be paid in
Yen—how does Best Buy pay them?
– Best Buy will have to purchase Yen from a foreign
exchange market (these markets are found in
larger cities or areas with large tourism
populations)
– Once completed they can purchase the TVs using
Yen
Financing International Trade
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Current exchange rates are:
British Pound = $1.57
Euro = $1.34
Swiss Franc = $1.09
Australian Dollar = $1.02
Canadian Dollar = $0.98
Chinese Yuan = $0.16
Mexican Peso = $0.07
Japanese Yen = $0.012
Vietnamese Dong = $0.00005 (1 of our dollars = 21K of
theirs)
Financing International Trade
• Let’s look at the example again…
– Best Buy wants to buy $1,000,000,000 worth of
product from Japan’s Samsung division
• How many Yen will it take to make the purchase?
• 1,000,000,000 x 0.12 = 120,000,000,000
– It will take ¥120,000,000,000 to equal $1M
– Japan will sell the $1M check they got from Best Buy
to an exchange bank in order to get the ¥120M that it
is worth
• NOTE: The exchange bank does not provide this service for
free—just like the stock market, there is a fee for trading
Financing International Trade
• Business transactions are not the only reason
that currencies need to be exchanged
– Vacations
– Purchasing stocks/investments
– Loan payments
Balance of Payments
• A balance of payments is the sum of all
transactions that take place between its
residents and foreigners
– This balance sheet is divided into three categories:
• Current Account—U.S. trade in currently produced
goods/services
• Capital Account—purchase/sell of assets (stocks,
factories, equipment)
• Official Reserves Account—The nation’s stock of foreign
currencies that are held in the Federal Reserve system
2010 Balance of Payments
1.
2.
3.
4.
5.
Goods and services exported = $1.837T
Goods and services imported = $2.337T
Balance on goods/services = - $ 500B
Capital accounts transaction = -$152M
Official Reserves Account
– US owned assets in foreign countries are the same as
imports when balancing the books (a hotel in Japan
owned by an American)
– Likewise foreign owned assets in the US are
considered exports (a Canadian owning a business in
the US)
2010 Balance of Payments
• US owned assets abroad = -$1.005T
• Foreign owned assets in US = $1.246T
– Official Reserves Balance = $241B
1. Balance on goods/services =
-$ 500B
2. Capital accounts transaction =
-$152M
3. Official Reserves Balance =
$241B
4. Basic Balance of Payments =
-$499B
• All BOPs have to equal $0 so how does this
-$499B turn into $0 (where does the money
come from)?
Flexible Exchange Rates
• There are two types of exchange rates:
– Flexible (floating): demand and supply of currency
determines the exchange rate (no government
involvement)
– Fixed: government sets the exchange rate and
makes changes to the economy to insure those
rates stay accurate/consistant
Flexible Exchange Rates
S£
$4.00
Dollar price per £
• The exchange rate
would be wherever
the supply curve
intersects the
demand curve
• Here it would be
$1.57 dollars = 1
£
• When using the
Flexible Exchange
Rate system the
price is subject to
change based on the
demand or supply of
the product
$1.57
$0.25
D£
Qe
Quantity of £
Flexible Exchange Rates
• What could cause the
supply or demand of a
currency to change?
• What happens to the
British Pound? U.S.
dollar?
• It now takes less U.S.
dollar to purchase a
British pound
• Dollar appreciates,
Pound depreciates
$4.00
Dollar price per £
– Change in taste:
British tea declines in
popularity in the US
S£
$1.57
$0.90
$0.25
D £2
D£
Q2 Qe
Quantity of £
Flexible Exchange Rate
• Your turn!
• In each of the scenarios draw the corresponding graph:
1. Change in relative income: Britain encounters a
recession & reduces imports while the US increases
input
2. Relative prices: Britain experiences a 3% inflation rate
compared to Canada’s 10% rate
3. Change in interest rates: US interest rates go up, the
British do no raise their rates
4. Speculation: Currency traders believe the US dollar
will have greater inflation than the British Pound
Pitfalls of Flexible Exchange Rates
• Uncertainty and Diminished Trade
– Because you don’t know what is going to happen, you
might be discouraged to engage in trade
• Terms-of-Trade Changes
– An increase in the dollar price per British pound could
mean that the US has to export more to get the same
amount of pounds
• Instability
– Wild fluctuations can depress industries and cause a
nightmare for making decisions with fiscal and
monetary policy
Fixed Exchange Rates
• In a fixed system two countries agree on a
fixed rate between them
– Britain and the US agree that the ration will be 2
US dollars = 1 British pound
• Problem: What if demand for the pound goes
up?
– If demand goes up (meaning the pound should be
more valuable) but the price doesn’t change a
SHORTAGE of British pound will occur
Fixed Exchange Rates
• How do you adjust for this scenario?
• There are 4 possible solutions:
– Use of Reserves—if you need to meet the demand
without changing the price, take some of the
money that was in reserve (not in circulation) and
put it in circulation
– Trade Policies—If the US is facing a shortage of
British pound they can discourage imports from
Britain (in other words, put a tariff on British
goods to prevent trade)
Fixed Exchange Rates
• Other techniques for controlling shortages:
– Exchange controls and rationing—the US
government could require that all pounds being
brought into circulation in the US has to go
through the Federal Government first. Therefore,
they can control how much is allowed in the
nation
• There are 4 issues that come with this option
Fixed Exchange Rates
• Four objections to exchange controls:
– Distorted trade—would disrupt the natural flow of
trade and thus interrupt comparative advantage
– Favoritism—in other words, nations who support
certain candidates could get “favored nation”
status
– Restricted choice—Freedom of choice would be
limited since the government is blocking access to
certain goods/countries
– Black markets—duh…
Fixed Exchange Rates
• A final attempt to deal with concerns is:
– Domestic macroeconomic adjustments
• In other words use monetary and fiscal policy to adjust
the inflation value of your money
And now…a video
• http://www.learner.org/series/econusa/unit2
8/