Ch. 33: International Finance
Del Mar College
John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
The Balance of Payments
• Balance of Payments: a periodic statement
(usually annual) of the money value of all
transaction between residents of one country and
residents of all other countries.
• Provides information about a nation’s imports and
exports, domestic residents’ earnings on assets
located abroad, foreign earnings on domestic
assets, gifts to and from foreign countries
(including foreign aid), and official transactions by
governments and central banks.
Debit and Credit
• Any transaction that
supplies the country’s
currency in the foreign
exchange market is
recorded as a debit.
• Any transaction that
creates a demand for the
country’s currency in the
foreign exchange market
is recorded as a credit.
Debits and Credits
U.S.
Balance of
Payments,
Year Z
The data in this
exhibit are
hypothetical, but
not unrealistic.
All numbers are
in billions of
dollars. The plus
and minus signs
in the exhibit
should be viewed
as operation
signs.
U.S. Balance of Payments, Year Z
The data in this exhibit are hypothetical, but not unrealistic.
All numbers are in billions of dollars. The plus and minus
signs in the exhibit should be viewed as operation signs.
Current Account
• Current Account includes all payments related to
the purchase and sale of goods and services.
Includes the following:
• Exports of Goods and Services: includes
investment income, goods, and services –
increases demand for U.S. dollars and supply of
foreign currency. Recorded as a credit.
• Imports of Goods and Services: includes goods,
services, and income on foreign owned assets –
increases demand for foreign currencies and
supply of U.S. dollars. Recorded as a debit.
Current Account (part 2)
• Net Unilateral Trade Abroad: one-way money
payments. Go from Americans or U.S. Government to
foreigners or foreign governments.
• Merchandise Trade Balance: The difference between
the value of merchandise exports and the value of
merchandise imports.
• Merchandise Trade Deficit: The situation where the
value of merchandise exports is less than the value of
merchandise imports.
• Merchandise Trade Surplus: The situation where the
value of merchandise exports is greater than the value of
merchandise imports.
U.S.
Merchandise
Trade Balance
SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.
In each of the years shown, 1990 – 1999, a
merchandise trade deficit has existed. The deficit
for 1999 is for January through September.
Capital Account
Capital Account includes all payments related to the
purchase and sale of assets and to borrowing and
lending activities.
• Outflow of U.S. Capital: American purchases of
foreign assets and U.S. loans to foreigners are
outflows of U.S. Capital
• Inflow of Foreign Capital: Foreign purchases of U.S.
assets and foreign loans to Americans are inflows of
foreign capital.
The Capital Account Balance is the summary statistic
for these two items.
Account and Discrepancy
• Official Reserve Account: A government possesses
official reserve balances in the form of foreign
currencies, gold, its reserve position in the International
Monetary Fund, and Special Drawing Rights. An
increase in official reserves is like an outflow of capital
in the capital account and appears as a payment with a
negative sign.
• Statistical Discrepancy: Balance of Payment accountants
do not have complete information; they can only record
credits and debits they observe. They use the statistical
discrepancy which is part of the balance of payments
that adjusts for missing information.
What the Balance Of Payments
Equals
•
•
•
•
•
•
•
•
Exports of goods and services
Imports of goods and services
Net unilateral transfers
Outflow of U.S. capital
Inflow of foreign capital
Increase in U.S. official reserve assets
Increase in foreign official assets in the U.S.
Statistical Discrepancy
Alternate Balance of Payments
Equals
• Current account
balance
• Capital account
balance
• Official reserve
balance
• Statistical discrepancy.
Q&A
• If an American retailer buys Japanese cars from a
Japanese manufacturer, is this transaction recorded
as a debit or a credit? Explain your answer.
• Exports of goods and services equal $200 billion
and imports of goods and services equal $300
billion. What is the merchandise trade balance?
• What is the difference between the merchandise
trade balance and the current account balance?
• A newspaper reports that the U.S. balance of
payments is -$100 billion. Can this be correct?
Flexible Exchange Rates
• Exchange Rate is the price
of one currency in terms
of another currency.
• Flexible Exchange Rate
System: The system
whereby exchange rates
are determined by the
forces of supply and
demand for a currency.
The Demand For Goods and
Currencies
• Country A’s demand for Country B’s goods
leads to a demand for B’s currency and a
supply of A’s currency on the foreign
exchange market.
• B’s demand for A’s goods leads to a demand
for A’s currency and a supply of B’s
currency on the foreign exchange market.
The Demand for Goods and the
Supply of Currencies
The Foreign
Exchange
Market
The demand for pounds is downward sloping. The higher the dollar
price for pounds, the fewer pounds will be demanded; the lower the
dollar price for pounds, the more pounds that will be demanded. At
$1.90 = £1, there is a surplus of pounds, placing downward pressure
on the exchange rate. At $1.10 = £ 1, there is a shortage of pounds,
placing upward pressure on the exchange rate. At the equilibrium
exchange rate, $1.50 = £ 1, the quantity demanded of pounds equals
the quantity supplied of pounds.
Changes in the Equilibrium Rate
A change in the demand or supply of a currency (or both)
will change the equilibrium dollar price for that currency.
The following can change the Equilibrium Rate:
– A Difference in Income Growth Rates: an increase in a nation’s
income will usually cause the nation’s residents to buy more of
both domestic and foreign goods. The increased demand for
imports will result in an increased demand for foreign currency.
The higher growth rate country’s currency depreciates, and the
lower growth rate country’s currency appreciates.
– Difference in Relative Inflation Rates: In the long run, changes in
the relative price levels of two countries will affect the exchange
rate in such a way that one unit of a country’s currency will
continue to buy the same amount of foreign goods as it did before
the change in relative price levels.
– Changes in Real Interest Rates: The flow of financial capital
demands on different countries real interest rate – the interest rate
adjusted for inflation.
The Purchasing Power Parity Theory
In the long run, and
frequently in the short run,
changes in the relative
price levels of two
countries will affect the
exchange rate in such a
way that one unit of a
country’s currency will
continue to buy the same
amount of the foreign
goods as it did before the
change in relative price
levels.
Q&A
• In the foreign exchange market, how is the
demand for dollars linked to the supply of pounds?
• What could cause the U.S. dollar to appreciate
against the British pound on the foreign exchange
market?
• Suppose the U.S. economy grows while the Swiss
economy does not. How will this affect the
exchange rate between the dollar and the Swiss
franc? Why?
• What does the Purchasing Power Parity Theory
say? Give an example to illustrate your answer.
Fixed Exchange Rates
• A Fixed Exchange Rate System is the system
where a nation’s currency is set at a fixed rate
relative to all other currencies, and central banks
intervene in the foreign exchange market to
maintain the fixed rate.
• Overvaluation occurs when a currency’s current
price, in terms of other currencies, is above the
equilibrium price.
• Undervaluation occurs when a currency’s current
price, in terms of other currencies, is below the
equilibrium price.
A Fixed Exchange Rate System
In a fixed exchange rate
system, the exchange rate is
fixed – and it may not be
fixed at the equilibrium
exchange rate. The exhibit
shows two cases. (1) If the
exchange rate is fixed at price
1, the pound is overvalued,
the dollar is undervalued, and
a surplus of pounds exist. (2)
If the exchange rate is fixed
at official price 2, the dollar
is overvalued, and a shortage
of pounds exist.
What’s so Bad About An
Overvalued Dollar?
• The exchange rate affects
the amount of U.S. exports
and imports – this then
affects the merchandise
trade balance.
• As U.S. exports become
more expensive for other
countries, they buy fewer
U.S. exports. If the
exports fall below imports,
the U.S. is in a trade
deficit.
Fixed
Exchange
Rates and
an
Overvalued
Dollar
Initially, the demand for and supply of pounds are represented by D1
and S1, respectively. The equilibrium exchange rate is $1.50 = £1,
which also happens to be the official (fixed) exchange rate. In time,
the demand for pounds rises to D2, and the equilibrium exchange rate
rises to $2 = £1. The official exchange rate is fixed, however, so the
dollar will be overvalued. As explained in the text, this can lead to a
trade deficit.
Government Involvement in a
Fixed Exchange System
Suppose there is a surplus of pounds.
• The Fed might buy the pounds with dollars,
causing the demand for pounds to increase and the
demand curve for pounds to shift to the right. This
would raise the equilibrium rate.
• The Bank of England might buy the pounds with
its reserve dollars, increasing the demand for
pounds and the equilibrium rate.
• Or, the Fed and the Bank of England might both
buy the pounds.
Options Under a Fixed Exchange
Rate System
Suppose there is a surplus of pounds that has lasted several
weeks. What might happen?
• Devaluation and Revaluation: Great Britain and the U.S. could
agree to reset the official price of the pound and the dollar.
– Devaluation occurs when the official price of a currency is lowered.
– Revaluation occurs when the official price of a currency is raised.
• Protectionist Trade Policy: A drop in the domestic consumption of
foreign goods goes hand in hand with a decrease in the demand for
foreign currencies.
• Changes in Monetary Policy: The U.S. might enact a tight monetary
policy to retard inflation and drive up interest rates (in the short run).
The tight monetary policy will reduce the U.S. rate of inflation and
thereby lower U.S. prices relative to prices in other nations.
The Gold Standard
• If nations adopt the gold
standard, they automatically
fix their exchange rates.
• To have a gold standard,
countries must do the
following:
– Define their currencies in terms
of gold.
– Stand ready and willing to
convert gold into paper money
and paper money into gold.
– Link their money supplies to
their holdings of gold.
Economists and The Gold Standard
• The change in the money supply that the
gold standard sometimes requires has
prompted some economists to say: the gold
system subjects domestic monetary policy
to international instead of domestic
considerations.
• Some economists say the same thing about
the fixed exchange rate system.
Q&A
• Under a fixed exchange rate system, if one
currency is overvalued then another currency must
be undervalued. Explain why this is true.
• How does an overvalued dollar affect U.S. exports
and imports?
• Under a fixed exchange rate system, why might
the United States want to devalue its own
currency?
Fixed Exchange Rates Vs.
Flexible Exchange Rates
• Fixed Exchange Rates provide certainty, and that
certainty of price & exchange promotes
international trade. Flexible Exchange Rates stifle
International trade.
• Flexible Exchange Rates allow a country to adopt
policies to meet domestic economic goals, instead
of sacrificing domestic economic goals to
maintain an exchange rate. There is a too great a
chance the Fixed Exchange Rate will diverge
greatly with the equilibrium exchange rate,
creating persistent balance of trade problems.
Optimal Currency Areas
Optimal Currency
Area is a geographic
are in which exchange
rates can be fixed or a
common currency
used without
sacrificing domestic
economic goals, such
as low unemployment.
Optimal Currency Areas
Assume Two Countries Exist, U.S. and Canada. Demand
for Canadian goods are falling as demand for U.S. goods
are rising:
• Trade and Labor Mobility: if labor is mobile, then
changes in relative demand pose no major economic
problems for either country.
• Trade and Labor Immobility: The results depend on
whether the Exchange Rates are fixed of flexible:
– If exchange rates are flexible, the value of U.S. currency
changes vis-à-vis Canadian currency.
– If exchange rates are fixed, U.S. goods will not become
relatively more expensive for Canadians and Canadian goods
will not become relatively less expensive for Americans. This
results in bad economic times for Canada.
Costs, Benefits, and Optimal
Currency Areas
• The costs include the cost of exchanging one
currency for another and the added risk of not
knowing the value of one’s currency will be on the
foreign market.
• When labor in countries within a certain
geographic area is mobile enough to move easily
and quickly in response to changes in relative
demand, the countries are said to constitute an
optimal currency area.
Q&A
• What is an optimal currency area? Give an example.
• Country 1 produces good  and Country 2 produces
good . People in both countries begin to demand
more of good  and less of good . Assume there is no
labor mobility between the two countries and that a
flexible exchange rate system exists. What will happen
to the unemployment rate in country 2? Explain your
answer.
• How important is labor mobility in determining
whether or not an area is an optimal currency area?
The Crackup of the Gold Standard
• From the 1870s to the 1930s, many nations tied their
currencies to gold.
• After World War I, some countries began to break the
rules of the gold standard by not contracting their
money supplies to the extent called for by the outflow
of gold.
• In the 1920s, Great Britain and France tried to restore
the gold standard, but set the gold at the “wrong”
official price. The pound was overvalued and the franc
was undervalued. This lead to trade surplus in France
and high unemployment and trade deficits in Great
Britain.
The Crackup of the Gold
Standard (Cont.)
• The Great Depression caused nations with trade
deficits to begin to feel that abiding by the rules of
the gold standard and contracting their money
supplies to restore balance of trade equilibrium
was too high a price to pay.
• In 1944, after it appeared the allies would win
World War 2, major negotiators from allied
countries met in Bretton Woods, New Hampshire
to create a new international monetary system.
The Bretton Woods System
• Created the International Monetary Fund.
• Nations were expected to maintain fixed exchange rates
(within a narrow range) by buying and selling their own
currencies.
• In the 1960s and early 1970s, the Bretton Woods system
became strained at the seams. One of the major
shortcomings of the system was that it encouraged
speculative attacks on a currency.
• Both Great Britain and the U.S. suffered speculative
attacks on their currencies.
• By 1973, the Bretton Woods System was dead.
The Current International
Monetary System
• Referred to as a Managed Float: a managed
flexible exchange rate system, under which
nations now and then intervene to adjust
their official reserve holdings to moderate
major swings in exchange rates.
• Like everything else, the current system has
proponents and opponents.
Proponents of the Managed Float
System Say:
• It allows nations to pursue independent
monetary policies.
• It solves trade problems without trade
restrictions (trade imbalances are usually
solved through changes in exchange rates).
• It is flexible and therefore can easily adjust
to shocks.
Opponents of the Managed Float
System Say:
• It promotes exchange rate volatility and
uncertainty and results in less international trade
than would be the case under fixed exchange rates.
• It promotes inflation.
• Changes in exchange rates alter trade balances in
the desired direction only after a long time, in the
short run, a depreciation in a currency can make
the situation worse instead of better.