Balance of
Payments &
Exchange
Rates
Barnett
AP Econ
UHS
Exchange Rates
 The
main difference between an
international transaction and a domestic
transaction concerns currency exchange.
 International exchange must be
managed in a way that allows each
partner in the transaction to wind up with
his or her own currency.
 The
exchange rate is the price of one
country’s currency in terms of another
country’s currency; the ratio at which two
currencies are traded for each other.
 Foreign
exchange is simply all currencies
other than the domestic currency of a given
country.
 The
balance of payments is the record of a
country’s transactions in goods, services, and
assets with the rest of the world; also the
record of a country’s sources (supply) and
uses (demand) of foreign exchange.
Current Account
United States Balance of Payments, 2002
CURRENT ACCOUNT
Goods exports
Goods imports
(1) Net export of goods
682.6
– 1,166.9
– 484.3
Export of services
Import of services
(2) Net export of services
289.3
– 240.5
48.8
Income received on investments
Income payments on investments
244.6
– 256.5
(3) Net investment income
(4) Net transfer payments
(5) Balance on current account (1 + 2 + 3 + 4)
CAPITAL ACCOUNT
(6) Change in private U.S. assets abroad (increase is –)
(7) Change in foreign private assets in the United States
(8) Change in U.S. government assets abroad (increase is –)
(9) Change in foreign government assets in the United States
(10) Balance on capital account (6 + 7 + 8 + 9)
(11) Statistical discrepancy
(12) Balance of payments (5 + 10 + 11)
– 11.9
– 56.0
– 503.4
– 152.9
533.7
– 3.3
46.6
474.1
29.3
0
Current Account
A
country’s current account is the sum of
its:



net exports (exports minus imports),
net income received from investments
abroad, and
net transfer payments from abroad.
Current Account
 Exports
earn foreign exchange and are a
credit (+) item on the current account.

Imports use up foreign exchange and
are a debit (–) item.
Current Account
 The
balance of trade is the difference
between a country’s exports of goods
and services and its imports of goods and
services.
A
trade deficit occurs when a country’s
exports are less than its imports.
 Net
exports of goods and services (NX), is
the difference between a country’s total
exports and total imports.
Current Account
 Investment
income consists of holdings of
foreign assets that yield dividends,
interest, rent, and profits paid to U.S. asset
holders (a source of foreign exchange).
Current Account
 Net
transfer payments are the difference
between payments from the United States
to foreigners and payments from
foreigners to the United States.
Current Account
 The
balance on current account consists
of net exports of goods, plus net exports
of services, plus net investment income,
plus net transfer payments. It shows how
much a nation has spent relative to how
much it has earned.
Capital Account
 For
each transaction recorded in the
current account, there is an offsetting
transaction recorded in the capital
account.
 The capital account records the changes
in assets and liabilities.
Capital Account
 The
balance on capital account in the
United States is the sum of the following
(measured in a given period):




the change in private U.S. assets abroad
the change in foreign private assets in the
United States
the change in U.S. government assets abroad,
and
the change in foreign government assets in the
United States
Capital Account
 In
the absence of errors, the balance on
capital account would equal the
negative of the balance on current
account.
 If the capital account is positive, the
change in foreign assets in the country is
greater than the change in the country’s
assets abroad, which is a decrease in the
net wealth of the country.
US as Debtor Nation
A
country’s net wealth is the sum of all its
past current account balances.
 Prior to the mid-1970s, the United States
was a creditor nation. After the mid1970s, the United Sates began to have a
negative net wealth position vis-à-vis the
rest of the world.
Debtor Nation
A
negative net wealth position vis-à-vis
the rest of the world reflects the fact that
the United States spent much more on
foreign goods and services than it earned
through the sales of its goods and
services.
Flexible Exchange Rates
 Floating,
or market-determined,
exchange rates are exchange rates
determined by the unregulated forces of
supply and demand.
 Exchange rate movements have
important impacts on imports, exports,
and movement of capital between
countries.
 In
a world where there are only two
countries, the United States and Britain,
the demand for pounds is comprised of
holders of dollars wishing to acquire
pounds. The supply of pounds is
comprised of holders of pounds seeking
to exchange them for dollars.
 The
equilibrium
exchange rate
occurs at the point at
which the quantity
demanded of a
foreign currency
equals the quantity of
that currency
supplied.
 An
excess supply of pounds will cause the
price of pounds to fall—the pound will
depreciate (fall in value) with respect to
the dollar.
 An
excess demand for pounds will cause
the price of pounds to rise—the pound will
appreciate (rise in value) with respect to
the dollar.
Exchange Rates
A
higher price level in
the United States
increases the demand
for pounds and
decreases the supply of
pounds. The result is
appreciation of the
pound against the
dollar.
Factors that Affect Exchange
Rates
 The
level of a country’s interest rate relative to
interest rates in other countries is another
determinant of the exchange rate. If U.S. interest
rates rise relative to British interest rates, British
citizens may be attracted to U.S. securities.
Exchange Rates
A
higher interest rate
in the United States
increases the supply
and decreases the
demand for pounds.
The result is
depreciation of the
pound against the
dollar.
Exchange Rates on the
Economy
 When
a country’s currency depreciates (falls in
value), its import prices rise and its export prices
(in foreign currencies) fall.
 When the U.S. dollar is cheap, U.S. products are
more competitive in world markets, and foreignmade goods look expensive to U.S. citizens.
A
depreciation of a country’s currency can
serve as a stimulus to the economy:

Foreign buyers are likely to increase their
spending on U.S. goods

Buyers substitute U.S.-made goods for imports

Aggregate expenditure on domestic output will
rise

Inventories will fall

GDP (Y) will increase
 Depreciation
of a country’s currency
tends to increase the price level.

Export demand rises.

Domestic buyers substitute domestic products
for the now more expensive imports.

If the economy is operating close to capacity,
the increase in aggregate demand is likely to
result in higher prices.

If import prices rise, costs may rise for business
firms, shifting the AS curve to the left.
Monetary Policy with Flexible
Exchange Rates
 Fed
actions to lower interest rates result in
a decrease in the demand for dollars and
an increase in the supply of dollars,
causing the dollar to depreciate.
 If
the purpose of the Fed is to stimulate
the economy, dollar depreciation is a
good thing. It increases U.S. exports and
decreases imports.